NOTE 4 — RESIDENTIAL MORTGAGE INVESTMENTS

Residential mortgage investments classified by collateral type and interest rate characteristics were as follows (dollars in thousands):


	*Unpaid* *Principal* *Balance*		Investment Premiums		*Amortized* *Cost Basis*		*Carrying* *Amount ^(a)*		*Net* *WAC ^(b)*			*Average* *Yield ^(b)*
September 30, 2012
Agency Securities:
Fannie Mae/Freddie Mac:
Fixed-rate	$	3,417	$	10	$	3,427	$	3,433		6.70	%		6.48	%
ARMs		11,887,228		363,586		12,250,814		12,586,241		2.74			1.82
Ginnie Mae ARMs		1,628,246		50,332		1,678,578		1,712,427		2.78			2.10

		13,518,891		413,928		13,932,819		14,302,101		2.74			1.86

Residential mortgage loans:
Fixed-rate		3,066		5		3,071		3,071		6.96			6.15
ARMs		5,139		20		5,159		5,159		3.51			3.83

		8,205		25		8,230		8,230		4.80			4.69
Collateral for structured financings		2,829		48		2,877		2,877		8.12			7.39

	$	13,529,925	$	414,001	$	13,943,926	$	14,313,208		2.75			1.86

*December 31, 2011*
Agency Securities:
Fannie Mae/Freddie Mac:
Fixed-rate	$	4,015	$	12	$	4,027	$	4,035		6.73	%		6.55	%
ARMs		10,378,503		285,963		10,664,466		10,880,200		2.85			2.08
Ginnie Mae ARMs		1,312,049		37,191		1,349,240		1,368,197		3.02			2.31

		11,694,567		323,166		12,017,733		12,252,432		2.87			2.11

Residential mortgage loans:
Fixed-rate		3,234		5		3,239		3,239		6.96			6.58
ARMs		5,887		22		5,909		5,909		3.48			3.66

		9,121		27		9,148		9,148		4.71			4.69
Collateral for structured financings		3,272		54		3,326		3,326		8.04			7.60

	$	11,706,960	$	323,247	$	12,030,207	$	12,264,906		2.87			2.11

(a)

Includes unrealized gains and losses for residential mortgage investments classified as available-for-sale (see NOTE 8).

(b)

Net WAC, or weighted average coupon, is the weighted average interest rate of the mortgage loans underlying the indicated investments net of servicing and other fees as of the indicated balance sheet date. Net WAC is expressed as a percentage calculated on an annualized basis on the unpaid principal balances of the mortgage loans underlying these investments. Average yield is presented for the quarter then ended, and is based on the cash component of interest income expressed as a percentage calculated on an annualized basis on average amortized cost basis (the “cash yield”) less the effects of amortizing investment premiums. Investment premium amortization is determined using the interest method and incorporates actual and anticipated future mortgage prepayments.

Agency Securities are considered to have limited, if any, credit risk, particularly in light of the conservatorship of the GSEs by the federal government in 2008. Residential mortgage loans held by the Company were originated prior to 1995 when Capstead operated a mortgage conduit and the related credit risk is borne by the Company. Collateral for structured financings consists of private residential mortgage securities obtained through the above-mentioned mortgage conduit that are pledged to secure repayment of related structured financings. The credit risk for these securities is borne by the related bondholders. The maturity of Residential mortgage investments that are mortgage securities is directly affected by prepayments of principal on the underlying mortgage loans. Consequently, actual maturities will be significantly shorter than the portfolio’s weighted average contractual maturity of 295 months.

Fixed-rate investments consist of residential mortgage loans and Agency Securities backed by residential mortgage loans with fixed rates of interest. Adjustable-rate investments generally are ARM Agency Securities backed by residential mortgage loans that have coupon interest rates that adjust at least annually to more current interest rates or begin doing so after an initial fixed-rate period. After the initial fixed-rate period, if applicable, mortgage loans underlying ARM securities either (i) adjust annually based on specified margins over the one-year Constant Maturity U.S. Treasury Note Rate (“CMT”) or the one-year London interbank offered rate (“LIBOR”), (ii) adjust semiannually based on specified margins over six-month LIBOR, or (iii) adjust monthly based on specified margins over indices such as one-month LIBOR, the Eleventh District Federal Reserve Bank Cost of Funds Index, or over a rolling twelve month average of the one-year CMT index, usually subject to periodic and lifetime limits, or caps, on the amount of such adjustments during any single interest rate adjustment period and over the contractual term of the underlying loans.

Capstead classifies its ARM securities based on each security’s average number of months until coupon reset (“months to roll”). Months to roll is an indicator of asset duration which is a measure of market price sensitivity to interest rate movements. Current-reset ARM securities have months to roll of less than 18 months while longer-to-reset ARM securities have months to roll of 18 months or greater. As of September 30, 2012, the average months to roll for the Company’s $8.07 billion (basis) in current-reset ARM securities was 5.4 months while the average months-to-roll for the Company’s $5.87 billion (basis) in longer-to-reset ARM securities was 44.1 months.

Under variable interest entity accounting rules, the Company began consolidating two townhome developments in the Dallas, Texas area that were collateral for subordinated loans made by the Company during 2009. The Company completed foreclosure proceedings in 2011, assuming ownership of the underlying collateral. By September 30, 2012 all of the remaining townhome units, which had a basis of $1.8 million at December 31, 2011, were sold. Included in Miscellaneous other revenue (expense) is $41,000 and $48,000 of gains on unit sales, net of operating costs, recorded during the quarter and nine months ended September 30, 2012, respectively. During the quarter and nine months ended September 30, 2011, net operating costs totaled $74,000 and $747,000, respectively, including a $470,000 impairment charge. In addition, the Company is a subordinated participant in the lending group to the Four Seasons resort in Nevis, West Indies which was foreclosed on in May 2010. The Company wrote off its related $39.2 million investment in December 2009. A recovery on this investment, if any, would come from the eventual disposition of the resort by the lending group.