<PAGE> 1
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED: JUNE 30, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ____________ TO ______________
COMMISSION FILE NUMBER: 1-8996
CAPSTEAD MORTGAGE CORPORATION
(Exact name of Registrant as specified in its Charter)
MARYLAND 75-2027937
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2711 NORTH HASKELL, DALLAS, TEXAS 75204
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (214) 874-2323
The Registrant meets the conditions set forth in General Instruction H(1)(a) and
(b) for Form 10-Q and is therefore filing this Form under the reduced disclosure
format.
Indicate by check mark whether the Registrant (1) has filed all documents and
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES [X] NO [ ]
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the last practicable date.
Common Stock ($0.01 par value) 61,576,000 as of August 11, 1998
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<PAGE> 2
CAPSTEAD MORTGAGE CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 1998
INDEX
<TABLE>
<CAPTION>
PART I. -- FINANCIAL INFORMATION
PAGE
----
<S> <C>
ITEM 1. Financial Statements
Consolidated Balance Sheet -- June 30, 1998 and December 31, 1997...................................... 3
Consolidated Statement of Operations -- Quarter and Six Months Ended
June 30, 1998 and 1997............................................................................... 4
Consolidated Statement of Cash Flows -- Six Months Ended
June 30, 1998 and 1997............................................................................... 5
Notes to Consolidated Financial Statements............................................................. 6
ITEM 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations............................................... 14
PART II. -- OTHER INFORMATION
ITEM 1. Legal Proceedings........................................................................... 23
ITEM 5. Other Information........................................................................... 23
ITEM 6. Exhibits and Reports on Form 8-K............................................................ 24
SIGNATURES................................................................................................ 25
</TABLE>
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PART I. -- FINANCIAL INFORMATION
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
ITEM 1. FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
JUNE 30, 1998 DECEMBER 31, 1997
------------- -----------------
(UNAUDITED)
<S> <C> <C>
ASSETS
Mortgage securities and other investments $ 5,697,068 $ 6,114,130
CMO collateral and investments 4,430,371 5,195,436
--------------- ---------------
10,127,439 11,309,566
Mortgage servicing rights 635,141 669,062
Prepaids, receivables and other 313,634 361,510
Cash and cash equivalents 13,636 17,377
--------------- ---------------
$ 11,089,850 $ 12,357,515
=============== ===============
LIABILITIES
Short-term borrowings $ 5,988,393 $ 7,099,706
Collateralized mortgage obligations 4,348,652 4,309,455
Accounts payable and accrued expenses 28,599 51,323
Mortgage servicing rights
acquisitions payable 20,336 8,423
--------------- ---------------
10,385,980 11,468,907
--------------- ---------------
STOCKHOLDERS' EQUITY
Preferred stock - $0.10 par value;
100,000 shares authorized:
$1.60 Cumulative Preferred Stock,
Series A, 375 and 408 shares
issued and outstanding ($6,150
aggregate liquidation preference) 5,238 5,698
$1.26 Cumulative Convertible
Preferred Stock, Series B, 17,298 and
17,081 shares issued and outstanding
($196,851 aggregate
liquidation preference) 193,206 189,800
Common stock - $0.01 par value; 100,000
shares authorized; 61,571 and 58,541
shares issued and outstanding 616 585
Paid-in capital 781,260 732,295
Undistributed income (loss) (292,388) 12,676
Accumulated other comprehensive
income (loss) 15,938 (52,446)
--------------- ---------------
703,870 888,608
--------------- ---------------
$ 11,089,850 $ 12,357,515
=============== ===============
</TABLE>
See accompanying notes to consolidated financial statements.
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<PAGE> 4
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
QUARTER ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
-------------------------- --------------------------
1998 1997 1998 1997
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
INTEREST INCOME:
Mortgage securities and other investments $ 104,213 $ 79,473 $ 202,997 $ 157,377
CMO collateral and investments 97,658 83,542 191,893 170,919
---------- ---------- ---------- ----------
Total interest income 201,871 163,015 394,890 328,296
---------- ---------- ---------- ----------
INTEREST AND RELATED EXPENSES:
Short-term borrowings:
Mortgage securities and other investments 95,429 68,649 183,839 133,504
CMO investments 10,997 5,788 22,323 12,023
Collateralized mortgage obligations 83,950 67,110 161,753 137,609
Mortgage insurance and other 982 1,355 2,094 2,781
---------- ---------- ---------- ----------
Total interest and related expenses 191,358 142,902 370,009 285,917
---------- ---------- ---------- ----------
Net margin on mortgage assets 10,513 20,113 24,881 42,379
---------- ---------- ---------- ----------
MORTGAGE BANKING REVENUES:
Servicing fees 33,316 30,726 66,833 60,859
Production and other 19,942 10,813 34,247 19,419
---------- ---------- ---------- ----------
Total mortgage banking revenues 53,258 41,539 101,080 80,278
---------- ---------- ---------- ----------
MORTGAGE SERVICING EXPENSES:
Direct servicing expenses 5,769 4,281 11,397 8,296
Indirect servicing expenses 1,551 1,826 3,230 3,551
Amortization of mortgage servicing rights
and related costs 22,479 16,385 42,408 30,412
Impairment of mortgage servicing rights,
net of related hedge gains 45,000 -- 45,000 --
Interest 5,612 5,482 11,353 10,412
---------- ---------- ---------- ----------
Total mortgage servicing expenses 80,411 27,974 113,388 52,671
---------- ---------- ---------- ----------
Net margin on mortgage banking operations (27,153) 13,565 (12,308) 27,607
---------- ---------- ---------- ----------
OTHER REVENUES (LOSSES):
Gain on sales and other 4,235 8,685 11,104 11,285
Loss on portfolio repositioning, net of
related hedge gains (255,321) -- (255,321) --
CMO administration 945 864 1,774 1,684
---------- ---------- ---------- ----------
Total other revenues (losses) (250,141) 9,549 (242,443) 12,969
---------- ---------- ---------- ----------
OTHER OPERATING EXPENSES 1,351 3,556 3,192 5,896
---------- ---------- ---------- ----------
NET INCOME (LOSS) $ (268,132) $ 39,671 $ (233,062) $ 77,059
========== ========== ========== ==========
Net income (loss) $ (268,132) $ 39,671 $ (233,062) $ 77,059
Less cash dividends on preferred stock (5,589) (6,663) (11,144) (13,862)
---------- ---------- ---------- ----------
Net income available (loss attributable)
to common stockholders $ (273,721) $ 33,008 $ (244,206) $ 63,197
========== ========== ========== ==========
NET INCOME (LOSS) PER COMMON SHARE:
Basic $ (4.47) $ 0.67 $ (4.04) $ 1.32
Diluted (4.47) 0.60 (4.04) 1.17
CASH DIVIDENDS PAID PER SHARE:
Common $ 0.500 $ 0.595 $ 1.000 $ 1.175
Series A Preferred 0.400 0.400 0.800 0.800
Series B Preferred 0.315 0.315 0.630 0.630
</TABLE>
See accompanying notes to consolidated financial statements.
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<PAGE> 5
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
<TABLE>
<CAPTION>
SIX MONTHS ENDED
JUNE 30
------------------------------------
1998 1997
--------------- ---------------
<S> <C> <C>
OPERATING ACTIVITIES:
Net income (loss) $ (233,062) $ 77,059
Noncash items:
Amortization of discount and premium 90,151 47,116
Amortization and impairment of mortgage
servicing rights and related costs, net of
related hedge gains 87,408 30,412
Depreciation and other amortization 3,099 1,904
Net change in prepaids, receivables, other
assets, accounts payable and accrued expenses (12,085) (13,030)
Net gain from investing activities (11,922) (10,976)
Loss on portfolio repositioning,
net of related hedge gains 255,321 --
--------------- ---------------
Net cash provided by operating activities 178,910 132,485
--------------- ---------------
INVESTING ACTIVITIES:
Purchases of mortgage securities and other investments (3,314,151) (1,415,694)
Purchases of CMO collateral and investments (758,615) (170,942)
Purchases of mortgage servicing rights (56,178) (47,482)
Purchases of derivative financial instruments (54,250) (21,582)
Principal collections on mortgage investments 1,303,124 553,507
Proceeds from sales of mortgage assets 3,195,240 432,475
Proceeds from sales of derivative financial
instruments 86,239 305
CMO collateral:
Principal collections 502,182 219,936
Decrease in accrued interest receivable 3,945 2,167
Increase in short-term investments (3,481) (2,370)
--------------- ---------------
Net cash provided (used) by investing activities 904,055 (449,680)
--------------- ---------------
FINANCING ACTIVITIES:
Increase (decrease) in short-term borrowings (1,111,313) 680,458
Increase (decrease) in mortgage servicing
acquisitions payable 11,912 (46,207)
Collateralized mortgage obligations:
Issuance of securities 597,934 --
Principal payments on securities (562,908) (335,199)
Increase (decrease) in accrued interest payable (590) 630
Capital stock transactions 50,261 79,717
Dividends paid (72,002) (71,323)
--------------- ---------------
Net cash provided (used) by financing activities (1,086,706) 308,076
--------------- ---------------
Net change in cash and cash equivalents (3,741) (9,119)
Cash and cash equivalents at beginning of period 17,377 21,003
--------------- ---------------
Cash and cash equivalents at end of period $ 13,636 $ 11,884
=============== ===============
</TABLE>
See accompanying notes to consolidated financial statements.
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<PAGE> 6
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1998
(UNAUDITED)
NOTE 1 -- BUSINESS
Capstead Mortgage Corporation, a national mortgage banking firm, engages in
servicing mortgage loans, investing in mortgage assets and other investment
strategies. The Company's business plan is to build a mortgage banking operation
with investments in mortgage servicing, mortgage production and mortgage assets
with the goal of producing reasonably balanced operating results in a variety of
interest rate environments. However, the current interest rate environment,
where long-term interest rates have fallen to near or even lower than short-term
interest rates, has significantly decreased the Company's net interest margins
and led to higher mortgage prepayment rates. As discussed in NOTE 3 and NOTE 4,
in the current quarter the Company recorded losses on repositioning its mortgage
asset portfolios and took an impairment charge against its investment in
mortgage servicing rights.
NOTE 2 -- BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been prepared
in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Rule 10-01 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the quarter and six months ended June 30,
1998 are not necessarily indicative of the results that may be expected for the
calendar year ending December 31, 1998. For further information refer to the
consolidated financial statements and footnotes thereto included in the
Company's annual report on Form 10-K for the year ended December 31, 1997.
On January 1, 1998 the Company adopted Statement of Financial Accounting
Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130
establishes standards for the reporting of comprehensive income and its
components in financial statements. As the term currently relates to the
Company, comprehensive income (loss) consists of net income (loss) plus the
change in unrealized gain (loss) on debt securities classified as
available-for-sale (see NOTE 9). The adoption of SFAS 130 has not had any impact
on the results of operations or financial position of the Company.
In June 1998 the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" ("SFAS No. 133"). SFAS No. 133 establishes accounting
and reporting standards for derivative financial instruments and hedging
activities. It requires that an entity recognize all derivatives as either
assets or liabilities in the statement of financial position and measure those
instruments at fair value. If certain conditions are met, a derivative may be
specifically designated as (i) a hedge of the exposure to changes in the fair
value of a recognized asset or liability or an unrecognized firm commitment;
(ii) a hedge of the exposure to variable
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<PAGE> 7
cash flows of a forecasted transaction; or (iii) in certain circumstances, a
hedge of a foreign currency exposure. This statement becomes effective in fiscal
year ending December 31, 2001. The adoption of SFAS 133 is not expected to have
a material impact on the financial position of the Company.
Certain amounts for prior periods have been reclassified to conform to the 1998
presentation.
NOTE 3 -- PORTFOLIO REPOSITIONING
In mid-June the Company committed to a significant repositioning of its mortgage
asset portfolios involving the sale of approximately $1.0 billion of
interest-only mortgage securities and $1.3 billion of adjustable-rate mortgage
securities. Also as part of this repositioning, sales of $795 million of
fixed-rate securities were completed by mid-July. Total losses of $255.3
million, net of related hedge gains, were recorded in the second quarter in
connection with these transactions. The portfolio repositioning has reduced but
not eliminated the Company's exposure to decreasing asset values should
long-term interest rates decline further.
NOTE 4 -- MORTGAGE SERVICING PORTFOLIO
The following table provides information regarding the primary mortgage
servicing portfolio (which excludes subservicing) and the related investment in
mortgage servicing rights (dollars in thousands):
<TABLE>
<CAPTION>
UNPAID MORTGAGE
PRINCIPAL NUMBER SERVICING
BALANCE OF LOANS RIGHTS
--------------- --------------- ---------------
<S> <C> <C> <C>
Loans serviced at December 31, 1997 $ 42,059,027 441,277 $ 669,062
Additions:
Purchases 1,651,178 15,208 36,203
Loan production 294,020 2,767 4,392
Run-off/amortization (4,670,700) (39,455) (37,572)
Impairment reserve -- -- (51,386)
Results of hedging activity -- -- (1,141)
--------------- --------------- ---------------
Loans serviced at June 30, 1998 39,333,525 419,797 619,558
Purchases pending transfer 818,721 6,644 15,583
--------------- --------------- ---------------
Total portfolio at June 30, 1998 $ 40,152,246 426,441 $ 635,141
=============== =============== ===============
</TABLE>
In addition, as of June 30, 1998, the Company subserviced $16.5 billion of
single-family mortgage loans under a subservicing arrangement with a large
national mortgage conduit.
The Company's investment in mortgage servicing rights had an aggregate fair
value of approximately $642 million at June 30, 1998. Derivative financial
instruments, specifically interest rate floors, have been held for several years
to help mitigate the effect of changes in value of the servicing portfolio
caused by falling mortgage interest rates and have been accorded hedge
accounting treatment. Recently, however, and particularly in the second quarter,
these instruments have under-performed relative to the change in value of the
servicing portfolio. As a result, the Company ceased hedge accounting for these
instruments in June. The Company continues to hold a portfolio of derivatives
that includes interest rate floors to help mitigate the effects of further
declines in mortgage interest rates. Beginning with
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<PAGE> 8
June, changes in value of these derivatives are charged to income rather than
recorded as an adjustment to the carrying amount of the servicing asset. At June
30, 1998 interest rate floor positions had related notional amounts totaling
$18.6 billion and a fair value of $164.3 million.
NOTE 5 -- MORTGAGE SECURITIES AND OTHER INVESTMENTS
Mortgage securities and other investments and the related average effective
interest rates (calculated including mortgage insurance costs on non-agency
securities and excluding unrealized gains and losses) were as follows (dollars
in thousands):
<TABLE>
<CAPTION>
QUARTER SIX MONTHS
ENDED ENDED
AS OF JUNE 30 JUNE 30 JUNE 30
------------------------------- -------------------------------- ---------------------------
1998 1997 1998 1997 1998 1997
------------- ------------- ------------- ------------- ------------- ----------
<S> <C> <C> <C> <C> <C> <C>
Agency and U.S.
Treasury securities:*
U.S. Treasury notes $ 709,277 $ -- 5.59% --% 5.59% --%
Fixed-rate 1,123,891 687,276 6.51 6.56 6.52 6.48
Medium-term 700,296 -- 5.94 -- 6.05 --
Adjustable-rate 2,538,495 4,290,764 5.68 6.28 5.79 6.28
Non-agency securities:
Fixed-rate 141,226 47,771 7.66 8.48 7.96 8.75
Medium-term 265,838 239,366 6.29 6.61 6.31 6.65
Adjustable-rate 123,958 187,931 6.72 7.15 6.87 7.15
Production warehouse 94,087 -- 7.03 -- 7.00 --
------------- -------------
$ 5,697,068 $ 5,453,108
============= =============
</TABLE>
* NOTE THAT $700 MILLION OF U.S. TREASURY NOTES AND FIXED-RATE MORTGAGE
SECURITIES INCLUDED ABOVE WERE SOLD BY MID-JULY IN CONNECTION WITH THE
PORTFOLIO REPOSITIONING (SEE NOTE 3).
The Company classifies its mortgage securities by interest rate characteristics
of the underlying mortgage loans. Fixed-rate mortgage securities either (i) have
fixed rates of interest for their entire terms, (ii) have an initial fixed-rate
period of 10 years after origination and then adjust annually based on a
specified margin over 1-year U.S. Treasury Securities ("1-year Treasuries"), or
(iii) were previously classified as medium-term and have adjusted to a fixed
rate for the remainder of their terms. Medium-term mortgage securities either
(i) have an initial fixed-rate period of 3 or 5 years after origination and then
adjust annually based on a specified margin over 1-year Treasuries, (ii) have
initial interest rates that adjust one time, approximately 5 years following
origination of the mortgage loan, based on a specified margin over Federal
National Mortgage Association ("Fannie Mae") yields for 30-year, fixed-rate
commitments at the time of adjustment, or (iii) fixed-rate mortgage securities
that have expected weighted average lives of 5 years or less. Adjustable-rate
mortgage securities either (i) adjust semiannually based on a specified margin
over the 6-month London Interbank Offered Rate ("LIBOR"), (ii) adjust annually
based on a specified margin over 1-year Treasuries, or (iii) were previously
classified as medium-term and have begun adjusting annually based on a specified
margin over 1-year Treasuries.
Agency and U.S. Treasury securities consist of mortgage-backed securities issued
by government-sponsored entities, either Freddie Mac, Fannie Mae or Ginnie Mae,
and U.S. government-issued fixed-rate securities, commonly referred to as U.S.
Treasury notes or bills (collectively, "Agency and U.S. Treasury Securities").
Non-agency securities consist of AAA-rated private
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<PAGE> 9
mortgage pass-through and other AAA-rated private mortgage securities (together,
"Non-agency Securities") and also include mortgage loans held for sale in
connection with loan production activities. The maturity of mortgage-backed
securities is directly affected by the rate of principal prepayments on the
underlying mortgage loans. At June 30, 1998 Agency and U.S. Treasury Securities
and Non-agency Securities were pledged to secure short-term borrowings.
NOTE 6 -- CMO COLLATERAL AND INVESTMENTS
Collateralized mortgage obligation ("CMO") collateral consists of
mortgage-backed securities and related investments pledged to secure CMO
borrowings ("Pledged CMO Collateral"). CMO investments have included investments
in Agency Trust interest-only mortgage securities (see NOTE 3) and investments
in other CMO securities such as other agency and private-issue interest-only and
principal-only mortgage securities. The components of CMO collateral and
investments are summarized as follows (in thousands):
<TABLE>
<CAPTION>
JUNE 30, 1998 DECEMBER 31, 1997
--------------- -----------------
<S> <C> <C>
Pledged CMO collateral:
Pledged mortgage securities $ 4,354,680 $ 4,326,696
Short-term investments 19,081 15,600
Accrued interest receivable 26,310 26,760
--------------- ---------------
4,400,071 4,369,056
Unamortized premium 3,426 2,752
--------------- ---------------
4,403,497 4,371,808
CMO investments:
Agency Trust interest-only
mortgage securities* 13,816 809,757
Other CMO investments 13,058 13,871
--------------- ---------------
$ 4,430,371 $ 5,195,436
=============== ===============
</TABLE>
* THESE SECURITIES WERE SOLD BY MID-JULY IN CONNECTION WITH THE PORTFOLIO
REPOSITIONING (SEE NOTE 3).
Pledged mortgage securities consist of fixed-rate, medium-term and
adjustable-rate mortgage-backed securities. All principal and interest on
pledged mortgage securities is remitted directly to a collection account
maintained by a trustee. The trustee is responsible for reinvesting those funds
in short-term investments. All collections on pledged mortgage securities and
reinvestment income earned thereon are available for the payment of principal
and interest on CMOs issued by the Company. The weighted average effective
interest rates for total Pledged CMO Collateral were 7.34 percent and 7.26
percent during the quarter and six months ended June 30, 1998, respectively.
Derivative financial instruments, specifically interest rate floors, have been
held for several years to help mitigate the effect of changes in value of CMO
investments caused by falling mortgage interest rates and have been accorded
hedge accounting treatment. Recently, however, and particularly in the second
quarter, these instruments have under-performed relative to the change in value
of the CMO investments. As a result, the Company ceased hedge accounting for
these instruments in the second quarter. Included in the loss on portfolio
repositioning (see NOTE 3) are realized and unrealized second quarter gains on
interest rate floors totaling $28.3 million.
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NOTE 7 -- DISCLOSURES REGARDING FAIR VALUES OF DEBT SECURITIES
Estimated fair values of debt securities have been determined using available
market information and appropriate valuation methodologies; however,
considerable judgment is required in interpreting market data to develop these
estimates. In addition, fair values fluctuate on a daily basis. Accordingly,
estimates presented herein are not necessarily indicative of the amounts that
could be realized in a current market exchange. The use of different market
assumptions and/or estimation methodologies may have a material effect on
estimated fair values.
The fair value of Agency and U.S. Treasury Securities, Non-agency Securities
(excluding mortgage loans held in the production warehouse) and CMO investments
was estimated using either quoted market prices when available, including quotes
made by lenders in connection with designating collateral for repurchase
arrangements, or offer prices for similar assets or market positions. Losses of
$9.9 million on certain sales that settled in July 1998 were included in the
loss on portfolio repositioning taken in the second quarter (see NOTE 3). As a
result, the cost bases of these securities have been reduced accordingly. The
fair value of Pledged CMO Collateral was based on projected cash flows, after
payment on the related CMOs, determined using market discount rates and
prepayment assumptions. The maturity of Pledged CMO Collateral is directly
affected by the rate of principal payments by mortgagors and clean-up calls of
the remaining CMOs outstanding.
The following table summarizes fair value disclosures for available-for-sale
debt securities (in thousands):
<TABLE>
<CAPTION>
GROSS GROSS
UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
AS OF JUNE 30, 1998
Mortgage securities and
other investments:
Agency and U.S.
Treasury Securities:
U.S. Treasury notes $ 698,088 $ 11,189 $ -- $ 709,277
Fixed-rate 1,121,882 3,633 1,624 1,123,891
Medium-term 697,864 2,444 12 700,296
Adjustable-rate 2,540,642 6,579 8,726 2,538,495
Non-agency Securities:
Fixed-rate 62,929 1,385 -- 64,314
Medium-term 214,162 968 -- 215,130
Adjustable-rate 121,941 2,017 -- 123,958
CMO investments 28,790 25 1,940 26,875
---------- ---------- ---------- ----------
$5,486,298 $ 28,240 $ 12,302 $5,502,236
========== ========== ========== ==========
</TABLE>
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<PAGE> 11
<TABLE>
<CAPTION>
GROSS GROSS
UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
AS OF DECEMBER 31, 1997
Mortgage securities and
other investments:
Agency Securities:
Fixed-rate $ 875,928 $ 2,903 $ 7,454 $ 871,377
Medium-term 615,360 1,678 46 616,992
Adjustable-rate 4,017,109 19,850 6,499 4,030,460
Non-agency Securities:
Fixed-rate 39,416 878 -- 40,294
Medium-term 222,054 398 28 222,424
Adjustable-rate 161,116 3,459 -- 164,575
CMO investments 891,213 332 67,917 823,628
---------- ---------- ---------- ----------
$6,822,196 $ 29,498 $ 81,944 $6,769,750
========== ========== ========== ==========
</TABLE>
Held-to-maturity debt securities consist of Pledged CMO Collateral and
collateral released from the related CMO indentures pursuant to clean-up calls
and held as Non-agency Securities. The following tables summarize fair value
disclosures for debt securities held-to-maturity (in thousands):
<TABLE>
<CAPTION>
GROSS GROSS
UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
AS OF JUNE 30, 1998
Pledged CMO Collateral $4,403,497 $ 197 $ 41,668 $4,362,026
Non-agency Securities 127,620 3,610 954 130,276
---------- ---------- ---------- ----------
$4,531,117 $ 3,807 $ 42,622 $4,492,302
========== ========== ========== ==========
AS OF DECEMBER 31, 1997
Pledged CMO Collateral $4,371,808 $ 2,988 $ 48,955 $4,325,841
Non-agency Securities 168,008 918 -- 168,926
---------- ---------- ---------- ----------
$4,539,816 $ 3,906 $ 48,955 $4,494,767
========== ========== ========== ==========
</TABLE>
Sales of released CMO collateral occasionally occur provided the collateral has
paid down to within 15 percent of its original issuance amounts. The following
table summarizes disclosures related to the disposition of debt securities held
available-for-sale and held-to-maturity (in thousands):
<TABLE>
<CAPTION>
QUARTER ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
-------------------------------- --------------------------------
1998 1997 1998 1997
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
Sale of securities held available-for-sale:
Amortized cost $ 2,586,480 $ 245,662 $ 3,237,953 $ 347,079
Gains (losses) (253,315) 8,209 (248,594) 9,086
Sale of released CMO collateral held-to-maturity:
Amortized cost -- -- 5,022 73,324
Gains -- -- 471 2,986
</TABLE>
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<PAGE> 12
NOTE 8 -- NET INTEREST INCOME ANALYSIS
The following tables summarize interest income and interest expense and average
effective interest rates for the periods indicated (dollars in thousands):
<TABLE>
<CAPTION>
QUARTER ENDED JUNE 30
----------------------------------------------------------------------------
1998 1997
----------------------------------- -----------------------------------
AMOUNT AVERAGE AMOUNT AVERAGE
--------------- ------------ --------------- ----------
<S> <C> <C> <C> <C>
Interest income:
Mortgage securities and other
investments $ 104,213 5.98% $ 79,473 6.41%
CMO collateral and investments 97,658 7.46 83,542 7.76
--------------- ---------------
Total interest income 201,871 163,015
--------------- ---------------
Interest expense:
Short-term borrowings 106,426 5.53 74,437 5.57
CMOs 83,950 7.66 67,110 7.50
--------------- ---------------
Total interest expense 190,376 141,547
--------------- ---------------
Net interest $ 11,495 $ 21,468
=============== ===============
</TABLE>
<TABLE>
<CAPTION>
SIX MONTHS ENDED JUNE 30
----------------------------------------------------------------------------
1998 1997
----------------------------------- -----------------------------------
AMOUNT AVERAGE AMOUNT AVERAGE
--------------- ------------ --------------- ----------
<S> <C> <C> <C> <C>
Interest income:
Mortgage securities and other
investments $ 202,997 6.07% $ 157,377 6.41%
CMO collateral and investments 191,893 7.37 170,919 7.80
--------------- ---------------
Total interest income 394,890 328,296
--------------- ---------------
Interest expense:
Short-term borrowings 206,162 5.58 145,527 5.50
CMOs 161,753 7.53 137,609 7.51
--------------- ---------------
Total interest expense 367,915 283,136
--------------- ---------------
Net interest $ 26,975 $ 45,160
=============== ===============
</TABLE>
The following tables summarize increases (decreases) in interest income and
interest expense due to changes in interest rates versus changes in volume for
the quarter and six months ended June 30, 1998 compared to the same periods in
1997 (in thousands):
<TABLE>
<CAPTION>
QUARTER ENDED JUNE 30, 1998
------------------------------------------------
RATE * VOLUME* TOTAL
------------ ------------ ------------
<S> <C> <C> <C>
Interest income:
Mortgage securities and other
investments $ (5,625) $ 30,365 $ 24,740
CMO collateral and investments (3,358) 17,474 14,116
------------ ------------ ------------
Total interest income (8,983) 47,839 38,856
------------ ------------ ------------
Interest expense:
Short-term borrowings (525) 32,514 31,989
CMOs 1,432 15,408 16,840
------------ ------------ ------------
Total interest expense 907 47,922 48,829
------------ ------------ ------------
Net interest $ (9,890) $ (83) $ (9,973)
============ ============ ============
</TABLE>
-12-
<PAGE> 13
<TABLE>
<CAPTION>
SIX MONTHS ENDED JUNE 30, 1998
-----------------------------------------------
RATE* VOLUME* TOTAL
------------ ------------ ------------
<S> <C> <C> <C>
Interest income:
Mortgage securities and other
investments $ (8,734) $ 54,354 $ 45,620
CMO collateral and investments (9,961) 30,935 20,974
------------ ------------ ------------
Total interest income (18,695) 85,289 66,594
------------ ------------ ------------
Interest expense:
Short-term borrowings 2,118 58,517 60,635
CMOs 330 23,814 24,144
------------ ------------ ------------
Total interest expense 2,448 82,331 84,779
------------ ------------ ------------
Net interest $ (21,143) $ 2,958 $ (18,185)
============ ============ ============
</TABLE>
* THE CHANGES IN INTEREST INCOME AND EXPENSE DUE TO BOTH VOLUME AND RATE HAVE
BEEN ALLOCATED TO VOLUME AND RATE CHANGES IN PROPORTION TO THE RELATIONSHIP
OF THE ABSOLUTE DOLLAR AMOUNTS OF THE CHANGE IN EACH.
NOTE 9 -- COMPREHENSIVE INCOME (LOSS)
Comprehensive income (loss) is net income (loss) plus other comprehensive income
(loss), which, for the periods presented, consists of the change in unrealized
gain (loss) on debt securities classified as available-for-sale. The following
table provides information regarding comprehensive income (loss) for the periods
indicated (in thousands):
<TABLE>
<CAPTION>
QUARTER ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
------------------------------ ------------------------------
1998 1997 1998 1997
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Net income (loss) $ (268,132) $ 39,671 $ (233,062) $ 77,059
------------ ------------ ------------ ------------
Other comprehensive income (loss):
Unrealized gain (loss) on debt securities:
Change in unrealized gain
(loss) during period (124,440) 28,252 (180,210) 42,364
Less: reclassification
adjustment for (gain)
loss included in net
income (loss) 253,315 (8,209) 248,594 (9,086)
------------ ------------ ------------ ------------
Other comprehensive income 128,875 20,043 68,384 33,278
------------ ------------ ------------ ------------
Comprehensive income (loss) $ (139,257) $ 59,714 $ (164,678) $ 110,337
============ ============ ============ ============
</TABLE>
NOTE 10 -- SUBSEQUENT EVENT: STOCKHOLDER LITIGATION
Subsequent to quarter-end, the Company and certain of its officers were served
with eleven class action lawsuits alleging, among other things, that the
defendants violated United States securities laws by publicly issuing false and
misleading statements and omitting to disclose material adverse information
regarding the Company's business from April 17, 1997 through July 24, 1998. Each
of the complaints claims that as a result of such alleged improper actions, the
market price of the Company's equity securities were artificially inflated at
the time stockholders in the classes acquired those securities. The complaints
seek monetary damages for the losses allegedly incurred by the members of the
various classes on whose behalf these actions are brought. The Company has not
yet answered the complaints, but intends to defend itself vigorously. Based on
available information, management believes the resolution of these suits will
not have a material adverse effect on the financial position of the Company.
-13-
<PAGE> 14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
FINANCIAL CONDITION
OVERVIEW
The Company's business plan is to build a mortgage banking operation with
investments in mortgage securities, mortgage servicing and mortgage production
with the goal of producing reasonably balanced operating results in a variety of
interest rate environments. However, the current interest rate environment,
where long-term interest rates have fallen to near or even lower than short-term
interest rates, has significantly decreased the Company's net interest margins
and mortgage servicing income because of high mortgage prepayment rates and
acquisitions of lower yielding securities, without any relief from lower
borrowing costs.
During 1997 mortgage interest rates peaked in late spring and then declined
nearly 1 1/2 percentage points through June 1998, which has spurred prepayments
on the Company's mortgage and collateralized mortgage obligation ("CMO")
investments and its mortgage servicing portfolio. After appearing to peak in
early spring of 1998, mortgage prepayment rates rose again in June and may
remain high at least through the summer and early fall. Meanwhile, the Company's
borrowing rates have remained above 5 1/2 percent in 1998, contributing to
narrower financing spreads on the Company's mortgage securities portfolios (see
"Effects of Interest Rate Changes").
A consequence of lower long-term interest rates and higher prepayments is a loss
in value of investments made in certain mortgage assets and in mortgage
servicing. Values of interest-only mortgage securities held in the Company's CMO
collateral and investment portfolio were particularly hard hit. In mid-June the
Company committed to a significant repositioning of its mortgage asset
portfolios in order to reduce its exposure to decreasing asset values should
long-term interest rates decline further. The repositioning involved selling the
Company's entire investment in Agency Trust interest-only mortgage securities
and portions of its adjustable-rate ("ARM") and fixed-rate mortgage securities
portfolios. The Company recorded a $255.3 million loss on these sales in the
second quarter, net of related hedge gains.
The portfolio repositioning has reduced the Company's exposure to decreasing
asset values should long-term interest rates decline; however, even if interest
rates remain unchanged the Company still expects its net interest margins on
remaining mortgage assets to be under pressure and expects to earn less due to
the reduced size of these portfolios. Perhaps more critically, current high
prepayments have put pressure on mortgage servicing results. A $45 million
impairment charge, net of related hedge gains, was recorded in the second
quarter and should prepayments continue at or increase from these levels, higher
amortization expense and further impairment of the mortgage servicing asset are
likely.
Although the current interest rate environment has created opportunities for the
Company, such as the successful streamline refinance program that is being
developed into a full-spectrum mortgage production business, the near-term
outlook for earnings has worsened and could deteriorate further should long-term
interest rates decline without a reduction in short-term interest rates. As a
consequence, the Company has announced that it will eliminate the common stock
dividend for a period of time in order to preserve stockholders' equity.
Preferred stock dividends are currently being paid.
-14-
<PAGE> 15
MORTGAGE SECURITIES AND OTHER INVESTMENTS
The mortgage securities and other investments portfolios consist of (i)
mortgage-backed securities issued by government-sponsored entities, either
Freddie Mac, Fannie Mae or Ginnie Mae, (ii) U.S. government-issued fixed-rate
securities, commonly referred to as U.S. Treasury notes or bills, and (iii)
AAA-rated private mortgage pass-through and other AAA-rated private mortgage
securities. These investments are referred to as "Agency and U.S. Treasury
Securities" or "Non-agency Securities," respectively. Non-agency Securities also
include mortgage loans held for sale in connection with loan production
activities. The mortgage securities and other investment portfolios are financed
under repurchase arrangements with investment banking firms pursuant to which
the portfolios are pledged as collateral (see "Liquidity and Capital
Resources").
With the declines in mortgage interest rates discussed above, ARM mortgage
securities have been particularly hard hit by higher prepayments because
homeowners are finding that it has become increasingly advantageous to refinance
into lower rate fixed-rate mortgage loans. As a result, purchase premiums paid
by the Company for ARM mortgage securities are being amortized to income sooner
than originally anticipated (see "Effects of Interest Rate Changes"). Although
the Company acquired $513 million of ARM mortgage securities during the current
quarter, these acquisitions were insufficient to replace run-off of the ARM
mortgage securities portfolio. In light of expected high prepayments on ARM
mortgage securities, the Company began expanding its investment focus in the
third quarter of 1997 to include more medium-term and fixed-rate securities. In
addition to providing additional net interest margin under the current interest
rate environment, fixed-rate securities help to offset declines in the value of
mortgage servicing portfolio should mortgage rates decline further. This
strategy continued into the second quarter of 1998 with the acquisition of $748
million of U.S. Treasury notes and $37 million of medium-term mortgage
securities.
In connection with the mid-June portfolio repositioning discussed above, the
Company sold $1.3 billion of ARM mortgage securities and $795 million of
fixed-rate securities bringing total holdings of mortgage securities and other
investments to $5.0 billion by mid-July 1998, down from $6.7 billion at March
31, 1998 and $6.1 billion at December 31, 1997. ARM mortgage securities
represented $2.7 billion, or 54 percent of the total, compared to $4.1 billion,
or 61 percent at March 31, 1998 and $4.2 billion, or 69 percent at December 31,
1997.
CMO COLLATERAL AND INVESTMENTS
Prior to 1995 the Company had been an active issuer of CMOs and other securities
backed by jumbo mortgage loans. The Company retained residual interests in these
securitizations consisting primarily of interest-only and principal-only
mortgage securities. Other than occasional CMO issuances (see below) or modest
issuances of previously held residual interests, the Company has not been an
active issuer of CMOs since 1994. In lieu of issuing CMOs, the Company had
increased its CMO investments (defined as CMO collateral and investments, net of
related bonds) by acquiring interest-only mortgage securities. In connection
with the mid-June portfolio repositioning discussed above, the Company sold its
entire investment in Fannie Mae and Freddie Mac Trust interest-only mortgage
securities at a substantial loss. This loss was aggravated by deteriorated
pricing due to a lack of demand for these securities caused by increasingly
pessimistic views taken by market participants regarding mortgage prepayments.
Primarily as a result of this repositioning, CMO investments declined from $943
million at March 31, 1998, to $68 million by mid-July 1998.
-15-
<PAGE> 16
Derivative financial instruments, specifically interest rate floors, have been
held for several years to help mitigate the effect of changes in value of CMO
investments caused by falling mortgage interest rates and have been accorded
hedge accounting treatment. Recently however, and particularly in the second
quarter, these instruments have under-performed relative to the change in value
of these investments. As a result, the Company ceased hedge accounting for these
instruments in the second quarter. Included in the loss on portfolio
repositioning are realized and unrealized second quarter gains on interest rate
floors totaling $28.3 million.
Since the Company exited the jumbo mortgage loan conduit business in 1995, it
has maintained several finance subsidiaries with remaining capacity to issue
CMOs and other securitizations ("securitization shelves"). In an effort to
recover costs associated with these securitization shelves, and to potentially
add to the Company's CMO administration activities, the Company may, from time
to time, purchase mortgage loans from originators or conduits and issue CMOs or
other securities backed by these loans. The Company may or may not retain a
significant residual economic interest in these securitizations. In the latter
half of 1997 the Company completed two such CMO transactions totaling $1.1
billion and during the first quarter of 1998 issued a $598 million CMO.
MORTGAGE BANKING OPERATIONS
The Company commenced mortgage servicing operations in 1993 and through steady
growth has become one of the 20 largest and most efficient mortgage servicers in
the country with a total mortgage servicing portfolio (including primary
servicing and subservicing) of $56.6 billion, a $1.1 billion increase from the
previous quarter. During 1996 the Company entered into a subservicing
arrangement with a large national mortgage conduit. As of June 30, 1998, the
subservicing portfolio totaled $16.5 billion, an increase of $2.8 billion during
the quarter. An advantage of subservicing arrangements is that further growth
and enhanced efficiencies can be achieved without the capital investment and
prepayment risk associated with owning additional mortgage servicing rights.
This arrangement is viewed by the Company as a confirmation of the quality and
cost effectiveness of the mortgage servicing operation and could lead to other
such relationships in the future.
The primary mortgage servicing portfolio (which excludes subservicing) declined
$1.6 billion, or 3.9 percent, during the quarter to $40.2 billion with a
weighted average interest rate of 7.42 percent and earning an average annual
service fee, excluding ancillary revenue and earnings on escrows, (the "Average
Service Fee") of 31.3 basis points. The June 30, 1998 investment in mortgage
servicing rights related to this portfolio was $635 million (158 basis points,
or a 5.05 multiple of the Average Service Fee) with an aggregate fair value of
approximately $642 million at June 30, 1998. Primary mortgage servicing
portfolio run-off, consisting of prepayments and scheduled payments on mortgage
loans serviced, was 25.7 percent during the quarter, up from 20.4 percent in the
first quarter of 1998 and 15.1 percent in the fourth quarter of 1997. Because of
the high level of run-off experienced, particularly in the current quarter, and
a greater likelihood of continued high prepayments, expectations for future cash
flows from the mortgage servicing portfolio have diminished. As a result, a $45
million impairment charge, net of related hedge gains, was recorded in the
second quarter and should prepayments continue at or increase from these levels,
higher amortization expense and further impairment of the mortgage servicing
asset are likely.
-16-
<PAGE> 17
Derivative financial instruments, specifically interest rate floors, have been
held for several years to help mitigate the effect of changes in value of the
servicing portfolio caused by falling mortgage interest rates and have been
accorded hedge accounting treatment. Recently, however, and particularly in the
second quarter, these instruments have under-performed relative to the change in
value of the servicing portfolio. As a result, the Company ceased hedge
accounting for these instruments in June. The Company continues to hold a
portfolio of derivatives that includes interest rate floors to help mitigate the
effects of further declines in mortgage interest rates. Beginning with June,
changes in value of these derivatives are charged to income rather than recorded
as an adjustment to the carrying amount of the servicing asset. At June 30, 1998
interest rate floor positions had related notional amounts totaling $18.6
billion and a fair value of $164.3 million (see "Effects of Interest Rate
Changes").
In January 1998 the Company entered the mortgage production business with the
introduction of a technology-driven refinancing program which allows the
Company's existing homeowners to take advantage of a low cost, efficient
refinancing alternative. This streamline refinance program has been well
received with the Company closing a total of 2,767 loans having an unpaid
principal balance of $294 million by June 30, 1998. Given the current level of
mortgage interest rates, monthly production is expected to average $100 million
or more this year and contribute significantly to 1998 income. As this program
is developed into a full-spectrum mortgage production business, the Company
anticipates that the resulting profits when mortgage origination volumes are
high due to low mortgage interest rates will further help to offset the effects
of increased run-off on mortgage servicing operations.
CAPITAL
The following table summarizes the Company's utilization of capital as of June
30, 1998 (in thousands):
<TABLE>
<CAPTION>
CAPITAL
ASSETS BORROWINGS EMPLOYED
--------------- --------------- ---------------
<S> <C> <C> <C>
Agency and U.S. Treasury securities:
U.S. Treasury notes $ 709,277 $ 692,125 $ 17,152
Fixed-rate 1,123,891 1,107,452 16,439
Medium-term 700,296 684,316 15,980
Adjustable-rate 2,538,495 2,485,512 52,983
Non-agency securities:
Fixed-rate 141,226 138,881 2,345
Medium-term 265,838 269,897 (4,059)
Adjustable-rate 123,958 123,077 881
Production warehouse 94,087 72,427 21,660
CMO collateral and investments 4,430,371 4,425,253* 5,118
Mortgage servicing rights 635,141 269,336** 365,805
Derivative financial instruments 166,760 89,105 77,655
--------------- --------------- ---------------
$ 10,929,340 $ 10,357,381 571,959
=============== ===============
Other assets, net of other liabilities 131,911
---------------
Total stockholders' equity $ 703,870
---------------
</TABLE>
* INCLUDES APPROXIMATELY $77 MILLION OF RELATED SHORT-TERM BORROWINGS.
** REPRESENTS AMOUNTS OWED UNDER CONTRACTS FOR BULK PURCHASES OF MORTGAGE
SERVICING RIGHTS AND $249 MILLION DRAWN OF AN AVAILABLE $376 MILLION
UNDER A $625 MILLION LINE OF CREDIT SECURED BY EXISTING MORTGAGE
SERVICING RIGHTS.
-17-
<PAGE> 18
During the quarter and six months ended June 30, 1998, the Company raised $22.3
million and $51.9 million, respectively, of new capital through the issuance of
stock (i) directly to investors pursuant to its direct stock purchase and
dividend reinvestment programs, (ii) daily sales of stock into the open market
and (iii) stock compensation programs. Effective early June the Company had
suspended its stock purchase program and open market sales until further notice.
The net loss recorded for the second quarter had a significant negative impact
on the book value of the Company, which declined to $8.13 per common share
(calculated assuming liquidation of the preferred stock) from $10.83 at March
31, 1998, and $11.74 at December 31, 1997.
In an effort to preserve stockholders' equity during this period of low
profitability, the Company has eliminated the common stock dividend for a period
of time. Preferred stock dividends are currently being paid.
RESULTS OF OPERATIONS
Comparative net operating results (interest income or fee revenues, net of
related interest expense and, in the case of mortgage banking and CMO
administration, related direct and indirect operating expenses) by source were
as follows (in thousands, except per share amounts):
<TABLE>
<CAPTION>
QUARTER ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
------------------------------ ------------------------------
1998 1997 1998 1997
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Agency and U.S. Treasury Securities $ 6,945 $ 8,928 $ 15,082 $ 19,572
Non-agency Securities 1,448 1,402 3,255 3,348
CMO investments 2,120 9,783 6,544 19,459
Mortgage banking operations 17,847 13,565 32,692 27,607
Gain on sales and other 4,235 8,685 11,104 11,285
CMO administration 945 864 1,774 1,684
------------ ------------ ------------ ------------
Contribution to income 33,540 43,227 70,451 82,955
Loss on portfolio repositioning,
net of related hedge gains (255,321) -- (255,321) --
Mortgage servicing impairment, (45,000) -- (45,000) --
net of related hedge gains
Other operating expenses (1,351) (3,556) (3,192) (5,896)
------------ ------------ ------------ ------------
Net income (loss) $ (268,132) $ 39,671 $ (233,062) $ 77,059
============ ============ ============ ============
Net income (loss) per common share:
Basic $ (4.47) $ 0.67 $ (4.04) $ 1.32
Diluted (4.47) 0.60 (4.04) 1.17
</TABLE>
Operating results for the quarter and six months ended June 30, 1998, excluding
the effects of the loss on portfolio repositioning and mortgage servicing
impairment, declined from those achieved in the same period in 1997. The benefit
of larger holdings of mortgage assets throughout most of the quarter was offset
by a narrowing of financing spreads due primarily to high levels of prepayments
(see above, "Financial Condition"). Likewise, mortgage banking results, while
benefiting from growth in the subservicing portfolio and the Company's recent
entry into the mortgage production business through the selective refinancing of
its existing homeowners, were hampered by higher amortization of mortgage
servicing rights due to the effects of high prepayments.
-18-
<PAGE> 19
Agency and U.S. Treasury Securities contributed less to income during the
quarter and six months ended June 30, 1998 than during the same periods in 1997.
The benefit to operating results of increased average holdings of these
securities during 1998 was offset by lower financing spreads. Financing spreads
were lower primarily because of higher prepayments and investments made in lower
yielding securities reflecting the general decline in long-term interest rates.
Financing spreads for the quarter and six months ended June 30, 1998 were 37 and
41 basis points, respectively, 36 and 38 basis points lower than spreads
achieved in the same periods in 1997. Average yields for this portfolio were
5.88 percent and 5.97 percent during the quarter and six months ended June 30,
1998, respectively, compared to 6.32 percent and 6.31 percent during the same
periods in 1997, while borrowing rates were 5.51 percent and 5.56 percent,
respectively, compared to 5.59 percent and 5.52 percent during the same periods
in 1997.
The Non-agency Securities contributions to income during the quarter and six
months ended June 30, 1998 were nearly the same as in the same periods in 1997
due primarily to increases in the average outstanding portfolios. Higher
prepayments were not as significant an influence on the decline in financing
spreads for this portfolio because of lower amounts of purchased premiums.
However, the yields on new asset purchases are lower reflecting the general
decline in long-term interest rates. As a result of asset purchases (including
mortgage loans from the new refinancing program) and CMO redemptions, the
average outstanding portfolio was $643 million and $662 million during the
quarter and six months ended June 30, 1998, respectively, compared to $458
million and $466 million for the same periods in 1997. Average yields for this
portfolio (calculated including mortgage insurance costs) were 6.74 percent and
6.78 percent during the quarter and six months ended June 30, 1998,
respectively, compared to 6.90 percent and 7.00 percent during the same periods
in 1997, while average borrowing rates were at 5.76 percent and 5.78 percent,
respectively, compared to 5.81 percent and 5.69 percent during the same periods
in 1997.
CMO investments contributed substantially less to income during the quarter and
six months ended June 30, 1998 than during the same periods in 1997 due
primarily to faster prepayment rates and higher hedging costs. Results were also
impacted by the liquidation of the Agency Trust interest-only mortgage
securities portfolio in June (see above, "Financial Condition"). Results from
remaining CMO investments were less than in the same periods in 1997 due to CMO
redemptions which have the effect of transferring the related financing spread
from this portfolio to Non-agency Securities.
Modestly higher mortgage banking results (before the impairment charge - see
above, "Financial Condition") reflect $9.7 billion of growth in the subservicing
portfolio to $16.5 billion at the end of the second quarter from $6.8 billion at
June 30, 1997 while the primary servicing portfolio grew only marginally to
$39.3 billion from $39.1 billion at June 30, 1997. The Company's recent entry
into the mortgage production business through refinancing mortgage loans in its
primary servicing portfolio also contributed nearly $4.5 million to current
quarter results (see above, "Financial Condition"). Revenues increased to $53.3
million and $101.1 million during the quarter and six months ended June 30,
1998, respectively, compared to $41.5 million and $80.3 million during the same
periods in 1997. Direct and indirect servicing expenses also increased, but not
to the same extent as revenues, reflecting further efficiencies gained in the
servicing process with continued growth in the total servicing portfolio.
Greater use of external borrowings secured by the primary mortgage servicing
-19-
<PAGE> 20
portfolio contributed to higher borrowing costs during the second quarter of
1998 compared to the same quarter in 1997.
In addition to the impairment charge recorded in the second quarter,
amortization of mortgage servicing rights of $22.5 million and $42.4 million
during the quarter and six months ended June 30, 1998, respectively, was higher
than the $16.4 million and $30.4 million recorded during the same periods in
1997 primarily due to higher levels of anticipated prepayments caused by lower
prevailing mortgage interest rates. Should prepayments continue at or increase
from these levels, higher amortization expense and further impairment of the
mortgage servicing asset are likely (see "Effects of Interest Rate Changes").
Operating expenses during 1998 were lower than during the same periods in 1997
primarily because of lower compensation-related costs due in part to the effects
of a January 2, 1998 restructuring of long-term compensation for key officers.
For discussion of the loss on portfolio repositioning, see above, "Financial
Condition". Included in gain on sales for the quarter ended June 30, 1998 are
$2.0 million in gains on the sale of $216 million of fixed-rate agency and U.S.
Treasury securities. Year-to-date gains totaled $7.2 million on sales of
mortgage assets totaling $872 million. In addition, the Company earned $2.1
million and $3.7 million in the quarter and six months ended June 30, 1998,
respectively, from a strategy of writing call options on a portion of the
Company's fixed-rate mortgage securities. If the calls are ultimately exercised,
the Company will realize a gain on sale of these mortgage securities in addition
to earning the call premiums received when the calls were written. This compares
to $314,000 in gains in the second quarter of 1997 and $1.1 million of losses
for the six months ended June 30, 1997 on interest rate floor positions held for
trading purposes.
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary sources of funds include monthly principal and interest
payments on mortgage securities and other investments, short-term borrowings,
excess cash flows on CMO investments, servicing fees and other revenue from
mortgage servicing, proceeds from sales of mortgage assets and equity offerings
(see above "Financial Condition"). The Company currently believes that these
funds are sufficient for growth of the mortgage servicing portfolio, development
of a full-spectrum mortgage production operation, the acquisition of mortgage
assets, repayments on short-term borrowings, the payment of cash dividends as
required for Capstead's continued qualification as a Real Estate Investment
Trust ("REIT") and common stock repurchases, if any, as described below. It is
the Company's policy to remain strongly capitalized and conservatively
leveraged.
Short-term borrowings are primarily made under repurchase arrangements. The
Company has uncommitted repurchase facilities with investment banking firms to
finance mortgage assets, subject to certain conditions. Interest rates on
borrowings under these facilities are based on overnight to 30-day London
Interbank Offered Rate ("LIBOR") rates. The terms and conditions of these
arrangements, including interest rates, are negotiated on a
transaction-by-transaction basis. By virtue of the perceived credit-worthiness
of securities issued by government-sponsored entities, or by the U.S. government
or that are AAA-rated, it has been the Company's experience that the mortgage
-20-
<PAGE> 21
securities and other investment portfolios have been highly liquid and easily
financed under such repurchase arrangements.
In addition to a repurchase arrangement to fund its production warehouse, at
June 30, 1998 the mortgage banking operation had available an additional $127
million of a $625 million revolving line of credit agreement maturing September
30, 1999 with an investment banking firm. The line is to be used primarily to
finance acquisitions of mortgage servicing rights on a collateralized basis. The
agreement requires, among other things, that the mortgage banking operation
maintain certain financial ratios and specified levels of unencumbered servicing
rights. The mortgage banking operation is in compliance with these requirements.
Interest rates on borrowings under this facility are based on LIBOR.
In 1996 the board of directors approved the repurchase of up to 1 million shares
of common stock to fund employee stock option and stock grant programs. As of
June 30, 1998 no such share repurchases had occurred.
EFFECTS OF INTEREST RATE CHANGES
Changes in interest rates may impact the Company's earnings in various ways. The
Company's earnings depend, in part, on the difference between the interest
received on mortgage securities and other investments and the interest paid on
related short-term borrowings. The resulting spread may be reduced in a rising
short-term interest rate environment. Because a substantial portion of the
Company's mortgage investments are ARM mortgage securities, the risk of rising
short-term interest rates is offset to some extent by increases in the rates of
interest earned on underlying ARM loans. Since ARM loans generally limit the
amount of such increase during any single interest rate adjustment period and
over the life of the loan, interest rates on borrowings can rise to levels that
may exceed the interest rates on the underlying ARM loans, resulting in a
negative financing spread. The Company may invest in derivative financial
instruments ("Derivatives") from time to time, specifically interest rate caps,
as a hedge against rising interest rates on a portion of its short-term
borrowings. Interest rate caps increase in value as related interest rates rise
and decline in value when such rates fall.
Another effect of changes in interest rates is that, as long-term interest rates
decrease, the rate of prepayment of mortgage loans underlying mortgage
investments generally increases. To the extent the proceeds of prepayments on
mortgage investments cannot be reinvested at a rate of interest at least equal
to the rate previously earned on such investments, earnings may be adversely
affected. Because prolonged periods of high prepayments can significantly reduce
the expected life of mortgage investments, the actual yields realized can be
lower due to faster amortization of purchase premiums. In addition, the rates of
interest earned on ARM investments generally will decline during periods of
falling short-term interest rates as the underlying ARM loans reset at lower
rates.
Changes in interest rates also impact earnings recognized from CMO investments,
which have consisted primarily of interest-only mortgage securities and
fixed-rate CMO residuals (see above, "Financial Condition"). The amount of
income that may be generated from interest-only mortgage securities is dependent
upon the rate of principal prepayments on the underlying mortgage collateral. If
mortgage interest rates fall significantly below interest rates on the
collateral, principal prepayments
-21-
<PAGE> 22
will increase, reducing or eliminating the overall return on these investments.
Sustained periods of high prepayments can result in losses. Conversely, if
mortgage interest rates rise, interest-only mortgage securities tend to perform
favorably because underlying mortgage loans will generally prepay at slower
rates, thereby increasing overall returns.
CMO residuals behave similarly to interest-only mortgage securities. If mortgage
interest rates fall, prepayments on the underlying mortgage loans generally will
be higher thereby reducing or even eliminating overall returns on these
investments. This is due primarily to the acceleration of the amortization of
bond discounts, a noncash item, as bond classes are repaid more rapidly than
originally anticipated. Conversely, if mortgage interest rates rise
significantly above interest rates on the collateral, principal prepayments will
typically diminish, improving the overall return on an investment in a
fixed-rate CMO residual because of an increase in time over which the Company
receives the larger positive interest spread.
The Company periodically sells mortgage assets. Such sales may become attractive
as values of mortgage assets fluctuate with changes in interest rates. At other
times it may become prudent to reposition investment portfolios, for example, to
mitigate exposure to further declines in mortgage interest rates (see above,
"Financial Condition"). In either case, sales of mortgage assets may increase
income volatility because of the recognition of transactional gains or losses.
The above discussion regarding how changes in interest rates impact mortgage
assets also applies to the Company's investment in mortgage servicing rights.
When mortgage interest rates rise, periodic amortization of amounts paid for
mortgage servicing rights is less since the average lives of the related
mortgage loans tend to be longer. Under these conditions, mortgage servicing
rights become more valuable. Conversely, lower mortgage interest rates will spur
prepayments thus reducing the time the Company can service the related loans.
Sustained periods of high prepayments can result in losses on the Company's
investment in mortgage servicing rights, particularly since this investment is
evaluated for impairment on a disaggregated basis and impairment charges are
necessary if the recorded amount for an individual servicing stratum exceeds its
fair value.
The Company supplements its business plan from time to time with Derivatives
held to hedge against the loss in value of certain assets, such as mortgage
servicing rights, should long-term interest rates decline further. Most
Derivatives used by the Company are interest rate floors that generally decrease
in value when interest rates rise and increase in value when rates decline.
Should interest rates remain at or near current levels, the fair value of these
Derivatives will erode over time and could also be impacted by other factors
such as changes in market demand for these instruments. Other Derivatives
acquired from time to time may include treasury futures contracts and options,
written options on mortgage assets or various other Derivatives available in the
market place that are compatible with the Company's risk management objectives.
In instances where such Derivatives are accorded hedge accounting treatment,
changes in value adjust the basis of the assets hedged. In instances where
Derivatives are held for trading purposes or are no longer accorded hedge
accounting treatment (see NOTE 4 to the accompanying consolidated financial
statements), changes in value are recorded in income as they occur, which could
increase income volatility.
-22-
<PAGE> 23
YEAR 2000
Many existing computer software programs use only two digits to identify the
year in date fields and, as such, could fail or create erroneous results by or
at the Year 2000. The Company utilizes a number of software systems to service
mortgage loans, administer securitizations and manage its mortgage assets. The
Company has made and will continue to make investments in its software systems
and applications to ensure the Company is Year 2000 compliant. In addition, the
Company has taken steps to ensure that the vendors it utilizes in various
capacities and institutions that it interfaces with are also taking the
necessary steps to become Year 2000 compliant. This process is expected to be
essentially complete by early 1999. The financial impact of becoming Year 2000
compliant has not been and is not expected to be material to the Company or
results of operations.
FORWARD-LOOKING STATEMENTS
This document contains "forward-looking statements" (within the meaning of the
Private Securities Litigation Reform Act of 1995) that inherently involve risks
and uncertainties. The Company's actual results could differ materially from
those anticipated in these forward-looking statements as a result of unforeseen
external factors. These factors may include, but are not limited to, changes in
general economic conditions, fluctuations in and market expectations for
fluctuations in interest rates and levels of mortgage prepayments, increases in
costs and other general competitive factors.
PART II. -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Between July 23, 1998 and August 11, 1998, the Company and certain of its senior
officers were sued in eleven different lawsuits, each of which alleged
violations of the federal securities laws. Ten of the lawsuits were filed in the
United States District Court for the Northern District of Texas. The eleventh
lawsuit was filed in the United States District Court for the Eastern District
of New York. In ten of the lawsuits, the individual defendants were Ronn K.
Lytle, Christopher T. Gilson, Julie A. Moore, Andrew F. Jacobs and William H.
Rudluff. In the eleventh, the individual defendants included only Messrs. Lytle
and Jacobs and Ms. Moore. Each of the actions is filed as a purported class
action, but the persons on behalf of who the lawsuits are allegedly filed and
the alleged class period vary somewhat among the various actions. The earliest
starting date for the alleged class period is April 17, 1997, the date on which
the Company issued a press release announcing its operating results for the
first quarter of fiscal year 1997, and the latest concluding date for the
alleged class period is July 24, 1998, the date on which the Company announced
its operating results for the second quarter of fiscal 1998 and also announced
that it was eliminating for a period of time the common stock dividend.
In substance, each of the lawsuits alleges that the Company caused the market
price for its securities to be artificially inflated during the alleged class
periods as a result of the Company having issued false and misleading statements
concerning the Company's business, operations, and financial condition and
omitting to disclose material adverse information regarding the same matters.
Each of the complaints seeks monetary damages. The Company intends to defend
vigorously the claims asserted against it.
-23-
<PAGE> 24
ITEM 5. OTHER INFORMATION
STOCKHOLDER PROPOSALS FOR 1999 ANNUAL MEETING OF STOCKHOLDERS
Any proposal of stockholders to be included in the Company's proxy statement
relating to the Company's 1999 Annual Meeting of Stockholders pursuant to Rule
14a-8 under the Exchange Act must be received by the Company at its principal
executive offices no later than November 15, 1998; such proposal must also
comply with Rule 14a-8 if the proposal is to be considered for inclusion in the
Company's proxy statement for such meeting. The Company must receive notice of
any stockholder proposal to be brought before the meeting outside the process of
Rule 14a-8 at the Company's principal executive offices not later than January
20, 1999.
PROMOTION OF ANDREW F. JACOBS TO EXECUTIVE VICE PRESIDENT
On August 11, 1998 the Company announced that Andrew F. Jacobs has been promoted
to Executive Vice President - Finance, Treasurer and Secretary. In this
promotion, Mr. Jacobs is assuming the responsibilities of Treasurer and
Secretary previously held by Julie Moore who is retiring after her maternity
leave.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K:
(a) Exhibits: The following Exhibits are presented herewith:
Exhibit 11 -- Computation of Earnings Per Share for the Quarter and Six
Months Ended June 30, 1998 and 1997.
Exhibit 12 -- Computation Ratio of Earnings to Combine Fixed Charges
and Preferred Stock Dividends.
Exhibit 27 -- Financial Data Schedule (electronic filing only).
(b) Reports on Form 8-K: None.
-24-
<PAGE> 25
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CAPSTEAD MORTGAGE CORPORATION
Date: August 11, 1998 By /s/ RONN K. LYTLE
------------------------------------
Ronn K. Lytle
Chairman and Chief Executive Officer
Date: August 11, 1998 By /s/ ANDREW F. JACOBS
------------------------------------
Andrew F. Jacobs
Executive Vice President - Finance,
Treasurer and Secretary
-25-
<PAGE> 26
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NUMBER EXHIBIT
- ------- -------
<S> <C>
EX 11 Computation of Earnings Per Share for the Quarter and Six
Months Ended June 30, 1998 and 1997.
EX 12 Computation Ratio of Earnings to Combine Fixed Charges and
Preferred Stock Dividends.
EX 27 Financial Data Schedule.
</TABLE>
<PAGE> 1
EXHIBIT 11
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
COMPUTATION OF NET INCOME PER SHARE
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
QUARTER ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
-------------------------- -------------------------
1998 1997 1998 1997
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
BASIC:
Average number of common
shares outstanding 61,168 49,231 60,385 47,736
Net income (loss) $ (268,132) $ 39,671 $ (233,062) $ 77,059
Less cash dividends paid on
convertible preferred stock:
Series A ($0.40 per share) (151) (173) (310) (353)
Series B ($0.315 per share) (5,438) (6,490) (10,834) (13,509)
---------- ---------- ---------- ----------
Net income (loss) available to
common stockholders $ (273,721) $ 33,008 $ (244,206) $ 63,197
========== ========== ========== ==========
Basic net income (loss)
per common share $ (4.47) $ 0.67 $ (4.04) $ 1.32
========== ========== ========== ==========
DILUTED:*
Average number of common
shares outstanding 49,231 47,736
Assumed conversion of convertible preferred stock:
Series A 908 924
Series B 15,472 16,052
Incremental shares calculated
using the Treasury Stock
method 1,005 1,063
---------- ----------
66,616 65,775
========== ==========
Net income $ 39,616 $ 77,059
========== ==========
Diluted net income (loss)
per common share $ (4.47) $ 0.60 $ (4.04) $ 1.17
========== ========== ========== ==========
</TABLE>
* AS PREFERRED SHARE CONVERSIONS ARE ANTI-DILUTIVE IN CALCULATING NET INCOME
PER COMMON SHARE FOR 1998, DILUTED EARNINGS PER SHARE IS THE SAME AS BASIC
EARNINGS PER SHARE FOR THE 1998 PERIODS PRESENTED.
<PAGE> 1
EXHIBIT 12
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
COMPUTATION OF RATIO OF EARNINGS TO COMBINED
FIXED CHARGES AND PREFERRED STOCK DIVIDENDS
(IN THOUSANDS, EXCEPT RATIOS)
(UNAUDITED)
(a) Computation of ratio of earnings to combined fixed charges and preferred
stock dividends (including CMO debt):
<TABLE>
<CAPTION>
SIX YEAR ENDED DECEMBER 31
MONTHS ENDED ----------------------------------------------------------------------
JUNE 30, 1998 1997 1996 1995 1994 1993
------------- ---------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C>
Fixed charges $ 379,268 $ 633,845 $ 598,312 $ 584,137 $ 474,844 $ 491,076
Preferred stock dividends 11,144 25,457 36,356 39,334 38,876 38,592
---------- ---------- ---------- ---------- ---------- ----------
Combined fixed charges and
preferred stock dividends 390,412 659,302 634,668 623,471 513,720 529,668
Net income (loss) (233,062) 159,926 127,228 77,359 85,579 94,256
---------- ---------- ---------- ---------- ---------- ----------
Total $ 157,350 $ 819,228 $ 761,896 $ 700,830 $ 599,299 $ 623,924
========== ========== ========== ========== ========== ==========
Ratio of earnings to combined
fixed charges and preferred
stock dividends 0.40:1 1.24:1 1.20:1 1.12:1 1.17:1 1.18:1
========== ========== ========== ========== ========== ==========
</TABLE>
(b) Computation of ratio of earnings to combined fixed charges and preferred
stock dividends (excluding CMO debt):
<TABLE>
<CAPTION>
SIX YEAR ENDED DECEMBER 31
MONTHS ENDED ----------------------------------------------------------------------
JUNE 30, 1998 1997 1996 1995 1994 1993
------------- ---------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C>
Fixed charges $ 217,515 $ 352,348 $ 283,974 $ 223,751 $ 139,188 $ 80,923
Preferred stock dividends 11,144 25,457 36,356 39,334 38,876 38,592
---------- ---------- ---------- ---------- ---------- ----------
Combined fixed charges and
preferred stock dividends 228,659 377,805 320,330 263,085 178,064 119,515
Net income (loss) (233,062) 159,926 127,228 77,359 85,579 94,256
---------- ---------- ---------- ---------- ---------- ----------
Total $ (4,403) $ 537,731 $ 447,558 $ 340,444 $ 263,643 $ 213,771
========== ========== ========== ========== ========== ==========
Ratio of earnings to combined
fixed charges and preferred
stock dividends (0.02):1 1.42:1 1.40:1 1.29:1 1.48:1 1.79:1
========== ========== ========== ========== ========== ==========
</TABLE>
Note: Because of the loss on portfolio repositioning recorded in the second
quarter of 1998, earnings were inadequate to cover combined fixed
charges and preferred stock dividends both including and excluding CMO
debt. Earnings of $233 million would be required to restore these
ratios to 1:1.
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM CAPSTEAD
MORTGAGE CORPORATION'S QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED JUNE
30, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL
STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> JUN-30-1998
<CASH> 13,636
<SECURITIES> 0
<RECEIVABLES> 0
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 0
<PP&E> 0
<DEPRECIATION> 0
<TOTAL-ASSETS> 11,089,850
<CURRENT-LIABILITIES> 6,037,328
<BONDS> 4,348,652
0
198,444
<COMMON> 616
<OTHER-SE> 504,810
<TOTAL-LIABILITY-AND-EQUITY> 0
<SALES> 0
<TOTAL-REVENUES> 253,527
<CGS> 0
<TOTAL-COSTS> 0
<OTHER-EXPENSES> 107,321
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 379,268
<INCOME-PRETAX> (233,062)
<INCOME-TAX> 0
<INCOME-CONTINUING> (233,062)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (233,062)
<EPS-PRIMARY> (4.04)
<EPS-DILUTED> (4.04)
</TABLE>
