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Executives

Kelly Sargent – IR Manager

Andy Jacobs – President and CEO

Robert Spears – EVP, Director of Residential Mortgage Investments

Analysts

Steve DeLaney – JMP Securities

Gabe Poggi – FBR Capital Markets

Mike Taiano – Sandler O'Neill

Matthew Howlett – Macquarie

Bose George – Keefe, Bruyette, Woods

Henry Coffey – Sterne Agee

Capstead Mortgage Corporation (CMO) Q1 2010 Earnings Call Transcript April 29, 2010 9:00 AM ET

Operator

Greetings, and welcome to the Capstead Mortgage Corp. first quarter 2010 earnings conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Kelly Sargent, Manager, Investor Relations for Capstead Mortgage Corp. Thank you, Ms. Sargent, you maybe begin.

Kelly Sargent

Thank you, Rob. Good morning. Thank you for attending Capstead's First Quarter 2010 Earnings Conference Call. Starting off today's call is Andy Jacobs, our President and CEO.

The first quarter 2010 earnings press release was issued yesterday, April 28th. The press release is posted on our website at Capstead.com. The link to this webcast is in the Investor Relations section of our website, and an archive of the webcast will be available for 60 days. A replay of this call will be available through May 13th, and details for the replay are included in yesterday's release.

As always, please remember our standard disclaimer about forward-looking statements. The remarks made today will contain forward-looking statements and information based on management's current expectations. The statements are being made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

Such forward-looking statements are subject to certain risks, uncertainties and assumptions. Information about the potential risk factors that could affect Capstead's financial results are available in yesterday's press release and are also in the Risk Factors section and the forward-looking statements section of our filings with the SEC.

The information contained in today's call is current as of date of today's call, January 28, 2010. The company assumes no obligation to update any statements, including forward-looking statements, made during this call.

With that, I will turn the call over to Andy.

Andy Jacobs

Good morning and welcome to our First Quarter 2010 Earnings call. As usual, I am joined by Robert Spears, our Portfolio Manager, and Phil Reinsch, our CFO, both of whom will be available for questions after my opening remarks.

For the first quarter, net income totaled 40.4 million, or $0.51 per diluted common share. Our net interest margins declined 2 million to 44.7 million for the quarter, primarily as a result of higher investment premium amortization associated with the Freddie Mac buy-out of seriously delinquent loans, which were included in our March runoff.

Financings spreads for the quarter declined 7 basis points to 214 basis points. As a result, on our yields on our interest-earning assets declined 51 basis points to 2.99%, primarily reflecting higher premium amortization during the quarter from the higher portfolio runoff.

And interest rates in our interest-bearing liabilities declined 44 basis points to 85 basis points, reflecting the low current interest rate environment – short-term interest rate environment, and the expiration – the benefits from the expiration of 1.7 billion in relatively high interest rate swap positions since November of 2009.

At March 31, the company's borrowings under repurchase arrangements consisted of 7 billion, primarily 30-day borrowings with 18 counterparties at an average rate of 23 basis points. Additionally, we had swapped out a good portion. We had 2.8 billion in notional two-year swap agreements with average maturities of 17 months and an average fixed rate of 1.34%.

After the expiration of 200 million in relatively high-rate swap positions in the second quarter of this year, most of our remaining swaps will be closer to current swap levels.

Regarding the portfolio, runoff for the first quarter totaled 764 million, which was heavily concentrated in our Freddie Mac portfolio as Freddie completed its buyout program of serious delinquent loans. In large part, because of uncertainties surrounding the extent of timing of the agency's buyout program, we only partially replaced portfolio runoff during the quarter, and, overall, we had a 6.2% decline in our portfolio side.

Portfolio runoff, as a result of this, was 31.8% on an annualized basis during the quarter compared to 20.9% of the fourth quarter. And as a result of the Fannie Mae buyout program, which began in March and was reflected in April runoff is – Fannie Mae will be completed over the next few months, probably ending sometime in July. We expect elevated levels of mortgage prepayment during the second quarter and potentially early in the third quarter.

We ended the quarter at 7.6 billion portfolio of almost exclusively residential ARM securities of which 85% were current reset ARM securities. Our portfolio leverage at quarter-end was 6.37 to 1 compared to 6.67 at year-end. And the duration of our assets and liabilities at the end of the quarter was nine months for the assets, seven and a quarter for the liabilities for a net duration gap of roughly one and three-quarters months.

Our book value from the end of the year declined 26 basis points as of March 31 to 11.77. Most of this was attributable to the higher portfolio runoff associated with the Freddie Macs during the quarter.

Looking forward, our borrowing costs should continue to benefit from those low short-term interest rate environments currently being orchestrated by the Federal Reserve. However, we anticipate lower portfolio yields over the next few months as Fannie Mae conducts this buyout program, which will lower our financing spread during the period.

Additionally, it may take until later this year to redeploy the capital made available from this surge in prepayments. But once this delinquency backlog is cleared, we expect mortgage prepayments and, hence, the investment premium amortization to moderate considerably, which should allow for a substantial recovery in portfolio yields and financing spreads later in the year.

Consequently, we anticipate earnings levels will decline during the second quarter before beginning to recover later in the year.

And, with that, Rob, I'll turn it over for questions.

Question-and-Answer Session

Operator

Thank you. We will be conducting now a question and answer session (Operator Instructions) Steve DeLaney, JMP Securities. Please proceed with your questions.

Steve DeLaney – JMP Securities

Hey good morning folks, how are you?

Andy Jacobs

Great. Good.

Steve DeLaney – JMP Securities

So, Andy, you were talking about partial portfolio replacement, and it looks like maybe you purchased about 250 million just in rough numbers? And I was wondering if Robert could comment on, you know, in terms of the replacement you did do, you know, what products did you focus on and what kind of net yields and spreads do you think on the margin you were able to achieve on the reinvestment that you did do in 1Q?

Robert Spears

Yes, Steve, we bought a little over 270 million. Most of that was earlier in the year, and we disclosed that those securities had a roughly 265 yield. The basis on them was just under 103. Obviously, set that point in time, prices have continued to go up, and yields have dropped in the ARM world. But most of those were bought earlier in the year.

Steve DeLaney – JMP Securities

Right, and those would be your short resets, so we should just – or offset, as far as cost of funds should pretty much just be repo, right?

Robert Spears

Yeah, pretty much. We look at it on an aggregate basis and it would include swaps in there and what not. But, yes, that's correct.

Steve DeLaney – JMP Securities

Okay, and then, Robert, since – you know, given – working with the book at 11.77, a bunch of companies have kind of commented that they were – I guess it was because just (inaudible) wide on a lot of stuff with the uncertainty about Fannie, but I've had people comment to me they didn't like their prices, their marks, that they got from the pricing services or at least they just thought they were not really reflective just because of the uncertainty in the market. Can you give us any color as we've gotten more clarity from Fannie, what has sort of been the price trend on the short ARMs and the seasoned hybrids subsequent to March 31?

Robert Spears

Sure, if you look at our book value and the numbers we break out our portfolio and just, generically speaking, during the first quarter, short reset securities were up about a half a point in price.

If you look at longer reset, new issue hybrids, they were up over a point. Our longer reset securities were down roughly – longer reset securities, in general, 6% type coupons, were down roughly three-quarters in price. And what transpired there was after the buyout news, you've got a lot of these securities that were trading well into the 106s that immediately dropped into the 104 to 105 area.

After you got through the buyouts, for instance, on the Freddie side, those 6% coupons gapped right back up to where they were trading before well into the 106s. And so the higher coupon Fannies haven't recovered as much yet. They are back now to the 105, 105.5 area, but you did have some sloppiness in that sector, and you continue to have that as people anticipate buyout. And you did have some dealers that were capping those prices at levels that weren't reflective of where the bonds were traced. So I would concur with that.

But basically you're talking about bonds that were trading low-to-mid 106s that dropped down into the 104, 105 area. As you get the buyouts out of the way, they are trading back into the 106s again. So a lot of those securities have already moved back up in price post-quarter-end.

Steve DeLaney – JMP Securities

And how about your short stuff? At quarter-end?

Robert Spears

I would say generically in ARMs, since the end of the third quarter, most ARMs are up 8 to 12.36 [ph] since quarter-end.

Steve DeLaney – JMP Securities

Okay. So about a quarter to a third of a point.

Robert Spears

Yes, a quarter to three-eighths, right.

Steve DeLaney – JMP Securities

All right. Got it. Thanks so much for the color.

Operator

Thank you. Our next question is from the line of Gabe Poggi of FBR Capital Markets. Please proceed with your questions.

Gabe Poggi – FBR Capital Markets

A few questions for you – Andy, you commented that it might take a you are going to put that money back to work – you get big 2Q prepayments. Is there a specific – I know you can't comment specifically but at what rate do you expect to put that back to work in terms of your leverages come down?

Do you expect leverage to tick down again because of the high prepays in 2Q, kind of, and bleed that into 3Q? I'm just trying to get an idea of how you intend to replace what's runoff and at what rate and if there is a target rate or if there is an ability to – if there are more opportunities would that be faster, obviously, than what we saw in the first quarter?

Andy Jacobs

Yeah, I will let Robert answer that but, obviously, it's going to be the relative value of the assets that we see. But, yes, if there is an opportunity, we will add more and get there quicker. But, you know, in this market, it's hard to see that coming. But, Robert – ?

Robert Spears

Yeah, sure. I mean, the issue right now is you're going to have about probably 50 to 60 billion in ARMs taken out of the market due to buyout. I think the total – the outstanding issuance of agency ARMs is about 380 billion right now. And so if you look at the first quarter, you've got 15 billion in new issuance.

So you've got negative issuance at a fairly decent clip right now, and if you just walk that forward and assume you've got 15 billion a quarter being produced, you really don't replace that negative supply in the marketplace until the latter part of this year.

And because of that, you have a lot of guys that are under-invested right now, and it's kind of a one-way trade where everybody is trying to buy short-duration securities. And so rather than chase that, we want to be judicious in our approach and look for value. And if we, kind of, we don't think we can earn mid-teens on those assets at realistic speed assumptions, we're not going to buy assets just for the sake of replacing our runoff in a two-month period or something like that.

And so I just think it makes sense to stretch it out and see what's out there and look for value and be smart when you buy bonds.

Gabe Poggi – FBR Capital Markets

Okay, and then a follow-up – have you thought about – I know you're heavy, obviously, the strategy is maintain a very short net duration. Have you guys thought about maybe putting some longer duration paper in there, or is it a constant kind of feel-on short duration is where you want to be?

Robert Spears

Well, I mean, we look at everything, and you never say never but, for the most part, if we've kept a short duration for most of this – the last few months – to extend that now – you know, I don't know how long the Fed is going to keep funds down around zero or whatever, but to extend your duration dramatically when, in all likelihood the next – well the next move is going to be up and raise, we just don't know when. But to do that now, I don't think it makes a whole lot of sense. And I am just not saying we won't buy a bond that is greater than 15 months to roll or whatever.

We look at everything. But I don't see it extending our duration materially anytime soon.

Gabe Poggi – FBR Capital Markets

Okay, thanks.

Operator

Thank you. Our next question is from the line of Mike Taiano with Sandler O'Neill. Please proceed with your questions.

Mike Taiano – Sandler O'Neill

Hi, good morning. Just hitting on the short duration versus long duration question – so, I mean, obviously, you had a significant runoff on the longer to reset side. So is it your expectation that you won't see that balance come back into balance anytime soon? It's mostly going to stay on the short side?

Robert Spears

Yes, I think we're, like, 85.15% long, short resets up. Long rest right now, I don't see it drifting much, much higher than that.

Mike Taiano – Sandler O'Neill

Okay, and since that's the case, would you expect your swaps as a percentage of repo to decline over the course of the year?

Robert Spears

I think we'll keep our duration gap pretty close to where it is now and so we're just under two months. And so I think we'll be pretty close to that. I think we have 200 million swaps maturing in July.

Outside of that, most of our swaps are out into 2011 and 2012. So we'll just kind of manage it in the context of the overall portfolio, keep our duration gap probably closer to two to three months.

Mike Taiano – Sandler O'Neill

Okay. And just curious, you raised about 10 million in capital through your ATM program. Was that just done at the beginning of the quarter? I'm just curious as to why you would raise it at all given all the excess cash you have coming in and the reduction in leverage?

Andy Jacobs

I think the challenge there was with the announcement by the agencies of the buyout program. There was just a lot of uncertainty and even – I think everybody in our peer sector had been carrying a very substantial amount of liquidity at year-end. And I think every one of us was very glad we had every penny we did.

And I think people were just being careful, and we actually raised this capital through our continuous offering at the latter part of the quarter. Just in anticipation – you know, looking at what could happen and just wanting to belt-and-suspender your liquidity to make sure that you didn't have any challenges.

Mike Taiano – Sandler O'Neill

Oh, because of the timing of the – ?

Andy Jacobs

Right. Yeah, it's not good to be unlucky with something like that were to hit you wrong. You better do everything you can to make sure you have no issues. I think for the sector as a whole, I think everybody fared fairly well.

Mike Taiano – Sandler O'Neill

Yeah, yeah. And just a last question – you gave some guidance in terms of the portfolio and that it will take some time to redeploy. How should we think about that, though, and would you expect by the end of the year to be back to sort of portfolio levels of where you were at the beginning of the year? And I guess the answer probably will depend on what sort of prices you find, but just generally speaking, is that sort of where you expect to be?

Robert Spears

Yeah. I mean, I think that's kind of what we said we'd like to have all of the runoff replaced by year-end. That would be our goal at a minimum.

Mike Taiano – Sandler O'Neill

Okay, that’s helpful, thanks.

Operator

Thank you. (Operator Instructions) our next question is from the line of Matthew Howlett with Macquarie. Please proceed with your questions sir.

Matthew Howlett – Macquarie

Thanks guys, thanks for taking my question. Just related to the buyouts – it's my understanding that Fannie, Freddie, they're not buying out delinquencies from post-reset ARMs or below 4% coupon. Is that still the case or did I read that wrong?

Andy Jacobs

Well, Freddie is not buying out lower coupons. Fannie, in their press release, did not indicate that they are following the same path. And so we're assuming we're going to get some buyouts on our low coupons as well.

They posted delinquency information by vintage for lower coupons whereas Freddie did not. And so we're going under the assumption right now that Fannie will be buying out lower coupons unlike Freddie.

Matthew Howlett – Macquarie

Okay, so the speed increase this quarter was just on the hybrids, the higher coupon Freddie hybrids and really nothing else?

Andy Jacobs

For the most part, yes.

Matthew Howlett – Macquarie

Okay, and you are assuming Fannie has it – would there be upside if Fannie doesn't touch the post-reset ARMs?

Andy Jacobs

Oh, sure. There would be a lot of upside if that happened.

Matthew Howlett – Macquarie

Okay, great, so we'll be watching that. And then, of course, going forward, they're going to continue to buy out delinquency. So do you have indications or what new delinquent inventories is going to come in? Or is anything – you said the speeds are going to normalize. Do you think that will have much of an impact going forward? Any new delinquent inventory coming in?

Andy Jacobs

From everything we are reading and hearing, it looks like delinquencies are kind of leveling off. And I think, at that margin, speed will get back down to very reasonable levels. I think they'll be a little faster than they were, say, eight or nine months ago because you're still going to have some issues with HAMP modifications. They're just being more – they are expediting the buyout process.

So I think we're going to be running at speeds a little faster than what we considered normal six or eight months ago. But it doesn't look like delinquencies are continuing to rise at a rapid cliff. It looks like they're leveling off.

Matthew Howlett – Macquarie

Right, right, and I would agree. And then just, again, on the topic of leverage – I think at 6.3, you're the lowest I think you've ever been in the history of the operating company, and I could be wrong on that. But when you look at if there was an opportunity to go out and take down a lot of assets really quickly, what do you see now, optimal leverage, which are haircuts? Has volatility picked up with the government backing out? I mean, what are you seeing on the repo front? And are we assuming 8 to 9 times, you know, in there you could go comfortably without raising additional capital?

Andy Jacobs

It's hard to put an exact number on it, but I would definitely say that we're – like you said, we're at a very low level. Could we take our book up to 8 times leverage? Yes. Will we anytime soon? That's a different question, but I think we could.

And we've got there the live liquidity on the repo side. The biggest issue right now is not overpaying for assets.

Matthew Howlett – Macquarie

Right, exactly.

Robert Spears

Matt, Street haircut levels haven't come back down to the levels we saw in 2006, 2007. That's a governor on leverage the people can use.

Matthew Howlett – Macquarie

So roughly 5% as opposed to 2.5% to 3.5%, sort of that area?

Robert Spears

Yes, that's fair.

Matthew Howlett – Macquarie

Okay, great guys. Thank you.

Operator

Thank you. Our next question is from Bose George of Keefe, Bruyette, Woods. Please proceed with your question.

Bose George – Keefe, Bruyette, Woods

Hey good morning guys.

Andy Jacobs

Good morning.

Bose George – Keefe, Bruyette, Woods

I had a question just one where prepayments – you know, what happened with prepayments in April relative to last quarter? And also is there any way we could – do you have an estimate of where the Fannie prepayment number could come in this quarter?

Andy Jacobs

We haven't made any disclosures relative to how April factors impacted Capstead. But Robert can probably speak generally about Fannie factors that came out.

Robert Spears

Yeah, I think the biggest surprise as far as ARMs go on the April factors generically, it looked like Fannie drew a line in the sand that said they were buying out 6.5 and higher securities and half [ph] modified loans. And looking at 6% IO ARMs, between 6 and 6.5 coupons, those speeds were significantly faster than most people expected, which tells you that that hard line they drew in the sand with a 6.5 coupon may have been breached.

And I think it may have something to do with looking at the gross mortgage rate of the underlying mortgages. And so you have more coupon dispersion in ARMs than you do fixed rate passthroughs. So it looks like 6% ARMs, that 6% to 6.5% ARMs that you would have expected to show up in May prepay, showed up in April.

And so there's still a lot of uncertainties around these buyouts is exactly what they're doing. And I think that was the biggest surprise for ARM investors. It didn't look like that 6.5 coupon was the ultimate governor on what was bought out of our pools.

And so, really, we're not going to know exactly – it's going to be three or four months before we see the dust settle. So that is my comment as far as ARM prepayments in April. It was kind of surprising. So I think, generically, ARM speeds were a little faster than expected. It looks like fixed rate securities were pretty much dead on, and you don't have as much loan coupon addressed [ph] on fixed rate securities as you do on the ARM.

Bose George – Keefe, Bruyette, Woods

Great, thanks. And just in terms of when they get around to the lower coupon hybrids, is that towards the end of the quarter or potentially into the third quarter?

Robert Spears

Well, yeah, I mean, I think when they – Fannie released their schedule, and they were starting with 6.5 coupons in month 1, 6 in month 2, 5s and up in month 3, and then everything else in month 4 is the way they disclosed it. So we're just assuming that's kind of what they're going to follow.

Bose George – Keefe, Bruyette, Woods

Okay great. Thanks a lot.

Operator

Thank you. Our next question is from the line of line of Henry Coffey with Sterne Agee. Please proceed with your questions, sir.

Henry Coffey – Sterne Agee

I know you’ve given us an awful lot of detail on the portfolio and, obviously, it looked like all the book value growth and whatever net gain there was and assets occurred in the short reset portion of the business, which is obviously everyone's favorite. What were the respective yields realized in both portions of the business? I know we have got the WACs on both, but I was wondering if you could help us – ?

Robert Spears

Yeah, we don't actually break that out.

Henry Coffey – Sterne Agee

Right, whatever you're comfortable with. And also what were kind of the reinvestment rates on that portion of the business?

Andy Jacobs

Well, I mentioned I disclosed it. Earlier in the year, we bought about 270 million in securities at roughly a 2.65 yield. So that's in the press release.

Henry Coffey – Sterne Agee

Is that where the business is today or –?

Andy Jacobs

I think, since that point in time, prices are higher, and yields are lower, which is another reason why we're not just chomping at the bit to be loading up on bonds right now.

Henry Coffey – Sterne Agee

Okay.

Robert Spears

Henry, if you look at the last page of the press release, we do break out our current longer resets with net WAC, fully indexed WAC, et cetera. From there you can get some sense of how they're yielding. And that's about the only thing we have.

Henry Coffey – Sterne Agee

Will do that. Thank you very much.

Robert Spears

You bet.

Operator

Thank you. There are no further questions at this time, I would like to turn the floor back to management for closing comments.

Kelly Sargent

Thanks again for joining us today. If you have further questions, please give us a call, and we look forward to speaking with you next quarter.

Operator

And this concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

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