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Operator

Greetings. Welcome to Capstead Mortgage Corporation (NYSE:CMO) Fourth Quarter 2011 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. If anyone should require operator assistance during the conference, please press *0 on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Kelly Sargent, manager, Investor Relations. Thank you, Ms. Sargent. You may begin.

Kelly Sargent, Investor Relations, Capstead Mortgage

Thank you Rob. Good morning. Thank you for attending Capstead's fourth quarter 2011 earnings conference call. The fourth quarter 2011 earnings press release was issued yesterday afternoon, February 1. The press release is posted on the website at www.capstead.com. The link to this webcast is in the investor relations section of our website and an archive of the call will be available for 60 days. A telephonic replay of this call will be available through March 2. Details for the replay are included in yesterday's earnings release.

Starting off today's call is Andy Jacobs, our President and CEO. But before we get started, I want to remind you that some of today's comments could be considered forward-looking statements pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, and are based on certain assumptions and expectations of management. For a detailed list of all the risk factors associated with our business, please refer to our 2010 Annual Report on Form 10-K and our 2011 quarterly reports on Form 10-Q, which are available on our website under the investor relations section, SEC filings. The information contained in this call is current only as of today's date, February 2, 2012. The company assumes no obligation to update any statements, including any forward-looking statements made during today's call. With that, I will turn the call over to Andy.

Andy Jacobs, President & CEO of Capstead Mortgage

Well, good morning, and also I'll give my welcoming for the fourth quarter 2011 earnings call. As usual I'm 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 operating results for the fourth quarter, net income totaled $42 million, or 43 cents per diluted common share, and we paid a common dividend of 43 cents on January 20, 2012. Net interest margins for the quarter increased slightly to $46 million, while our total financing spread declined one basis point to 1.46%. Yields on the company's interest-earning assets averaged 2.07%, representing a five basis point decline over the previous quarter. If you look at that decline relative to what this decline was from the second quarter to the third quarter; in the third quarter this yield declined 22 basis points, so it's a 22 in the third quarter versus a five basis point decline in the fourth. So, this smaller decline in yields reflects the smaller declines in the coupon interest rates in the mortgage loans that reset during the quarter, and this is primarily the result of higher prevailing indexes on the six-month and twelve-month LIBOR, which is the basis for coupon resets on much of our portfolio.

Yields also benefited from lower levels of mortgage prepayments during the quarter, which declined to an annualized CPR of 15.6% in the fourth quarter, from 16.9% in the previous quarter. In our previous earnings releases, we discussed how prepayment on our more seasoned securities continued to be suppressed by low housing prices and credit problems being experienced by many of these borrowers, while prepayment on newer originations remained somewhat elevated. Both of these factors continue to be correct, proved to be correct in the fourth quarter and are continuing.

Interest rates on the company's interest-bearing liabilities averaged 51 basis points for the fourth quarter, representing a four basis point decline from the previous quarter. This reflects the expiration of that $1.3 billion in the last six months of some higher rate swap agreements. Those were replaced primarily with much lower levels than what we previously had. The benefits to that, however, were a bit muted by higher borrowing rates on our repos in the fourth quarter, largely due to the European sovereign debt issues.

Regarding the portfolio, I would like to discuss what we believe is a fundamental difference between our investment portfolio and those of our peers, which is our focus on investing entirely in ARM [adjustable-rate mortgage] securities. At year end, 72% of our portfolio was invested in ARM securities backed by loans that will reset in less than 18 months, typically to a lower level in today's environment.

Looking at the portfolio as a whole, the average borrower underlying our securities has an average mortgage coupon rate of a relatively low 3.53%. Basically, you can arrive at this number if you take the weighted average coupon we disclosed on page 11 in our press release and add about 60-70 basis points for servicing fees and guarantee fees so that you get to what the homeowner rate is. As a result, most of the borrowers in our portfolio lack the ability to meaningfully lower their monthly mortgage payments even if they can overcome the other impediments that we mentioned earlier. For these reasons we expect prepays to remain largely in check in 2012.

Portfolio acquisitions during the quarter were $612 million, which offset portfolio runoff of $580 million, increasing our investment portfolio to $12.26 billion at year end. Also at year end the duration of our investment portfolio stood at 9 ¾ months, while the duration of our liabilities was six months, resulting in a duration gap of 3 ¾ months, and during the period our leverage at year end declined slightly to 8.1 times our long term investment capital. During the fourth quarter we were able to raise $42 million through our previous capital raises and we ended the quarter with total long term investment capital of $1.39 billion, and book value ticked up slightly from $12.50 to $12.52.

I think, in summary, we've mentioned in previous earnings releases that we felt the lackluster performance of the economy and the global economic headwinds, we said, were likely to keep interest rates low for some time. The FOMC's recent announcement that economic conditions are likely to warrant exceptionally low levels of Fed funds through 2014 confirmed our views. As a result, we anticipate yields on our current reset ARM securities will trend modestly lower as coupon interest rates on the underlying loans mortgage loans continue resetting to more current rates, while our borrowing rates, which declined in January to this point from higher levels experienced in the third, in the fourth quarter; we expect these borrowing rates will remain relatively low with declining hedging cost providing some offset to our lower portfolio yield. And at this point I will open it up for questions.

Operator

Thank you. We will now be conducting the question and answer session. If you would like to ask a question, please press *1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press *2 to remove your question from the queue. Participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please while we poll for questions.

Thank you. Our first question is from the line of Jason Weaver of Sterne Agee. Please proceed with your question.

Jason Weaver, Sterne Agee

Hi, good morning guys and thanks for taking my question. In line with what you said regarding the interest rate environment and your expectations for yields going forward, would you say that using a higher leverage ratio would be an offset you might use to preserve your portfolio ROE?

Capstead Mortgage

I think if you look at where spreads are in the market right now on new purchases, we still think we can generate mid-teen size returns with leverage close to current levels, in the 8-8 ¼ levels, and we don't foresee a meaningful increase in leverage anytime soon.

Jason Weaver, Sterne Agee

Fair enough. And in sort of follow-up to that, out of the portion of the portfolio that's listed under current reset ARMs, how much of that would you say has already reset to lower coupon rates over the past six months? Has it been substantially all of it or do we have more to come along?

Capstead Mortgage

If you look at page 11, the current reset ARMs, the bulk of those have reset at least once. The only ones, if you look at the Freddie Mac agency securities that have a slightly higher net WACC of 3.22%, you have some securities in there that have not reset, but they'll be resetting in the next twelve months, which kind of makes sense; that's why that coupon is a little higher than the rest of our current reset ARMs.

Jason Weaver, Sterne Agee

Okay, thank you very much.

Capstead Mortgage

Sure.

Operator

Thank you. Our next question is on the line of Bose George with KBW. State your question.

Bose George, Keefe Bruyette & Woods

Hey guys, this is Bose. Just a follow-up to that, the incremental spreads, I just wanted to get a feel for where they are based on your hedging mix.

Capstead Mortgage

On new purchases?

Bose George, Keefe Bruyette & Woods

Yeah, on new purchases.

Capstead Mortgage

Yeah, I think, Bose, right now, if you look at what's happened post-Fed and where securities in general are trading, I would say most of the ARMs that we look at, shorter ARMs out to 5/1, yields are anywhere from 1 ½ to 2%. Yields have come down. I mean, you now have 15 year fixed rate pass-throughs that are trading sub-2%, but at the same time you have two and three year swaps running in the 50 basis point area, and if you look at repo rates in the upper 20s on a blended basis, I think we're looking at 150 or 160 basis points in spread. That's kind of what we're shooting for, and at our current leverage ratio we're very happy with the returns that we'll generate.

Bose George, Keefe Bruyette & Woods

Okay, great. And then I just wanted to discuss HARP [Home Affordable Refinance Program]. I was just curious for any updated thoughts on how your portfolio's positioned relative to that.

Capstead Mortgage

Yeah, I think HARP is pretty much a non-event for our portfolio. I mean, they pretty much have ruled out ARMs from the HARP program for the most part, right? They're capping the LTV at 105%, you can't do an interest-only refinance, and if you look at the underlying mortgage rate, on our ARM securities, a gross rate of 3-3 ½%, that borrower is not incented to go into a 30 year fixed rate or a 15 year fixed rate where his payment's going to be higher, so for the most part, we do have some, a very small percentage of higher coupon ARMs that we were talking about earlier in our Freddie Mac bucket, but those reset in the next six to twelve months, so HARP is pretty much a non-event for us, as far as we're concerned.

Jason Weaver, Sterne Agee

Okay, great, thanks.

Capstead Mortgage

Sure.

Operator

Our next question is from the line of Steve Delaney of JMP securities. Please proceed with your question.

Steve Delaney, JMP Securities

Thank you. Good morning everyone. Robert, we noticed the fair value, I guess the average fair value price as a percentage of principal value really didn't change much from September 30 to December, right around 104.8%. We had maybe expected a slight increase, especially in the short ARMs for the reason you said, that we thought those that had already reset down close to 3% wouldn't be impacted very much by HARP, but it looks like maybe the short ARMs were up a touch but the higher coupon seasoned hybrids lost a little value. Is that a fair assessment of what you saw in the fourth quarter?

Capstead Mortgage

Yes, that's a fair statement. I think that for the most part generically short reset securities lost roughly a quarter of a point or so and the longer reset that we have, the phenomenon we are seeing in that market is that as those securities season and speeds ramp up a little bit you're actually seeing slight deterioration in those prices, and also part of the difference too, if you think about it, we have roughly $600 million that ran off in the fourth quarter, and we had a roughly two point gain in those bonds, so that's $12 million, and divide that by the share count, that theoretically, that's another reason why value didn't go up as much as you might expect.

Steve Delaney, JMP Securities

Good point, yeah. Basically the runoff of the appreciated bonds.

Capstead Mortgage

Exactly.

Steve Delaney, JMP Securities

So, could you give us a little color, Robert, on price trends? I mean, most of the agency MBS universe is up pretty strongly with this bond rally, but in your specific corner of the world with short duration ARMs, what you're seeing in terms of price trends so far in the month of January here.

Capstead Mortgage

Well, I'd say generically very short reset securities are up around a quarter of a point. If you look at new issue 5/1s they're up about a half a point in price, and the further you go out the curve, if you get out into, not that we traffic in those, but 10/1s, 15 year passthroughs and 30 year passthroughs, lower coupons, they're up as much as a point there. But in the space we traffic in most securities are up anywhere from a quarter to half a point.

Steve Delaney, JMP Securities

Right. One final thing going back to Andy's comments trying to explain why HARP is, and I think you added to that too, a non-event for you, could you tell us what percentage of your ARMs generally are interest-only? Because it would seem that now that 30 year quotes are coming down below four and 15 year quotes just a little over 3, you're almost getting to the point where you could get a 15 year at close to the same loan pay rate as your reset ARM, but I think if you're not paying, if you're only paying interest then that principal, that probably adds, if you switch to an amortizing loan that's going to add a lot of payment.

Capstead Mortgage

Yes, we haven't disclosed that, but we do have a large percentage of our book that is interest-only, and you're exactly right in the point you're making. Those guys are kind of stuck, and the other thing I want to add about why we're somewhat positive on the prepayment front: If you look at what happened in the mortgage origination world recently, mortgage bankers aren't pricing in the full extent of this rally, and if anything, I was reading a piece yesterday about a fairly large originator that went out with a 30 year kind of no-cost type loan rate of 3 7/8 and got flooded and kicked it up to 4 ¼, so I still think you're looking at a four handle for a 30-year no cost, and kind of 3 ¼ for a 15 year no cost, and the payment differential for those guys that have interest-only loans with the same gross mortgage rate, they're going to end up paying more so they're not incented to refinance. But we do have a decent-sized chunk of interest-only ARMs.

Steve Delaney, JMP Securities

All right. Thanks a lot, gentlemen.

Capstead Mortgage

Sure.

Operator

Thank you. As a reminder, if you would like to ask a question, press *1 on your telephone keypad. The next question is from Jason Arnold of RBC Capital Markets. Please proceed with your question.

Jason Arnold, RBC Capital Markets

Hi, good morning guys. I was just curious, you commented on the yield pickup on the current resets from the higher six and twelve month LIBOR witnessed during the quarter. Is there any way to quantify sort of differential you were seeing on those resets?

Capstead Mortgage

Well, six month and one year LIBOR actually went up about 25 basis points in the fourth quarter. Now, obviously we have a percentage of our portfolio rolling every month, so in theory it would affect roughly two months of resets on our securities, but the one thing that you note, on page 11 we're much closer to the fully-indexed WACC and a lot of that is because of the elevated LIBOR indexes. Our net WACC on our short resets is 2.67% and fully indexed is 2.42%, so that implies only 25 basis points of downward reset and that's spread over a twelve-month period. And so if you do that and then look at the 28 percent of our longer resets where the coupons don't change you can kind of come up with an average of what our coupon drift should be on a quarterly basis. So really there's not a lot of drift in our portfolio anymore.

Jason Arnold, RBC Capital Markets

Okay, great, thanks for the color on that. And I guess there's just one additional follow-up. I was curious if you could talk about the difference you're seeing in prepayment speeds on the current reset side of your book versus the longer reset segments. I assume the current reset is perhaps paying a good deal slower than what the average is, but just curious about your perspective there.

Capstead Mortgage

Yes, if you generically look at a basket of those types of securities, the seasoned shorter-reset securities are prepaying in the low- to mid-teens, and the longer-reset securities with those type of coupon characteristics are in the low- to mid-twenties.

Jason Arnold, RBC Capital Markets

Perfect. Thanks so much for the color.

Capstead Mortgage

You bet.

Operator

Thank you. Ladies and gentlemen, once again as a reminder, to ask a question you may press *1 on your telephone keypad. Our next question is from the line of Matthew Howlett with Macquarie. Please proceed with your question.

Matthew Howlett, Macquarie Group

Hey guys, thanks for taking my question. I know you just said HARP, you didn't think would have much of an impact, but I guess Obama this week is talking about expanding HAMP, and I know a year or two ago you went through a delinquency cleanup and that had speeds artificially high for I think it was a month or two, but I guess the question is do you think you would be impacted by an expansion of the HAMP program?

Capstead Mortgage

No, I don't think so. Once again it goes back to, if you look at the book that we have, the higher coupon five-ish type securities that we have, it's a very small percentage of our portfolio now, and they all reset in the next few months. And Fannie and Freddie are cleaning up delinquent loans as you go, so we see those as normal prepayments anyway when they get 120 days, so once again I don't think that HAMP or HARP will have much of an effect on our book.

Matthew Howlett, Macquarie Group

Okay, great. And then just a follow-up on the issue with the SEC and the Investment Act, is there any more color on that? Has the SEC gotten back? Can you address that topic for a little bit?

Capstead Mortgage

Well, it probably won't take too long to address it. There is no new information. The SEC is not on any time schedule. They haven't set anything out publicly as to when they want to meet again. But we're actively reaching out. As everyone knows, November 7th had the response date for their concept release, and there was quite a number of us in the REIT sector as well as a group out of NAREIT that responded, and I think at least the NAREIT one was a very lengthy letter that we sent and I think they're still absorbing that and looking at where they want to take it. But we'll be reaching back out to them here, currently, but I don't have a whole lot of confidence that anything's going to move real fast. It would be nice to get some clarity to the market. I'm not worried about it; I think it's just a process we'll just have to let run its course.

Matthew Howlett, Macquarie Group

And do you think it's more likely they just let it go and just don't do anything, or they come back and say there needs to be some regulation in this industry like we're going to cap leverage at 12 turns and we're going to prohibit certain types of hedging? Is it more likely that or is it more likely they don't do anything and just let it go?

Capstead Mortgage

Well, I think the ability for them, for the SEC to come and put restrictions on like that, I don't think they have that ability. I think the Congressional intent was, back in the 40's, leading up to the '40 act creation, there was none of that. For them to be more restrictive and start adding stuff, I don't think that that's a likely solution. I think really in my mind the benefit to this is that we may get clarity, that we're going to understand more. I think they may make available more types of assets to us rather than less types. For one, they're coming up with ideas with the risk retention requirements of Dodd-Frank, they're coming up with different types of securities that will still be passthrough securities but they're not be whole-pool, which you know we have a certain percentage that's whole-pool. I think there's a legitimate chance that they will modernize their whole pools to partial pools where there's not much of a distinction. That's what I'm pushing for and I think that would be helpful to the industry. But I don't see them coming in with restrictions on leverage or whatever. All of our banks that we as an industry borrow from, those guys can control our leverage. You don't need the SEC to come up with some arbitrary number.

Matthew Howlett, Macquarie Group

Great, thanks Andy, appreciate it.

Capstead Mortgage

Welcome.

Operator

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

Kelly Sargent, Investor Relations, Capstead Mortgage

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

Operator

This concludes today's teleconference. You may disconnect at this time. Thank you for your participation.

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