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Capstead Mortgage Corp. (NYSE:CMO)

Q4 2007 Earnings Call

February 11, 2008 10:00 am ET

Executives

Bethany Siggins - VP, IR

Andy Jacobs - President and CEO

Phil Reinsch - CFO

Robert Spears - Director of Residential Mortgage Investments

Analysts

Steve Delaney - JMP Securities

David Hochstim - Bear Stearns

Mike Widner - Stifel Nicolaus

George Bose - KBW

Dan Weldon - Diamondback Capital

Matthew Howlett - Fox-Pitt Kelton

Operator

Greetings and welcome to the Capstead Mortgage Corporation's fourth quarter 2007 Earnings 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's now my pleasure to introduce your host, Ms. Bethany Siggins, Vice President, of Investor Relations. Thank you, Ms. Siggins, you may begin.

Bethany Siggins

Thanks Anthony. Good morning and thank you to everyone for joining us for Capstead's fourth quarter 2007 earnings conference call. Today's speakers are Andy Jacobs, our President and CEO; Phil Reinsch, our CFO; and Robert Spears, our Director of Residential Mortgage Investments.

We issued our fourth-quarter 2007 earnings press release Thursday afternoon, February 7, after market hours. The press release is on our website at www.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 the end of the day on Monday, February 25. The investor presentation referred in today's call is currently posted to our website.

Before we begin, I would like to remind you of our standard disclaimer about forward-looking statements. The remarks made today will contain forward-looking-statements and information based on management's current expectations, and these 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 the company's financial results, is available in the press release we issued on February 7th, and are also in the risk factors section and the forward-looking statements section of the company's filings with the SEC.

The information contained in this call is current only as of the date of this call, February 11th, 2008. The company assumes no obligation to update any statements, including forward-looking statements, made during this call.

Now, I will turn the call over to Andy.

Andy Jacobs

Thank you, Bethany. Well, the fourth quarter was a much better quarter from where we were in the third quarter of 2007, pretty much as expected. For the year, I think as everybody knows, being an agency securities REIT as we are, 99% of our portfolio is in Fannie, Freddie, Ginnie mortgage-backed securities. At the end of the year our portfolio was about $7.1 billion.

If you go to slide 4, and just a little definition here, the current-reset security and the longer-to-reset securities that you're seeing on this particular page, our portfolio, we invested in just eight loans. These are loans that are going to reset annually, or after a fixed period of five years or less. And, if the current-reset securities that we have are going to be reset over the next 18 months, we will be fine with the current-resets. If it is over 18 months, it will be longer to reset.

I think, looking at this particular page, the key features here are, up to a blend of about 50% of our portfolio comprising the longer-to-reset securities today. That's up from about 35% at the end of the third quarter. And the reason why we are up at this level is. as people here know. We did have the opportunity to enter the capital market a couple of times here in the fourth quarter. Most of the proceeds from those offerings were in the longer-to-reset securities, and so about 70% on a blend of the new capital we got in the fourth quarter went into the longer-reset securities, which moved the mix up to the 50-50 level.

The way we finance this portfolio is one of the key things that you need to understand. The current-reset security is financed with 30 day borrowings, and those are going to be borrowings that adjust within the next 30 days. So that portfolio will benefit from further rate cuts accordingly.

The longer-to-reset securities are financed with a combination of longer dated repo, and a portion of 30 day repo. But on the 30 day repo, we will enter into swap agreements today, to help mitigate the interest rate risk so that they function fairly, much like the longer dated repo.

On a net-net basis, what we continue to try to do is to manage the duration, the net durations, and perhaps that the liability tends to keep it between three to six months. I think currently, we have some in the five month level. It helps to understand that if the Fed is going to continue to lower interest rates, the current reset portfolio that has not been funded with 30-day paper will continue to benefit from that, and a portion of a longer-to-reset securities will continue to benefit from reductions in the Fed funds rate.

With that I'll turn it over to Phil.

Phil Reinsch

Thanks, Andy. If you turn to page 5 of the webcast, we've highlighted for you some of the key takeaways from our fourth quarter financial performance.

Our net interest margins on operating earnings increased significantly quarter-over-quarter, as our financing spread more than doubled to 93 basis points, and we grew our portfolio by $2.3 billion to about $7.1 billion at year end. Financing spreads benefited in a large part, from lower borrowing rates, with the Fed reducing its Fed fund target rates beginning in mid-September, by 100 basis points through the end of the year.

With these rate cuts, and despite some liquidity issues still impacting our market through year end, our borrowing rates declined on average, 38 basis points quarter-over-quarter, with the full benefit of the rate cuts still to come in the first quarter of 2008.

Yields increased to a more modest 13 basis points quarter-over-quarter, due to several factors, including favorable mortgage prepayment, some of our bonds still pricing up in yields, higher yields on acquisitions, particularly early in the quarter, and the sale in the third quarter of faster-prepaying lower-yielding bonds in connection with reducing our balance sheet leverage from about 11.5 times to 10 times.

Portfolio runoff rose significantly during the fourth quarter with an annualized rate of 24%. This reflects seasonal factors, but also national trends toward declining housing values, and tighter mortgage loan underwriting standards.

The growth in our portfolio reflects investing the proceeds from equity offerings during the fourth quarter as Andy alluded to. We raised $199 million in our October and November follow-on public offerings. Another $7 million was raised primarily in December, through our continuous offerings program. These offerings added a $1.11 to common share to our year-end book value, which increased the $1.68 during the quarter to $9.25. The rest of the increase in book value was primarily the result of higher pricing on our residential mortgage securities portfolio at year-end.

Subsequently at year-end we closed on another follow-on offering of 8 million shares at $15.50 per share on February 1st, and just this past Friday we closed on another 600,000 shares, representing one-half of the greenshoe from this offering. Together, after underwriting fees and expenses, this offering provided us with an additional $127 million in common equity capital.

Of course, you are all aware that Fed has cut rates, another 125 basis points in January, and could cut rates further in the coming months. To jump to the cumulative effect on our borrowing cost; from the 225 basis points in rate cuts thus far, we are anticipating a significant increase in our financing spreads in the first quarter, on a substantially larger portfolio. We'll get more into that later in the call.

If you turn to slide 6, our comparative income statement, I wanted to mention a couple of items. We did realize a $593,000 gain during the fourth quarter, from selling about a half of our small non-agency security portfolio, and from the sale back to Fannie Mae of one of their bonds at their request. We currently do not anticipate further asset sales in the coming quarters of any significant amount.

Other revenue during the fourth quarter was relatively high, reflecting high overnight investment balances, due in part to the fourth quarter capital raises, and some other small non-recurring items.

Turning to slide 7, our comparative balance sheet, a couple of items are worth mentioning. As Andy mentioned earlier, the portfolio additions during the fourth quarter allowed our portfolio to migrate to roughly 50/50 mix of current reset, and longer to reset ARM securities by yearend. Robert will provide some additional color on that a little later in the presentation.

Also, I want to point out that the first quarter, it looks as if we made some commercial loan investments, but what actually happened, and it's described in the footnote on this page, we purchased our joint venture partner’s 25% interest in the Redtail Capital joint venture that was previously reflected as an unconsolidated affiliate. Now, the JV sold loan, which is in runoff, is included in the gross on our balance sheet with the rest of our investment, and in some related financing, is included with our borrowings.

Turning to slide 8, this slide graphically depicts our long-term investment capital. Our long-term investment capital consists of $100 million of trust-preferred securities that are actually reflected as unsecured borrowings on our balance sheet. And $180 million of perpetual preferred equity and our common equity capital.

The trust preferred and perpetual preferred capital cost us roughly 10.3%, and provides us significant amount of leverage on our common equity that is very beneficial in the current interest-rate environment. And returns on our ARM securities portfolio are significantly north to the cost of preferred capital. This additional common equity leverages is an important differentiating point in comparing Capstead capital structure to those of our peers.

In the fourth quarter, with fourth quarter capital raises and improvements in the value of our portfolio, our investment capital increased, quarter-over-quarter by $231 million to $661 million by year-end. And after adjusting for these latest offerings that we just closed, our capital increased on pro forma basis, to $788 million today before consideration of other changes in portfolio valuation sequent to year-end.

Overtime, we may leverage our long-term investment capital anywhere from 8 to 12 times, depending upon a variety of factors. Although as you recall, we took our leverage down to about 10 times during the market disruption of the third quarter, and after deploying the fourth quarter capital raises, we ended the year at just over 9.8 to 1 leverage. We expect to maintain our leverage at approximately 10 to 1 in coming quarters, although we will temporarily lower as we deploy the recently raised capital.

Now I'll turn the discussion over to Robert.

Robert Spears

Thank you Phil. This slide covers our counterparties and sources of financing. As of year-end, we had repo position of about $6.5 billion on with 14 different counterparties. We still add $1.5 billion of longer-term repo, which had average maturity of 15 months. Our rate cuts in all of our shorter-term repo position doesn't maintain at 3 point.

We have excess capacity right now, and repo front, we have counterparties actively looking to increase their balance sheet with us right now. Our current reflective repo rate is around 3.15%, with [funds] at 3%, LIBOR roughly 3.13%. So, everything is very positive on the counterparties front right now, but as I mentioned earlier, we have a lot of excess capacity, and we will probably add a handful counterparties at the coming months.

If you go to the next slide, this was discussed earlier, what we did with the most recent capital in the fourth quarter, we bought approximately $2.7 billion of securities to lever up of the new capital to roughly 10 times. The mixture was 75% longer-reset, 25% shorter reset, which brought our aggregate book to just more the $7 billion with a 50-50 mix of shorter and longer reset securities.

Spreads went down in the fourth quarter, and we have some very attractive purchases, which ended up growing our spreads roughly 160 basis points. We are buying assets in the 560 yield area, and following them in the 4% area. We continue to maintain our duration gap of between three and six months, right now it's about five months.

If you think about it, from a mix of our liabilities, they are now about 40% longer-term. We are talking about a longer-term of 18 months and 60% shorter term. As our earnings release said, we had a $1.5 billion longer-dated repo, which roll off in 15 months and that starts coming along this year and as a matter of fact, that adds up to roughly 5%.

At year end we owned $900 million in swap at roughly 4%, and subsequently the year end, we put on another $600 million of interest rate swap at approximately 3%. So, we are going to maintain our leverage into the 10 times area, hedge our longer reset securities through a duration of about year and quarter, and keep our duration gap at between three and six months.

The most recent capital acted yields have obviously dropped as funds costs have come down, but the spread is still very attractive. We are looking at deploying the capital with interest spreads of around a 125 basis points.

Right now, yields on assets are between 4.25 and 4.5%. We are funding Fed funds at 3%, our repo is around 3.15%, and two years swaps are just south of 2.70 right now. So a combination of interest rates, swaps, and short-dated repo that should total off spreads were around 125 basis points. The goal is to maintain our portfolio in the 50-50 shorter to longer reset mix that we have now, and keep our duration gap between three and six months.

With that I'll turn it back over to Andy.

Andy Jacobs

Okay. On slide 11, replay on the fourth quarter, I think, Phil has already gone through that. For the quarter, we had net spreads on our interests, and on our assets and borrowings of 93 basis points. If you look over to the right, you'll see in the first quarter, our anticipation is that the yields on our portfolio will be slightly down to about 5.70. Our expectation is that our borrowing costs will be substantially lower at about 4.18. The net interest spreads should grow to 152 basis points in the first quarter of 2008.

I think one of the important things to realize here is, going forward with the 50-50 mix of our current reset to longer reset securities, I think one of the things to understand if I can use a technical term here, the yield on the portion of the portfolio that's the longer to reset, is going to be sticky on that. That's my technical view, because half of the portfolio isn't going to reset over the next 12 months, it's going to reset over the next three or four years or so. So the yields on those assets that we are putting on in the fourth quarter and to-date in the first quarter, those yields are going to be more stable in there on half of the portfolio.

The other half of the portfolio which you have to understand is they will be resetting over the next 12 to 18 months, and so depending on when they reset, and if we just assume a straight line over the next 12 months is reset, I think the realization is that the current indexes to which these type of portfolios reset, which are short indexes.

The yields will be coming down on the other half of the portfolio over time. It will take at least 12 months for the full impact of that to take effect. But in this environment we've also run into interest to the cap on the underlying mortgage loans. Ginnie's can move up to a 100 basis points within a year, and they're locked out of so many things before that.

So they could take two years to adjust to current levels, and Fannie and Freddie will typically have a 200 basis points cap as to how much they can move. So, understanding the characteristics that they have for the portfolio that will be adjusting, the yield will decline on that particular portfolio. But the other half will be a little more sticky with the yields that we have been able to put the capital to work.

We go to page 12, page 12; we've raised almost 30 million shares of new common stock in the last four months, $333 million of new capital. I think from an accretion standpoint, it's been very accretive to the book value of our company. The new capital has been accretive by over $2 by sale, not to mention the improved value of the portfolio. But I think what has happened as you see in the fourth quarter, and will be impacting us going forward, the new capital raises have been accretive to earnings and dividends, and will continue to be.

I think one important feature with our motivation for trying to get the capital rates and put the work in here is that we were focused on the liquidity of our stock from our peer group, which is the Annaly, MFA and Hanover. We were the smallest guys from a book value standpoint, from the amount of market capitalization. As of September 30, we had about $193 million in market cap. Now we are over $850 million in market cap, and I think the underlying liquidity to that is a good story for our new mix of investors.

During this period our average daily trading volume has improved. If you go back before the first offering that we did in October, for the previous year, our trading volume averaged about 100,000 shares. Since that first offering, we have averaged 600,000 shares, and today in 2008, we have averaged over a million shares on a daily basis.

I don't expect that that's going to continue at those elevated levels, but suffice it to say, it's going to be substantially higher than what we have seen prior to doing the first offering. Overall for 2008 and 2009, we are excited about the opportunities in here. Earnings and dividends will improve in 2008, the first quarter dividend we plan to announce on March 13, and I think its exception was a 152 basis points net interest credit, it's going to be higher than what it was in the fourth quarter. And with that I will turn it over to Anthony to pool up the questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Steve Delaney with JMP Securities. Please proceed with your question.

Steve Delaney - JMP Securities

Good morning, Andy, and congratulations to you and the team on a great quarter.

Andy Jacobs

Thanks Steve.

Steve Delaney – JMP Securities

First thing here, the additional $600 million in swaps that were added subsequent to year-end, I just wanted to confirm that and putting those on, they were related to new investments made in the fourth quarter along with the 900. So I guess the way I’m looking at it is swaps that were added were $1.5 billion and the net portfolio growth in the fourth quarter was like 2.4. So about swaps represented about 60% the [ARMDS] portfolio growth, is that correct?

Andy Jacobs

Well, as I mentioned earlier we are hedging our longer-reset securities for a duration of about a year and quarter. So yes, those were in conjunction with fourth quarter purchases and as well as purchases in the New Year.

Steve Delaney – JMP Securities

Okay, oh, you're saying that some of that 600 had to do with purchases in January as well.

Andy Jacobs

Yes.

Steve Delaney – JMP Securities

Okay, well that's what I was trying to understand, the exact [percent] what securities the swaps were related to, but you would not include the January 28, raise in that or are you speaking to purchases made earlier in January?

Andy Jacobs

We're just hedging our portfolio on a macro basis.

Steve Delaney – JMP Securities

Okay

Andy Jacobs

Our duration gap in line and obviously we know that we have proactively walk-ons in January and February.

Steve Delaney – JMP Securities

Okay and switching to the short reset part of the portfolio. I mean it looks like it still was one of the unique characteristic with Capstead versus your peers. I think it was close to 70% back in September and still over 50% of the book at the end of December. I was just curious if you guys are seeing any changes in consumer behavior. I know in the past you said to close -- like 3:1 and 5:1 are approaching reset, which is a catch on fire in terms of prepaid fees. And given what's going on with home price declines and inside our mortgage credit, I was wondering if you've seen any change of behavior and whether you are expecting to get longer, larger and longer sales that of those resetting average?

Robert Spears

It's still kind of early to determine what prepayment fees are going to do this year. I will say that you have a fairly large chuck of the mortgage universe that credit is there right now, ones that we're originating two or three years ago, higher LTV, low Doc etcetera. That in conjunction with, if you think about these shorter retake guys, that’s to say generically LIBOR is 3% and they have a 250 gross margin, they are not only looking at resetting up or resetting down actually in some cases the 5.5% with a 30-year low cost re-buy still close to 6% and a 5, 1 low cost if you are such an animal in the high fives, that should be a positive to a certain degree.

And we are at this low point in the year on fees right now. And we are expecting to see, the two things given where we are in the rate cycle. Fees aren’t growing yearly as fast as they were in the past. So still a little early to determine the exact numbers. But I still think the prepayment trends are - not really what you are getting out on the rate front. A lot of that was going to offset on a credit front and people want resets at actually lower rates right now.

Steven DeLaney – JMP Securities

All right. Well, we'll keep an eye on that in the first quarter. That's great. Thank you, Robert.

Operator

Our next question comes from the line of David Hochstim with Bear Stearns. Please proceed with your question.

David Hochstim - Bear Stearns

Hi. Good morning. I had a sort of follow-up question on that. Just somehow a bit about where you are in the way of premiums and sort of what's the amortization is like at this point of the premiums and what the sensitivity to higher prepayments will be? And so if prepayment fees become more then you expected, could you kind of talk through what would happen, in terms of funding mix?

Andy Jacobs

Our portfolio ended at a basis level not that far different then where we were at the end of the third quarter. And we did include on the bottom of the slide 6, because there somebody was asking about, it was the amount of premium amortization we recorded in the fourth-quarter.

David Houston - Bear Stearns

But I guess I was wondering can you say anything else about what's happened in the first part because there were a lot of purchases subsequent to?

Andy Jacobs

Yeah. Purchases in the first quarter are running, that the yields are down rather. So prices are up. So we'll be adding a little higher premium portfolio all in all. Robert might be able to give a little better color on that.

Robert Spears

Yes. At year-end our aggregate premium was just north of 101 in the quarter. With the drop in rates and spreads tightening somewhat in the first quarter, most of the mortgage universe is now trading north of 102 but at the margin we're only at a low point right now, the first quarter its just seasonal.

So you could see speed picking up generically in the ARM lifting from the high-teens right now to the high-twenties over the next -- by the middle part of the year. But our legacy portfolio at such a lower premium that should be in rather detrimental to our earnings.

Andy Jacobs

The mix of our portfolio being 50-50 with the current reset and longer-to-reset, the complexion of the portfolio will change a little bit from a year-over-year offering being equal. You would generally expect because of that mix that will be a little bit lower than previous year level. So, that does come into play to some extent we will be lower as it relates to that.

David Hochstim - Bear Stearns

Okay and then can you say anything about the range of maturities and the longer duration fees, the average you said I think it was 15 months, but…?

Andy Jacobs

On the liability size?

David Hochstim - Bear Stearns

Yeah.

Andy Jacobs

In our earnings press release we did kind of give a little color on that, we indicated that the range of maturities is -- you will find it in here -- about 9, 8 months to 20 months, something like that.

Robert Spears

Yes, it got a longer repo, and credit [swap] on longer than two years. So, our average longer reset liabilities rating mark with the longer-term repo position starting to come off this year as early as September of this year and on the swap front we have been utilizing two year swaps.

David Hochstim - Bear Stearns

Okay and thanks.

Operator

Our next question comes from the line of Mike Widner with Stifel Nicolaus. Please proceed with your question.

Mike Widner - Stifel Nicolaus

Good morning guys thanks for taking the call. And just a couple of minor items. First there is an other revenue item for $852 million, sorry if you guys talked about that early, but could you just elaborate a little bit as I wasn't in there.

Phil Reinsch

Yeah we mentioned what is lot of overnight earnings with the offerings and with the capital market where we have capital at more REVPAR and earn a little bit more in our overnight investments than we would have, may be in a more calm quarter. And also there are a few minor non-recurring items really not worth getting into in any kind of detail.

Mike Widner - Stifel Nicolaus

All right. Second question, you had chart in there on your common equity in the past didn't more highly leverage related to peers. The question I've got -- you see these guys are issuing more preferred, trust preferred, any comments on that or what you think in this environment if that's...?

Andy Jacobs

Yeah. I'll say this, the trust preferred market for mortgage special, mortgage REITs in particular really isn't there, and you're not having issuers like us put into those trust at this point in the credit cycle. And other if you look at the market for perpetual preferred is relative high rate environment as well. So, that's going to color our decisions going down a line in terms of how much preferred capital leverage we will employ.

Mike Widner - Stifel Nicolaus

All right, that's I think answered their question. On the leverage, you mentioned I think reasonably conservative in the 10 to 1 range. Is there anything that we change to make you either choose the lower that down to 3 and closer to 9 times or potentially raise it back to, so the higher end where you been in the past?

Andy Jacobs

We are pretty comfortable with 10 times is given us plenty of liquidity to weather a storm like we saw in August and September. So, a decision to take it down further we would have to depend upon things being worse than what we saw in last fall I'd say. Robert you got some comments on that.

Robert Spears

No, I mean I think returns that we are able to generate now however 10 times are satisfactory. We've got excess repo capacity, but there is no reason at this point that I see either to take it down or up.

Mike Widner - Stifel Nicolaus

Right. So, if we see I guess I'm just thinking about scenarios, where you might take it down to -- further flattening or seedling of the yield curve or so, maybe uncertainty in kind of macro indicators, we're looking at the potential. Right now overwhelmingly everyone can expect additional Fed cut, but if we start seeing sort of more uncertainty -- with that change your tune volume of we see strong in point, if we see inflation remember you said -- that kind of thing?

Robert Spears

Sure, I mean, if the environment changes substantially from where it is now, we may alter the decision, but I don't think in any regard we wouldn't be taking our leverage up. Here we potentially take it down at some point sure, if macro indicators change, if liquidity changes etcetera, but we doesn't see down near-term horizon.

Mike Widner - Stifel Nicolaus

Okay, all right, great. Thanks guys. That answers the questions and congratulations a solid quarter.

Andy Jacobs

Thank you.

Phil Reinsch

Thank you.

Operator

Our next question comes from the line of George Bose with KBW. Please proceed with your question.

George Bose - KBW

I had a question on your book value, you have said earlier in the call, the markets trading around 1 or 2, suggest that pretty material improvement in your portfolio asset. Is that a reasonable way to back into the increase in your portfolio, the value of your portfolio since quarter end?

Robert Spears

Well, yes, it's going to drop. And obviously, we tell you that what our duration gap is and so not getting into other stress tighten or widen our portfolio. We trade to a duration of somewhere between three and six months. And so, you kind of do the math and look at where breadth of two year swaps move and apply from duration to that you get a pretty idea on where our portfolio is trading to that.

George Bose - KBW

Okay. Actually just on the clarification from an earlier point you made. Did you say 40% of the liabilities are termed out with swaps, is that what you're saying?

Robert Spears

Well a combination swaps and longer-dated we have 3 billion and we gave you that a . 1.5 billion in long-term repo and then $1.5 billion in swaps.

George Bose - KBW

Okay, great. And just question more of a theoretical question on how you guys would see new capital to given that now the spreads on your portfolio are hard materially higher and probably will going-forward will be even higher than what's you guys are seeing in the market is that change your appetite for new capital. And how do you guys think about that?

Andy Jacobs

Well, I think capital going forward opportunities to do any additional offerings depends on, what we look at the underlying assets that we can put that capital to work with. This last offering we did, we actually could have done more capital than we did, but it was all the function of where we felt comfortable being able to deploy the capital -- maintain and the discipline with the way we look at our portfolios.

We don't like paying high premiums in assets at some levels, some particular our will be rich. We like to raise in the right amount of capital -- working to get the right loans, but that's what we are tying to do going-forward, with what happens in the market assets. We can apply the same discipline perspective to how we raise capital on the future and how we and where we deploy.

George Bose - KBW

Okay great. Thanks a lot.

Andy Jacobs

Thank you.

Operator

Our next question comes from the line of Dan Weldon with Diamondback Capital. Please proceed with your question.

Dan Weldon - Diamondback Capital

Hi, thanks. All of my questions actually already been answered.

Andy Jacobs

Okay excellent.

Operator

Our next question comes from the line of Matthew Howlett with Fox-Pitt Kelton. Please proceed with your question.

Matthew Howlett - Fox-Pitt Kelton

Thanks for taking the question. Just on the new lenders looking to do business with you as you get bigger, and you get more quote clout out there in the market, significant improvement in the financing rates from your existing lenders or some of the new players coming in?

Robert Spears

You are seeing that right now more because LIBOR funds that have moved back into a more normalized spread relationship. But, yes, I think you could see rates on a relative basis improve just because guys are looking at balance sheets right now. And I think agency repo is a fairly risk free profit centre for some of these repos vendors now and so think some of these guys or one of them have more distinctive. So it's hard to just say that rates are improving, but that the biggest difference is hardware versus funds coming in. But obviously if more people are looking or seeking new business on a relative basis your funding costs are going to come down.

Matthew Howlett - Fox-Pitt Kelton

Right, that's okay. And then just switching to some of the purchase yields have come down relative to some of your acquisitions in the fourth quarter relative to sort of January and February. How much of that was due to tightening between OAS spreads and treasuries versus just a decline in the long-yielded for bonds. What is your expectation going forward this year, given we could see I think agency and the SREs under performing treasuries in the first week of February and given the increase in supply and given the increase in the performing loan balance could there be under performance going forward, what's your expectation for a sort of performance going forward in that market?

Robert Spears

Breadth has come in 20 to 30 basis points in the first quarter and a lot of that guys who were skittish over year-end not wanting to add positions, liquidity has increased on the repo front as we talked about earlier. Obviously a lot of REIT's have raised capital in here. So from the standpoint and more often than not spreads have a tendency to come in the first quarter.

Going forward performance wise I still think there is a decent amount of capital out there, supply -- net supply is down a little bit in the first couple of months. And so you're not seeing the spreads selling like you saw in the latter part of last year, which is another reason, spreads have come in.

And said that when mortgage assets we are trading in some cases over [1 out 3] you're obviously not a front of upside on the price front and so that's where you will see some widening early on because a lot of guys don't want to add those kind of premiums. At the same time lower priced assets right now probably have more room to run just because there is a shortage up is out there, but new supply and a more lower rate environment is created that become more normalize as well.

So, I think right now the fundamental and the technical -- it's harder to see spreads dampening out from they we are now. I'd say they have a tendency to tighten a little more although higher dollar prices, we are going to limit how much they can tighten here.

Matthew Howlett - Fox-Pitt Kelton

And then, everything I've heard is the increased -- potential increase in the conforming loan balance would actually be very helpful in terms of OS, but would widen them. Would that because sort of an investing standpoint if the longer-dated is raised?

Robert Spears

Well, my opinion if I'd say they raised the loan on the $625,000 and earlier talking about in fixed rate past through, those loans probably won't be [TVALS4]. So, they will be securitized by themselves in all likelihood. On the ARM front, doesn't TVA market.

So if we co-mingle with every other ARM loan that's originated, at the margin you -- we come back to the profile that a $600,000 one is much more negative than a $200,000 one. That on top of, the fact that almost everything being originated in our squeaky clean [Toolbox ADLTV], because the agency that pioneered underwriting standards and so many [of them having in-depth research] are gone. I think what you are going to get is cleaner product with our larger average loan balance, which is from a prepayment standpoint is usually a negative.

So, our view would be to try to stay away from newer production as much as possible and focus more on seasoned securities that were originated two or three years ago, that have a smaller average loan balance, might be somewhat credit impaired from a refinancing standpoint and should have a better prepayment profile.

So, I think security selection is going to be very important and critical in this environment. So, to me in a nutshell, the higher average loan limit for new production is a negative.

I mean obviously the borrowing increase, which is a positive but the characteristics of the securities will not be as attractive as the ones created two or three years ago.

Matthew Howlett - Fox-Pitt Kelton

Okay. So, you don't -- look towards the more seasoned loans out there and you don't mind sort of adding premium on a sort of season basis or on the newer production. You got to see -- look sort of closer to par type prices?

Andy Jacobs

Yeah and obviously it depends upon where your trade, once is created, you run [after going to months] and estimate where you think fees are going to be and it's like it fixed rate advance you go to the market about these larger loan securities potentially trading a [point back] generic fixed rate pattern. And that's the case in ARM and those securities traded at a price discount that compensates you for the added fee risk, sure you take a shot. But it's too early to tell right now and the biggest -- the term loan will be how the securities are priced relative to season securities.

Matthew Howlett - Fox-Pitt Kelton

Great. Thank you guys.

Operator

There are no further questions at this time. I would like to turn the floor back over to Bethany Siggins for closing comments.

Bethany Siggins

All right, that’s it. Thank you for joining today. If you have further questions, which can be raised and we are available to you. Have a great week and we will speak with you again next quarter.

Operator

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

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Source: Capstead Mortgage Corp. Q4 2007 Earnings Call Transcript
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