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Executives

Kelly L. Sargent - Manager of Investor Relations

Andrew F. Jacobs - Chief Executive Officer, President, Director and Member of Executive Committee

Robert R. Spears - Executive Vice President and Director of Residential Mortgage Investments

Phillip A. Reinsch - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Secretary

Analysts

Bose George - Keefe, Bruyette, & Woods, Inc., Research Division

Steven C. Delaney - JMP Securities LLC, Research Division

Jasper Burch - Macquarie Research

Joel J. Houck - Wells Fargo Securities, LLC, Research Division

Stuart Quint

Capstead Mortgage (CMO) Q2 2012 Earnings Call July 26, 2012 9:00 AM ET

Operator

Good morning, and welcome to the Capstead Mortgage Second Quarter 2012 Earnings Conference Call and Webcast. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Ms. Kelly Sargent, VP, Investor Relations. Ms. Sargent, please go ahead.

Kelly L. Sargent

Thank you, Sue. Good morning. Thank you for attending Capstead's Second Quarter 2012 Earnings Conference Call. The second quarter 2012 earnings press release was issued yesterday, July 25. The press release is posted on our website at www.capstead.com. The link to this webcast is in the Investor Relations section of our website and the archive of the webcast will be available for 60 days. The telephonic replay of this call will be available through August 28. Details for the replay are included in yesterday's 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 the today's comment should 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 filings with the SEC which are available on our website. Information contained in today's call is current only as of today, July 26, 2012. The company assumes no obligation to update any statements, including any forward-looking statements made during this call. With that, I will turn this call over to Andy.

Andrew F. Jacobs

Good morning, and welcome to our second quarter 2012 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.

Regarding the operating results. Net income for the second quarter totaled $43.3 million, a $0.40 per diluted common share, and we paid a dividend of $0.40 per share on July 20. Net interest margins for the quarter decreased to $47.3 million as a result of a 15 basis points decline in our total financial spread to 137 basis points.

Yields on our interest-earning assets averaged 1.98%, representing a 10 basis points decline from the first quarter. Yields were impacted by higher premium amortization charges, primarily as a result of higher level of mortgage prepayment. Portfolio runoff during the second quarter measured in CPR averaged 15.9% compared to 14.5% in the first quarter. Weighted average coupon on our current reset ARM securities were basically flat at 2.64% at June 30, reflecting an increasing number of the mortgage loans underlying these securities, approaching fully indexed levels.

Interest rate on our borrowing averaged 51 basis points during the second quarter, which were 5 basis points higher than in the previous quarter, reflecting higher borrowing rates on our repurchase agreement.

Operating cost as a percent of our long-term investment capital declined 1.06 basis points during the quarter, and for the year have averaged 112 basis points and are trending lower.

Regarding the portfolio, acquisitions during the second quarter totaled $1.35 billion, which more than offset the $628 million of runoff during the period and which increased our investment portfolio to $13.8 billion as of the end of the quarter. 52% of this portfolio is invested in ARM securities, which are backed by loans that will reset in rate in less than 18 months.

As mentioned earlier, portfolio's runoff during the quarter increased 1.4% CPR to 15.9%, reflecting higher seasonal prepayment patterns, as well as lower prevailing mortgage interest rates available to consumers. While the current low interest rate environment may persist for some time, we believe certain characteristics of our portfolio will lessen the risk to earnings from sharply higher prepayment levels.

Essential to this belief, the fundamental differences between our investment portfolio and those of our peers is our focus solely on ARM security. As of the end of the quarter, our overall portfolio was backed by mortgages requiring borrowers to make payment at relatively low rate of 3.44%, of which 60% of these loans were originated prior to 2009. In addition, these prepayments on these more seasoned loans continue to be suppressed by low housing prices and credit problems being experienced by many of these borrowers, even as prepayments on the more recent mortgage originations that we purchased remained somewhat elevated. As a result, most of our borrowers underlying our securities likely ability to meaningfully lower their mortgage prepayment, even if they can overcome the impediments for refinancing.

For these reasons, we expect further increases in mortgage prepayments to be relatively modest during the third and fourth quarter. As of the end of the quarter, repurchase arrangements totaled $12.73 billion, consisting primarily of 30-day borrowings with 23 counterparties and rates averaging 39 basis points and that's before considering our interest rate swap agreements.

As with respect to our swap agreement, we held $3.7 billion of 2-year swap positions at June 30 at an average rate of 80 basis points. And also at quarter end, we had $1.4 billion of forward-starting swap positions at average rates of 55 basis points, so it will become operational between now and March of 2013.

At the end of the quarter, our portfolio leverage remained at 8.05 of our long-term investment capital, and our net duration gap was roughly 3.5 months. Our long-term investment capital increased $79 billion -- $79 million, excuse me, during the second quarter to $1.58 billion, primarily as a result of accretive capital-raising activity through our ATM program and higher portfolio pricing levels.

Our book value per common share improved $0.19 to $13.23 reflecting a $0.28 improvement in the value of the portfolio, $0.03 in accretion from capital raises, offset by an $0.11 reduction in the value of our swap position, hedging our trust preferred securities. And with that, I will open it up for questions. Sue, back to you.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Bose George of KBW.

Bose George - Keefe, Bruyette, & Woods, Inc., Research Division

First question, you give your fully indexed WAC in the release. I'm just wondering what would you fully index spread be like if all things stay the same for the next year, where does this spread go?

Robert R. Spears

Well, I'm kind of a little confused at the question. I mean, if you look at it will be truly a function of where the coupon goes and then the corresponding deal versus our funding cost, so if you look at our shorter resets, we show a 2.64 coupon fully indexed as 2.43. Those will roll down to that 2.43 over a 12-month period and so just kind of circulating that. And then you look at the fixed nature of the longer resets and you're looking at about a drift of 3-or-so basis points per quarter.

Bose George - Keefe, Bruyette, & Woods, Inc., Research Division

And I guess, the question more is on the liability side, what's the decline over there?

Robert R. Spears

Well, that eligibility function of swaps that roll off, and so you've got to circulate the table that we have with the swaps that come off over time. And then if you assume we replaced those swaps at current swap rates, so that would -- you would just have to kind of do the math that way. And so if you assume, theoretically, that we keep our mix where it is and roughly 40% of our book is swapped out, as those swaps come off, we would replace those at current market. And so we didn't provide the math, but it should be pretty easy to just walk-through the table and kind of come up with that.

Andrew F. Jacobs

Bose, this is Andy. If you look at -- I guess, it's on Page 8 of the press release, we have -- we do not between now and the end of 2012, we only have about $200 million of swaps rolling off in the third quarter. We don't have any swaps rolling off of any size until the first quarter, which we have $1.1 billion, which are on average 81 basis points. In the second quarter, there's another $700 million which are at 96 basis points, I think. I think what you're looking for there is -- I mean, today in the swap environment we're down around 0.5 point on the 2-year swap, which is what we would generally replace those at. So I think there'll be some more meaningful improvement in that from the -- when you get into early next year.

Robert R. Spears

Yes. Bose, I think you could really kind of -- if you just look at, as Andy mentioned, the third quarter swaps and the first quarter, we have a -- call it $1.3 billion rolling off then. And then if you look at those forward-starting swaps down there, they're coming on basically when -- more or less when those swaps roll off, it's 50 basis points and change. And so you're replacing 82 basis point swaps with, call it, 54, 55 basis points swaps. So that portion of the liabilities would come down by roughly 30 basis points on that first $1.3 billion that's coming off.

Andrew F. Jacobs

And, Bose, back to the -- one of my earlier points is that the current refits of portfolio, which has a net WAC of 2.64 as of end of the quarter, that basically changed 1 basis point quarter-over-quarter. And as we said, I mean, because this portfolio is so seasoned, we're getting down to the end. The gap between our fully indexed and our net WAC was much higher 12 months ago. But if you went back a year ago and looked at these same type of numbers, it's clear that this, to this point, we haven't declined as far as the instantaneous fully indexed WAC would have indicated back then and a lot of that is because of the portfolio composition of what's running off and what we're adding. Today, we're adding a bit more longer-reset securities than we are current-reset securities. But again, our longer-reset securities are rolling down to some extent and moving on to the current-reset category, which is what we expect them to do.

Bose George - Keefe, Bruyette, & Woods, Inc., Research Division

Okay, great. That's very helpful. And just a related question, where are sort of incremental spreads on stuff you're putting on now?

Robert R. Spears

Right now we're probably looking in the 130 to 150 basis point area. I mean, if you kind of use as a proxy for funding right now, whether it'd be repo or short swaps that are around 40 basis points and then we're looking at mostly 130 to 150 over that.

Operator

Our next question comes from Steve Delaney of JMP Securities.

Steven C. Delaney - JMP Securities LLC, Research Division

A couple of things here. I think your new investment in the quarter, I think, was -- it's a little under $1 million in terms of new investment, and you indicated a yield of 2.19%. I was just wondering if Robert could give us more a little more color on -- so that the vintage and coupon in dollar price just kind of in a representative way regarding what you're investing. Obviously, Andy, as you alluded it's -- you're finding more value in the season with longer reset hybrids.

Robert R. Spears

Yes, I mean, Steve, obviously, our percentage of shorter-reset securities continues to come down towards now roughly 62% of our book, which I think dropped another 4%, 5% from the last quarter. So that tells you right there that the vast majority of the securities we bought were longer resets. Now we did buy some new issue, but we also bought some higher coupons, fees and securities that we thought there was some value there as well and that is a lifetime yield assumption as well. And as you know, those yields are not attainable right now in the current environment. So that 2.19% is based on lifetime yields. We don't break out the coupons but our average purchase price was around 104. So it was slightly higher than current coupon, new issue in most cases. And yields are, as I indicated earlier, are definitely sub-to now, so we couldn't replicate those purchases right now.

Steven C. Delaney - JMP Securities LLC, Research Division

Okay. That's great. That's good additional color and helpful, Robert. And then, you guys, I know -- forgive me but your gross WAC or you're actually -- your average loan rate, that's very useful. I don't know if that's recent disclosure. I hadn't noticed that particular data point in the past, but thank you for that. And I guess my question is, that's for the whole portfolio. So could you give us an estimate of what the gross WAC would be just on the current reset portfolio and if you notice...

Phillip A. Reinsch

Yes, Steve, we provided a table in the back of our press release in the last page that breaks that down.

Steven C. Delaney - JMP Securities LLC, Research Division

Well, I'm seeing net, Phil. I'm seeing net of 2.64, but am I missing something on the actual loan pay rate.

Phillip A. Reinsch

I think, Steve, if you take that 2.64 in this case and you add about 60 or 70 basis points, then you'll get close to the homeowners' rate to that portfolio.

Steven C. Delaney - JMP Securities LLC, Research Division

And that's what I was looking for, so maybe midpoint of that 65 or something like that would get us there.

Phillip A. Reinsch

Yes.

Andrew F. Jacobs

Yes.

Operator

Our next question comes from Jasper Burch of Macquarie.

Jasper Burch - Macquarie Research

Could you give a little more color on -- in the press release you said there were various factors that drove repo rates a bit higher, so a little more color on what those were and whether they're endemic to the entire market or specific to your securities, and also just what are repos at now that you're putting on.

Robert R. Spears

No, I think, it's -- it was representative of the entire market. Balance sheet from repo lenders is in a little bit of a premium right now so just looking at first-order, we were repo-ing in the kind of low 30s and addressed it at the high 30s second quarter, and I think it's a function of balance sheet being a little more precious to some of these guys. Some of the banks are still delevering and at the same time there is lot more supply in our sector. More guys have been raising capital and looking for repo. And so I think it's kind of a supply demand dynamic to it as well. So -- and repo rates have eased a little bit, since the end of the quarter. Yes, we were kind of, at the term, kind of in the very low 40s and now it's kind of in the upper 30s to 40 area, so maybe 2 or 3 basis points since the quarter end.

Andrew F. Jacobs

Yes. In addition to that, I think the just -- I don't know if it's conspiracy theory or whatever, but the Operation Twist that the Fed's doing, they're selling their shorter securities, those shorter securities which are being put onto the market, those people are in the leverage and put them into repo, and so that's taking up some of the capacity as well. At least it's a theory we read on Bloomberg, a number of weeks ago. Whether that's happening, I mean, we really can see that, but it sounded legitimate.

Jasper Burch - Macquarie Research

That's very interesting. And then I guess -- it might be a little early to talk about this. But in terms of the LIBOR rigging scandal, have you guys looked at what sort of impact it may have had to your operations over that time period, and whether you -- I mean, do you think that there might be a potential for any recourse or settlement?

Andrew F. Jacobs

I'll answer that. I've sat on a number of conference calls that are talking about it globally and what the impact to the banking community, that was part of the scandal side of it. And I think they put it to the entire banking sector, that $16 billion to $18 billion as a whole. From our standpoint, because we received 6 from our swap counterparties on one hand, theoretically, our rates may have been understated of what we were receiving. And looking at it, with -- that $17 billion number I was throwing out for the banking, people ask to what the liabilities were, that's about 1 basis points difference in rate. It's how that number is calculated. If you use that same math about us, you're talking about $0.25 million. So from our standpoint, it's definitely not worth pursuing anything to that range. Now on the other hand, we have a large portfolio of mortgages that are based on LIBOR index and such. So theoretically, those got held down by -- on average 1 basis points or so. And at that point, you get maybe a couple million dollars, theoretically. But at that same time what you end up with is, it's probably good that the homeowners are on that side of the equation, because you don't have the Consumer Protection Bureau coming after all these banks as well for all the homeowners across America. They were all benefited in this environment. So I -- we don't think it's going to be of any great degree. We definitely -- if it's levels that we're looking at, we're not look at pursuing anything.

Operator

[Operator Instructions] Our next question comes from Joel Houck of Wells Fargo.

Joel J. Houck - Wells Fargo Securities, LLC, Research Division

I mean, obviously, you've seen the mortgage curve compressed along the entire curve, and you guys seen less sensitivity to prepayments. However, there was a slight uptick in the quarter. I'm wondering if you might offer a kind of perspective looking out the balance of the year in terms of what your expectations are for prepaid fees in your books.

Robert R. Spears

Sure. If you look at the latest release, July factors, the last prepaid number generically ARMs picked up another 1, 1.5 CPR and they'll probably drift a little higher the next couple of months before they start to tail off at yearend. So we're expecting modest prepayment increases over the next couple of months, and they should kind of peak in the next 2 to 3 months. But speeds are up in the third quarter as the first release of the quarter shift. So I think -- it's in the first month, they kicked up 1, 1.5 CPR, then probably just a little higher from there. And that's kind of what we are expecting in the short run.

Joel J. Houck - Wells Fargo Securities, LLC, Research Division

Okay. And then lastly, just a reminder if you guys have de minimis or no exposure to HARP 2.0.

Robert R. Spears

Yes, very little. Minimal. We really don't have that many high coupons left in our portfolios. It's not even worth -- we don't disclose the amount, but it's very minimal.

Operator

The next question is from Stuart Quint of Brinker Capital.

Stuart Quint

Just a -- just a question on -- if you've been -- have you been following the situation where -- I forget the guy's name but it's in Santa Barbara where they wanted to essentially do refinancing of underwater mortgages and try to refinance in a lower rates and stuff like that. Do you see any potential that, that spreads to other municipalities and potentially messing up the prepayment assumptions on some of these underwater mortgages?

Andrew F. Jacobs

Are you referring to the eminent...

Stuart Quint

Yes.

Andrew F. Jacobs

Okay, yes. From the standpoint of housing across America, I think that's a very slippery slope. I think you'll have it -- I think you'll be very limited. California would be expected to be the first place they will try to do something like that. I can definitely see a lot of communities wanting to have conversations about that. But from the standpoint of helping a few isolated -- well, I wouldn't say isolated, a few -- some percent of your homeowners, at the other side, 80% or 90% are -- valuations you're impacting them. It's hard to make it -- see how this segment is going to get really taken off in any great extent, but that's a new theory out there as well. And it's an interesting -- worth following, but I think there's a lot more downside to the overall housing marketing in the United States of doing something like that. I think at the end of the day, it will be minimal.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Kelly Sargent for any closing remarks.

Kelly L. Sargent

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

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

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