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Capstead Mortgage Corporation (NYSE:CMO)

Q2 2008 Earnings Call

July 28, 2008 11:00 am ET

Executive

Andy Jacobs - President and Chief Executive Officer

Phil Reinsch - Chief Financial Officer

Robert Spears - Director of Residential Mortgage Investments

Bethany Siggins - Vice President, Investor Relations

Analyst

George Bose - KBW

Mike Widner - Stifel Nicolaus

Steven Delaney - JMP Securities

Jason Arnold - RBC Capital Markets

Operator

Welcome to the Capstead Mortgage Corporation second quarter 2008 earnings conference call. (Operator Instructions) It is now my pleasure to introduce your host Ms. Bethany Siggins, Vice President, Investor Relations for Capstead Mortgage Corp.

Bethany Siggins

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 second quarter 2008 earnings press release Thursday evening July 24, 2008. 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 to the end of the day on Monday, August 11. The details for the replay are in our last Thursday’s press release. The investor presentation we are covering today is also currently posted through 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 are available on the press release we issued last Thursday and are also in the Risk Factor section in the forward-looking statements section of the company's fillings with the SEC.

The information contained in this call is current only as of the date of this call, July 28, 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. If you would move forward to slide four in the presentation and on slide four is a quick overview of our long-term capital as of July 24, with market prices at that point in time, just kind of a reminder because that’s kind of a jumping off point for what we’re going to be talking about a lot of time here in the next few minutes.

The market capitalization of our common equity as of this date was about $642 million and including the trust and perpetual preferred stock, our total investment capital totaled $942 million at this point. As you recall I’m sure, the aggregate cost of the combined trust preferred and perpetual preferred has a blended rate of about 10.28% as of this point in time.

The second quarter, it represented our third consecutive quarter of reporting very strong financial results. A large positive is the action taken late in the first quarter by both the Federal Reserve and federal regulators to improve market liquidity; generally caped are the continuing difficulties in the credit markets outside our agency back sector which was a very positive.

The second quarter we reported net income of $36.7 million, which was up from $31.6 million in the previous quarter and that primarily is the result of increasing financing spreads which improved to 205 basis points. Our book value per common share increased over $1 to up to $10.42 as the mortgage-backed securities in our portfolio improved despite heightened inflation concerns which moved long-term interest rates higher.

What happened is our mortgage heightened relative to our treasury and so we did get improvement in the value of our securities in spite of higher rates. The higher rate also improved the valuation of our interest rate swap and basically recovered the decline in value reported in the first quarter and lastly relative to book value, we raised $77 million of new common equity capital which added about $0.35 to our book value per common share for the quarter.

While credit market conditions improved significantly during the second quarter and the availability of traditional repo financing remained plentiful, we continue to believe it is appropriate to maintain our portfolio leverage at the lower end of our traditional range of eight to 12 times long-term investment capital and we believe that maintaining at this lower level we’ll continue to provide sufficient liquidity to navigate any difficult market that we see in coming periods and even at this level we will return very attractive spreads and returns to our shareholders.

Regarding the more recent news, Fannie, Freddie I will leave some of those comments to Robert and maybe respond a little bit later on those activities, at this point; Phil.

Phil Reinsch

Thank you, Andy. Shown on page five of the webcast, the pics, the components of our agency-guarantee investment portfolio and how these investments are financed and hedged. Our Current-Reset ARMs totaled $4.5 billion at June 30, up nearly $400 million from $4.1 billion at the end of the first quarter, as we focused our acquisition efforts on this component of our portfolio.

Current-Reset-ARMs as we defined them consist of traditional 11-CMT ARMs, six and 12 month LIBOR based ARMs and moving average ARMs based on one-year treasury rates or copy as well as season three-ones and five-ones that we’ll begin resetting a rate within the next 18 months.

Our Longer-to-Reset ARMs consists primarily of five-one ARMs securities not scheduled to begin resetting in rates for 19 months or so. This of course in our portfolio increased $3.3 billion from $3.2 billion at March 31.

Having reached our goal of approximately 8:1 leverage by the end of the April, we had resumed replacing portfolio runoff and deploying new capital into additional holdings of ARMs securities as I just described. In total we’ve increased our portfolio by $464 million to $7.9 billion during the quarter. Acquisitions totaled $858 million with a purchase yield of 4.78%, while runoff totaled $400 million.

Currently, we are financing this portfolio with $5.6 billion of 30 day to 90 day repurchase agreements and still have $1.5 billion of longer-day to repurchase agreements that we’ve entered into prior to September 2007; that will mature over the next three to 14 months.

Because our longer-dated repo has generally not been available at attractive returns since last fall, late last year we began using two year pay-fixed received LIBOR interest rates swap agreements to mitigate our interest rate risk on our holdings of Longer-to-Reset ARMs securities. You can see that we had a $1.7 billion of these swaps on the books at June 30. We did add a couple hundred million more in swaps in July at about 3.17% rate.

Quite longer-dated repo borrowings; these derivatives still lock in a significant portion of the financing spread on our Longer-to-Reset ARMs over the weighted average expected life, as well as provide an offset to changes in the five-ones fair value due to changes in interest rates. From an overall interest rate risk management perspective, we’ll generally keep the net duration of our portfolio and related borrowings to between three and six months. As of this quarter end our duration gap was approximately four months, about 10 months or so on our assets and about six months or so on our borrowings.

Turning to page six of the webcast we've highlighted for you some of the key takeaways from our second quarter financial performance. Net interest margins and earnings increased quarter-over-quarter due to growth in our portfolio, as our financing spreads benefited from the Fed reducing the Fed fund target rate. We’ve done 325 basis points since last fall with our last cut on April 30.

As Andy mentioned, book value increased $1.02 to $10.42 during the quarter, with the three reasons being the improvement in value of our swap positions and decent pricing on our mortgage securities as well as accretion from raising new common equity capital this quarter. Year-to-date the changes in valuations of the swaps and the mortgages basically offset in all of a $1.17 increase in book value that can be attributed to accretive capital ratings.

During the third quarter we anticipate our financing spreads will decline about 20 basis points to 185 basis points as we continue to add portfolio with lower purchase yields and as our Current-Reset ARMs continue resetting to market rates.

Moving to page seven, this is a sequential depiction of our earnings over the last several quarters. You can see the dramatic improvement in net margin for the last three quarters and at the bottom of the page we show our average portfolio outstanding; you can see it decline somewhat in the second quarter as we adjusted our leverage down, but as we added portfolio late in the quarter to the $7.9 billion level by quarter end, we should expect to see a resumed growth in this metric for the third quarter.

Turning to page eight, is our balance sheet. If I can get this thing to advance, I can’t change the slide here, but anyway you can see we’ve got growth in our common equity, capital component or long-term investment of capital over the last 18 months pretty substantially and that’s primarily the result of the capital we’ve raised for the last nine months. Without spending more time on that, I’ll turn the presentation over to Robert.

Robert Spears

Thank you, Phil. Slide nine is a chart of Fed Funds versus LIBOR in our portfolio spreads over the last several years. Obviously our spreads have improved as the Fed have cut rates down to 2%, at the same time prepayments fees have slowed, so it’s a very good environment right now. Just recently we earned 205 basis points in spreads, but if you look historically, the highest spreads we’ve earned was 371 basis points, which was in the second quarter of 2002 of that to the Fed, it cut the funds right to 1%.

The low was negative 15 basis points in the third quarter of ’06 and that was after the Feds raised rates from 1% back up to five in a quarter. On the average over this period it’s been about 136 basis points which is skewed somewhat due to the 1% funds environment; a much longer-term average is closer to between 75 basis points and 100 basis points, but that was more under the assumption of 10 times the leverage.

As Phil mentioned earlier our third quarter spreads are going to decline slightly to around a 185 basis points, but that’s because we have about 60% of our book in Current-Reset ARMs that are continuing to adjust down. We also are projecting speeds to pick up a little bit in the third quarter.

At this point in time new purchases are still very attractive; spreads have been waffling around in the 150 to 175 basis points area on a hedge basis, which throws off returns in the high-teens. It’s still very compelling to invest capital at eight times the leverage and as mentioned earlier, prepayments continues to slow and I think that’s going to be a good story going forward.

On slide 10, there’s obviously being a lot of concern about financing sources and sales force. Our repo counterparties are up from year-end; we at 14 grew up to 18 now. We are not really seeing any financing pressure at this point in time. There was a lot of talk early on about haircuts going up, that momentum is largely stalled right now. Right now our average haircut with our 18 repo counterparties is just more of a 4.25%.

As we go to slide 11, this is just our spread analysis for the second and third quarter. Our assets in the second quarter earned about 530, we financed in it 3.5 or 205 basis points in spreads. Third quarter we are projecting that to drop somewhat, although we’d note in here, we have speed going up on a run off basis from 20 to 23 which equates about 21 CPR. We have the first month end which is flat to what we saw in the second quarter, so we could see improvement if speeds aren’t as fast as we are projecting and/or some of the pressure in the financing markets in the form of one month repo rate comes off a little bit.

Right now one month LIBOR is around 245, funds are around 2%. We are repelling on average around 240, I have seen some lower than that, but we’re about 40 over funds right now. If that spread becomes more normalized we could see some improvement on the borrowing side as well. With that I’ll turn it back over to Andy.

Andy Jacobs

Okay, thank Robert. On slide 12, it’s just a depiction of our long-term investment capital over a period of time, so since June ’05. We’ve kind of already gone over this, but I think the takeaway from here is that from the first quarter and second quarter we did raise $77 million in new common equity during the second quarter through our continuous offering program that we have and we may issue more common equity through that similar program, if the markets remain supportive and if investment opportunities remain available.

I think on a overall basis, we’ve reported very strong financial results for the first half of the year and even though we’ve anticipated that are financing spreads are going narrow somewhat in the coming quarters, we will continue to report strong earnings and pay a very attractive dividend for sometime to come. With that I will turn it back over to the operator for questions.

Question-and-Answer

Operator

(Operator Instructions) Our first question today is coming from the line of George Bose for KBW; please go ahead with your question.

George Bose - KBW

Hi, good mornings guys. I have a question on the -- you said the spread on your new assets is in the 150 to 170 basis points range and I was wondering what the yield is on the ARMs that are resetting, because I was just trying to back into your spread guidance of the 185 basis points and also I was just wondering how much of an impact your decision to tighten your duration gap is having on new incremental spreads?

Phil Reinsch

Well those on new assets, short-reset securities are yielding in the 425 to 450 area, we’re not hedging those, we’re funding those with one-month repo, so you’re looking at closer to 175 basis points there. On five-ones, right now five-ones are yielding around five and a quarter; two year slots are around 350, so kind of the same spread area and it’s been wobbling back and forth.

We’ve made a conscious effort in hear to increase our shorter reset securities as the percentage of our book. I think going forward we will be closer to that 60:40 shorter-to-longer reset number and the spreads are very attractive on shorter reset securities right now and dollar prices are hard and low 101 handles and if you think the next move by the Fed is going to be up we’d rather be somewhat defensive in here.

I mean once again those spreads are very attractive, so we’ll continue to -- in the second quarter our purchases were closer to 75:25 mix, shorter to longer resets and that’s probably going to be the norm going forward, but keeping our duration gap at around four months we should still earn a very attractive return.

Our current portfolio, the legacy portfolio, our shorter-reset securities are about 75 basis points above fully indexed and so that’s why our yields come down slightly. That coupon drifts down between 5 and 10 basis points a month. If rates remain where they are, it will become fully index towards the latter part of the year, but even at those levels, these are very attractive spreads.

George Bose - KBW

And just in terms of the fully index spread on this is up, the 175 basis point number is that sort of where everything shakes up and assuming rates remain stable?

Andy Jacobs

Yes, I mean if look at the mortgage market there is really not a huge aura between -- I mean fixed rate pass-throughs on a hedged basis or yield curve swaps are about 150 or so. ARMs look attractive versus fixed rate pass-throughs right now, but on if you really hedge it, that’s kind of where we are and look again, that grows a high-teens return at a eight times leverage.

Operator

And your next question is coming from the line of Mike Widner from Stifel Nicolaus.

Mike Widner - Stifel Nicolaus

Those covered some of the stuff I was interested in, but one clarifying question; I think I know the answers to is when you present all the numbers here on page 11, you’re embedding the swaps cost into your 272, 30 days to 90 day interest rates and in there you’re not assuming or I guess you’re assuming the same kind of spreads if you do add new swaps, the 175 basis points sort of hedged rate, hedged study you’ve talked about for a projected third quarter.

Andy Jacobs

Well we mentioned we added $200 million in July at a 317 levels and we’ll just see how it works out going forward.

Phil Reinsch

On a perspective base for modeling purposes we always do assume that if we buy longer-reset securities we hedges those out.

Mike Widner - Stifel Nicolaus

Okay and as far as that assumptions go in that number you’re assuming that the Fed stays flat in 3Q?

Phil Reinsch

Absolutely, yes.

Mike Widner - Stifel Nicolaus

And then I have just one other question; one of the things I was surprised about, pleasantly surprised in your release was to see the positive mark on the MBS, the positive swaps, more like in the accretion from the offerings was expected, but the MBS accretion I was surprised by, so I was wondering if you could comment specifically on how the Current-Reset ARMs versus the Longer-Reset ARMs moved over the course of the quarter and then maybe any color you have on how pricings been going over the last month or so really at the Fannie and Freddie concerns, that thing kind of notched up a level.

Andy Jacobs

Sure, the out performance in the second quarter of our portfolio was attributable to a couple of things; number one, I think we have a higher percentage of shorter reset securities in most of our competitors. What you saw, those securities that beat up around the time of Colorado more so than a lot of the ARM product out there, at the same time as spreads started tightening back in, a inflation fear started creping back in and there was a fear that said start raising rates and so the demand for Short-Reset securities picked up substantially and so ARMs in general over the quarter tightened roughly 85 basis points on a dollar price basis.

Short-Reset securities in our book were up roughly a quarter of a point and so in essence what you saw securities that were turning the car handles kind of moved up a little over one-over-one. The other piece of the puzzle is if you look at our Longer-Reset books, it’s somewhat unique as well. The coupon on it is more than 6%, about six-ten or so with about 39 months to role.

The bulk of those securities were originated in 2005, 2006. 2006 was kind of the peak when it came to home price appreciation, aggressive terms on mortgages etc and so the speed on a tier coupon, two year old security, have been significantly slower than most models out there and so there was a big demand for five and three quarter and higher coupons. Three-one is to five-one type favor which is the bulk of our Longer-Reset book and so what you saw on a relative basis, those securities were virtually unchanged in price; that the hybrid ARMs that got hit worse were more product price, lower coupons 5 to 5.5 and we really don’t own any of those.

So, the combination of those two factors are very Short-Reset securities were up slightly in price and our Longer-Reset securities were basically flat and so we have a small improvement and then with our $1.7 billion in swaps, two year swap rates went up 110 basis points. So, that’s kind of the story of the second quarter. What’s happen since June 30 with all of the turmoil with Fannie and Freddie spreads, it’s been kind of a daily discovery type issue.

Initially when the government announced that they were going to back up the agencies security spreads tightened. Then as people started looking further into it and so as Freddie announced they’re going to raise $5.5 billion and they said they may strengthen their mortgage portfolio, then it turned into a supply concern where the agency might go from net buyers to net sellers, spreads widened back out, then they tightened back in and so the net results of everything since June 30, right now we are almost at the same spot on the swap curve and both fixed rate pass-throughs are wider by about 20 basis points, ARMs are wider by anywhere from 10 to 25 basis points and so our portfolio is down slightly, but nothing significant.

Operator

Our next question is coming from the line of Steve Delaney with JMP Securities.

Steven Delaney - JMP Securities

I’m just wondering when you talk about your term repo, the $1.5 billion at 5.02%. Would you be willing to share like how much of that might be rolling off in say the third and fourth quarter or at least over the second-half of the year?

Phil Reinsch

You can see that by looking on our last 10-Q, you can see that there is about $368 million or $370 million of stuff that was going to roll off by the end of the year, so that’s in our last 10-Q.

Steven Delaney - JMP Securities

I’m sorry 378..

Phil Reinsch

368 I believe …

Steven Delaney - JMP Securities

Okay, about 370, okay and then the balance of that over the …

Phil Reinsch

Over the next, well 14 months from here, yes.

Steven Delaney - JMP Securities

I think we are pretty appropriately proactive in the quarter, taking leverage down just giving the volatility and uncertainty and I guess your right, just a touch over 8%; could you give us a sense for sort of leverage I guess is never just one number, it’s kind of a range, but as you see the world right now, at least the third quarter maybe towards the end of year, where do you see that range playing out say from sort of a low -- I mean I guess I’m looking for something other than the historic eight to 12, more like, because that’s too wide, we can drive a truck though that, but something as tight as you’re willing to give us as far as where you see us operating under such circumstances.

Andy Jacobs

Spreads right now are very attractive at eight, nine leverage and personally I don’t think spreads are going to gap in anytime soon. There is still some uncertainty in the agency securities markets and so I think you will be able to continue to add paper at attractive levels and because of that I don’t see really any reason to go much above the lower end of our eight to 12 range.

Steven Delaney - JMP Securities

Okay, alright. That’s about what I expected to hear and I guess the last thing is, at quarter end we saw actual pricing on 30 day repo move up, may be 10, 15 basis points to this current 240 level and I guess I was just curios if you guys think that the spread widening, the OAS widening on the paper and sort of the volatility and the collateral prices; you think that has anything to play with where the dealers are actually pricing repo right now and if that’s the case, if that were to tighten in as some were expecting to take place over the next couple of months. What would cause pricing on the repo to maybe improve a little bit back to the two and quarter level?

Phil Reinsch

Sure, I think there are still some balance sheet issues out there.

Andy Jacobs

The lenders.

Phil Reinsch

Yes, the lenders; we also have talked about Fannie and Freddie, their debenture, where they’re having to issue new debt has obviously gone up, so there’s some talk out there, Fannie and Freddie utilizing the dollar role and the repo market more; whether that comes to pass or not, I don’t know. I just think in general right now lenders are going to be somewhat conservative because they can; whether I don’t know if the Fannie, Freddie, the noise that those guys use more repo facilities, if that’s going to come to past or whatever, but its just one of those markets were lenders can charge it, so they continue to do that.

Andy Jacobs

To use a politically correct word, they are being opportunistic. Times are wide for people like us.

Steven Delaney - JMP Securities

And I guess the only way for that to play out for your advantage would be, more capacity showing up and assuming the GFTs don’t have that market, you guys don’t mess with dollar much, I don’t think anyway.

Phil Reinsch

No, that’s correct.

Steven Delaney - JMP Securities

If unless they would have sort have tried to past this straight 30 day repo market, I guess it’s just a matter of capacity being there and people having more demand for the collateral?

Andy Jacobs

Where 30 day LIBOR is relative to funds, I mean it’s 45 basis point, 46 basis points over Fed funds which is well outside it’s historic range and of course that tightening back end, could see some improvement, but with just all the static going on in the markets today, outside our sector for the most part, but all of that static is probably going to keep the spreads between funds and one months LIBOR wider than most but when it does come in we will see some tightening and improvement from that standpoint?

Phil Reinsch

Yes, I mean the bid/ask spread and the repo market right now is attractive from our repo lender standpoint and so as long as people continue to utilize that market, I think it’s going to stay that way.

Operator

Our next question is coming from the line of Jason Arnold with RBC Capital Markets.

Jason Arnold - RBC Capital Markets

Actually to follow-up on the leverage question, you mentioned that haircuts went from, I think last quarter somewhere around maybe by 5% on average to about 4.25% and I was wondering if you could just give us an outline for what sort of circumstances would have made the credit come about to increase your leverage?

Robert Spears

It’s really, we’ve got excess liquidity right now, but given were spreads are, the risk reward trade offs is not fair. People were talking six months ago about seven point haircuts and so, I mean at this point in time Ginnie’s high-teens return at eight times the leverage is pretty good.

I just felt that its not even if the haircuts came in somewhat, at the same time, if the forward curve is correct the Fed could be raising rates and if that happens we obviously don’t want to be lower levered and so it’s not just a haircut issue, it’s where we are in the rate cycle and historically you don’t want to encourage your leverage when the Feds pretty much telling you they are not easing anymore. We want to keep excess liquidity and if rate due start moving up, we can deploy capital then.

Andy Jacobs

And just one point of clarity on relative to as Robert said, seven point haircuts is what the fear was. That was towards the end of the first quarter in that market and one of the huge resolutions since that time has been with the recent action relative to Fannie Mae. People were uncertain at that point weather the guarantee of Fannie and Freddie or the government was worth anything.

I think now that’s been result and so, that’s a point in time type of number and the goods news is things appear to be much more common in the financing sector and we’re probably going to continue to waffle closer to the 4% over that near-term with where haircuts are and we’ll do summit three and summit five, but all-in-all it can be relatively positive and I don’t think we’re going to move back to the seven or 10 point haircuts as people feared back in the first quarter for the recent event.

Operator

Our final question is coming from the line of Jason (inaudible). Please go ahead with your question sir.

Jason – Capital Peak

My questions have been answered. Thanks.

Operator

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

Bethany Siggins

Alright, well thank you Rob and thank you everyone for joining us today. If you have further questions, just please give us a call. Have a great week and we look forward to speaking with you next quarter.

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