UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended: March 31, 2009

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to _________

CAPSTEAD MORTGAGE CORPORATION

(Exact name of Registrant as specified in its Charter)

Maryland		75-2027937
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

8401 North Central Expressway, Suite 800, Dallas, TX		75225
(Address of principal executive offices)		(Zip Code)

(214) 874-2323
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES þ NO o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES o NO o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES o NO þ

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common Stock ($0.01 par value)		63,493,132 as of May 8, 2009

 

 

CAPSTEAD MORTGAGE CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2009

INDEX

		Page
PART I. — FINANCIAL INFORMATION
ITEM 1. Financial Statements (unaudited)
Consolidated Balance Sheets — March 31, 2009 and December 31, 2008			3
Consolidated Statements of Income — Quarter Ended March 31, 2009 and 2008			4
Consolidated Statements of Cash Flows — Quarter Ended March 31, 2009 and 2008			5
Notes to Consolidated Financial Statements			6
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			17
ITEM 3. Qualitative and Quantitative Disclosure of Market Risk			36
ITEM 4. Controls and Procedures			36
PART II. — OTHER INFORMATION
ITEM 4. Submission of Matters to a Vote of Security Holders			37
ITEM 6. Exhibits and Reports on Form 8-K			38
SIGNATURES			39
Computation of Ratio of Income from Continuing Operations
Certification Pursuant to Section 302(a)
Certification Pursuant to Section 302(a)
Certification Pursuant to Section 906
EX-12
EX-31.1
EX-31.2
EX-32

ITEM 1. FINANCIAL STATEMENTS

PART I. — FINANCIAL INFORMATION

CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)

		March 31, 2009				December 31, 2008
		(unaudited)
Assets:
Mortgage securities and similar investments ($7.3 billion pledged under repurchase arrangements)		$	7,640,072			$	7,499,530
Cash collateral receivable from interest rate swap counterparties			48,182				53,676
Cash and cash equivalents			116,852				96,839
Receivables and other assets			85,928				76,200
Investments in unconsolidated affiliates			3,117				3,117
		$	7,894,151			$	7,729,362
Liabilities:
Repurchase arrangements and similar borrowings		$	6,849,684			$	6,751,500
Unsecured borrowings			103,095				103,095
Interest rate swap agreements at fair value			38,344				46,679
Common stock dividend payable			35,501				22,728
Accounts payable and accrued expenses			28,640				44,910
			7,055,264				6,968,912
Stockholders’ equity:
Preferred stock — $0.10 par value; 100,000 shares authorized:
$1.60 Cumulative Preferred Stock, Series A, 195 and 197 shares issued and outstanding at March 31, 2009 and December 31, 2008, respectively ($3,191 aggregate liquidation preference)			2,720				2,755
$1.26 Cumulative Convertible Preferred Stock, Series B, 15,819 shares issued and outstanding at March 31, 2009 and December 31, 2008 ($180,025 aggregate liquidation preference)			176,705				176,705
Common stock — $0.01 par value; 250,000 shares authorized:
63,395 and 63,135 shares issued and outstanding at March 31, 2009 and December 31, 2008, respectively			634				631
Paid-in capital			979,016				975,893
Accumulated deficit			(356,641	)			(358,155	)
Accumulated other comprehensive income (loss)			36,453				(37,379	)
			838,887				760,450
		$	7,894,151			$	7,729,362

See accompanying notes to consolidated financial statements.

CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
(unaudited)

		Quarter Ended March 31
		2009				2008
Interest income:
Mortgage securities and similar investments		$	87,884			$	106,351
Other			217				804
			88,101				107,155
Interest expense:
Repurchase arrangements and similar borrowings			(39,957	)			(69,306	)
Unsecured borrowings			(2,187	)			(2,187	)
			(42,144	)			(71,493	)
			45,957				35,662
Other revenue (expense):
Loss from portfolio restructurings			—				(1,408	)
Miscellaneous other revenue (expense)			(105	)			39
Incentive compensation expense			(1,134	)			(2,250	)
General and administrative expense			(2,707	)			(1,961	)
			(3,946	)			(5,580	)
Income before equity in earnings of unconsolidated affiliates			42,011				30,082
Equity in earnings of unconsolidated affiliates			65				65
Net income		$	42,076			$	30,147
Net income available to common stockholders:
Net income		$	42,076			$	30,147
Less cash dividends paid on preferred shares			(5,061	)			(5,064	)
		$	37,015			$	25,083
Net income per common share:
Basic		$	0.59			$	0.54
Diluted		$	0.58			$	0.53
Cash dividends declared per share:
Common		$	0.560			$	0.520
Series A Preferred			0.400				0.400
Series B Preferred			0.315				0.315

See accompanying notes to consolidated financial statements.

CAPSTEAD MORTGAGE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands, unaudited)

		Quarter Ended March 31
		2009				2008
Operating activities:
Net income		$	42,076			$	30,147
Noncash items:
Amortization of investment premiums			5,523				7,127
Depreciation and other amortization			70				53
Equity-based compensation costs			328				320
Amounts related to interest rate swap agreements			(67	)			186
Loss from portfolio restructurings			—				1,408
Net change in receivables, other assets, accounts payable and accrued expenses			(25,542	)			3,352
Net cash provided by operating activities			22,388				42,593
Investing activities:
Purchases of mortgage securities and similar investments			(367,080	)			(1,461,893	)
Proceeds from sales of mortgage securities and similar investments			—				766,800
Principal collections on mortgage securities and similar investments			286,047				384,104
Net cash used in investing activities			(81,033	)			(310,989	)
Financing activities:
Proceeds from repurchase arrangements and similar borrowings			16,263,193				17,531,660
Principal payments on repurchase arrangements and similar borrowings			(16,165,006	)			(17,235,730	)
Payment on early termination of interest rate swap agreement			—				(2,275	)
Proceeds (remittances) related to cash collateral receivable from interest rate swap counterparties			5,494				(46,895	)
Capital stock transactions			2,767				131,189
Dividends paid			(27,790	)			(14,851	)
Net cash provided by financing activities			78,658				363,098
Net change in cash and cash equivalents			20,013				94,702
Cash and cash equivalents at beginning of period			96,839				6,653
Cash and cash equivalents at end of period		$	116,852			$	101,355

See accompanying notes to consolidated financial statements.

CAPSTEAD MORTGAGE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2009
(unaudited)

NOTE 1 — BUSINESS

Capstead Mortgage Corporation operates as a self-managed real estate investment trust for federal income tax purposes (a “REIT”) and is based in Dallas, Texas. Unless the context otherwise indicates, Capstead Mortgage Corporation, together with its subsidiaries, is referred to as “Capstead” or the “Company.” Capstead earns income from investing in a leveraged portfolio of residential mortgage pass-through securities consisting almost exclusively of adjustable-rate mortgage (“ARM”) securities issued and guaranteed by government-sponsored entities, either Fannie Mae or Freddie Mac (together the “GSEs”), or by an agency of the federal government, Ginnie Mae. Agency-guaranteed mortgage securities (“Agency Securities”), carry an implied AAA rating with limited, if any, credit risk.

NOTE 2 — BASIS OF PRESENTATION

Interim Financial Reporting and Reclassifications

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the quarter ended March 31, 2009 are not necessarily indicative of the results that may be expected for the calendar year ending December 31, 2009. For further information refer to the consolidated financial statements and footnotes thereto incorporated by reference in the Company’s annual report on Form 10-K for the year ended December 31, 2008. Certain prior year amounts have been reclassified to conform to the current year presentation.

Accounting for Seller-financed Acquisitions of Mortgage Securities

On January 1, 2009, Capstead adopted the Financial Accounting Standards Board’s Staff Position FAS140-3 “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions” (“FSP140-3”). Under FSP140-3, certain seller-financed acquisitions of mortgage investments entered into after December 31, 2008 will not qualify as acquisitions if the related borrowings under repurchase arrangements are considered sufficiently linked to the acquisition transaction. Any such seller-financed acquisitions that are deemed to be sufficiently linked will generally be reported net of related financings at fair value with related changes in fair value reported in earnings until such time as the assets are no longer financed with the sellers. No such linked acquisitions have occurred during the quarter ended March 31, 2009; therefore, implementing FSP140-3 has not had any effect on Capstead’s results of operations, taxable income or financial condition.

NOTE 3 — EARNINGS PER COMMON SHARE

Basic earnings per common share is computed by dividing net income, after deducting preferred share dividends, by the weighted average number of common shares outstanding. Diluted earnings per common share is computed by dividing net income, after deducting dividends on convertible preferred shares when such shares are antidilutive, by the weighted average number of common shares and common share equivalents outstanding, giving effect to equity awards and convertible preferred shares, when such awards and shares are dilutive. For calculation purposes the Series A and B preferred shares

are considered dilutive whenever basic earnings per common share exceeds each Series’ dividend divided by the conversion rate applicable for that period. Components of the computation of basic and diluted earnings per common share were as follows (dollars in thousands, except per share amounts):

		Quarter Ended March 31
		2009				2008
Numerators for basic earnings per common share:
Net income		$	42,076			$	30,147
Less Series A and B preferred share dividends			(5,061	)			(5,064	)
Income available to common stockholders		$	37,015			$	25,083
Weighted average common shares outstanding			62,752				46,154
Basic earnings per common share		$	0.59			$	0.54
Numerator for diluted earnings per common share:
Income available to common stockholders		$	42,076			$	30,147
Denominator for diluted earnings per common share:
Weighted average common shares outstanding			62,752				46,154
Net effect of dilutive equity awards (a)			192				441
Net effect of dilutive convertible preferred shares			9,929				9,818
			72,873				56,413
Diluted earnings per common share		$	0.58			$	0.53

NOTE 4 — MORTGAGE SECURITIES AND SIMILAR INVESTMENTS

Mortgage securities and similar investments and related weighted average coupon rates and yields classified by collateral type and interest rate characteristics were as follows (dollars in thousands):

		Principal				Investment								Carrying				Net				Average
		Balance				Premiums				Basis				Amount (a)				WAC (b)				Yield (b)
March 31, 2009
Agency Securities:
Fannie Mae/Freddie Mac:
Fixed-rate		$	9,358			$	29			$	9,387			$	9,406				6.65	%			6.43	%
ARMs			7,020,705				90,752				7,111,457				7,183,323				5.02				4.70
Ginnie Mae ARMs			379,434				2,004				381,438				385,290				4.70				4.58
			7,409,497				92,785				7,502,282				7,578,019				5.01				4.70
Residential mortgage loans:
Fixed-rate			5,175				7				5,182				5,182				7.21				8.10
ARMs			8,734				78				8,812				8,812				5.11				5.38
			13,909				85				13,994				13,994				5.89				6.43
Commercial real estate loans			43,874				—				43,874				43,874				—				—
Collateral for structured financings			4,117				68				4,185				4,185				8.10				7.74
		$	7,471,397			$	92,938			$	7,564,335			$	7,640,072				4.98				4.68

		Principal				Investment Premiums								Carrying				Net				Average
		Balance				(Discounts)				Basis				Amount (a)				WAC (b)				Yield (b)
December 31, 2008
Agency Securities:
Fannie Mae/Freddie Mac:
Fixed-rate		$	9,991			$	31			$	10,022			$	10,041				6.64	%			6.56	%
ARMs			6,928,385				90,942				7,019,327				7,029,002				5.29				4.90
Ginnie Mae ARMs			394,909				2,056				396,965				397,443				4.94				4.81
			7,333,285				93,029				7,426,314				7,436,486				5.27				4.90
Residential mortgage loans:
Fixed-rate			5,880				(8	)			5,872				5,872				7.16				7.09
ARMs			9,053				79				9,132				9,132				5.58				5.90
			14,933				71				15,004				15,004				6.20				6.36
Commercial real estate loans			43,444				—				43,444				43,444				7.03				8.48
Collateral for structured financings			4,523				73				4,596				4,596				8.09				7.79
		$	7,396,185			$	93,173			$	7,489,358			$	7,499,530				5.29				4.92

Agency Securities carry an implied AAA rating and therefore limited credit risk. Residential mortgage loans held by the Company were originated prior to 1995 when Capstead operated a mortgage conduit and the related credit risk is borne by the Company. Commercial real estate loans are subordinate loans that carry credit risk associated with specific commercial real estate collateral. Collateral for structured financings consists of private residential mortgage pass-through securities obtained through the above-mentioned mortgage conduit that are pledged to secure securitizations. The related credit risk is borne by bondholders of the securitizations. The maturity of mortgage securities is directly affected by the rate of principal prepayments on the underlying mortgage loans.

Fixed-rate investments are either residential mortgage loans or Agency Securities backed by mortgage loans with fixed rates of interest. Adjustable-rate investments generally are ARM Agency Securities backed by residential mortgage loans that have coupon interest rates that adjust at least annually to more current interest rates or begin doing so after an initial fixed-rate period. After the initial fixed-rate period, if applicable, mortgage loans underlying ARM securities either (i) adjust annually based on specified margins over the one-year Constant Maturity U.S. Treasury Note Rate (“CMT”) or the one-year London interbank offered rate (“LIBOR”), (ii) adjust semiannually based on specified margins over six-month LIBOR, or (iii) adjust monthly based on specified margins over indexes such as one-month LIBOR or the Eleventh District Federal Reserve Bank Cost of Funds Index, or over a rolling twelve month average of the one-year CMT index, usually subject to periodic and lifetime limits on the amount of such adjustments during any single interest rate adjustment period and over the contractual term of the loans. The Company classifies its ARM securities based on each security’s average number of months until coupon reset (“months-to-roll”). Current-reset ARM securities have a months-to-roll of 18 months or less while longer-to-reset ARM securities have a months-to-roll of greater than 18 months. The average months-to-roll for the $4.81 billion (basis) in current-reset ARM securities held by the Company as of March 31, 2009 was 4.6 months compared to 32.6 months for the Company’s $2.69 billion (basis) in longer-to-reset ARM securities.

As of March 31, 2009, commercial real estate loans consist of (a) $5.4 million in subordinated loans expected to be repaid through townhome and land sales and (b) $38.4 million in subordinated loans collateralized by a Four Seasons hotel in the Nevis West Indies that matured October 9, 2008 and was subsequently damaged by Hurricane Omar. This property has wind and business interruption insurance

coverage, which together with related reserves, should be sufficient to repair the hotel for reopening late in 2009. In January 2009 the Company filed suit against the loan servicer and a lien holder subordinate to Capstead to enforce the Company’s rights under the loan documents. These rights include, among other items, the right to be named the controlling holder representing the lending group in reaching a resolution for the financing of this property. Included in Receivables and other assets is $808,000 in accrued interest associated with these investments and $855,000 of interest was recognized during the fourth quarter of 2008 after it was determined that impairment conditions existed. In light of deteriorating commercial real estate market conditions and the past due status of these loans, no interest was recognized during the quarter ended March 31, 2009. Management has concluded that the Company is likely to recover its investments in these loans and no impairment charges were deemed appropriate at March 31, 2009.

NOTE 5 — INVESTMENTS IN UNCONSOLIDATED AFFILIATES

To facilitate the issuance of Unsecured borrowings, in September and December 2005 and in September 2006 Capstead formed and capitalized a series of three Delaware statutory trusts through the issuance to the Company of the trusts’ common securities totaling $3.1 million (see NOTE 7). The Company’s equity in the earnings of the trusts consists solely of the common trust securities’ pro rata share in interest accruing on Unsecured borrowings issued to the trusts.

NOTE 6 — REPURCHASE ARRANGEMENTS AND SIMILAR
BORROWINGS, INCLUDING RELATED HEDGING ACTIVITY

Capstead generally pledges its Mortgage securities and similar investments as collateral under uncommitted repurchase arrangements with commercial banks and other financial institutions, the terms and conditions of which are negotiated on a transaction-by-transaction basis when each borrowing is initiated or renewed. Related borrowing rates are generally based on prevailing rates corresponding to the terms of the borrowings. Amounts available to be borrowed are dependent upon the fair value of the securities pledged as collateral, which fluctuates with changes in interest rates, credit quality and liquidity conditions within the banking, mortgage finance and real estate industries. In response to declines in fair value of pledged securities, lenders may require the Company to post additional collateral or pay down borrowings to re-establish agreed upon collateral requirements, referred to as margin calls. The maturity of outstanding structured financings is directly affected by the rate of principal prepayments on the related mortgage pass-through securities pledged as collateral. In addition, structured financings are currently subject to redemption by the residual bondholders. Repurchase arrangements and similar borrowings, classified by type of collateral and maturities, and related weighted average interest rates were as follows (dollars in thousands):

		March 31, 2009								December 31, 2008
		Borrowings				Average				Borrowings				Average
Collateral Type		Outstanding				Rate *				Outstanding				Rate *
Borrowings with maturities of 30 days or less:
Agency Securities		$	6,003,234				0.86	%		$	5,179,137				2.74	%
Borrowings with maturities greater than 30 days:
Agency Securities (31 to 90 days)			285,285				2.01				835,628				2.87
Agency Securities (91 to 360 days)			556,980				5.17				732,139				5.13
			842,265				4.10				1,567,767				3.93
Similar borrowings:
Collateral for structured financings			4,185				8.10				4,596				8.09
		$	6,849,684				1.26			$	6,751,500				3.02

Prior to the fourth quarter of 2007, Capstead routinely made use of longer-dated repurchase arrangements to effectively lock in financing spreads on a portion of its investments in longer-to-reset ARM Agency Securities for a significant portion of the fixed-rate terms of these investments. As of March 31, 2009, remaining longer-term committed borrowings consisted of a series of repurchase arrangements totaling $732 million at an average interest rate of 5.13% maturing within the next five months. Late in 2007 the Company began using two-year term, one- and three-month LIBOR-indexed, pay-fixed, receive-variable, interest rate swap agreements for this purpose in lieu of longer-dated repurchase arrangements. As of March 31, 2009, the Company’s swap positions consisted of 18 swap agreements with three large commercial banks with notional amounts totaling $2.3 billion at an average fixed rate of 3.08% and average remaining terms of 12 months, including agreements with notional amounts totaling $900 million that terminate in November and December 2009. All swap agreements have been designated as cash flow hedges of the variability of the underlying benchmark interest rate of certain current and forecasted 30- to 90-day repurchase arrangements. This hedge relationship in effect establishes a relatively stable fixed rate on the designated borrowings with the variable-rate payments to be received on the swap agreements providing an offset to interest accruing on the designated borrowings, leaving the fixed-rate payments to be paid on the swap agreements as the Company’s effective borrowing rate, subject to certain adjustments including the effects of measured hedge ineffectiveness and the spread between variable rates on the swap agreements and related actual borrowing rates. Disclosures related to these Derivatives were as follows as of and for the indicated periods (in thousands):

		Balance Sheet				March 31,				December 31,
		Location				2009				2008
Balance sheet-related
Derivatives designated as cash flow hedging instruments:
Interest rate swap agreements at fair value — assets			(a)			$	—			$	—
Interest rate swap agreements at fair value — (liabilities) (c)			(a)				(38,344	)			(46,679	)
Related net interest payable			(b)				(16,192	)			(12,909	)
						$	(54,536	)		$	(59,588	)

		Location of
		Gain or (Loss)
		Recognized in				Quarter Ended March 31
		Net Income				2009				2008
Income statement-related
Components of effect on interest expense:			(a)
Amount of gain (loss) reclassified from AOCI:
Effective portion of active positions						$	(12,025	)		$	(228	)
Effective portion of terminated positions (d)							(256	)			(61	)
							(12,281	)			(289	)
Amount of gain (loss) recognized (ineffective portion)							235				663
(Increase) decrease in interest expense							(12,046	)			374
Holding gains on interest rate swap agreements realized prior to designation as cash flow hedges			(e)				—				81
(Decrease) increase in Net income as a result of the use of interest rate swap agreements						$	(12,046	)		$	455
Other comprehensive income-related:
Amount of gain (loss) recognized in other comprehensive income (loss) (effective portion)						$	(4,014	)		$	(30,046	)

The Company’s interest rate swap agreements are measured at fair value on a recurring basis primarily using Level Two Inputs in accordance with the provisions of Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS157”). In determining fair value estimates for these agreements, the Company utilizes the standard methodology of netting the discounted future fixed cash payments and the discounted expected variable cash receipts based on expected future interest rates derived from observable market interest rate curves. The Company also incorporates both its own nonperformance risk and its counterparties’ nonperformance risk as applicable in determining the fair value of its interest rate swap agreements. In considering the effect of nonperformance risk, the Company considered the impact of netting and credit enhancements, such as collateral postings and guarantees, and has concluded that counterparty risk is not significant to the overall valuation of these agreements.

NOTE 7 — UNSECURED BORROWINGS

Unsecured borrowings consist of 30-year junior subordinated notes issued in 2006 and 2005 to three special-purpose, statutory trusts. These unconsolidated affiliates of the Company were formed to issue $3.1 million of the trusts’ common securities to Capstead and to privately place $100 million of preferred securities with unrelated third party investors. Included in Receivables and other assets are $2.7 million in remaining issue costs associated with these transactions. Note balances and related weighted average interest rates as of March 31, 2009 and December 31, 2008 (calculated including issue cost amortization) were as follows (dollars in thousands):

		Borrowings				Average
		Outstanding				Rate
Junior subordinated notes:
Capstead Mortgage Trust I		$	36,083				8.31	%
Capstead Mortgage Trust II			41,238				8.46
Capstead Mortgage Trust III			25,774				8.78
		$	103,095				8.49

The junior subordinated notes pay interest to the trusts quarterly calculated at fixed rates of 8.19% to 8.685% for ten years from issuance and subsequently at prevailing three-month LIBOR rates plus 3.30% to 3.50% for 20 years, reset quarterly. The trusts remit dividends pro rata to the common and preferred trust securities based on the same terms as the subordinated notes provided that payments on the trusts’ common securities are subordinate to payments on the related preferred securities. The Capstead Mortgage Trust I notes and trust securities mature in October 2035 and are redeemable, in whole or in part, without penalty, at the Company’s option anytime on or after October 30, 2010. The Capstead Mortgage Trust II notes and trust securities mature in December 2035 and are redeemable, in whole or in part, without penalty, at the Company’s option anytime on or after December 15, 2015. The Capstead Mortgage Trust III notes and trust securities mature in September 2036 and are redeemable, in whole or in part, without penalty, at the Company’s option anytime on or after September 15, 2016. The weighted average effective interest rate for Unsecured borrowings (calculated including issue cost amortization) was 8.49% during the quarter ended March 31, 2009.

NOTE 8 — COMPREHENSIVE INCOME (LOSS)

Comprehensive income (loss) is net income plus other comprehensive income (loss). Other comprehensive income (loss) currently consists of the change in unrealized gain on mortgage securities classified as available-for-sale and amounts related to derivative financial instruments held as cash flow hedges. As of March 31, 2009, the Accumulated other comprehensive income (loss) component of Stockholders’ equity consisted of $75.7 million in net unrealized gains on mortgage securities held available-for-sale, $38.3 million in net unrealized losses on Derivatives held as cash flow hedges and the amortized balances of a $1.0 million realized loss and $48,000 in realized gains related to terminated cash flow hedges.

The following provides information regarding the components of comprehensive income (loss) (in thousands):

		Quarter Ended March 31
		2009				2008
Net income		$	42,076			$	30,147
Other comprehensive income (loss):
Amounts related to available-for-sale securities:
Reclassification adjustments for amounts included in net income			—				1,408
Change in net unrealized gains			65,565				(10,465	)
Amounts related to cash flow hedges:
Change in net unrealized losses			(4,014	)			(27,771	)
Early termination of interest rate swap agreement			—				(2,275	)
Reclassification adjustment for amounts included in net income			12,281				289
Other comprehensive income (loss)			73,832				(38,814	)
Comprehensive income (loss)		$	115,908			$	(8,667	)

NOTE 9 — DISCLOSURES REGARDING FAIR VALUES OF MORTGAGE SECURITIES

The following tables and related discussion provide fair value disclosures as of the indicated balance sheet dates for Capstead’s holdings of mortgage securities, nearly all of which are classified as held available-for-sale, and are measured at fair value on a recurring basis using Level Two Inputs in accordance with the provisions of SFAS157. In determining fair value estimates for mortgage securities the Company considers recent trading activity for similar investments and pricing levels indicated by lenders in connection with designating collateral for repurchase arrangements, provided such pricing levels are considered indicative of actual market clearing transactions. These fair value estimates are influenced by changes in, and market expectations for changes in, interest rates and market liquidity conditions, as well as other factors beyond the control of management. Fair value disclosures for mortgage securities were as follows (in thousands):

						Gross Unrealized
		Basis				Gains				Losses				Fair Value
As of March 31, 2009
Agency Securities classified as available-for-sale		$	7,493,117			$	94,065			$	18,328			$	7,568,854
Mortgage securities classified as held-to-maturity			13,350				422				—				13,772
As of December 31, 2008
Agency Securities classified as available-for-sale		$	7,416,520			$	49,904			$	39,732			$	7,426,692
Mortgage securities classified as held-to-maturity			14,390				332				—				14,722

Additional required disclosures for mortgage securities in an unrealized loss position were as follows (in thousands):

		March 31, 2009								December 31, 2008
		Fair				Unrealized				Fair				Unrealized
		Value				Loss				Value				Loss
Securities in an unrealized loss position:
One year or greater		$	478,496			$	5,645			$	157,675			$	2,454
Less than one year			1,264,460				12,683				2,762,619				37,278
		$	1,742,956			$	18,328			$	2,920,294			$	39,732

Managing a leveraged portfolio of primarily ARM Agency Securities remains the core focus of Capstead’s investment strategy and management expects these securities will be held until payoff absent a major shift in the Company’s investment focus. Declines in fair value caused by increases in interest rates are typically modest for investments in relatively short-duration ARM Agency Securities compared to investments in longer-duration, fixed-rate assets. These declines are generally recoverable in a relatively short period of time as the coupon interest rates on the underlying mortgage loans reset to rates more reflective of the then current interest rate environment allowing for the potential recovery of financing spreads diminished during periods of rising interest rates. Consequently, any such declines in value generally would not constitute other-than-temporary impairments in value necessitating impairment charges.

Since August 2007, deteriorating conditions in the credit markets have led to concerns about the ability of the GSEs to fulfill their guarantee obligations and the availability of sufficient financing to maintain then existing leverage levels for the mortgage REIT industry. From a credit risk perspective, the real or implied federal government guarantee associated with Agency Securities, particularly in light of the September 2008 conservatorship of the GSEs and other government support for these entities, helps ensure that fluctuations in value due to credit risk associated with these securities will be limited. From a market liquidity perspective, in 2008 and 2007 Capstead reduced its portfolio leverage by raising a significant amount of new common equity capital, selling a limited amount of mortgage securities, and when appropriate, curtailing the replacement of portfolio runoff. Together with maintaining higher than usual cash balances and expanding the number of lending counterparties with whom the Company routinely does business, these actions have increased the Company’s financial flexibility to address challenging credit market conditions.

During the quarter ended March 31, 2008 the Company sold Agency Securities classified as available-for-sale with a cost basis of $768 million recognizing a loss from portfolio restructurings totaling $1.4 million (gross realized losses of $2.7 million, and gross realized gains of $1.3 million). No asset sales occurred during the quarter ended March 31, 2009.

NOTE 10 — COMPENSATION PROGRAMS

The compensation committee of Capstead’s board of directors administers all compensation programs for officers and employees including base salaries, annual incentive compensation, long-term equity-based awards, as well as other benefit programs.

To augment base salaries of certain executive officers, in 2008 the committee implemented a cash compensation program that provides for payments equal to the per share dividend declared on the Company’s common stock multiplied by a notional amount of non-vesting or “phantom” common shares (“Dividend Equivalents”). Dividend Equivalents are not attached to any stock or option awards and only have the right to receive the same cash distributions as the Company’s common stockholders are entitled to receive during the term of the Dividend Equivalents, subject to certain conditions, including continuous service. In implementing this program, initial Dividend Equivalents for 225,000 phantom common shares with terms ending on July 1, 2012 were made to certain executive officers. During the quarter ended March 31, 2009, the Company recognized in General and administrative expense $126,000 related to this program.

In order to provide officers and employees with an appropriate performance-based annual incentive compensation opportunity, each year the committee approves an incentive formula to create an incentive pool equal to a percentage participation in the Company’s earnings in excess of a pre-established performance threshold. The committee has complete discretion with respect to the amount to be distributed from the pool, including its allocation between executive officers and other employees. The committee used its discretion to limit the total amount of annual incentive compensation awarded for the

year ended December 31, 2008 to $6 million. For 2009 the committee modified the formula for determining the incentive pool and established a guideline for determining the maximum amount available to be paid in any single year equal to 50 basis points multiplied by average long-term investment capital, as defined. For purposes of the 2009 calculation, the incentive pool will equal a 10% participation in “annual earnings” (defined as Net income excluding Incentive compensation expense, any gain or loss from portfolio restructurings and interest on Unsecured borrowings, net of equity in the earnings of related statutory trusts reflected in the balance sheet as Investments in unconsolidated affiliates) in excess of a benchmark amount based on “average long-term investment capital” (defined as Unsecured borrowings, net of related investments in statutory trusts and average Stockholders’ equity, excluding Accumulated other comprehensive income (loss), incentive compensation accruals, any gain or loss from portfolio restructurings and interest on Unsecured borrowings, net of equity in the earnings of related statutory trusts) multiplied by the greater of 8.00% or the average 10-year U.S. Treasury rate plus 200 basis points.

The Company sponsors long-term equity-based award plans to provide for the issuance of stock awards, option awards and other long-term equity-based awards to directors and employees (collectively, the “Plans”). As of March 31, 2009, the Plans had 1,583,299 common shares remaining available for future issuance.

Service-based stock awards issued to directors and employees that vest in annual installments in 2009 and future years, subject to certain restrictions (principally continuous service), were as follows as of March 31, 2009:

						Total
Year of		Grant Date				Original				Remaining Shares Vesting In:
Grant		Fair Value				Grants				2009*				2010				2011				2012				2013				2014
2005		$	7.86				172,600				35,100				—				—				—				—				—
2006			8.06				218,957				53,126				48,124				48,124				—				—				—
2007			12.93				156,000				24,672				24,672				24,665				24,665				24,663				24,663
2008			12.87				6,000				6,000				—				—				—				—				—

Performance-based stock awards totaling 140,658 common shares were issued in December 2008 to employees (grant date fair value $10.18). The first 50% of these awards vest provided certain performance criteria pertaining to a three-year measurement period ending December 31, 2011 are met. The remaining 50% vests provided performance criteria pertaining to a three-year measurement period ending December 31, 2012 are met. If the performance criteria are not met at the end of a three-year measurement period, vesting will be deferred and a new three-year measurement period will be established to include the subsequent year, up to and including the year 2015. Any remaining unvested awards will expire if the performance criteria for the final three-year measurement period ending December 31, 2015 are not met. The performance criteria establishes an annualized threshold return on the Company’s long-term investment capital, subject to certain adjustments, of the greater of 8.0% or the average 10-year U.S. Treasury rate plus 200 basis points that must be exceeded for the awards to vest.

Stock award activity during the quarter ended March 31, 2009 is summarized below:

						Weighted Average
		Number of				Grant Date
		Shares				Fair Value
Stock awards outstanding at December 31, 2008			479,132			$	10.30
Vested			(72,798	)			9.84
Stock awards outstanding at March 31, 2009			406,334				10.38

Option awards currently outstanding have contractual terms and vesting requirements at the grant date of up to ten years and generally have been issued with strike prices equal to the quoted market prices of the Company’s common shares on the date of grant. The fair value of each option award is estimated on the date of grant using a Black-Scholes option pricing model. The Company estimates option exercises, expected holding periods and forfeitures based on past experience and current expectations for option performance and employee or director attrition. Risk-free rates are based on market rates for the expected life of the option. Expected dividends are based on historical experience and expectations for future performance. Expected volatility factors are based on historical experience.

Stock options issued to directors and employees that vest in annual installments in 2009 and future years, subject to certain restrictions (principally continuous service), were as follows as of March 31, 2009:

Year of		Grant Date		Strike		Total		Remaining Shares Vesting In:
Grant		Fair Value *		Price		Original Grants		2009		2010		2011
2005		$0.61		$7.85		430,000		71,875		—		—
2006		0.78		7.43		258,000		48,500		48,500		—
2007		0.89		10.46		220,500		47,000		47,000		47,000
2008		2.08		12.87		30,000		30,000		—		—

Option award activity during the quarter ended March 31, 2009 is summarized below:

		Number of				Weighted Average
		Shares				Exercise Price
Option awards outstanding at December 31, 2008			555,750			$	9.12
Exercises			(50,000	)			7.51
Option awards outstanding at March 31, 2009			505,750				9.28

Exercisable option awards outstanding as of March 31, 2009 totaled 165,875 and had a weighted average remaining contractual term of seven years, an average exercise price of $9.37 and aggregate intrinsic value of $264,000. The total intrinsic value of option awards exercised during the quarter ended March 31, 2009 was $183,000. Unrecognized compensation costs for all unvested equity awards totaled $3.8 million as of March 31, 2009, to be expensed over a weighted average period of 2.3 years.

The Company sponsors a qualified defined contribution retirement plan for all employees and a nonqualified deferred compensation plan for certain of its officers. In general the Company matches up to 50% of a participant’s voluntary contribution up to a maximum of 6% of a participant’s compensation and discretionary contributions of up to another 3% of compensation regardless of participation in the plans. All Company contributions are subject to certain vesting requirements. During the quarter ended March 31, 2009, the Company recognized in General and administrative expense related contribution expense of $111,000 related to these plans.

NOTE 11 — NET INTEREST INCOME ANALYSIS

The following summarizes interest income, interest expense and weighted average interest rates as well as related changes in interest income and interest expense due to changes in interest rates versus changes in volume (dollars in thousands):

		Quarter Ended March 31
		2009								2008
						Average								Average
		Amount				Rate				Amount				Rate
Interest income:
Mortgage securities and similar investments		$	87,884				4.68	%		$	106,351				5.68	%
Other			217				0.70				804				3.88
			88,101				4.61				107,155				5.66
Interest expense:
Repurchase arrangements and similar borrowings			(39,957	)			2.35				(69,306	)			3.96
Unsecured borrowings			(2,187	)			8.49				(2,187	)			8.49
			(42,144	)			2.45				(71,493	)			4.03
		$	45,957				2.16			$	35,662				1.63

		Rate*				Volume*				Total*
Interest income:
Mortgage securities and similar investments		$	(18,792	)		$	325			$	(18,467	)
Other			(871	)			284				(587	)
			(19,663	)			609				(19,054	)
Interest expense:
Repurchase arrangements and similar borrowings			(27,351	)			(1,998	)			(29,349	)
Unsecured borrowings			—				—				—
			(27,351	)			(1,998	)			(29,349	)
		$	7,688			$	2,607			$	10,295

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

FINANCIAL CONDITION

Overview

Capstead Mortgage Corporation (together with its subsidiaries, “Capstead” or the “Company”) operates as a self-managed real estate investment trust for federal income tax purposes (a “REIT”) and is based in Dallas, Texas. Capstead earns income from investing in a leveraged portfolio of residential mortgage pass-through securities consisting almost exclusively of adjustable-rate mortgage (“ARM”) securities issued and guaranteed by government-sponsored entities, either Fannie Mae or Freddie Mac (the “GSEs”), or by an agency of the federal government, Ginnie Mae. Agency-guaranteed mortgage securities (“Agency Securities”), carry an implied AAA rating with limited, if any, credit risk. Management believes this strategy can produce attractive risk-adjusted returns over the long term while substantially eliminating credit risk and reducing, but not eliminating, sensitivity to changes in interest rates.

Capstead typically finances its investments with its long-term investment capital, which consists of common stockholders’ equity together with $179 million of perpetual preferred stockholders’ equity (recorded amount) and $100 million of long-term unsecured borrowings (net of related investments in statutory trusts) supported by its borrowings under repurchase arrangements with commercial banks and other financial institutions. During the first quarter of 2009, the Company’s long-term investment capital increased by $78 million to $939 million, primarily because of increases in the fair value of the Company’s holdings of Agency Securities as a result of efforts by the federal government to lower mortgage interest rates and improve overall liquidity in the residential mortgage market. This contributed to an increase in the Company’s financial flexibility as evidenced by a decline in portfolio leverage (borrowings under repurchase arrangements divided by long-term investment capital) from 7.85 to one at year-end to 7.30 to one at the end of the first quarter. The Company’s mortgage securities and similar investments portfolio totaled $7.64 billion at March 31, 2009, an increase of $141 million during the quarter.

Capstead earned $42 million during the first quarter of 2009 compared to $30 million during the same period in 2008 primarily as a result of increased total financing spreads (the difference between yields on the Company’s interest-earning assets and rates on interest-bearing liabilities). Total financing spreads averaged 216 basis points during the current quarter, compared to 163 basis points during the same period in 2008, benefiting from significantly lower borrowing rates primarily attributable to lower short-term interest rates.

The size and composition of Capstead’s investment portfolio depends on investment strategies being implemented by management, the availability of investment capital as well as overall market conditions, including the availability of attractively priced investments and suitable financing to appropriately leverage the Company’s investment capital. Market conditions are influenced by, among other things, current levels of, and expectations for future levels of, short-term interest rates, mortgage prepayments and market liquidity.

Risk Factors and Critical Accounting Policies

Under the captions “Risk Factors” and “Critical Accounting Policies” are discussions of risk factors and critical accounting policies affecting Capstead’s financial condition and earnings that are an integral part of this discussion and analysis. Readers are strongly urged to consider the potential impact of these factors and accounting policies on the Company and its financial results while reading this document.

Book Value per Common Share

Nearly all of Capstead’s mortgage investments and all of its interest rate swap agreements are reflected at fair value on the Company’s balance sheet and are therefore included in the calculation of book value per common share. The fair value of these positions is impacted by credit market conditions, including changes in interest rates, and the availability of financing at reasonable rates and leverage levels. The Company’s investment strategy attempts to mitigate these risks by focusing almost exclusively on investments in Agency Securities, which are considered to have little, if any, credit risk and are collateralized by ARM loans that have interest rates that reset periodically to more current levels. Because of these characteristics, the fair value of Capstead’s portfolio is considerably less vulnerable to significant pricing declines caused by credit concerns or rising interest rates compared to portfolios that contain a significant amount of non-agency and/or fixed-rate mortgage securities of any type, which generally results in a more stable book value per common share. As of March 31, 2009, Capstead’s book value per common share (total stockholders’ equity, less liquidation preferences of the Company’s Series A and B preferred shares, divided by common shares outstanding) was $10.34, an increase of $1.20 from December 31, 2008. The following table progresses book value per common share during the quarter ended March 31, 2009:

		Per Common
		Share
Book value, beginning of quarter		$	9.14
Accretion attributed to capital transactions			0.01
Earnings in excess of dividend distributions			0.02
Improvement in value of mortgage securities classified as available-for-sale			1.04
Improvement in value of interest rate swap agreements designated as cash flow hedges			0.13
Book value, end of quarter		$	10.34

Residential Mortgage Investments

Managing a large portfolio of residential mortgage investments consisting primarily of ARM Agency Securities is the core focus of Capstead’s investment strategy. As of March 31, 2009, residential mortgage investments totaled $7.60 billion, consisting of over 99% ARM Agency Securities. This compares with residential mortgage investments totaling $7.46 billion as of December 31, 2008. Non-agency-guaranteed residential mortgage investments held by Capstead were limited to $18 million as of March 31, 2009 consisting of well-seasoned, low loan-to-value mortgage loans remaining from a conduit operation operated by the Company in the early 1990’s. The Company holds the related credit risk associated with $14 million of these loans, and the remainder of these investments are held as collateral for structured financings whereby the related credit risk is borne by the securitizations’ bondholders.

Agency Securities carry an implied AAA rating with limited, if any, credit risk because the timely payment of principal and interest is guaranteed by the GSEs, which are federally chartered corporations, or an agency of the federal government, Ginnie Mae. The September 2008 conservatorship of the GSEs by their federal regulator, and related capital commitments to the GSEs made by the U.S. Treasury, have served to help alleviate market concerns regarding the ability of the GSEs to fulfill their guarantee obligations. By focusing on investing in relatively short-duration ARM Agency Securities, declines in fair value caused by increases in interest rates are typically relatively modest compared to investments in longer-duration, fixed-rate assets. These declines are generally recoverable in a relatively short period of time as the coupon interest rates on the underlying mortgage loans reset to rates more reflective of the then current interest rate environment allowing for the potential recovery of financing spreads diminished during periods of rising interest rates.

ARM securities are backed by residential mortgage loans that have coupon interest rates that adjust at least annually to more current interest rates or begin doing so after an initial fixed-rate period. After the initial fixed-rate period, if applicable, mortgage loans underlying ARM securities either (i) adjust annually based on specified margins over the one-year Constant Maturity U.S. Treasury Note Rate (“CMT”) or the one-year London interbank offered rate (“LIBOR”), (ii) adjust semiannually based on specified margins over six-month LIBOR, or (iii) adjust monthly based on specified margins over indexes such as one-month LIBOR or the Eleventh District Federal Reserve Bank Cost of Funds Index, or over a rolling twelve month average of the one-year CMT index, usually subject to periodic and lifetime limits on the amount of such adjustments during any single interest rate adjustment period and over the contractual term of the loans. The Company classifies its ARM securities based on each security’s average number of months until coupon reset (“months-to-roll”). Current-reset ARM securities have a months-to-roll of 18 months or less while longer-to-reset ARM securities have a months-to-roll of greater than 18 months. As of March 31, 2009, the Company’s ARM securities featured the following characteristics (dollars in thousands):

										Fully				Average				Average				Average				Months
						Net				Indexed				Net				Periodic				Lifetime				To
ARM Type		Basis (a)				WAC (b)				WAC (b)				Margins				Caps				Caps				Roll
Current-reset ARMs:
Agency Securities:
Fannie Mae/Freddie Mac		$	4,419,893				4.35	%			3.01	%			1.83	%			3.83	%			10.49	%			4.5
Ginnie Mae			381,438				4.70				2.16				1.53				1.00				9.99				5.5
Residential mortgage loans			8,812				5.11				3.77				2.05				1.53				11.14				5.2
			4,810,143				4.38				2.94				1.81				3.61				10.45				4.6
Longer-to-reset ARMs:
Agency Securities:
Fannie Mae/Freddie Mac			2,691,564				6.13				3.41				1.68				2.79				11.61				32.6
		$	7,501,707				5.00				3.11				1.76				3.31				10.87				14.6

Capstead typically finances its current-reset ARM securities using 30-day borrowings under uncommitted repurchase arrangements with commercial banks and other financial institutions that are re-established monthly, although terms on a portion of these borrowings may be extended at times to manage market liquidity conditions or to take advantage of attractive terms. Interest rates on these borrowings are based on prevailing rates corresponding to the terms of the borrowings. Prior to the credit market turmoil that began in August 2007, the Company used longer-dated repurchase arrangements to effectively lock in financing spreads on investments in longer-to-reset ARM securities for a significant portion of the fixed-rate terms of these investments. As of March 31, 2009, these longer-term borrowings consisted of a series of repurchase arrangements totaling $732 million with an average rate of 5.13% that mature over the next five months. As of March 31, 2009, borrowings under repurchase arrangements totaled $6.85 billion.

In November 2007 the Company began using two-year term, one- and three-month LIBOR-indexed, pay-fixed, receive-variable, interest rate swap agreements entered into with three large commercial banks in lieu of longer-term borrowings. Under the terms of the interest rate swap agreements held by Capstead as of March 31, 2009, the Company pays fixed rates of interest averaging 3.08% on notional amounts totaling $2.30 billion with an average maturity of 12 months, including agreements with notional amounts totaling $900 million that terminate in November and December 2009. Variable payments received by the Company under these agreements provide an offset to interest accruing on a like amount of the

Company’s 30- to 90-day borrowings leaving the fixed-rate payments to be paid on the swap agreements as the Company’s effective borrowing rate, subject to certain adjustments including the effects of measured hedge ineffectiveness and the spread between variable rates on the swap agreements and related actual borrowing rates. The Company intends to continue to manage interest rate risk associated with holdings of longer-to-reset ARM securities by utilizing suitable derivative financial instruments (“Derivatives”) such as interest rate swap agreements as well as longer-dated committed borrowings if available at attractive terms.

In response to deteriorating credit market conditions during 2007 and 2008, Capstead reduced its portfolio leverage during those periods by raising a significant amount of new common equity capital, selling a limited amount of Agency Securities and, when appropriate, curtailing the replacement of portfolio runoff. In addition, the Company increased the number of lending counterparties with which it had borrowings outstanding to 16 as of March 31, 2009, up from ten in September 2007. During the first quarter of 2009, the Company resumed its usual practice of replacing portfolio runoff and deploying new common equity capital. Acquisitions for the quarter totaled $361 million in principal amount with a net WAC of 4.75% and a purchase yield of 3.30%, while portfolio runoff totaled $286 million in principal amount, resulting in an increase in portfolio of $75 million. Combined with a $66 million improvement in pricing of Agency Securities classified as available-for-sale, the Company’s holdings of residential mortgage investments increased $141 million during the quarter ended March 31, 2009. Total portfolio runoff declined to an average annualized rate of 14.3% during the first quarter from an average rate of 18.4% throughout 2008. This reflects the pronounced contraction seen in residential mortgage lending, largely because of national trends toward declining home values and tighter mortgage loan underwriting standards. Since Capstead typically purchases investments at a premium to the asset’s unpaid principal balance, high levels of mortgage prepayments can put downward pressure on ARM security yields because the level of mortgage prepayments impacts how quickly investment premiums are written off against earnings as portfolio yield adjustments.

Commercial Real Estate-related Assets

In prior years Capstead periodically augmented its core investment strategy with investments in credit-sensitive commercial real estate-related assets that could earn attractive risk-adjusted returns. Over the years these alternative investments have included a portfolio of net-leased senior living centers as well as commercial mortgage securities and subordinated loans supported by interests in commercial real estate; however, the overall level of capital committed to these investments has been relatively modest. In light of overall credit market conditions, management has concluded that it will not pursue additional investments in commercial real estate-related assets in order to focus its efforts on the Company’s core portfolio of ARM Agency Securities.

As of March 31, 2009, Capstead’s remaining investments in commercial real estate-related assets consisted of (a) $5 million in subordinated loans to a Dallas, Texas-based developer expected to be repaid through townhome and land sales, and (b) $38 million in subordinated loans collateralized by a Four Seasons hotel in the Nevis West Indies that matured October 9, 2008 and was subsequently damaged by Hurricane Omar. This property has wind and business interruption insurance coverage, which together with related reserves, should be sufficient to repair the hotel for reopening late in 2009. In January 2009 the Company filed suit against the loan servicer and a lien holder subordinate to Capstead, to enforce the Company’s rights under the loan documents. These rights include, among other items, the right to be named the controlling holder representing the lending group in reaching a resolution for the financing of this property. Included in receivables and other assets is $808,000 in accrued interest associated with these investments. In light of deteriorating commercial real estate market conditions and the past due status of these loans, no interest was recognized during the quarter ended March 31, 2009. Management has concluded that the Company is likely to recover its investments in these loans and no impairment charges were deemed appropriate at March 31, 2009.

Utilization of Long-term Investment Capital and Potential Liquidity

Capstead finances a majority of its holdings of residential mortgage securities with commercial banks and other financial institutions using borrowings under repurchase arrangements supported by the Company’s long-term investment capital. Assuming potential liquidity is available, borrowings under repurchase agreements generally can be increased or decreased on a daily basis to meet cash flow requirements and otherwise manage capital resources efficiently. Consequently, the Company’s potential liquidity inherent in its investment portfolios is as important as the actual level of cash and cash equivalents carried on the balance sheet. Potential liquidity is affected by, among other things, real (or perceived) changes in market value of assets pledged; principal prepayments; collateral requirements of the Company’s lenders; and general conditions in the commercial banking and mortgage finance industries. Future levels of portfolio leverage will be dependent upon many factors, including the size and composition of the Company’s investment portfolio (see “Liquidity and Capital Resources.”) Capstead’s utilization of long-term investment capital and its estimated potential liquidity were as follows as of March 31, 2009 in comparison with December 31, 2008 (in thousands):

						Repurchase
						Arrangements
						and Similar				Capital				Potential
		Investments (a)				Borrowings				Employed (a)				Liquidity (a)
Residential mortgage securities		$	7,596,198			$	6,849,684			$	746,514			$	323,034
Commercial real estate-related assets			43,874				—				43,874				—
		$	7,640,072			$	6,849,684				790,388				323,034
Other assets, net of other liabilities											183,978				116,852
First quarter common dividend											(35,501	)			(35,501	) (b)
										$	938,865			$	404,385
Balances as of December 31, 2008		$	7,499,530			$	6,751,500			$	860,428			$	302,931

In order to prudently and efficiently manage its liquidity and capital resources, Capstead attempts to maintain sufficient liquidity reserves to fund margin calls (requirements to pledge additional collateral or pay down borrowings), including margin calls resulting from monthly principal payments (that are not remitted to the Company for 20 to 45 days after any given month-end), as well as anticipated declines in the market value of pledged assets under stressed market conditions.

In response to deteriorating market conditions experienced the latter part of 2007 and in 2008, Capstead reduced its portfolio leverage by raising new common equity capital, selling a limited amount of mortgage securities, and, when appropriate, curtailing the replacement of portfolio runoff. As a result of these efforts, the Company lowered its portfolio leverage from 11.50 to one at June 30, 2007 to 7.85 to one by December 31, 2008. Portfolio leverage declined further to 7.30 to one by the end of the first quarter of 2009, primarily due to higher portfolio pricing since year-end. Together with maintaining higher than usual cash balances and expanding the number of lending counterparties with whom the Company routinely does business, these steps have increased the Company’s financial flexibility to address challenging credit market conditions. Management currently believes it is appropriate to maintain the Company’s leverage at or below the low end of its targeted range of eight to 12 times long-term investment capital and will take actions similar to those described above in order to maintain sufficient financial flexibility should market conditions warrant.

Accounting for Seller-Financed Acquisitions of Mortgage Securities

On January 1, 2009, Capstead adopted the Financial Accounting Standards Board’s Staff Position FAS140-3 “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions” (“FSP140-3”). Under FSP140-3, certain seller-financed acquisitions of mortgage investments entered into after December 31, 2008 will not qualify as acquisitions if the related borrowings under repurchase arrangements are considered sufficiently linked to the acquisition transaction. Any such seller-financed acquisitions that are deemed to be sufficiently linked will generally be reported net of related financings at fair value with related changes in fair value reported in earnings until such time as the assets are no longer financed with the sellers. No such linked acquisitions have occurred during the quarter ended March 31, 2009; therefore, implementing FSP140-3 has not had any effect on Capstead’s results of operations, taxable income or financial condition.

RESULTS OF OPERATIONS

		Quarter Ended March 31
		2009				2008
Income statement data (dollars in thousands, except per share data):
Interest income:
Mortgage securities and similar investments		$	87,884			$	106,351
Other			217				804
			88,101				107,155
Interest expense:
Repurchase arrangements and similar borrowings			(39,957	)			(69,306	)
Unsecured borrowings			(2,187	)			(2,187	)
			(42,144	)			(71,493	)
			45,957				35,662
Other revenue (expense):
Loss from portfolio restructurings			—				(1,408	)
Miscellaneous other revenue (expense)			(105	)			39
Incentive compensation expense			(1,134	)			(2,250	)
General and administrative expense			(2,707	)			(1,961	)
			(3,946	)			(5,580	)
			42,011				30,082
Equity in earnings of unconsolidated affiliates			65				65
Net income		$	42,076			$	30,147
Net income available to common stockholders, after preferred share dividends		$	37,015			$	25,083
Diluted earnings per common share		$	0.58			$	0.53
Average diluted shares outstanding:			72,873				56,413
Key portfolio statistics (dollars in millions):
Average yields:
Mortgage securities and similar investments			4.68	%			5.68	%
Other			0.70				3.88
Total average yields			4.61				5.66
Average borrowing rates:
Repurchase arrangements and similar borrowings			2.35				3.96
Unsecured borrowings			8.49				8.49
Total borrowing rates			2.45				4.03
Financing spreads			2.16				1.63
Net yield on total interest-earning assets			2.44				1.89
Average portfolio runoff rate			14.28				18.98
Average interest-earning assets and interest-bearing liabilities:
Mortgage securities and similar investments		$	7,517			$	7,494
Other interest-earning assets			126				83
Repurchase arrangements and similar borrowings			6,789				6,923
Unsecured borrowings			103				103
Average long-term investment capital			920				734
General and administrative and incentive compensation expense as a percentage of average long-term investment capital			1.69	%			2.31	%
Return on average long-term investment capital			19.48				17.67