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Capstead Mortgage (NYSE:CMO)
Q3 2019 Earnings Call
Oct 24, 2019, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Good day, and welcome to the Capstead Mortgage third-quarter 2019 earnings conference call. All participants will be in a listen-only mode. [Operator instructions]. After today's presentation there will be an opportunity to ask questions.

[Operator instructions]. Please note that this event is being recorded. I would now like to turn the conference over to Lindsey Crabbe. Please go ahead.

Lindsey Crabbe -- Director of Investor Relations

Good morning. Thank you for attending Capstead's third-quarter earnings conference call. The third-quarter earnings release was issued yesterday October 23, 2019 and is posted on our website at www.capstead.com under the investor relations tab. The link to this webcast is also in the investor relations section of our website.

an archive of this webcast and a replay of this call will be available through January 29, 2019. Details for the replay are included in yesterday's release. With me today are Phil Reinsch, president and chief executive officer; Robert Spears, executive vice president and chief investment officer; and Lance Phillips, senior vice president and chief financial officer. Before we get started, I want to remind you that some of today's comments could be considered forward-looking statements pursuant to the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995 and are based on certain assumptions and expectations of management.

For a detailed list of all the risk factors associated with our business, please refer to our filings with the SEC, which are available on our website. The information contained in this call is current only as of the date of this call October 24, 2019. The company assumes no obligation to update any statements, including any forward-looking statements made during this call. With that, I will turn it over to Phil.

Phil Reinsch -- President and Chief Executive Officer

Thank you, Lindsey. After a few brief remarks Lance will give a recap of the quarter and then we'll open the call up for questions. With this quarters core earnings per share of $0.11 we have now reported core earnings as or near our current $0.12 dividend runrate for each of the last three quarters. This quarter we absorbed higher mortgage prepayments due to both seasonality and the declines in longer-term interest rates experienced the last two quarters.

We also weathered lower swap received receipts due to declines in three months LIBOR relative to prevailing repo costs and dealt with the late September repo market funding stresses with little impact on our borrowing cost. That said repo rate have been stubbornly elevated relative to said funds for some time now representing a headwind for our financing spreads and earnings. Further lower prevailing rates and higher levels of market volatility have had a negative effect on portfolio and swap valuations contributing to a 3.7% decline in book value this quarter and making us to take a cautious approach to leverage levels and the deployment of 75 million in new common equity capital raised in early August. Despite these market conditions Fed Funds cuts in July, mid-September, and perhaps the end of this month will benefit us significantly and should contribute to stronger earnings in the quarters to come.

Additionally we took advantage of lower prevailing interest rates earlier in the quarter to replace higher rate swaps in our hedging book with new lower rate swaps although not dramatically altering our overall hedge position and effectively locking in market expectations at the time of these trades to a more Fed rate cuts. As a result of these efforts at September 30th the fixed rate on our swap books stood at 2.04% down considerably from an average fixed rate of 2.14% during this quarter which will lead to significantly lower hedging costs in the quarters to come. I want to emphasize that while the mortgage prepayment levels we experienced this quarter were higher, the rate of increase at under 15% quarter over quarter was significantly less than the overall 40% increase in agency fixed rate speeds. Further ARM speeds actually declined for October versus continued increases in the fixed rate universe.

To wrap this up we are increasingly optimistic about our earnings prospects with mortgage prepayments moderating, short-term interest rates declining with no small help from the Fed, hedging costs declining, attractive returns available on agency ARMs, and dry powder thanks to cautious leveraged management and our timely equity race. With that I'll turn the call over to Lance.

Lance Phillips -- Senior Vice President and Chief Financial Officer

Thank you, Phil. We reported GAAP net income of 3.2 million this quarter, a net loss of $0.02 per diluted common share. Our core earnings were 14.8 million or $0.11 per diluted common share. The difference between our GAAP and core results this quarter primarily relates to the impact of lower prevailing interest rates on our interest rate swap agreements and other derivatives held for hedging purposes.

We include a reconciliation of these differences on page 9 of our press release. Portfolio yields averaged 2.76% during the quarter, a decrease of six basis points from the 2.82% we reported in the second quarter. Yields declined primarily due to the effects of higher mortgage fee credit levels while cash yields were largely unchanged. Our portfolio related borrowing costs after adjusting for our hedging activities averaged 2.31% during the third quarter, four basis points lower than in the prior quarter.

The benefit of a larger decline in unhedged rates and a lower fixed rate -- lower fixed rates on our swap book were partially offset by the continued decline in three month LIBOR which negatively impacted the received leg of these derivatives. Book value decreased $0.33 per share during the third quarter aiming at $8.60 per common share reflecting a $0.23 decline associated with our hedging activities, $0.06 in initial dilution related to our capital issuance in August, and $0.03 in partially related pricing change, a portfolio related pricing change. With that we'll open the call up to questions.

Questions & Answers:


Operator

[Operator instructions]. Our first question comes from Eric Hagen with KBW. Please go ahead.

Eric Hagen -- KBW -- Analyst

Thanks. Good morning. At what point did you guys reduce leverage during the quarter always. It looks like there was a fair amount of nominal spread widening which would suggest that you might actually want that leverage to capture the return available to you in a relatively more attractive spread environment, I'm just trying to get a sense for the timing and kind of nature of reducing leverage? Thanks.

Phil Reinsch -- President and Chief Executive Officer

Sure. I mean we made a conscious decision during the quarter to take our leverage down just gathering what was going on in the market at that point in time. Obviously we raised 75 million in capital. We didn't feel the need to completely deploy that at that point in time -- running high and there was disarray in the repo markets.

So we just thought there might be some better entry points. And if you look at where we are now in the fourth quarter spreads haven't snapped back. So we have some dry powder to deploy if we see some year-end selling. Having said that given where spreads are right now we can deploy that in a three quarters to nine area and get returns there comparable to what we were getting at nine and a half times leverage a few months ago as you alluded to because of the spread widening.

So we just think it's prudent at this point in time given what's gone on in the repo markets and freebase to keep our leverage a little lower.

Eric Hagen -- KBW -- Analyst

OK. So the capital raised in July was not used directly for delevering, it was -- the delevering took place after a separate...?

Phil Reinsch -- President and Chief Executive Officer

Yeah, we continue to buy bonds throughout the quarter. We just didn't buy as many as we could have because we made a conscious decision to take our leverage down irrespective of the capital that we write.

Lance Phillips -- Senior Vice President and Chief Financial Officer

Yeah, I guess so a lot of the return of some of what we experienced in the second quarter with rates dropping and market volatility picking up and that helped inform our decision making.

Eric Hagen -- KBW -- Analyst

Ok, that makes sense. I guess, could you have also captured in a sense the same goal of reducing risk on the balance sheet by buying back some of your preferred stock with the comment that you raised in July. I guess the risk looks somewhat higher that if prepays remain somewhat elevated and your book value remains under a little bit of pressure because of pay downs that the preferred in your capital structure will just continue to consume a larger proportion of your overall equity base and you guys have a fairly large chunk of preferred that's costing you more than your overall return on equity, and I guess there's no free lunch, I realize that there's the potential for that to hit book value if you were to use common to buyback preferred but I'm just curious how you guys thought about the option to reduce leverage at the overall business level versus just delevering the common investor?

Phil Reinsch -- President and Chief Executive Officer

So when you look at that preferred that we have outstanding and the 100 million of unsecured borrowings that has about almost 20 years to run, the overall cost of that capital is pretty reasonable around seven and three quarters so a little bit under that. And that's pretty tough to replace in this environment, even the perpetual preferred market today is a five year fixed and floating environment which from a permanent capital perspective isn't -- we don't view it as nearly as attractive as perpetually fixed coupon preferred. And at the levels that are getting done out there you wouldn't refinance that preferred with the new preferred. In terms of using common equity to reduce our preferred equity through a redemption of some sort you could do that but then you're giving up the option of having that mezzanine capital out there when your overall returns exceed that preferred cost of capital.

And on the margin deploying that capital in from runoff or from the equity raise into new securities whereas considerably higher ROE than that preferred cost of capital such that over time we will be earning in excess of the preferred cost, that's the plan and that preferred will once again be accretive to our common returns.

Eric Hagen -- KBW -- Analyst

OK.

Operator

[Operator instructions]. Our next question comes from Steve DeLaney with JMP Securities. Please go ahead.

Steve DeLaney -- JMP Securities -- Analyst

Thanks and appreciate you guys taking my questions. Robert I was wondering if we look at Fed Funds today at 180, the GCF RMBS rate of 193 or so. Where does that put your 30 day repo rate to you from the dealers?

Robert Spears

What we're seeing right now is around 207 and as Phil alluded to in his message if you look at what we're paying for repo rates versus various short-term money market rates it's elevated. If you go back over the last three or four years and look at what we paid in repo over the last three or four months versus either Fed Funds or one month LIBOR we're paying on a spread basis 10 to 20 basis points more than you would have expected if those spreads would have just remained constant. So having said that if the Fed cuts like people expect at the end of October we would expect that repo rate to drop to say 185. Obviously a positive but on a spread basis versus where in one month LIBOR will be still at an elevated spread.

Steve DeLaney -- JMP Securities -- Analyst

And with given what we saw in September and I know the Feds responded aggressively but anything different this year as you approach year-end in terms of you got that yeah, be nice to lock in now but you also want to wait for a rate cut which possibly doesn't come until December?

Robert Spears

Yeah, we'll probably proactively manage the repo both well, we might extend some roles if we see advantageous rates over year-end, we might not -- we primarily do 30 day stuff in 60 or 90 day rates that look attractive to get us over year-end, we will probably do some of that trade because it's anybody's guess as to what the funding markets are going to look like at year-end. I mean I think the Fed has been obviously a positive but it was pretty ugly mid-September through the end of the quarter. And so I still think there is a question of how much of that borrowing rate that primaries are getting through the Fed's repo operations, how much of that they actually pass down to their either other intermediaries or two other counter parties. So, well we'll just kind of look at that as we go but we will probably also position a little early just to make sure our book is in good shape if you're in.

Steve DeLaney -- JMP Securities -- Analyst

Got it, well given where given where we are today at say 205-210 on repo and your new lower two year swap rates, at the margin issue and you brought -- I know you are not looking to actively redeploy but at the margin what type of net interest spread would you say you're looking at today?

Lance Phillips -- Senior Vice President and Chief Financial Officer

I think we're probably looking at kind of the 90 to 95 basis point area which as I mentioned to Eric earlier even at eight and three quarters nine times leverage that's still throwing off 10.5 to 11% type returns. So we have some dry powder to take advantage if there are opportunities in the fourth quarter and we are looking to do that. So spreads are still extremely attractive but obviously it's because of the conditions in the market right because of prepay uncertainty and repo at Fed uncertainty. So they look attractive now but we don't know.

But we could think leverage up if we needed to.

Steve DeLaney -- JMP Securities -- Analyst

Right, you got a little flexibility there if you saw a great opportunity. So yeah, and one last -- my last thing, obviously I have -- we have here some work to do on our premium amortization, you guys beat us handily in this quarter so congrats. Help me understand we're now with the concept of sort of a lifetime CPR approach and obviously speeds were up but I'm trying to rationalize the fact that you've moved to a more stabilized lifetime approach but yet in the quarter you lost six basis points which you attributed primarily that decline to 276 from 282 you attributed to higher prepay. So I'm sort of trying to rationalize sort of the lifetime approach but then the impact of quarter-to-quarter changes and speed is anything straight forward that you can say about that, I know it's a pretty complicated calculation?

Phil Reinsch -- President and Chief Executive Officer

I don't know what all we can tell you. You know we're amortizing under our effective yield method with a lifetime speed assumption and so the level yield calculation pretty much throws out what your amortization is going to do. And that's just how it rolls. So you're seeing less, you're seeing a less aggressive amortization of our premium than from years ago.

And we think that's appropriate. And...

Steve DeLaney -- JMP Securities -- Analyst

Oh yeah, I'm not questioning it. I totally think it's appropriate. And I was just trying to trying to rationalize the two. What I'm hearing you say Phil is while you have a lifetime expectation you are still going to be impacted in terms of amortization based on actual speed, is that so I think I was...?

Phil Reinsch -- President and Chief Executive Officer

Absolutely right and that's the way it should be. Yeah, you got -- if you're running low or high that's going to have an incremental impact on your overall effective yield for the life of your investment and it will be accounted for in the current period when that occurs.

Steve DeLaney -- JMP Securities -- Analyst

OK, well I think I'll follow-up when I am going to demotic. I'll follow up the plans and just see how we can tighten things up. And just I said last but just one final thing your swap, your repositioning of your swaps in the quarter do you have any estimate of what impact that that had on either GAAP or core earnings?

Phil Reinsch -- President and Chief Executive Officer

Well we tried to give a data point that would help you get there by indicating what our average fixed swap rate was of 2.14% average fixed and at the end of the quarter it stood at 2.04%. Now we do have some swaps burning off in the fourth quarter that are at lower levels. So that will impact future swap rates as well. But that should be able to help you quantify it to some extent.

Steve DeLaney -- JMP Securities -- Analyst

Yup, got that in the notes. OK, thanks for the comments.

Operator

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

Lindsey Crabbe -- Director of Investor Relations

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

Operator

[Operator signoff]

Duration: 23 minutes

Call participants:

Lindsey Crabbe -- Director of Investor Relations

Phil Reinsch -- President and Chief Executive Officer

Lance Phillips -- Senior Vice President and Chief Financial Officer

Eric Hagen -- KBW -- Analyst

Steve DeLaney -- JMP Securities -- Analyst

Robert Spears

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