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: June 30, 2006

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)

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

Indicate by check mark whether the Registrant (1) has filed all documents and 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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act). (Check one):

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o

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

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

Common Stock ($0.01 par value)		19,043,902 as of August 1, 2006

 

 

CAPSTEAD MORTGAGE CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2006

INDEX

		Page
PART I. — FINANCIAL INFORMATION
ITEM 1. Financial Statements
Consolidated Balance Sheets — June 30, 2006 and December 31, 2005			3
Consolidated Statements of — Operations Quarter and Six Months Ended June 30, 2006 and 2005			4
Consolidated Statements of Cash Flows — Six Months Ended June 30, 2006 and 2005			5
Notes to Consolidated Financial Statements			6
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			16
ITEM 3. Qualitative and Quantitative Disclosure of Market Risk			31
ITEM 4. Controls and Procedures			31
PART II. — OTHER INFORMATION
ITEM 6. Exhibits and Reports on Form 8-K			31
SIGNATURES			32
Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends
Certification Pursuant to Section 302(a)
Certification Pursuant to Section 302(a)
Certification Pursuant to Section 906

ITEM 1. FINANCIAL STATEMENTS

PART I. ¾ FINANCIAL INFORMATION

CAPSTEAD MORTGAGE CORPORATION

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

		June 30, 2006				December 31, 2005
		(unaudited)				(NOTE 2)
Assets:
Mortgage securities and similar investments ($4.6 billion pledged under repurchase arrangements)		$	4,787,645			$	4,368,025
Investments in unconsolidated affiliates			18,645				9,246
Receivables and other assets			67,331				53,040
Cash and cash equivalents			—				33,937
		$	4,873,621			$	4,464,248
Liabilities:
Repurchase arrangements and similar borrowings		$	4,462,835			$	4,023,686
Unsecured borrowings			77,321				77,321
Liabilities of discontinued operation			—				2,884
Common stock dividend payable			381				381
Accounts payable and accrued expenses			11,906				15,127
			4,552,443				4,119,399
Stockholders’ equity:
Preferred stock — $0.10 par value; 100,000 shares authorized:
$1.60 Cumulative Preferred Stock, Series A, 202 shares issued and outstanding at June 30, 2006 and December 31, 2005 ($3,317 aggregate liquidation preference)			2,828				2,828
$1.26 Cumulative Convertible Preferred Stock, Series B, 15,819 shares issued and outstanding at June 30, 2006 and December 31, 2005 ($180,025 aggregate liquidation preference)			176,705				176,705
Common stock — $0.01 par value; 100,000 shares authorized:
19,028 and 19,043 shares issued and outstanding at June 30, 2006 and December 31, 2005, respectively			190				190
Paid-in capital			505,266				512,933
Accumulated deficit			(352,803	)			(352,803	)
Accumulated other comprehensive income (loss)			(11,008	)			4,996
			321,178				344,849
		$	4,873,621			$	4,464,248

See accompanying notes to consolidated financial statements.

CAPSTEAD MORTGAGE CORPORATION

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

		Quarter Ended								Six Months Ended
		June 30								June 30
		2006				2005				2006				2005
Mortgage securities and similar investments:
Interest income		$	57,349			$	30,589			$	110,275			$	59,112
Interest expense			(54,685	)			(23,794	)			(102,228	)			(43,827	)
			2,664				6,795				8,047				15,285
Other revenue (expense):
Other revenue			200				215				366				411
Interest expense on unsecured borrowings			(1,621	)			—				(3,208	)			—
Other operating expense			(1,576	)			(1,482	)			(3,249	)			(3,012	)
			(2,997	)			(1,267	)			(6,091	)			(2,601	)
Income (loss) before equity in earnings of unconsolidated affiliates and discontinued operation			(333	)			5,528				1,956				12,684
Equity in earnings of unconsolidated affiliates			608				—				1,030				—
Income from continuing operations			275				5,528				2,986				12,684
Income from discontinued operation			—				462				—				908
Net income		$	275			$	5,990			$	2,986			$	13,592
Net income available (loss attributable) to common stockholders:
Net income		$	275			$	5,990			$	2,986			$	13,592
Less cash dividends paid on preferred stock			(5,064	)			(5,064	)			(10,128	)			(10,128	)
		$	(4,789	)		$	926			$	(7,142	)		$	3,464
Basic and diluted earnings (loss) per common share:
Income (loss) from continuing operations		$	(0.25	)		$	0.03			$	(0.38	)		$	0.13
Income from discontinued operation			—				0.02				—				0.05
		$	(0.25	)		$	0.05			$	(0.38	)		$	0.18
Cash dividends declared per share:
Common		$	0.020			$	0.100			$	0.040			$	0.280
Series A Preferred			0.400				0.400				0.800				0.800
Series B Preferred			0.315				0.315				0.630				0.630

See accompanying notes to consolidated financial statements

CAPSTEAD MORTGAGE CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

		Six Months Ended June 30
		2006				2005
Operating activities:
Net income		$	2,986			$	13,592
Noncash items:
Amortization of investment premiums			11,737				10,131
Depreciation and other amortization			50				60
Stock-based compensation			244				77
Undistributed earnings of unconsolidated affiliates			(181	)			—
Net change in receivables, other assets, accounts payable and accrued expenses			(13,418	)			(2,860	)
Net cash provided by operating activities of continuing operations			1,418				21,000
Net cash provided by operating activities of discontinued operation			—				1,375
Net cash provided by operating activities			1,418				22,375
Investing activities:
Purchases of mortgage securities and similar investments			(1,306,819	)			(710,966	)
Principal collections on mortgage securities and similar investments			855,293				625,374
Investments in unconsolidated affiliate – commercial real estate loan limited partnership			(9,218	)			—
Net cash used in investing activities of continuing operations			(460,744	)			(85,592	)
Net cash used in investing activities of discontinued operation			(2,884	)			—
Net cash used in investing activities			(463,628	)			(85,592	)
Financing activities:
Net increase (decrease) in repurchase arrangements and similar borrowings			439,170				8,135
Capital stock transactions			(8	)			26
Dividends paid			(10,889	)			(17,676	)
Net cash provided by (used in) financing activities of continuing operations			428,273				(9,515	)
Net cash used in financing activities of discontinued operation			—				(117	)
Net cash provided by (used in) financing activities			428,273				(9,632	)
Net change in cash and cash equivalents			(33,937	)			(72,849	)
Cash and cash equivalents at beginning of period			33,937				73,030
Cash and cash equivalents at end of period		$	—			$	181

See accompanying notes to consolidated financial statements.

CAPSTEAD MORTGAGE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2006
(unaudited)

NOTE 1 ¾ BUSINESS

Capstead Mortgage Corporation operates as a 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 real estate-related assets on a leveraged basis. These investments consist primarily of financial assets, specifically residential adjustable-rate mortgage (“ARM”) securities issued and guaranteed by government-sponsored entities, either Fannie Mae or Freddie Mac, or by an agency of the federal government, Ginnie Mae (collectively, “Agency Securities”). Capstead also seeks to opportunistically invest a portion of its investment capital in credit-sensitive commercial real estate-related assets, including subordinate commercial real estate loans.

NOTE 2 ¾ BASIS OF PRESENTATION

Interim Financial Reporting

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 and six months ended June 30, 2006 are not necessarily indicative of the results that may be expected for the calendar year ending December 31, 2006. 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, 2005.

Reclassifications

Certain prior year amounts have been reclassified to conform to the current year presentation. These reclassifications were necessary in large part because of the December 30, 2005 sale of Capstead’s real estate held for lease. All accounts associated with this investment have been reflected as a discontinued operation. Except as otherwise noted, all amounts and disclosures reflect only the Company’s continuing operations. Additionally, amounts related to collateral for structured financings and related borrowings have been reclassified as a component of Mortgage securities and similar investments and related borrowings in light of the declining significance of these amounts.

Stock-Based Compensation

Effective January 1, 2006, Capstead adopted the provisions of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment” (“SFAS123R”). SFAS123R establishes accounting for stock-based awards exchanged for director and employee services. Under the provisions of SFAS123R, stock-based compensation cost is measured at grant date, based on the fair value of the award, and is recognized as an expense over the related requisite service period. Through December 31, 2005 Capstead accounted for stock-based awards under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations (“APB25”) and provided the required pro forma disclosures of Statement of Financial Accounting Standards No. 123 “Accounting for Stock-based Compensation” (“SFAS123”).

The Company elected to use the modified prospective application method of adopting SFAS123R, and, accordingly, the Company recognized in Other operating expense compensation expense totaling $39,000 and $80,000 for the three and six months ended June 30, 2006, respectively, for the requisite service rendered during these periods relating to the unvested portion of stock option awards that previously were not given accounting recognition in earnings. Additionally, $80,000 and $164,000 was expensed related to nonvested stock awards. No previous awards were modified or repurchased during 2006. Stock-based compensation expense recognized for the three and six months ended June 30, 2005 under APB25 totaled $47,000 and $77,000, respectively. This expense would have been $19,000 and $21,000 higher for these periods under the fair value provisions of SFAS123 which would have had no effect on diluted earnings per share for these periods.

Accounting for Acquisitions of Mortgage Securities Seller-Financed using Repurchase Arrangements

From time to time Capstead will finance acquisitions of mortgage investments with the seller using repurchase arrangements. Consistent with prevailing industry practice, the Company records such assets and the related financings gross on its balance sheet, and the corresponding interest income and interest expense gross on its income statement. In addition, the asset is typically a security held available-for-sale, and any change in fair value of the asset is recorded as a component of Other comprehensive income (loss).

However, under a recent technical interpretation of the pertinent accounting rules, in a transaction where assets are acquired from and financed under a repurchase agreement with the same counterparty, the acquisition may not qualify as a sale from the seller’s perspective; in such cases, the seller may be required to continue to consolidate the assets sold based on their “continuing involvement” with such investments. The result is that the buyer may be precluded from presenting any such assets gross on its balance sheet and may instead be required to treat its net investment in such assets as a derivative financial instrument (“Derivative”) until such time as the assets are no longer financed with the seller. The resulting Derivative would be marked to market through earnings.

This potential change in accounting treatment does not affect the economics of the transactions but does affect how the transactions are reported in the financial statements. Should Capstead be required to adopt this accounting, its cash flows, liquidity and ability to pay a dividend would be unchanged, and Capstead does not believe taxable income would be affected. In addition, this would not affect Capstead’s status as a REIT or cause it to fail to qualify for its Investment Company Act exemption. Management understands that this issue has been submitted to accounting standard setters for resolution. The Company had less than $50 million in acquisitions that were seller-financed as of June 30, 2006 and December 31, 2005, respectively. Management does not believe changing the accounting treatment for any past transactions, if eventually required, would have a material affect on its earnings or financial position.

NOTE 3 ¾ EARNINGS (LOSS) PER COMMON SHARE

Basic earnings (loss) per common share is computed by dividing the reportable components of net income (Income from continuing operations and Income from discontinued operation), after deducting preferred share dividends, by the weighted average number of common shares outstanding. Diluted earnings (loss) per common share is computed by dividing the reportable components of 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 stock options and convertible preferred shares when such options and shares are dilutive. For calculation purposes the Series A and B preferred shares are considered dilutive whenever basic income from continuing operations per common share exceeds each Series’ dividend divided by the conversion rate applicable for that period.

The components of the computation of basic and diluted earnings (loss) per common share were as follows (in thousands, except per share amounts):

		Quarter Ended								Six Months Ended
		June 30								June 30
		2006				2005				2006				2005
Numerators for basic earnings (loss) per common share:
Income from continuing operations		$	275			$	5,528			$	2,986			$	12,684
Less Series A and B preferred share dividends			(5,064	)			(5,064	)			(10,128	)			(10,128	)
Income from continuing operations available (loss attributable) to common stockholders			(4,789	)			464				(7,142	)			2,556
Income from discontinued operation			—				462				—				908
		$	(4,789	)		$	926			$	(7,142	)		$	3,464
Weighted average common shares outstanding			18,894				18,869				18,883				18,865
Basic earnings (loss) per common share:
Income (loss) from continuing operations		$	(0.25	)		$	0.03			$	(0.38	)		$	0.13
Income from discontinued operation			—				0.02				—				0.05
		$	(0.25	)		$	0.05			$	(0.38	)		$	0.18
Numerators for diluted earnings (loss) per common share:
Income from continuing operations		$	275			$	5,528			$	2,986			$	12,684
Less dividends on antidilutive convertible preferred shares			(5,064	)			(5,064	)			(10,128	)			(10,128	)
Income from continuing operations available (loss attributable) to common stockholders			(4,789	)			464				(7,142	)			2,556
Income from discontinued operation			—				462				—				908
		$	(4,789	)		$	926			$	(7,142	)		$	3,464
Denominator for diluted earnings (loss) per common share:
Weighted average common shares outstanding			18,894				18,869				18,883				18,865
Net effect of dilutive stock options			—				39				—				40
Net effect of dilutive convertible preferred shares			—				—				—				—
			18,894				18,908				18,883				18,905
Diluted earnings (loss) per common share:
Income (loss) from continuing operations		$	(0.25	)		$	0.03			$	(0.38	)		$	0.13
Income from discontinued operation			—				0.02				—				0.05
		$	(0.25	)		$	0.05			$	(0.38	)		$	0.18
Antidilutive securities excluded from the calculation of diluted earnings (loss) per common share:
Nonvested stock grants and shares issuable under stock option awards			948				338				948				318
Series A preferred shares			202				202				202				202
Series B preferred shares			15,819				15,819				15,819				15,819

NOTE 4 ¾ MORTGAGE SECURITIES AND SIMILAR INVESTMENTS

Fixed-rate investments generally are mortgage securities backed by mortgage loans that have fixed rates of interest over the life of the loans. Adjustable-rate investments generally are ARM 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, ARM securities either (i) adjust annually based on a specified margin 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 a specified margin over six-month LIBOR, or (iii) adjust monthly based on a specified margin over an index such as LIBOR, CMT or the Eleventh District Federal Reserve Bank Cost of Funds Index, usually subject to periodic and lifetime limits on the amount of such adjustments during any single interest rate adjustment period and over the life 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 $1.1 billion in longer-to-reset ARM securities held by the Company as of June 30, 2006 was 41 months compared to six months for the Company’s current-reset ARM securities. Mortgage securities and similar investments and related weighted average rates classified by collateral type and interest rate characteristics were as follows (dollars in thousands):

		Principal												Carrying								Average
		Balance				Premiums				Basis				Amount(a)				WAC(b)				Yield (b)
June 30, 2006
Agency Securities:
Fannie Mae/Freddie Mac:
Fixed-rate		$	20,031			$	68			$	20,099			$	20,128				6.62	%			6.26	%
ARMs			3,784,735				56,512				3,841,247				3,830,664				5.65				4.75
Ginnie Mae ARMs			870,031				2,853				872,884				871,943				4.76				4.75
			4,674,797				59,433				4,734,230				4,722,735				5.49				4.75
Non-agency Securities:
Fixed-rate			21,339				73				21,412				21,456				7.15				6.55
ARMs			36,232				358				36,590				36,851				6.37				5.79
			57,571				431				58,002				58,307				6.66				6.07
Collateral for structured financings			6,502				101				6,603				6,603				8.02				6.87
		$	4,738,870			$	59,965			$	4,798,835			$	4,787,645				5.51				4.77
December 31, 2005
Agency Securities:
Fannie Mae/Freddie Mac:
Fixed-rate		$	23,547			$	87			$	23,634			$	23,670				6.63	%			6.29	%
ARMs			3,268,374				54,792				3,323,166				3,324,118				5.13				3.99
Ginnie Mae ARMs			933,897				4,222				938,119				941,542				4.46				4.07
			4,225,818				59,101				4,284,919				4,289,330				4.99				4.03
Non-agency Securities:
Fixed-rate			26,493				114				26,607				26,689				7.12				6.76
ARMs			42,150				467				42,617				42,908				5.33				4.72
			68,643				581				69,224				69,597				6.02				5.47
CMBS — adjustable-rate			—				—				—				—				—				4.99
Collateral for structured financings			8,960				138				9,098				9,098				7.80				7.49
		$	4,303,421			$	59,820			$	4,363,241			$	4,368,025				5.01				4.07

NOTE 5 ¾ INVESTMENTS IN UNCONSOLIDATED AFFILIATES

In July 2005 Capstead and Crescent Real Estate Equities Company (NYSE: CEI) formed Redtail Capital Partners, L.P. (“Redtail Capital”), a limited partnership owned and capitalized 75% by Capstead and 25% by CEI, for the purpose of investing in a leveraged portfolio of subordinate commercial real estate loans. As of June 30, 2006, the parties have contributed $22 million towards a total commitment of up to $100 million in equity capital to Redtail Capital to be invested over a two-year period ending in July 2007. A master agreement between the parties contemplates a follow-on partnership with similar terms to invest an additional $100 million in capital over the following two-year period. Each partnership is expected to have a four to six year existence, depending upon the timing of repayments on the related investments. CEI is responsible for identifying investment opportunities and managing the loan portfolio and is paid a management fee and may earn incentives based on portfolio performance.

Redtail Capital finances up to 75% of the value of its investments using a $225 million committed master repurchase agreement with a major investment banking firm through August 9, 2007, after which four equal repurchase payments are due quarterly through August 9, 2008, unless the term of the agreement is extended. Amounts available to be borrowed under this facility and related borrowing rates are dependent upon the characteristics of the pledged collateral and can change based on changes in the fair value of the pledged collateral. As of June 30, 2006, Redtail Capital had borrowed $37.9 million under this facility to fund investments totaling $58.6 million consisting of junior liens on three luxury full-service hospitality properties. After contributing an additional $9.2 million in equity capital in February, Capstead’s investment in Redtail Capital totaled $16.3 million as of June 30, 2006 and the Company’s equity in earnings totaled $560,000 and $935,000 for the three and six months ended June 30, 2006, respectively.

To facilitate the issuance of long-term unsecured borrowings, in September and December 2005 Capstead formed and capitalized two Delaware statutory trusts through the issuance to the Company of the trusts’ common securities totaling $2.3 million (see NOTE 8). The Company’s equity in the earnings of the trusts (consisting solely of the common trust securities’ pro rata share in interest on Capstead’s junior subordinated notes issued to the trusts) totaled $48,000 and $95,000 during the three and six months ended June 30, 2006, respectively.

NOTE 6 ¾ SALE OF DISCONTINUED OPERATION (REAL ESTATE HELD FOR LEASE)

On December 30, 2005 Capstead sold its portfolio of six independent senior living facilities to an affiliate of Brookdale Senior Living Inc. (NYSE: BKD). BKD had operated the properties under a net-lease arrangement since Capstead acquired the portfolio in 2002. The sale generated net cash proceeds to Capstead of $54.5 million and resulted in a gain of $38.2 million that was recognized in earnings during the fourth quarter of 2005. Through the utilization of available tax attributes, including a capital loss carryforward expiring December 31, 2005, Capstead retained the resulting gain and early in 2006 deployed the proceeds from this sale primarily into new mortgage securities investments.

NOTE 7 ¾ REPURCHASE ARRANGEMENTS AND SIMILAR BORROWINGS

Capstead generally pledges its Mortgage securities and similar investments as collateral under uncommitted repurchase arrangements with well-established investment banking firms, the terms and conditions of which are negotiated on a transaction-by-transaction basis. Repurchase arrangements supporting current-reset ARM securities typically have maturities of less than 31 days, while the Company will typically extend maturities on its borrowings supporting longer-to-reset ARM securities. Interest rates on repurchase arrangements are generally based on the corresponding LIBOR rate for the maturity of each borrowing. Amounts available to be borrowed under these arrangements 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 investment banking, mortgage finance and real estate

industries. Until 1995 the Company operated a mortgage conduit, pooling mortgage loans into Non-agency Securities and issuing structured financings backed by both Agency and Non-agency Securities. The maturity of outstanding structured financings is directly affected by the rate of principal prepayments on the related collateral and are subject to redemption provided certain requirements specified in the related indenture have been met (referred to as “Clean-up Calls”). Related weighted average interest rates for the dates indicated, classified by type of collateral and maturities, were as follows (dollars in thousands):

		June 30, 2006								December 31, 2005
		Borrowings				Average				Borrowings				Average
		Outstanding				Rate				Outstanding				Rate
Borrowings with maturities of 30 days or less:
Agency Securities		$	2,348,052				5.25	%		$	3,133,090				4.23	%
Non-agency Securities			53,840				5.84				63,734				4.88
			2,401,892				5.26				3,196,824				4.24
Borrowings with maturities greater than 30 days:
Agency Securities (31 to 90 days)*			1,209,553				5.32				25,000				3.25
Agency Securities (91 to 360 days)			240,224				4.13				331,907				2.79
Agency Securities (greater than 360 days)			604,563				4.81				460,857				4.50
			2,054,340				5.03				817,764				3.77
Collateral for structured financings			6,603				7.21				9,098				7.95
		$	4,462,835				5.16			$	4,023,686				4.15

The weighted average effective interest rate on Repurchase arrangements and similar borrowings was 4.83% during the quarter ended June 30, 2006.

NOTE 8 ¾ UNSECURED BORROWINGS

Unsecured borrowings consist of 30-year junior subordinated notes issued in September and December 2005 by Capstead to Capstead Mortgage Trust I and Trust II, respectively. These unconsolidated affiliates of the Company were formed to issue $2.3 million of the trusts’ common securities to Capstead and to privately place $75 million of preferred securities with unrelated third party investors. The note balances and related weighted average interest rates (calculated including issue cost amortization) listed by trust were as follows as of June 30, 2006 and December 31, 2005 (dollars in thousands):

		Borrowings				Average
		Outstanding				Rate
Junior subordinated notes:
Capstead Mortgage Trust I		$	36,083				8.31	%
Capstead Mortgage Trust II			41,238				8.45
		$	77,321				8.39

The junior subordinated notes pay interest to the trusts quarterly calculated at fixed-rates of 8.19% to 8.36% for ten years 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. Included in Receivables and other assets are $2.3 million in issue costs associated with these transactions. The weighted average effective interest rate for Unsecured borrowings (calculated including issue cost amortization) was 8.39% for the quarter ended June 30, 2006.

NOTE 9 ¾ DISCLOSURES REGARDING FAIR VALUES OF FINANCIAL INSTRUMENTS

Fair values of the Company’s investments are influenced by changes in, and market expectations for changes in, interest rates and levels of mortgage prepayments as well as other factors beyond the control of management. Because most of the Company’s investments adjust to more current rates at least annually, or will begin adjusting annually after an initial fixed-rate period, declines in fair value caused by increases in interest rates can be largely recovered in a relatively short period of time. Given that managing a large portfolio of primarily ARM mortgage securities remains the core focus of Capstead’s investment strategy, management expects these securities will be held to maturity. Consequently, temporary declines in value because of increases in interest rates would not constitute other-than-temporary impairments in value necessitating writedowns, absent a major shift in the Company’s investment focus. Disclosures for mortgage securities in an unrealized loss position as of the indicated dates were as follows (in thousands):

		June 30, 2006								December 31, 2005
		Fair				Unrealized				Fair				Unrealized
		Value				Loss				Value				Loss
Securities in an unrealized loss position:
One year or greater		$	659,008			$	9,659			$	472,584			$	6,313
Less than one year			2,063,052				16,837				1,431,465				8,611
		$	2,722,060			$	26,496			$	1,904,049			$	14,924

Fair value disclosures for mortgage securities classified as available-for-sale were as follows (in thousands):

						Gross				Gross
						Unrealized				Unrealized				Fair
		Basis				Gains				Losses				Value
As of June 30, 2006
Agency Securities:
Fixed-rate		$	386			$	29			$	—			$	415
ARMs			4,714,131				14,842				26,366				4,702,607
			4,714,517				14,871				26,366				4,703,022
Non-agency Securities			29,677				331				26				29,982
		$	4,744,194			$	15,202			$	26,392			$	4,733,004
As of December 31, 2005
Agency Securities:
Fixed-rate		$	440			$	36			$	—			$	476
ARMs			4,261,285				19,273				14,898				4,265,660
			4,261,725				19,309				14,898				4,266,136
Non-agency Securities			33,987				390				17				34,360
		$	4,295,712			$	19,699			$	14,915			$	4,300,496

Mortgage securities classified as held-to-maturity were as follows (in thousands):

						Gross				Gross
						Unrealized				Unrealized				Fair
		Basis				Gains				Losses				Value
As of June 30, 2006
Collateral released from structured financings:
Agency Securities		$	19,713			$	209			$	11			$	19,911
Non-agency Securities			28,325				314				93				28,546
Collateral for structured financings			6,603				—				—				6,603
		$	54,641			$	523			$	104			$	55,060
As of December 31, 2005
Collateral released from structured financings:
Agency Securities		$	23,194			$	636			$	—			$	23,830
Non-agency Securities			35,237				590				9				35,818
Collateral for structured financings			9,098				—				—				9,098
		$	67,529			$	1,226			$	9			$	68,746

NOTE 10 ¾ COMPREHENSIVE INCOME (LOSS)

Comprehensive income (loss) is net income plus other comprehensive income (loss), which, for the periods presented, consists primarily of the change in valuation of mortgage securities classified as available-for-sale. The following table provides information regarding comprehensive income (loss) (in thousands):

		Quarter Ended								Six Months Ended
		June 30								June 30
		2006				2005				2006				2005
Net income		$	275			$	5,990			$	2,986			$	13,592
Other comprehensive income (loss):
Amounts related to cash flow hedges:
Reclassification adjustment for amounts included in net income			(14	)			(18	)			(30	)			(52	)
Amounts related to discontinued operation			—				6				—				(7	)
Amounts related to securities held available-for-sale:
Change in valuation of mortgage securities held available-for-sale			(8,456	)			2,916				(15,974	)			(2,205	)
Other comprehensive income (loss)			(8,470	)			2,904				(16,004	)			(2,264	)
Comprehensive income (loss)		$	(8,195	)		$	8,894			$	(13,018	)		$	11,328

NOTE 11 ¾ LONG-TERM INCENTIVE AND OTHER PLANS

The Company sponsors long-term incentive plans to provide for the issuance of stock grants, stock option grants and other incentive-based stock awards to directors and employees (collectively, the “Plans”). As of June 30, 2006, the Plans had 567,409 common shares remaining available for future issuance.

In May and June 2005 nonvested stock grants for a total of 172,600 common shares were issued to directors and employees (average grant date fair value $7.86 per share) that vest proportionally over four years, subject to certain restrictions including continuous service. A summary of nonvested stock grant activity for the six months ended June 30, 2006 is presented below:

Nonvested Stock Grant Activity
						Weighted Average
		Number of				Grant Date
		Shares				Fair Value
As of December 31, 2005			172,600			$	7.86
Grants			—				—
Forfeitures			(17,800	)			7.82
Vested			(42,750	)			7.86
As of June 30, 2006			112,050				7.87

Stock option grants 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 stock on the date of grant. The fair value of each stock option grant 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/director attrition. The risk-free rate is based on market rates for the expected life of the option. Expected dividends are based on historical experience and expectations for future performance. In measuring volatility factors in recent years, the Company considered volatilities experienced by certain other companies in the mortgage REIT industry in addition to historical volatilities of Capstead shares given past circumstances affecting the trading of Capstead shares not expected to reoccur. A summary of stock option grant activity for the six months ended June 30, 2006 is presented below:

Stock Option Grant Activity
		Number of				Weighted Average
		Shares				Exercise Price
As of December 31, 2005 (419,782 exercisable at average price: $21.87)			777,669			$	15.33
Grants (average fair value: $0.80)			208,000				7.58
Forfeitures			(73,750	)			7.73
Expirations			(76,348	)			22.86
Exercises			—				—
As of June 30, 2006 (465,071 exercisable at average price: $17.89)			835,571				13.38

As of June 30, 2006 the weighted average remaining contractual term for outstanding and exercisable stock option grants was seven and five years, respectively. The aggregate intrinsic value for outstanding and exercisable stock option grants at June 30, 2006 was $101,000. Unrecognized compensation costs for unvested awards as of June 30, 2006 totaled $1.1 million, expected to be recognized over a weighted average period of approximately three years.

The Company also sponsors a qualified defined contribution retirement plan for all employees and a 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 an employee’s compensation regardless of participation in the plans. All Company contributions are subject to certain vesting requirements. Contribution expenses were $28,000 and $59,000 for the three and six months ended June 30, 2006, respectively.

NOTE 12 ¾ NET INTEREST INCOME ANALYSIS

The following summarizes interest income, interest expense (excluding interest expense on Unsecured borrowings) and related weighted average interest rates and financing spreads (dollars in thousands):

		Quarter Ended June 30
		2006								2005
						Average								Average
		Amount				Rate				Amount				Rate
Interest income		$	57,349				4.77	%		$	30,589				3.53	%
Interest expense			(54,685	)			4.83				(23,794	)			2.92
		$	2,664				(0.06	)		$	6,795				0.61

		Six Months Ended June 30
		2006								2005
						Average								Average
		Amount				Rate				Amount				Rate
Interest income		$	110,275				4.65	%		$	59,112				3.43	%
Interest expense			(102,228	)			4.61				(43,827	)			2.72
		$	8,047				0.04			$	15,285				0.71

Changes in interest income and interest expense during the indicated periods due to changes in interest rates versus changes in volume (average portfolio or borrowings outstanding) were as follows (in thousands):

		Quarter Ended June 30, 2006
		Rate *				Volume *				Total *
Total interest income		$	12,719			$	14,041			$	26,760
Total interest expense			19,121				11,770				30,891
		$	(6,402	)		$	2,271			$	(4,131	)

		Six Months Ended June 30, 2006
		Rate *				Volume *				Total *
Total interest income		$	24,829			$	26,334			$	51,163
Total interest expense			37,678				20,723				58,401
		$	(12,849	)		$	5,611			$	(7,238	)

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 real estate investment trust for federal income tax purposes (a “REIT”) and is based in Dallas, Texas. Capstead earns income from investing in real estate-related assets on a leveraged basis. These investments currently consist primarily of residential adjustable-rate mortgage (“ARM”) securities issued and guaranteed by government-sponsored entities, either Fannie Mae or Freddie Mac, or by an agency of the federal government, Ginnie Mae (collectively, “Agency Securities”).

Capstead also seeks to opportunistically invest a portion of its investment capital in credit-sensitive commercial real estate-related assets, including subordinate commercial real estate loans. In this regard, during 2005 Capstead and Crescent Real Estate Equities Company (NYSE: CEI) formed Redtail Capital Partners, L.P. (“Redtail Capital”) to invest in a leveraged portfolio of subordinate commercial real estate loans. Management believes such investments, when available at favorable prices and combined with the prudent use of leverage, can produce attractive risk-adjusted returns over the long term with relatively low sensitivity to changes in interest rates and provide earnings support during periods of rising interest rates.

Financing spreads earned on Capstead’s core portfolio of mortgage securities and similar investments (the difference between yields earned on these investments and interest rates charged on related borrowings) declined steadily over the past several years due to higher borrowing rates, despite increasing portfolio yields. While interest rates on most of the Company’s borrowings rise (and fall) almost immediately in response to changes in short-term interest rates, yields on ARM securities change slowly by comparison because coupon interest rates on the underlying mortgage loans generally reset only once or twice a year and the amount of each reset can be limited or capped. After absorbing 17 consecutive 25 basis point increases in the federal funds rate at each of the Federal Open Market Committee (the “Federal Reserve”) meetings held since June 2004 to a current level of 5.25% as of June 30, 2006, the financial markets currently anticipate that the Federal Reserve may soon begin to slow its pace of increasing rates. Once borrowing rates begin to stabilize, ARM security yield increases should allow for improving financing spreads and larger holdings of ARM securities should allow for increased contributions to earnings from this portfolio.

During the latter part of 2005, Capstead significantly bolstered its investment capital by raising $73 million in net proceeds from the issuance of long-term unsecured borrowings and the year-end sale of its real estate held for lease, generating net proceeds of nearly $55 million. The resulting increase in investment capital from the sale was retained primarily through the use of available tax attributes that otherwise would have expired unused on December 31, 2005 and was fully invested primarily into additional ARM securities early in 2006. The size and composition of Capstead’s investment portfolios depend on investment strategies being implemented by management, the availability of investment capital and overall market conditions, including the availability of attractively-priced investments. Market conditions are influenced by, among other things, current levels of, and expectations for future levels of, short-term interest rates and mortgage prepayments.

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 results of operations 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 while reading this document.

Accounting for Acquisitions of Mortgage Securities Seller-Financed using Repurchase Arrangements

As discussed more fully in NOTE 2 to the accompanying financial statements, under a recent technical interpretation of the pertinent accounting rules, when assets are acquired from and financed under a repurchase agreement with the same counterparty, the acquisitions may not qualify as purchases and the buyer may be precluded from presenting any such assets gross on its balance sheet and instead may be required to treat its net investment in such assets as a derivative financial instrument (“Derivative”) until such time as the assets are no longer financed with the seller. The resulting Derivative would be marked to market through earnings. This potential change in accounting treatment does not affect the economics of the transactions but does affect how the transactions are reported in the financial statements. Should Capstead be required to adopt this accounting, its cash flows, liquidity and ability to pay a dividend would be unchanged, and Capstead does not believe taxable income would be affected, particularly given the limited use by the Company of seller-financing.

Mortgage Securities and Similar Investments

As of June 30, 2006, Capstead’s mortgage securities and similar investments portfolio consisted primarily of ARM Agency Securities. ARM securities held by the Company generally 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. 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 Company’s $3.6 billion in current-reset ARM securities was six months as of June 30, 2006 while the average months-to-roll for the Company’s $1.1 billion in longer-to-reset ARM securities was 41 months. Agency Securities carry an implied AAA-rating with limited credit risk. Non-agency securities are private mortgage pass-through securities whereby the related credit risk of the underlying loans is borne by the Company or by AAA-rated private mortgage insurers (“Non-agency Securities”). Mortgage securities held by Capstead are generally financed under repurchase arrangements with investment banking firms pursuant to which specific securities are pledged as collateral.

During the second quarter of 2006 Capstead maintained its mortgage securities and similar investments portfolio at approximately $4.8 billion with acquisitions of current- and longer-to-reset ARM securities totaling $459 million offsetting $452 million of portfolio runoff. This follows net portfolio additions of over $400 million during the first quarter of 2006 and $700 million during the fourth quarter of 2005 as the Company deployed $128 million in investment capital made available late last year through the issuance of long-term unsecured borrowings and the sale of the Company’s portfolio of senior living facilities. Mortgage prepayments increased during the second quarter to an annualized runoff rate of 32% from 30% during the first quarter, due primarily to seasonal factors and changes in portfolio composition. The level of mortgage prepayments impacts how quickly purchase premiums are written off against earnings as portfolio yield adjustments. 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 these investment premiums are written off against earnings as yield adjustments. After experiencing relatively high mortgage prepayments during most of 2005, prepayments were lower during the first half of 2006 due to changes in portfolio composition and higher prevailing mortgage interest rates. Higher mortgage interest rates can ease prepayment pressures by removing much of the incentive for many homeowners with ARM loans to refinance and lock-in attractive longer-term interest rates. Additionally, recent additions to the portfolio have been purchased with lower investment premiums and some acquisitions have limited prepay protection which should help lessen the Company’s exposure to higher levels of prepayments in future periods. The Company anticipates that it will continue to pursue acquisitions of current- and longer-to-reset ARM securities to replace portfolio runoff depending upon availability of attractively-priced securities and other investment opportunities.

The following yield and cost analysis illustrates results achieved during the second quarter of 2006 for components of the mortgage securities and similar investments portfolio and projected third quarter 2006 annualized portfolio yields, borrowing rates and financing spreads given the assumptions more fully described in the accompanying notes (dollars in thousands):

																						Projected				Lifetime
		2nd Quarter Average												As of June 30, 2006								3rd Quarter				Runoff
		Basis (a)				Yield/Cost				Runoff				Premiums				Basis (a)				Yield/Cost (b)				Assumptions
Agency Securities:
Fannie Mae/Freddie Mac:
Fixed-rate		$	21,195				6.26	%			30	%		$	68			$	20,099				6.40	%			38	%
ARMs			3,826,930				4.75				32				56,512				3,841,247				5.10				32
Ginnie Mae ARMs			887,618				4.75				32				2,853				872,884				4.79				29
			4,735,743				4.75				32				59,433				4,734,230				5.05				31
Non-agency Securities:
Fixed-rate			22,726				6.55				36				73				21,412				6.85				37
ARMs			38,183				5.79				25				358				36,590				6.29				38
			60,909				6.07				30				431				58,002				6.50				38
Collateral for structured financings			7,196				6.87				45				101				6,603				7.24				30
			4,803,848				4.77				32			$	59,965				4,798,835				5.06				31
Related borrowings:
30-day LIBOR			3,494,207				4.97												3,611,445				5.30
>30-day LIBOR			970,906				4.34												844,787				4.65
Structured financings			7,196				6.87												6,603				7.24
			4,472,309				4.83												4,462,835				5.17
Capital employed/ financing spread		$	331,539				(0.06)											$	336,000				(0.11	)
Return on assets (c)							0.22																0.13