NOTE 11 ¾ COMPENSATION PROGRAMS

The compensation committee of Capstead’s board of directors (the “Committee”) administers all compensation programs for employees including salaries, short- and long-term incentive compensation, including equity-based awards, as well as other benefit programs. After reviewing existing programs and practices and soliciting feedback from investors during 2013, the Committee made a number of important changes that became effective in 2013 and early 2014. The most prominent changes involved replacing an absolute return-based but discretionary bonus program with a largely nondiscretionary and formulaic, target-based annual incentive compensation program focusing more on relative return metrics and implementing a new performance-based long-term incentive compensation program.

Short-term Incentive Compensation Programs

Through June 30, 2013, the Committee utilized an incentive formula that allowed for participation in Capstead’s earnings in excess of a pre-established performance threshold, subject to a maximum amount, or cap. Awards made under this annual incentive compensation program were at the Committee’s discretion as to (i) the amount actually awarded, (ii) its allocation among executives and with other employees and (iii) the form of payment (e.g., cash or equity awards). This program was replaced with a new annual incentive compensation program for key executives referred to as the “2013 Program.” The 2013 Program determined levels of annual cash incentive compensation based on relative performance metrics measured against the Company’s peers in the mortgage REIT industry and the attainment of individual goals and objectives for participating executives. The relative performance metrics used were relative economic return (change in book value plus dividends) and relative operating efficiency (operating expenses divided by Unsecured borrowings and Stockholders’ equity), calculated for the full year and prorated for the six month period during which the program was effective in 2013. The 2013 Program defined maximum payout percentages based on a multiple of salary for each program metric thereby limiting the amount payable to each participating executive. For 2014 the Committee added an absolute economic return performance metric to this program which measures performance against established return levels.

Included in Accounts payable and accrued expenses at September 30, 2014 are accruals totaling $1.1 million for the 2014 annual incentive compensation program as well as separately determined bonus amounts for officers and employees not participating in this program. Recognized in Short-term incentive compensation are $391,000 and $883,000 related to these programs for the quarter and nine months ended September 30, 2014, respectively.

In 2008 the Committee instituted an additional performance-based short-term incentive compensation program for key executives that provides for quarterly cash payments equal to per share dividends declared on Capstead’s common stock multiplied by a notional amount of non-vesting or “phantom” common shares (“Dividend Equivalent Rights” or “DERs”). DERs are not attached to any stock or option awards and only represent the right to receive the same cash distributions that the Company’s common stockholders are entitled to receive during the term of the grants, subject to certain conditions, including continuous service. DERs outstanding at September 30, 2014 totaled 654,000. All grants expire July 1, 2015. Included in Accounts payable and accrued expenses are third quarter 2014 DERs distribution amounts totaling $222,000 that were paid in October 2014. Recognized in Short-term incentive compensation are $222,000 and $667,000 related to the DERs program for the quarter and nine months ended September 30, 2014, respectively.

Long-term Equity-based Incentive Awards

Capstead sponsors equity-based award plans to provide for the issuance of stock awards, restricted stock unit awards, option awards and other long-term equity-based incentive awards to directors and employees. In May 2014 stockholders approved the Amended and Restated 2014 Flexible Incentive Plan, which provides for the issuance of up to five million common shares pursuant to future equity-based awards as well as other incentive awards that recognize the creation of value for stockholders and promote the Company’s long-term growth and success. At September 30, 2014, the Plan had 4,965,000 common shares remaining available for future issuances.

In December 2013 the Committee adopted a new performance-based long-term incentive compensation program granting key executives a total of 242,505 restricted stock units. These units are convertible into common shares following a three-year performance period ending December 31, 2016 contingent upon whether, and to what extent, defined performance levels established for certain relative and absolute return performance metrics are met or exceeded. The relative return metrics measure the Company’s performance against its peers in the mortgage REIT industry on the basis of relative economic return and relative total stockholder return (change in stock price plus reinvested dividends). An absolute economic return metric measures performance against established return levels. For conversion purposes, each performance metric is assigned a weighting and the Company’s performance relative to each metric is calculated separately. The actual number of common shares the units can convert into for each of the metrics, if any, can range from one-half of a common share per unit if that metric’s minimum threshold of performance is met, to two common shares per unit if the related maximum performance threshold is met or exceeded, adjusted for the weighting assigned to the metric. If a metric’s minimum performance threshold is not met, no shares are issuable under that metric. Dividends accrue from the date of grant and will be paid in cash when the units convert into common shares based on the number of common shares ultimately issued, if any.

Under a prior absolute return performance-based stock award program, the Committee granted stock awards from 2008 through 2012 to all employees with staggered three-year vesting periods subject to Capstead generating annualized returns in excess of established return levels. If the required returns are not generated during 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 seventh calendar year after the year of grant. Any remaining unvested awards issued under this program will expire if the required returns are not generated for the final three-year measurement period. Information pertaining to absolute return performance-based stock awards issued to employees pursuant to this program is as follows:

							Final			Remaining Shares with
	Grant Date		Total				Measurement			Initial Measurement Periods
Year of	Fair Value		Original				Period Ends			Ending December 31
Grant	Per Share		Grants		Forfeited		December 31			2014		2015		2016
2008 ^(a)	$	10.18		140,658		5,464		n/	a		–		–		–
2009 ^(b)		14.33		110,917		4,571		n/	a		–		–		–
2010 ^(c)		12.44		128,766		5,759		2017			61,499		–		–
2011		12.72		132,490		5,050		2018			63,722		63,718		–
2012		11.67		145,399		5,697		2019			–		69,853		69,849

(a)

The absolute return metrics for the three-year measurement periods ending December 31, 2012 and 2011 were met resulting in the vesting of 67,595 shares associated with the second 50% of this grant in January 2013 and 67,599 shares associated with the first 50% of this grant in February 2012.

(b)

The absolute return metrics for the three-year measurement periods ending December 31, 2013 and 2012 were met resulting in the vesting of 52,915 shares associated with the second 50% of this grant in January 2014 and 53,431 shares associated with the first 50% of this grant in January 2013.

(c)

The absolute return metric for the first three-year measurement period ending December 31, 2013 was met resulting in the vesting of 61,508 shares associated with the first 50% of this grant in January 2014.

In December 2013 the Committee granted service-based stock awards for 35,703 common shares with a grant date fair value of $12.34 to employees that weren’t awarded performance-based restricted stock units. These awards vest January 2, 2017. As a component of the Company’s director compensation program, directors are granted stock awards annually upon election or re-election to the board of directors that vest approximately one year from issuance. In April 2014, director grants awarded in 2013 for 28,000 shares with a grant date fair value of $13.02 vested. In July 2014, director stock awards for 35,000 shares with a grant date fair value of $13.16 were granted that vest in July 2015. In January 2014 the remaining 22,164 shares associated with 2007 service-based stock awards issued to all employees vested.

Performance-based and service-based stock award activity for quarter and nine months ended September 30, 2014 is summarized below:

				Weighted Average
	Number of			Grant Date
	Shares			Fair Value
Unvested stock awards outstanding at December 31, 2013		528,931		$	12.51
Grants		35,000			13.16
Vestings		(164,587	)		13.23
Unvested stock awards outstanding at September 30, 2014		399,344			12.28

During the quarter and nine months ended September 30, 2014, the Company recognized in Long-term incentive compensation $372,000 and $1.1 million, respectively, related to amortization of the grant date fair value of employee performance-based and service-based stock awards. The amounts amortized for these periods assumed that performance metrics, if applicable, would continue to be met for related initial measurement periods. In addition, the Company recognized in Other general and administrative expense $77,000 and $199,000 related to amortization of the grant date fair value of service-based director stock awards during the quarter and nine months ended September 30, 2014, respectively. Unrecognized compensation expense for unvested stock awards totaled $1.8 million as of September 30, 2014, to be expensed over a weighted average period of 1.3 years (assumes minimal employee and director attrition and, if applicable, absolute return performance metrics being met for related initial measurement periods).

During the quarter and nine months ended September 30, 2014 the Company recognized in Long-term incentive compensation $252,000 and $755,000, respectively, related to the performance-based restricted stock units granted in December 2013. A grant date fair value of $12.45 was assigned to each unit based on estimated outcomes for each nonmarket-based performance metric and a Monte Carlo simulation for the relative total stockholder return performance metric. Assuming certain targeted performance levels are achieved and there are no forfeitures, $3.0 million can be expected to be expensed over the related three-year performance period. However, the value associated with the nonmarket-based performance metrics is subject to change over the units’ performance period. Actual expense assuming no forfeitures will range from a minimum of $625,000 (the grant date fair value of the total stockholder return performance metric and assuming no shares are ultimately issued under the terms of these grants because the Company’s performance for all performance metrics was less than the related minimum threshold performance levels) to approximately $5.4 million assuming maximum performance levels are met or exceeded for all performance metrics resulting in the issuance of 485,010 common shares.

All service-based stock awards receive dividends on a current basis without risk of forfeiture if the related awards do not vest. All outstanding performance-based stock awards and restricted stock units defer the payment of dividends accruing between the grant dates and the end of related performance periods. If performance-based stock awards do not vest or to the extent restricted stock units do not convert into common shares, the related accrued dividends will be forfeited. Included in Common stock dividend payable at September 30, 2014 is estimated dividends payable pertaining to these awards totaling $1.6 million.

Option awards currently outstanding have ten-year contractual terms from the grant date and were 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 option awards was estimated on the date of grant using a Black-Scholes option pricing model. The Company estimated option exercises, expected holding periods and forfeitures based on past experience and expectations for option performance and employee or director attrition. Risk-free rates were based on market rates for the expected life of the options. Expected dividends were based on historical experience and expectations for future performance. Expected volatility factors were based on historical experience. No option awards have been granted since 2010.

Option award activity for the nine months ended September 30, 2014 is summarized below:

	Number of			Weighted Average
	Shares			Exercise Price
Option awards outstanding at December 31, 2013		77,500		$	11.75
Expirations		(10,000	)		14.41
Exercises (aggregate intrinsic value: $67,000)		(27,500	)		10.63
Option awards outstanding at September 30, 2014		40,000			11.86

All outstanding option awards are exercisable at September 30, 2014. These awards have a weighted average remaining contractual term of 3.7 years and an aggregate intrinsic value of $25,000.

Other Benefit Programs

Capstead sponsors a qualified defined contribution retirement plan for all employees and a nonqualified deferred compensation plan for certain of its executives. In general the Company matches up to 50% of a participant’s voluntary contribution up to a maximum of 6% of a participant’s base salary and annual incentive compensation payments and makes discretionary contributions of up to another 3% of such compensation regardless of participation in the plans. Company contributions are subject to certain vesting requirements that have been met by nearly all of Capstead’s current employees. During the quarter and nine months ended September 30, 2014, the Company recognized in Salaries and benefits $68,000 and $187,000, respectively, related to contributions to these plans.