================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
|X| Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended September 30, 2004
|_| Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
DYNEX CAPITAL, INC.
(Exact name of registrant as specified in its charter)
Commission File Number 1-9819
Virginia 52-1549373
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
4551 Cox Road, Suite 300, Glen Allen, Virginia 23060-6740
(Address of principal executive offices) (Zip Code)
(804) 217-5800
(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 ninety days.
|X| Yes |_| No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2).
|_| Yes |X| No
As of October 31, 2004, the registrant had 12,162,391 shares of common stock
outstanding with a par value of $.01 per share, which is the registrant's only
class of common stock.
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DYNEX CAPITAL, INC.
FORM 10-Q
INDEX
Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets at September 30, 2004
and December 31, 2003 (unaudited).......................................1
Condensed Consolidated Statements of Operations and
Comprehensive Income for the three and nine months ended
September 30, 2004 and 2003 (unaudited) .................................2
Condensed Consolidated Statements of Cash Flows for
the nine months ended September 30, 2004 and 2003 (unaudited) ..........3
Notes to Condensed Consolidated Financial Statements (unaudited).........4
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations...........................11
Item 3. Quantitative and Qualitative Disclosures about Market Risk..............24
Item 4. Controls and Procedures.................................................26
PART II. OTHER INFORMATION
Item 1. Legal Proceedings ......................................................27
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.............28
Item 3. Defaults Upon Senior Securities.........................................28
Item 4. Submission of Matters to a Vote of Security Holders.....................28
Item 5. Other Information.......................................................28
Item 6. Exhibits................................................................29
SIGNATURE.................................................................................30
EXHIBIT INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED
BALANCE SHEETS (UNAUDITED)
(amounts in thousands except share data)
-----------------------------------------------
September 30, December 31,
2004 2003
-------------------- ---------------------
ASSETS
Cash and cash equivalents $ 40,392 $ 7,386
Other assets 5,114 4,174
-------------------- ---------------------
45,506 11,560
Investments:
Securitized finance receivables:
Loans, net 1,308,519 1,518,613
Debt securities 216,999 255,580
Other investments 13,204 37,903
Securities 28,013 33,275
Other loans 5,964 8,304
-------------------- ---------------------
1,572,699 1,853,675
-------------------- ---------------------
$ 1,618,205 $ 1,865,235
==================== =====================
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Non-recourse securitization financing $ 1,466,293 $ 1,679,830
Repurchase agreements 15,381 23,884
Senior notes 823 10,049
-------------------- ---------------------
1,482,497 1,713,763
Accrued expenses and other liabilities 2,489 1,626
-------------------- ---------------------
1,484,986 1,715,389
-------------------- ---------------------
Commitments and contingencies (Note 11) - -
SHAREHOLDERS' EQUITY
Preferred stock, par value $.01 per share, 50,000,000 shares authorized:
9.75% Cumulative Convertible Series A, None and 493,595 shares issued and - 11,274
outstanding (None and $16,322 aggregate liquidation preference,
respectively)
9.55% Cumulative Convertible Series B, None and 688,189 shares issued and - 16,109
outstanding (None and $23,100 aggregate liquidation preference,
respectively)
9.73% Cumulative Convertible Series C, None and 684,893 shares issued and - 19,631
outstanding (None and $28,295 aggregate liquidation preference,
respectively)
9.75% Cumulative Convertible Series D, 5,628,737 shares and none issued and 55,666 -
outstanding ($56,287 and no aggregate liquidation preference, respectively)
Common stock, par value $.01 per share, 100,000,000 shares authorized, 122 109
12,162,391 and 10,873,903 shares issued and outstanding, respectively
Additional paid-in capital 366,896 360,684
Accumulated other comprehensive income (loss) 1,999 (3,882)
Accumulated deficit (291,464) (254,079)
-------------------- ---------------------
133,219 149,846
-------------------- ---------------------
$ 1,618,205 $ 1,865,235
==================== =====================
See notes to unaudited condensed consolidated financial statements.
DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED STATEMENTS
OF OPERATIONS AND COMPREHENSIVE INCOME (UNAUDITED)
(amounts in thousands except share and per share data)
------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
---------------------------------- ---------------------------------------
2004 2003 2004 2003
--------------- --------------- ----------------- -----------------
Interest income:
Securitized finance receivables $ 29,260 $ 35,815 $ 94,615 $ 111,992
Securities 509 199 1,623 608
Other loans 181 175 514 428
Other investments 76 1,018 122 3,522
--------------- --------------- ----------------- -----------------
30,026 37,207 96,874 116,550
--------------- --------------- ----------------- -----------------
Interest and related expense:
Non-recourse securitization financing 23,485 27,747 77,912 85,674
Repurchase agreements and senior notes 97 556 422 1,540
Other 50 72 192 234
--------------- --------------- ----------------- -----------------
23,632 28,375 78,526 87,448
--------------- --------------- ----------------- -----------------
Net interest margin before provision for loan
losses 6,394 8,832 18,348 29,102
Provision for loan losses (1,291) (5,831) (17,438) (29,715)
--------------- --------------- ----------------- -----------------
Net interest margin 5,103 3,001 910 (613)
Impairment charges (162) (2,277) (9,569) (4,482)
(Loss) gain on sale of investments, net (3,147) 769 (3,143) 1,779
Other (expense) income (3) 130 (264) 170
General and administrative expenses (1,847) (2,124) (6,330) (6,296)
--------------- --------------- ----------------- -----------------
Net loss (56) (501) (18,396) (9,442)
Preferred stock (charge) benefit (1,381) (1,191) (527) 8,039
--------------- --------------- ----------------- -----------------
Net loss to common shareholders $ (1,437) $ (1,692) $ (18,923) $ (1,403)
--------------- --------------- ----------------- -----------------
Change in net unrealized gain/(loss) on:
Investments classified as available-for-sale
during the period 211 (2,004) 3,526 976
Hedge instruments 349 1,010 2,354 (109)
--------------- --------------- ----------------- -----------------
Comprehensive income (loss) $ 504 $ (1,495) $ (12,516) $ (8,575)
=============== =============== ================= =================
Net loss per common share:
Basic and diluted $ (0.12) $ (0.16) $ (1.70) $ (0.13)
=============== =============== ================= =================
Weighted average number of common shares outstanding:
Basic and diluted 12,162,391 10,873,903 11,144,102 10,873,903
=============== =============== ================= =================
See notes to unaudited condensed consolidated financial statements.
DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED STATEMENTS
OF CASH FLOWS (UNAUDITED)
(amounts in thousands)
-------------------------------------------------
Nine Months Ended
September 30,
-------------------------------------------------
2004 2003
---------------------- -----------------------
Operating activities:
Net loss $ (18,396) $ (9,442)
Adjustments to reconcile net loss to net cash provided by operating
activities:
Provision for loan losses 17,438 29,715
Impairment charges 9,569 4,482
Loss (gain) on sale of investments 3,143 (1,779)
Amortization and depreciation 3,548 947
Net change in other assets, accrued expenses and other liabilities 1,048 1,332
---------------------- -----------------------
Net cash and cash equivalents provided by operating activities 16,350 25,255
---------------------- -----------------------
Investing activities:
Principal payments received on securitized finance receivables 223,255 228,325
Payments received on other investments, securities and other loans 18,539 13,159
Proceeds from sales of securities and other investments 23,065 2,536
Purchase of or advances on investments (11,087) (1,669)
Other 45 170
---------------------- -----------------------
Net cash and cash equivalents provided by investing activities 253,817 242,521
---------------------- -----------------------
Financing activities:
Principal payments on non-recourse securitization financing (224,076) (234,285)
Proceeds from sale of redemption rights 7,377 -
Repayment of repurchase agreement borrowings (8,502) -
Repayment of senior notes (10,050) (18,020)
Retirement of preferred stock (647) (19,553)
Dividends paid (1,263) (1,787)
---------------------- -----------------------
Net cash and cash equivalents used for financing activities (237,161) (273,645)
---------------------- -----------------------
Net increase (decrease) in cash and cash equivalents 30,006 (5,869)
Cash and cash equivalents at beginning of period 7,386 15,077
---------------------- -----------------------
Cash and cash equivalents at end of period $ 40,392 $ 9,208
====================== =======================
Supplement disclosures of cash flow information:
Cash paid for interest $ 80,880 $ 81,610
Supplemental disclosure of non-cash financing activities:
9.50% senior unsecured notes due February 2005 issued in
connection with Preferred Stock tender offer $ - $ 32,079
---------------------- -----------------------
See notes to unaudited condensed consolidated financial statements.
DYNEX CAPITAL, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
September 30, 2004
(amounts in thousands except share and per share data)
NOTE 1 - BASIS OF PRESENTATION
The accompanying condensed consolidated financial statements have been prepared
in accordance with the instructions to Form 10-Q and do not include all of the
information and notes required by accounting principles generally accepted in
the United States of America, hereinafter referred to as "generally accepted
accounting principles," for complete financial statements. The condensed
consolidated financial statements include the accounts of Dynex Capital, Inc.
and its qualified real estate investment trust ("REIT") subsidiaries and taxable
REIT subsidiary ("Dynex" or the "Company"). All inter-company balances and
transactions have been eliminated in consolidation.
The Company follows the equity method of accounting for investments with greater
than 20% and less than a 50% interest in partnerships when it is able to
influence the financial and operating policies of the investee. For all other
investments in partnerships, the cost method is applied.
The Company believes it has complied with the requirements for qualification as
a REIT under the Internal Revenue Code (the "Code"). To the extent the Company
qualifies as a REIT for federal income tax purposes, it generally will not be
subject to federal income tax on the amount of its income or gain that is
distributed as dividends to shareholders.
In the opinion of management, all significant adjustments, consisting of normal
recurring accruals considered necessary for a fair presentation of the condensed
consolidated financial statements have been included. The financial statements
presented are unaudited. Operating results for the three and nine months ended
September 30, 2004 are not necessarily indicative of the results that may be
expected for the year ending December 31, 2004. For further information, refer
to the audited consolidated financial statements and footnotes included in the
Company's Form 10-K for the year ended December 31, 2003.
The preparation of financial statements, in conformity with generally accepted
accounting principles, requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenue and expenses during the reporting period. Actual
results could differ from those estimates. The primary estimates inherent in the
accompanying condensed consolidated financial statements are discussed below.
The Company uses estimates in establishing fair value for its financial
instruments as discussed in Note 2.
The Company also has credit risk on loans in its portfolio as discussed in Note
5. An allowance for loan losses has been estimated and established for currently
existing losses in the loan portfolio. The allowance for loan losses is
evaluated and adjusted periodically by management based on the actual and
projected timing and amount of credit losses. Provisions made to increase the
allowance for loan losses are presented as provision for loan losses in the
accompanying condensed consolidated statements of operations. The Company's
actual credit losses may differ from those estimates used to establish the
allowance.
Certain reclassifications have been made to the financial statements for 2003 to
conform to the presentation for 2004.
NOTE 2 - FAIR VALUE
Securities classified as available-for-sale are carried in the accompanying
financial statements at estimated fair value. Securities are both fixed-rate and
adjustable-rate. Estimates of fair value for securities are based on market
prices provided by certain dealers, when available. Estimates of fair value for
certain other securities, including securities pledged as securitized finance
receivables, are determined by calculating the present value of the projected
cash flows of the instruments using market based assumptions such as estimated
future interest rates and estimated market spreads to applicable indices for
comparable securities, and using collateral based assumptions such as prepayment
rates and credit loss assumptions based on the most recent performance and
anticipated performance of the underlying collateral.
NOTE 3 - NET LOSS PER COMMON SHARE
Net loss per common share is presented on both a basic and diluted per common
share basis. Diluted net loss per common share assumes the conversion of the
convertible preferred stock into common stock, using the if-converted method and
stock appreciation rights to the extent that there are rights outstanding, using
the treasury stock method, but only if these items are dilutive. The Series D
preferred stock is convertible into one share of common stock for each share of
preferred stock. The Series A, Series B and Series C preferred stock was
convertible into one share of common stock for two shares of preferred stock.
The following table reconciles the numerator and denominator for both basic
and diluted net loss per common share for the three and nine months ended
September 30, 2004 and 2003.
----------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
----------------------------------------------------------------------------------------------
2004 2003 2004 2003
----------------------------------------------------------------------------------------------
Weighted- Weighted- Weighted- Weighted-
Average Average Average Average
Number Number Number Number
Loss Of Shares Loss Of Shares Loss Of Shares Loss Of Shares
----------- ----------------------- ----------------------- ---------------------- -----------
Net loss $ (56) $ (501) $ (18,396) $ (9,442)
Preferred stock (charge) (1,381) (1,191) (527) 8,039
benefit
------------- ----------- ---------- ----------
Net loss to common $ (1,437) 12,162,391 $ (1,692) 10,873,903 $ (18,923) 11,144,102 $ (1,403) 10,873,903
shareholders
=========== =========== =========== =========== =========== =========== ========== ===========
Net loss per share:
Basic and diluted $(0.12) $(0.16) $(1.70) $(0.13)
============ ============ ============ ===========
Reconciliation of shares not included in
calculation of earnings per share due to
anti-dilutive effect
Series A $ - - $ (289) 246,798 $ (337) 126,101 $ (964) 300,659
Series B - - (403) 344,095 (537) 175,815 (1,342) 418,711
Series C - - (499) 342,447 (666) 174,973 (1,669) 417,940
Series D (1,381) 5,628,737 - - (2,644) 2,773,283 - -
Expense and incremental
shares of stock - - - 19,304 - 21,045 - 19,170
appreciation rights
----------- ----------- ----------- ----------- ----------- ----------- ---------- -----------
$ (1,381) 5,628,737 $ (1,191) 952,644 $ (4,184) 3,271,217 $(3,975) 1,156,480
============ ========== ============ ========== ============ ========== =========== ==========
----------------------------------------------------------------------------------------------------------------------------
NOTE 4 - SECURITIZED FINANCE RECEIVABLES
During the three months ended September 30, 2004, the Company reclassified its
investment in a debt security pledged as securitized finance receivables from
available-for-sale to held-to-maturity, as the Company's intention to hold the
asset changed. At the time of this reclassification, a final market value
adjustment was recorded and net unrealized gains of $2.9 million were
reclassified as a basis adjustment to the security, while amounts included in
comprehensive income will be recognized in income as an adjustment of the
effective yield on the security over its remaining life, to be offset by the
amortization of the basis adjustment. The debt security will be carried at
amortized cost.
The following table summarizes the types of securitized finance receivables as
of September 30, 2004 and December 31, 2003:
----------------------------------------------------------------------------------------------------------------------------
September 30, December 31,
2004 2003
----------------------------------------------------------------------------------------------------------------------------
Loans, at amortized cost $ 1,354,652 $1,561,977
Allowance for loan losses (46,133) (43,364)
----------------------------------------------------------------------------------------------------------------------------
Loans, net 1,308,519 1,518,613
Debt securities 216,999 255,580
----------------------------------------------------------------------------------------------------------------------------
$ 1,525,518 $ 1,774,193
----------------------------------------------------------------------------------------------------------------------------
The following table summarizes the amortized cost basis, gross unrealized gains
and losses and estimated fair value of debt securities pledged as securitized
finance receivables as of September 30, 2004 and December 31, 2003:
----------------------------------------------------------------------------------------------------------------------------
September 30, December 31, 2003
2004
----------------------------------------------------------------------------------------------------------------------------
Debt securities, at amortized cost:
Held-to-maturity $ 213,976 $ -
Available-for-sale 2,937 255,462
Gross unrealized gains on available-for-sale securities 86 118
----------------------------------------------------------------------------------------------------------------------------
$ 216,999 $ 255,580
----------------------------------------------------------------------------------------------------------------------------
The components of securitized finance receivables at September 30, 2004 and
December 31, 2003 are as follows:
----------------------------------------------------------------------------------------------------------------------------
September 30, 2004 December 31, 2003
----------------------------------------------------------------------------------------------------------------------------
Debt Debt
Loans, net Securities Total Loans, net Securities Total
---------------------------------------- ------------- ------------- ------------- ------------- ------------- -------------
Collateral:
Commercial $ 666,414 $ - $ 666,414 $ 758,144 $ - $ 758,144
Manufactured housing 448,023 153,863 601,886 491,230 172,847 664,077
Single-family 245,581 59,558 305,139 317,631 80,468 398,099
------------- ------------- ------------- ------------- ------------- -------------
1,360,018 213,421 1,573,439 1,567,005 253,315 1,820,320
Allowance for loan losses (46,133) - (46,133) (43,364) - (43,364)
Funds held by trustees 131 94 225 131 147 278
Accrued interest receivable 8,602 233 8,835 9,878 1,594 11,472
Unamortized discounts and premiums, net (14,099) 3,165 (10,934) (15,037) 406 (14,631)
Unrealized gain, net - 86 86 - 118 118
----------------------------------------------------------------------------------------------------------------------------
$ 1,308,519 $ 216,999 $1,525,518 $1,518,613 $ 255,580 $ 1,774,193
----------------------------------------------------------------------------------------------------------------------------
NOTE 5 - ALLOWANCE FOR LOAN LOSSES
The Company reserves for credit risk where it has exposure to losses on loans in
its investment portfolio. The following table summarizes the aggregate activity
for the allowance for loan losses on investments for the nine months ended
September 30, 2004 and 2003:
----------------------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30,
--------------------------------------------------
2004 2003
------------------------- ------------------------
Allowance at beginning of period $ 43,364 $ 25,472
Provision for loan losses 17,438 29,715
Credit losses, net of recoveries (14,669) (14,194)
----------------------------------------------------------------------------------------------------------------------------
Allowance at end of period $ 46,133 $ 40,993
----------------------------------------------------------------------------------------------------------------------------
An allowance for loan losses has been estimated and established for currently
existing and probable losses to the extent losses are borne by the Company under
the terms of the securitization transaction. Factors considered in establishing
an allowance include current loan delinquencies, historical cure rates of
delinquent loans, and historical and anticipated loss severity of the loans as
they are liquidated. The allowance for loan losses is evaluated and adjusted
periodically by management based on the actual and estimated timing and amount
of probable credit losses, using the above factors, as well as industry loss
experience. Where loans are considered homogeneous, the allowance for losses is
established and evaluated on a pool basis. Otherwise, the allowance for losses
is established and evaluated on a loan-specific basis. Provisions made to
increase the allowance are a current period expense to operations. Generally,
the Company considers manufactured housing loans to be impaired when they are
thirty days past due. The Company also provides an allowance for currently
existing credit losses within outstanding manufactured housing loans that are
current as to payment but which the Company has determined to be impaired based
on default trends, current market conditions and empirical observable
performance data on the loans. Single-family loans are considered impaired when
they are sixty days past due.
Commercial mortgage loans are evaluated for impairment when they are thirty days
past due or when the ratio of net operating income on the underlying collateral
to the required debt service falls below 1:1. Once deemed impaired, loan losses
on commercial mortgage loans are estimated based on several factors including
the net operating income and estimated capitalization rates, or appraised value,
if available. The following table presents certain information on commercial
mortgage loans that the Company has determined to be impaired. Impaired loans at
September 30, 2004 declined from December 31, 2003 based on the repayment in
full during the third quarter of approximately $47,326 of loans previously
considered impaired, and the reclassification of loans previously considered
impaired. Of the $191,484 in impaired loans at December 31, 2003, approximately
$90,088 of these loans (which amount includes the $47,326 repaid in full during
the third quarter) had loss reimbursement guarantees from a `AAA'-rated
counterparty where such counterparty bore the risk of credit loss on these
loans, and therefore no allowance was provided by the Company. At September 30,
2004, impaired loans include two large loans secured by office buildings with an
aggregate principal balance of approximately $32,120 which were not considered
impaired at December 31, 2003.
----------------------------------------------------------------------------------------------------------------------------
Recorded Investment in Amount for which there is a Amount for which there is no
Related Allowance for Related Allowance for Credit
Impaired Loans Credit Losses Losses
----------------------------------------------------------------------------------------------------------------------------
December 31, 2003 $ 191,484 $ 10,861 $ 180,623
September 30, 2004 69,602 17,526 52,076
----------------------------------------------------------------------------------------------------------------------------
NOTE 6 - OTHER INVESTMENTS
The following table summarizes the Company's other investments as of September
30, 2004 and December 31, 2003:
---------------------------------------------------------------------------------------------------------------------------
September 30, December 31,
2004 2003
------------------ ------------------
Delinquent property tax receivables and securities, at amortized cost $ 11,321 $ 34,939
Real estate owned 1,881 2,960
Other 2 4
---------------------------------------------------------------------------------- ------------------ ------------------
$ 13,204 $ 37,903
---------------------------------------------------------------------------------------------------------------------------
At September 30, 2004 and December 31, 2003, the Company has real estate owned
with a current carrying value of $1,881 and $2,960, respectively, resulting from
foreclosures on delinquent property tax receivables and securities. During the
nine months ended September 30, 2004 and 2003, the Company collected an
aggregate of $6,170 and $8,798, respectively, on delinquent property tax
receivables and securities, including net sales proceeds from related real
estate owned. The Company also accrued interest income of none and $3,437,
respectively, during such periods. Delinquent property tax securities included
in other investments are classified as held-to-maturity and are carried at
amortized cost.
During the third quarter of 2004, the Company sold all of its right, title and
interest in its delinquent property tax receivable portfolio and servicing
operation located in Cuyahoga County, Ohio to a third party for $19,075. The
Company may also receive contingent consideration of up to $750 based on
discounts received by the purchaser on subsequent purchases from Cuyahoga
County. Of the $19,075 in consideration received, $700 is being held in escrow
for up to one year for customary representations and warranties and is included
within Other Assets.
NOTE 7 - SECURITIES
The following table summarizes Dynex's amortized cost basis of securities
classified as held-to-maturity and fair value of securities classified as
available-for-sale, as of September 30, 2004 and December 31, 2003, and the
effective interest rate of these securities as of the respective period end:
----------------------------------------------------------------------------------------------------------------------------
September 30, 2004 December 31, 2003
------------------------------ --------------------------------
Fair Effective Fair Effective
Value Interest Rate Value Interest Rate
-------------- --------------- --------------- ----------------
Securities, available-for-sale:
Fixed-rate mortgage securities $ 19,220 7.04% $ 29,713 7.79%
Mortgage-related securities 43 - 54 -
Equity security 7,930 3,000
------------------------------------------------------------ -------------- --------------- --------------- ----------------
27,193 32,767
Gross unrealized gains 921 517
Gross unrealized losses (522) (810)
------------------------------------------------------------ -------------- --------------- --------------- ----------------
Securities, available-for-sale 27,592 32,474
Asset-backed security, held-to-maturity 421 801
------------------------------------------------------------ -------------- --------------- --------------- ----------------
$ 28,013 $ 33,275
----------------------------------------------------------------------------------------------------------------------------
NOTE 8 - REPURCHASE AGREEMENTS AND SENIOR NOTES
The following table summarizes Dynex's recourse debt outstanding at September
30, 2004 and December 31, 2003:
-----------------------------------------------------------------------------------------------------------------------------
September 30, 2004 December 31, 2003
-----------------------------------------------------------
Repurchase agreements $ 15,381 $ 23,884
9.50% Senior Notes (due 4/30/2007) 823 -
9.50% Senior Notes (due 2/28/2005) - 10,049
-----------------------------------------------------------------------------------------------------------------------------
$ 16,204 $ 33,933
-----------------------------------------------------------------------------------------------------------------------------
Repurchase agreements are collateralized by securities with a fair value of
$18,212 and $26,517 as of September 30, 2004, and December 31, 2003,
respectively. On October 15, 2004, in accordance with the procedures set forth
in the associated indenture, the Company fully redeemed all of its outstanding
9.50% Senior Notes due 2007.
NOTE 9 - PREFERRED STOCK
In the second quarter of 2004, the Company completed a recapitalization plan
whereby the Company converted the Series A, Series B, and Series C preferred
stock into a new Series D preferred stock and common stock. As part of the
recapitalization plan, the Company exchanged 9.50% Senior Notes due 2007 for
Series A, Series B and Series C preferred stock. The remaining Series A, Series
B and Series C preferred stock were converted into 5,628,737 shares of Series D
preferred stock and 1,288,488 shares of common stock. All prior
dividends-in-arrears on the Series A, Series B and Series C preferred stock were
extinguished. The Company is currently precluded from paying a dividend on its
common stock under the terms of the Series D Preferred Stock until such time
that total shareholders' equity equals or exceeds 300% of the Series D Preferred
Stock outstanding.
NOTE 10 - DERIVATIVE FINANCIAL INSTRUMENTS
The Company has entered into an interest rate swap agreement which matures on
June 28, 2005, to mitigate its interest rate risk exposure on $100,000 in
notional value of its variable rate non-recourse securitization financing, which
finance a like amount of fixed rate assets. Under the agreement, the Company
will pay interest at a fixed rate of 3.73% on the notional amount and will
receive interest based on the one-month London Inter-Bank Offering Rate
("LIBOR") on the same amount. This contract has been treated as a cash flow
hedge with the changes in the value of the hedge being reported as a component
of accumulated other comprehensive income. During the nine months ended
September 30, 2004, the Company recognized $1,868 in other comprehensive gain on
this hedge instrument and incurred $1,905 of interest expense related to net
payments made on the interest-rate swap. At September 30, 2004, the aggregate
accumulated other comprehensive loss on this hedge instrument was $1,070. As the
repricing dates, interest rate indices and formulae for computing net
settlements of the interest rate swap agreement match the corresponding terms of
the underlying securitization financing being hedged, no ineffectiveness is
assumed on this agreement and, accordingly, any prospective gains or losses are
included in other comprehensive income until the interest rate swap payments are
settled. Based on the forward LIBOR curve as of September 30, 2004, over the
next twelve months the Company expects to reclassify $1,070 of this other
comprehensive loss to interest expense.
In October 2002, the Company entered into a synthetic three-year amortizing
interest-rate swap with an initial notional balance of approximately $80,000 to
mitigate its exposure to rising interest rates on a portion of its variable rate
non-recourse securitization financing, which finance a like amount of fixed rate
assets. This contract has been accounted for as a cash flow hedge with gains and
losses associated with the change in the value of the hedge being reported as a
component of accumulated other comprehensive income. At September 30, 2004, the
current notional balance of the amortizing synthetic swap was $24,000, and the
remaining weighted-average fixed-rate payable by the Company under the terms of
the synthetic swap was 2.56%. The synthetic swap amortizes through September
2005. During the nine months ended September 30, 2004, the Company recognized
$391 in other comprehensive gain and incurred $429 of interest expense related
to net payments made on this position. At September 30, 2004, the aggregate
accumulated other comprehensive loss was $203. During the three months ended
September 30, 2004, the Company determined that this hedge instrument ceased to
be effective due to a significant deterioration of correlation between the
synthetic interest-rate swap hedge and the non-recourse securitization being
financed, as measured by the correlation between three-month Eurodollar futures
and one-month LIBOR. Accordingly, the Company has discontinued hedge accounting
and reflected the changes in market value of the hedge instrument in its
statement of operations as Other Expense. The remaining unrealized loss in other
comprehensive income at the time the Company discontinued hedge accounting will
be amortized over the remaining life of the contracts. Based on the forward
Eurodollar curve as of September 30, 2004, over the next twelve months the
Company expects to reclassify $203 into earnings.
NOTE 11 - COMMITMENTS AND CONTINGENCIES
GLS Capital, Inc. ("GLS"), a subsidiary of the Company, together with the County
of Allegheny, Pennsylvania ("Allegheny County"), were defendants in a lawsuit in
the Commonwealth Court of Pennsylvania (the "Commonwealth Court"), the appellate
court of the state of Pennsylvania. Plaintiffs were two local businesses seeking
status to represent as a class, delinquent taxpayers in Allegheny County whose
delinquent tax liens had been assigned to GLS. Plaintiffs challenged the right
of Allegheny County and GLS to collect certain interest, costs and expenses
related to delinquent property tax receivables in Allegheny County, and whether
the County had the right to assign the delinquent property tax receivables to
GLS and therefore employ procedures for collection enjoyed by Allegheny County
under state statute. This lawsuit was related to the purchase by GLS of
delinquent property tax receivables from Allegheny County in 1997, 1998, and
1999. In July 2001, the Commonwealth Court issued a ruling that addressed, among
other things, (i) the right of GLS to charge to the delinquent taxpayer a rate
of interest of 12% per annum versus 10% per annum on the collection of its
delinquent property tax receivables, (ii) the charging of a full month's
interest on a partial month's delinquency; (iii) the charging of attorney's fees
to the delinquent taxpayer for the collection of such tax receivables, and (iv)
the charging to the delinquent taxpayer of certain other fees and costs. The
Commonwealth Court in its opinion remanded for further consideration to the
lower trial court items (i), (ii) and (iv) above, and ruled that neither
Allegheny County nor GLS had the right to charge attorney's fees to the
delinquent taxpayer related to the collection of such tax receivables. The
Commonwealth Court further ruled that Allegheny County could assign its rights
in the delinquent property tax receivables to GLS, and that plaintiffs could
maintain equitable class in the action. In October 2001, GLS, along with
Allegheny County, filed an Application for Extraordinary Jurisdiction with the
Supreme Court of Pennsylvania, Western District appealing certain aspects of the
Commonwealth Court's ruling. In March 2003, the Supreme Court issued its opinion
as follows: (i) the Supreme Court determined that GLS can charge delinquent
taxpayers a rate of 12% per annum; (ii) the Supreme Court remanded back to the
lower trial court the charging of a full month's interest on a partial month's
delinquency; (iii) the Supreme Court revised the Commonwealth Court's ruling
regarding recouping attorney fees for collection of the receivables indicating
that the recoupment of fees requires a judicial review of collection procedures
used in each case; and (iv) the Supreme Court upheld the Commonwealth Court's
ruling that GLS can charge certain fees and costs, while remanding back to the
lower trial court for consideration the facts of each individual case. Finally,
the Supreme Court remanded to the lower trial court to determine if the
remaining claims can be resolved as a class action. In August 2003, the
Pennsylvania legislature enacted a law amending and clarifying certain
provisions of the Pennsylvania statute governing GLS' right to the collection of
certain interest, costs and expenses. The law is retroactive to 1996, and amends
and clarifies that as to items (ii)-(iv) noted above by the Supreme Court, that
GLS can charge a full month's interest on a partial month's delinquency, that
GLS can charge the taxpayer for legal fees, and that GLS can charge certain fees
and costs to the taxpayer at redemption. Subsequent to the enactment of the law,
challenges to its retroactivity provisions were filed in separate cases, which
did not include GLS as a defendant. In September 2004, the trial court in that
litigation upheld the retroactive provisions enacted in 2003. Specific damages
related to the issues remanded back to the Trial Court have not been determined,
and the Company believes that the ultimate outcome of this litigation will not
have a material impact on its financial condition, but may have a material
impact on reported results for the particular period presented.
The Company and Dynex Commercial, Inc. ("DCI"), formerly an affiliate of the
Company and now known as DCI Commercial, Inc., are defendants in state court in
Dallas County, Texas in the matter of Basic Capital Management, et. al. v. Dynex
Commercial, Inc., et. al. The suit was filed in April 1999, originally against
DCI. In March 2000, Basic Capital Management (hereafter "BCM") amended the
complaint and added the Company as a defendant. The complaint, which was further
amended during pretrial proceedings, alleged that, among other things, DCI and
the Company failed to fund tenant improvement or other advances allegedly
required on various loans made by DCI to BCM, which loans were subsequently
acquired by the Company; that DCI breached an alleged $160,000 "master" loan
commitment entered into in February 1998; and that DCI breached another alleged
loan commitment of approximately $9,000. The trial commenced in January 2004 and
in February 2004, the jury in the case rendered a verdict in favor of one of the
plaintiffs and against the Company on the alleged breach of the loan agreements
for tenant improvements, and awarded that plaintiff damages in the amount of
$253. The jury entered a separate verdict against DCI in favor of BCM under two
mutually exclusive damage models, for $2,200 and $25,600, respectively. The jury
found in favor of DCI on the alleged $9,000 loan commitment, but did not find in
favor of DCI for counterclaims made against BCM. The jury also awarded the
plaintiffs attorneys' fees in the amount of $2,100. After considering post-trial
motions, the presiding judge entered judgment in favor of the Company and DCI,
effectively overturning the verdicts of the jury and dismissing damages awarded
by the jury. Plaintiffs have filed an appeal. DCI is a former affiliate of the
Company, and the Company believes that it will have no obligation for amounts,
if any, awarded to the plaintiffs as a result of the actions of DCI.
Although no assurance can be given with respect to the ultimate outcome of the
above litigation, the Company believes the resolution of these lawsuits will not
have a material effect on the Company's consolidated balance sheet, but could
materially affect consolidated results of operations in a given year.
NOTE 12 - RECENT ACCOUNTING PRONOUNCEMENTS
In March 2004, the Emerging Issues Task Force ("EITF") amended and ratified
previous consensus reached on EITF 03-01, "The Meaning of Other-Than-Temporary
Impairment," to introduce a three-step model to: 1) determine whether an
investment is impaired; 2) evaluate whether the impairment is
other-than-temporary; and 3) account for other-than-temporary impairments. In
part, this amendment requires companies to apply qualitative and quantitative
measures to determine whether a decline in the fair value of a security is
other-than-temporary. The amount of other-than-temporary impairments to be
recognized, if any, will be dependent on market conditions and management's
intentions and ability at the time of evaluation to hold underwater investments
until forecasted recovery in the fair value up to and beyond the adjusted cost.
This amendment is effective for financial periods beginning after June 15, 2004.
The Company has reviewed this statement and does not believe that its adoption
will have a significant impact on its financial position, results of operations
or cash flows.
NOTE 13 - SUBSEQUENT EVENTS
The Company entered into an agreement to sell its optional redemption rights in
its MERIT Series 13 securitization, as well as its remaining interests in this
securitization, for $11.9 million. The sale took place in October 2004, and at
that time the Company derecognized $241.8 million of securitized finance
receivables with a recorded book value of $217.5 million and $225.3 million of
associated securitized financing. The Company also recorded a gain of $17.8
million, or $1.47 per common share, in the fourth quarter as a result of this
sale. The Company owns the serving of these loans and has engaged a sub-servicer
to service these assets. The Company recorded a related $1.7 million servicing
liability within Other Liabilities, as the costs of this sub-servicing
arrangement are expected to exceed cash receipts over the remaining life of the
deal. This liability reduced the gain recorded on the sale.
On October 15, 2004, the Company fully redeemed the 9.50% Senior Notes due April
2007.
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Dynex Capital, Inc. was incorporated in the Commonwealth of Virginia in 1987.
References to "Dynex" or "the Company" contained herein refer to Dynex Capital,
Inc. together with its qualified real estate investment trust (REIT)
subsidiaries and taxable REIT subsidiary. Dynex is a financial services company,
which invests in loans and securities consisting of or secured by, principally
single-family mortgage loans, commercial mortgage loans, manufactured housing
installment loans and delinquent property tax receivables. The loans and
securities in which the Company invests have generally been pooled and pledged
(i.e. securitized) as securitized finance receivables for non-recourse bonds
("non-recourse securitization financing"), which provides long-term financing
for such loans while limiting credit, interest rate and liquidity risk. The
Company earns the net interest spread between the interest income on the loans
and securities in its investment portfolio and the interest and other expenses
associated with the non-recourse securitization financing. The Company also
services its delinquent property tax receivables portfolio.
The Company has elected to be treated as a REIT for federal income tax purposes
under the Internal Revenue Code of 1986, as amended, and, as such, must
distribute substantially all of its taxable income to shareholders unless such
taxable income is reduced by the Company's available net operating loss
carry-forwards as further discussed below. Provided that the Company meets all
of the prescribed Internal Revenue Code requirements for a REIT, the Company
will generally not be subject to federal income tax.
The Company's strategic focus for 2004 has been managing the cash flow from its
investment portfolio, exercising its optional redemption rights on non-recourse
securitization financing where such exercise is economic, selling non-core
investments and opportunistically purchasing new investments. In the second
quarter of 2004, the Company completed a recapitalization plan whereby the
Company converted its Series A, Series B, and Series C preferred stock into a
new Series D preferred stock and common stock. As part of the recapitalization
plan, the Company exchanged 9.50% Senior Notes due 2007 for Series A, Series B
and Series C preferred stock. The remaining Series A, Series B and Series C
preferred stock were converted into 5,628,737 shares of Series D preferred stock
and 1,288,488 shares of common stock. All prior dividends-in-arrears on the
Series A, Series B and Series C preferred stock were extinguished. In September
2004, the Company sold its delinquent property tax receivables portfolio located
in Cuyahoga County, Ohio and its associated servicing operation, for $19.2
million. In addition, the Company may receive contingent consideration of up to
$750 thousand that also would be held in escrow for customary representations
and warranties until the first anniversary of the sale. The Company redeemed
certain outstanding classes of bonds in its MERIT Series 12-1 securitization,
and sold these classes for a net premium of $7.4 million. The Company also
entered into an agreement to sell all of its optional redemption rights in its
MERIT Series 13 securitization, as well as its remaining interests in this
securitization, for $11.9 million. The sale was completed in October 2004, and
at that time the Company derecognized $241.8 million of securitized finance
receivables with a recorded book value of $217.5 million and $225.3 million of
associated securitized financing. The Company expects to record a gain of $17.8
million, or $1.47 per common share, in the fourth quarter as a result of this
sale. The Company owns the serving of these loans and has engaged a sub-servicer
to service these assets. The Company recorded a related $1.7 million servicing
liability within Other Liabilities, as the costs of this sub-servicing
arrangement are expected to exceed cash receipts over the remaining life of the
deal. This liability reduced the gain recorded on the sale.
The Company has a net operating loss (NOL) carry-forward with a current
estimated balance of $130 million which does not begin to materially expire
until 2019. Unlike other mortgage REITs, because of the NOL carry-forward, the
Company's REIT income distribution requirements are limited, and will likely
remain so for an extended period of time. Because of these limited distribution
requirements, and because, as a REIT, the Company is not a tax-paying entity,
the Company believes that it can invest its capital and can compound returns on
that invested capital essentially tax-free until the net operating loss is fully
utilized. The Company believes that this is a benefit to its shareholders,
allowing the Company to drive increases in book value while taking lower levels
of risk in its investment strategy than some of its competitors. The Company's
strategic focus for the remainder of 2004 and for 2005 will be to
opportunistically invest principally in mortgage related assets with overall
targeted leveraged returns on invested capital of 10%. Depending on the
availability of suitable investments, the Company may or may not be able to
reach such targeted returns, and in some cases may actually exceed this targeted
return. The Company's investment objectives will include only higher credit
quality, shorter duration securities in order to keep credit risk and
interest-rate risk at acceptable levels. The Company believes that market
conditions today are difficult for investors in mortgage-backed securities given
low absolute levels of interest rates, historical and anticipated prepayments on
these securities, and general competitive pressures.
The Company is currently precluded from paying a dividend on its common stock
under the terms of the Series D Preferred Stock until such time that total
shareholders' equity equals or exceeds 300% of the Series D Preferred Stock
outstanding. The Company does not anticipate meeting this covenant for the
foreseeable future. By not paying a common dividend, however, assuming that it
properly executes its investment strategy, the Company will be able to compound
its returns more quickly on its investable capital as a result of not paying
such common dividend. Once the Series D Preferred Stock covenant is met, the
Board will likely continually review the payment of a common dividend to its
shareholders, balancing the benefit of retaining capital with providing the
common shareholders a cash distribution on their investment.
CRITICAL ACCOUNTING ESTIMATES
The discussion and analysis of the Company's financial condition and results of
operations are based in large part upon its consolidated financial statements,
which have been prepared in conformity with accounting principles generally
accepted in the United States of America. The preparation of the financial
statements requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the reported amounts
of revenue and expenses during the reported period. Actual results could differ
from those estimates.
Critical accounting estimates are defined as those that are reflective of
significant judgments or uncertainties, and which may result in materially
different results under different assumptions and conditions, or the application
of which may have a material impact on the Company's financial statements. The
following are the Company's critical accounting estimates.
Consolidation of Subsidiaries. The consolidated financial statements represent
the Company's accounts after the elimination of inter-company transactions. The
Company follows the equity method of accounting for investments with greater
than 20% and less than a 50% interest in partnerships and corporate joint
ventures when it is able to influence the financial and operating policies of
the investee. For all other investments, the cost method is applied.
Impairments. The Company evaluates all securities in its investment portfolio
for other-than-temporary impairments. A security is generally defined to be
other-than-temporarily impaired if, for a maximum period of three consecutive
quarters, the carrying value of such security exceeds its estimated fair value
and the Company estimates, based on projected future cash flows or other fair
value determinants, that the carrying value is not likely to exceed fair value
in the foreseeable future. A security will be considered other-than-temporarily
impaired sooner than three consecutive quarters if the security is subject to
credit losses, and credit performance of such collateral has deteriorated and is
not anticipated to substantially recover for the foreseeable future. If an
other-than-temporary impairment is deemed to exist, the Company records an
impairment charge to adjust the carrying value of the security down to its
estimated fair value. In certain instances, as a result of the
other-than-temporary impairment analysis, the recognition or accrual of interest
will be discontinued and the security will be placed on non-accrual status.
The Company considers an investment to be impaired if the fair value of the
investment is less than its recorded cost basis. Impairments of other
investments are considered other-than-temporary when the Company determines that
the collection trends indicate the investment is not recoverable. The impairment
recognized on other investments is the difference between the book value of the
investment and the expected collections less collection costs.
Allowance for Loan Losses. The Company has credit risk on loans pledged in
securitization financing transactions and classified as securitized finance
receivables in its investment portfolio. An allowance for loan losses has been
estimated and established for currently existing probable losses to the extent
losses are borne by the Company under the terms of the securitization
transaction. Factors considered in establishing an allowance include current
loan delinquencies, historical cure rates of delinquent loans, and historical
and anticipated loss severity of the loans as they are liquidated. The allowance
for loan losses is evaluated and adjusted periodically by management based on
the actual and estimated timing and amount of probable credit losses, using the
above factors, as well as industry loss experience. Where loans are considered
homogeneous, the allowance for losses is established and evaluated on a pool
basis. Otherwise, the allowance for losses is established and evaluated on a
loan-specific basis. Provisions made to increase the allowance are a current
period expense to operations. Generally, the Company considers manufactured
housing loans to be impaired when they are thirty days past due. The Company
also provides an allowance for currently existing credit losses within
outstanding manufactured housing loans that are current as to payment but which
the Company has determined to be impaired based on default trends, current
market conditions and empirical observable performance data on the loans.
Single-family loans are considered impaired when they are sixty days past due.
Commercial mortgage loans are evaluated on a loan-by-loan basis for impairment.
Generally, commercial mortgage loans with a debt service coverage ratio less
than 1:1, except loans secured by low income housing tax credit properties, are
considered impaired. Loans secured by low income housing tax credit properties
with a debt service coverage ratio less than 1:1 are not automatically
considered impaired due to the significant incentive for the owner/borrower to
support the continued operation of the property, or risk partial recapture of
the cumulative tax credits taken. Based on the specific details of a loan, loans
with a debt service coverage ratio greater than 1:1 may be considered impaired;
conversely, loans with a debt service coverage ratio less than 1:1 may not be
considered impaired. Low income housing tax credit properties are deemed
impaired when such loans are thirty days past due or if the underlying property
is near the expiration of its tax credit compliance period and the debt service
coverage ratio is below 1:1. A range of loss severity assumptions are applied to
these impaired loans to determine the level of reserves necessary. Certain of
the commercial mortgage loans are covered by loan guarantees that limit the
Company's exposure on these loans. The level of allowance for loan losses
required for these loans is reduced by the amount of applicable loan guarantees.
The Company's actual credit losses may differ from those estimates used to
establish the allowance.
FINANCIAL CONDITION
----------------------------------------------------------------------------- ----------------------- -----------------------
(amounts in thousands except per share data) September 30, 2004 December 31, 2003
----------------------------------------------------------------------------- ----------------------- -----------------------
Investments:
Securitized finance receivables:
Loans, net $ 1,308,519 $ 1,518,613
Debt securities 216,999 255,580
Other investments 13,204 37,903
Securities 28,013 33,275
Other loans 5,964 8,304
Non-recourse securitization financing 1,466,293 1,679,830
Repurchase agreements 15,381 23,884
Senior notes 823 10,049
Shareholders' equity 133,219 149,846
Book value per common share 6.33 7.55
----------------------------------------------------------------------------- ----------------------- -----------------------
Securitized finance receivables. As of September 30, 2004, the Company had 19
series of securitization financing outstanding. Loans, net decreased to $1.31
billion at September 30, 2004 compared to $1.52 billion at December 31, 2003.
This decrease of $210.1 million is primarily the result of $192.4 million in
principal paydowns on the securitized finance receivables, $17.4 million of
additions to allowance for loan losses and decreases of accrued interest
receivables of $1.3 million, partially offset by $0.9 million of net premium
amortization. Debt securities decreased to $217.0 million at September 30, 2004
compared to $255.6 million at December 31, 2003. This decrease of $38.6 million
is primarily the result of $30.9 million in principal paydowns on the
securitized finance receivables, $7.0 million of impairment charges, reduction
of accrued interest receivables of $1.4 million and other decreases of $0.2
million, partially offset by $2.8 million of market value adjustments.
During the three months ended September 30, 2004, the Company reclassified a
debt security from available-for-sale to held-to-maturity. Unrealized gains of
$2.9 million were reclassified as a basis adjustment to the security.
Other investments. Other investments at September 30, 2004 consist primarily of
delinquent property tax receivables. Other investments decreased from $37.9
million at December 31, 2003, to $13.2 million at September 30, 2004. This
decrease is primarily the result of the sale of the Company's Ohio tax lien
portfolio with a basis of $22.3 million, pay-downs of delinquent property tax
receivables, which totaled $5.0 million, and sales of real estate owned
properties of $0.7 million. These decreases were partially offset by additional
advances for collections of $3.8 million.
Securities. Securities decreased during the nine months ended September 30, 2004
by $5.3 million, to $28.0 million at September 30, 2004 from $33.3 million at
December 31, 2003 due primarily to principal payments of $11.0 which were
partially offset by an additional purchase of $4.9 million of common stock of
another mortgage REIT and $0.7 million of market value adjustments.
Other loans. Other loans decreased by $2.3 million from $8.3 million at December
31, 2003, to $6.0 million at September 30, 2004, principally as the result of
pay-downs during the nine month period.
Non-recourse securitization financing. Non-recourse securitization financing
decreased $213.5 million; from $1.7 billion at December 31, 2003 to $1.5 billion
at September 30, 2004. This decrease was primarily a result of principal
payments received of $223.3 million on the associated securitized finance
receivables pledged which were used to pay down the non-recourse securitization
financing in accordance with the respective indentures. Additionally, for
certain securitizations, surplus cash in the amount of $1.9 million was retained
within the security structure and used to cover losses, as certain performance
triggers were not met in such securitizations. These decreases were partially
offset by the addition of $7.4 million of premium on the call and reissue of a
securitization financing and $3.8 million of amortization of bond premium during
the nine months ended September 30, 2004.
Senior notes. Of the $32.1 million of February 2005 Senior Notes issued in
exchange for Preferred Stock in February 2003, the $10.0 million remaining
balance was paid in March 2004. In conjunction with the recapitalization plan
completed in May 2004, $0.8 million of 9.50% Senior Notes due April 2007 were
issued in exchange for Series A, Series B, and Series C preferred shares. The
April 2007 Senior Notes were fully redeemed in October 2004.
Shareholders' equity. Shareholders' equity decreased to $133.2 million at
September 30, 2004, from $149.8 million at December 31, 2003. This decrease was
primarily the result of a net loss of $18.4 million and a net decrease of $4.1
million resulting from the issuance costs of, and shares tendered for, senior
notes in connection with the recapitalization transaction completed in May 2004,
partially offset by a net increase in accumulated other comprehensive income of
$5.9 million. The increase in accumulated other comprehensive income is
comprised of an increase in unrealized gain on investments available-for-sale of
$0.8 million, a $2.9 million final fair value increase of a debt security being
reclassified as held to maturity, $0.1 million of which was amortized into
income during the quarter, and $2.4 million of other comprehensive income from
hedging instruments during the period.
RESULTS OF OPERATIONS
----------------------------------------------------------------------------------------------------------------------------
(amounts in thousands except per share Three Months Ended Nine Months Ended
information) September 30, September 30,
----------------------------------- ----------------------------------
2004 2003 2004 2003
--------------- --------------- --------------- ---------------
Net interest margin before provision for $ 6,394 $ 8,832 $ 18,348 $ 29,102
losses
Net interest margin 5,103 3,001 910 (613)
Impairment charges (162) (2,277) (9,569) (4,482)
(Loss) gain on sales of investments, net (3,147) 769 (3,143) 1,779
General and administrative expenses (1,847) (2,124) (6,330) (6,296)
Net loss (56) (501) (18,396) (9,442)
Preferred stock (charge) benefit (1,381) (1,191) (527) 8,039
Net loss to common shareholders (1,437) (1,692) (18,923) (1,403)
Net loss per common share:
Basic and diluted $(0.12) $(0.16) $(1.70) $(0.13)
----------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, 2004 Compared to Three Months Ended September
30, 2003. Net loss and net loss per common share decreased during the three
months ended September 30, 2004 as compared to the same period in 2003. The
decrease in net loss is primarily the result of a $4.5 million decrease in
provision for loan losses as the Company's credit loss exposure on manufactured
housing loans was fully reserved in the second quarter 2004, a $2.1 million
decrease of impairment charges resulting from a third quarter 2003 impairment
charge on the Company's property tax receivables portfolio, and a $0.3 million
decrease of general and administrative expense resulting from lower litigation
expenses and property tax portfolio servicing costs. As a partial offset to the
above items, the Company recorded a $3.2 million loss during the quarter from
the sale of the Ohio delinquent property tax receivable portfolio.
Net interest margin before provision for loan losses for the three months ended
September 30, 2004 decreased to $6.4 million from $8.8 million for the same
period in 2003. Net interest margin decreased during the three months ended
September 30, 2004 primarily due to a decline in net interest spread and a
decline in interest earning assets compared to the three months ended September
30, 2003. Approximately 70% of the decline in net margin was due to the decrease
in net interest spread with the remaining 30% being due to the decline in
interest earning assets.
Impairment charges decreased by $2.1 million for the three months ended
September 30, 2004 from the same period last year due to the impairment in 2003
of the Company's investment in a delinquent property tax receivables portfolio
located in Allegheny County, Pennsylvania.
General and administrative expenses decreased by $0.3 million to $1.8 million
for the three months ended September 30, 2004 compared to the same period in
2003 due principally to lower litigation related expenses and lower general and
administrative expenses on the Company's delinquent property tax receivable
servicing operation. General and administrative expenses are expected to
continue to decline for the balance of the year as a result of reductions in the
Company's tax receivable servicing operation in Pennsylvania, and the sale of
the similar operation in Ohio.
Nine Months Ended September 30, 2004 Compared to Nine Months Ended September 30,
2003. Net loss and net loss per common share increased during the nine months
ended September 30, 2004 as compared to the same period in 2003. The increase in
net loss is primarily the result of decreased net interest margin, increased
impairment charges, and net losses on the sale of investments. Net loss to
common shareholders increased from $1.4 million for the nine months ended
September 30, 2003 to $18.9 million for the nine months ended September 30,
2004. Net loss to common shareholders in 2003 includes an $8.0 million preferred
stock benefit due to the net effect of the tender offer completed in February
2003.
Net interest margin for the nine months ended September 30, 2004 increased to
income of $0.9 million from a loss of $0.6 million for the same period in 2003.
This increase was primarily the result of a $12.3 million decrease in provision
for loan losses as the Company's net investment in its manufactured housing loan
portfolio was fully reserved in the second quarter 2004. Net interest margin
before provision for loan losses decreased by $10.8 million during the nine
months ended September 30, 2004 compared to the same period in 2003 by a decline
in net interest spread and a decline in interest earning assets compared to the
nine months ended September 30, 2003. Approximately 75% of this decline in net
interest margin before provision for loan losses was due to the decrease in net
interest spread while the remaining 25% resulted from declines in interest
earning assets.
Impairment charges increased by $5.1 million for the nine months ended September
30, 2004 from the same period last year. This increase was primarily a result of
losses on debt securities pledged as securitized finance receivables and
comprised largely of manufactured housing loans. Impairment of these debt
securities is determined as the difference between the fair value of the
security, as measured by discounting the cash flows of the security certificates
utilizing prepayment and loan loss rate assumptions, at discount rates that a
market participant would use, and the book value of those securities. The fair
value of these debt securities had declined during the second quarter 2004 as
the result of an increase in losses during the quarter, which was not
anticipated to improve for the foreseeable future. The Company believes that
market participants will use the higher loss rate assumptions in evaluating the
fair value of these securities.
(Loss) gain on sales of investments, net decreased by $4.9 million due to the
loss of $3.2 million on the sale of the Company's Ohio tax receivable portfolio
in 2004 versus an approximate $2.0 million gain from the sale of loans acquired
from redeemed securities in 2003.
General and administrative expense were essentially unchanged for the nine
months ended September 30, 2004 compared to the same period in 2003.
The following table summarizes the average balances of interest-earning assets
and their average effective yields, along with the average interest-bearing
liabilities and the related average effective interest rates, for each of the
periods presented.
Average Balances and Effective Interest Rates
--------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
---------------------------------------------------------------------------------------------------
2004 2003 2004 2003
---------------------------------------------------------------------------------------------------
(amounts in thousands) Average Effective Average Effective Average Effective Average Effective
Balance Rate Balance Rate Balance Rate Balance Rate
----------------------------------------------------------------------------------------------------
Interest-earning
assets(1):
Securitized finance
receivables(2) (3) $1,583,883 7.39% $1,907,501 7.51% $1,686,373 7.48% $1,987,618 7.51%
Securities 20,205 8.02% 2,167 36.77% 24,275 7.92% 3,738 21.70%
Other loans 6,407 11.29% 10,374 6.75% 7,130 9.61% 9,142 6.25%
Cash and other 24,651 1.23% 63,104 6.46% 16,308 1.00% 62,845 7.47%
investments
----------------------------------------------------------------------------------------------------
Total interest- $1,635,146 7.32% $1,983,146 7.50% $1,734,086 7.43% $2,063,343 7.53%
earning assets
====================================================================================================
Interest-bearing
liabilities:
Non-recourse
securitization $1,486,352 6.16% $1,787,534 6.07% $1,580,285 6.42% $1,864,194 6.00%
financing(3)
Repurchase agreements 16,293 1.72% - - 19,724 1.51% - -
Senior notes 823 11.93% 23,248 9.56% 2,649 9.90% 21,547 9.53%
----------------------------------------------------------------------------------------------------
Total
interest-bearing $1,503,468 6.11% $1,810,782 6.11% $1,602,658 6.37% $1,885,741 6.04%
liabilities
====================================================================================================
Net interest spread on
all investments(3) 1.21% 1.39% 1.07% 1.49%
============ ============ =========== ============
Net yield on average
interest-earning 1.69% 1.91% 1.55% 2.01%
assets(3)
============ ============ =========== ============
---------------------------------------------------------------------------------------------------------------------------
(1) Average balances exclude adjustments made in accordance with Statement of
Financial Accounting Standards No. 115, "Accounting for Certain
Investments in Debt and Equity Securities" to record available-for-sale
securities at fair value.
(2) Average balances exclude funds held by trustees of $211 and $347 for
the three months ended September 30, 2004 and 2003, respectively, and
$352 and $406 for the nine months ended September 30, 2004 and 2003,
respectively.
(3) Effective rates are calculated excluding non-interest related
collateralized bond expenses. If included, the effective rate on
interest-bearing liabilities would be 6.29% and 5.87% for the three months
ended September 30, 2004 and 2003, respectively, and 6.53% and 5.82% for
the nine months ended September 30, 2004 and 2003, respectively
The net interest spread decreased 18 basis points to 121 basis points for the
three months ended September 30, 2004, from 139 basis points for the same period
in 2003 (each basis point is 0.01%). The net interest spread for the nine months
ended September 30, 2004 decreased relative to the same period in 2003, to 107
basis points from 149 basis points. The decrease in the net interest spread for
the three months ended September 30, 2004 versus the same period in 2003 is due
to declining yields in interest-earning assets, due principally from prepayments
of investments, and the reinvestment of the Company's capital into lower
yielding investments. During the three months ended September 30, 2004, the
Company received a prepayment penalty on one commercial mortgage loan of $0.7
million, and recorded adjustments of $1.0 million to the effective yield on its
securitization financing from changes in prepayment expectations on its
commercial mortgage loan portfolio. Together these items increase the Company's
net interest spread on its investments by approximately 43 basis points.
The decrease in the Company's net interest spread for the nine month period
ended September 30, 2004 compared to the prior year period can also be
attributed to the resetting of interest rates on adjustable rate mortgage loans
in the Company's investment portfolio and the prepayment of higher rate loans in
that portfolio which together caused a decline in interest earning asset yield
of 46 basis points. In addition, the majority of the Company's variable-rate
interest-bearing liabilities are indexed relative to One-Month LIBOR.
Interest-bearing liability costs increased by 33 basis points for the nine month
period ended September 30, 2004. In addition, as two higher-rated bonds paid off
during the period, more cash flowed to the lower-rated bond classes in the
waterfall structure, which interest rates are approximately 25-30 basis points
higher.
The Company would expect its net interest spread on its interest-earning assets
for the balance of 2004 to continue to decrease as borrowing costs increase and
as the Federal Reserve continues to increase the Federal Funds target rate going
forward as anticipated by the forward yield curve. The average One-Month LIBOR
rate increased to 1.60% and 1.29% for the three and nine month periods ended
September 30, 2004, respectively, from 1.11% and 1.23% for the three and nine
month periods ended September 30, 2003. One-Month LIBOR has increased from 1.12%
at year-end 2003 to 1.84% at September 30, 2004.
Interest Income and Interest-Earning Assets. At September 30, 2004, $1.3 billion
of the investment portfolio consisted of loans and securities which pay a
fixed-rate of interest, and approximately $274.4 million of the investment
portfolio is comprised of loans and securities that have coupon rates which
adjust over time (subject to certain periodic and lifetime limitations) in
conjunction with changes in short-term interest rates. The Company finances its
investment portfolio with principally non-recourse securitization financing. At
September 30, 2004, approximately $1.0 billion of fixed-rate bonds and $436
million of adjustable rate bonds were outstanding. The following table presents
a breakdown, by principal balance, of the Company's securitized finance
receivables and ARM and fixed mortgage securities by type of underlying loan.
This table excludes mortgage-related securities, other investments and other
loans.
Investment Portfolio Composition(1)
---------------------------- ------------------ ----------------- ------------------ ------------------- ------------------
($ in millions) Other Indices
LIBOR Based CMT(3) Based Based ARM(2)
ARM(2) Loans ARM(2) Loans Loans Fixed-rate Loans Total
---------------------------- ------------------ ----------------- ------------------ ------------------- ------------------
2003, Quarter 3 $ 288.8 $ 53.4 $ 48.2 $ 1,519.2 $ 1,909.6
2003, Quarter 4 258.2 48.8 45.4 1,512.2 1,864.6
2004, Quarter 1 235.3 46.5 45.0 1,479.0 1,805.8
2004, Quarter 2 215.8 41.9 40.8 1,443.1 1,741.6
2004, Quarter 3 196.1 38.8 39.5 1,335.8 1,610.2
---------------------------- ------------------ ----------------- ------------------ ------------------- ------------------
(1) Includes only the principal amount of securitized finance receivables,
ARM securities and fixed-rate mortgage securities.
(2) Adjustable rate mortgage loans
(3) Constant maturity treasury rate
Credit Exposures. The Company invests in non-recourse securitization financing
or pass-through securitization structures. Generally these securitization
structures use over-collateralization, subordination, third-party guarantees,
reserve funds, bond insurance, mortgage pool insurance or any combination of the
foregoing as a form of credit enhancement. The Company generally has retained a
limited portion of the direct credit risk in these securities. In most instances
the Company retained the "first-loss" credit risk on pools of loans that it
securitized.
The following table summarizes the aggregate principal amount of securitized
finance receivables and securities outstanding; the direct credit exposure
retained by the Company (represented by the amount of over-collateralization
pledged and subordinated securities owned by the Company), net of the credit
reserves and discounts maintained by the Company for such exposure; and the
actual credit losses incurred for each year.
The table excludes other forms of credit enhancement from which the Company
benefits, and based upon the performance of the underlying loans, may provide
additional protection against losses. These additional protections include loss
reimbursement guarantees with a remaining balance of $29.5 million and a
remaining deductible aggregating $0.6 million on $36.7 million of securitized
single-family mortgage loans which are subject to such reimbursement agreements;
guarantees aggregating $19.9 million on $224.4 million of securitized commercial
mortgage loans, whereby losses on such loans would need to exceed the respective
guarantee amount before the Company would incur credit losses; and $126.3
million of securitized single-family mortgage loans which are subject to various
mortgage pool insurance policies whereby losses would need to exceed the
remaining stop loss of at least 64% on such policies before the Company would
incur losses.
Credit Reserves and Actual Credit Losses
---------------------------------------------------------------------------------------------------------------------------
($ in millions) Credit Exposure, Net
Outstanding Loan Credit Exposure, Net Actual to Outstanding Loan
Principal Balance of Credit Reserves Credit Losses Balance
---------------------------------------------------------------------------------------------------------------------------
2003, Quarter 3 $ 1,903.7 $ 67.6 $ 5.7 3.55%
2003, Quarter 4 1,830.2 64.7 7.2 3.54%
2004, Quarter 1 1,775.1 54.3 6.0 3.06%
2004, Quarter 2 1,716.1 48.0 8.0 2.80%
2004, Quarter 3 1,613.4 39.8 6.5 2.47%
---------------------------------------------------------------------------------------------------------------------------
The following table summarizes single family mortgage loan, manufactured housing
loan and commercial mortgage loan delinquencies as a percentage of the
outstanding securitized finance receivables balance for those securities in
which the Company has retained a portion of the direct credit risk. The
delinquencies as a percentage of the outstanding securitized finance receivables
balance have increased to 7.60% at September 30, 2004 from 4.85% at September
30, 2003 primarily due to net increase of twelve delinquent commercial mortgage
loans since September 30, 2003. Of the delinquent commercial mortgage loans,
five are low income housing tax credit ("LIHTC") loans with an aggregate unpaid
principal balance of $19 million, which were repaid in full in October 2004. The
adjusted delinquency percentage excluding these five loans is 6.45%. The Company
monitors and evaluates its exposure to credit losses and has established
reserves based upon anticipated losses, general economic conditions and trends
in the investment portfolio. As of September 30, 2004, management believes the
level of credit reserves is appropriate for currently existing losses.
Delinquency Statistics(1)(3)
----------------------------------------------------------------------------------------------------------------------------
30 to 60 days delinquent 60 to 90 days 90 days and over
delinquent delinquent(2) Total
----------------------------------------------------------------------------------------------------------------------------
2003, Quarter 3 1.63% 0.50% 2.72% 4.85%
2003, Quarter 4 1.63% 0.43% 2.72% 4.78%
2004, Quarter 1 3.47% 0.50% 2.60% 6.57%
2004, Quarter 2 3.00% 2.17% 4.88% 10.05%
2004, Quarter 3 2.49% 0.45% 4.66% 7.60%
----------------------------------------------------------------------------------------------------------------------------
(1) Excludes other investments and loans held for sale or securitization.
(2) Includes foreclosures, repossessions and REO.
(3) Reflects updated delinquency data for prior periods.
General and Administrative Expense. The following tables present a breakdown of
general and administrative expense. Included in the first, second and third
quarters of 2004 is an aggregate $906 thousand of litigation related expense for
the litigation in Dallas County, Texas and Pittsburgh, Pennsylvania.
--------------------------------------------------------------------------------------------------------------------------
($ in thousands) Servicing Corporate/Investment Total
Portfolio Management
-------------------------------- ------------------------------ ------------------------------ ---------------------------
2003, Quarter 3 $ 1,240.6 $ 884.1 $ 2,124.7
2003, Quarter 4 1,199.4 1,136.8 2,336.2
2004, Quarter 1 1,008.9 1,459.6 2,468.5
2004, Quarter 2 986.8 1,028.1 2,014.9
2004, Quarter 3 930.3 916.8 1,847.1
--------------------------------------------------------------------------------------------------------------------------
Recent Accounting Pronouncements. In March 2004, the Emerging Issues Task Force
("EITF") amended and ratified previous consensus reached on EITF 03-01, "The
Meaning of Other-Than-Temporary Impairment," to introduce a three-step model to:
1) determine whether an investment is impaired; 2) evaluate whether the
impairment is other-than-temporary; and 3) account for other-than-temporary
impairments. In part, this amendment requires companies to apply qualitative and
quantitative measures to determine whether a decline in the fair value of a
security is other-than-temporary. The amount of other-than-temporary impairments
to be recognized, if any, will be dependent on market conditions and
management's intentions and ability at the time of evaluation to hold underwater
investments until forecasted recovery in the fair value up to and beyond the
adjusted cost. This amendment is effective for financial periods beginning after
June 15, 2004. The Company has reviewed this statement but does not believe that
its adoption will have a significant impact on its financial position, results
of operations or cash flows.
Non-GAAP Information on Securitized Finance Receivables and Non-Recourse
Securitization Financing
The Company finances its securitized finance receivables through the issuance of
non-recourse securitization financing. The Company presents in its condensed
consolidated financial statements the securitized finance receivables as assets,
and the associated securitization financing as a liability. Because the
securitization financing is recourse only to the finance receivables pledged,
and is therefore not a general obligation of the Company, the risk to the
Company on its investment in securitized finance receivables is limited to its
net investment (i.e., the excess of the finance receivables pledged over the
non-recourse securitization financing). This excess is often referred to as
over-collateralization. The purpose of the information presented in this section
is to present the securitized finance receivables on a net investment basis, and
to provide estimated fair value information using various assumptions on such
net investment. The Company monitors and evaluates the performance of these
securitization transactions based on the Company's net investment in such
transactions, and believes the tables below will assist the investor in
understanding the Company's actual investment in these transactions, the credit
risk which the Company has retained on its investments, the performance of these
investments, and the estimated fair value of these investments based on the
assumptions set forth below.
In the tables below, the "principal balance of net investment" in securitized
finance receivables represents the excess of the principal balance of the
collateral pledged over the outstanding balance of the associated non-recourse
securitization financing owned by third parties. The "amortized cost basis of
net investment" is principal balance of net investment plus or minus premiums,
discounts and related costs. The Company generally has sold the investment grade
classes of the securitization financing to third parties, and has retained the
portion of the securitization financing that is below investment grade.
The Company estimates the fair value of its net investment in collateralized
bond securities in the tables below as the present value of the projected cash
flow from the collateral, adjusted for the impact of and assumed level of future
prepayments and credit losses, less the projected principal and interest due on
the bonds owned by third parties. The Company master-services four of its
collateral for collateralized bond securities. Structured Asset Securitization
Corporation (SASCO) Series 2002-9 is master-serviced by Wells Fargo Bank. CCA
One Series 2 and Series 3 are master-serviced by Bank of New York. Monthly
payment reports for those securities master-serviced by the Company may be found
on the Company's website at www.dynexcapital.com.
Below is a summary as of September 30, 2004, by each series of the Company's net
investment in securitized finance receivables where the fair value exceeds $0.5
million. The following tables show the Company's net investment in each of the
securities presented below on both a principal balance and amortized cost basis,
as those terms are defined above. The accompanying condensed consolidated
financial statements of the Company present the securitized finance receivables
as an asset, and presents the associated securitization financing bond
obligation as a non-recourse liability. As a result, the table below is not
meant to present the Company's investment in securitized finance receivables or
the non-recourse securitization financing in accordance with generally accepted
accounting principles applicable to the Company's transactions. See below for a
reconciliation of the amounts included in the table to the Company's condensed
consolidated financial statements.
-----------------------------------------------------------------------------------------------------------------------------
(amounts in thousands) Principal
Principal balance of
balance of non-recourse
securitized securitization Amortized Cost
finance financing Principal Basis of Net
Collateralized Bond Collateral Type receivables outstanding to Balance of Net Investment
Series(1) pledged third parties Investment
-----------------------------------------------------------------------------------------------------------------------------
MERIT Series 11 Debt securities backed by
Single-family loans and
Manufactured housing loans $ 226,539 $ 198,220 $ 28,319 $ 29,005
MERIT Series 12-1 Manufactured housing loans 204,372 189,984 14,388 3,970
MERIT Series 13(2) Manufactured housing loans 243,651 226,402 17,249 20,109
SASCO 2002-9 Single family loans 245,582 237,328 8,254 12,542
MCA One Series 1 Commercial mortgage loans 71,211 66,492 4,719 718
CCA One Series 2 Commercial mortgage loans 242,007 219,904 22,103 12,108
CCA One Series 3 Commercial mortgage loans 353,195 312,249 40,946 58,516
-----------------------------------------------------------------------------------------------------------------------------
$ 1,586,557 $ 1,450,579 $ 135,978 $ 136,968
-----------------------------------------------------------------------------------------------------------------------------
(1) MERIT stands for MERIT Securities Corporation; MCA stands for Multifamily
Capital Access One, Inc. (now known as Commercial Capital Access One,
Inc.); and CCA stands for Commercial Capital Access One, Inc. Each such
entity is a wholly-owned limited purpose subsidiary of the Company. SASCO
stands for Structured Asset Securitization Corporation.
(2) Merit Series 13 was sold in October 2004.
The following table reconciles the balances presented in the table above with
the amounts included for securitized finance receivables and non-recourse
securitization financing in the accompanying consolidated financial statements.
-----------------------------------------------------------------------------------------------------------------------------
(amounts in thousands) Securitized Non-recourse
Securitization
Finance Receivables Financing
-----------------------------------------------------------------------------------------------------------------------------
Principal balances per the above table $ 1,586,557 $ 1,450,579
Principal balance of security excluded from above table 2,888 2,912
Recorded impairments on debt securities (16,006) -
Premiums and discounts (10,934) 6,044
Unrealized gain 86 -
Accrued interest and other 9,060 6,758
Allowance for loan losses (46,133) -
-----------------------------------------------------------------------------------------------------------------------------
Balance per consolidated financial statements $ 1,525,518 $ 1,466,293
-----------------------------------------------------------------------------------------------------------------------------
The following table summarizes the fair value of the Company's net investment in
collateralized bond securities, the various assumptions made in estimating value
and the cash flow received from such net investment during the nine months ended
September 30, 2004. As the Company does not present its investment in
non-recourse securitization financing on a net investment basis, the table below
is not meant to present the Company's investment in securitized finance
receivables or non-recourse securitization financing in accordance with
generally accepted accounting principles applicable to the Company's
transactions.
-----------------------------------------------------------------------------------------------------------------------------
Fair Value Assumptions ($ in thousands)
------------------------------------------------------------------------
Cash flows
Collateralized Weighted-average Projected cash flow Fair value of received in
Bond Series prepayment speeds Losses Termination date net 2004, net(1)
investment(1)
-----------------------------------------------------------------------------------------------------------------------------
MERIT Series 11 35% CPR on SF 4.5% annually on Anticipated final maturity $ 10,704 $ 9,410
securities; 7% CPR MH securities in 2025
on MH securities
MERIT Series 12-1 8% CPR 3.5% annually on Anticipated final maturity 1,105 805
MH Loans in 2027
MERIT Series 13(4) 7% CPR 4.3% annually Anticipated final maturity 11,061 887
in 2026
SASCO 2002-9 30% CPR 0.10% annually Anticipated call date in 13,828 7,933
2005
MCA One Series 1 (2) 0.80% annually Anticipated final maturity 2,466 1,245
in 2018
CCA One Series 2 (3) 0.80% annually Anticipated call date in 12,248 1,297
beginning in 2004 2011
CCA One Series 3 (3) 1.2% annually Anticipated call date in 20,825 1,367
beginning in 2004 2009
-----------------------------------------------------------------------------------------------------------------------------
$ 72,237 $ 22,944
-----------------------------------------------------------------------------------------------------------------------------
(1) Calculated as the net present value of expected future cash flows,
discounted at 16%. Expected cash flows were based on the forward LIBOR
curve as of September 30, 2004, and incorporate the resetting of the
interest rates on the adjustable rate assets to a level consistent with
projected prevailing rates. Increases or decreases in interest rates and
index levels from those used would impact the calculation of fair value,
as would differences in actual prepayment speeds and credit losses versus
the assumptions set forth above. Cash flows received by the Company during
the nine months ended September 30, 2004, equal to the excess of the cash
flows received on the collateral pledged, over the cash flow requirements
of the collateralized bond security.
(2) Computed at 0% CPR until maturity.
(3) Computed at 0% CPR until the respective call date.
(4) Merit Series 13 was sold in October 2004 for 11,900.
The above tables illustrate the Company's estimated fair value of its net
investment in certain collateralized bond securities. In its consolidated
financial statements, the Company carries its investments at amortized cost.
Including the recorded allowance for loan losses of $46.1 million, the Company's
net investment in collateralized bond securities is approximately $59.2 million.
This amount compares to an estimated fair value, utilizing a discount rate of
16%, of approximately $60.3 million, as set forth in the table above. The
difference between the $59.2 million in net investment as included in the
consolidated financial statements and the $60.3 million of estimated fair value,
is due to the difference between the estimated fair value of such net investment
and amortized cost.
The following table compares the fair value of these investments at various
discount rates, but otherwise using the same assumptions as set forth for the
two immediately preceding tables:
-----------------------------------------------------------------------------------------------------------------------------
Fair Value of Net Investment
-----------------------------------------------------------------------------------------------------------------------------
Collateralized Bond Series 12% 16% 20% 25%
---------------------------------------------------------- --------------------- --------------------- ---------------------
MERIT Series 11A $ 12,031 $ 10,704 $ 9,647 $ 8,601
MERIT Series 12-1 1,073 1,105 1,112 1,100
MERIT Series 13(1) 10,831 11,061 11,233 11,392
SASCO 2002-9 15,643 13,828 12,432 11,091
MCA One Series 1 3,015 2,466 2,048 1,657
CCA One Series 2 14,709 12,248 10,292 8,390
CCA One Series 3 24,104 20,825 18,051 15,172
------------------------------------- --------------------- --------------------- --------------------- ---------------------
$ 81,406 $ 72,237 $ 64,815 $ 57,403
------------------------------------- --------------------- --------------------- --------------------- ---------------------
(1) Merit Series 13 was sold in October 2004.
LIQUIDITY AND CAPITAL RESOURCES
The Company has historically financed its operations from a variety of sources.
The Company's primary source today of funding its operations is principally the
cash flow generated from the investment portfolio, which includes net interest
income and principal payments and prepayments on these investments. During the
third quarter the Company also generated sales proceeds of approximately $19.2
million, $0.7 million of which is currently being held in escrow for customary
representations and warranties, from the sale of its portfolio of delinquent
property tax receivables in Ohio. From the cash flow on its investment
portfolio, the Company funds its operating overhead costs, including the
servicing of its delinquent property tax receivables, repays any remaining
recourse debt, and makes additional investments. In addition, while the Company
was actively originating loans or accumulating assets for its investment
portfolio, the Company funded these operations through short-term warehouse
lines of credit with commercial and investment banks, repurchase agreements and
the capital markets via the asset-backed securities market (which provides
long-term non-recourse funding of the investment portfolio via the issuance of
non-recourse securitization financing). Should the Company's future operations
require access to sources of capital such as lines of credit and repurchase
agreements, the Company believes that it would be able to access such sources.
The Company's cash flow from its investment portfolio is subject to fluctuation
due to changes in interest rates, repayment rates and default rates and related
losses. In a period of rapidly rising interest rates, the Company's net interest
margin and cash flow from the investment portfolio is likely to be significantly
impacted due to increased borrowing costs on variable-rate non-recourse
securitization financing. The Company anticipates, however, that it will have
sufficient cash flow from its investment portfolio to meet all of its
obligations.
Non-recourse securitization financing. Dynex, through limited-purpose finance
subsidiaries, has issued non-recourse debt in the form of non-recourse
securitization financing to fund the majority of its investment portfolio. The
obligations under the non-recourse securitization financing are payable solely
from the securitized finance receivables and are otherwise non-recourse to the
Company. The maturity of each class of non-recourse securitization financing is
directly affected by the rate of principal prepayments on the related collateral
and is not subject to margin call risk. Each series is also subject to
redemption according to specific terms of the respective indentures, generally
on the earlier of a specified date or when the remaining balance of the bonds
equals 35% or less of the original principal balance of the bonds. At September
30, 2004, Dynex had $1.5 billion of non-recourse securitization financing
outstanding. Approximately $1.0 billion of the non-recourse securitization
financing carries a fixed rate of interest, and approximately $436 million
carries a rate of interest, which adjusts monthly based on One-Month LIBOR.
Senior notes. In April, the Company issued $823 thousand of 9.50% Senior Notes
due April 2007 in exchange for 8,890 shares of Series A preferred stock, 10,553
shares of Series B preferred stock and 8,584 shares of Series C preferred stock.
At September 30, 2004, the outstanding balance of the Senior Notes was $823
thousand. Subsequently, in October 2004 the Company redeemed early all its
outstanding 9.50% Senior Notes due April 2007.
FORWARD-LOOKING STATEMENTS
Certain written statements in this Form 10-Q made by the Company that are not
historical fact constitute "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. Such forward-looking statements may
involve factors that could cause the actual results of the Company to differ
materially from historical results or from any results expressed or implied by
such forward-looking statements. The Company cautions the public not to place
undue reliance on forward-looking statements, which may be based on assumptions
and anticipated events that do not materialize. The Company does not undertake,
and the Securities Litigation Reform Act specifically relieves the Company from,
any obligation to update any forward-looking statements.
Factors that may cause actual results to differ from historical results or from
any results expressed or implied by forward-looking statements include the
following:
Economic Conditions. The Company is affected by general economic conditions. The
risk of defaults and credit losses could increase during an economic slowdown or
recession. This could have an adverse effect on the performance of the Company's
securitized loan pools and on the Company's overall financial performance.
Capital Resources. Cash flows from the investment portfolio fund the Company's
operations and repayments of recourse debt, and are subject to fluctuation due
to changes in interest rates, repayment rates, default rates and related losses.
Interest Rate Fluctuations. The Company's income and cash flow depends on its
ability to earn greater interest on its investments than the interest cost to
finance these investments. Interest rates in the markets served by the Company
generally rise or fall with interest rates as a whole. Approximately $1.3
billion of the loans currently pledged as securitized finance receivables by the
Company are fixed-rate. The Company currently finances these fixed-rate assets
through non-recourse securitization financing, approximately $1.0 billion is
fixed-rate and approximately $177 million is variable rate and resets monthly.
Through the use of interest rate swaps and synthetic swaps, the Company has
reduced this exposure by approximately $124 million at September 30, 2004 on an
amortizing basis through approximately June 2005. In addition, approximately
$274 million of the investments held by the Company are adjustable-rate
securitized finance receivables, which generally reset on a delayed basis and
have periodic interest rate caps. These investments are financed through
long-term non-recourse securitization financing which resets monthly and which
has no periodic caps. In total, at September 30, 2004, the Company has
approximately $436 million of adjustable-rate non-recourse securitization
financing.
The net interest spread and cash flow for the Company could decrease materially
during a period of rapidly rising short-term interest rates, despite the use of
interest-rate swaps and synthetic swaps, as a result of the monthly reset in the
rate on the adjustable-rate non-recourse securitization financing issued by the
Company.
Defaults. Defaults by borrowers on loans securitized by the Company may have an
adverse impact on the Company's financial performance, if actual credit losses
differ materially from estimates made by the Company. Although the Company
believes that its reserves for loan losses are adequate as of September 30,
2004, the allowance for losses is calculated on the basis of historical
experience and management's best estimates. Actual default rates or loss
severity may differ from the Company's estimate as a result of economic
conditions. In particular, the default rate and loss severity on the Company's
portfolio of manufactured housing loans has been higher than initially
estimated. Actual defaults on adjustable-rate loans may increase during a rising
interest rate environment.
Third-party Servicers. Third-party servicers service the majority of the
Company's investment portfolio. To the extent that these servicers are
financially impaired, the performance of the Company's investment portfolio may
deteriorate, and defaults and credit losses may be greater than estimated.
Prepayments. Prepayments by borrowers on loans securitized by the Company may
have an adverse impact on the Company's financial performance. Prepayments are
expected to increase during a declining interest rate or flat yield curve
environment. The Company's exposure to rapid prepayments is primarily (i) the
faster amortization of premium on the investments and, to the extent applicable,
amortization of bond discount, and (ii) the replacement of investments in its
portfolio with lower yield securities.
Competition. The financial services industry is a highly competitive market.
Increased competition in the market has adversely affected the Company, and may
continue to do so.
Regulatory Changes. The Company's businesses as of September 30, 2004 are not
subject to any material federal or state regulation or licensing requirements.
However, changes in existing laws and regulations or in the interpretation
thereof, or the introduction of new laws and regulations, could adversely affect
the Company and the performance of the Company's securitized loan pools or its
ability to collect on its delinquent property tax receivables.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk generally represents the risk of loss that may result from the
potential change in the value of a financial instrument due to fluctuations in
interest and foreign exchange rates and in equity and commodity prices. Market
risk is inherent to both derivative and non-derivative financial instruments.
Accordingly, the scope of the Company's market risk management extends beyond
derivatives to include all market risk sensitive financial instruments. As a
financial services company, net interest margin comprises the primary component
of the Company's earnings. Additionally, cash flow from the investment portfolio
represents the primary component of the Company's incoming cash flow. The
Company is subject to risk resulting from interest rate fluctuations to the
extent that there is a gap between the amount of the Company's interest-earning
assets and the amount of interest-bearing liabilities that are prepaid, mature
or re-price within specified periods. While certain investments may perform
poorly in an increasing or decreasing interest rate environment, other
investments may perform well, and others may not be impacted at all.
The Company focuses on the sensitivity of its cash flow, and measures such
sensitivity to changes in interest rates. Changes in interest rates are defined
as instantaneous, parallel, and sustained interest rate movements in 100 basis
point increments. The Company estimates its net interest margin cash flow for
the next twenty-four months assuming interest rates follow the forward LIBOR
curve (based on ninety-day Eurodollar futures contracts) as of September 30,
2004. Once the base case has been estimated, cash flows are projected for each
of the defined interest rate scenarios. Those scenario results are then compared
against the base case to determine the estimated change to cash flow.
The following table summarizes the Company's net interest margin cash flow
sensitivity analysis as of September 30, 2004. This analysis represents
management's estimate of the percentage change in net interest margin cash flow
given a shift in interest rates, as discussed above. Other investments are
excluded from this analysis because they are not interest rate sensitive. The
"Base" case represents the interest rate environment as it existed as of
September 30, 2004. At September 30, 2004, one-month LIBOR was 1.84% and
six-month LIBOR was 2.20%. The analysis is heavily dependent upon the
assumptions used in the model. The effect of changes in future interest rates,
the shape of the yield curve or the mix of assets and liabilities may cause
actual results to differ significantly from the modeled results. In addition,
certain financial instruments provide a degree of "optionality." The most
significant option affecting the Company's portfolio is the borrowers' option to
prepay the loans. The model applies prepayment rate assumptions representing
management's estimate of prepayment activity on a projected basis for each
collateral pool in the investment portfolio. The model applies the same
prepayment rate assumptions for all five cases indicated below. The extent to
which borrowers utilize the ability to exercise their option may cause actual
results to significantly differ from the analysis. Furthermore, the projected
results assume no additions or subtractions to the Company's portfolio, and no
change to the Company's liability structure. Historically, there have been
significant changes in the Company's assets and liabilities, and there are
likely to be such changes in the future.
------------------------------------- ------- -------------------------------- ------ ----------------------------
Projected Change in Net
Basis Point Interest Margin Projected Change in Value,
Increase (Decrease) Cash Flow From Expressed as a Percentage
in Interest Rates Base Case of Shareholders' Equity
------------------------------------- -------------------------------- ----------------------------
+200 (11.2)% (4.1)%
+100 (4.2)% (1.5)%
Base - -
-100 10.2% 2.0%
-200 25.7% 5.1%
------------------------------------- ------- -------------------------------- ------ ----------------------------
The Company's interest rate rise is related both to the rate of change in
short-term interest rates and to the level of short-term interest rates.
Approximately $274 million of the Company's investment portfolio as of September
30, 2004 is comprised of loans or securities that have coupon rates which adjust
over time (subject to certain periodic and lifetime limitations) in conjunction
with changes in short-term interest rates. Approximately 70% and 14% of the
adjustable rate loans underlying the Company's adjustable rate securities and
securitized finance receivables are indexed to and reset based upon the level of
six-month LIBOR and one-year CMT, respectively.
Generally, during a period of rising short-term interest rates, the Company's
net interest spread earned on its investment portfolio will decrease. The
decrease of the net interest spread results from (i) the lag in resets of the
adjustable rate loans underlying the adjustable rate securities and securitized
finance receivables relative to the rate resets on the associated borrowings and
(ii) rate resets on the adjustable rate loans which are generally limited to 1%
every nine months or 2% every twelve months and subject to lifetime caps, while
the associated borrowings have no such limitation. As to item (i), the Company
has substantially limited its interest rate risk on such investments through (a)
the issuance of fixed-rate non-recourse securitization financing which
approximated $1.0 billion as of September 30, 2004, and (b) equity, which was
$133.2 million. In addition, the Company has entered into interest rate swaps
and synthetic swaps to mitigate its interest rate risk exposure on fixed-rate
investments financed with variable rate bonds as further discussed below. As to
item (ii), as short-term interest rates stabilize and the ARM loans reset, the
net interest margin may be partially restored as the yields on the ARM loans
adjust to market conditions. The remaining portion of the Company's investment
portfolio as of September 30, 2004, approximately $1.3 billion, is comprised of
loans or securities that have coupon rates that are fixed.
Item 4. Controls and Procedures
(a) Evaluation of disclosure controls and procedures.
Disclosure controls and procedures are controls and other
procedures that are designed to ensure that information
required to be disclosed in the Company's reports filed or
submitted under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in
the SEC's rules and forms. Disclosure controls and procedures
include, without limitation, controls and procedures designed
to ensure that information required to be disclosed in the
Company's reports filed under the Exchange Act is accumulated
and communicated to management, including the Company's
management, as appropriate, to allow timely decisions
regarding required disclosures.
As of the end of the period covered by this report, the
Company carried out an evaluation of the effectiveness of the
design and operation of the Company's disclosure controls and
procedures pursuant to Rule 13a-15 under the Exchange Act.
This evaluation was carried out under the supervision and with
the participation of the Company's management, including the
Company's Principal Executive Officer and Chief Financial
Officer. Based upon that evaluation, the Company's management
concluded that the Company's disclosure controls and
procedures are effective.
In conducting its review of disclosure controls, management
concluded that sufficient disclosure controls and procedures
did exist to ensure that information required to be disclosed
in the Company's reports filed or submitted under the Exchange
Act is recorded, processed, summarized and reported within the
time periods specified in the SEC's rules and forms.
(b) Changes in internal controls.
The Company's management is also responsible for establishing
and maintaining adequate internal control over financial
reporting. There were no changes in the Company's internal
controls or in other factors during the quarter covered by
this report that could materially affect, or are reasonably
likely to materially affect the Company's internal controls
subsequent to the Evaluation Date, nor any significant
deficiencies or material weaknesses in such internal controls
requiring corrective actions.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
GLS Capital, Inc. ("GLS"), a subsidiary of the Company, together with the County
of Allegheny, Pennsylvania ("Allegheny County"), were defendants in a lawsuit in
the Commonwealth Court of Pennsylvania (the "Commonwealth Court"), the appellate
court of the state of Pennsylvania. Plaintiffs were two local businesses seeking
status to represent as a class, delinquent taxpayers in Allegheny County whose
delinquent tax liens had been assigned to GLS. Plaintiffs challenged the right
of Allegheny County and GLS to collect certain interest, costs and expenses
related to delinquent property tax receivables in Allegheny County, and whether
the County had the right to assign the delinquent property tax receivables to
GLS and therefore employ procedures for collection enjoyed by Allegheny County
under state statute. This lawsuit was related to the purchase by GLS of
delinquent property tax receivables from Allegheny County in 1997, 1998, and
1999. In July 2001, the Commonwealth Court issued a ruling that addressed, among
other things, (i) the right of GLS to charge to the delinquent taxpayer a rate
of interest of 12% per annum versus 10% per annum on the collection of its
delinquent property tax receivables, (ii) the charging of a full month's
interest on a partial month's delinquency; (iii) the charging of attorney's fees
to the delinquent taxpayer for the collection of such tax receivables, and (iv)
the charging to the delinquent taxpayer of certain other fees and costs. The
Commonwealth Court in its opinion remanded for further consideration to the
lower trial court items (i), (ii) and (iv) above, and ruled that neither
Allegheny County nor GLS had the right to charge attorney's fees to the
delinquent taxpayer related to the collection of such tax receivables. The
Commonwealth Court further ruled that Allegheny County could assign its rights
in the delinquent property tax receivables to GLS, and that plaintiffs could
maintain equitable class in the action. In October 2001, GLS, along with
Allegheny County, filed an Application for Extraordinary Jurisdiction with the
Supreme Court of Pennsylvania, Western District appealing certain aspects of the
Commonwealth Court's ruling. In March 2003, the Supreme Court issued its opinion
as follows: (i) the Supreme Court determined that GLS can charge delinquent
taxpayers a rate of 12% per annum; (ii) the Supreme Court remanded back to the
lower trial court the charging of a full month's interest on a partial month's
delinquency; (iii) the Supreme Court revised the Commonwealth Court's ruling
regarding recouping attorney fees for collection of the receivables indicating
that the recoupment of fees requires a judicial review of collection procedures
used in each case; and (iv) the Supreme Court upheld the Commonwealth Court's
ruling that GLS can charge certain fees and costs, while remanding back to the
lower trial court for consideration the facts of each individual case. Finally,
the Supreme Court remanded to the lower trial court to determine if the
remaining claims can be resolved as a class action. In August 2003, the
Pennsylvania legislature enacted a law amending and clarifying certain
provisions of the Pennsylvania statute governing GLS' right to the collection of
certain interest, costs and expenses. The law is retroactive to 1996, and amends
and clarifies that as to items (ii)-(iv) noted above by the Supreme Court, that
GLS can charge a full month's interest on a partial month's delinquency, that
GLS can charge the taxpayer for legal fees, and that GLS can charge certain fees
and costs to the taxpayer at redemption. Subsequent to the enactment of the law,
challenges to its retroactivity provisions were filed in separate cases, which
did not include GLS as a defendant. In September 2004, the trial court in that
litigation upheld the retroactive provisions enacted in 2003. Specific damages
related to the issues remanded back to the Trial Court have not been determined,
and the Company believes that the ultimate outcome of this litigation will not
have a material impact on its financial condition, but may have a material
impact on reported results for the particular period presented.
The Company and Dynex Commercial, Inc. ("DCI"), formerly an affiliate of the
Company and now known as DCI Commercial, Inc., are defendants in state court in
Dallas County, Texas in the matter of Basic Capital Management, et. al. v. Dynex
Commercial, Inc., et. al. The suit was filed in April 1999 originally against
DCI but in March 2000, Basic Capital Management (hereafter, "BCM" or
"Plaintiffs") amended the complaint and added the Company as a defendant. The
complaint, which was further amended during pretrial proceedings, alleged that,
among other things, DCI and the Company failed to fund tenant improvement or
other advances allegedly required on various loans made by DCI to BCM, which
loans were subsequently acquired by the Company; that DCI breached an alleged
$160 million "master" loan commitment entered into in February 1998; and that
DCI breached another alleged loan commitment of approximately $9 million. The
trial commenced in January 2004 and in February 2004, the jury in the case
rendered a verdict in favor of one of the plaintiffs and against the Company on
the alleged breach of the loan agreements for tenant improvements and awarded
that plaintiff damages in the amount of $.3 million. The jury entered a separate
verdict against DCI in favor of BCM under two mutually exclusive damage models,
for $2.2 million and $25.6 million, respectively. The jury found in favor of DCI
on the alleged $9 million loan commitment, but did not find in favor of DCI for
counterclaims made against BCM. The jury also awarded the plaintiffs attorneys
fees in the amount of $2.1 million. After considering post-trial motions, the
presiding judge entered judgment in favor of the Company and DCI, effectively
overturning the verdicts of the jury and dismissing damages awarded by the jury.
Plaintiffs have filed an appeal. DCI is a former affiliate of the Company, and
the Company believes that it will have no obligation for amounts, if any,
awarded to the plaintiffs as a result of the actions of DCI.
Although no assurance can be given with respect to the ultimate outcome of the
above litigation, the Company believes the resolution of these lawsuits will not
have a material effect on the Company's consolidated balance sheet, but could
materially affect consolidated results of operations in a given year.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
On July 20, 2004, the Annual Meeting of shareholders was held to elect the
members of the Board of Directors, approve the Dynex Capital, Inc. 2004 Stock
Incentive Plan and approve an adjournment of the meeting to a later date or
dates, if necessary, in order to permit the further solicitation of proxies. The
following table summarizes the results of those votes.
------------------------------ ------------------- ---------------- ---------------- ---------------- -----------------------
Director For Against Withheld Abstentions Broker Non-Votes
------------------------------ ------------------- ---------------- ---------------- ---------------- -----------------------
Common Share Votes
------------------
Thomas B. Akin 11,478,770 - 165,837 - -
J. Sidney Davenport 11,322,701 - 321,906 - -
Donald B. Vaden 11,321,782 - 322,825 - -
Eric P. Von der Porten 11,479,582 - 165,025 - -
Preferred Share Votes
---------------------
Leon A. Felman 5,379,470 - 24,006 - -
Barry Igdaloff 5,379,470 - 24,006 - -
Other Votes
Dynex Capital, Inc. 2004 5,401,793 706,005 - 56,752 -
Stock Incentive Plan
Approval of adjournment, if 10,938,308 321,885 - 384,414 -
needed
------------------------------ ------------------- ---------------- ---------------- ---------------- -----------------------
Item 5. Other Information
None
Item 6. Exhibits
(a) Exhibits
31.1 Certification of Principal Executive Officer and Chief
Financial Officer pursuant to Section 302 of the Sarbanes-
Oxley Act of 2002.
32.1 Certification of Principal Executive Officer and Chief
Financial Officer pursuant to Section 906 of the Sarbanes-
Oxley Act of 2002.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DYNEX CAPITAL, INC.
Dated: November 15, 2004 By: /s/ Stephen J. Benedetti
-----------------------------------
Stephen J. Benedetti
Executive Vice President
(authorized officer of registrant,
principal accounting officer)
EXHIBIT INDEX
Exhibit No.
31.1
Certification of Principal Executive Officer and Chief
Financial Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1
Certification of Principal Executive Officer and Chief
Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.