Form 10-Q June 30, 2006
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q

þ Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period June 30, 2006

o Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number: 1-9819

DYNEX CAPITAL, INC.
(Exact name of registrant as specified in its charter)

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 90 days.
Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o Accelerated filer o  Non-accelerated filer þ

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

On June 30, 2006, the registrant had 12,130,831shares outstanding of common stock, $.01 par value, which is the registrant’s only class of common stock.
 


 
DYNEX CAPITAL, INC.
FORM 10-Q

INDEX


     
Page
PART I.
FINANCIAL INFORMATION
  
       
 
Item 1.
  
       
   
1
       
   
2
       
   
3
       
   
4
       
 
Item 2.
12
       
 
Item 3.
26
       
 
Item 4.
27
       
PART II.
OTHER INFORMATION
  
       
 
Item 1.
28
       
 
Item 1A.
28
       
 
Item 2.
29
       
 
Item 3.
29
       
 
Item 4.
29
       
 
Item 5.
30
       
 
Item 6.
30
       
31






i


PART I. FINANCIAL INFORMATION
 
Item 1. Financial Statements
 
DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED
BALANCE SHEETS (UNAUDITED)
(amounts in thousands except share data)

   
June 30,
  
December 31,
  
   
2006
  
2005
  
           
ASSETS
          
Cash and cash equivalents
  
$
47,692
  
$
45,235
  
Other assets
    
4,273
   
4,332
 
     
51,965
   
49,567
 
Investments:
              
Securitized finance receivables, net
    
668,143
   
722,152
 
Securities
    
16,186
   
24,908
 
Other investments
    
3,524
   
4,067
 
Other loans
    
4,674
   
5,282
 
     
692,527
   
756,409
 
               
   
$
744,492
  
$
805,976
  
               
LIABILITIES AND SHAREHOLDERS' EQUITY
              
LIABILITIES
              
Securitization financing:
              
Non-recourse securitization financing
  
$
487,429
  
$
516,578
  
Repurchase agreements secured by securitization financing
    
113,488
   
133,104
 
Repurchase agreements secured by securities
    
84
   
211
 
Other liabilities
    
7,108
   
6,749
 
     
608,109
   
656,642
 
               
Commitments and Contingencies (Note 11)
              
               
SHAREHOLDERS' EQUITY
              
Preferred stock, par value $0.01 per share, 50,000,000 shares authorized,
              
9.5% Cumulative Convertible Series D,
              
4,221,539 and 5,628,737 shares issued and outstanding, respectively,
              
($43,218 and $57,624 aggregate liquidation
              
preference, respectively)
    
41,749
   
55,666
 
Common stock, par value $0.01 per share, 100,000,000 shares authorized,
              
12,130,831 and 12,163,391 shares issued and outstanding, respectively
    
121
   
122
 
Additional paid-in capital
    
366,633
   
366,903
 
Accumulated other comprehensive income
    
588
   
140
 
Accumulated deficit
    
(272,708
)
  
(273,497
)
     
136,383
   
149,334
 
               
   
$
744,492
  
$
805,976
  
               
See notes to unaudited condensed consolidated financial statements.
              


1

DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED STATEMENTS
OF OPERATIONS AND COMPREHENSIVE INCOME (UNAUDITED)
(amounts in thousands except share and per share data)

   
Three Months Ended
  
Six Months Ended
  
   
June 30,
  
June 30,
  
   
2006
  
2005
  
2006
  
2005
  
                   
Interest income:
                  
Securitized finance receivables
  
$
13,139
  
$
16,927
  
$
27,025
  
$
38,924
  
Securities
    
426
   
938
   
973
   
2,064
 
Other investments
    
463
   
209
   
690
   
467
 
Other loans
    
164
   
459
   
270
   
1,131
 
     
14,192
   
18,533
   
28,958
   
42,586
 
                           
Interest and related expenses:
                          
Non-recourse securitization financing
    
10,201
   
15,410
   
21,189
   
33,515
 
Repurchase agreements
    
1,519
   
436
   
3,034
   
1,886
 
Other
    
(71
)
  
(45
)
  
(96
)
  
(4
)
     
11,649
   
15,801
   
24,127
   
35,397
 
                           
Net interest income
    
2,543
   
2,732
   
4,831
   
7,189
 
(Provision for) recapture of loan losses
    
-
   
(664
)
  
119
   
(2,925
)
                           
Net interest income after provision for loan losses
    
2,543
   
2,068
   
4,950
   
4,264
 
                           
Impairment charges
    
-
   
(1,586
)
  
-
   
(1,673
)
Gain on sale of investments, net
    
116
   
9,552
   
140
   
9,850
 
Other income
    
121
   
958
   
230
   
978
 
General and administrative expenses
    
(1,165
)
  
(1,398
)
  
(2,492
)
  
(2,890
)
                           
Net income
    
1,615
   
9,594
   
2,828
   
10,529
 
Preferred stock charge
    
(1,003
)
  
(1,337
)
  
(2,039
)
  
(2,674
)
                           
Net income to common shareholders
  
$
612
  
$
8,257
  
$
789
  
$
7,855
  
                           
Change in net unrealized gain/(loss) on :
                          
Investments classified as available-for-sale
    
84
   
(465
)
  
448
   
(4,348
)
Hedge instruments
    
-
   
201
   
-
   
584
 
                           
Comprehensive income
  
$
1,699
  
$
9,330
  
$
3,276
  
$
6,765
  
                           
Net income per common share:
                          
Basic
  
$
0.05
  
$
0.68
  
$
0.06
  
$
0.65
  
Diluted
  
$
0.05
  
$
0.54
  
$
0.06
  
$
0.59
  
                           
See notes to unaudited condensed consolidated financial statements.
                  



2



DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED STATEMENTS
OF CASH FLOWS (UNAUDITED)
(amounts in thousands)

   
Six Months Ended
  
   
June 30,
  
   
2006
  
2005
  
Operating activities:
          
Net income
  
$
2,828
  
$
10,529
  
Adjustments to reconcile net income to cash
             
provided by operating activities:
              
(Recapture of) provision for loan loss
    
(119
)
  
2,925
 
Impairment charges
    
-
   
1,673
 
Gain on sale of investments
    
(141
)
  
(9,850
)
Amortization and depreciation
    
346
   
1,106
 
Compensation expense for stock options
    
104
   
-
 
Net change in other assets and other liabilities
    
752
   
298
 
Net cash and cash equivalents provided by operating activities
    
3,770
   
6,681
 
               
               
Investing activities:
              
Principal payments received on investments
    
51,479
   
66,740
 
Purchase of securities and other investments
    
(16,642
)
  
(34,770
)
Payments received on securities, other investments and loans
    
26,238
   
29,580
 
Proceeds from sales of securities and other investments
    
1,136
   
18,374
 
Other
    
(561
)
  
179
 
Net cash and cash equivalents provided by investing activities
    
61,650
   
80,103
 
               
Financing activities:
              
Principal payments on non-recourse securitization financing
    
(26,555
)
  
(59,656
)
Net (repayment of) borrowings under repurchase agreement
    
(19,743
)
  
142,466
 
Redemption of securitization financing bonds
    
-
   
(195,653
)
Retirement of common stock
    
(220
)
  
-
 
Retirement of preferred stock
    
(14,072
)
  
-
 
Dividends paid
    
(2,373
)
  
(2,674
)
Net cash and cash equivalents used for financing activities
    
(62,963
)
  
(115,517
)
Net increase (decrease) in cash and cash equivalents
    
2,457
   
(28,733
)
Cash and cash equivalents at beginning of period
    
45,235
   
52,522
 
Cash and cash equivalents at end of period
 
$
47,692
  
$
23,789
  





3

DYNEX CAPITAL, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
June 30, 2006
(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 (together, “Dynex” or the “Company”). All inter-company balances and transactions have been eliminated in consolidation.
 
The Company consolidates entities in which it owns more than 50% of the voting equity and control does not rest with others. 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 or when it is able to influence the financial and operating policies of the investee but owns less than 50% of the voting equity. For all other investments, 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 six months ended June 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. Certain information and footnote disclosures normally included in the consolidated financial statements prepared in accordance with generally accepted accounting principles have been omitted. The unaudited financial statements included herein should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, filed with the Securities and Exchange Commission.
 
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. Securities classified as available-for-sale are carried in the accompanying financial statements at estimated fair value. Estimates of fair value for securities are based on market prices provided by certain dealers, when available. When market prices are not available, fair value estimates 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.
 
The Company also has credit risk on loans in its portfolio as discussed in Note 4. An allowance for loan losses has been estimated and established for currently existing losses in the loan portfolio, which are deemed probable as to their occurrence. 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. Provisions made to increase or decrease the allowance for loan losses are presented as provision for 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 amounts for 2005 have been reclassified to conform to the presentation adopted in 2006.
 

4

NOTE 2 - NET INCOME PER COMMON SHARE
 
Net income per common share is presented on both a basic and diluted per common share basis. Diluted net income per common share assumes the conversion of the convertible preferred stock into common stock, using the if-converted method, and stock appreciation rights and options to the extent that they are 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 following table reconciles the numerator and denominator for both basic and diluted net income per common share for the three and six months ended June 30, 2006 and 2005.
 
   
Three Months Ended June 30,
  
Six Months Ended June 30,
  
   
2006
  
2005
  
2006
  
2005
  
   
Income
  
Weighted-
Average
Number
Of Shares
  
Income
  
Weighted-
Average
Number
Of Shares
  
Income
  
Weighted-
Average
Number
Of Shares
  
Income
  
Weighted-
Average
Number
Of Shares
  
Net income
 
$
1,615
        
$
9,594
        
$
2,828
        
$
10,529
        
Preferred stock charge
    
(1,003
)
        
(1,337
)
        
(2,039
)
        
(2,674
)
      
Net income to common shareholders
  
$
612
    
12,138,469
  
$
8,257
    
12,163,061
  
$
789
    
12,150,011
  
$
7,855
    
12,162,728
  
                                                   
Net income per share:
                                                  
Basic
        
$
0.05
        
$
0.68
        
$
0.06
        
$
0.65
  
Diluted
        
$
0.05
        
$
0.54
        
$
0.06
        
$
0.59
  
                                                   
Reconciliation of shares included in calculation of earnings per share due to dilutive effect
                                                  
Series D preferred stock
  
$
-
    
-
  
$
(1,337
)
  
5,628,737
  
$
-
    
-
  
$
(2,674
)
  
5,628,737
  
Expense and incremental shares of stock appreciation rights
    
-
    
-
    
-
    
-
    
-
    
-
    
-
    
129
  
 
   $ -    
-
  
$
(1,337
)
  
5,628,737
  
$
-
    
-
  
$
(2,674
)
  
5,628,866
  
                                                   
Reconciliation of shares not included in calculation of earnings per share due to anti-dilutive effect
                                                  
Series D preferred stock
  
$
(1,003
)
  
4,221,539
  
$
-
    
-
  
$
(2,039
)  
  
4,291,510
  
$
-
    
-
  
Expense and incremental shares of stock appreciation rights
    
-
    
(89,162
)
  
-
    
-
    
-
    
(89,757
)
  
-
    
-
  
   
$
(1,003
) 
  
4,132,377
  
$
-
    
-
  
$
(2,039
)  
  
4,201,753
  
$
-
    
-
  
                                                   
 
 


5

NOTE 3 - SECURITIZED FINANCE RECEIVABLES
 
The following table summarizes the components of securitized finance receivables at June 30, 2006 and December 31, 2005:

   
June 30, 2006
  
December 31, 2005
  
Collateral:
          
Commercial
  
$
535,528
  
$
570,199
  
Single-family
    
136,954
    
161,058
  
     
672,482
    
731,257
  
Funds held by trustees, including funds held for defeasance
    
7,456
    
6,648
  
Accrued interest receivable
    
4,883
    
5,114
  
Unamortized discounts and premiums, net
    
(1,809
)
  
(1,832
)
Loans, at amortized cost
    
683,012
    
741,187
  
Allowance for loan losses
    
(14,869
)
  
(19,035
)
   
$
668,143
  
$
722,152
  

The commercial securitized finance receivables are encumbered by non-recourse securitization financing. The non-recourse securitization financing bonds collateralized by the single-family loans that were redeemed by the Company during 2005 remain outstanding and are held by the Company as of June 30, 2006. The redeemed bonds, which are eliminated from the condensed consolidated financial statements in consolidation, collateralize the repurchase agreement, which partially financed the redemption of these bonds. This repurchase agreement has been presented as securitization financing in the financial statements.
 
NOTE 4 - ALLOWANCE FOR LOAN LOSSES
 
The Company reserves for probable estimated credit losses on securitized finance receivables and other loans in its investment portfolio. The following table summarizes the aggregate activity for the allowance for loan losses for the three-month and six-month periods ended June 30, 2006 and 2005, respectively:
 
   
Three Months Ended June 30,
  
Six Months Ended June 30,
  
   
2006
  
2005
  
2006
  
2005
  
Allowance at beginning of period
  
$
18,913
  
$
27,681
  
$
19,035
  
$
28,014
  
Provision for (recapture of) loan losses
    
-
    
664
    
(119
)
  
2,925
  
Charge-offs, net of recoveries
    
(4,044
)
  
(499
)
  
(4,047
)
  
(3,093
)
Portfolio sold
    
-
    
(11,310
)
  
-
    
(11,310
)
Allowance at end of period
  
$
14,869
  
$
16,536
  
$
14,869
  
$
16,536
  

The Company identified $43,295 and $54,558 of impaired commercial mortgage loans at June 30, 2006 and December 31, 2005, respectively. The decline is primarily due to improvements in the performance of the underlying real estate collateralizing the impaired loans and the liquidation of a $7,769 non-performing loan. At June 30, 2006 and December 31, 2005, the Company had approximately $27,940 and $39,758 of commercial mortgage loans that were sixty or more days delinquent. One of these loans, with an unpaid principal balance of $23,161 was in foreclosure at June 30, 2006 and was subsequently purchased at the foreclosure sale in July 2006.
 

6

NOTE 5 - OTHER INVESTMENTS
 
The following table summarizes the Company’s other investments at June 30, 2006 and December 31, 2005:
 
   
June 30, 2006
  
December 31, 2005
  
Delinquent property tax receivable securities
  
$
2,804
  
$
3,220
  
Real estate owned
    
720
    
847
  
   
$
3,524
  
$
4,067
  

Delinquent property tax receivable securities includes an unrealized gain of $311 and $55 at June 30, 2006 and December 31, 2005, respectively. Real estate owned is acquired from foreclosures on delinquent property tax receivables. During the six months ended June 30, 2006 and 2005, the Company collected an aggregate of $1,043 and $1,582, respectively, on delinquent property tax receivables and securities, including net sales proceeds from the related real estate owned.
 
NOTE 6 - SECURITIES
 
The following table summarizes the fair value of the Company’s securities classified as available-for-sale at June 30, 2006 and December 31, 2005:

   
June 30, 2006
  
December 31, 2005
  
   
Fair
Value
  
Effective Interest Rate
  
Fair
Value
  
Effective Interest Rate
  
Securities, available-for-sale:
                  
Fixed-rate mortgage securities
  
$
13,307
    
7.29
%
$
22,900
    
6.14
%
Equity securities
    
2,602
          
1,602
        
Other securities
    
-
          
320
        
     
15,909
          
24,822
        
Gross unrealized gains
    
446
          
332
        
Gross unrealized losses
    
(169
)
        
(246
)
      
   
$
16,186
        
$
24,908
        

NOTE 7 - OTHER LOANS
 
The following table summarizes Dynex’s carrying basis for other loans at June 30, 2006 and December 31, 2005, respectively.
 
   
June 30, 2006
  
December 31, 2005
  
Single-family mortgage loans
  
$
4,210
 
$
4,825
  
Multifamily and commercial mortgage loan participations
    
979
    
995
  
     
5,189
    
5,820
  
Unamortized discounts
    
(515
)
  
(538
)
   
$
4,674
  
$
5,282
  
 
NOTE 8 - NON-RECOURSE SECURITIZATION FINANCING
 
Dynex, through limited-purpose finance subsidiaries, has issued bonds pursuant to indentures in the form of non-recourse securitization financing. Each series of securitization financing may consist of various classes of bonds, either at fixed or variable rates of interest. Payments received on securitized finance receivables and any reinvestment income thereon are used to make payments on the securitization financing (see Note 3). The obligations under the securitization financings are payable solely from the securitized finance receivables and are otherwise non-recourse to Dynex. The stated maturity date for each class of bonds is generally calculated based on the final scheduled payment date of the underlying collateral pledged. The actual maturity of each class will be directly affected by the rate of principal prepayments on the related collateral. Each
 

7

series is also subject to redemption at Dynex’s option according to specific terms of the respective indentures. As a result, the actual maturity of any class of a series of securitization financing is likely to occur earlier than its stated maturity. If Dynex does not exercise its option to redeem a class or classes of bonds when it first has the right to do so, the interest rates on the bonds not redeemed will automatically increase by 0.30% to 2.00%.
 
Dynex may retain certain bond classes of securitization financing issued, including investment grade classes, financing these retained bonds with equity. As these limited-purpose finance subsidiaries are included in the consolidated financial statements of Dynex, such retained bonds are eliminated in the consolidated financial statements, while the associated repurchase agreements outstanding, if any, are included as recourse debt.
 
The components of non-recourse securitization financing along with certain other information at June 30, 2006 and December 31, 2005 are summarized as follows:

   
June 30, 2006
  
December 31, 2005
  
   
Bonds Outstanding
  
Range of Interest Rates
  
Bonds Outstanding
  
Range of Interest Rates
  
Fixed-rate classes
  
$
483,368
    
6.6% - 8.8
%
$
509,923
    
6.6% - 8.8
%
Accrued interest payable
    
3,257
          
3,438
        
Deferred costs
    
(14,547
)
        
(16,912
)
      
Unamortized net bond premium
    
15,351
          
20,129
        
   
$
487,429
        
$
516,578
        
                           
Range of stated maturities
    
2009-2028
          
2009-2028
        
Number of series
    
3
          
3
        

At June 30, 2006, the weighted-average coupon on the fixed rate classes was 6.8%. The average effective rate on non-recourse securitization financing, which includes the amortization of the related bond premium and deferred costs, was 8.3%, and 7.4%, for the six months ended June 30, 2006 and the year ended December 31, 2005, respectively.
 
NOTE 9 - REPURCHASE AGREEMENTS
 
The Company uses repurchase agreements, which are recourse to the Company, to finance certain of its investments. The Company had repurchase agreements of $113,488 and $133,104, at June 30, 2006 and December 31, 2005, respectively, which are collateralized by certain securitization financing bonds that were redeemed during 2005. The repurchase agreements mature monthly and have a weighted average rate of 0.10% over one-month LIBOR (5.44% at June 30, 2006). The securitization financing bonds collateralizing these repurchase agreements have a fair value of $130,235 at June 30, 2006 and pay interest at a blended rate of one-month LIBOR plus 0.31%.
 
Dynex also utilizes other recourse repurchase agreements to finance certain of its securities. There were $84 and $211 outstanding at June 30, 2006 and December 31, 2005, respectively, which were collateralized by securities with a market value of $10,036 and $20,133, respectively. These repurchase agreements bear interest based on one-month LIBOR plus a spread ranging from 0.20% to 0.60%, which represented a weighted average rate of 5.58% at June 30, 2006.
 
NOTE 10 - PREFERRED STOCK
 
In January 2006, Dynex redeemed 1,407,198 shares of the outstanding 9.5% Series D Preferred stock with cash of $14,105.
 
At June 30, 2006 and December 31, 2005, the liquidation preference on the Preferred Stock was $43,218 and $57,624, respectively, and includes accrued dividends payable of $0.2375 per share or $1,003 and $1,337 at June 30, 2006 and December 31, 2005, respectively.
 

8

NOTE 11 - COMMITMENTS AND CONTINGENCIES
 
As discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, the Company and certain of its subsidiaries are defendants in litigation. The following discussion is the current status of the litigation.
 
GLS Capital, Inc. (“GLS”), a subsidiary of the Company, and the County of Allegheny, Pennsylvania (“Allegheny County”), are defendants in a lawsuit in the Court of Common Pleas of Allegheny County, Pennsylvania (the “Court”).  Plaintiffs allege that GLS illegally charged the taxpayers of Allegheny County certain attorney fees, costs and expenses, and interest in the collection of delinquent property tax receivables owned by GLS.  Plaintiffs are seeking class action status.  During 2005, the Court held hearings in this matter, and has not yet ruled on whether it will grant class action status in the litigation.  Plaintiffs have not enumerated its damages in this matter.  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 appellees (or “respondents”) in the Court of Appeals for the Fifth Judicial District of Texas at Dallas, related to the matter of Basic Capital Management et al  (collectively, “BCM” or “the Plaintiffs”) versus Dynex Commercial, Inc. et al. Plaintiff’s appeal seeks to overturn a judgment in favor of the Company and DCI which denied recovery to Plaintiffs, and to have a judgment entered in favor of Plaintiffs based on a jury award for damages against the Company of $253, and against DCI for $2,200 or $25,600, all of which was set aside by the trial court.  In the alternative, Plaintiffs are seeking a new trial. The Court of Appeals heard the oral argument on the matter on April 18, 2006 but have not yet issued a ruling on the appeal.  
 
On February 11, 2005, a putative class action complaint alleging violations of the federal securities laws and various state common law claims was filed against Dynex Capital, Inc., our subsidiary MERIT Securities Corporation, Stephen J. Benedetti, the Company's Executive Vice President, and Thomas H. Potts, the Company's former President and a former Director, in United States District Court for the Southern District of New York ("District Court") by the Teamsters Local 445 Freight Division Pension Fund ("Teamsters").  The lawsuit purported to be a class action on behalf of purchasers of MERIT Series 13 securitization financing bonds, which are collateralized by manufactured housing loans.  On May 31, 2005, the Teamsters filed an amended class action complaint.  The amended complaint dropped all state common law claims but added federal securities claims related to the MERIT Series 12 securitization financing bonds.   On July 15, 2005, the defendants moved to dismiss the amended complaint.  On February 10, 2006, the District Court dismissed the claims against Messrs. Benedetti and Potts, but did not dismiss the claims against Dynex and MERIT.  On February 24, 2006, Dynex and MERIT moved for reconsideration and interlocutory appeal of the District Court's order denying the motion to dismiss Dynex and MERIT.  The Company has evaluated the allegations and believes them to be without merit and intends to continue to vigorously defend itself against them.

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 our consolidated balance sheet but could materially affect our consolidated results of operations in a given year.
 
NOTE 12 - STOCK BASED COMPENSATION
 
Pursuant to Dynex’s shareholder approved 2004 Stock Incentive Plan (the “Stock Incentive Plan”), Dynex may grant to eligible officers, directors and employees stock options, stock appreciation rights (“SARs”) and restricted stock awards. An aggregate of 1,500,000 shares of common stock is available for distribution pursuant to the Employee Incentive Plan. Dynex may also grant dividend equivalent rights (“DERs”) in connection with the grant of options or SARs.

Effective January 1, 2006, Dynex adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment, (SFAS 123(R)) using the modified-prospective-transition method. Under this transition method, compensation cost in 2006 includes cost for options granted prior to but not vested as of December 31, 2005, and options vested in 2006. Therefore results for prior periods have not been restated.

9

On January 2, 2005, Dynex granted 126,297 SARs to certain of its employees and officers under the Stock Incentive Plan. The SARs vest over the next four years in equal annual installments, expire on December 31, 2011 and have an exercise price of $7.81 per share, which was the market price of the stock on the grant date.
 
On June 17, 2005, Dynex granted options to acquire an aggregate of 40,000 shares of common stock to the members of its Board of Directors under the Stock Incentive Plan. The options have an exercise price of $8.46 per share, which represents 110% of the closing stock price on the grant date, expire on June 17, 2010 and were fully vested when granted.
 
On January 12, 2006, Dynex granted 77,000 SARs to certain of its employees and officers under the Stock Incentive Plan. The SARs vest over the next four years in equal annual installments, expire on December 31, 2012 and have an exercise price of $6.61 per share, which was the market price of the stock on the grant date.

On June 16, 2006, the Company granted options to acquire an aggregate of 35,000 shares of common stock to the members of its Board of Directors under the Stock Incentive Plan, which had a fair value of approximately $64 on the grant date. The options have an exercise price of $7.43 per share, which represents 110% of the closing stock price on the grant date, expire on June 16, 2011, and were fully vested when granted.
 
The following table presents the 2005 effect on net income and earnings per share if the Company had applied the fair value method to the SARs and options granted to employees and Directors using the Black-Scholes option pricing model.

 
  
Three Months Ended
June 30, 2005
  
Six Months Ended
June 30, 2005
  
Net income to common shareholders
  
$
8,257
  
$
7,855
  
Fair value method stock based compensation expense
    
(84
)
  
(100
)
Pro forma net income to common shareholders
  
$
8,173
  
$
7,755
  
 
          
Net income per common share:
          
Basic - as reported
  
$
0.68
  
$
0.65
  
Basic - pro forma
  
$
0.67
  
$
0.64
  
Diluted - as reported
  
$
0.54
  
$
0.59
  
Diluted - pro forma
  
$
0.53
  
$
0.59
  
 
          

The following table presents a summary of the SAR activity for the Stock Incentive Plan:
 
   
Three Months Ended
  
Six Months Ended
  
   
June 30, 2006
  
June 30, 2006
  
   
Number of Shares
  
Weighted-Average Exercise Price
  
Number of Shares
  
Weighted-Average
Exercise Price
  
SARs outstanding at beginning of period
    
203,297
    
7.36
    
126,297
    
7.81
  
SARs granted
    
-
    
-
    
77,000
    
6.61
  
SARs forfeited or redeemed
    
-
    
-
    
-
    
-
  
SARs exercised
    
-
    
-
    
-
    
-
  
SARs outstanding at end of period
    
203,297
    
7.36
    
203,297
    
7.36
  
SARs vested and exercisable
    
31,574
    
7.81
    
31,574
    
7.81
  

 


10

The following table presents a summary of the option activity for the Stock Incentive Plan:
 
   
Three Months Ended
  
Six Months Ended
  
   
June 30, 2006
  
June 30, 2006
  
   
Number of Shares
  
Weighted-Average Exercise Price
  
Number of Shares
  
Weighted-Average Exercise Price
  
Options outstanding at beginning of period
    
40,000
    
8.46
    
40,000
    
8.46
  
Options granted
    
35,000
    
7.43
    
35,000
    
7.43
  
Options forfeited or redeemed
    
-
    
-
    
-
    
-
  
Options exercised
    
-
    
-
    
-
    
-
  
Options outstanding at end of period
    
75,000
    
7.98
    
75,000
    
7.98
  
Options vested and exercisable
    
75,000
    
7.98
    
75,000
    
7.98
  

NOTE 13 - RECENT ACCOUNTING PRONOUNCEMENTS
 
In late 2005, the Financial Accounting Standards Board (FASB) staff issued Staff Position (FSP) 115-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. This FSP provides additional guidance on when an investment in a debt or equity security should be considered impaired and when that impairment should be considered other-than-temporary and recognized as a loss. Additionally, the FSP requires certain disclosures about unrealized losses which have not been recognized as other-than-temporary. This guidance did not have a material effect on the Company’s consolidated financial statements upon implementation on January 1, 2006.

In February 2006, the FASB issued SFAS 155, “Accounting for Certain Hybrid Financial Instruments”. Key provisions of SFAS 155 include: (1) a broad fair value measurement option for certain hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation; (2) clarification that only the simplest separations of interest payments and principal payments qualify for the exception afforded to interest-only strips and principal-only strips from derivative accounting under paragraph 14 of FAS 133 (thereby narrowing such exception); (3) a requirement that beneficial interests in securitized financial assets be analyzed to determine whether they are freestanding derivatives or whether they are hybrid instruments that contain embedded derivatives requiring bifurcation; (4) clarification that concentrations of credit risk in the form of subordination are not embedded derivatives; and (5) elimination of the prohibition on a Qualified Special Purpose Entity (“QSPE”) holding passive derivative financial instruments that pertain to beneficial interests that are or contain a derivative financial instrument. In general, these changes will reduce the operational complexity associated with bifurcating embedded derivatives, and increase the number of beneficial interests in securitization transactions, including interest-only strips and principal-only strips, required to be accounted for in accordance with FAS 133. Management does not believe that SFAS 155 will have a material effect on the financial statements of the Company.
 
In March 2006 the FASB issued SFAS No.156, “Accounting for Servicing of Financial Assets--an amendment of FASB Statement No. 140” (SFAS 156). This Statement amends FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, with respect to the accounting for separately recognized servicing assets and servicing liabilities. This Statement requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations and to initially measure those servicing assets and servicing liabilities at fair value, if practicable. SFAS 156 permits an entity to measure each class of separately recognized servicing assets and servicing liabilities by either amortizing the servicing asset or liability and assessing the mortgage servicing asset or servicing liability for impairment at each reporting date. Alternatively, an entity may choose to measure the servicing asset or servicing liability at fair value at each reporting date and report changes in fair value in earnings in the period the changes occur. SFAS 156 permits, at its initial adoption, a one-time reclassification of available-for-sale securities to trading securities by entities with recognized servicing rights, without calling into question the

11

treatment of other available-for-sale securities under Statement 115, provided that the available-for-sale securities are identified in some manner as offsetting the entity’s exposure to changes in fair value of servicing assets or servicing liabilities that a servicer elects to subsequently measure at fair value. This statement is effective as of the beginning of its first fiscal year that begins after September 15, 2006. The Company is currently evaluating the potential impact this statement may have on its financial statements.

 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following discussion and analysis of the financial condition and results of operations of the Company as of and for the three-month and six-month periods ended June 30, 2006 should be read in conjunction with the Company’s Unaudited Condensed Consolidated Financial Statements and the accompanying Notes to Unaudited Condensed Consolidated Financial Statements included in this report.
 
The Company is a specialty finance company organized as a real estate investment trust (REIT) that invests in loans and securities consisting principally of single family residential and commercial mortgage loans. The Company finances these loans and securities through a combination of non-recourse securitization financing, repurchase agreements, and equity. Dynex employs financing in order to increase the overall yield on its invested capital.
 
The Company has an investment policy which is reviewed and approved annually by the Board of Directors. The investment policy provides the framework for the allocation of the Company’s investment capital into various funds or strategies, each with its own specific investment objective. These strategies or funds include a liquidity fund, consisting primarily of cash and equivalents, a fixed income fund, consisting primarily of high-quality mortgage securities, a residual investment fund, consisting of primarily credit-sensitive investments with structured leverage (securitization financing), and a strategic fund, consisting primarily of equity and equity-like investments. The Company currently manages the capital allocated to these strategies but is currently seeking joint-venture or other arrangements with money managers, Wall Street firms, other mortgage REITs, hedge funds, and specialty finance companies for leveraging their expertise and resources. To date the Company has had numerous discussions with potential third parties. The Company has sought and will continue to seek a diversification of its capital invested in credit-sensitive investments, predominantly its commercial mortgage securities.

The Company continued repurchasing its common shares during the quarter under the stock repurchase plan authorized by the Company's Board of Directors. The Company repurchased 12,260 shares of its common stock during the quarter at an average cost of $6.80 per share and may repurchase up to an additional 967,440 shares under the current Board authorization. Subject to the applicable securities laws and the terms of the Series D Preferred Stock designation, future repurchases of common stock will be made at times and in amounts as the Company deems appropriate and may be suspended or discontinued at any time.
 
CRITICAL ACCOUNTING POLICIES
 
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 policies 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 policies.
 
Consolidation of Subsidiaries. The consolidated financial statements represent the Company’s accounts after the elimination of inter-company transactions. The Company consolidates entities in which it owns more than 50% of the voting equity and control of the entity does not rest with others. 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 or when it is able to influence the financial and operating policies of the investee but owns less than 50% of the voting equity. For all other investments, the cost method is applied. 
 

12

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 we estimate, based on projected future cash flows or other fair value determinants, that the fair value will remain below the carrying value 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.
 
Dynex 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 generally considered to be other-than-temporary when the fair value remains below the carrying value for three consecutive quarters. If the impairment is determined to be other-than-temporary, an impairment charge is recorded in order to adjust the carrying value of the investment to its estimated value.

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. 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 loan losses is established and evaluated on a pool basis. Otherwise, the allowance for loan losses is established and evaluated on a loan-specific basis. Provisions made to increase the allowance are a current period expense to operations.
 
Generally, single-family loans are considered impaired when they are 60-days past due. Commercial mortgage loans are evaluated on an individual basis for impairment. Generally, given its collateral dependent nature, a commercial loan with a debt service coverage ratio of less than one is considered impaired. However, based on information specific to a commercial loan, commercial loans with a debt service coverage ratio less than one may not be considered impaired; conversely, commercial loans with a debt service coverage ratio greater than one may be considered impaired. 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 the estimates used to establish the allowance.
 

 

13

 
FINANCIAL CONDITION
 
Below is a discussion of the Company's financial condition.

(amounts in thousands except per share data)
  
June 30, 2006
  
December 31, 2005
  
Investments:
          
Securitized finance receivables, net
  
$
668,143
  
$
722,152
  
Securities
    
16,186
    
24,908
  
Other loans
    
4,674
    
5,282
  
Other investments
    
3,524
    
4,067
  
               
Non-recourse securitization financing
    
487,429
    
516,578
  
Repurchase agreements secured by securitization financing bonds
    
113,488
    
133,104
  
Repurchase agreements secured by securities
    
84
    
211
  
               
Shareholders’ equity
    
136,383
    
149,334
  
Common book value per share
   
7.76
    
7.65
  

Securitized finance receivables. Securitized finance receivables decreased to $668.1 million at June 30, 2006 compared to $722.2 million at December 31, 2005. This decrease of $54.1 million is primarily the result of $40.6 million of unscheduled and $10.8 million of scheduled principal payments on the loan collateral and $2.7 million of other items principally related to the liquidation of certain foreclosed securitized commercial loans.

Securities. Securities decreased during the six months ended June 30, 2006 by $8.7 million, to $16.2 million at June 30, 2006 from $24.9 million at December 31, 2005 due primarily to principal payments of $25.0 million received on securities during the period. This decrease was partially offset by $16.6 million of security purchases during the period. The Company sold $0.8 million of equity securities during the period for a gain of $0.1 million and had a net increase of $0.2 million in the net unrealized gain on securities. 
 
Other investments. Other investments at June 30, 2006 consist primarily of a security collateralized by delinquent property tax receivables. Other investments decreased from $4.1 million at December 31, 2005 to $3.5 million at June 30, 2006. This decrease is primarily the result of collections on the tax liens and proceeds from the sale of real estate owned properties which totaled $1.0 million during the quarter. This decrease was partially offset by an increase in the unrealized gain of $0.3 million on the security and $0.2 million of capitalized recoverable advances.
 
Other loans. Other loans decreased by $0.6 million from $5.3 million at December 31, 2005 to $4.7 million at June 30, 2006 primarily as the result of scheduled and unscheduled pay-downs during the period.
 
Non-recourse securitization financing. Non-recourse securitization financing decreased $29.2 million, from $516.6 million at December 31, 2005 to $487.4 million at June 30, 2006. This decrease was primarily a result of principal payments of $26.6 million on the non-recourse securitization financing made from the collections on the related securitized finance receivables and a reduction in bond premium of approximately $3.1 million.
 
Repurchase Agreements. The balance of repurchase agreements declined to $113.6 million at June 30, 2006 from $133.3 million at December 31, 2005. The decrease was due to net repayments of $19.7 during the period as a result of principal received on the underlying investments being financed. 
 
Shareholders’ equity. Shareholders' equity decreased to $136.4 million at June 30, 2006 from $149.3 million at December 31, 2005. This decrease was primarily the result of the redemption of 1,407,198 shares of Series D Preferred Stock and the repurchase of 32,560 shares of common stock during the six months ended June 30, 2006, which contributed to a $14.3 million decrease in equity, and the preferred stock dividend of $2.0 million. These decreases were partially offset by net income of $2.8 million for the period, a $0.4 million increase in net unrealized gains on securities and a $0.1 increase in equity for the fair value of the stock options granted to the members of the Company’s Board of Directors during the second quarter of 2006.
 

14

Supplemental Discussion of Investments
 
 
As further discussed below, the Company manages its investment portfolio on a net investment basis, consisting of the amortized cost basis or fair value of the investment less the associated external financing of the investment, if any. Below is the net basis of the Company's investments as of June 30, 2006. Excluded from this table are cash and cash equivalents, other assets, and other liabilities.
 
As the cash flows received on our investments are generally subordinate to the obligations under the associated financing of the investment, the investment portfolio is evaluated and managed based on the net capital invested in that particular investment. Net capital invested is generally defined as the cost basis of the investment net of the associated financing for that investment. For securitized finance receivables, because the securitization financing is recourse only to the finance receivables pledged and is, therefore, not a general obligation of the Company, the risk on the investment in securitized finance receivables from an economic point of view is limited to the Company's net retained investment in the securitization trust. Below is the net basis of Dynex's investments as of June 30, 2006. Included in the table is an estimate of the fair value of the net investment. The fair value of the net investment in securitized finance receivables is based on the present value of the projected cash flow from the collateral, adjusted for the impact and assumed level of future prepayments and credit losses, less the projected principal and interest due on the securitization financing bonds owned by third parties. The fair value of securities is based on quotes obtained from third-party dealers, or from management estimates.


(amounts in thousands)
  
June 30, 2006
  
 
  
Amortized cost basis
  
Financing
  
Net basis
  
Fair value of net basis (1)
  
Securitized finance receivables:
  
 
  
 
  
 
  
 
  
Single family mortgage loans
  
$
139,456
  
$
113,488
  
$
25,968
  
$
26,597
  
Commercial mortgage loans
    
543,556
    
487,429
    
56,127
    
39,944
  
Allowance for loan losses
    
(14,869
)
  
-
    
(14,869
)
  
-
  
 
    
668,143
    
600,917
    
67,226
    
66,541
  
Securities:
                  
Investment grade single-family
    
12,750
    
84
    
12,666
    
12,751
  
Non-investment grade single-family
    
641
    
-
    
641
    
641
  
Equity and other
    
2,795
    
-
    
2,795
    
2,795
  
 
    
16,186
    
84
    
16,102
    
16,187
  
 
                  
Other loans and investments
    
8,198
    
-
    
8,198
    
9,356
  
 
                  
Total
  
$
692,527
  
$
601,001
  
$
91,526
  
$
92,084
  
 
                  

(1) 
Fair values are based on dealer quotes or bids from independent third parties, and where dealer quotes are not available fair values are calculated as the net present value of expected future cash flows, discounted at 16%. Fair value also includes capital invested in redeemed securitization financing bonds. Expected future cash flows were based on the forward LIBOR curve as of June 30, 2006, and incorporate the resetting of the interest rates on the adjustable rate assets to a level consistent with projected prevailing rates. Expected cash flows were also based on estimated prepayment speeds and credit losses on the underlying loans set forth in the table below. 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.
 


15

The following table summarizes the assumptions used in estimating fair value for our net investment in securitized finance receivables and the cash flow related to those net investments at June 30, 2006.

 (amounts in thousands)
Fair Value Assumptions
  
Loan type
Weighted-average prepayment speeds
Annual 
Losses
Weighted-Average
Discount Rate
Projected cash flow termination date
Cash flows received in 2006 (1)
 
 
 
 
 
 
Single-family mortgage loans
30% CPR
0.2%
16%
Anticipated final maturity 2024
$ 1,667
 
 
 
 
 
 
Commercial mortgage loans (2)
(3)
0.8%
16%
(4)
$ 3,209
 
 
 
 
 
 
 
(1) 
Represents the excess of the cash flows received on the collateral pledged over the cash flow requirements of the securitization financing  bond security.
(2) 
Includes loans pledged to three different securitization trusts.
(3) 
Assumed CPR speeds generally are governed by underlying pool characteristics, prepayment lock-out provisions, and yield maintenance provisions. Loans currently delinquent in excess of 30 days are assumed liquidated in month six.
(4)
Cash flow termination dates are modeled based on the repayment dates of the loans or optional redemption dates of the underlying securitization financing bonds.

The following table presents the Net Basis of Investments of $91,526 at June 30, 2006 and $106,516 at December 31, 2005 included in the table above by their rating classification. Investments in the unrated and non-investment grade classification include primarily other loans which do not have a rating but are substantially seasoned and are performing loans. Securitization over-collateralization generally includes the excess of the securitized finance receivable collateral pledged over the bonds issued by the securitization trust.
 
(amounts in thousands)
  
June 30, 2006
  
December 31, 2005
  
           
Cash and cash equivalents
  
$
47,692
  
$
45,235
  
Investments:
              
AAA rated and agency MBS fixed income securities
    
23,550
    
36,223
  
AA and A rated fixed income securities
    
4,996
    
6,480
  
Unrated and non-investment grade
    
11,834
    
11,781
  
Securitization over-collateralization
    
51,146
    
52,032
  
   
$
91,526
  
$
106,516
  
               

 

16

RESULTS OF OPERATIONS
 
(amounts in thousands except per share information)
  
Three Months Ended
June 30,
  
Six Months Ended
June 30,
  
   
2006
  
2005
  
2006
  
2005
  
                   
Net interest income
 
$
2,543
  
$
2,732
  
$
4,831
  
$
7,189
  
(Provision for) recapture of loan losses
    
-
    
(664
)
  
119
    
(2,925
)
Net interest income after provision for losses
    
2,543
    
2,068
    
4,950
    
4,264
  
Impairment charges
    
-
    
(1,586
)
  
-
    
(1,673
)
Gain on sale of investments, net
    
116
    
9,552
    
140
    
9,850
  
General and administrative expenses
    
(1,165
)
  
(1,398
)
  
(2,492
)
  
(2,890
)
Net income
   
1,615
    
9,594
    
2,828
    
10,529
  
Preferred stock charge
    
(1,003
)
  
(1,337
)
  
(2,039
)
  
(2,674
)
Net income to common shareholders
    
612
    
8,257
    
789
    
7,855
  
                           
Net income per common share:
                          
Basic
 
$
0.05
  
$
0.68
  
$
0.06
  
$
0.65
  
Diluted
  
$
0.05
  
$
0.54
  
$
0.06
  
$
0.59
  
                           

Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005. The decrease in net income and net income per common share during the three months ended June 30, 2006 as compared to the same period in 2005 is primarily the result of a gain of $8.2 million on the sale of securitized finance receivables and a gain of $1.4 million on the sale of four healthcare mezzanine loans, which were realized during the three months ended June 30, 2005. The impact of those gains was partially offset by a $1.6 million impairment taken in 2005 on the Company’s investment in delinquent property tax receivable security. Gain on sale of investments for the three months ended June 30, 2006 include the gain from the sale of equity securities during the period.

Net interest income decreased from $2.7 million to $2.5 million for the quarter ended June 30, 2006 from the same period in 2005 primarily as a result of a decline in average interest earning assets for the three-month periods ended June 30, 2006 and 2005, and an increasing cost of funds, offset in part by an increase in the average yield on interest earning assets. The decline in average earning assets was primarily due to the sale of certain securitized finance receivables during the second quarter of 2005 and unscheduled principal collections on the Company’s securitized commercial mortgage loans. Net interest income after provision for loan losses for the three months ended June 30, 2006 increased to $2.5 million from $2.1 million for the same period for 2005. No provision for loan losses were recognized during the three months ended June 30, 2006 compared to $0.7 million for the second quarter of 2005 due primarily to the Company not needing to make any additional provisions for its securitized commercial loans during the quarter and decreased delinquencies in the Company's non-pool insured securitized single family loans.

General and administrative expense decreased to $1.2 million for the three-months ended June 30, 2006 from $1.4 million for the same period in 2005. This decrease was primarily the result of the reductions in expenses associated with the Company's tax lien servicing operations and a decline in litigation related expenses.
 
Six Months Ended June 30, 2006 Compared to Six Months Ended June 30, 2005. The decrease in net income and net income per common share during the six months ended June 30, 2006 as compared to the same period in 2005 is primarily the result of a gain of $8.2 million on the sale of securitized finance receivables and a gain of $1.4 million on the sale of four healthcare mezzanine loans were realized during the three months ended June 30, 2005, which was partially offset by a $1.7 million impairment taken in 2005 on the Company’s investment in delinquent property tax receivables.

Net interest income decreased from $7.2 million to $4.8 million for the six months ended June 30, 2006 from the same period in 2005 primarily as a result of a decline in average interest earning assets. The decline in average interst earning assets was primarily related to the sale of certain securitized finance receivables during the second quarter of 2005 and unscheduled principal collections on the Company securitized commercial mortgage loans. Net interest income after provision for loan

17

losses for the six months ended June 30, 2006 increased to $4.9 million from $4.3 million for the same period for 2005. Provision for loan losses decreased from an expense of $2.9 million for the six months ended 2005 to a benefit of $0.1 million for the same period in 2006 due primarily to the Company not needing to make any additional provisions for its securitized commercial loans during the quarter and decreased delinquencies in the Company's non-pool insured securitized single family loans.

General and administrative expense decreased to $2.5 million for the six-months ended June 30, 2006 from $2.9 million for the same period in 2005. This decrease was primarily the result of the reductions in expenses associated with the Company's tax lien servicing operations and a decline in litigation related expenses.
 
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. Assets that are on non-accrual status are excluded from the table below for each period presented.
 
Average Balances and Effective Interest Rates
 
   
Three Months Ended June 30,
  
Six Months Ended June 30,
  
   
2006
  
2005
  
2006
  
2005
  
(amounts in thousands)
  
Average
Balance
  
Effective
Rate
  
Average
Balance
  
Effective
Rate
  
Average
Balance
  
Effective
Rate
  
Average
Balance
  
Effective
Rate
  
Interest-earning assets(1):
                                  
Securitized finance receivables(2) (3)
  
  $
684,483
    
7.61
%
  $
945,090
    
7.16
%
  $
700,873
    
7.65
%
  $
1,085,971
    
7.17
%
Cash
   
38,353
    
4.83
%
  
35,841
    
2.56
%
  
27,703
    
4.98
%
  
44,489
    
2.38
%
Securities
    
16,365
    
9.68
%
  
71,854
    
5.02
%
  
25,938
    
7.23
%
  
72,614
    
5.33
%
Other loans
   
4,909
    
13.33
%
  
6,486
    
12.90
%
  
5,046
    
10.71
%
  
6,789
    
13.75
%
Other investments
    
-
    
-
%
  
4,756
    
19.35
%
  
-
    
-
%
  
6,075
    
19.83
%
Total interest-earning assets
  
  $
744,110
    
7.55
%
  $
1,064,027
    
6.95
%
  $
759,560
    
7.56
%
  $
1,215,938
    
6.98
%
                                                   
Interest-bearing liabilities:
                                                 
Non-recourse securitization financing(3)
  
  $
491,666
    
8.13
%
$
731,625
    
7.73
%
  $
499,530
    
8.31
%
  $
939,569
    
6.97
%
Repurchase agreements secured by securitization financing
    
118,025
    
5.11
%
  
123,581
    
3.12
%
  
123,085
    
4.92
%
  
61,790
    
3.20
%
Repurchase agreements
    
123
    
5.24
%
  
57,177
    
3.02
%
  
158
    
4.96
%
  
63,197
    
2.80
%
Total interest-bearing liabilities
  
  $
609,813
    
7.54
%
  $
912,383
    
6.81
%
  $
622,773
    
7.64
%
  $
1,064,556
    
6.50
%
Net interest spread on all investments(3)
          
0.01
%
        
0.14
%
        
(0.08
)%
        
0.48
%
Net yield on average interest-earning assets(3) (4)
          
1.38
%
        
1.10
%
        
1.30
%
        
1.29
%
 
(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 $7,473 and $251 for the three months ended June 30, 2006 and 2005, respectively, and $7,045 and $242 for the six months ended June 30, 2006 and 2005, respectively.
(3) 
Effective rates are calculated excluding non-interest related securitization financing expenses. If included, the effective rate on interest-bearing liabilities would be 7.64% and 6.93% for the three months ended June 30, 2006 and 2005, respectively, and 7.75% and 6.65% for the six months ended June 30, 2006 and 2005, respectively.
(4)
Net yield on average interest-earning assets reflects net interest income excluding non-interest related securitization financing expenses divided by average interest earning assets for the period, annualized.

18

The net interest spread decreased 13 basis points, to 0.01% for the three months ended June 30, 2006 from 0.14% for the same period in 2005. The net yield on average interest earning assets for the three months ended June 30, 2006 increased to 1.38% from 1.10% for the same period in 2005 . The decline in the Company's net interest spread can be attributed primarily to an increase of 73 basis points in the effective rate on interest-bearing liabilities and an increase of 60 basis points in the effective rate on interest-earning assets, which are both principally a result of the sale of approximately $367.2 million of securitized finance receivables and the extinguishment of approximately $363.9 million of the related securitization financing bonds. The net yield on average interest earning assets in 2005 also includes interest income on the Company’s investment in delinquent property tax receivable securities for most of the quarter in 2005, but none in 2006, because the investment was placed on non-accrual at the end of May 2005.

The net interest spread decreased 56 basis points, to negative 0.08% for the six months ended June 30, 2006 from 0.48% for the same period in 2005. The net yield on average interest earning assets for the six months ended June 30, 2006 increased relative to the same period in 2005, to 1.30% from 1.29%. The decline in the Company's net interest spread can be attributed primarily to an increase of 114 basis points in the effective rate on interest-bearing liabilities, partially offset by an increase of 58 basis points in the effective rate on interest-earning assets. Amounts for 2005 in the above table include income recognized through May 2005 on the Company’s delinquent property tax receivables portfolio, which were placed on non-accrual at the end of May 2005. The effective rate on interest-earning assets was also negatiely impacted as a result of certain impaired securitized commercial loans being on non-accrual during the six months ended June 30, 2006, which decreased interest income for the six months ended 2006 by approximately $1.0 million from the amount that was recognized on those loans for the same period in 2005. There were also effective interest rate adjustments recorded in 2005 resulting in a decrease of $1.0 million from 2005.

The following table summarizes the amount of change in interest income and interest expense due to changes in interest rates versus changes in volume:

   
Three Months Ended June 30, 2006 vs. 2005
  
(amounts in thousands)
  
Rate
  
Volume
  
Total
  
   
 
  
 
  
 
  
Securitized finance receivables
  
$
1, 043
  
$
(4,913
)
$
(3,870
)
Cash and cash equivalents
    
162
    
72
    
234
  
Securities
    
508
    
(1,014
)
  
(506
)
Other loans
    
7
    
(52
)
  
(45
)
Other investments
    
(115
)
  
(115
)
  
(230
)
               
Total interest income
    
1,605
    
(6,022
)
  
(4,417
)
               
Securitization financing
    
965
    
(4,582
)
  
(3,617
)
Repurchase agreements
    
222
    
(656
)
  
(434
)
               
Total interest expense
    
1,187
    
(5,238
)
  
(4,051
)
               
Net interest income
  
$
418
  
$
(784
)
$
366
  


19


   
Six Months Ended June 30, 2006 vs. 2005
  
(amounts in thousands)
  
Rate
  
Volume
  
Total
  
   
 
  
 
  
 
  
Securitized finance receivables
  
$
2,555
  
$
(14,628
)
$
(12,073
)
Cash and cash equivalents
    
26
    
135
    
161
  
Securities
    
601
    
(1,599
)
  
(998
)
Other loans
    
(91
)
  
(106
)
  
(197
)
Other investments
    
(301
)
  
(301
)
  
(602
)
               
Total interest income
    
2,790
    
(16,499
)
  
(13,709
)
               
Securitization financing
    
4,084
    
(14,028
)
  
(9,944
)
Repurchase agreements
    
375
    
(1,261
)
  
(886
)
               
Total interest expense
    
4,459
    
(15,289
)
  
(10,830
)
               
Net interest income
  
$
(1,669
)
$
(1,210
)
$
(2,879
)
 
Note:  The change in interest income and interest expense due to changes in both volume and rate, which cannot be segregated, has been allocated proportionately to the change due to volume and the change due to rate. This table excludes non-interest related dividends on equity securities, securitization financing expense, other interest expense and provision for credit losses.

For the six months ended June 30, 2005 compared to the same period for 2006, average interest-earning assets declined $456 million, or approximately 38%. Approximately 56% of that decline resulted from the derecognition of two securitization trusts collateralized by manufactured housing loans. Another large portion of such reduction relates to paydowns on the Company's adjustable-rate single-family mortgages.

Credit Exposures. The predominate securitization structure used by Dynex is non-recourse securitization financing, whereby loans and securities are pledged to a trust, and the trust issues bonds pursuant to an indenture. 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. From an economic point of view, we generally have retained a limited portion of the direct credit risk in these securities. In many instances, we retained the “first-loss” credit risk on pools of loans that it has securitized.
 
The following table summarizes the aggregate principal amount of certain or our investments; the direct credit exposure we have retained (represented by the amount of over-collateralization pledged and subordinated securities we own), net of the credit reserves, premiums and discounts we maintain for such exposure; and the actual credit losses incurred for each quarter presented. Credit Exposure, Net of Credit Reserves is based on the credit risk retained by the Company for the loans and securities pledged to the securitization trust, from an economic point of view. The table includes any subordinated security retained by the Company if such subordinated security is rated below investment grade by one or more of the nationally recognized credit rating agencies. Credit Exposure, Net of Credit Reserves increased from the second quarter 2005 by $4.1 million and from the fourth quarter of 2005 by $2.1 million as the Company has amortized premiums on bonds issued and sold by the Company, which had previously been allocated for credit reserves. The actual credit loss in the second quarter of 2006 relates to a $7.8 million securitized commercial mortgage loan which was liquidated during the period.

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 $18.7 million and a remaining deductible aggregating $0.5 million on $17.6 million of securitized single-family mortgage loans which are subject to such reimbursement agreements; guarantees
 

20

aggregating $16.7 million on $162.2 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 $41.0 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 93% on such policies before the Company would incur losses.
 
Credit Reserves and Actual Credit Losses
 
(amounts in millions)
  
Outstanding Loan Principal Balance
  
Credit Exposure, Net
Of Credit Reserves
  
Actual
Credit Losses
  
Credit Exposure, Net to Outstanding Loan Balance
  
2005, Quarter 2
  
$
828.9
  
$
29.0
  
$
0.5
    
3.50
%
2005, Quarter 3
    
786.5
    
29.3
    
0.3
    
3.73
%
2005, Quarter 4
    
753.2
    
31.0
    
0.0
    
4.12
%
2006, Quarter 1
    
724.4
    
32.0
    
0.5
    
4.42
%
2006, Quarter 2
    
693.8
    
33.1
    
7.1
    
4.77
%

The following tables summarize single-family mortgage loan and commercial mortgage loan delinquencies as a percentage of the outstanding commercial securitized finance receivables balance for those securities in which we have retained a portion of the direct credit risk. The delinquencies as a percentage of all outstanding securitized finance receivables balance have decreased to 6.7% at June 30, 2006 from 7.3% at June 30, 2005 primarily as a result of prepayment of one previously delinquent commercial mortgage loan and the liquidation of another at a $6.8 million loss, which was fully reserved. We monitor and evaluate our exposure to credit losses and have established reserves based upon anticipated losses, general economic conditions and trends in the investment portfolio. At June 30, 2006, management believes the level of credit reserves is appropriate for currently existing losses within these loan pools.

Single family mortgage loan delinquencies as a percentage of the outstanding loan balance increased by approximately 1.04% to 8.28% at June 30, 2006 from 7.24% at June 30, 2005 and increased by 0.87% from 7.41% at December 31, 2005 as the unpaid principal balance of the portfolio declines. The following table provides the percentage of delinquent single family loans.

Single-Family Loan Delinquency Statistics

 
30 to 59 days delinquent
60 to 89 days delinquent
90 days and over delinquent (1)
Total
2005, Quarter 2
4.09%
0.69%
2.46%
7.24%
2005, Quarter 3
3.33%
1.43%