Form 10-Q 09-30-06
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934

For the quarterly period September 30, 2006

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 September 30, 2006, the registrant had 12,131,262 shares 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.
13
       
 
Item 3.
30
       
 
Item 4.
32
       
PART II.
OTHER INFORMATION
  
       
 
Item 1.
32
       
 
Item 1A.
33
       
 
Item 2.
33
       
 
Item 3.
34
       
 
Item 4.
34
       
 
Item 5.
34
       
 
Item 6.
34
       
35






i


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,
  
   
2006
  
2005
  
ASSETS
          
Cash and cash equivalents
  
$
52,285
  
$
45,235
  
Securitized finance receivables, net
    
362,629
   
722,152
 
Securities
    
14,968
   
24,908
 
Other investments
    
3,069
   
4,067
 
Other mortgage loans
    
4,289
   
5,282
 
Investment in joint venture
    
36,618
   
-
 
Other assets
    
5,817
   
4,332
 
               
   
$
479,675
  
$
805,976
  
               
LIABILITIES AND SHAREHOLDERS' EQUITY
              
LIABILITIES
              
Securitization financing:
              
Non-recourse securitization financing
  
$
219,050
  
$
516,578
  
Repurchase agreements secured by securitization financing
    
103,253
   
133,104
 
Repurchase agreements secured by securities
    
-
   
211
 
Obligation under payment agreement
    
16,369
   
-
 
Other liabilities
    
5,982
   
6,749
 
     
344,654
   
656,642
 
               
Commitments and Contingencies (Note 12)
              
               
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,
              
12,131,262 and 12,163,391 shares issued and outstanding, respectively
    
121
   
122
 
Additional paid-in capital
    
366,637
   
366,903
 
Accumulated other comprehensive income
    
440
   
140
 
Accumulated deficit
    
(273,926
)
  
(273,497
)
     
135,021
   
149,334
 
               
   
$
479,675
  
$
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
  
Nine Months Ended
  
   
September 30,
  
September 30,
  
   
2006
  
2005
  
2006
  
2005
  
Interest income:
                  
Securitized finance receivables
  
$
11,863
  
$
14,470
  
$
38,888
  
$
53,394
  
Securities
    
330
   
974
   
1,303
   
3,038
 
Other investments
    
613
   
124
   
1,303
   
1,255
 
Other loans
    
194
   
149
   
464
   
616
 
     
13,000
   
15,717
   
41,958
   
58,303
 
                           
Interest and related expenses:
                          
Non-recourse securitization financing
    
8,236
   
12,716
   
29,425
   
47,226
 
Repurchase agreements
    
1,533
   
365
   
4,567
   
1,256
 
Obligation under payment agreement
    
121
   
-
   
121
   
-
 
Other
    
(59
)
  
22
   
(155
)
  
18
 
     
9,831
   
13,103
   
33,958
   
48,500
 
                           
Net interest income
    
3,169
   
2,614
   
8,000
   
9,803
 
(Provision for) recapture of loan losses
    
(67
)
  
(1,622
)
  
52
   
(4,547
)
                           
Net interest income after provision for loan losses
    
3,102
   
992
   
8,052
   
5,256
 
                           
Equity in loss of joint venture
    
(1,661
)
  
-
   
(1,661
)
  
-
 
Loss on capitalization of joint venture
    
(1,194
)
  
-
   
(1,194
)
  
-
 
Gain (loss) on sale of investments, net
    
85
   
(48
)
  
226
   
9,802
 
Impairment charges
    
-
   
(207
)
  
-
   
(2,259
)
Other income (expense)
    
433
   
(1,026
)
  
662
   
331
 
General and administrative expenses
    
(980
)
  
(1,610
)
  
(3,473
)
  
(4,500
)
                           
Net (loss) income
    
(215
)
  
(1,899
)
  
2,612
   
8,630
 
Preferred stock charge
    
(1,003
)
  
(1,336
)
  
(3,041
)
  
(4,010
)
                           
Net (loss) income to common shareholders
  
$
(1,218
)
$
(3,235
)
$
(429
)
$
4,620
  
                           
Change in net unrealized gain/(loss) on:
                          
Investments classified as available-for-sale
    
(148
)
  
(116
)
  
300
   
(4,464
)
Hedge instruments
    
-
   
21
   
-
   
605
 
                           
Comprehensive (loss) income
  
$
(363
)
$
(1,994
)
$
2,912
  
$
4,771
  
                           
Net (loss) income per common share:
                          
Basic and diluted
  
$
(0.10
)
$
(0.27
)
$
(0.04
)
$
0.38
  
                           
             
See notes to unaudited condensed consolidated financial statements.
            



- 2 -



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

   
Nine Months Ended
  
   
September 30,
  
   
2006
  
2005
  
Operating activities:
          
Net income
  
$
2,612
  
$
8,630
  
Adjustments to reconcile net income to cash
             
provided by operating activities:
              
(Recapture of) provision for loan loss
    
(52
)
  
4,547
 
Equity in loss of joint venture
    
1,661
       
Impairment charges
    
-
   
2,259
 
Loss on capitalization of joint venture
    
1,194
   
-
 
Gain on sale of investments
    
(226
)
  
(9,802
)
Amortization and depreciation
    
246
   
1,425
 
Compensation expense for stock options
    
104
   
-
 
Net change in other assets and other liabilities
    
(576
)
  
164
 
Net cash and cash equivalents provided by operating activities
    
4,963
   
7,223
 
               
               
Investing activities:
              
Principal payments received on investments
    
77,776
   
106,593
 
Purchase of securities and other investments
    
(17,221
)
  
(45,572
)
Payments received on securities, other investments and loans
    
27,816
   
51,767
 
Proceeds from sales of securities and other investments
    
2,129
   
20,297
 
Other
    
886
   
171
 
Net cash and cash equivalents provided by investing activities
    
91,386
   
133,256
 
               
Financing activities:
              
Principal payments on non-recourse securitization financing
    
(41,573
)
  
(81,309
)
Net (repayment of) borrowings under repurchase agreement
    
(30,062
)
  
107,185
 
Redemption of securitization financing bonds
    
-
   
(195,653
)
Retirement of common stock
    
(216
)
  
-
 
Retirement of preferred stock
    
(14,072
)
  
-
 
Dividends paid
    
(3,376
)
  
(4,010
)
Net cash and cash equivalents used for financing activities
    
(89,299
)
  
(173,787
)
Net increase (decrease) in cash and cash equivalents
    
7,050
   
(33,308
)
Cash and cash equivalents at beginning of period
    
45,235
   
52,522
 
Cash and cash equivalents at end of period
 
$
52,285
  
$
19,214
  
               
Supplemental information:
              
Interest paid during the period
    
35,383
   
48,189
 
Non-cash transactions:
              
Acquisition of investment in joint venture
    
38,248
   
-
 
               
               
See notes to unaudited condensed consolidated financial statements.
              


- 3 -

DYNEX CAPITAL, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
September 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 nine months ended September 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 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 nine months ended September 30, 2006 and 2005.
 
   
Three Months Ended September 30,
  
Nine Months Ended September 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 (loss) income
  
$
(215
)
      
$
(1,899
)
      
$
2,612
        
$
8,630
        
Preferred stock charge
    
(1,003
)
        
(1,336
)
        
(3,041
)
        
(4,010
)
      
Net (loss) income to common shareholders
  
$
(1,218
)
  
12,130,836
  
$
(3,235
)
  
12,163,391
  
$
(429
)
  
12,143,549
  
$
4,620
    
12,162,951
  
                                                   
Net (loss) income per share:
                                                  
Basic and diluted
        
$
(0.10
)
      
$
(0.27
)
      
$
(0.04
)
      
$
0.38
  
                                                   
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
  
$
(1,336
)
  
5,628,737
  
$
3,041
    
4,267,930
  
$
(4,010
)
  
5,628,737
  
Expense and incremental shares of stock appreciation rights
    
-
    
(63,902
)
  
-
    
-
    
-
    
(70,615
)
  
-
    
86
  
   
$
1,003
    
4,157,637
  
$
(1,336
)
  
5,628,737
  
$
3,041
    
4,197,315
  
$
(4,010
)
  
5,628,823
  
 
NOTE 3 - SECURITIZED FINANCE RECEIVABLES
 
The following table summarizes the components of securitized finance receivables at September 30, 2006 and December 31, 2005:

   
September 30,
2006
  
December 31, 2005
  
Collateral:
          
Commercial mortgage loans
  
$
232,118
  
$
570,199
  
Single-family mortgage loans
    
125,621
    
161,058
  
     
357,739
    
731,257
  
Funds held by trustees, including funds held for defeasance
    
7,404
    
6,648
  
Accrued interest receivable
    
2,430
    
5,114
  
Unamortized discounts and premiums, net
    
(455
)
  
(1,832
)
Loans, at amortized cost
    
367,118
    
741,187
  
Allowance for loan losses
    
(4,489
)
  
(19,035
)
   
$
362,629
  
$
722,152
  

The finance receivables are encumbered by non-recourse securitized financing as discussed in Note 9.
 
During the third quarter of 2006, Dynex contributed its interests in approximately $279,003 of securitized finance receivables and the associated securitization trust and approximately $254,454 in related securitization financing debt in exchange for an interest in the newly formed joint venture (see Note 8) and recognized a loss on the capitalization of the joint venture of $1,194.
 

- 5 -

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 nine-month periods ended September 30, 2006 and 2005, respectively:
 
   
Three Months Ended
September 30,
  
Nine Months Ended
September 30,
  
   
2006
  
2005
  
2006
  
2005
  
Allowance at beginning of period
  
$
14,869
  
$
16,536
  
$
19,035
  
$
28,014
  
Provision for (recapture of) loan losses
    
67
    
1,622
    
(52
)
  
4,547
  
Charge-offs, net of recoveries
    
(94
)
  
(357
)
  
(4,141
)
  
(3,450
)
Portfolio sold/transferred
    
(10,353
)
  
-
    
(10,353
)
  
(11,310
)
Allowance at end of period
  
$
4,489
  
$
17,801
  
$
4,489
  
$
17,801
  

The Company identified $16,781 and $54,558 of impaired commercial mortgage loans at September 30, 2006 and December 31, 2005, respectively. The decline is primarily due to the contribution of one of the Company’s three commercial loan securitizations to a joint venture during the three months ended September 30, 2006, which resulted in the reversal of $10,353 of allowance for loan losses. In addition, performance of the underlying real estate collateralizing the impaired loans improved and six non-performing loans with a total unpaid balance of $12,177 liquidated during the nine-month period ended September 30, 2006.  At September 30, 2006 and December 31, 2005, the Company had approximately $3,195 and $39,758 of commercial mortgage loans that were sixty days or more delinquent.

NOTE 5 - OTHER INVESTMENTS
 
The following table summarizes the Company’s other investments at September 30, 2006 and December 31, 2005:
 
   
September 30,
2006
  
December 31,
2005
  
Delinquent property tax receivable securities
  
$
2,528
  
$
3,220
  
Real estate owned
    
541
    
847
  
   
$
3,069
  
$
4,067
  

Delinquent property tax receivable securities include an unrealized gain of $213 and $55 at September 30, 2006 and December 31, 2005, respectively. Real estate owned is acquired from foreclosures on delinquent property tax receivables. During the nine months ended September 30, 2006 and 2005, the Company collected an aggregate of $1,482 and $2,279, respectively, on delinquent property tax receivables and securities, including net sales proceeds from the related real estate owned.
 

- 6 -

NOTE 6 - SECURITIES
 
The following table summarizes the fair value of the Company’s securities classified as available-for-sale at September 30, 2006 and December 31, 2005:

   
September 30, 2006
  
December 31, 2005
  
   
Fair
Value
  
Effective Interest Rate
  
Fair
Value
  
Effective Interest Rate
  
Securities, available-for-sale:
                  
Fixed-rate mortgage securities
  
$
12,246
    
7.27
%
$
22,900
    
6.14
%
Equity securities
    
2,512
          
1,602
        
Other securities
    
-
          
320
        
     
14,758
          
24,822
        
Gross unrealized gains
    
409
          
332
        
Gross unrealized losses
    
(199
)
        
(246
)
      
   
$
14,968
        
$
24,908
        

NOTE 7 - OTHER LOANS
 
The following table summarizes Dynex’s carrying basis for other loans at September 30, 2006 and December 31, 2005, respectively.
 
   
September 30, 2006
  
December 31, 2005
  
Single-family mortgage loans
  
$
3,761
 
$
4,825
  
Multifamily and commercial mortgage loan participations
    
971
    
995
  
     
4,732
    
5,820
  
Unamortized discounts
    
(443
)
  
(538
)
   
$
4,289
  
$
5,282
  
 
NOTE 8 - INVESTMENT IN JOINT VENTURE
 
On September 15, 2006, Issued Holdings Capital Corporation (“IHCC”), a wholly-owned subsidiary of the Company, DBAH Capital, LLC, a subsidiary of Deutsche Bank, A.G., and Dartmouth Investments, LLP formed a joint venture, Copperhead Ventures, LLC, in which the parties interest is 49.875%, 49.875% and 0.25%, respectively. In connection with the formation and initial capitalization of the joint venture, the Company contributed its interest in a commercial mortgage securitization trust issued by Commercial Capital Access One (“CCAO”), and additionally agreed under a payment agreement to make payments to the joint venture based on cash flows received by the Company from a second commercial mortgage securitization trust.
 
The Company’s interests in the commercial mortgage securitization trust contributed to the joint venture included three subordinate commercial mortgage backed securities and the redemption rights for all of the outstanding non-recourse securitization financing bonds issued by that trust. The contribution of these interests resulted in the derecognition of the related collateral of $279,003 and securitization financing of $254,454, the capitalization of $1,354 of accrued interest to which the Company retained the right to receive and the recognition of a loss of $1,194 for the quarter ended September 30, 2006.
 
The Company also entered into a payment agreement, which requires it to remit all of the cash flows received on its interests in a second commercial securitization to the joint venture. The Company has the right to repurchase this agreement from the joint venture at any time at its then fair value, and the Company has the right of first refusal should the joint venture decide to sell the agreement in the future. The Company has recorded an investment in and a liability to the joint venture equal to the estimated fair value of the future estimated cash flows of the trust. The difference between the gross cash flows and the recorded liability is amortized into interest expense using the effective interest method.
 

- 7 -

The total fair value of the consideration contributed by the Company for its interest in the joint venture was $37,281, which exceeded its proportionate share of the net assets of the joint venture at formation by $967. This difference is recorded in investment in joint venture and will be amortized over the estimated life of the joint venture as a charge to the Company’s equity in the earnings or loss of the joint venture.
 
The Company accounts for its investment in the joint venture using the equity method, under which it recognizes its proportionate share of the joint ventures earnings or loss and changes in accumulated other comprehensive income. The Company recorded $1,661 for its equity in the net loss of the joint venture and $18 for the increase in accumulated other comprehensive income of the joint venture for the quarter ended September 30, 2006. The joint venture’s loss related to the impairment of one of the joint venture’s commercial mortgage backed securities due to an increase in the estimate of the loss on the liquidation of a foreclosed loan collateralizing the security.
 
NOTE 9 - 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 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 0.83%.
 
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 September 30, 2006 and December 31, 2005 are summarized as follows:

   
September 30, 2006
  
December 31, 2005
  
   
Bonds Outstanding
  
Range of Interest Rates
  
Bonds Outstanding
  
Range of Interest Rates
  
Fixed-rate classes
  
$
213,188
    
6.6% - 8.8
%
$
509,923
    
6.6% - 8.8
%
Accrued interest payable
    
1,480
          
3,438
        
Deferred costs
    
(2,972
)
        
(16,912
)
      
Unamortized net bond premium
    
7,354
          
20,129
        
   
$
219,050
        
$
516,578
        
                           
Range of stated maturities
    
2024-2027
          
2009-2028
        
Number of series
    
2
          
3
        

At September 30, 2006, the weighted-average coupon on the fixed rate classes was 6.9%. The average effective rate on non-recourse securitization financing, which includes the amortization of the related bond premium and deferred costs, was 7.6%, and 7.4%, for the nine months ended September 30, 2006 and the year ended December 31, 2005, respectively.
 
As discussed in Note 3 and Note 8, the Company contributed its interest in a securitization trust to a joint venture during the quarter resulting in the derecognition of approximately $254,454 of non-recourse securitization financing.
 

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NOTE 10 - 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 $103,253 and $133,104, at September 30, 2006 and December 31, 2005, respectively, which are collateralized by certain of the Company’s retained interests in a prior securitization. The repurchase agreements mature monthly and have a weighted average rate of 0.10% over one-month LIBOR (5.37% at September 30, 2006). The securitization financing bonds collateralizing these repurchase agreements have a fair value of $118,570 at September 30, 2006 and pay interest at a blended rate of one-month LIBOR plus 0.10%.
 
Dynex has also utilized other recourse repurchase agreements to finance certain of its securities. These were all repaid during the three-months ended September 2006. There were $211 outstanding at December 31, 2005 which were collateralized by securities with a market value of $20,133.
 
NOTE 11 - 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 September 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 September 30, 2006 and December 31, 2005, respectively.
 
NOTE 12 - 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.  On October 27, 2006, the Court certified the class action status of the litigation, which was originally filed in 1998. In its Order, the Court left open the possible decertification of the class if the fees, costs and expenses charged by GLS are in accordance with public policy considerations as well as the statute and relevant ordinance.  The Company may seek to stay this action pending the outcome of other litigation before the Pennsylvania Supreme Court in which GLS is not directly involved but has filed an Amicus brief in support of the defendants.  Plaintiffs have not enumerated its damages in this matter, 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 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

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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 13 - 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.

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.
 

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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
September 30, 2005
  
Nine Months Ended
September 30,2005
  
Net (loss) income to common shareholders
  
$
(3,235
)
$
4,620
  
Fair value method stock based compensation expense
    
2
    
(98
)
Pro forma net (loss) income to common shareholders
  
$
(3,233
)
$
4,522
  
 
          
Net (loss) income per common share:
          
Basic and diluted - as reported
  
$
(0.27
)
$
0.38
  
Basic and diluted - pro forma
  
$
(0.27
)
$
0.37
  

The following table presents a summary of the SAR activity for the Stock Incentive Plan:

   
Three Months Ended
  
Nine Months Ended
  
   
September 30, 2006
  
September 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
  

The following table presents a summary of the option activity for the Stock Incentive Plan:

   
Three Months Ended
  
Nine Months Ended
  
   
September 30, 2006
  
September 30, 2006
  
   
Number of Shares
  
Weighted-Average Exercise Price
  
Number of Shares
  
Weighted-
Average
Exercise
Price
  
Options outstanding at beginning of period
    
75,000
  
$
7.98
    
40,000
  
$
8.46
  
Options granted
    
-
    
-
    
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 14 - RECENT ACCOUNTING PRONOUNCEMENTS
 
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

- 11 -

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.

On September 25, 2006, the FASB met and determined to propose a scope exception under FAS 155 for securitized interests that only contain an embedded derivative that is tied to the prepayment risk of the underlying prepayable financial assets, and for which the investor does not control the right to accelerate the settlement. If a securitized interest contains any other embedded derivative (for example, an inverse floater), then it would be subject to the bifurcation tests in FAS 133, as would securities purchased at a significant premium. The FASB plans to expose the proposed guidance for a 30-day comment period in the form of a FAS 133 Derivatives Implementation Issue in early November; re-deliberate the issue in December 2006 following the completion of the 30-day comment period, and issue their final position in early 2007.

The Company does not expect that the January 1, 2007 anticipated adoption of FAS 155 will have a material impact. However, to the extent that certain of the Company’s future investments in securitized financial assets do not meet the scope exception ultimately adopted by the FASB, the Company’s future results of operations may exhibit volatility as certain of its future investments may be marked to market value in their entirety through the income statement. Under the current accounting rules, changes in the market value of the Company’s investment securities are made through other comprehensive income, a component of stockholders’ equity.
 
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 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.

In April 2006, the FASB issued FSP FIN 46(R)-6, “Determining the Variability to be Considered When Applying FASB Interpretation No.46(R)” (“FIN 46(R)-6”). FIN 46(R)-6 addresses the approach to determine the variability to consider when applying FIN 46(R). The variability that is considered in applying Interpretation 46(R) may affect (i) the determination as to whether an entity is a variable interest entity (“VIE”), (ii) the determination of which interests are variable in the entity, (iii) if necessary, the calculation of expected losses and residual returns on the entity, and (iv) the determination of which party is the primary beneficiary of the VIE. Thus, determining the variability to be considered is necessary to apply the provisions of Interpretation 46(R). FIN 46(R)-6 is required to be prospectively applied to entities in which the Company first become involved after July 1, 2006 and would be applied to all existing entities with which the Company is involved if and when a “reconsideration event” (as described in FIN 46) occurs. The Company is currently evaluating the impact of adopting FIN 46(R)-6 on its consolidated financial statements.


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In September 2006, the FASB issued SFAS 157, Fair Value Measures (SFAS 157). This statement defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measures. This statement is effective as of the beginning of its first fiscal year that begins after November 15, 2007. The Company is currently evaluating the potential impact this statement may have on its financial statements.

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108 (SAB 108). Due to diversity in practice among registrants, SAB 108 expresses the SEC staff views regarding the process by which misstatements in financials statements are evaluated for purposes of determining whether financial statement restatement is necessary. SAB 108 is effective for fiscal years ending after November 15, 2006, and early application is encouraged. The Company does not believe SAB 108 will have a material impact on its consolidated financials 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 nine-month periods ended September 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 highly-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.

During the three-months ended September 30, 2006, the Company entered into a joint venture with an affiliate of Deutsche Bank, A.G. The Company invested in the joint venture in order to leverage its internal investment capabilities and to gain access to additional investment opportunities primarily in mortgage-related investments and special situations. In connection with the initial formation of the joint venture, the Company contributed its interests in $279.0 million of securitized finance receivables (backed by commercial mortgage loans) which had been pledged to a trust and which secured $254.5 million in securitization financing. As a result of the contribution, the Company derecognized these amounts from its consolidated balance sheet, and recognized a loss of $1.2 million on the transfer to the joint venture. Also in connection with the formation of the joint venture, the Company agreed to remit cash flows that it receives on an additional $182.4 million in securitized finance receivables, which collateralizes $165.7 million in securitization financing, by recording an investment in the joint venture and a corresponding liability of $16.4 million to reflect this commitment. The $182.4 million in securitized finance receivables and the $165.7 million in securitization financing will continue to be carried in the Company’s financial statements. In return for the contributions discussed above, the Company received a 49.875% investment in the joint venture, an amount equal to that received by the Deutsche Bank affiliate. The Company’s aggregate initial investment in the joint venture was $38.3 million. The Company views this joint venture as a means of diversifying its risk in the investments contributed to the joint venture, and also as a means of partnering on equal terms with a much larger organization, which has greater resources and capital and access to more investment opportunities than the Company currently does.


- 13 -

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 accounting policies that are reflective of significant judgments or uncertainties, and which may result in materially different results under different assumptions and conditions, or whose application 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. 
 
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 generally are 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.
 

 

- 14 -

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

(amounts in thousands except per share data)
  
September 30, 2006
  
December 31, 2005
  
           
Securitized finance receivables, net
  
$
362,629
  
$
722,152
  
Securities
    
14,968
    
24,908
  
Other mortgage loans
    
4,289
    
5,282
  
Other investments
    
3,069
    
4,067
  
Investment in joint venture
    
36,618
    
-
  
               
Non-recourse securitization financing
    
219,050
    
516,578
  
Repurchase agreements secured by securitization financing bonds
    
103,253
    
133,104
  
Obligation under payment agreement
    
16,369
    
-
  
               
Shareholders’ equity
    
135,021
    
149,334
  
Common book value per share
   
7.65
    
7.65
  

Securitized finance receivables. Securitized finance receivables decreased to $362.6 million at September 30, 2006 compared to $722.2 million at December 31, 2005. This decrease of $359.5 million is primarily the result of the contribution of receivables backed by commercial mortgage loans with an amortized cost basis of $279.0 million in connection with the establishment of an investment in joint venture discussed further below. Also contributing to the decrease in securitized finance receivables was $62.3 million of unscheduled and $15.5 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 mortgage loans.

Securities. Securities decreased during the nine months ended September 30, 2006 by $9.9 million, to $15.0 million at September 30, 2006 from $24.9 million at December 31, 2005 due primarily to principal payments of $26.1 million received on securities during the period. This decrease was partially offset by $17.2 million of security purchases during the period. The Company sold $1.5 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 September 30, 2006 consist of a security collateralized by delinquent property tax receivables. Other investments decreased from $4.1 million at December 31, 2005 to $3.1 million at September 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 of $1.7 million during the quarter. This decrease was partially offset by an increase in the unrealized gain of $0.2 million on the security and $0.5 million of capitalized costs.
 
Other motgage loans. Other mortgage loans decreased by $1.0 million from $5.3 million at December 31, 2005 to $4.3 million at September 30, 2006 due primarily to scheduled and unscheduled pay-downs during the period.
 
Investment in joint venture. The Company acquired a 49.875% interest in a joint venture during the quarter in exchange for certain its interests in one commercial mortgage securitization trust and the execution of an obligation under payment agreement discussed further below.  The initial value ascribed to the investment in joint venture was $38.3 million. The investment in joint venture was reduced for the Company’s proportionate share of the joint venture’s losses for the quarter, which totaled $1.7 million and related to the impairment of one of the joint venture’s commercial mortgage backed securities due to an increase in the estimate of the loss on the liquidation of a foreclosed loan collateralizing the security.
 

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Non-recourse securitization financing. Non-recourse securitization financing decreased $297.5 million, from $516.6 million at December 31, 2005 to $219.1 million at September 30, 2006. This decrease was primarily a result of the derecognition of $253.1 million of securitization financing, which were collateralized by the commercial mortgage loans contributed to a joint venture. Also contributing to this decrease were principal payments of $41.6 million on the non-recourse securitization financing made from the collections on the related securitized finance receivables and premium amortization of approximately $3.1 million.
 
Repurchase Agreements. The balance of repurchase agreements declined to $103.3 million at September 30, 2006 from $133.3 million at December 31, 2005. The decrease was due to net repayments of $30.0 during the period as a result of principal received on the underlying investments being financed. 
 
Obligation under payment agreement. The increase in the balance is due to the Company entering an agreement to remit to a joint venture all of the cash flows received on its interests in a commercial securitization, CCAO Series 2, as part of the intial capitalization of the joint venture.
 
Shareholders’ equity. Shareholders' equity decreased to $135.0 million at September 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 nine months ended September 30, 2006, which contributed to a $14.3 million decrease in equity, and the preferred stock dividends of $3.0 million. These decreases were partially offset by net income of $2.6 million for the period, a $0.3 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.
 
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 September 30, 2006. Excluded from this table are cash and cash equivalents, other assets, and other liabilities.
 
As the cash flows received on the Company's 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.

- 16 -

Below is the net basis of Dynex's investments as of September 30, 2006. 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.  The fair value of investment in joint venture is based on the fair value of the assets held by the joint venture.  The fair value of other investments and loans is based on the projected cash flow from the collateral discounted at estimated market rates.

Estimated Fair Value of Net Investment
  
(amounts in thousands)
  
September 30, 2006
  
 
  
Amortized cost basis
  
Financing
  
Net investment basis
  
Fair value of net investment basis (1)
  
Securitized finance receivables:
  
 
  
 
  
 
  
 
  
Single family mortgage loans
  
$
127,951
  
$
103,253
  
$
24,698
  
$
25,689
  
Commercial mortgage loans
    
239,167
    
235,419
    
3,748
    
3,610
  
Allowance for loan losses
    
(4,489
)
  
-
    
(4,489
)
  
-
  
 
    
362,629
    
338,672
    
23,957
    
29,299
  
Securities:
                  
Investment grade single-family
    
11,624
    
-
    
11,624
    
11,819
  
Non-investment grade single-family
    
452
    
-
    
452
    
608
  
Equity and other
    
2,683
    
-
    
2,683
    
2,541
  
 
    
14,759
    
-
    
14,759
    
14,968
  
 
                  
Investment in joint venture
    
36,618
    
-
    
36,618
    
35,651
  
Other investments and loans
    
7,145
    
-
    
7,145
    
8,232
  
Net unrealized gain
    
422
    
-
    
422
    
-
  
 
                  
Total portfolio assets
  
$
421,573
  
$
338,672
  
$
82,901
  
$
88,150
  
 
                  
 
(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%. Expected future cash flows were based on the forward LIBOR curve as of September 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.  The fair value of the investment in joint venture represents the Company’s proportionate share of the net assets of the joint venture, which are recorded at estimated fair value on the joint venture’s books. 
 


- 17 -

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 September 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
$ 7,869
 
 
 
 
 
 
Commercial mortgage loans (2)
(3)
0.8% (5)
16%
(4)
$ 286
 
(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 a securitization trust.
(3) 
Assumed constant prepayment rates (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.
(5)
In addition to the constant default rate of 0.8%, loans which are currently greater than 30 days delinquent are assumed to take a 35% loss within six months. 
 
The following table presents the Net Basis of Investments of $82,901at September 30, 2006 included in the “Estimated Fair Value of Net Investment” table above by their rating classification. Investments in the unrated and non-investment grade classification primarily include other loans that have not been given a rating but that are substantially seasoned and 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)
  
September 30, 2006
  
       
Cash and cash equivalents
  
$
52,285
  
Investments:
        
AAA rated and agency MBS fixed income securities
    
21,611
  
AA and A rated fixed income securities
    
4,997
  
Unrated and non-investment grade
    
10,705
  
Securitization over-collateralization
    
8,970
  
Investment in joint venture
    
36,618
  
   
$
82,901
  
 
Supplemental Discussion of Common Equity Book Value

The Company believes that its shareholders, as well as shareholders of other companies in the mortgage REIT industry, consider book value per common share an important measure. The Company’s reported book value per common share is based on the carrying value of the Company’s assets and liabilities as recorded in the consolidated financial statements in accordance with generally accepted accounting principles. A substantial portion of the Company’s assets are carried on a historical, or amortized, cost basis and not at estimated fair value. The table included in the “Supplemental Discussion of Investments”section above compares the amortized cost base of the Company’s investments to their estimated fair value based on assumptions set forth in the table.

The Company believes that book value per common share, adjusted to reflect the carrying value of investments at their fair value (hereinafter referred to as ‘Adjusted Common Equity Book Value), would also be a meaningful measure for its shareholders, representing effectively the estimated going-concern value for the Company. The following table calculates Adjusted Common Equity Book Value and Adjusted Common Equity Book Value per Share using the estimated fair value information contained in the “Estimated Fair Value of Net Investment” table above. The amounts set forth in the table in the Adjusted Common Equity Book Value column include all assets and liabilities of the Company at their estimated fair values, and exclude any value attributable to the Company’s tax net operating loss carryforwards and other matters that might impact the value of the Company.

- 18 -


   
September 30, 2006
  
(amounts in thousands)
  
Book Value
  
Adjusted Book Value
  
           
Total portfolio assets (per table above)
  
$
82,901
  
$
88,150
  
Cash and cash equivalents
    
52,285
    
52,285
  
Other assets and liabilities, net
    
(165
)
  
(165
)
     
135,021
    
140,270
  
Less: Preferred stock liquidation preference
    
(42,215
)
  
(42,215
)
Common equity book value and adjusted book value
  
$
92,806
   $
98,015
  
               
Common equity book value per share and adjusted book value per share
   $
7.65
   $
8.08
  
 
 

- 19 -

 
RESULTS OF OPERATIONS
 
(amounts in thousands except per share information)
  
Three Months Ended
September 30,
  
Nine Months Ended
September 30,
  
   
2006
  
2005
  
2006
  
2005
  
                   
Net interest income
 
$
3,169
  
$
2,614
  
$
8,000
  
$
9,803
  
(Provision for) recapture of loan losses
    
(67
)
  
(1,622
)
  
52
    
(4,547
)
Net interest income after provision for losses
    
3,102
    
992
    
8,052
    
5,256
  
Equity in loss of joint venture
    
(1,661
)
  
-
    
(1,661
)
  
-
  
Loss on capitalization of joint venture
    
(1,194
)
  
-
    
(1,194
)
  
-
  
Gain (loss) on sale of investments, net
    
85
    
(48
)
  
226
    
9,802
  
Impairment charges
    
-
    
(207
)
  
-
    
(2,259
)
Other income (expense)
    
433
    
(1,026
)
  
662
    
331
 
General and administrative expenses
    
(980
)
  
(1,610
)
  
(3,473
)
  
(4,500
)
Net (loss) income
    
(215
)
  
(1,899
)
  
2,612
    
8,630
  
Preferred stock charge
    
(1,003
)
  
(1,336
)
  
(3,041
)
  
(4,010
)
Net (loss) income to common shareholders
    
(1,218
)
  
(3,235
)
  
(429
)
  
4,620
  
                           
Net (loss) income per common share:
                          
Basic and diluted
  
$
(0.10
)
$
(0.27
)
$
(0.04
)
$
0.38
  

Three Months Ended September 30, 2006 Compared to Three Months Ended September 30, 2005. The decrease in net loss and net loss per common share during the three months ended September 30, 2006 as compared to the same period in 2005 is primarily the result of a decrease of $1.6 million in provision for loan losses and an increase in other income (expense) of $1.5 million. These increases were partially offset by the recognition by Dynex of its proportionate share of the losses, $1.7 million, incurred during the three months ended September 30, 2006 incurred as a result of its participation in a joint venture with Deutsche Bank. Provisions for loan losses in the commercial loan portfolio decreased compared to the three months ended September 30, 2005 by $1.2 million due to the contribution of a securitization backed by commercial loans to the joint venture. The $0.4 million decrease in provisions for loan losses in the single family loan portfolio is the consequence of decreases in delinquencies of non-pool insured loans. The $1.5 million increase in other income (expense) reflects prepayment penalty income on prepaid commercial loans recorded in the current quarter, funds relating to a securitization issued by the Company that were released by the trustee during the current quarter, the recognition in 2005 of an escrow claim relating to potentially uncollectible property tax receivables sold to a third party in 2005 and the recognition in 2005 of a third party claim on prepayment penalties on voluntarily prepaid commercial loans.

Net interest income increased from $2.6 million to $3.1 million for the quarter ended September 30, 2006 from the same period in 2005 primarily as a result of the stabilization of one-month LIBOR during the 2006 period. Interest expense decreased more quickly than interest income as interest rates on securitized finance receivables continued to reset higher while interest rates on variable-rate securitization financing leveled off during the current period, which resulted in an increase in net interest income of $0.6 million. Net interest income after provision for loan losses for the three months ended September 30, 2006 increased to $3.1 million from $1.0 million for the same period for 2005. Provision for loan losses of $0.1 million were recognized during the three months ended September 30, 2006 compared to $1.6 million for the third quarter of 2005 as explained above.

The loss on capitalization of the joint venture was $1.2 million for the quarter ended September 30, 2006. The Company’s interests in one of the commercial mortgage securitization trusts were contributed to the joint venture resulting in the derecognition of the related collateral of $279.0 million and securitization financing of $254.5 million and the capitalization of $1.4 million of accrued interest which the Company retained the right to receive.

General and administrative expense decreased to $1.0 million for the three-months ended September 30, 2006 from $1.6 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 decrease in accounting expenses.
 

- 20 -

Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005. The decrease in net (loss) income and net (loss) income per common share during the nine months ended September 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 that were realized during the nine months ended September 30, 2005, a decrease in net interest income of $1.8 million, and a $1.7 million equity in loss of joint venture. These decreases in net income were partially offset by a reduction in impairment charges to zero versus a $1.7 million impairment charge recognized in 2005 on the Company’s investment in delinquent property tax receivables, a $4.6 million decrease in provision for loan losses and $1.0 million decrease in general and administrative expenses. The $4.6 million decrease in loan loss reserves resulted primarily from the transfer of commercial mortgage loans to a joint venture during the quarter ended September 30, 2006. General and administrative expense decreased due to the reductions in expenses associated with the Company's tax lien servicing operations and a decrease in accounting expenses.

Net interest income decreased from $9.8 million to $8.0 million for the nine months ended September 30, 2006 from the same period in 2005 essentially as a result of the sale in the second quarter of 2005 of two securitizations backed by manufactured housing loans. This sale resulted in the derecognition of $367.2 million in interest-earning assets and $363.9 million in interest-bearing liabilities. Net interest income after provision for loan losses for the nine months ended September 30, 2006 increased to $8.0 million from $5.3 million for the same period for 2005. Provision for loan losses decreased from an expense of $4.5 million for the nine months ended 2005 to a benefit of $0.1 million for the same period in 2006 due primarily to improvements in the performance of the commercial loan portfolio and decreased delinquencies in the Company's non-pool insured securitized single family loans.

General and administrative expense decreased to $3.5 million for the nine-months ended September 30, 2006 from $4.5 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.
 

- 21 -

Average Balances and Effective Interest Rates
 
   
Three Months Ended September 30,
  
Nine Months Ended September 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)
  
$
563,518
    
8.41
%
$
788,361
    
7.34
%
$
654,585
    
7.92
%
$
986,768
    
7.21
%
Cash
   
48,476
    
5.06
%
  
16,543
    
2.99
%
  
36,209
    
4.80
%
  
35,173
    
2.47
%
Securities
    
14,564
    
7.85
%
  
81,894
    
4.66
%
  
22,105
    
7.38
%
  
75,707
    
5.09
%
Other loans
   
4,596
    
16.90
%
  
3,586
    
16.66
%
  
4,894
    
12.65
%
  
5,722
    
14.36
%
Other investments
    
-
    
-
%
  
-
    
-
%
  
-
    
-
%
  
4,050
    
19.83
%
Total interest-earning assets
  
$
631,154
    
8.21
%
$
890,384
    
7.05
%
$
717,793
    
7.77
%
$
1,107,420
    
7.00
%
                                                   
Interest-bearing liabilities:
                                                 
Non-recourse securitization financing(3)
  
$
393,009
    
8.15
%
$
546,030
    
8.00
%
$
463,633
    
8.27
%
$
808,389
    
7.20
%
Repurchase agreements secured by securitization financing
    
109,808
    
5.46
%
  
160,100
    
3.60
%
  
118,611
    
5.07
%
  
94,560
    
3.45
%
Repurchase agreements
    
25
    
5.58
%
  
39,646
    
3.61
%
  
113
    
4.98
%
  
53,713
    
3.08
%
Total interest-bearing liabilities
  
$
502,842
    
7.56
%
$
745,776
    
6.82
%
$
582,357
    
7.62
%
$
956,662
    
6.60
%
Net interest spread on all investments
          
0.65
%
        
0.23
%
        
0.15
%
        
0.40
%
Net yield on average interest-earning assets (4)
          
2.16
%
        
1.31
%
        
1.58
%
        
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 $7,419 and $2,479 for the three months ended September 30, 2006 and 2005, respectively, and $7,170 and $988 for the nine months ended September 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 7.82% and 7.03% for the three months ended September 30, 2006 and 2005, respectively, and 7.77% and 6.76% for the nine months ended September 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.

The net interest spread increased 41 basis points, to 0.64% for the three months ended September 30, 2006 from 0.23% for the same period in 2005. The net yield on average interest earning assets for the three months ended September 30, 2006 increased to 2.16% from 1.31% for the same period in 2005. The increase in the Company's net interest spread can be attributed primarily to an increase of 74 basis points in the effective rate on interest-bearing liabilities and an increase of 116 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 during the third quarter 2005 and the third quarter 2006 contribution of approximately $279.0 million of securitized finance receivables to a joint venture and the derecognition of approximately $254.5 million of the related securitization financing bonds. In addition, approximately $30 million of repurchase agreement financing outstanding at year-end 2005 was repaid in second and third quarters of 2006. These asset sales and repurchase agreement repayments resulted in the yields of remaining assets, which are unencumbered by financing expense, assuming a larger proportion of the net interest spread.

- 22 -


The net interest spread decreased 25 basis points, to 0.15% for the nine months ended September 30, 2006 from 0.40% for the same period in 2005. The net yield on average interest earning assets for the nine months ended September 30, 2006 increased relative to the same period in 2005, to 1.58% from 1.29%. The decline in the Company's net interest spread can be attributed primarily to an increase of 102 basis points in the effective rate on interest-bearing liabilities compared to an increase of 77 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. There were also effective interest rate adjustments recorded in 2005 resulting in a decrease of $1.3 million from 2005. 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 during the third quarter of 2005, the third quarter of 2006 transfer of approximately $279.0 million of securitized finance receivables and the extinguishment of approximately $254.5 million of the related securitization financing bonds and the repayment in the second and third quarters 2006 of approximately $30 million of repurchase agreement financing outstanding at year-end 2005 resulted in a lower overall net interest spread.

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 September 30, 2006 vs. 2005
  
(amounts in thousands)
  
Rate
  
Volume
  
Total
  
   
 
  
 
  
 
  
Securitized finance receivables
  
$
1,910
  
$
(4,526
)
$
(2,616
)
Cash and cash equivalents
    
128
 
  
361
    
489
  
Securities
    
445
    
(1,113
)
  
(668
)
Other loans
    
55
    
(10
)
  
45
  
               
Total interest income
    
2,538
    
(5,288
)
  
(2,750
)
               
Securitization financing
    
797
    
(3,669
)
  
(2,872
)
Repurchase agreements
    
282
    
(647
)
  
(365
)
               
Total interest expense
    
1,079
    
(4,316
)
  
(3,237
)
               
Net interest income
  
$
1,459
  
$
(972
)
$
487
 


- 23 -


   
Nine Months Ended September 30, 2006 vs. 2005
  
(amounts in thousands)
  
Rate
  
Volume
  
Total
  
   
 
  
 
  
 
  
Securitized finance receivables
  
$
4,823
  
$
(19,358
)
$
(14,535
)
Cash and cash equivalents
    
631
    
20
    
651
  
Securities
    
1,050
    
(2,717
)
  
(1,667
)
Other loans
    
(29
)
  
(122
)
  
(151
)
Other investments
    
(301
)
  
(301
)
  
(602
)
               
Total interest income
    
6,174
    
(22,478
)
  
(16,304
)
               
Securitization financing
    
7,115
    
(19,946
)
  
(12,831
)
Repurchase agreements
    
426
    
(1,678
)
  
(1,252
)
               
Total interest expense
    
7,541
    
(21,624
)
  
(14,083
)
               
Net interest income
  
$
(1,367
)
$
(854
)
$
(2,221
)

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 nine months ended September 30, 2005 compared to the same period for 2006, average interest-earning assets declined $390 million, or approximately 35%. Approximately 44% of that decline resulted from the derecognition in 2005 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, the Company generally has retained a limited portion of the direct credit risk in these securities. In many instances, the Company 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 the Company has retained (represented by the amount of over-collateralization pledged and subordinated securities the Company owns), net of the credit reserves, premiums and discounts the Company maintains 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 decreased from the third quarter 2005 by $7.8 million and from the fourth quarter of 2005 by $9.5 million as the result of the contribution of a securitization backed by commercial loans to a joint venture.

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 $17.0 million and a remaining deductible aggregating $0.6 million on $16.3 million of securitized single-family mortgage loans which are subject to such reimbursement agreements; guarantees aggregating $6.9 million on $74.1 million of securitized commercial mortgage loans, whereby losses on such loans would
 

- 24 -

need to exceed the respective guarantee amount before the Company would incur credit losses; and $36.5 million of securitized single-family mortgage loans which are subject to various mortgage pool insurance policies whereby all expected losses would be recoverable.