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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 ended March 31, 2008

or

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, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

Large accelerated filer
o
Accelerated filer
þ
Non-accelerated filer
o  (Do not check if a smaller reporting company)
Smaller reporting company
o

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

On April 30, 2008, the registrant had 12,169,762 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.
Financial Statements
 
       
   
Condensed Consolidated Balance Sheets at March 31, 2008 (unaudited) and December 31, 2007
1
       
   
Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the three months ended March 31, 2008 and 2007  (unaudited)
2
       
   
Condensed Consolidated Statement of Shareholders’ Equity for the three months ended March 31, 2008 (unaudited)
3
       
   
Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2008 and 2007  (unaudited)
4
       
   
Notes to Unaudited Condensed Consolidated Financial Statements
4
       
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
15
       
 
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
35
       
 
Item 4.
Controls and Procedures
37
       
PART II.
OTHER INFORMATION
 
       
 
Item 1.
Legal Proceedings
37
       
 
Item 1A.
Risk Factors
38
       
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
38
       
 
Item 3.
Defaults Upon Senior Securities
38
       
 
Item 4.
Submission of Matters to a Vote of Security Holders
38
       
 
Item 5.
Other Information
39
       
 
Item 6.
Exhibits
39
       
SIGNATURES
40



 
 

 

PART I.  FINANCIAL INFORMATION
Item 1.  Financial Statements

DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED
BALANCE SHEETS
(amounts in thousands except share data)

   
March 31,
   
December 31,
 
   
2008
   
2007
 
   
(Unaudited)
       
ASSETS
           
Cash and cash equivalents
  $ 37,935     $ 35,352  
Other assets
    3,770       5,671  
      41,705       41,023  
Investments:
               
Securitized mortgage loans, net
    271,537       278,463  
Securities
    58,280       29,231  
Investment in joint venture
    13,380       19,267  
Other loans and investments
    3,549       6,774  
      346,746       333,735  
                 
    $ 388,451     $ 374,758  
                 
LIABILITIES AND SHAREHOLDERS' EQUITY
               
LIABILITIES
               
Securitization financing
  $ 200,313     $ 204,385  
Repurchase agreements
    29,556       4,612  
Obligation under payment agreement
    11,244       16,796  
Other liabilities
    6,972       7,029  
      248,085       232,822  
                 
Commitments and Contingencies (Note 13)
               
                 
SHAREHOLDERS' EQUITY
               
Preferred stock, par value $0.01 per share, 50,000,000 shares authorized,
               
9.5% Cumulative Convertible Series D, 4,221,539 shares issued
               
and outstanding, ($43,218 aggregate liquidation preference)
    41,749       41,749  
Common stock, par value $0.01 per share, 100,000,000 shares authorized,
               
12,169,762 and 12,136,262 shares issued and outstanding, respectively
    122       121  
Additional paid-in capital
    366,731       366,716  
Accumulated other comprehensive (loss) income
    (4,916 )     1,093  
Accumulated deficit
    (263,320 )     (267,743 )
      140,366       141,936  
                 
    $ 388,451     $ 374,758  
                 
See notes to unaudited condensed consolidated financial statements.
               

 
1

 



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


   
Three Months Ended
 
   
March 31,
 
   
2008
   
2007
 
             
             
Interest income:
           
Securitized mortgage loans
  $ 5,602     $ 7,025  
Securities
    428       324  
Cash and cash equivalents
    324       739  
Other loans and investments
    129       127  
      6,483       8,215  
                 
Interest and related expenses:
               
Securitization financing
    3,599       4,096  
Repurchase agreements
    54       1,258  
Obligation to joint venture under payment agreement
    401       367  
Other
    8       34  
      4,062       5,755  
                 
Net interest income
    2,421       2,460  
(Provision for) recapture of provision for loan losses
    (26 )     523  
                 
Net interest income after provision for loan losses
    2,395       2,983  
                 
Equity in (loss) income of joint venture
    (2,251 )     630  
Gain (loss) on sale of investments, net
    2,093       (6 )
Fair value adjustments, net
    4,231        
Other income (expense)
    67       (539 )
General and administrative expenses
    (1,216 )     (1,126 )
                 
Net income
    5,319       1,942  
Preferred stock dividends
    (1,003 )     (1,003 )
                 
Net income to common shareholders
  $ 4,316     $ 939  
                 
Change in net unrealized gain (loss) on :
               
Investments classified as available-for-sale
    (2,373 )     126  
Investment in joint venture
    (3,636 )     829  
                 
Comprehensive (loss) income
  $ (690 )   $ 2,897  
                 
Net income per common share:
               
Basic
  $ 0.36     $ 0.08  
Diluted
  $ 0.32     $ 0.08  
                 
See notes to unaudited condensed consolidated financial statements.
 
 
 

 
2

 


DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY (UNAUDITED)

Three-months ended March 31, 2008
(amounts in thousands except share data)

   
Preferred
Stock
   
Common
Stock
   
Additional
Paid-in
Capital
   
Accumulated Other
Compre­hen­sive
(Loss) Income
   
Accumulated
Deficit
   
Total
 
Balance at December 31, 2007
  $ 41,749     $ 121     $ 366,716     $ 1,093     $ (267,743 )   $ 141,936  
                                                 
Cumulative effect of adoption of SFAS 159
                            1,323       1,323  
                                                 
Net income
                            5,319       5,319  
Other comprehensive income (loss):
                                               
Change in market value of securities and other investments
                      (3,916 )           (3,916 )
Reclassification adjustment for net gains included in net income
                      (2,093 )           (2,093 )
Total comprehensive income (loss)
                                            (690 )
                                                 
Dividends on common stock
                            (1,217 )     (1,217 )
Dividends on preferred stock
                            (1,002 )     (1,002 )
Grant and vesting of restricted stock
          1       15                   16  
                                                 
Balance at March 31, 2008
  $ 41,749     $ 122     $ 366,731     $ (4,916 )   $ (263,320 )   $ 140,366  

See notes to unaudited condensed consolidated financial statements.

 
3

 

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

   
Three Months Ended
 
   
March 31,
 
   
2008
   
2007
 
Operating activities:
           
Net income
  $ 5,319     $ 1,942  
Adjustments to reconcile net income to cash provided by operating activities:
               
Equity in (loss) income of joint venture
    2,251       (630 )
Provision for (recapture of provision for) loan losses
    26       (523 )
Gain on sale of investments
    (2,093 )     6  
Fair value adjustments, net
    (4,231 )      
Amortization and depreciation
    (264 )     (335 )
Net change in other assets and other liabilities
    1,912       1,407  
Net cash and cash equivalents provided by operating activities
    2,920       1,867  
                 
Investing activities:
               
Principal payments received on securitized mortgage loans
    6,825       15,578  
Purchase of securities and other investments
    (37,730 )     (5,591 )
Payments received on securities and other loans and investments
    2,581       2,811  
Proceeds from sales of securities and other investments
    8,991       83  
Other
    85       937  
Net cash and cash equivalents (used for) provided by investing activities
    (19,248 )     13,818  
                 
Financing activities:
               
Principal payments on securitization financing
    (3,814 )     (4,657 )
Net borrowings (repayments on) repurchase agreement
    24,945       (9,100 )
Proceeds from sale of common stock
    -       37  
Dividends paid
    (2,220 )     (1,002 )
Net cash and cash equivalents provided by (used for) financing activities
    18,911       (14,722 )
Net increase in cash and cash equivalents
    2,583       963  
Cash and cash equivalents at beginning of period
    35,352       56,880  
Cash and cash equivalents at end of period
  $ 37,935       57,843  
                 
                 
See notes to unaudited condensed consolidated financial statements.
               




 
4

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.

March 31, 2008
(amounts in thousands except share and per share data)

 
NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
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 intercompany 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 and variable interest entities in which it is determined to be the primary beneficiary in accordance with Financial Interpretation (“FIN”) 46(R).  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 of 1986, as amended (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 months ended March 31, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008. 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, 2007, filed with the Securities and Exchange Commission (the “SEC”).
 
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.
 

 
5

 


 
The Company evaluates all securities in its investment portfolio for other-than-temporary impairments.  A security is generally defined to be other-than-temporarily impaired if, for a maximum period of three consecutive quarters, the carrying value of such security exceeds its estimated fair value, and the Company estimates, based on projected future cash flows or other fair value determinants, that the 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.
 
The Company considers impairments of other investments 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.
 
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 the allowance for loan losses are presented as provision for losses or recapture of provision for loan losses, in the accompanying condensed consolidated statements of operations.  The Company’s actual credit losses may differ from those estimates used to establish the allowance.
 

New Accounting Standards

In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51.”  SFAS 160 addresses reporting requirements in the financial statements of non-controlling interests to their equity share of subsidiary investments.   SFAS 160 applies to reporting periods beginning after December 15, 2008.  The Company is currently evaluating the potential impact on adoption of SFAS 160.

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS 141(R)”) which revised SFAS No. 141, “Business Combinations.”  This pronouncement is effective as of January 1, 2009.  Under SFAS No. 141, organizations utilized the announcement date as the measurement date for the purchase price of the acquired entity.  SFAS 141(R) requires measurement at the date the acquirer obtains control of the acquiree, generally referred to as the acquisition date.  SFAS 141(R) will have a significant impact on the accounting for transaction costs, restructuring costs, as well as the initial recognition of contingent assets and liabilities assumed during a business combination.  Under SFAS 141(R), adjustments to the acquired entity’s deferred tax assets and uncertain tax position balances occurring outside the measurement period are recorded as a component of the income tax expense, rather than goodwill.  As the provisions of SFAS 141(R) are applied prospectively, the impact cannot be determined until the transactions occur.  The Company is currently evaluating the impact, if any, that SFAS 141(R) may have on the Company’s financial statements.

On March 20, 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133” (“SFAS 161”).  SFAS 161 provides for enhanced disclosures about how and why an entity uses derivatives and how and where those derivatives and related hedged items are reported in the entity’s financial statements.  SFAS 161 also requires certain tabular formats for disclosing such information.   SFAS 161 is effective for fiscal years and interim periods beginning after November 15, 2008 with early application encouraged.  SFAS 161 applies to all entities and all derivative instruments and related hedged items accounted for under SFAS 133.  Among other things, SFAS 161 requires disclosures of an entity’s objectives and strategies for using derivatives by primary underlying risk and certain disclosures about the potential future collateral or cash requirements as a result of contingent credit-related features.  The Company is currently evaluating the impact, if any, that the adoption of SFAS 161 will have on the Company’s financial statements.

 
6

 


 
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 options, 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 the basic and diluted net income per common share for the three months ended March 31, 2008 and 2007.
 
   
Three Months Ended March 31,
 
   
2008
   
2007
 
   
Income
   
Weighted-Average Common Shares
   
Income
   
Weighted-
Average
Common
Shares
 
                         
Net income
  $ 5,319           $ 1,942        
Preferred stock charge
    (1,003 )           (1,003 )      
Net income to common shareholders
  $ 4,316       12,156,887     $ 939       12,133,151  
Effect of dilutive items
    1,003       4,230,105             495  
Diluted
  $ 5,319       16,386,992     $ 939       12,133,646  
                                 
Net income per share:
 
Basic
          $ 0.36             $ 0.08  
Diluted
          $ 0.32             $ 0.08  
                                 
Reconciliation of shares included in calculation of earnings per share due to dilutive effect:
     
Net effect of dilutive:
                               
Preferred stock
    1,003       4,221,539              
Stock options
          8,566             495  
    $ 1,003       4,230,105     $       495  

 
NOTE 3 — SECURITIZED MORTGAGE LOANS, NET
 
The following table summarizes the components of securitized mortgage loans at March 31, 2008 and December 31, 2007.

   
March 31,
2008
   
December 31, 2007
 
Securitized mortgage loans:
           
Commercial mortgage loans
  $ 184,040     $ 185,998  
Single-family mortgage loans
    81,280       86,088  
      265,320       272,086  
Funds held by trustees, including funds held for defeased loans
    7,166       7,225  
Accrued interest receivable
    1,850       1,940  
Unamortized discounts and premiums, net
    (54 )     (67 )
Loans, at amortized cost
    274,282       281,184  
Allowance for loan losses
    (2,745 )     (2,721 )
    $ 271,537     $ 278,463  


 
7

 


All of the securitized mortgage loans are encumbered by securitization financing bonds.
 
 
NOTE 4 — ALLOWANCE FOR LOAN LOSSES
 
The allowance for loan losses is included in securitized mortgage loans, net in the accompanying Condensed Consolidated Balance Sheets.  The following table summarizes the aggregate activity for the allowance for loan losses for the three months ended March 31, 2008 and 2007.

 
   
Three Months Ended March 31,
 
   
2008
   
2007
 
Allowance at beginning of period
  $ 2,721     $ 4,495  
Provision for (recapture of) loan losses
    26       (523 )
Charge-offs, net of recoveries
    (2 )     (434 )
Allowance at end of period
  $ 2,745     $ 3,538  

The Company identified $12,148 of impaired commercial loans at March 31, 2008 compared to $13,792 of impaired commercial loans at December 31, 2007, none of which were delinquent.
 
The following table presents certain information on impaired securitized commercial mortgage loans at December 31, 2007 and March 31, 2008.

   
Investment in Impaired Loans
   
Reserves on Impaired Loans
   
Investment in Excess of Reserves
 
December 31, 2007
  $ 13,792     $ 2,590     $ 11,202  
March 31, 2008
    12,148       2,590       9,558  
 
 
NOTE 5 — SECURITIES
 
The following table summarizes the amortized cost basis and fair value of the Company’s securities, all of which are classified as available-for-sale, and the related average effective interest rates at March 31, 2008 and December 31, 2007.
 
   
March 31, 2008
   
December 31, 2007
 
   
Value
   
Effective Interest Rate
   
Value
   
Effective Interest Rate
 
Securities, available-for-sale at amortized cost:
                       
Agency mortgage-backed securities
  $ 34,545       4.69 %   $ 7,410       9.03 %
Non-agency mortgage-backed securities
    7,374       10.56 %     7,684       9.41 %
Equity securities
    12,423               7,704          
Corporate debt securities
    4,722               4,722          
      59,064               27,520          
Gross unrealized gains
    865               2,406          
Gross unrealized losses
    (1,649 )             (695 )        
Securities, available-for-sale at fair value
  $ 58,280             $ 29,231          


 
8

 

In March 2008, the Company purchased two Fannie Mae certificates for $27,742 and financed the purchase with $24,944 of repurchase agreements.  The Company also sold approximately $5,247 of equity securities during the quarter ended March 31, 2008 on which it recognized a gain of approximately $2,088 and purchased approximately $9,988 of equity securities of certain publicly traded mortgage real estate investment trusts.

 
NOTE 6 — INVESTMENT IN JOINT VENTURE
 
The Company, through a wholly-owned subsidiary, holds a 49.875% interest in a joint venture, Copperhead Ventures, LLC, primarily between the Company and DBAH Capital, LLC, an affiliate of Deutsche Bank, A. G.
 
The Company accounts for its investment in the joint venture using the equity method, under which it recognizes its proportionate share of the joint venture’s earnings and comprehensive income.  The Company’s interest in the earnings (loss) and other comprehensive income (loss) of the joint venture for the three months ended March 31, 2008 were $(2,251) and $(3,636), respectively.
 
The joint venture had total assets at March 31, 2008 of $25,417, which were comprised primarily of $6,262 of cash and cash equivalents, $7,708 of available-for-sale subordinate commercial mortgage-backed-securities, a financial instrument backed by commercial mortgage loans accounted for under SFAS 159 with a fair value of $11,244 and  other assets of $203.
 
 
NOTE 7 — OTHER LOANS AND INVESTMENTS
 
The following table summarizes the Company’s other loans and investments at March 31, 2008 and December 31, 2007:

   
March 31, 2008
   
December 31, 2007
 
Single-family mortgage loans
  $ 2,323     $ 2,486  
Multifamily and commercial mortgage loan participations
    917       927  
Unamortized discounts on mortgage loans
    (275 )     (289 )
Mortgage loans, net
    2,965       3,124  
                 
Delinquent property tax receivable securities
    482       2,127  
Notes receivable and other investments
    102       1,523  
Other loans and investments
  $ 3,549     $ 6,774  

On February 5, 2008, the Company’s subsidiary, GLS Capital, Inc., received $1,625 for the sale of substantially all of the delinquent property tax receivables it owned in Allegheny County, Pennsylvania.
 
NOTE 8 –FAIR VALUE MEASURMENTS

On January 1, 2008, the Company adopted the provisions of SFAS No. 157 for all assets that are measured at fair value and its obligation to joint venture under payment agreement liability.  Fair value is defined as the price at which an asset could be exchanged in a current transaction between knowledgeable, willing parties. A liability’s fair value is defined as the amount that would be paid to transfer the liability to a new obligor, not the amount that would be paid to settle the liability with the creditor. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available, valuation models are applied. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency for the instruments or market and the instruments’ complexity.


 
9

 

Assets and liabilities recorded at fair value in the Condensed Consolidated Balance Sheets are categorized based upon the level of judgment associated with the inputs used to measure their fair value. Hierarchical levels, defined by SFAS 157 and directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities, are as follows:

Level 1 — Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.  The types of assets and liabilities carried at Level 1 fair value generally are equity securities listed in active markets.

Level 2 — Inputs (other than quoted prices included in Level 1) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.  Fair valued assets and liabilities that are generally included in this category are certain agency securities and certain derivatives.

Level 3 — Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.  Generally, assets and liabilities carried at fair value and included in this category are certain mortgage and asset-backed securities, certain corporate debt securities, certain delinquent property tax receivables and the obligation under payment agreement liability.

 
The following table presents the Company’s assets and liabilities, which are accounted for at fair value, segregated by the hierarchy level of the fair value estimate.

         
Fair Value Measurements at March 31, 2008
 
   
March 31, 2008
   
Level 1
   
Level 2
   
Level 3
 
Assets
                       
Agency mortgage-backed securities
  $ 34,670     $     $ 34,670     $  
Non-agency mortgage-backed securities
    7,402                   7,402  
Equity securities
    12,186       12,186              
Corporate debt securities
    4,022                   4,022  
Delinquent property tax receivables
    482                   482  
Derivative instrument
    103             103        
Total assets carried at fair value
  $ 58,865     $ 12,186     $ 34,773     $ 11,906  
                                 
Liabilities
                               
Obligation under payment agreement
  $ 11,244     $     $     $ 11,244  
Total liabilities carried at fair value
  $ 11,244     $     $     $ 11,244  


 
10

 

The following is a reconciliation of the beginning and ending balances of the Level 3 fair value estimates.
 
   
Level 3 Fair Values
 
   
Non-agency mortgage-backed securities
   
Corporate debt securities
   
Delinquent property tax receivables
   
Total assets
   
Obligation under payment agreement
 
Balance at January 1, 2008
  $ 7,726     $ 4,347     $ 2,127     $ 14,200     $ 15,473  
Total realized and unrealized gains (losses)
                                       
Included in earnings
                5       5       4,229  
Included in other comprehensive income
    (16 )     (325 )     123       (218 )      
Purchases, sales, issuances and other settlements, net
    (308 )           (1,773 )     (2,081 )      
Transfers in and/or out of Level 3
                             
Balance at March 31, 2008
  $ 7,402     $ 4,022     $ 482     $ 11,906     $ 11,244  


There were no assets or liabilities which were measured at fair value on a non-recurring basis during the three months ended March 31, 2008.
 
NOTE 9 – ADOPTION OF SFAS 159

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS 159 permits entities to choose to measure many financial instruments, and certain other items, at fair value (the fair value option).  The election to use the fair value option for a financial asset or financial liability is made when the instrument is first recorded, with subsequent changes in fair value recorded in the income statement.

The Company adopted SFAS 159 on January 1, 2008 for its obligation to joint venture under payment agreement.  The obligation to joint venture under payment agreement is a liability to remit certain cash flows to an unconsolidated joint venture in which the Company owns 49.875% interest.  The right to receive those cash flows is recorded as an asset on the joint ventures balance sheet, which is marked to market as an available-for-sale security.  Prior to the adoption of SFAS 159, the instrument was accounted for differently on the Company’s books and the joint ventures books.  Electing the fair value option by the Company for the obligation under payment agreement will increase the consistency with which the instrument is accounted for and is expected to decrease the volatility in the Company’s reported earnings and book value over time.

As a result of the one-time election to account for the obligation to joint venture under payment agreement under the fair value option, the Company reclassified the difference between the recorded basis and the fair value of the obligation under payment agreement as an adjustment to increase beginning accumulated deficit in the amount of $1,323.


NOTE 10 – SECURITIZATION FINANCING

The Company, 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 and having varying repayment terms.  The Company, on occasion, may retain bonds at issuance, or redeem bonds and hold such bonds outstanding for possible future issuance.  Payments received on securitized mortgage loans and any reinvestment income earned thereon are used to make payments on the bonds.
 

 
11

 

The obligations under the securitization financings are payable solely from the securitized mortgage loans and are otherwise non-recourse to the Company.  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 the Company’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.
 
The components of non-recourse securitization financing along with certain other information at March 31, 2008 and December 31, 2007 are summarized as follows.

   
March 31, 2008
   
December 31, 2007
 
   
Bonds Outstanding
   
Range of Interest Rates
   
Bonds Outstanding
   
Range of Interest Rates
 
Fixed-rate classes
  $ 165,381       6.6% - 8.8 %   $ 167,398       6.6% - 8.8 %
Variable rate class
    32,703       3.4 %     34,500       5.1 %
Accrued interest payable
    1,160               1,186          
Deferred costs
    (1,680 )             (1,851 )        
Unamortized net bond premium
    2,749               3,152          
    $ 200,313             $ 204,385          
                                 
Range of stated maturities
    2024-2027               2024-2027          
Estimated weighted average life
 
3.2 years
           
3.3 years
         
Number of series
    3               3          

At March 31, 2008, the weighted-average effective rate of the coupon on the bonds outstanding was 6.3%.  The average effective rate on the bonds was 7.1% and 7.2% for the three months ended March 31, 2008 and the year ended December 31, 2007, respectively.
 
NOTE 11 – 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 $29,556 and $4,612, which were collateralized by securities with a fair value of $65,522 and $42,975 at March 31, 2008 and December 31, 2007, respectively.
 
The repurchase agreements reprice monthly with interest rates based on a spread to one-month LIBOR.  As of March 31, 2008, the repurchase agreements had a weighted average interest rate of 2.91%.
 
 
NOTE 12 – PREFERRED AND COMMON STOCK
 
The Company is authorized to issue up to 50,000,000 shares of preferred stock.  For all series issued, dividends are cumulative from the date of issue and are payable quarterly in arrears.  The dividend per share is equal to the greater of (i) the per quarter base rate of $0.2375 for Series D, or (ii)  the quarterly dividend declared on the Company’s common stock.  One share of Series D Preferred Stock is convertible at any time at the option of the holder into one share of common stock.  The series is redeemable by the Company at any time, in whole or in part, (i) at a rate of one share of preferred stock for one share of common stock, plus accrued and unpaid dividends, provided that for 20 trading days within any period of 30 consecutive trading days, the closing price of the common stock equals or exceeds the issue price, or (ii) for cash at the issue price, plus any accrued and unpaid dividends.
 
In the event of liquidation, the holders of this series of preferred stock will be entitled to receive out of the Company’s assets, prior to any such distribution to the common shareholders, the issue price per share in cash, plus any accrued and unpaid dividends.  If the Company fails to pay dividends for two consecutive quarters or if the
 

 

 
12

 

Company fails to maintain consolidated shareholders’ equity of at least 200% of the aggregate issue price of the Series D preferred stock, then these shares automatically convert into a new series of 9.50% senior notes.  The Company paid dividends of $0.95 per share of Series D Preferred Stock for each of the years ended December 31, 2007, 2006 and 2005.
 
The following table presents the changes in the number of preferred and common shares outstanding:
 
   
Shares
 
   
Preferred
       
   
Series D
   
Common
 
December 31, 2007
    4,221,539       12,136,262  
Restricted shares granted
    -       33,500  
March 31, 2008
    4,221,539       12,169,762  

 
On February 5, 2008, the Company’s Board of Directors declared a dividend of $0.10 per common share to shareholders of record on February 15, 2008, which was paid on February 29, 2008 in the amount of $1,217.  On March 19, 2008, the Company’s Board of Directors declared a dividend of $0.2375 per share of Series D Preferred Stock to shareholders of record on March 31, 2008, which was paid in the amount of $1,003 on April 30, 2008.
 
NOTE 13 — COMMITMENTS AND CONTINGENCIES
 
The Company and its subsidiaries may be involved in certain litigation matters arising in the ordinary course of business from time to time.  Although the ultimate outcome of these matters cannot be ascertained at this time, and the results of legal proceedings cannot be predicted with certainty, the Company believes, based on current knowledge, that the resolution of these matters will not have a material adverse effect on the Company’s financial position or results of operations.
 
Information on litigation arising out of the ordinary course of business is described below.
 
One of the Company’s subsidiaries, GLS Capital, Inc. (GLS), and the County of Allegheny, Pennsylvania (Allegheny County), are defendants in a class action lawsuit filed in 1997 in the Court of Common Pleas of Allegheny County, Pennsylvania (the Court of Common Pleas).  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 which were purchased from Allegheny County.   In 2007, the Court of Common Pleas stayed 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.  Several of the allegations in that lawsuit are similar to those being made against GLS in this litigation.  Plaintiffs have not enumerated their 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 its reported results for the particular period presented.
 
Dynex Capital, Inc. and Dynex Commercial, Inc. (DCI), a former 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.  The Court of Appeals heard oral arguments in this matter in April 2006.  The appeal sought to overturn the trial court’s judgment in the Company’s and DCI’s favor which denied recovery to Plaintiffs.  Plaintiffs sought a reversal of the trial court’s judgment, and sought rendition of judgment against the Company for alleged breach of  loan agreements for tenant improvements in the amount of $253.  They also sought reversal of the trial court’s judgment and rendition of judgment against DCI in favor of BCM under two mutually exclusive damage models, for $2,200 and $25,600, respectively, related to the alleged breach by DCI of a $160,000 “master” loan commitment.   Plaintiffs also sought reversal and rendition of a judgment in their favor for attorneys’ fees in the amount of $2,100.  Alternatively, Plaintiffs sought a new trial.  On February 22, 2008, the Court of Appeals ruled in
 

 

 
13

 

favor of the Company and DCI, upholding the trial court’s judgment.  On May 7, 2008, Plaintiffs filed an appeal with the Supreme Court of Texas.  Even if Plaintiffs were to be successful on appeal, DCI is a former affiliate of the Company, and the Company believes that it would have no obligation for amounts, if any, awarded to the Plaintiffs as a result of the actions of DCI.
 
The Company and MERIT Securities Corporation, a subsidiary, are defendants in a putative class action complaint alleging violations of the federal securities laws in the United States District Court for the Southern District of New York (District Court) by the Teamsters Local 445 Freight Division Pension Fund (Teamsters).  The complaint was filed on February 7, 2005, and purports to be a class action on behalf of purchasers between February 2000 and May 2004 of MERIT Series 12 and MERIT Series 13 securitization financing bonds (the Bonds), which are collateralized by manufactured housing loans.   The complaint seeks unspecified damages and alleges, among other things, misrepresentations in connection with the issuance of and subsequent reporting on the Bonds.  The complaint initially named the Company’s former president and its current Chief Operating Officer as defendants.   On February 10, 2006, the District Court dismissed the claims against the Company’s former president and its current Chief Operating Officer, but did not dismiss the claims against the Company or MERIT.  The Company and MERIT petitioned for an interlocutory appeal with the United States Court of Appeals for the Second Circuit (Second Circuit).  The Second Circuit granted the Company’s petition on September 15, 2006 and heard oral argument on the appeal on January 30, 2008.  The Company has evaluated the allegations made in the complaint, believes them to be without merit and intends 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 its consolidated balance sheet but could materially affect its consolidated results of operations in a given year or period.
 
 
NOTE 14 — STOCK BASED COMPENSATION
 
Pursuant to Dynex’s 2004 Stock Incentive Plan, as approved by the shareholders at Dynex’s 2005 annual shareholders’ meeting (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 Stock Incentive Plan.  Dynex may also grant dividend equivalent rights (“DERs”) in connection with the grant of options or SARs.

On February 4, 2008, Dynex granted 33,500 shares of restricted common stock to certain of its employees and officers under the Stock Incentive Plan.  Of the restricted stock granted, 3,500 shares vest equally each quarter of 2008.  The remaining 30,000 shares of restricted stock vest 25% per year (on the grant date) over the next four years The weighted-average grant-date fair value of the restricted stock grants was $8.80 per share for a total compensation cost of $294, which will be recognized in expense evenly over the vesting period.

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

   
Three Months Ended
 
   
March 31, 2008
 
   
Number of Shares
   
Weighted-Average Exercise Price
 
SARs outstanding at beginning of period
    278,146     $ 7.27  
SARs granted
           
SARs forfeited or redeemed
           
SARs exercised
           
SARs outstanding at end of period
    278,146     $ 7.27  
SARs vested and exercisable
    149,073     $ 7.41  


 
14

 


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

   
Three Months Ended
 
   
March 31, 2008
 
   
Number of Shares
   
Weighted-Average Exercise Price
 
Options outstanding at beginning of period
    95,000     $ 8.28  
Options granted
           
Options forfeited or redeemed
           
Options exercised
           
Options outstanding at end of period
    95,000     $ 8.28  
Options vested and exercisable
    95,000     $ 8.28  

As required by SFAS No. 123(R), “Share Based Payments,” stock options, which are settleable only in shares of common stock, have been treated as equity awards, with their fair value measured at the grant date, and SARs, which are settleable in cash, have been treated as liability awards, with their fair value measured at the grant date and remeasured at the end of each reporting period.  The fair value of SARs was estimated at March 31, 2008 using the Black-Scholes option valuation model based upon the assumptions in the table below.

Dynex recognized a stock based compensation benefit of $67 and expense of $72 for the three months ended March 31, 2008 and 2007, respectively, related to the restricted stock and SARs.  The total compensation cost related to non-vested awards was $519 and $407 at March 31, 2008 and December 31, 2007, respectively, and will be recognized as the awards vest.

The following table describes the weighted average of assumptions used for calculating the fair value of SARs outstanding at March 31, 2008.

 
SARs Fair Value
 
March 31, 2008
Expected volatility
16.91%-20.01%
Weighted-average volatility
17.48%
Expected dividends
4.26%
Expected term (in months)
48
Risk-free rate
3.21%

 
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 for the three months ended March 31, 2008 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.
 
In February 2008, the Company’s Board of Directors authorized the investment of a significant portion of its capital in residential mortgage backed securities (“RMBS”) issued or guaranteed by a federally chartered corporation, such
 

 

 
15

 

 as Fannie Mae or Freddie Mac, or an agency of the U.S. government, such as Ginnie Mae (commonly referred to as Agency RMBS).  While the Company has occasionally invested in Agency RMBS in the past, the Company believes that risk-adjusted returns for investing in Agency RMBS are currently compelling given current yields available and the favorable terms and costs to finance the Agency RMBS.  The Company expects to use repurchase agreement leverage in order to enhance the overall returns on its invested capital.  The leverage ratio on these and other investments may vary depending on market and economic conditions.  The Company also expects to employ derivatives in order to manage its interest rate risk.
 
The Company purchased approximately $27.7 million of Agency RMBS during the quarter and $41.2 million more in April 2008.  The Company’s Agency RMBS are currently financed with repurchase agreement financing and equity.  The Company expects to significantly increase its holdings of Agency RMBS using its existing capital and may attempt to raise additional equity capital to deploy in this strategy.
 
As a REIT, the Company is required to distribute to shareholders as dividends at least 90% of its taxable income, which is the Company’s income as calculated for tax, after consideration of any tax net operating loss (NOL) carryforwards.  However, unlike other mortgage REITs, the Company may be able to limit its REIT income distributions by utilizing its NOL carryforwards, which were approximately $150 million at December 31, 2007, although the Company has not finalized its 2007 federal income tax return.  As a result, the Company has the option of being able to invest its capital and compound the returns on an essentially tax-free basis instead of distributing its earnings to its shareholders.  The Company will balance the desire to retain its capital and compound its returns with dividend distributions to shareholders.
 
The Board of Directors of the Company declared a dividend of $0.10 per common share for the first quarter of 2008, and a dividend of $0.15 per common share for the second quarter of 2008.  The Company also expects to pay a dividend in the third and fourth quarters of 2008.
 
During the first quarter of 2008, the Company sold approximately $5.2 million of equity securities for a gain of approximately $2.1 million and purchased approximately $10.0 million of equity securities later in the same quarter.
 

 
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 and variable interest entities in which it is determeinced to be the primary beneficiary in accordance with Financial Interpretation (“FIN”) 46(R).  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 the Company 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.
 

 
16

 


 
Securitization.  The Company has securitized loans and securities in a securitization financing transaction by transferring financial assets to a wholly owned trust, and the trust issues non-recourse bonds pursuant to an indenture.  Generally, the Company retains some form of control over the transferred assets, and/or the trust is not deemed to be a qualified special purpose entity.  In instances where the trust is deemed not to be a qualified special purpose entity, the trust is included in the Company’s consolidated financial statements.  A transfer of financial assets in which the Company surrenders control over those assets is accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange.  For accounting and tax purposes, the loans and securities financed through the issuance of bonds in a securitization financing transaction are treated as the Company’s assets, and the associated bonds issued are treated as its debt as securitization financing.  The Company may retain certain of the bonds issued by the trust and will generally transfer collateral in excess of the bonds issued.  This excess is typically referred to as over-collateralization.  Each securitization trust generally provides the Company with the right to redeem, at its option, the remaining outstanding bonds prior to their maturity date.
 
Impairments.  The Company evaluates all securities in its investment portfolio for other-than-temporary impairments.  A security is generally defined to be other-than-temporarily impaired if, for a maximum period of three consecutive quarters, the carrying value of such security exceeds its estimated fair value and the Company estimates, based on projected future cash flows or other fair value determinants, that the fair value will remain below the carrying value for the foreseeable future.  If an other-than-temporary impairment is deemed to exist, an impairment charge is recorded to adjust the carrying value of the security down to its estimated fair value.  In certain instances, as a result of the other-than-temporary impairment analysis, the recognition or accrual of interest will be discontinued and the security will be placed on non-accrual status.
 
The Company considers impairments of other investments 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 losses is established and evaluated on a pool basis.  Otherwise, the allowance for losses is established and evaluated on a loan-specific basis.  Provisions made to increase the allowance are a current period expense to operations.  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, a commercial loan with a debt service coverage ratio of less than one is considered impaired.  However, based on the attributes of the respective loan, or the attributes of the underlying real estate which secures the loan, commercial loans with a debt service 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.
 

 
17

 

FINANCIAL CONDITION

Below is a discussion of the Company’s financial condition.

(amounts in thousands except per share data)
 
March 31, 2008
   
December 31, 2007
 
Investments:
           
Securitized mortgage loans, net
  $ 271,537     $ 278,463  
Securities
    58,280       29,231  
Investment in joint venture
    13,380       19,267  
Other loans and investments
    3,549       6,774  
                 
Securitization financing
    200,313       204,385  
Repurchase agreements
    29,556       4,612  
Obligation under payment agreement
    11,244       16,796  
                 
Shareholders’ equity
    140,366       141,936  
Common book value per share
  $ 8.07     $ 8.22  

Securitized Mortgage Loans, Net

Securitized mortgage loans are comprised of loans secured by first deeds of trust on single-family residential and commercial properties.  The following table presents the Company’s net basis in these loans at amortized cost, which includes accrued interest receivable, discounts, premiums, deferred costs and reserves for loan losses, by the type of property collateralizing the loan.
 

(amounts in thousands)
 
March 31, 2008
   
December 31, 2007
 
Securitized mortgage loans, net:
           
Commercial
  $ 188,638     $ 190,570  
Single-family
    82,899       87,893  
      271,537       278,463  

Securitized commercial mortgage loans includes the loans pledged to two securitization trusts, which were issued in 1993 and 1997, and which have outstanding principal balances of $34.0 million and $150.0 million, respectively, at March 31, 2008.  The decrease in these loans was primarily related to scheduled principal payments of $2.0 million received during the quarter.
 
Securitized single-family mortgage loans includes loans pledged to one securitization trust, which was issued in 2002 using loans that were principally originated between 1992 and 1997.  The decrease in the single-family mortgage loans is primarily related to principal payments on the loans of $4.8 million, $4.0 million of which was unscheduled.
 
Securities

Our securities, which are classified as available-for-sale and carried at their fair value, are comprised of the following.
 
(amounts in thousands)
 
March 31, 2008
   
December 31, 2007
 
Securities:
           
Non-agency RMBS
  $ 7,402     $ 7,726  
Agency RMBS
    34,670       7,456  
Equity securities
    12,186       9,701  
Corporate debt securities
    4,022       4,347  
    $ 58,280     $ 29,230  


 
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Non-agency RMBS declined approximately $0.3 million to $7.4 million at March 31, 2008.  The decrease was primarily related to the principal payments received on these securities during the year.
Agency RMBS increased by $27.2 million to $34.7 million at March 31, 2008.  This increase was primarily the result of the purchase of $27.7 million of Agency RMBS during the first quarter of 2008, which was partially offset by the receipt of $0.6 million of principal on the Agency RMBS during the quarter.
 
Equity securities increased approximately $2.5 million to $12.2 million and include preferred stock and common stock issued by publicly-traded mortgage REITs.  The Company purchased approximately $10.0 million of equity securities during the first quarter and sold approximately $5.2 million of equity securities on which the Company recognized a net gain of $2.1 million.
 
Investment in Joint Venture

Investment in joint venture declined as a result of the Company’s interest in the net loss and other comprehensive loss of the joint venture due primarily to adjustments to fair value of the CMBS securities owned by the joint venture as previously discussed.  The Company wrote-down the carrying value of the investment in joint venture by an additional $3.6 million reflecting temporary declines in fair value of securities owned by the joint venture due to widening credit spreads in CMBS since the end of the December. During the first quarter of 2008, the Company also recorded an adjustment of $4.2 million which is included in other income for the obligation under payment agreement due to the joint venture, reflecting the fair value change during the quarter of this obligation.
 
Other Loans and Investments

Other loans and investments declined approximately $3.2 million to $3.5 million at March 31, 2008.  The balance at March 31, 2008 is comprised primarily of $3.0 million of seasoned residential and commercial mortgage loans and $0.5 million related to the Company’s remaining investment in delinquent property tax receivables.  The decline is primarily related to the sale of the majority of the Company’s tax lien receivables to Allegheny County, Pennsylvania for $1.6 million during the quarter and the collection of a $1.4 million note receivable that was outstanding at December 31, 2007.
 
Securitization Financing

Securitization financing are bonds issued by a securitization trust, which the Company sponsored and is consolidated in its financial statements.  These bonds are secured only by the securitized mortgage loans pledged to the trust and are otherwise non-recourse to the Company.  Principal and interest on the bonds are paid from the cash flows generated by the loans collateralizing the bonds.   The following table presents the Company’s net basis, which includes accrued interest, discounts, premiums and deferred costs in securitization financing.
 
(amounts in thousands)
 
March 31, 2008
   
December 31, 2007
 
Securitization financing bonds:
           
Fixed, secured by commercial mortgage loans
  $ 168,308     $ 170,623  
Variable, secured by single-family mortgage loans
    32,005       33,762  
    $ 200,313     $ 204,385  

The fixed rate bonds finance the Company’s securitized commercial mortgage loans, which are also fixed rate.  The $2.3 million decrease is primarily related to principal payments on the bonds during the three months ended March 31, 2008 of $2.0 million.  There was also $0.3 million of net amortization of bond premiums and deferred costs.  Approximately $29.2 million of these bonds are callable by the Compoany in June of 2008.  Those bonds have premiums and deferred costs associated with them, representing a net credit of approximately $1.3 million, which are being amortized over the life of the bonds.  If the Company chooses to call those bonds in 2008, any unamortized premium and deferred costs would be written-off and recognized as a gain at that time.
 

 
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The Company’s single-family securitized mortgage loans are financed by variable rate securitization financing bonds.  The $1.8 million decline in the balance to $32.0 million at March 31, 2008 is primarily related to principal payments on the bonds of $1.8 million, which was partially offset by $0.1 million of bond discount amortization.  The Company redeemed all of the bonds issued by this securitization trust in 2005, financed the redemption with repurchase agreements and its own capital, and held the bonds for potential reissue  The Company still holds a senior bond issued by this trust, which had a par value of $41.3 million at March 31, 2008 and is partially financed with repurchase agreements.  As the securitization trust which issued this bond is consolidated in the Company’s financial statements, this bond is eliminated in its consolidated financial statements.
 
Repurchase Agreements

Repurchase agreements increased $24.9 million to $29.6 million at March 31, 2008.  This increase related to the purchase of Agency RMBS, discussed above, which the Company financed with $24.9 million of repurchase agreements and had a fair value of $27.7 million at March 31, 2008.
 
Obligation Under Payment Agreement

On January 1, 2008, the Company adopted the provisions of SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”).  SFAS 159 permits entities to choose to measure financial instruments at fair value.  The effect of the adoption of SFAS 159 was to decrease beginning accumulated deficit by $1.3 million.  During the first quarter of 2008, the Company recorded an additional adjustment of $4.2 million, which is included in fair value adjustments, reflecting the change in fair value during the quarter of the obligation to the joint venture under payment agreement.
 
Shareholders’ Equity

Shareholders’ equity decreased by $1.6 million to $140.4 million.  This decrease was primarily related to a $6.0 million decline in accumulated other comprehensive income, related to an increase in the unrealized losses on certain of the Company’s available for sale investments, securities and investment in joint venture.  The Company also paid $1.0 million of preferred dividends and $1.2 million of common dividends during the quarter.  These decreases were partially offset by net income during the quarter of $5.3 million and a $1.3 million increase in accumulated deficit for the cumulative effect of initially adopting SFAS 159 on January 1, 2008 related to the Company’s obligation to joint venture under payment agreement.
 
Supplemental Discussion of Investments
 
The Company evaluates and manages its investment portfolio in large part based on its 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 mortgage loans, because the securitization financing is recourse only to the mortgage loans pledged and is, therefore, not a general obligation of the Company, the risk on the Company’s investment in securitized mortgage loans from an economic point of view is limited to its net retained investment in the securitization trust.
 
Below is the net basis of the Company’s investments as of March 31, 2008.  Included in the table is an estimate of the fair value of each net investment.  The fair value of the net investment in securitized mortgage loans 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 is calculated by discounting estimated future cash flows at market rates.  For securities and other investments, the Company may employ leverage to enhance its overall returns on the net capital invested in these particular assets.
 

 
20

 


 
   
March 31, 2008
 
(amounts in thousands)
 
Amortized cost basis
   
Financing(4)
   
Net investment
   
Fair value of net investment
 
Securitized mortgage loans: (1)
                       
Single-family mortgage loans
  $ 83,054     $ 36,618     $ 46,436     $ 40,487  
Commercial mortgage loans
    191,228       168,308       22,920       15,338  
Allowance for loan losses
    (2,745 )           (2,745 )      
      271,537       204,926       66,611       55,825  
Securities: (2)
                               
Investment grade single-family
    41,645       24,944       16,701       16,739  
Non-investment grade single-family
    274             274       340  
Equity and other
    17,145             17,145       16,257  
Net unrealized loss
    (784 )           (784 )      
      58,280       24,944       33,336       33,336  
                                 
Investment in joint venture(3)
    13,380             13,380       13,049  
Obligation to joint venture under payment agreement(1)
          11,244       (11,244 )     (11,244 )
Other loans and investments(2)
    3,549             3,549       4,251  
                                 
Total
  $ 346,746     $ 241,114     $ 105,632     $ 95,217  
                                 

 
(1)
Fair values for securitized mortgage loans and the obligation to joint venture under payment agreement are based on discounted cash flows using assumptions set forth in the table below, inclusive of amounts invested in redeemed securitization financing bonds.
 
(2)
Fair values are based on dealer quotes, if available, and closing prices from a national exchange where applicable.  Approximately $22 million of fair value of securities were based on available dealer quotes or closing prices from a national exchange.   Where dealer quotes are not available, fair values are calculated as the net present value of expected future cash flows, discounted at a weighted average discount rate of 7.5% for investment grade securities and 35.3% for non-investment grade securities.
 
(3)
Fair value for investment in joint venture represents the Company’s share of the fair value of the joint venture’s assets valued using methodologies and assumptions consistent with Note 1 above.
 
(4)
Financing includes securitization financing issued to third parties and repurchase agreements.

The following table summarizes the assumptions used in estimating fair value for the Company’s net investment in securitized finance receivables and the cash flow related to those net investments during 2008.

 
Fair Value Assumptions
 
Loan type
Weighted-average prepayment speeds
Losses
Weighted-average
discount rate(6)
Projected cash flow termination date
(amounts in thousands)
YTD 2008 Cash Flows (1)
           
Single-family mortgage loans
20% CPR
0.2% annually
20%
Anticipated final maturity 2024
$         848
           
Commercial mortgage loans(2)
(3)
0.8% annually
(4)
(5)
$         517

(1)
Represents the excess of the cash flows received on the collateral pledged over the cash flow required to service the related securitization financing.
(2)
Includes loans pledged to two different securitization trusts.

 
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(3)
Assumed constant prepayment rate (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 to be liquidated in six months at a loss amount that is calculated for each loan based on its specific facts.
(4)
Weighed-average discount rates for the two securitization trusts were 16.0% and 22.1%, respectively.
(5)
Cash flow termination dates are modeled based on the repayment dates of the loans or optional redemption dates of the underlying securitization financing bonds.
(6)
Represents management’s estimate of the market discount rate that would be used by a third party in valuing these or similar assets.

The following table presents the Net Basis of Investments included in the first 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 mortgage loan collateral pledged over the outstanding bonds issued by the securitization trust.
 
(amounts in thousands)
 
March 31, 2008
 
       
Cash and cash equivalents
  $ 37,935  
Investments:
       
AAA rated and agency MBS fixed income securities
    52,783  
AA and A rated fixed income securities
    451  
Unrated and non-investment grade
    20,327  
Securitization over-collateralization
    18,691  
Investment in joint venture
    13,380  
    $ 105,632  

Supplemental Discussion of Common Equity Book Value

Management believes that the Company’s 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 its 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 first table included in the “Supplemental Discussion of Investments” section above compares the amortized cost basis of  investments to their estimated fair value based on assumptions set forth in the second table.
 
Management 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”), is also a meaningful measure for the Company’s shareholders, representing effectively the Company’s estimated going-concern value.  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 of the Company’s assets and liabilities 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 Company’s value.
 

 
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March 31, 2008
 
(amounts in thousands, except per share information)
 
Book Value
   
Adjusted Book Value
 
             
Total investment assets (per table above)
  $ 105,632     $ 95,217  
Cash and cash equivalents
    37,935       37,935  
Other assets and liabilities, net
    (3,201 )     (3,201 )
      140,366       129,951  
Less:  Preferred stock redemption value
    (42,215 )     (42,215 )
Common equity book value and adjusted book value
  $ 98,151     $ 87,736  
                 
Common equity book value per share and adjusted book value per share
  $ 8.07     $ 7.21  

 
Discussion of Credit Risk

A major risk in the Company’s investment portfolio today is credit risk (i.e., the risk that the Company will not receive all amounts contractually due it on an investment as a result of a default by the borrower and the resulting deficiency in proceeds from the liquidation of the collateral securing the obligation).  In many instances, the Company retained the “first-loss” credit risk on pools of loans and securities that it securitized.  In addition to the retained interests in certain securitizations, the Company also has credit risk on approximately $3.5 million of unrated or non-investment grade mortgage securities and loans.
 
The following table summarizes the Company’s credit exposure in securitized mortgage loans and subordinate mortgage securities.  The Company’s net credit exposure increased from 2007 to 2008 primarily due to amortization of premiums and the reduction in the balance of the Company’s allowance for loan losses of $0.8 million as a result of improved performance of the Company’s securitized commercial mortgage loan portfolio.
 
Credit Reserves and Actual Credit Losses

(amounts in millions)
 
Credit Exposure (1)
   
Credit Exposure, Net of Allowance (2)
   
Actual Credit Losses
   
Credit Exposure, Net of Allowance to Outstanding Loan Balance (3)
 
2007, Quarter 1
  $ 25.8     $ 22.2     $ 0.4       6.45 %
2007, Quarter 2
    26.5       23.0       0.0       6.95  
2007, Quarter 3
    26.9       24.3       0.1       7.91  
2007, Quarter 4
    27.5       24.8       0.0       8.58  
2008, Quarter 1
    27.9       25.2       0.0       8.91  

(1)
Represents the overcollateralization pledged to a securitization trust and subordinate securities the Company owns, net of any premiums and  discounts.
(2)
Represents credit exposure, net of allowance for loan losses.
(3)
Represents credit exposure net of allowance divided by current unpaid principal balance of loans in the securitization trust

The Company monitors and evaluates its exposure to credit losses and has established reserves based upon anticipated losses, general economic conditions and trends in the investment portfolio.  Delinquencies as a percentage of all outstanding securitized mortgage loans decreased to 2.6% at March 31, 2008 from 3.1% at March 31, 2007.  At March 31, 2008, management believes the level of credit reserves is appropriate for currently existing
 

 

 
23

 

losses.  The following tables summarize single-family mortgage loan and commercial mortgage loan delinquencies as a percentage of the outstanding commercial securitized mortgage loans or single-family balance for those securitizations in which the Company has retained a portion of the direct credit risk.
 
Loans secured by low-income housing tax credit (LIHTC) properties account for 88% of the Company’s securitized commercial loan portfolio.  Section 42 of the Code provides tax credits to investors in projects to construct or substantially rehabilitate properties that provide housing for qualifying low income families.  Failure to comply with certain income and rental restrictions required by Section 42 or default on a loan financing a Section 42 property during the compliance period can result in the recapture of previously received tax credits.  The potential cost of tax credit recapture provides an incentive to the property owner to support the property during the compliance period.  The following table shows the weighted average remaining compliance period of the Company’s portfolio of LIHTC commercial loans at March 31, 2008 as a percent of the total LIHTC commercial loan portfolio.
 
Months remaining to end of compliance period
 
As a Percent of Unpaid Principal Balance
 
Compliance period already exceeded
    28.5 %
Zero through twelve months remaining
    4.5  
Thirteen through thirty six months remaining
    53.6  
Thirty seven through sixty months remaining
    13.4  
      100.0 %

There were no delinquent commercial mortgage loans at March 31, 2008 or December 31, 2007.
 
Single-family mortgage loan delinquencies decreased by $0.5 million to $7.4 million at March 31, 2008 from $7.9 million at December 31, 2007.  Serious delinquencies, defined as 60+ day delinquencies, increased from $2.9 million to $3.3 million for the same period.  The Company’s single-family loan portfolio, which had an aggregate unpaid principal balance of $89.7 million at March 31, 2008, was originated primarily between 1992 and 1997 and continues to perform and pay-down as expected and with minimal losses.  Approximately $1.2 million of the 60+ day delinquent loans are credit enhanced with mortgage pool insurance, and the Company does not expect any realized losses on these loans.  For loans without mortgage pool insurance, the Company expects losses to be minimal given the seasoning of the underlying loans.  During 2007 and 2006, the Company incurred less than $0.1 million of actual losses in each of those years.
 
Single-Family Loan Delinquency Statistics

(amounts in thousands)
 
30 to 59 days delinquent
   
60 to 89 days
delinquent
   
90 days and over delinquent (1)
   
Total
 
2007, Quarter 1
  $ 5,389     $ 937     $ 4,273     $ 10,599  
2007, Quarter 2
    4,180       874       3,157       8,211  
2007, Quarter 3
    2,381       551       3,058       5,990  
2007, Quarter 4
    5,003       562       2,342       7,907  
2008, Quarter 1
    4,092       761       2,543       7,396  

(1)
Includes foreclosures and real estate owned.


 
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RESULTS OF OPERATIONS
   
Three Months Ended
 
   
March 31,
 
(amounts in thousands except per share information)
 
2008
   
2007
 
             
Net interest income
  $ 2,421     $ 2,460  
(Provision for) recapture of provision for loan losses
    (26 )     523  
Net interest income after recapture of loan losses
    2,395       2,983  
Gain (loss) on sales of investments
    2,093       (6 )
Equity in (loss) earnings of joint venture
    (2,251 )     630  
Fair value adjustments, net
    4,231        
Other income (expense)
    67       (539 )
General and administrative expenses
    (1,216 )     (1,126 )
Net income
    5,319       1,942  
Preferred stock charge
    (1,003 )     (1,003 )
Net income to common shareholders
    4,316       939  
                 
Net income per common share:
               
Basic
  $ 0.36     $ 0.08  
Diluted
  $ 0.32     $ 0.08  

 
Three Months Ended March 31, 2008 Compared to Three Months Ended March 31, 2007
 
Interest Income

Interest income includes interest earned on the investment portfolio and also reflects the amortization of any related discounts, premiums and deferred costs.  The following tables present the significant components of the Company’s interest income.
 
   
Three Months Ended March 31,
 
(amounts in thousands)
 
2008
   
2007
 
Interest income:
           
Securitized mortgage loans
  $ 5,602     $ 7,025  
Securities
    428       324  
Cash and cash equivalents
    324       739  
Other loans and investments
    129       127  
    $ 6,483     $ 8,215  

 
The change in interest income on securitized mortgage loans and securities is examined in the discussion and tables that follow.
 
Interest income on cash and cash equivalents decreased $0.4 million in 2008 compared to 2007.  This decrease is primarily the result of an $13.9 million decrease in the average balance of cash and cash equivalents outstanding during 2008 compared to 2007 and a decrease in short-term interest rates.  The yield on cash decreased from 5.2% for the three months ended March 31, 2007 to 3.0% for the same period in 2008.
 

 
25

 

Interest Income – Securitized Mortgage Loans

The following table summarizes the detail of the interest income earned on securitized mortgage loans.
 
   
Three Months Ended March 31,
 
   
2008
   
2007
 
(amounts in thousands)
 
Interest Income
   
Net Amortization
   
Total Interest Income
   
Interest Income
   
Net Amortization
   
Total Interest Income
 
Securitized mortgage loans:
                                   
Commercial
  $ 3,985     $ 100     $ 4,085     $ 4,868     $ 87     $ 4,955  
Single-family
    1,604       (87 )     1,517       2,205       (135 )     2,070  
Total mortgage loans
  $ 5,589     $ 13     $ 5,602     $ 7,073     $ (48 )   $ 7,025  

The majority of the decrease of $0.9 million in interest income on commercial mortgage loans is primarily related to the decline in the average balance of the commercial mortgage loans outstanding during the first quarter of 2008, which decreased approximately $38.4 million (54%) from the balance for the same period in 2007.
 
Interest income on securitized single-family mortgage loans declined $0.6 million to $1.5 million for the three months ended March 31, 2008.  The decline in interest income on single-family loans was primarily related to the decrease in the average balance of the loans outstanding from the first quarter of 2007, which declined approximately $27.4 million, or approximately 24%, to $85.7 million for the first quarter of 2008.  The decline in interest income on single-family mortgage loans was also negatively impacted by a decrease in the average yield on the Company’s single-family loan portfolio, approximately 87% of which were variable rate at March 31, 2008.
 
Interest Income – Securities

The following table presents the components of interest income on securities.
 
   
Three Months Ended March 31,
 
(amounts in thousands)
 
2008
   
2007
 
Non-agency RMBS
  $ 176     $ 262  
Agency RMBS
    104       62  
Corporate debt securities and other interest-bearing securities
    148        
    $ 428     $ 324  

Although the balance of securities increased significantly from March 31, 2007 to March 31, 2008, interest income only increased by approximately $0.1 million for the three months ended March 31, 2008 compared to the corresponding period in 2007.  This small increase income was due to the increase in the balance of securities occurring late in March 2008.
 

 
26

 

Interest Expense

Interest expense includes the interest paid and accrued on the Company’s financings as well as the amortization of any related discounts, premiums and deferred costs.  The following tables present the significant components of interest expense.
 
   
Three Months Ended March 31,
 
(amounts in thousands)
 
2008
   
2007
 
Interest expense:
           
Securitization financing
  $ 3,599     $ 4,096  
Repurchase agreements
    54       1,258  
Obligation under payment agreement
    401       367  
Other
    8       34  
    $ 4,062     $ 5,755  

Interest Expense – Securitization Financing

The following table summarizes the detail of the interest expense recorded on securitization financing bonds.
 
   
Three Months Ended March 31,
 
   
2008
   
2007
 
(amounts in thousands)
 
Interest Expense
   
Net Amortization
   
Total Interest Expense
   
Interest Expense
   
Net Amortization
   
Total Interest Expense
 
Securitization financing:
                                   
Commercial
  $ 3,441     $ (325 )   $ 3,116     $ 4,273     $ (286 )   $ 3,987  
Single-family
    338       52       390