10-Q: Quarterly report pursuant to Section 13 or 15(d)
Published on August 13, 2001
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
|X| Quarterly Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the quarter ended June 30, 2001
|_| 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
(Address of principal executive offices) (Zip Code)
(804) 217-5800
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past ninety days. | | Yes |X|No
On July 31, 2001, the registrant had 11,444,206 shares of common stock of $.01
value outstanding, which is the registrant's only class of common stock.
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DYNEX CAPITAL, INC.
FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
DYNEX CAPITAL, INC.
CONSOLIDATED BALANCE SHEETS
(amounts in thousands except share data)
DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS, UNAUDITED
(amounts in thousands except share data)
DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS, UNAUDITED
(amounts in thousands)
DYNEX CAPITAL, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2001 (amounts in
thousands except share data)
NOTE 1--BASIS OF PRESENTATION
The accompanying 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 generally accepted accounting principles for
complete financial statements. The consolidated financial statements include the
accounts of Dynex Capital, Inc. and its qualified REIT subsidiaries (together,
"Dynex REIT"). Certain of the Company's operations were previously conducted
through Dynex Holding, Inc. ("DHI"), a taxable affiliate of Dynex REIT. During
2000, Dynex REIT owned all of the outstanding non-voting preferred stock of DHI
representing a 99% economic ownership interest in DHI. The common stock of DHI
represented a 1% economic ownership of DHI and was owned by certain officers of
Dynex REIT. For the six months ended June 30, 2000, DHI was accounted for under
an accounting method similar to the equity method. In November 2000, certain
subsidiaries of DHI were sold to Dynex REIT, and on December 31, 2000, DHI was
liquidated in a taxable transaction into Dynex REIT. As a result of the
liquidation, effectively all of the assets and liabilities of DHI have been
transferred to Dynex REIT as of December 31, 2000. References to the "Company"
mean Dynex Capital, Inc., its consolidated subsidiaries, and, to the extent they
existed, DHI and its consolidated subsidiaries. All significant intercompany
balances and transactions with Dynex REIT's consolidated subsidiaries have been
eliminated in consolidation of Dynex REIT.
In the opinion of management, all material adjustments, consisting of normal
recurring adjustments, considered necessary for a fair presentation of the
consolidated financial statements have been included. The Consolidated Balance
Sheet at June 30, 2001, the Consolidated Statements of Operations for the three
and six months ended June 30, 2001 and 2000, the Consolidated Statement of
Shareholders' Equity for the six months ended June 30, 2001, the Consolidated
Statements of Cash Flows for the six months ended June 30, 2001 and 2000 and
related notes to consolidated financial statements are unaudited. Operating
results for the six months ended June 30, 2001 are not necessarily indicative of
the results that may be expected for the year ending December 31, 2001. For
further information, refer to the audited consolidated financial statements and
footnotes included in the Company's Form 10-K for the year ended December 31,
2000.
Certain reclassifications have been made to the financial statements for 2000 to
conform to presentation for 2001.
Risks and Uncertainties
Since early 1999, the Company has focused its efforts on conserving its capital
base and repaying its outstanding recourse borrowings. On a long-term basis, the
Company believes that competitive pressures, including competing against larger
companies which generally have significantly lower costs of capital and access
to both short-term and long-term financing sources, will generally keep
specialty finance companies like Dynex from earning an adequate risk-adjusted
return on its invested capital. The Company's current business operations are
essentially limited to the management of its investment portfolio and the active
collection of its portfolio of delinquent property tax receivables. The Company
currently has no loan origination operations, and for the foreseeable future
does not intend to purchase loans or securities in the secondary market.
However, as a result of a previously existing contractual obligation, the
Company will likely acquire up to $8,000 in delinquent property tax receivables
during 2001.
The Board of the Company initiated a process in the fall of 1999 to evaluate
various courses of action to improve shareholder value given the depressed
prices of the Company's preferred and common stocks. As a result of this
evaluation, the Company entered into a merger agreement in November 2000, which
was subsequently terminated in January 2001 by the Company due to breaches by
the other party. See Note 11 below. In addition, in an effort to improve the
liquidity of the Company's Series A, Series B, and Series C Preferred Stock
(together, the "Preferred Stock"), on June 8, 2001, the Company completed a
tender offer on the Preferred Stock, resulting in the purchase by the Company of
820,601 shares of the Preferred Stock for $10,918, net of legal fees, which had
an issue price of $21,405, and including cumulative dividends in arrears, a
liquidation preference of approximately $25,110. The Board of Directors may take
further actions to improve shareholder value and to provide greater liquidity
for the Company's preferred and common stocks.
Since December 31, 2000, the Company has repaid $62,590 of on-balance sheet
recourse debt outstanding, and released off-balance sheet liabilities of
$66,765. While the Company's current business prospects are limited, based on
current projected cash flow estimates on its investment portfolio and estimated
proceeds on the call and subsequent sale or resecuritization of investment
portfolio assets, the Company anticipates that it will be able to repay its
remaining outstanding recourse debt in accordance with their respective terms.
Cash - Restricted
At June 30, 2001 and December 31, 2000, cash in the aggregate amount of
approximately $3,040 and $23,288, respectively, was held in escrow as collateral
for letters of credit or to cover losses on securities not otherwise covered by
insurance.
NOTE 2--NET INCOME PER COMMON SHARE
Net income per common share is presented on both a basic net income per common
share and diluted net income 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 to
the extent that there are rights outstanding, using the treasury stock method,
but only if these items are dilutive. As a result of the two-for-one split in
May 1997 and the one-for-four reverse split in July 2000 of Dynex REIT's common
stock, the preferred stock is convertible into one share of common stock for two
shares 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 and six months ended June
30, 2001 and 2000.
NOTE 3 -- COLLATERAL FOR COLLATERALIZED BONDS AND SECURITIES
The following table summarizes Dynex REIT's amortized cost basis and fair value
of investments classified as available-for-sale, as of June 30, 2001 and
December 31, 2000, and the related average effective interest rates:
Collateral for collateralized bonds. Collateral for collateralized bonds
consists primarily of securities backed by adjustable-rate and fixed-rate
mortgage loans secured by first liens on single family housing, fixed-rate loans
on multifamily and commercial properties and manufactured housing installment
loans secured by either a UCC filing or a motor vehicle title. Collateral for
collateralized bonds also includes delinquent property tax receivables. All
collateral for collateralized bonds is pledged to secure repayment of the
related collateralized bonds. All principal and interest (less servicing-related
fees) on the collateral is remitted to a trustee and is available for payment on
the collateralized bonds. Dynex REIT's exposure to loss on collateral for
collateralized bonds is generally limited to the amount of collateral pledged to
the collateralized bonds in excess of the amount of the collateralized bonds
issued, as the collateralized bonds issued by the limited-purpose finance
subsidiaries are non-recourse to Dynex REIT.
Securities. Adjustable-rate mortgage securities ("ARM") consist of mortgage
certificates secured by ARM loans. Fixed-rate mortgage securities consist of
mortgage certificates secured by mortgage loans that have a fixed rate of
interest for at least one year from the balance sheet date. Derivative
securities are classes of collateralized bonds, mortgage pass-through
certificates or mortgage certificates that pay to the holder substantially all
interest (i.e., an interest-only security), or substantially all principal
(i.e., a principal-only security). Residual interests represent the right to
receive the excess of (i) the cash flow from the collateral pledged to secure
related mortgage-backed securities, together with any reinvestment income
thereon, over (ii) the amount required for principal and interest payments on
the mortgage-backed securities or repurchase arrangements, together with any
related administrative expenses.
Sale of Securities. Proceeds from sales of securities totaled $20,111 for the
six months ended June 30, 2000. There was one security sold during the six
months ended June 30, 2001 for $113. See Note 9, Net Gain (Loss) on Sales,
Write-downs, Impairment Charges and Litigation for further discussion.
NOTE 4 - USE OF ESTIMATES
Fair Value. Dynex REIT uses estimates in establishing fair value for its
financial instruments. Estimates of fair value for financial instruments may be
based on market prices provided by certain dealers. Estimates of fair value for
certain other financial instruments including collateral for collateralized
bonds, are determined by calculating the present value of the projected cash
flows of the instruments using appropriate discount rates, prepayment rates and
credit loss assumptions. Discount rates used are those management believes would
be used by willing buyers of these financial instruments at prevailing market
rates. The discount rate used in the determination of fair value of the
collateral for collateralized bonds at both June 30, 2001 and December 31, 2000
was 16%. Variations in market discount rates, prepayments rates and credit loss
assumptions may materially impact the resulting fair values of the Company's
financial instruments. In addition to variations in such assumptions, as
discussed further in Note 11, due to an adverse ruling rendered by the
Commonwealth Court of Pennsylvania on July 5, 2001, the Company's ability to
collect certain amounts of interest, fees and costs incurred on its delinquent
property tax receivables pledged as collateral for collateralized bonds may be
adversely impacted. The Company, based on consultation with counsel, reasonably
believes that the Appellate Court's decision will ultimately be reversed or that
the ultimate outcome of the litigation will not result in a material impact on
the carrying value of the delinquent property tax receivables.
Estimates of fair value for other financial instruments are based primarily on
management's judgment. Since the fair value of Dynex REIT's financial
instruments is based on estimates, actual gains and losses recognized may differ
from those estimates recorded in the consolidated financial statements.
NOTE 5 -- RECOURSE DEBT
Dynex REIT utilizes repurchase agreements, notes payable and secured credit
facilities (together, "recourse debt") to finance certain of its investments.
The following table summarizes Dynex REIT's recourse debt outstanding at June
30, 2001 and December 31, 2000:
At June 30, 2001 and December 31, 2000, recourse debt consisted of $13,058 and
$35,015, respectively, of repurchase agreements secured by investments and
retained collateralized bonds, none and $2,000, respectively, outstanding under
a revolving credit facility secured by other investments, and $324 and $430,
respectively, of amounts outstanding under a capital lease. The secured
revolving credit facility was extinguished in January 2001. At June 30, 2001,
all recourse debt in the form of repurchase agreements was with Lehman Brothers,
Inc., had overnight or "one-day" maturity, and bears interest at rates indexed
to LIBOR. If Lehman Brothers, Inc. fails to return the collateral, the ultimate
realization of the security by Dynex REIT may be delayed or limited.
As of June 30, 2001 and December 31, 2000, Dynex REIT had $58,365 and $97,250,
respectively, outstanding of its Senior Unsecured Notes issued in July 1997 and
due July 15, 2002 (the "July 2002 Notes"). On March 30, 2001, the Company
entered into an amendment to the related indenture governing the July 2002 Notes
whereby the Company pledged to the Trustee of the July 2002 Notes substantially
all of the Company's unencumbered assets in its investment portfolio and the
stock of its subsidiaries. In consideration of this pledge, the indenture was
further amended to provide for the release of the Company from certain covenant
restrictions in the indenture, and specifically provided for the Company's
ability to make distributions on its capital stock in an amount not to exceed
the sum of (i) $26,000, (ii) the cash proceeds of any "permitted subordinated
indebtedness", (iii) the cash proceeds of the issuance of any "qualified capital
stock", and (iv) any distributions required in order for the Company to maintain
its REIT status. In addition, the Company entered into a Purchase Agreement with
holders of 50.1% of the July 2002 Notes which require the Company to purchase,
and such holders to sell, their respective July 2002 Notes at various discounts
prior to maturity based on a computation of the Company's available cash.
Through June 30, 2001, the Company has retired $38,885 of July 2002 Notes for
$35,185 in cash under the Purchase Agreement. The discounts provided for under
the Purchase Agreement are as follows: by April 15, 2001, 10%; by July 15, 2001,
8%; by October 15, 2001, 6%; by January 15, 2002, 4%; by March 1, 2002, 2%;
thereafter until maturity, 0%. As discussed in Note 11, the validity of the
March 30, 2001 amendment to the indenture and the subsequent entering into of
the Purchase Agreement has been challenged in US District Court Southern
District of New York by a third-party who insures $25 million of the July 2002
Notes for the benefit of the holder of these Notes. Such third party also
purchased $1 million of the July 2002 Notes in June 2001.
At December 31, 2000, Dynex REIT had a secured non-revolving credit facility
under which $66,765 of letters of credit to support tax-exempt bonds had been
issued. These letters of credit were released during the first quarter of 2001,
as a result of the purchase, sale or transfer of the underlying tax-exempt
bonds, and the facility was extinguished.
NOTE 6-- ADOPTION OF FINANCIAL ACCOUNTING STANDARDS
Statement of Financial Accounting Standards ("FAS") No. 133, "Accounting
for Derivative Instruments and Hedging Activities" is effective for all fiscal
years beginning after June 15, 2000. FAS No. 133, as amended, establishes
accounting and reporting standards for derivative instruments, including certain
derivative instruments embedded in other contracts, and for hedging activities.
The Company adopted FAS No. 133 effective January 1, 2001. The adoption of FAS
No. 133 did not have a significant impact on the financial position, results of
operations, or cash flows of the Company.
In September 2000, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 140, "Accounting for Transfers
and Servicing of Financial Assets and Extinguishment of Liabilities" ("FAS No.
140"). FAS No. 140 replaces the Statement of Financial Accounting Standards No.
125 "Accounting for the Transfers and Servicing of Financial Assets and
Extinguishment of Liabilities" ("FAS No. 125"). FAS No. 140 revises the
standards for accounting for securitization and other transfers of financial
assets and collateral and requires certain disclosure, but it carries over most
of FAS No. 125 provisions without reconsideration. FAS No. 140 is effective for
transfers and servicing of financial assets and extinguishment of liabilities
occurring after March 31, 2001. FAS No. 140 is effective for recognition and
reclassification of collateral and for disclosures relating to securitization
transactions and collateral for fiscal years ending after December 15, 2000.
Disclosures about securitization and collateral accepted need not be reported
for periods ending on or before December 15, 2000, for which financial
statements are presented for comparative purposes. FAS No. 140 is to be applied
prospectively with certain exceptions. Other than those exceptions, earlier or
retroactive application of its accounting provision is not permitted. The
adoption of FAS No. 140 did not have a material impact on the Company's
financial statements
In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard (SFAS) No. 141, Business Combinations. SFAS No.
141 requires that all business combinations initiated after June 30, 2001 be
accounted for under the purchase method and addresses the initial recognition
and measurement of goodwill and other intangible assets acquired in a business
combination. Business combinations originally accounted for under the pooling of
interest method will not be changed. Management does not expect the adoption of
SFAS 141 to have an impact on the financial position, results of operations or
cash flows of the Company.
In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard (SFAS) No. 142, Goodwill and Other Intangible
Assets. SFAS No. 142 addresses the initial recognition and measurement of
intangible assets acquired outside of a business combination and the accounting
for goodwill and other intangible assets subsequent to their acquisition. SFAS
No. 142 provides that intangible assets with finite useful lives be amortized
and that goodwill and intangible assets with indefinite lives will not be
amortized, but will rather be tested at least annually for impairment. As the
Company has no goodwill or intangible assets that it is amortizing, the adoption
of SFAS No. 142 will have no effect on the financial position, results of
operations or cash flows of the Company.
NOTE 7--DERIVATIVE FINANCIAL INSTRUMENTS
Dynex REIT may enter into interest rate swap agreements, interest rate cap
agreements, interest rate floor agreements, financial forwards, financial
futures and options on financial futures ("Interest Rate Agreements") to manage
its sensitivity to changes in interest rates. These Interest Rate Agreements are
intended to provide income and cash flow to offset potential reduced net
interest income and cash flow under certain interest rate environments. At the
inception of the hedge, these instruments are designated as either hedge
positions or trade positions using criteria established in FAS No. 133.
For Interest Rate Agreements designated as hedge instruments, Dynex REIT
evaluates the effectiveness of these hedges against the financial instrument
being hedged under various interest rate scenarios. The effective portion of the
gain or loss on an Interest Rate Protection Agreement designated as a hedge is
reported in accumulated other comprehensive income, and the ineffective portion
of such hedge is reported in income.
As a part of Dynex REIT's interest rate risk management process, Dynex REIT may
be required periodically to terminate hedge instruments. Any realized gain or
loss resulting from the termination of a hedge is amortized into income or
expense of the corresponding hedged instrument over the remaining period of the
original hedge or hedged instrument.
If the underlying asset, liability or commitment is sold or matures, the hedge
is deemed partially or wholly ineffective, or the criteria that was executed at
the time the hedge instrument was entered into no longer exists, the Interest
Rate Agreement is no longer accounted for as a hedge. Under these circumstances,
the accumulated change in the market value of the hedge is recognized in current
income to the extent that the effects of interest rate or price changes of the
hedged item have not offset the hedge results or otherwise previously been
recognized in income.
For Interest Rate Agreements entered into for trading purposes, realized and
unrealized changes in fair value of these instruments are recognized in the
consolidated statements of operations as trading activities in the period in
which the changes occur or when such trade instruments are settled. Amounts
payable to or receivable from counterparties, if any, are included on the
consolidated balance sheets in accrued expenses and other liabilities. In March
2001, the Company entered into three separate short positions aggregating
$1,300,000 on the June 2001, September 2001, and December 2001 90-day Eurodollar
Futures Contracts. The Company entered into these positions to, in effect,
lock-in its borrowing costs on a forward basis relative to its floating-rate
liabilities. In addition, in April and May 2001, the Company entered into two
short positions on the one-month LIBOR futures contract, both of which were
settled during the second quarter. These instruments fail to meet the hedge
criteria of FAS No. 133, and therefore are accounted for on a trading basis.
Changes in market value for these contracts, and the gain or loss recognized at
the termination of these contracts, will be recognized in current period
earnings. During the six months ended June 30, 2001, given the continued decline
in one-month LIBOR due to reductions in the targeted Federal Funds Rate, the
Company recognized $1,720 in losses related to these contracts. At June 30,
2001, the aggregate remaining short position was $700,000 and on July 2, 2001,
the Company terminated $400,000 of the position for an additional cost of $15.
NOTE 8--PREFERRED STOCK
On June 8, 2001, the Company completed a tender offer on its Series A, Series B,
and Series C Preferred Stock (together, the "Preferred Stock"), resulting in the
purchase by the Company of 820,601 shares of the Preferred Stock, consisting of
202,090 shares of Series A, 363,708 shares of Series B and 254,803 shares of
Series C, respectively, for an aggregate $10,918, and which had an aggregate
issue price of $21,405, a book value of $20,503, and including dividends in
arrears, a liquidation preference of $25,110. The difference of $9,585 between
the repurchase price and the book value has been included in the accompanying
Statement of Operations for the three and six month periods ended June 30, 2001
as an addition to net income available to common shareholders in the line item
captioned Preferred Stock benefit (charges) as required by EITF's D-42 and D-53.
Also included in Preferred Stock benefit (charges) is the cumulative dividend in
arrears of $3,964 related to those shares tendered on June 8, 2001, and which
was effectively cancelled at such time. In addition, Preferred Stock benefit
(charges) includes the current period dividend amount for the Preferred Stock
outstanding for the three and six month periods ended June 30, 2001.
As of June 30, 2001 and December 31, 2000, the total amount of dividends in
arrears were $20,331 and $19,367 respectively. Individually, the amount of
dividends in arrears on the Series A, the Series B and the Series C were $4,857
($4.39 per Series A share), $6,795 ($4.39 per Series B share) and $8,679 ($5.48
per Series C share), at June 30, 2001 and $4,595 ($3.51 per Series A share),
$6,713 ($3.51 per Series B share) and $8,059 ($4.38 per Series C share), at
December 31,2000.
NOTE 9 - NET GAIN (LOSS) ON SALES, WRITE-DOWNS, IMPAIRMENT CHARGES
AND LITIGATION
The following table sets forth the composition of net gain (loss) on sales,
write-downs and impairment charges for the six months ended June 30, 2001 and
2000.
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Six months ended June 30,
-----------------------------------
2001 2000
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Phase-out of commercial production operations 401 $ (1,586)
Sales of investments 113 (15,639)
Impairment/Writedowns - (67,214)
AutoBond litigation and AutoBond securities 7,111 -
Other (81) (471)
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$ 7,544 $ (84,910)
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During the six months ending June 30, 2001 the Company resolved litigation
related to AutoBond Acceptance Corporation to the mutual satisfaction of the
parties involved. The Company received $7,111 net of legal fees incurred related
to the litigation. During the six months ended June 30, 2000, the Company
recognized losses of $67,214 related to (i) the permanent impairment in the
carrying value of certain securities, (ii) write-downs to market value of
commercial and multifamily loans held for sale and (iii) the accrual of losses
related to contingent obligations on its off-balance sheet tax-exempt bond
positions. Also, securities with an aggregate principal balance of $34,448 were
sold during the six months ended June 30, 2000 for an aggregate loss of $15,639.
Loss on sale of investments at June 30, 2000 also includes realized losses of
$1,586 related to the sale of $115,231 of commercial loans during the six months
ended June 30, 2000.
NOTE 10 -- COMMITMENTS
The Company makes various representations and warranties relating to the sale or
securitization of loans. To the extent the Company were to breach any of these
representations or warranties, and such breach could not be cured within the
allowable time period, the Company would be required to repurchase such loans,
and could incur losses. In the opinion of management, no material losses are
expected to result from any such representations and warranties.
The Company has made various representations and warranties relating to the sale
of various production operations. To the extent the Company were to breach any
of these representations or warranties, and such breach could not be cured
within the allowable time period, the Company would be required to cover any
losses and expenses up to certain limits. In the opinion of management, no
material losses are expected to result from any such representations and
warranties.
NOTE 11 -- LITIGATION
On November 7, 2000, the Company entered into an Agreement and Plan of Merger
with California Investment Fund, LLC ("CIF"), for the purchase of all of the
equity securities of the Company for $90,000 (the "Merger Agreement"). Among
other things, the Merger Agreement obligated CIF to, deliver to the Company
evidence of commitments for the financing of the acquisition based upon a
predetermined timeline. CIF failed to deliver such evidence of the financing
commitments pursuant to the terms of the Merger Agreement. Pursuant to a letter
dated December 22, 2000, the Company agreed to forbear its right to terminate
the Merger Agreement and extended the timeline. In return, CIF agreed to deliver
written binding financing commitments and evidence of the consent of the holders
of the July 2002 Notes to the merger transaction on or before January 25, 2001.
On January 25, 2001, CIF failed to meet the requirements as set forth in the
Merger Agreement and the letter of December 22, 2000, and the Company terminated
the Merger Agreement effective January 26, 2001 and requested that the escrow
agent release to the Company the $1,000 and 572,178 shares of common stock of
the Company which CIF placed in escrow under the Merger Agreement (the "Escrow
Amount"). On January 29, 2001, the Company filed for Declaratory Judgment in
United States District Court for the Eastern District of Virginia, Alexandria
Division (the "Court"). CIF has filed a counterclaim and demand for jury trial
and asked for damages of $45,000 as both a tort claim and a contract claim. On
April 19, 2001, based on a motion brought by the Company, the Court dismissed
CIF's tort claim for $45,000 of damages, but let such claim remain as a contract
claim. The Company believes that the Agreement is clear that the maximum damages
that CIF may recover from the Company are $2,000. The Company intends to defend
itself vigorously against the counterclaim by CIF, and will seek the release of
the Escrow Amount. The Company does not expect that the resolution of this
matter will have a material effect on its financial statements.
In February 2001, the Company resolved a matter related to AutoBond Acceptance
Corporation to the mutual satisfaction of the parties involved. In connection
with the resolution of this matter, the Company received $7,111, net of related
legal fees.
GLS Capital, Inc. ("GLS"), a subsidiary of the Company, together with the County
of Allegheny, Pennsylvania ("Allegheny County"), were defendants in a lawsuit in
the Commonwealth Court of Pennsylvania (the "Commonwealth Court") wherein the
plaintiffs challenged the right of Allegheny County and GLS to collect certain
interest, costs and expenses related to delinquent property tax receivables in
Allegheny County. This lawsuit was related to the purchase by GLS of delinquent
property tax receivables from Allegheny County in 1997, 1998, and 1999 for
approximately $58,300. On July 5, 2001, the Commonwealth Court ruling addressed,
among other things, (i) the right of the Company to charge to the delinquent
taxpayer a rate of interest of 12% versus 10% on the collection of its
delinquent property tax receivables, (ii) the charging of attorney's fees to the
delinquent taxpayer for the collection of such tax receivables, and (iii) the
charging to the delinquent taxpayer of certain other fees and costs. The
Commonwealth Court remanded for further consideration to the Court of Common
Pleas items (i) and (iii), and ruled that neither Allegheny County nor GLS had
the right to charge attorney's fees to the delinquent taxpayer related to the
collection of such tax receivables, reversing the Court of Common Pleas
decision. GLS and Allegheny County have filed an Application for Reargument of
Appellees with the Commonwealth Court of Pennsylvania. Allegheny County and GLS
are in the process of filing a Petition for Extraordinary Jurisdiction as well
as a Petition for Allowance of Appeal with the Supreme Court of Pennsylvania,
which will seek to reverse the Commonwealth Court's decision. No damages have
been claimed in the action; however, as discussed in Note 4, the decision may
impact the ultimate recoverability of the delinquent property tax receivables.
To date, GLS has incurred attorneys fees of $2 million, approximately $1 million
of which have been reimbursed to GLS by the taxpayer or through liquidation of
the underlying real property.
On May 4, 2001, ACA Financial Guaranty Corporation ("ACA") commenced an action
in the United States District Court for the Southern District of New York (the
"District Court"), (the "Action"), in which ACA sought injunctive relief as well
as money damages of $25,000 based on causes of action for fraudulent conveyance
and breach of contract. The complaint challenged, among other things, the
validity of the March 30, 2001 Supplemental Indenture to the 1997 Senior Note
Indenture as amended ("1997 Indenture") discussed in Note 5, pursuant to which
in 1997 Dynex issued its 7.875% Senior Notes due July 2002. In particular, the
complaint challenged the validity, among other things, of the Purchase
Agreement, and the Supplemental Indenture and the related amendment to certain
restrictive covenants in the Indenture to allow for certain distributions to
holders of Dynex equity securities, including the Preferred Stock. ACA is a
financial guaranty company who has insured $25,000 of the July 2002 Notes for
repayment at maturity on July 15, 2002, for the benefit of the holder of the
Notes. The Company is not a party to this insurance contract. On June 7, 2001,
the District Court granted the Company's cross-motion to dismiss the Action on
the grounds that ACA lacked standing to pursue claims against the Company in its
capacity as an insurer. The District Court dismissed the action without reaching
ACA's request for a preliminary injunction. Subsequently, ACA purchased $1
million of the July 2002 Notes, and on June 12, 2001, filed a motion for
reconsideration of the order dismissing the Action. On July 30, 2001, the
District Court granted ACA leave to file an amended complaint in its capacity as
a Note holder, and stated that it would consider the parties' arguments with
respect to a preliminary injunction. The Company is vigorously opposing the
Action and believes it to be without merit.
The Company is also subject to other lawsuits or claims which have arisen in the
ordinary course of its business, some of which seek damages in amounts which
could be material to the financial statements. Although no assurance can be
given with respect to the ultimate outcome of any such litigation or claim, the
Company believes the resolution of such lawsuits or claims will not have a
material effect on the Company's consolidated balance sheet, but could
materially affect consolidated results of operations in a given year.
NOTE 12 -- RELATED PARTY TRANSACTIONS
During 2000, Dynex REIT had a credit arrangement with DHI whereby DHI and any of
DHI's subsidiaries could borrow funds from Dynex REIT to finance its operations.
Under this arrangement, Dynex REIT could also borrow funds from DHI. The terms
of the agreement allowed DHI and its subsidiaries to borrow up to $50 million
from Dynex REIT at a rate of Prime plus 1.0%. Dynex REIT could borrow up to $50
million from DHI at a rate of one-month LIBOR plus 1.0%. Effective with the
liquidation of DHI at December 31, 2000, this credit agreement was terminated.
Net interest expense under this agreement was $754 for the six months ended June
30, 2000.
Dynex REIT has entered into subservicing agreements with Dynex Commercial
Services, Inc. ("DCSI"), and GLS Capital Services, Inc ("GLS") to service
commercial, single family, consumer, manufactured housing loans and property tax
receivables. DCSI and GLS were subsidiaries of DHI in 2000, and are now
subsidiaries of Dynex REIT. For servicing the commercial loans, DSCI receives an
annual servicing fee of 0.02% of the aggregate unpaid principal balance of the
loans. For servicing the property tax receivables, GLS receives an annual
servicing fee of 0.72% of the aggregate unpaid principal balance of the property
tax receivables. Servicing fees paid by Dynex REIT under such agreements were
$143 during the six months ended June 30, 2000 and $38 during the same period
ended June 30, 2001.
The Company has made a loan to Thomas H. Potts, president of the Company, as
evidenced by a demand promissory note in the aggregate principal amount of $935
(the "Potts Note"). Mr. Potts directly owns 399,502 shares of common stock of
the Company, all of which have been pledged as collateral to secure the Potts
Note. Interest is charged on the Potts Note at the applicable short-term monthly
applicable federal rate (commonly known as the AFR Rate) as published by the
Internal Revenue Service. As of June 30, 2001 and December 31, 2000, the
outstanding balance of the Potts Note was $577 and $687, respectively, and
interest was current.
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Dynex Capital, Inc. (the "Company") is a financial services company
that invests in a portfolio of securities and investments backed principally by
single family mortgage loans, commercial mortgage loans and manufactured housing
installment loans. Such loans have been funded generally by the Company's loan
production operations or purchased in bulk in the market. Loans funded through
the Company's production operations have generally been pooled and pledged as
collateral using a collateralized bond security structure, which provides
long-term financing for the loans while limiting credit, interest rate and
liquidity risk.
FINANCIAL CONDITION
(amounts in thousands except per share data)
================================================================================
June 30, 2001 December 31, 2000
- --------------------------------------------------------------------------------
Investments:
Collateral for collateralized bonds $ 2,722,844 $ 3,042,158
Securities 9,193 9,364
Other investments 31,857 42,284
Loans held for sale 3,429 19,102
Non-recourse debt - collateralized bonds 2,540,164 2,856,728
Recourse debt 71,578 134,168
Shareholders' equity 175,703 157,131
================================================================================
Collateral for collateralized bonds
Collateral for collateralized bonds consists primarily of securities
backed by adjustable-rate and fixed-rate mortgage loans secured by first liens
on single family housing, fixed-rate loans secured by first liens on multifamily
and commercial properties, manufactured housing installment loans secured by
either a UCC filing or a motor vehicle title and property tax receivables. As of
June 30, 2001, the Company had 24 series of collateralized bonds outstanding.
The collateral for collateralized bonds decreased to $2.72 billion at June 30,
2001 compared to $3.04 billion at December 31, 2000. This decrease of $0.32
billion is primarily the result of $315.7 million in paydowns on the collateral.
Securities
Securities consist primarily of adjustable-rate and fixed-rate
mortgage-backed securities. Securities also include derivative and residual
securities. Securities declined slightly during the six months ended June 30,
2001, from paydowns, which was partially offset by the improvement in the market
value of the underlying securities during the quarter.
Other investments
Other investments at June 30, 2001 consist primarily of property tax
receivables. Other investments decreased from $42.3 million at December 31, 2000
to $31.9 million at June 30, 2001. This decrease is primarily the result of the
receipt of the final $9.5 million annual principal payment on the note
receivable from the 1996 sale of the Company's single family mortgage
operations.
Loans held for sale
Loans held for sale, which consists principally of commercial mortgage
and mezzanine loans on healthcare facilities at June 30, 2001, decreased from
$19.1 million at December 31, 2000 to $3.4 million at June 30, 2001 as the
result of the sale of loans during the first six months of the year. These loans
are carried at the lower of cost or market.
Non-recourse debt
Collateralized bonds issued by Dynex REIT are recourse only to the
assets pledged as collateral, and are otherwise non-recourse to Dynex REIT.
Collateralized bonds decreased from $2.9 billion at December 31, 2000 to $2.5
billion at June 30, 2001. This decrease was primarily a result of principal
payments received on the associated collateral pledged which were used to pay
down the collateralized bonds in accordance with the respective indentures.
Recourse debt
Recourse debt decreased to $71.6 million at June 30, 2001 from $134.2
million at December 31, 2000. This decrease was due to a $40.5 million of
principal repayments made on the July 2002 Notes, $21.8 million of repayments
made on repurchase agreements and the $2.0 million payoff of the Dominion note.
Shareholders' equity
Shareholders' equity increased to $175.7 million at June 30, 2001 from
$157.1 million at December 31, 2000. This increase was a combined result of a
$16.7 million decrease in the net unrealized loss on investments
available-for-sale from $124.6 million at December 31, 2000 to $107.9 million at
June 30, 2001 and net income of $14.4 million during the six months ended June
30, 2001. This was partially offset by the completion of the tender offer on
Preferred Stock completed in June 2001, which reduced shareholders' equity by
$11.0 million.
RESULTS OF OPERATIONS
Three and Six Months Ended June 30, 2001 Compared to Three and Six Months Ended
June 30, 2000. The increase in net income and net income per common share during
the three and six months ended June 30, 2001 as compared to the same period in
2000 is primarily the result of several positive non-recurring items in 2001,
including the favorable settlement of litigation, and an extraordinary gain
related to the early extinguishment of $38.9 million of the Company's July 2002
Notes, versus losses in 2000 resulting from the sale/write-down of certain
securities, the writedown of certain commercial mortgage loans held for sale,
and the accrual of losses on certain off-balance sheet tax-exempt bond
positions. In addition, basic and diluted earnings per common share for the
second quarter 2001 reflect the discount to book value of the purchase price of
the Company's Series A, Series B, and Series C Preferred Stock tendered pursuant
to the tender offer for the Preferred Stock completed on June 8, 2001, and the
associated cumulative dividend in arrears on those tendered shares, which were
cancelled.
Net interest margin for the six months ended June 30, 2001 increased to
$10.3 million from $7.9 million for the same period for 2000. This increase was
primarily the result of an increase in net interest spread from 0.65% for the
six months ending June 30, 2000 to 1.16% for the six months ended June 30, 2001,
offset by the decline in average interest-earning assets from $4.0 billion for
the six months ended June 30, 2000 to $3.0 billion for the six months ended June
30, 2001. In addition, provision for losses increased to $13.2 million during
the six months ended June 30, 2001 compared to $10.8 million during the six
months ended June 30, 2000. This increase in provision for losses was a result
of increasing the reserve for probable losses on various manufactured housing
loan pools pledged as collateral for collateralized bonds where the Company has
retained credit risk.
Net gain (loss) on sales, write-downs, impairment charges and
litigation improved $92.4 million, from a loss of $84.9 million during the six
months ended June 30, 2000, to a gain of $7.5 million during the six months
ended June 30, 2001. During 2001, the Company favorably resolved litigation for
$7.1 million net of legal expenses. During the six months ended June 30, 2000,
the Company recognized losses of $67.2 million related to (i) the permanent
impairment in the carrying value of certain securities, (ii) write-downs to
market value of commercial and multifamily loans held for sale and (iii) the
accrual of losses related to contingent obligations on its off-balance sheet
tax-exempt bond positions. Also, securities with an aggregate principal balance
of $34.4 million were sold during the six months ended June 30, 2000 for an
aggregate loss of $13.9 million. The Company also realized losses of $1.6
million related to the sale of $115.2 million of commercial loans during the six
months ended June 30, 2000.
The following table summarizes the average balances of interest-earning
assets and their average effective yields, along with the average
interest-bearing liabilities and the related average effective interest rates,
for each of the periods presented.
Average Balances and Effective Interest Rates
================================================================================
The net interest spread increased 0.85%, to 1.31% for the three months
ended June 30, 2001 from 0.46% for the same period in 2000. The net interest
spread for the six months ended June 30, 2001 also improved relative to the same
period in 2000, to 1.16% from 0.65%. The improvement in the Company's net
interest spread can be attributed to a decline in the cost of interest-bearing
liabilities for the respective 2001 periods, which have declined as One-Month
LIBOR has declined (although not as sharply) reflecting the recent reduction in
short-term interest rates by the Federal Reserve. The majority of the Company's
interest-bearing liabilities are priced relative to One-Month LIBOR.
Interest-bearing liability costs declined 0.83% and 0.28% for the three and
six-month periods ended June 30, 2001, compared to the same periods in 2000. For
both the three and six month periods ended June 30, 2001, there has been little
to no corresponding decline in the effective interest-earning yield on the
collateral for collateralized bonds due to the `reset' lag (the loans generally
adjust or `reset' every six or twelve months) on the approximate $1 billion in
single-family ARM loans that comprise a portion of the collateral for
collateralized bonds. The Company would expect yields on its interest-earning
assets for the balance of 2001 to decline relative to the first six-months of
2001.
Over the past 18 months as the Company continued to reduce its operations
and sold various assets, total interest-earning assets and interest-bearing
liabilities have measurably declined and the mix of the investment portfolio has
changed. For the three months ended June 30, 2001 compared to the three months
ended June 30, 2000, average interest-earning assets declined $884 million, or
approximately 23%. The decline for the six-month period was $933 million, or
approximately 23%. A large portion of such reduction relates to paydowns on the
Company's adjustable-rate single-family mortgage loans and the sale of
fixed-rate commercial mortgage loans that were held for sale. The Company's
portfolio now consists of $909.8 million of adjustable rate assets and $1.9
billion of fixed-rate assets. The Company currently finances approximately
$191.2 million of the fixed-rate assets with non-recourse LIBOR based
floating-rate liabilities, and to the extent that short-term rates continue to
decline, the Company's net interest spread should continue to benefit. Once
rates stabilize, however, the remaining single-family ARM loans should continue
to reset downwards in rate which will have the impact of reducing net interest
spread in future periods.
Interest Income and Interest-Earning Assets
At June 30, 2001, $1.85 billion of the investment portfolio consists of
loans which pay a fixed-rate of interest. Also at June 30, 2001, approximately
$1 billion of the investment portfolio is comprised of loans or securities that
have coupon rates which adjust over time (subject to certain periodic and
lifetime limitations) in conjunction with changes in short-term interest rates.
Approximately 65% of the ARM loans underlying the ARM securities and collateral
for collateralized bonds are indexed to and reset based upon the level of
six-month LIBOR; approximately 25% of the ARM loans are indexed to and reset
based upon the level of the one-year Constant Maturity Treasury (CMT) index. The
following table presents a breakdown, by principal balance, of the Company's
collateral for collateralized bonds and ARM and fixed mortgage securities by
type of underlying loan. This table excludes derivative and residual securities,
other investments and loans held for sale.
Investment Portfolio Composition (1)
($ in millions)
================================================================================
The average asset yield is reduced for the amortization of premiums,
net of discounts on the investment portfolio. As indicated in the table below,
net premium on the collateral for collateralized bonds, ARM securities,
fixed-rate mortgage securities at June 30, 2001 was $25.7 million, or
approximately 0.92% of the aggregate balance of collateral for collateralized
bonds, ARM securities and fixed-rate securities. The $25.7 million net premium
consists of gross collateral premiums of $54.1 million, less gross collateral
discounts of $28.4 million. Of the $54.1 million in gross premiums on
collateral, $35.4 million relates to the premium on multifamily and commercial
mortgage loans with a principal balance of $811.9 million at June 30, 2001, and
that have average initial prepayment lockouts or yield maintenance for at least
ten years. Net premium on such multifamily and commercial loans is $28.7
million. Amortization expense as a percentage of principal paydowns has
decreased from 1.56% for the three months ended June 30, 2000 to 1.31% for the
same period in 2001. The principal prepayment rate for the Company (indicated in
the table below as "CPR Annualized Rate") was approximately 28% for the three
months ended June 30, 2001. CPR or "constant prepayment rate" is a measure of
the annual prepayment rate on a pool of loans.
Premium Basis and Amortization
($ in millions)
================================================================================
Credit Exposures
The Company securitizes its loan production into collateralized bonds
or pass-through securitization structures. With either structure, the Company
may use overcollateralization, subordination, third-party guarantees, reserve
funds, bond insurance, mortgage pool insurance or any combination of the
foregoing as a form of credit enhancement. With all forms of credit enhancement,
the Company may retain a limited portion of the direct credit risk after
securitization.
The following table summarizes the aggregate principal amount of collateral
for collateralized bonds and ARM and fixed-rate mortgage pass-through securities
outstanding; the direct credit exposure retained by the Company (represented by
the amount of overcollateralization pledged and subordinated securities owned by
the Company and rated below BBB by one of the nationally recognized rating
agencies), net of the credit reserves maintained by the Company for such
exposure; and the actual credit losses incurred for each year. Credit reserves
maintained by the Company and included in the table below includes third-party
reimbursement guarantees of $30.3 million. The table excludes any risks related
to representations and warranties made on loans funded by the Company and
securitized in mortgage pass-through securities generally funded prior to 1995.
This table also excludes any credit exposure on loans held for sale or
securitization, and other investments. The Company's credit exposure declines
principally as a result of charge-offs against the Company's investment in the
respective security structure, and the amount of provision for losses that the
Company records during the period relative to such charge-offs.
The Company is currently engaged in a dispute with the counterparty to
the $30.3 million in reimbursement guarantees. Such guarantees are payable when
cumulative loss trigger levels are reached on certain of the Company's
single-family mortgage loan securitizations. Currently, these trigger levels
have been reached on four of the Company's securities, and the Company has made
claims under the reimbursement guarantees in amounts approximating $1.7 million.
The counterparty has denied payment on these claims, citing various deficiencies
in loan underwriting which would render these loans and corresponding claims
ineligible under the reimbursement agreements. The Company disputes this
classification and is pursuing this matter through court-ordered arbitration.
Credit Reserves and Actual Credit Losses
($ in millions)
================================================================================
- --------------------------------------------------------------------------------
The following table summarizes single family mortgage loan,
manufactured housing loan and commercial mortgage loan delinquencies as a
percentage of the outstanding collateral balance for those securities in which
Dynex REIT has retained a portion of the direct credit risk. The delinquencies
as a percentage of the outstanding collateral balance have decreased to 1.74% at
June 30, 2001 from 1.86% at June 30, 2000. The Company monitors and evaluates
its exposure to credit losses and has established reserves based upon
anticipated losses, general economic conditions and trends in the investment
portfolio. As of June 30, 2001, management believes the credit reserves are
sufficient to cover anticipated losses that may occur as a result of current
delinquencies presented in the table below.
Delinquency Statistics (1)
================================================================================
Recent Accounting Pronouncements
Statement of Financial Accounting Standards ("FAS") No. 133, "Accounting
for Derivative Instruments and Hedging Activities" is effective for all fiscal
years beginning after June 15, 2000. FAS No. 133, as amended, establishes
accounting and reporting standards for derivative instruments, including certain
derivative instruments embedded in other contracts, and for hedging activities.
The Company adopted FAS No. 133 effective January 1, 2001. The adoption of FAS
No. 133 did not have a significant impact on the financial position, results of
operations, or cash flows of the Company.
In September 2000, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 140, "Accounting for Transfers
and Servicing of Financial Assets and Extinguishment of Liabilities" ("FAS No.
140"). FAS No. 140 replaces the Statement of Financial Accounting Standards No.
125 "Accounting for the Transfers and Servicing of Financial Assets and
Extinguishment of Liabilities" ("FAS No. 125"). FAS No. 140 revises the
standards for accounting for securitization and other transfers of financial
assets and collateral and requires certain disclosure, but it carries over most
of FAS No. 125 provisions without reconsideration. FAS No. 140 is effective for
transfers and servicing of financial assets and extinguishment of liabilities
occurring after March 31, 2001. FAS No. 140 is effective for recognition and
reclassification of collateral and for disclosures relating to securitization
transactions and collateral for fiscal years ending after December 15, 2000.
Disclosures about securitization and collateral accepted need not be reported
for periods ending on or before December 15, 2000, for which financial
statements are presented for comparative purposes. FAS No. 140 is to be applied
prospectively with certain exceptions. Other than those exceptions, earlier or
retroactive application of its accounting provision is not permitted. The
adoption of FAS No. 140 did not have a material impact on the Company's
financial statements.
In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard (SFAS) No. 141, Business Combinations. SFAS No.
141 requires that all business combinations initiated after June 30, 2001 be
accounted for under the purchase method and addresses the initial recognition
and measurement of goodwill and other intangible assets acquired in a business
combination. Business combinations originally accounted for under the pooling of
interest method will not be changed. Management does not expect the adoption of
SFAS 141 to have an impact on the financial position, results of operations or
cash flows of the Company.
In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard (SFAS) No. 142, Goodwill and Other Intangible
Assets. SFAS No. 142 addresses the initial recognition and measurement of
intangible assets acquired outside of a business combination and the accounting
for goodwill and other intangible assets subsequent to their acquisition. SFAS
No. 142 provides that intangible assets with finite useful lives be amortized
and that goodwill and intangible assets with indefinite lives will not be
amortized, but will rather be tested at least annually for impairment. As the
company has no goodwill or intangible assets which it is amortizing, the
adoption of SFAS No. 142 will have no effect on the financial position, results
of operations or cash flows of the Company.
LIQUIDITY AND CAPITAL RESOURCES
The Company has historically financed its operations from a variety of
sources. These sources have included cash flow generated from the investment
portfolio, including net interest income and principal payments and prepayments,
common stock offerings through the dividend reinvestment plan, short-term
warehouse lines of credit with commercial and investment banks, repurchase
agreements and the capital markets via the asset-backed securities market (which
provides long-term non-recourse funding of the investment portfolio via the
issuance of collateralized bonds). Historically, cash flow generated from the
investment portfolio has satisfied its working capital needs, and the Company
has had sufficient access to capital to fund its loan production operations, on
both a short-term (prior to securitization, and recourse) and long-term (after
securitization, and non-recourse) basis. However, market conditions since
October 1998 have substantially reduced the Company's access to capital. The
Company has been unable to access short-term warehouse lines of credit, and,
with the possible exception for the resecuritization of seasoned loans in its
investment portfolio, has been unable to efficiently access the asset-backed
securities market to meet its long-term funding needs. Largely as a result of
its inability to access additional capital, the Company sold its manufactured
housing and model home purchase/leaseback operations in 1999, and ceased issuing
new commitments in its commercial lending operations. Since 1999, the Company
has focused on substantially reducing its recourse debt and minimizing its
capital requirements. The Company has made substantial progress in both areas
since 1999, and based upon its expected investment portfolio cash flows, and
anticipated proceeds from the sale or resecuritization of assets, the Company
anticipates that it will repay all of its recourse debt obligations in
accordance with their respective terms.
Non-recourse Debt
Dynex REIT, through limited-purpose finance subsidiaries, has issued
non-recourse debt in the form of collateralized bonds to fund the majority of
its investment portfolio. The obligations under the collateralized bonds are
payable solely from the collateral for collateralized bonds and are otherwise
non-recourse to Dynex REIT. Collateral for collateralized bonds is not subject
to margin calls. The maturity of each class of collateralized bonds is directly
affected by the rate of principal prepayments on the related collateral. Each
series is also subject to redemption according to specific terms of the
respective indentures, generally when the remaining balance of the bonds equals
35% or less of the original principal balance of the bonds. At June 30, 2001,
Dynex REIT had $2.5 billion of collateralized bonds outstanding.
Recourse Debt
The Company also uses repurchase agreements to finance a portion of its
investments. Repurchase agreements allow the Company to sell investments for
cash together with a simultaneous agreement to repurchase the same investments
on a specified date for a price that is equal to the original sales price plus
an interest component. At June 30, 2001, the Company had repurchase agreements
outstanding of $13.0 million, all with Lehman Brothers, Inc. (Lehman). These
repurchase agreements remain on an "overnight" or one-day basis, and were
secured by securities with an unpaid principal balance of approximately $99
million, and an estimated fair value of approximately $67 million. The majority
of these securities are rated investment grade.
Increases in short-term interest rates, long-term interest rates or
market risk could negatively impact the valuation of securities and may limit
the Company's borrowing ability or cause Lehman to initiate margin calls for
securities financed using repurchase agreements. Additionally, certain
investments are classes of securities rated AA, A or BBB that are subordinated
to other classes from the same series of securities, and which further may be
secured by less liquid collateral such as delinquent property tax receivables.
These classes of securities may have less liquidity than classes of securities
that are not subordinated, and the value of such classes is more dependent on
the credit rating of the related insurer or the credit performance of the
underlying loans or receivables. In instances of a downgrade of an insurer or
the deterioration of the credit quality of the underlying collateral, the
Company may be required to sell certain investments in order to maintain
liquidity. If required, these sales could be made at prices lower than the
carrying value of the assets, which could result in losses.
As of June 30, 2001, the Company has $58.4 million outstanding of its
senior notes issued in July 1997 and due July 15, 2002 (the "July 2002 Notes").
On March 30, 2001, the Company entered into an amendment to the related
indenture governing the July 2002 Notes whereby the Company pledged to the
Trustee of the July 2002 Notes substantially all of the Company's unencumbered
assets and the stock of its subsidiaries. In consideration of this pledge, the
indenture was further amended to provide for the release of the Company from
certain covenant restrictions in the indenture, and specifically provided for
the Company's ability to make distributions on its capital stock in an amount
not to exceed the sum of (a) $26 million, (b) the cash proceeds of any
"permitted subordinated indebtedness", (c) the cash proceeds of the issuance of
any "qualified capital stock", and (d) any distributions required in order for
the Company to maintain its REIT status. In addition, the Company entered into a
Purchase Agreement with holders of 50.1% of the July 2002 Notes which require
the Company to purchase, and such holders to sell, their respective July 2002
Notes at various discounts based on a computation of the Company's available
cash. The discounts provided for under the Purchase Agreement are as follows: by
April 15, 2001, 10%; by July 15, 2001, 8%; by October 15, 2001, 6%; by January
15, 2002, 4%; by March 1, 2002, 2%; thereafter until maturity, 0%. Through June
30, 2001, the Company has retired $38,885 of July 2002 Notes for $35,185 in cash
under the Purchase Agreement.
Table 1
Net Balance Sheet (1)
($ in thousands)
FORWARD-LOOKING STATEMENTS
Certain written statements in this Form 10-Q made by the Company, that are
not historical fact constitute "forward-looking statements" within the meaning
of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. Such forward-looking statements may
involve factors that could cause the actual results of the Company to differ
materially from historical results or from any results expressed or implied by
such forward-looking statements. The Company cautions the public not to place
undue reliance on forward-looking statements, which may be based on assumptions
and anticipated events that do not materialize. The Company does not undertake,
and the Securities Litigation Reform Act specifically relieves the Company from,
any obligation to update any forward-looking statements.
Factors that may cause actual results to differ from historical results or
from any results expressed or implied by forward-looking statements include the
following:
Economic Conditions. The Company is affected by general economic
conditions. The risk of defaults and credit losses could increase during an
economic slowdown or recession. This could have an adverse effect on the
Company's financial performance and the performance on the Company's securitized
loan pools.
Capital Resources. The Company relies on a repurchase facility with an
investment banking firm to meet its remaining short-term funding needs. This
repurchase facility is currently on an overnight maturity basis. The Company's
access to alternative or additional sources of financing has been significantly
reduced.
Capital Markets. The Company relies on the capital markets for the sale
upon securitization of its collateralized bonds or other types of securities.
While the Company has historically been able to sell such collateralized bonds
and securities into the capital markets, the Company's access to capital markets
has been substantially reduced, which may impair the Company's ability to
re-securitize its existing securitizations in the future.
Interest Rate Fluctuations. The Company's income depends on its ability to
earn greater interest on its investments than the interest cost to finance these
investments. Interest rates in the markets served by the Company generally rise
or fall with interest rates as a whole. A majority of the loans currently
pledged as collateral for collateralized bonds by the Company are fixed-rate.
The Company currently finances these fixed-rate assets through non-recourse
debt, $191.2 million of which is variable rate. In addition, a significant
amount of the investments held by the Company are variable rate collateral for
collateralized bonds. These investments are financed through non-recourse
long-term collateralized bonds and, to a lesser extent, recourse short-term
repurchase agreements. The net interest spread for these investments could
decrease during a period of rapidly rising short-term interest rates, since the
investments generally have periodic interest rate caps and the related borrowing
have no such interest rate caps.
Defaults. Defaults by borrowers on loans included in the Company's
investment portfolio may have an adverse impact on the Company's financial
performance, if actual credit losses differ materially from estimates made by
the Company. The Company's allowance for losses is calculated on the basis of
historical experience, industry data, and management's estimates. Actual default
rates or loss severities may differ from the Company's estimate for a variety of
reasons, including economic conditions. Actual defaults on ARM loans may
increase during a rising interest rate environment. The Company believes that
its reserves are adequate for such risks on loans that were delinquent as of
June 30, 2001.
Prepayments. Prepayments by borrowers on loans securitized by the Company
may have an adverse impact on the Company's financial performance. Prepayments
are expected to increase during a declining interest rate or flat yield curve
environment. The Company's exposure to rapid prepayments is primarily (i) the
faster amortization of premium on the investments and, to the extent applicable,
amortization of bond discount, and (ii) the more rapid decline in its portfolio
of earning assets.
Competition. The financial services industry is a highly competitive
market. Increased competition in the market has adversely affected the Company,
and may continue to do so.
Regulatory Changes. The Company's businesses as of June 30, 2001 are not
subject to any material federal or state regulation or licensing requirements.
However, changes in existing laws and regulations or in the interpretation
thereof, or the introduction of new laws and regulations, could adversely affect
the Company and the performance of the Company's securitized loan pools or its
ability to collect on its delinquent property tax receivables.
Risks and Uncertainties. See Note 1 to the Company's audited financial
statements for the year ended December 31, 2000.
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk generally represents the risk of loss that may result from
the potential change in the value of a financial instrument due to fluctuations
in interest and foreign exchange rates and in equity and commodity prices.
Market risk is inherent to both derivative and non-derivative financial
instruments, and accordingly, the scope of the Company's market risk management
extends beyond derivatives to include all market risk sensitive financial
instruments. As a financial services company, net interest income comprises the
primary component of the Company's earnings. As a result, the Company is subject
to risk resulting from interest rate fluctuations to the extent that there is a
gap between the amount of the Company's interest-earning assets and the amount
of interest-bearing liabilities that are prepaid, mature or re-price within
specified periods. The Company's strategy has been to mitigate interest rate
risk through the creation of a diversified investment portfolio of high quality
assets that, in the aggregate, preserves the Company's capital base while
generating stable income in a variety of interest rate and prepayment
environments.
The Company monitors the aggregate cash flow, projected net yield and
market value of its investment portfolio under various interest rate and
prepayment assumptions. While certain investments may perform poorly in an
increasing or decreasing interest rate environment, other investments may
perform well, and others may not be impacted at all.
The Company measures the sensitivity of its net interest income,
excluding various accounting adjustments including provision for losses, and
premium and discount amortization, to changes in interest rates. Changes in
interest rates are defined as instantaneous, parallel, and sustained interest
rate movements in 100 basis point increments. The Company estimates its interest
income for the next twelve months assuming no changes in interest rates from
those at period end. Once the base case has been estimated, cash flows are
projected for each of the defined interest rate scenarios. Those scenario
results are then compared against the base case to determine the estimated
change to net interest income, excluding various accounting adjustments as set
forth above.
The following table summarizes the Company's net interest margin
sensitivity analysis as of June 30, 2001. This analysis represents management's
estimate of the percentage change in net interest margin given a parallel shift
in interest rates. The "Base" case represents the interest rate environment as
it existed as of June 30, 2001. The analysis is heavily dependent upon the
assumptions used in the model. The effect of changes in future interest rates,
the shape of the yield curve or the mix of assets and liabilities may cause
actual results to differ from the modeled results. In addition, certain
financial instruments provide a degree of "optionality." The model considers the
effects of these embedded options when projecting cash flows and earnings. The
most significant option affecting the Company's portfolio is the borrowers'
option to prepay the loans. The model applies prepayment rate assumptions
representing management's estimate of prepayment activity on a projected basis
for each collateral pool in the investment portfolio. While the Company's model
considers these factors, the extent to which borrowers utilize the ability to
exercise their option may cause actual results to significantly differ from the
analysis. Furthermore, its projected results assume no additions or subtractions
to the Company's portfolio, and no change to the Company's liability structure.
Historically, there have been significant changes in the Company's assets and
liabilities, and there are likely to be such changes in the future.
Basis Point % Change in Net
Increase (Decrease) in Interest Margin
Interest Rates from Base Case
- -------------------------- -----------------------
+200 (7.7)%
+100 (3.0)%
Base
- -100 3.2%
- -200 9.0%
The Company's investment policy sets forth guidelines for assuming
interest rate risk. The investment policy stipulates that given a 200 basis
point increase or decrease in interest rates over a twelve month period, the
estimated net interest margin may not change by more than 25% of current net
interest margin during the subsequent one year period. The Company is in
compliance with such investment policy.
Approximately $0.91 billion of the Company's investment portfolio as of
June 30, 2001 is comprised of loans or securities that have coupon rates which
adjust over time (subject to certain periodic and lifetime limitations) in
conjunction with changes in short-term interest rates. Approximately 65% and 25%
of the ARM loans underlying the Company's ARM securities and collateral for
collateralized bonds are indexed to and reset based upon the level of six-month
LIBOR and one-year CMT, respectively.
Generally, during a period of rising short-term interest rates, the
Company's net interest spread earned on its investment portfolio will decrease.
The decrease of the net interest spread results from (i) the lag in resets of
the ARM loans underlying the ARM securities and collateral for collateralized
bonds relative to the rate resets on the associated borrowings and (ii) rate
resets on the ARM loans which are generally limited to 1% every six months or 2%
every twelve months and subject to lifetime caps, while the associated
borrowings have no such limitation. As short-term interest rates stabilize and
the ARM loans reset, the net interest margin may be restored to its former level
as the yields on the ARM loans adjust to market conditions. Conversely, net
interest margin may increase following a fall in short-term interest rates. This
increase may be temporary as the yields on the ARM loans adjust to the new
market conditions after a lag period. In each case, however, the Company expects
that the increase or decrease in the net interest spread due to changes in the
short-term interest rates to be temporary. The net interest spread may also be
increased or decreased by the proceeds or costs of interest rate swap, cap or
floor agreements, to the extent that the Company has entered into such
agreements.
The remaining portion of the Company's investments portfolio as of June
30, 2001, approximately $1.85 billion, is comprised of loans or securities that
have coupon rates that are fixed. The Company has substantially limited its
interest rate risk on such investments through (i) the issuance of fixed-rate
collateralized bonds and notes payable which approximated $1.4 billion as of
June 30, 2001, and (ii) equity, which was $175.7 million. Overall, the Company's
interest rate risk is related both to the rate of change in short term interest
rates, and to the level of short-term interest rates.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
On November 7, 2000, the Company entered into an Agreement and Plan of Merger
with California Investment Fund, LLC ("CIF"), for the purchase of all of the
equity securities of the Company for $90 million (the "Merger Agreement"). Among
other things, the Merger Agreement obligated CIF todeliver to the Company
evidence of commitments for the financing of the acquisition based upon a
predetermined timeline. CIF failed to deliver such evidence of the financing
commitments pursuant to the terms of the Merger Agreement. Pursuant to a letter
dated December 22, 2000, the Company agreed to forbear its right to terminate
the Merger Agreement and extended the timeline. In return, CIF agreed to deliver
written binding financing commitments and evidence of the consent of the holders
of the July 2002 Notes to the merger transaction on or before January 25, 2001.
On January 25, 2001, CIF failed to meet the requirements as set forth in the
Merger Agreement and the letter of December 22, 2000, and the Company terminated
the Merger Agreement effective January 26, 2001 and requested that the escrow
agent release to the Company the $1 million and 572,178 shares of common stock
of the Company which CIF placed in escrow under the Merger Agreement (the
"Escrow Amount"). On January 29, 2001, the Company filed for Declaratory
Judgment in United States District Court for the Eastern District of Virginia,
Alexandria Division (the "Court"). CIF has filed a counterclaim and demand for
jury trial and asked for damages of $45 million. On April 19, 2001, on a motion
brought by the Company, the Court dismissed CIF's claim for $45 million of
damages, but let such claim remain as a contract claim. The Company believes
that the Agreement is clear that the maximum damages that CIF may recover from
the Company are $2 million. The Company intends to defend itself vigorously
against the counterclaim by CIF, and will seek the release of the Escrow Amount.
The Company does not expect that the resolution of this matter will have a
material effect on its financial statements.
GLS Capital, Inc. ("GLS"), a subsidiary of the Company, together with the County
of Allegheny, Pennsylvania ("Allegheny County"), were defendants in a lawsuit in
the Commonwealth Court of Pennsylvania (the "Commonwealth Court") wherein the
plaintiffs challenged the right of Allegheny county and GLS to collect certain
interest, costs and expenses related to delinquent property tax receivables in
Allegheny County. This lawsuit was related to the purchase by GLS of delinquent
property tax receivables from Allegheny County in 1997, 1998 and 1999 for
approximately $58.3 million. On July 5, 2001, the Commonwealth Court ruling
addressed, among other things, (i) the right of the Company to charge to the
delinquent taxpayer a rate of interest of 12% versus 10% on the collection of
its delinquent property tax receivables, (ii) the charging of attorney's fees to
the delinquent taxpayer for the collection of such tax receivables, and (iii)
the charging to the delinquent taxpayer of certain other fees and costs. The
Commonwealth Court remanded for further consideration to the Court of Common
Pleas items (i) and (iii), and ruled that neither Allegheny County nor GLS had
the right to charge attorney's fees to the delinquent taxpayer related to the
collection of such tax receivables, reversing the Court of Common Pleas
decision. GLS and Allegheny County have filed an Application for Reargument of
Appellees with the Commonwealth Court of Pennsylvania. Allegheny County and GLS
are in the process of filing a Petition for Extraordinary Jurisdiction as well
as a Petition for Allowance of Appeal with the Supreme Court of Pennsylvania,
which will seek to reverse the Commonwealth Court's decision. No damages have
been claimed in the action; however, as discussed in Note 4, the decision may
impact the ultimate recoverability of the delinquent property tax receivables.
To date, GLS has incurred attorneys fees of $2 million, approximately $1 million
of which have been reimbursed to GLS by the taxpayer or through liquidation of
the underlying real property.
On May 4, 2001, ACA Financial Guaranty Corporation ("ACA") commenced an action
in the United States District Court for the Southern District of New York (the
"District Court"), (the "Action"), in which ACA sought injunctive relief as well
as money damages of $25 million based on causes of action for fraudulent
conveyance and breach of contract. The complaint challenged, among other things,
the validity of the March 30, 2001 Supplemental Indenture to the 1997 Senior
Note Indenture as amended ("1997 Indenture") discussed in Note 5, pursuant to
which in 1997 Dynex issued its 7.875% Senior Notes due July 2002. In particular,
the complaint challenged the validity, among other things, of the Purchase
Agreement, and the Supplemental Indenture and the related amendment to certain
restrictive covenants in the Indenture to allow for certain distributions to
holders of Dynex equity securities, including the Preferred Stock. ACA is a
financial guaranty company who has insured $25 million of the July 2002 Notes
for repayment at maturity on July 15, 2002, for the benefit of the holder of the
Notes. The Company is not a party to this insurance contract. On June 7, 2001,
the District Court granted the Company's cross-motion to dismiss the Action on
the grounds that ACA lacked standing to pursue claims against the Company in its
capacity as an insurer. The District Court dismissed the action without reaching
ACA's request for a preliminary injunction. Subsequently, ACA purchased $1
million of the July 2002 Notes, and on June 12, 2001, filed a motion for
reconsideration of the order dismissing the Action. On July 30, 2001, the
District Court granted ACA leave to file an amended complaint in its capacity as
a Note holder, and stated that it would consider the parties' arguments with
respect to a preliminary injunction. The Company is vigorously opposing the
Action and believes it to be without merit.
The Company is also subject to other lawsuits or claims which arise in the
ordinary course of its business, some of which seek damages in amounts which
could be material to the financial statements. Although no assurance can be
given with respect to the ultimate outcome of any such litigation or claim, the
Company believes the resolution of such lawsuits or claims will not have a
material effect on the Company's consolidated balance sheet, but could
materially affect consolidated results of operations in a given year.
Item 2. Changes in Securities and Use of Proceeds
Not applicable
Item 3. Defaults Upon Senior Securities
Not applicable
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
None
(b) Reports on Form 8-K
Current Report on Form 8-K as filed with the Commission on
April 6, 2001, regarding (i) the Purchase Agreement by and
among Dynex Capital, Inc. and the holders of a majority of the
outstanding principal amount of its 7.875% senior notes due
July 15, 2002, and (ii) the approval of an amendment to the
related indenture of senior notes.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DYNEX CAPITAL, INC.
By: /s/ Thomas H. Potts
-------------------------------------
Thomas H. Potts, President
(authorized officer of registrant)
/s/ Stephen J. Benedetti
-------------------------------------
Stephen J. Benedetti,
Vice President, Treasurer
(principal accounting officer)
Dated: August 10, 2001