10-Q: Quarterly report pursuant to Section 13 or 15(d)
Published on August 14, 1998
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, 1998
|_| 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.)
10900 Nuckols Road, 3rd Floor, 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.
|X| Yes |_| No
On July 31, 1998, the registrant had 45,981,020 shares of common stock of
$.01 value outstanding, which is the registrant's only class of common stock.
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
(amounts in thousands except share data)
DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(amounts in thousands except share data)
DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOW
DYNEX CAPITAL, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 1998
(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., its wholly-owned subsidiaries, and certain
other entities. As used herein, the "Company" refers to Dynex Capital, Inc.
("Dynex") and each of the entities that is consolidated with Dynex for financial
reporting purposes. A portion of the Company's operations are operated by
taxable corporations that are consolidated with Dynex for financial reporting
purposes, but are not consolidated for income tax purposes. All significant
intercompany balances and transactions have been eliminated in consolidation.
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 Sheets at June 30, 1998 and December 31, 1997, the Consolidated
Statements of Operations for the three and six months ended June 30, 1998 and
1997, the Consolidated Statement of Shareholders' Equity for the six months
ended June 30, 1998, the Consolidated Statements of Cash Flows for the six
months ended June 30, 1998 and 1997 and related notes to consolidated financial
statements are unaudited. Operating results for the six months ended June 30,
1998 are not necessarily indicative of the results that may be expected for the
year ending December 31, 1998. 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, 1997.
Certain amounts for 1997 have been reclassified to conform with the
presentation for 1998.
NOTE 2--EARNINGS PER SHARE
Earnings per share ("EPS") as shown on the consolidated statements of
operations for the three and six months ended June 30, 1998 and 1997 is
presented on both a basic and diluted EPS basis. Diluted EPS assumes the
conversion of the convertible preferred stock into common stock, using the
if-converted method, and stock appreciation rights ("SARs"), using the treasury
stock method but only if these items are dilutive. As a result of the
two-for-one split of the Company's common stock in May 1997, the preferred stock
is convertible into two shares of common stock for one share of preferred stock.
The following tables reconcile the numerator and denominator for both the
basic and diluted EPS for the three and six months ended June 30, 1998 and 1997.
NOTE 3--COLLATERAL FOR COLLATERALIZED BONDS, MORTGAGE SECURITIES AND OTHER
INVESTMENTS
The following table summarizes the Company's amortized cost basis and fair
value of collateral for collateralized bonds, mortgage securities and other
investments classified as available-for-sale at June 30, 1998 and December 31,
1997, and the related average effective interest rates (calculated excluding
unrealized gains and losses) for the month ended June 30, 1998 and December 31,
1997:
Collateral for collateralized bonds consists of debt securities backed
primarily by adjustable-rate and fixed-rate mortgage loans secured by first
liens on single family and multifamily residential housing properties and
commercial properties, manufactured housing installment loans secured by either
a UCC filing or a motor vehicle title, and 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. The Company's exposure to credit losses on collateral
for collateralized bonds is generally limited to the principal amount of
collateral pledged in excess of the related collateralized bonds issued, as the
collateralized bonds issued by the limited-purpose finance subsidiaries are
non-recourse to the Company.
Mortgage securities with an aggregate principal balance of $84,537 were
sold during the six months ended June 30, 1998 for an aggregate gain of $1,897.
The specific identification method is used to calculate the basis of mortgage
securities sold. Gain on sale of investments and trading revenue also includes
realized gains of $4,873 on various trading positions closed during the six
months ended June 30, 1998. At June 30, 1998, the Company had outstanding open
treasury future positions with a notional value of $855 million remaining. Such
positions had a mark-to-market gain of $1,038 based upon quotes obtained from
third party dealers, which was included in the gain on sale of investments and
trading revenue.
The Company 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 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. The discount rates used are based
on management's estimates of market rates, and the cash flows are projected
utilizing the current interest rate environment and forecasted prepayment rates.
Estimates of fair value for other financial instruments are based primarily on
management's judgment. Since the fair value of the Company's financial
instruments is based on estimates, actual gains and losses recognized may differ
from those estimates recorded in the consolidated financial statements.
NOTE 4--ADOPTION OF FINANCIAL ACCOUNTING STANDARDS
In January 1998, the Company adopted the Statement of Financial Accounting
Standard No. 130, "Reporting Comprehensive Income" ("FAS No. 130"). FAS No. 130
requires companies to classify items of other comprehensive income by their
nature in a financial statement and display the accumulated balance of other
comprehensive income separately from retained earnings and additional paid-in
capital in the equity section of a statement of financial position. The impact
of adopting FAS No. 130 did not result in a material change to the Company's
financial position and results of operations.
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard No. 131, "Disclosures about Segments of an
Enterprise and Related Information" ("FAS No. 131"). FAS No. 131 establishes
standard for reporting information about operating segments and is effective for
financial statements issued for fiscal years beginning after December 15, 1997.
There will be no significant changes to the Company's disclosures pursuant to
the adoption of FAS No. 131.
In January 1998, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standard No. 132, "Employers' Disclosure about Pensions
and Other Postretirement Benefits" ("FAS No. 132"). FAS No. 132 revises
employers' disclosures about pension and other postretirement benefit plans and
is effective for financial statements issued for fiscal years beginning after
December 15, 1998. There will be no significant changes to the Company's
disclosures pursuant to the adoption of FAS No. 132.
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard No. 133, "Accounting for Derivative Instruments
and Hedging Activities" ("FAS No. 133"). FAS No. 133 establishes accounting and
reporting standards for derivative instruments and for hedging activities. FAS
No. 133 is effective for all fiscal quarters of fiscal years beginning after
June 15, 1999. The impact of adopting FAS No. 133 has not yet been determined.
NOTE 5--DERIVATIVE FINANCIAL INSTRUMENTS
The Company enters 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 trade
date, these instruments are designated as either hedge positions or trade
positions.
For Interest Rate Agreements designated as hedge instruments, the Company
evaluates the effectiveness of these hedges periodically against the financial
instrument being hedged under various interest rate scenarios. The revenues and
costs associated with interest rate swap agreements are recorded as adjustments
to interest income or expense on the asset or liability being hedged. For
interest rate cap agreements, the amortization of the cost of the agreements is
recorded as a reduction in the net interest income on the related investment.
The unamortized cost is included in the carrying amount of the related
investment. Revenues or cost associated with futures and option contracts are
recognized in income or expense in a manner consistent with the accounting for
the asset or liability being hedged. Amounts payable to or receivable from
counterparties are included in the financial statement line of the item being
hedged. Interest Rate Agreements that are hedge instruments and hedge an asset
which is carried at its fair value are also carried at fair value, with
unrealized gains and losses reported as a separate component of shareholders'
equity.
The Company may also enter into forward delivery contracts and interest
rate futures and options contracts for hedging interest rate risk associated
with commitments made to fund loans. Gains and losses on such contracts are
either (i) deferred as an adjustment to the carrying value of the related loans
until the loan has been funded and securitized, after which the gains or losses
will be amortized into income over the remaining life of the loan using a method
that approximates the effective yield method, or (ii) deferred until such time
as the related loans are funded and sold.
If the underlying asset, liability or commitment is sold or matures, 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.
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 revenue 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.
NOTE 6 - EMPLOYEE BENEFITS
During the six months ended June 30, 1998, 24,000 SARs were exercised for a
total value of $322. During the same period, 220,795 additional SARs were
granted. The total SARs remaining to be exercised was 884,435 at June 30, 1998.
The Company expensed $600 related to the Employee and Board Incentive Plans
during the six months ended June 30, 1998.
NOTE 7 -- COMMITTMENTS
On June 10, 1998, the Company entered into an agreement with AutoBond
Acceptance Corporation ("AutoBond"). AutoBond is a specialty consumer finance
company that underwrites, acquires, services and securitizes retail installment
contracts originated by automobile dealers to borrowers that are credit
impaired. The common stock of AutoBond trades on the American Stock Exchange
under the symbol "ABD". Through a funding note structure, the Company will
provide AutoBond with limited funding over a one year period to finance its
retail installment contracts up to $25 million per month. The Company also
purchased from AutoBond a $3.0 million senior note convertible into 500,000
shares of AutoBond's common stock. In exchange, the Company, through a taxable
affiliate, received an option to purchase 5.5 million shares of common stock of
AutoBond held by the three principal shareholders of AutoBond, for a price of
$6.00 per share.
NOTE 8 -- OTHER MATTERS
During the six months ended June 30, 1998, the Company issued 329,112
shares of its common stock pursuant to its dividend reinvestment program for net
proceeds of $4,040.
The Company repurchased 55,000 shares of its common stock outstanding at an
aggregate purchase price of $609, or $11.03 per share, during the six months
ended June 30, 1998. The Company is authorized to repurchase up to one million
shares of its common stock.
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Dynex Capital, Inc. (the "Company") is a financial services company
electing to be treated as a real estate investment trust. The Company originates
mortgage loans secured by multifamily and commercial properties and loans
secured by manufactured homes. The Company will generally securitize the loans
funded as collateral for collateralized bonds, thereby limiting its credit and
liquidity risk and providing long-term financing for its investment portfolio.
FINANCIAL CONDITION
Collateral for collateralized bonds
As of June 30, 1998, the Company had 33 series of collateralized bonds
outstanding. The collateral for collateralized bonds increased to $5.0 billion
at June 30, 1998 compared to $4.4 billion at December 31, 1997. This increase of
$0.6 billion is primarily the result of the addition of $1.7 billion of
collateral related to the issuance of one series of collateralized bonds during
the six months ended June 30, 1998, net of $1.0 billion in paydowns on such
collateral.
Mortgage securities
Mortgage securities decreased to $264.1 million at June 30, 1998 compared
to $513.8 million at December 31, 1997. This decrease of $249.7 million was
primarily the result of the Company pledging $710.1 million of mortgage
securities as part of the collateral for collateralized bonds issued during the
six months ended June 30, 1998. In addition, the Company sold $54.3 million of
mortgage securities and received $86.6 million in paydowns during the six months
ended June 30, 1998. These decreases were partially offset by the Company
exercising its bond call rights on $452.1 million of mortgage securities and
purchasing $155.3 million of mortgage securities during the same period.
Other investments
Other investments consists primarily of single family homes leased to home
builders, corporate bonds, a note receivable received in connection with the
sale of the Company's single family mortgage operations in May 1996 and property
tax receivables. Other investments increased from $214.1 million at December 31,
1997 to $229.1 million at June 30, 1998. This increase of $15.0 million is
primarily the result of additional purchases or financing of $63.8 million of
model homes during the six months ended June 30, 1998. In addition, the Company
purchased $25.0 million of corporate bonds during the six months ended June 30,
1998. These increases were partially offset during the same period by the sale
of $26.1 million in model homes and the receipt of the $9.5 million annual
principal payment on the note receivable from the 1996 sale of the single family
mortgage operations. In addition, the Company securitized $37.2 million of
property tax receivables to secure collateralized bonds issued during the six
months ended June 30, 1998.
Assets held for securitization
Assets held for securitization increased from $235.0 million at December
31, 1997 to $524.9 million at June 30, 1998. This increase was due to new loan
fundings from the Company's production operations totaling $478.9 million and
bulk purchases of single family loans totaling $562.0 million, during the six
months ended June 30, 1998. In addition, as part of its agreement with AutoBond
Acceptance Corporation the Company funded $38.3 million of funding notes secured
by automobile installment contracts during the six months ended June 30, 1998.
These increases were partially offset by the securitization of $827.3 million of
assets as collateral for collateralized bonds in May.
Non-recourse debt - collateralized bonds
Collateralized bonds increased to $4.1 billion at June 30, 1998 from $3.6
billion at December 31, 1997 primarily as a result of the issuance of $1.6
billion of collateralized bonds during the six months ended June 30, 1998. The
series of collateralized bonds issued during the first half of 1998 was
collateralized by securities secured by single family mortgage loans,
manufactured housing loans and property tax receivables. This increase was
partially offset by $1.0 billion in paydowns on collateralized bonds.
Recourse debt
Recourse debt increased to $1.4 billion at June 30, 1998 from $1.1 billion
at December 31, 1997. This increase was primarily due to the addition of $115.2
million of repurchase agreements secured by collateralized bonds retained by the
Company from the $1.7 billion securitization in May 1998 and the addition of
$349.1 million of notes payable as a result of additional assets funded during
the six months ended June 30, 1998. These increases were partially offset by a
$198.3 million reduction in repurchase agreements due to the securitization of
$258.0 million mortgage securities as collateral for collateralized bonds during
the six months ended June 30, 1998 which were previously financed by repurchase
agreements.
Shareholders' equity
Shareholders' equity decreased to $543.0 million at June 30, 1998 from
$560.9 million at December 31, 1997. This decrease was primarily the result of a
$17.3 million decrease in the net unrealized gain on investments
available-for-sale from $79.4 million at December 31, 1997 to $62.1 at June 30,
1998. Also, the Company repurchased 55,000 of its common shares at an aggregate
purchase price of $0.6 million, or $11.03 per share, during the six months ended
June 30, 1998. These decreases were partially offset by $4.0 million of common
stock proceeds received through the dividend reinvestment plan during the same
period.
Production Activity
($ in thousands)
RESULTS OF OPERATIONS
Three and Six Months Ended June 30, 1998 Compared to Three and Six Months
Ended June 30, 1997. The decrease in the Company's earnings during the three and
six months ended June 30, 1998 as compared to the same period in 1997 is
primarily the result of the decrease in the net interest margin and the increase
in general and administrative expenses.
Net interest margin for the six months ended June 30, 1998 decreased to
$36.0 million, or 14%, below the $42.1 million for the same period for 1997. Net
interest margin for the three months ended June 30, 1998 decreased to $18.3
million, or 15%, below the $21.5 million for the same period for 1997. These
decreases were primarily the result of a $3.0 million and $7.7 million increase
in premium amortization expense during the three and six months ended June 30,
1998, respectively, compared to the same period in 1997. These increases in
premium amortization resulted from a higher rate of prepayments in the
investment portfolio during the first half of 1998. Amortization expense arises
from the amortization of premiums on assets in the Company's investment
portfolio due to scheduled payments and unscheduled principal payments received.
In addition, the net interest spread on the Company's investment portfolio
decreased to 1.23% for the six months ended June 30, 1998 from 1.65% for the
same period in 1997. The net interest spread on the Company's investment
portfolio decreased to 1.22% for the three months ended June 30, 1998 from 1.59%
for the same period in 1997. These decreases in net interest spread for the
three and six months ended June 30, 1998 relative to the same period in 1997 are
also primarily the result of higher premium amortization as a result of the
increase in principal prepayments as well as the decrease in spreads between the
indices on which the Company's interest-earning assets and interest-bearing
liabilities are based.
The gain on sale of investments and trading revenue for the six months
ended June 30, 1998 increased to $8.2 million, as compared to $4.7 million for
the six months ended June 30, 1997. The increase in the net gain is primarily
the result of gains recognized of $5.9 million on trading positions entered into
during the six months ended March 31, 1998. In addition, mortgage securities
with an aggregate principal balance of $84.5 million were sold during the six
months ended June 30, 1998, for an aggregate net gain of $1.9 million.
General and administrative expenses increased $5.0 million, or 45%, to
$16.0 million for the six months ended June 30, 1998 as compared to the same
period for 1997. The increase in general and administrative expenses is a result
of the continued growth in the Company's production operations, both in the
Company's manufactured housing and commercial lending business. Management would
expect general and administrative expenses in the third quarter of 1998 to
approximate first quarter 1998 totals, with further material increases only if
loan fundings materially increase quarter-to-quarter. The following table
summarizes the average balances of the Company's interest-earning assets and
their average effective yields, along with the Company's 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 decreased to 1.23% for the six months ended June
30, 1998 from 1.65% for the same period in 1997. This decrease was primarily the
result of the decline in the spread on collateral for collateralized bonds due
to an increase in premium amortization. The overall yield on interest-earning
assets decreased to 7.66% for the three and six months ended June 30, 1998, from
7.93% and 7.99% for three and six months ended June 30, 1997, respectively.
These decreases of 0.27% and 0.33%, respectively, are primarily due to the
previously discussed increase in premium amortization expense. In addition, the
net interest spread was adversely impacted by the origination or purchase of
lower coupon collateral, principally A+ quality single family adjustable-rate
mortgage ("ARM") loans during the second half of 1997.
Individually, the net interest spread on collateral for collateralized
bonds decreased 33 basis points, from 120 basis points for the six months ended
June 30, 1997 to 87 basis points for the same period in 1998. This decline was
primarily due to (i) the securitization of lower coupon collateral, principally
A+ quality single family ARM loans during the second half of 1997, (ii) higher
premium amortization caused by increased prepayments during the first half of
1998 and (iii) the decline in spread between six-month LIBOR and one-month
LIBOR. Approximately 56% of the Company's collateral for collateralized bonds is
indexed to six-month LIBOR, and substantially all of the collateralized bond
obligations are indexed to one-month LIBOR. The net interest spread on mortgage
securities decreased 14 basis points, from 257 basis points for the six months
ended June 30, 1997 to 243 basis points for the six months ended June 30, 1998.
This decrease was a result of the purchase of lower coupon fixed-rate mortgage
securities during the first quarter of 1998. The net interest spread on other
investments increased 55 basis points, from 208 basis points for the six months
ended June 30, 1997, to 263 basis points for the same period in 1998, due
primarily to lower borrowing costs associated with the Company's single family
model home purchase and leaseback business during 1998 than during the same
period in 1997. The net interest spread on assets held for securitization
increased 46 basis points, from 221 basis points from the six months ended June
30, 1997, to 267 basis points for the same period in 1998. This increase is
primarily attributable to lower borrowing costs as a result of a higher level of
compensating cash balances during the first half of 1998 than during the same
period in 1997. Credits earned from these compensating cash balances are used by
the Company to offset interest expense.
Interest Income and Interest-Earning Assets
The Company's average interest-earning assets were $5.5 billion for the six
months ended June 30, 1998, an increase of approximately 34% from $4.1 billion
of average interest-earning assets during the same period of 1997. This increase
in average interest-earning assets was primarily the result of new loan fundings
of $1.9 billion for the twelve months ended June 30, 1998. In addition, the
Company purchased $149.5 million of mortgage securities and exercised bond call
rights on $945.2 million of mortgage securities during the twelve months ended
June 30, 1998. These were partially offset by $1.8 billion of principal paydowns
on investments during the same period. Total interest income rose approximately
29%, from $162.8 million for the six months ended June 30, 1997 to $209.4
million for the same period of 1998. This increase in total interest income was
due to the growth in average interest-earnings assets. Overall, the yield on
interest-earning assets declined to 7.66% for the six months ended June 30, 1998
from 7.99% for the six months ended June 30, 1997, as the premium amortization
expense grew due to an increase in principal prepayments on investments. Premium
amortization expense reduced the average interest-earning asset yield 0.57% for
the first half of 1998 versus 0.38% for the first half of 1997.
On a quarter to quarter basis, average interest-earning assets for the
quarter ended June 30, 1998 were $5.8 billion versus $5.1 billion for the
quarter ended March 31, 1998. This increase in average interest-earning assets
was primarily the result of $337.1 million of loans funded through the
production operations during the quarter ended June 30, 1998. In addition, the
Company exercised its bond call rights on $208.3 million of mortgage securities
during the same period. Total interest income for the quarter ended June 30,
1998 was $111.1 million versus $98.3 million for the quarter ended March 31,
1998. This increase in total interest income was due to the growth in
interest-earning assets. Approximately $4.0 billion of the Company's investment
portfolio as of June 30, 1998 is comprised of loans or securities that have
coupon rates which adjust over time (subject to certain periodic and lifetime
limitations) in conjunction with changes in short-term interest rates.
Approximately 57% of the ARM loans underlying the Company's ARM securities and
collateral for collateralized bonds are indexed to and reset based upon the
level of six-month LIBOR; approximately 33% are indexed to and reset based upon
the level of the One Year Constant Maturity Treasury Index (CMT).
Earning Asset Yield
($ in millions)
The average asset yield is reduced for the amortization of premiums, net of
discounts on the Company's investment portfolio. By creating its investments
through its production operations, the Company believes that premium amounts are
less than if the investments were acquired in the market. As indicated in the
table below, net premiums on the Company's collateral for collateralized bonds,
ARM securities and fixed-rate securities at June 30, 1998 were $45.7 million, or
approximately 0.93% of the aggregate investment portfolio balance as compared to
$62.7 million and 1.46% at June 30, 1997. Amortization expense as a percentage
of principal paydowns has declined to 1.24% for the three months ended June 30,
1998, from 1.94% for the same period in 1997 and 1.56% for the three months
ended March 31, 1998, as the Company's investment portfolio mix changes to
assets funded primarily at par or at a discount. The principal repayment rate
for the Company (indicated in the table below as "CPR Annualized Rate") was
approximately 36% for the three months ended June 30, 1998. CPR or "constant
prepayment rate" is a measure of the annual prepayment rate on a pool of loan.
Excluded from this table are the Company's assets held for securitization, which
are carried are a net discount at June 30, 1998.
Premium Basis and Amortization
($ in millions)
Interest Expense and Cost of Funds
The Company's largest expense is the interest cost on borrowed funds. Funds
to finance the investment portfolio are generally borrowed in the form of
non-recourse collateralized bonds or repurchase agreements. The interest rates
paid on collateralized bonds are either fixed or floating rates; the interest
rates on the repurchase agreements are floating rates. The Company may use
interest rate swaps, caps and financial futures to manage its interest rate
risk. The net cost of these instruments is included in the cost of funds table
below as a component of interest expense for the period to which it relates. The
Company's average borrowed funds increased from $3.9 billion for the three
months ended June 30, 1997 to $5.5 billion for the same period in 1998. This
increase resulted primarily from the issuance of $3.0 billion of collateralized
bonds during the twelve months ended June 30, 1998. This increase was partially
offset by a reduction of repurchase agreements during 1997 and the first half of
1998 primarily as a result of the Company securitizing $513.5 million of ARM
securities previously financed with repurchase agreements as collateral for
collateralized bonds. For the three months ended June 30, 1998, interest expense
increased to $89.1 million from $61.4 million for the three months ended June
30, 1997, while the average cost of funds increased to 6.44% for the three
months ended June 30, 1998 compared to 6.34% for the same period in 1997. The
increased average cost of funds for the second quarter of 1998 compared to the
second quarter of 1997 was due mainly to the increase in amortization of bond
premium due to an increase in payments on the collateralized bonds as a result
of the increase in prepayments on the collateral for collateralized bonds.
Cost of Funds
($ in millions)
Interest Rate Agreements
As part of the Company's asset/liability management process for its
investment portfolio, the Company enters into interest rate agreements such as
interest rate caps and swaps and financial futures contracts. These agreements
are used to reduce interest rate risk which arises from the lifetime yield caps
on the ARM securities, the mismatched repricing of portfolio investments versus
borrowed funds, the funding of fixed interest rates on certain portfolio
investments with the floating rate borrowings and finally, assets repricing on
indices such as the prime rate which differ from the related borrowing indices.
The agreements are designed to protect the portfolio's income and cash flow, and
to provide income and capital appreciation to the Company in the event that
short-term interest rates rise quickly.
The following table includes all interest rate agreements in effect as of
the various quarter ends for asset/liability management of the investment
portfolio. This table excludes all interest rate agreements in effect for the
Company's loan production operations as generally these agreements are used to
hedge interest rate risk associated with forward commitments to fund loans.
Generally, interest rate swaps and caps are used to manage the interest rate
risk associated with assets that have periodic and annual interest rate reset
limitations financed with borrowings that have no such limitations. Financial
futures contracts and options on futures are used to lengthen the terms of
repurchase agreement financing, generally from one month to three and six
months. Amounts presented are aggregate notional amounts. To the extent any of
these agreements are terminated, gains and losses are generally amortized over
the remaining period of the original agreement.
Instruments Used for Interest Rate Risk Management Purposes (1)
($ in millions)
Net Interest Rate Agreement Expense
The net interest rate agreement expense, or hedging expense, equals the
cost of the agreements presented in the previous table, net of any benefits
received from these agreements. For the quarter ended June 30, 1998, net hedging
expense amounted to $1.83 million compared to $1.23 million and $1.23 million
for the quarters ended March 31, 1998 and June 30, 1997, respectively. Such
amounts exclude the hedging costs and benefits associated with the Company's
production activities as these amounts are deferred as additional premium or
discount on the loans funded and amortized over the life of the loans as an
adjustment to their yield. The increase in the net interest rate agreement
expense for the three months ended June 30, 1998 compared to the same period in
1997 is primarily related to benefits received on financial futures used to
lengthen repurchase agreement maturities during the second quarter of 1997 and
the additional notional amounts of interest rate swap agreements entered into
during 1998 used to hedge the interest rate risk on fixed-rate manufactured
housing loans which were securitized during 1997 and the first half of 1998.
Net Interest Rate Agreement Expense
($ in millions)
Fair Value
The fair value of the available-for-sale portion of the Company's
investment portfolio as of June 30, 1998, as measured by the net unrealized gain
on investments available-for-sale, was $62.1 million above its cost basis, which
represents a $17.3 million decrease from $79.4 million at December 31, 1997.
This decrease in the portfolio's value is primarily attributable to the
accelerated prepayment activity for the quarter ended June 30, 1998. This was
partially offset by the increase in the value of the collateral for
collateralized bonds relative to the collateralized bonds issued during 1998.
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, 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 pass-through securities outstanding; the maximum
direct credit exposure retained by the Company (represented by the amount of
overcollateralization pledged and subordinated securities rated below BBB owned
by the Company), net of the credit reserves maintained by the Company for such
exposure; and the actual credit losses incurred for each year. 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
assets held for securitization (which will be included as the assets are
securitized) and other investments. The increase in net credit exposure as a
percentage of the outstanding loan principal balance from 1.17% at June 30, 1997
to 2.71% at June 30, 1998 is related primarily to the credit exposure retained
by the Company on its $3.2 billion in securitizations during the twelve months
ended June 30, 1998. The increase from 2.22% at March 31, 1998 to 2.71% at June
30, 1998 is principally due to the credit exposure retained by the Company on
its $1.7 billion in securitizations during the three months ended June 30, 1998.
The net credit exposure in the table below includes $22 million of credit
exposure from the Company's commercial loan securitization in October 1997. The
Company anticipates that such exposure will be substantially eliminated during
the second half of 1998 through the sale or resecuritization of currently
retained classes from that securitization, though no assurance can be given that
these retained classes will be sold or resecuritized. There were no
delinquencies on loans included in this security at June 30, 1998.
Credit Reserves and Actual Credit Losses
($ 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 mentioned above in which the
Company has retained a portion of the direct credit risk. The decrease in
delinquencies as a percentage of the outstanding collateral balance from 2.74%
at March 31, 1998 to 1.75% at June 30, 1998 is primarily related to the
Company's basis in certain subordinated securities being reduced to $0 during
the second quarter of 1998, which as a result, eliminated any remaining credit
exposure to the Company. Delinquencies from these subordinated securities are
excluded from the table at June 30, 1998. As of June 30, 1998, the Company
believes that its credit reserves are sufficient to cover any losses which may
occur as a result of current delinquencies presented in the table below.
Delinquency Statistics
The following table summarizes the credit rating for securities held in the
Company's investment portfolio. This table excludes the Company's other residual
and derivative securities (as the risk on such securities is primarily
prepayment-related, not credit-related), certain other investments which are not
debt securities and assets held for securitization. The carrying balances of the
investments rated below A are net of credit reserves and discounts. The average
credit rating of the Company's investments at the end of the second quarter of
1998 was AAA. At June 30, 1998, securities with a credit rating of AA or better
were $5.0 billion, or 96.9% of the Company's total investments compared to 97.6%
and 98.5% at March 31, 1998 and June 30, 1997, respectively. At the end of the
second quarter 1998, $37.4 million of investments were AA rated by one rating
agency and lower rated by another rating agency. Where investments were
split-rated, for purposes of this table, the Company classified such investments
based on the higher credit rating.
Investments by Credit Rating (1)
($ in millions)
General and Administrative Expenses
General and administrative expenses ("G&A expense") consist of expenses
incurred in conducting the Company's production activities and managing the
investment portfolio, as well as various other corporate expenses. G&A expense
increased for the three month period ended June 30, 1998 as compared to the same
period in 1997, primarily as a result of continued costs in connection with the
build-up of the production infrastructure for the manufacturing housing,
commercial lending, and specialty finance businesses.
The following table summarizes the Company's efficiency and the ratio of
G&A expense to average interest- earning assets.
Operating Expense Ratios
Net Income and Return on Equity
Net income decreased from $18.4 million for the three months ended June 30,
1997 to $15.6 million for the three months ended June 30, 1998. Net income
available to common shareholders decreased from $14.7 million to $12.3 million
for the same periods, respectively. Return on common equity (excluding the
impact of the net unrealized gain on investments available-for-sale) decreased
from 18.3% for the three months ended June 30, 1997 to 13.8% for the three
months ended June 30, 1998. The decrease in the return on common equity is
primarily the result of a decrease in net income available to common
shareholders due to an increase in amortization expense (which reduced net
interest income) and G&A expense and the issuance of new common shares through
the dividend reinvestment program.
Components of Return on Equity
($ in thousands)
Dividends and Taxable Income
The Company and its qualified REIT subsidiaries (collectively "Dynex REIT")
have elected to be treated as a real estate investment trust for federal income
tax purposes. The REIT provisions of the Internal Revenue Code require Dynex
REIT to distribute to shareholders substantially all of its taxable income,
thereby restricting its ability to retain earnings.
The Company intends to declare and pay out as dividends 100% of its taxable
income over time. The Company's current practice is to declare quarterly
dividends per share. Generally, the Company strives to declare a quarterly
dividend per share which, in conjunction with the other quarterly dividends,
will result in the distribution of most or all of the taxable income earned
during the calendar year. At the time of the dividend announcement, however, the
total level of taxable income for the quarter is unknown. Additionally, the
Company has considerations other than the desire to pay out most of its taxable
earnings, which may take precedence when determining the level of dividends.
Dividend Summary
($ in thousands, except per share amounts)
Taxable income differs from the financial statement net income which is
determined in accordance with generally accepted accounting principles ("GAAP").
For the six months ended June 30, 1998, the Company's taxable income per share
of $0.73 was higher than the Company's declared dividend per share of $0.60. The
majority of the difference was caused by GAAP and tax differences related to the
sale of the single family operations in May 1996. For tax purposes, the sale of
the single family operations is accounted for on an installment sale basis with
annual taxable income of approximately $10 million from 1996 through 2001.
Cumulative undistributed taxable income represents timing differences in the
amounts earned for tax purposes versus the amounts distributed. Such amounts can
be distributed for tax purposes in the subsequent year as a portion of the
normal quarterly dividend. Such amounts also include certain estimates of
taxable income until such time that the Company files its federal income tax
returns for each year.
Year 2000
The Year 2000 issue affects virtually all companies and organizations. Many
companies have existing computer applications which use only two digits to
identify a year in the date field. These applications were designed and
developed without considering the impact of the change of the century. If not
corrected these computer applications may fail or create erroneous results by
the year 2000.
The majority of the Company's information critical systems have been
developed internally since 1992. The development of these systems was undertaken
with full awareness of issues involving the Year 2000, and consequently the
Company does not expect to encounter any significant Year 2000 problems with
these systems.
The Company also relies upon a small number of third party software vendors
for certain information systems. Testing of these vendors' systems is expected
to be completed by the end of 1998, and the Company does not expect to see any
significant impact to the operations supported by these vendors as a result of
Year 2000 problems. Additionally, the Company does not expect that any expenses
incurred as a result of any necessary modifications will be material to the
results of operations.
LIQUIDITY AND CAPITAL RESOURCES
The Company has various sources of cash flow upon which it relies for its
working capital needs. Sources of cash flow from operations include primarily
net interest margin and the return of principal on the investment portfolio. The
Company's primary source of borrowings is through the issuance of collateralized
bonds. Other borrowings such as repurchase agreements and lines of credit to
finance assets held for securitization provide the Company with additional cash
flow in the event that it is necessary. Historically, these sources have
provided sufficient liquidity for the conduct of the Company's operations.
However, if a significant decline in the market value of the Company's
investment portfolio that is funded with recourse debt should occur, or if there
is a dislocation in the secondary market such that the Company is unable to
securitize assets held for securitization, the Company's available liquidity
from these other borrowings may be reduced. As a result of such a reduction in
liquidity, the Company may be forced to sell certain investments in order to
maintain liquidity. If required, these sales could be made at prices lower than
the carrying value of such assets, which could result in losses.
In order to grow its equity base, the Company may issue additional capital
stock. Management strives to issue such additional shares when it believes
existing shareholders are likely to benefit from such offerings through higher
earnings and dividends per share than as compared to the level of earnings and
dividends the Company would likely generate without such offerings. During the
six months ended June 30, 1998, the Company issued 329,112 shares of its common
stock pursuant to its dividend reinvestment program for net proceeds of $4.0
million.
The Company borrows funds on a short-term basis to support the accumulation
of assets prior to the issuance of collateralized bonds. These borrowings may
bear fixed or variable interest rates, may require additional collateral in the
event that the value of the existing collateral declines, and may be due on
demand or upon the occurrence of certain events. If borrowing costs are higher
than the yields on the assets financed with such funds, the Company's ability to
acquire or fund additional assets may be substantially reduced and it may
experience losses. These short-term borrowings consist of the Company's lines of
credit and repurchase agreements. These borrowings are paid down as the Company
securitizes or sells assets.
A substantial portion of the assets of the Company are pledged to secure
indebtedness incurred by the Company. Accordingly, those assets would not be
available for distribution to any general creditors or the stockholders of the
Company in the event of the Company's liquidation, except to the extent that the
value of such assets exceeds the amount of the indebtedness they secure.
Non-recourse Debt
The Company, through limited-purpose finance subsidiaries, has issued
non-recourse debt in the form of collateralized bonds to fund its investment
growth. The obligations under the collateralized bonds are payable solely from
the collateral for collateralized bonds and are otherwise non-recourse to the
Company. Collateral for collateralized bonds are not subject to margin calls.
The maturity of each class 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, 1998, the Company has $4.1 billion of
collateralized bonds outstanding as compared to $3.6 billion at December 31,
1997.
Recourse Debt
Secured. At June 30, 1998, the Company had four credit facilities
aggregating $800 million to finance loan fundings of which $550 million expires
in 1999 and $250 million expires in 2000. One of these facilities includes
several sublines aggregating $250 million to serve various purposes, such as
commercial loan fundings, working capital, and manufactured housing loan
fundings. Unsecured working capital borrowings under this facility are limited
to 10% of the aggregate committed amount of the facility. The Company expects
these credit facilities will be renewed, if necessary, at their respective
expiration dates, although there can be no assurance of such renewal. The lines
of credit contain certain financial covenants which the Company met as of June
30, 1998. However, changes in asset levels or results of operations could result
in the violation of one or more covenants in the future. At June 30, 1998, the
Company had $450.2 million outstanding under its credit facilities.
The Company finances a portion of its investments through repurchase
agreements generally with thirty day maturities. 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 which is equal
to the original sales price plus an interest component. At June 30, 1998, the
Company had outstanding obligations of $798.4 million under such repurchase
agreements compared to $889.0 million at December 31, 1997.
Increases in either short-term interest rates or long-term interest rates
could negatively impact the valuation of mortgage securities and may limit the
Company's borrowing ability or cause various lenders to initiate margin calls
for mortgage securities financed using repurchase agreements. Additionally,
certain of the Company's investments are classes of securities rated AA, A, or
BBB that are subordinate to other classes from the same series of securities.
Such subordinated classes may have less liquidity than 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
mortgage loans. In instances of a downgrade of an insurer or the deterioration
of the credit quality of the underlying mortgage 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.
To reduce the Company's exposure to changes in short-term interest rates on
its repurchase agreements, the Company may lengthen the duration of its
repurchase agreements secured by investments by entering into certain interest
rate futures and/or purchased option contracts. As of June 30, 1998, the Company
had no such financial futures or option contracts outstanding.
Unsecured. Since 1994, the Company has issued three series of unsecured
notes payable totaling $150 million. The proceeds from these issuances have been
used to reduce short-term debt related to financing assets held for
securitization during the accumulation period as well as for general corporate
purposes. These notes payable have an outstanding balance at June 30, 1998 of
$141 million. The Company also has various acquisition notes payable totaling
$1.2 million at June 30, 1998. The above note agreements contain certain
financial covenants which the Company met as of June 30, 1998. However, changes
in asset levels or results of operations could result in the violation of one or
more covenants in the future.
Total recourse debt increased from $1.1 billion for December 31, 1997 to
$1.4 billion for June 30, 1998. This increase is primarily a result of the
purchase or production of $1.9 billion of loans and investments during the first
half of 1998, net of the securitization of $1.7 billion of those investments,
which previously were financed through repurchase agreement and notes payable,
as collateral for collateralized bonds. Total recourse debt decrease $1.0
billion from $2.4 billion at March 31, 1998 to $1.4 billion at June 30, 1998 as
a result of the securitization during May 1998. Total recourse debt should
continue to increase during the third quarter of 1998 as the Company anticipates
it will finance its third quarter production and purchases through repurchase
agreements and notes payable. Recourse debt in the fourth quarter of 1998 should
decrease as a result of anticipated securitizations.
Total Recourse Debt
($ in millions)
Potential immediate sources of liquidity for the Company include cash
balances and unused availability on the credit facilities described above. The
potential immediate sources of liquidity increased 7% at June 30, 1998 in
comparison to March 31, 1998. This increase in potential immediate sources of
liquidity was due primarily to the securitization during the second quarter of
1998 which reduced recourse borrowings by approximately $1.0 billion. The
Company anticipates that the potential immediate sources of liquidity will
decrease during the third quarter as the Company continues to finance its
production in the short-term through its credit facilities and repurchase
agreements until securitization.
Potential Immediate Sources of Liquidity
($ in millions)
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 consumer demand for
manufactured housing, multifamily housing and other products which it finances.
A material decline in demand for these products and services would result in a
reduction in the volume of loans originated by the Company. 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 various credit facilities and
repurchase agreements with certain investment banking firms to help meet the
Company's short-term funding needs. The Company believes that as these
agreements expire, they will continue to be available or will be able to be
replaced; however no assurance can be given as to such availability or the
prospective terms and conditions of such agreements or replacements.
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
originated by the Company are fixed-rate. The profitability of a particular
securitization may be reduced if interest rates increase substantially before
these loans are securitized. In addition, the majority of the investments held
by the Company are variable rate collateral for collateralized bonds and
adjustable-rate investments. These investments are financed through non-recourse
long-term collateralized bonds and 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 retained by the Company may have
an adverse impact on the Company's financial performance, if actual credit
losses differ materially from estimates made by the Company at the time of
securitization. The allowance for losses is calculated on the basis of
historical experience and management's best estimates. Actual defaults may
differ from the Company's estimate as a result of 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.
Prepayments. Prepayments by borrowers on loans securitized by the Company
may have an adverse impact on the Company's financial performance. Prepayments
are expected to increase during a declining interest rate or flat yield curve
environment. The Company's exposure to rapid prepayments is primarily (i) the
faster amortization of premium on the investments and, to the extent applicable,
amortization of bond discount, and (ii) the replacement of investments in its
portfolio with lower yield securities. At June 30, 1998, the yield curve was
still considered flat relative to its normal shape, and as a result, the Company
expects continued high levels of prepayment through the third quarter of 1998.
Competition. The financial services industry is a highly competitive
market. Increased competition in the market could adversely affect the Company's
market share within the industry and hamper the Company's efforts to expand its
production sources.
Regulatory Changes. The Company's business is subject to federal and state
regulation which, among other things require the Company to maintain various
licenses and qualifications and require specific disclosures to borrowers.
Changes in existing laws and regulations or in the interpretation thereof, or
the introduction of new laws and regulations, could adversely affect the
Company's operation and the performance of the Company's securitized loan pools.
New Production Sources. The Company has expanded both its manufactured
housing and commercial lending businesses. The Company is incurring or will
incur expenditures related to the start-up of these businesses, with no
guarantee that production targets set by the Company will be met or that these
businesses will be profitable. Various factors such as economic conditions,
interest rates, competition and the lack of the Company's prior experience in
these businesses could all impact these new production sources.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
None
Item 2. Changes in Securities
Not Applicable
Item 3. Defaults Upon Senior Securities
Not applicable
Item 4. Submission of Matters to a Vote of Security Holders
At the Company's annual meeting of shareholders held on May 19, 1998, for
which proxies were solicited pursuant to Regulation 14 under the Securities
Exchange Act of 1934, the following matters were voted upon by shareholders.
1. The election of five directors for a term expiring in 1999:
J. Sidney Davenport
Richard C. Leone
Thomas H. Potts
Paul S. Reid
Donald B. Vaden
2. Approval of an amendment to the Company's Articles of Incorporation to
delete paragraph (7) of Article VI in its entirety and substituting therefor:
"(7) Application of Article. Nothing contained in this Article or in any other
provision hereof shall limit the authority of the Board of Directors to take any
and all other action as it in its sole discretion deems necessary or advisable
to protect the Corporation and the interests of its shareholders by maintaining
the Corporation's eligibility to be, and preserving the Corporation's status as,
a qualified real estate investment trust under the Code; provided, however, that
nothing in this Article VI or elsewhere in these Articles shall preclude
settlement of any transaction entered into or through the facilities of the New
York Stock Exchange or any other exchange on which the Corporation's common
shares may be listed from time to time."
Item 5. Other Information
On June 30, 1998, the Company elected Barry S. Shein to the Board of
Directors. The election of Mr. Shein increases the number of board members from
five to six, five of whom are outside directors.
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 July 29, 1998,
relating to the change in the Registrant's Accountant.
Current Report on Form 8-K/A as filed with the Commission on August 11,
1998, relating to the change in the Registrant's Accountant.
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/ Lynn K. Geurin
Lynn K. Geurin, Executive Vice
President and Chief Financial Officer
(principal accounting officer)
Dated: August 14, 1998