10-Q: Quarterly report pursuant to Section 13 or 15(d)
Published on November 15, 1999
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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 September 30, 1999
|_| 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 October 31, 1999, the registrant had 11,443,840 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
PAGE
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets at September 30, 1999 and December 31,1998........3
Consolidated Statements of Operations for the three and nine months ended
September 30, 1999 and 1998...................................................4
Consolidated Statement of Shareholders' Equity for the nine months ended
September 30, 1999............................................................5
Consolidated Statements of Cash Flows for the nine months ended September
30, 1999 and 1998.............................................................6
Notes to Unaudited Consolidated Financial Statements .........................7
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations........................................................15
Item 3. Quantitative and Qualitative Disclosures about Market Risk......43
PART II. OTHER INFORMATION
Item 1. Legal Proceedings..............................................46
Item 2. Changes in Securities and Use of Proceeds......................47
Item 3. Defaults Upon Senior Securities................................47
Item 4. Submission of Matters to a Vote of Security Holders............47
Item 5. Other Information..............................................47
Item 6. Exhibits and Reports on Form 8-K...............................47
SIGNATURES...................................................................48
ART 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
For the nine months ended September 30, 1999
(amounts in thousands)
DYNEX CAPITAL, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 1999
(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"). The loan production operations are primarily conducted through
Dynex Holding, Inc. ("DHI"), a taxable affiliate of Dynex REIT. Dynex REIT owns
all the outstanding non-voting preferred stock of DHI which represents a 99%
economic ownership interest in DHI. Prior to December 1998, Dynex REIT had
consolidated DHI for financial reporting purposes. The common stock of DHI
represents a 1% economic ownership of DHI and is owned by certain officers of
Dynex REIT. In light of these factors, DHI is accounted for under a method
similar to the equity method. Dynex REIT has revised the 1998 accompanying
financial statements to give retroactive effect to the change in accounting
method during 1998. The accounting change had no impact on net income. Under the
equity method, Dynex REI's original investment in DHI is recorded at cost and
adjusted by Dynex REIT's share of earnings or losses and decreased by dividends
received. References to the "Company mean Dynex Capital, Inc., its consolidated
subsidiaries, and 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 Sheets at September 30, 1999 and December 31, 1998, the Consolidated
Statements of Operations for the three and nine months ended September 30, 1999
and 1998, the Consolidated Statement of Shareholders' Equity for the nine months
ended September 30, 1999, the Consolidated Statements of Cash Flows for the nine
months ended September 30, 1999 and 1998 and related notes to consolidated
financial statements are unaudited. Operating results for the nine months ended
September 30, 1999 are not necessarily indicative of the results that may be
expected for the year ending December 31, 1999. 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, 1998.
Certain reclassifications have been made to the financial statements for
1998 to conform to presentation for 1999.
NOTE 2--EARNINGS PER SHARE
Earnings per share ("EPS") as shown on the Consolidated Statements of
Operations for the three and nine months ended September 30, 1999 and 1998 is
presented on both a basic and diluted EPS basis. Any reference herein to EPS or
the number of shares of common stock, except the number of shares authorized,
issued and outstanding at December 31, 1998, are after the effect of the
one-for-four reverse split of the Company's common stock discussed in Note 11.
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.
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 EPS for the three and nine months ended September 30, 1999 and
1998.
NOTE 3 -- COLLATERAL FOR COLLATERALIZED BONDS AND SECURITIES
The following table summarizes Dynex REIT's amortized cost basis and fair
value of investments, as of September 30, 1999 and December 31, 1998, classified
as available-for-sale 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. 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 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 Dynex REIT.
During the nine months ended September 30, 1999, Dynex REIT securitized
$1.8 billion of collateral, through the issuance of two series of collateralized
bonds. The collateral securitized was primarily single family mortgage loans and
manufactured housing loans. The securitizations were accounted for as financing
of the underlying collateral pursuant to Statement of Accounting Standards No.
125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities" ("FAS No. 125") as Dynex REIT retained call
rights which were substantially in excess of a clean-up call as defined by this
accounting standard.
Securities. Funding notes consist of fixed-rate funding notes secured by
fixed-rate automobile installment contracts. 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. Other securities consists primarily of
a corporate bond purchased by Dynex REIT.
Sale of Investments. Securities with an aggregate principal balance of
$18,540 were sold during the nine months ended September 30, 1999 for an
aggregate loss of $1,210. The specific identification method is used to
calculate the basis of securities sold. Net (loss) gain on sale of investments
and trading activities at September 30, 1999 also includes (i) realized losses
of $5,751 related to the sale or writedown of $67,374 of commercial loans during
the nine months ended September 30, 1999; (ii) realized losses of $2,680
primarily related to write-off of hedging positions on $64,433 of commercial
loan commitments during the nine months ended September 30, 1999, (iii) realized
gains of $4,176 on various derivative trading positions entered into during the
nine months ended September 30, 1999 and (iv) writedowns of $8,192 and of $863
for permanent impairment of certain securities and other investments,
respectively. At September 30, 1999, the Company had no open derivative
positions outstanding.
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 -- RECOURSE DEBT
Dynex REIT utilizes repurchase agreements, notes payable and warehouse
credit facilities (together, "recourse debt") to finance certain of its
investments. The following table summarizes Dynex REIT's recourse debt
outstanding at September 30, 1999 and December 31, 1998:
Of the $1,098,307 of secured recourse debt outstanding at September 30,
1999, $598,288 was outstanding under repurchase agreements, $497,909 represented
amounts outstanding under committed credit facilities and $2,110 represented
amounts outstanding under a capital lease. During the nine months ended
September 30, 1999, Dynex REIT extinguished $2,750 of its 7.875% Senior Notes
resulting in a $597 extraordinary gain.
NOTE 5-- ADOPTION OF FINANCIAL ACCOUNTING STANDARDS
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards 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. It
requires that an entity recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments
at fair value. If certain conditions are met, a derivative may be specifically
designated as (a) a hedge of the exposure to changes in the fair value of a
recognized asset or liability or an unrecognized firm commitment, (b) a hedge of
the exposure to variable cash flows of a forecasted transaction, or (c) a hedge
of the foreign currency exposure of a net investment in a foreign operation, an
unrecognized firm commitment, an available-for-sale security, or a
foreign-currency-denominated forecasted transaction. In June 1999, the Financial
Accounting Standards Board issued Statement of Financial Accounting Standards
No. 137, "Accounting for Derivative Instruments and Hedging Activities -
Deferral of the Effective Date of FASB Statement No. 133" ("FAS No. 137"). FAS
No. 137 amends FAS No. 133 to defer its effective date to all fiscal quarters of
all fiscal years beginning after June 15, 2000. The Company is in the process of
determining the impact of adopting FAS No. 133.
NOTE 6--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 trade
date, these instruments are designated as either hedge positions or trade
positions.
For Interest Rate Agreements designated as hedge instruments, Dynex REIT
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
available for sale investment which is carried at its fair value are also
carried at fair value, with unrealized gains and losses reported as accumulated
other comprehensive 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 as a yield adjustment.
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.
Dynex REIT 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 in a collateralized bond structure,
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.
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.
NOTE 7 -- EMPLOYEE BENEFITS
During the nine months ended September 30, 1999, 149,742 Stock Appreciation
Rights ("SARs") under the Employee Incentive Plan were awarded. The total SARs
either forfeited or exercised during the nine months ended September 30, 1999
were 9,604. The total SARs remaining to be exercised were 357,833 at September
30, 1999. The Company expensed $2 related to the Employee and Board Incentive
Plans during the nine months ended September 30, 1999.
NOTE 8 -- 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
mortgage loans, and could incur losses. In the opinion of management, no
material losses are expected to result from any such representations and
warranties.
Dynex REIT facilitates the issuance of tax-exempt multifamily housing
bonds, the proceeds of which are used to fund mortgage loans on multifamily
properties. Dynex REIT is required to pay principal and interest to the
bondholders in the event there is a payment shortfall from the construction
proceeds. In addition, Dynex REIT is required to purchase the bonds if such
bonds are not able to be remarketed by the remarketing agent. Therefore, Dynex
REIT enters into standby letter of credit agreements to cover such commitments.
At September 30, 1999, Dynex REIT provided letters of credit to support its
obligations in amounts equal to $123,216.
NOTE 9 -- RELATED PARTY TRANSACTIONS
Dynex REIT has a credit arrangement with DHI whereby DHI and any of DHI's
subsidiaries can borrow funds from Dynex REIT to finance its production
operations. Under this arrangement, Dynex REIT can also borrow funds from DHI.
The terms of the agreement allow DHI and its subsidiaries to borrow up to $50
million from Dynex REIT at a rate of prime plus 1.0%. Dynex REIT can borrow up
to $50 million from DHI at a rate of one-month LIBOR plus 1.0%. This agreement
has a one-year maturity which is extended automatically unless notice is
received from one of the parties to the agreement within 30 days of the
anticipated termination of the agreement. As of September 30, 1999 and December
31, 1998, net borrowings due to DHI under this agreement totaled $30,212 and
$8,583, respectively. Net interest expense under this agreement was $395 and
$933 for the nine months ended September 30, 1999 and 1998, respectively.
Dynex REIT also has a loan origination agreement with Dynex Financial, Inc.
("DFI"), an operating subsidiary of DHI, whereby Dynex REIT pays DFI on a fee
plus cost basis for the origination of manufactured housing loans on behalf of
Dynex REIT. During the nine months ended September 30, 1999 and 1998, Dynex REIT
paid DFI $12,057 and $11,207, respectively under such agreement. This agreement
was terminated on October 8, 1999.
Dynex REIT has a loan origination agreement with Dynex Commercial, Inc.
("DCI"), an operating subsidiary of DHI, whereby Dynex REIT pays DCI a fee per
commercial real estate loan originated on behalf of Dynex REIT. Dynex REIT paid
DCI $1,870 and $3,832, respectively under this agreement for the nine months
ended September 30, 1999 and 1998.
Dynex REIT has various note agreements with Dynex Residential, Inc.
("DRI"), an operating subsidiary of DHI, and DRI's subsidiaries whereby DRI and
its subsidiaries can borrow up to $287,000 from Dynex REIT on a secured basis to
finance the acquisition of model homes from single family home builders. The
interest rate on the notes is adjustable and is based on 30-day LIBOR plus
2.875%. The outstanding balance of the notes as of September 30, 1999 and
December 31, 1998 was $198,790 and $159,377, respectively. Interest income
recorded by Dynex REIT on the notes for the nine months ended September 30, 1999
and 1998 was $10,956 and $8,709, respectively. These note agreements were
terminated on November 9, 1999.
Dynex REIT has entered into subservicing agreements with DCI, Dynex
Commercial Services, Inc. ("DCSI"), DFI and GLS Capital Services, Inc ("GLS") to
service commercial, single family, consumer, manufactured housing loans and
property tax receivables. For servicing the commercial loans, DCI or DSCI, as
applicable, receives an annual servicing fee of 0.02% of the aggregate unpaid
principal balance of the loans. For servicing the single family mortgage,
consumer and manufactured housing loans, DFI receives annual fees ranging from
sixty dollars ($60) to one hundred forty-four dollars ($144) per loan and
certain incentive fees. 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 $2,108 and $752 during the nine months ended September 30, 1999
and 1998, respectively.
Dynex REIT through its ownership of preferred stock, has a 99% economic
ownership interest in DHI.
NOTE 10 -- INVESTMENT IN AND NET ADVANCES TO DYNEX HOLDING, INC.
In December 1998, Dynex REIT changed its method of accounting for its
investment in DHI from the full consolidation method to a method that
approximates the equity method. The accounting change had no impact on net
income. For consistency purposes, Dynex REIT has revised the September 1998
financial statements to give retroactive effect to the change in accounting
method.
Investment in and net advances to DHI accounted for under a method similar
to the equity method amounted to $198,523 and $169,384 at September 30, 1999 and
December 31, 1998, respectively. The results of operations and financial
position of DHI are summarized below:
NOTE 11--OTHER MATTERS
During the nine months ended September 30, 1999, the Company issued 1,789
shares of its common stock pursuant to its dividend reinvestment program for net
proceeds of $29.
The Company repurchased 66,100 shares of its common stock outstanding at an
aggregate purchase price of $700, or $10.59 per share, during the nine months
ended September 30, 1999. The Company has remaining authorization to purchase up
to 848,900 shares of its common stock.
The Company did not declare a dividend on its preferred stock during the
third quarter of 1999. As of September 30, 1999, the amount of dividends in
arrears on the 9.75% Cumulative Convertible Series A Preferred Stock, the 9.55%
Cumulative Convertible Series B Preferred Stock and the 9.73% Cumulative
Convertible Series C Preferred Stock was $766 ( $0.585 per Series A share),
$1,119 ($0.585 per Series B share) and $1,343 ($0.73 per Series C share),
respectively.
At the special meeting of shareholders, held on July 26, 1999, the
shareholders approved an amendment to the Articles of Incorporation to effect a
one-for-four reverse split of the issued and outstanding shares of the Company's
$0.01 par value common stock to holders of record on August 2, 1999. All
references in the accompanying financial statements to the per share amounts and
the number of shares of common stock, except for shares authorized, issued and
outstanding for 1998 have been restated to reflect the reverse stock split.
NOTE 12--SUBSEQUENT EVENTS
On November 10, 1999, the Company sold the model home sale/leaseback
operations and related assets to Residential Funding Corporation, an indirect
subsidiary of General Motors Corporation. Total proceeds received on the sale of
the operations were approximately $197,000. The Company used the proceeds of the
sale to pay down $181,000 of recourse debt. The Company expects to record a gain
on the sale net of the reserves. Asa result of the sale, the Company's
investment in and net advances to Dynex Holding, Inc. were reduced by
approximately $190,000.
On October 11, 1999, the Company signed a non-binding letter of intent with
a financial services company for the sale of the Company's manufactured housing
lending operations and related assets. However, a definitive purchase agreement
has not been executed as of the date hereof, and no assurance can be made that
such interested party will execute such an agreement. The transaction, if
completed, is not expected to have a material impact on the Company's
financial statements.
On November 12, 1999, the Company re-securitized approximately $388,000 of
single family residential collateral through the issuance of one series of
collateralized bonds. The Company used the proceeds of such securitzation to pay
down $357,000 of recourse debt. This securitization will be accounted for as a
financing transaction under generally accepted accounting principles.
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
primarily 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 Collateral for collateralized bonds
consists primarily of securities backed by adjustable-rate and fixed-rate
mortgage loans secured by first liens on single family properties, 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 September 30, 1999, the
Company had 28 series of collateralized bonds outstanding. The collateral for
collateralized bonds decreased to $3.9 billion at September 30, 1999 compared to
$4.3 billion at December 31, 1998. This decrease of $0.4 billion is primarily
the result of $958.5 million in paydowns on collateral, which was principally
offset by the net addition of $548.5 million of collateral as a result of the
issuance of two series of collateralized bonds in March 1999 and September 1999.
Securities Securities consist primarily of fixed-rate "funding notes"
secured by automobile installment contracts, adjustable-rate and fixed-rate
mortgage-backed securities, and corporate bonds. Securities also include
derivative and residual securities. 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.
Securities decreased to $191.8 million at September 30, 1999 compared to $244.0
million at December 31, 1998. This decrease was primarily the result of $66.3
million of paydowns and the sale of $18.5 million of securities during the nine
months ended September 30, 1999. These decreases were partially offset by the
purchase of $23.7 million of securities during the nine months ended September
30, 1999.
Other investments Other investments consists primarily of 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 $30.4 million at December 31, 1998 to $51.0 million at September 30, 1999.
This increase of $20.6 million is primarily the result of the purchase of $16.9
million of property tax receivables during the nine months ended September 30,
1999.
Loans held for securitization Loans held for securitization decreased from
$388.8 million at December 31, 1998 to $317.4 million at September 30, 1999.
This decrease was primarily due to the securitization of $548.5 million of loans
held for securitization as collateral for collateralized bonds issued during the
nine months ended September 30, 1999 and the sale of $37.2 million of loans held
for securitization during the nine months ended September 30, 1999. This
decrease was partially offset by new loan fundings from the Company's production
operations totaling $594.7 million during the nine months ended September 30,
1999.
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. The non-recourse debt decreased from $3.7 billion at December 31,
1998 to $3.0 billion at September 30, 1999. This decrease was primarily a result
of paydowns on all collateralized bonds of $937.4 million during the nine months
ended September 30, 1999. In addition, during the third quarter of 1999 Dynex
REIT called $456.1 million of its collateralized bonds which were subsequently
financed through repurchase agreements. These decreases were partially offset by
Dynex REIT adding $1.7 billion of collateralized bonds during the nine months
ended September 30, 1999. Of this $1.7 billion of collateralized bonds, $1.0
billion related to the collapse and re-securitization of six series of
collateralized bonds.
Recourse debt Recourse debt increased to $1.2 billion at September 30, 1999
from $1.0 billion at December 31, 1998. This increase was primarily due to the
net addition of $369.5 million of repurchase agreements as a result of Dynex
REIT calling $456.1 million of collateralized bonds during the third quarter of
1999 and the net addition of $379.6 million of notes payable resulting from
additional loan fundings during the nine months ended September 30, 1999. These
increases were partially offset by the securitization of $648.4 million of
manufactured housing loans as collateral for collateralized bonds during the
nine months ended September 30, 1999. These loans were previously financed by
$84.1 million of repurchase agreements and $256.2 million of notes payable.
Shareholders' equity Shareholders' equity decreased to $426.5 million at
September 30, 1999 from $452.8 million at December 31, 1998. This decrease was
primarily the result of a $25.3 million increase in the net unrealized loss on
investments available-for-sale from $3.1 million at December 31, 1998 to $28.4
million at September 30, 1999.
Loan Production Activity
($ in thousands)
Direct loan production for the nine months ending September 30, 1999
totaled $736.8 million compared to $1,031.0 million for the same period in 1998.
This decrease in loan production was due to decreased origination volume of
commercial loans and specialty finance loans during 1999. This decreased volume
was partially offset by increased origination volume of manufactured housing
loans during 1999. In addition to the Company's direct loan production, the
Company funded $13.7 million of funding notes and called $0.2 million of bonds
during the nine months ended September 30, 1999 compared to $100.3 million of
funding notes and $455.7 million of bond calls during the same period in 1998.
There were no bulk purchases during the first nine months of 1999 compared to
$562.0 million of bulk purchases during the same period in 1998.
On November 10, 1999, the Company sold the model home sale/leaseback
operations and related assets to Residential Funding Corporation, an indirect
subsidiary of General Motors Corporation. Total proceeds received on the sale of
the operations were approximately $197,000. The Company used the proceeds of the
sale to pay down $181,000 of recourse debt. The Company expects to record a gain
on the sale net of the reserves. As a result of the sale, the Company's
investment in and net advances to Dynex Holding, Inc. were reduced by
approximately $190,000.
On October 11, 1999, the Company signed a non-binding letter of intent with
a financial services company for the sale of the Company's manufactured housing
lending operations and related assets. However, a definitive purchase agreement
has not been executed as of the date hereof, and no assurance can be made that
such interested party will execute such an agreement. the transaction, if
completed, is not expected to have a material impact on the Company's financial
statements.
RESULTS OF OPERATIONS
Three and Nine Months Ended September 30, 1999 Compared to Three and Nine
Months Ended September 30, 1998. The decrease in net income and net income per
common share during the three and nine months ended September 30, 1999 as
compared to the same period in 1998 is primarily the result of a decrease in net
interest margin and a decrease in the gain on sale of investments and trading
activities.
Net interest margin for the nine months ended September 30, 1999 decreased
to $38.1 million, or 22% below the $49.0 million for the same period for 1998.
Net interest margin for the three months ended September 30, 1999 decreased to
$12.3 million, or 16%, below the $14.6 million for the same period for 1998.
These decreases were primarily the result of the decline in average
interest-earning assets from $5.6 billion and $5.5 billion for the three and
nine months ended September 30, 1998, respectively, to $4.6 billion and $4.7
billion for the three and nine months ended September 30, 1999, respectively. In
addition, provision for losses increased to $10.9 million or 0.31% on an
annualized basis of average interest-earning assets during the nine months ended
September 30, 1999 compared to $5.4 million and 0.13% during the nine months
ended September 30, 1998. Provision for losses increased to $3.3 million or
0.29% on an annualized basis of average interest-earnings assets during the
three months ended September 30, 1999 compared to $2.2 million and 0.16% during
the same period in 1998. This increase in provision for losses was a result of
increasing the provision for potential losses on the commercial loans that
collateralize the securitization issued in December 1998 and increasing the
reserves for potential losses on single family and manufactured housing loans.
Net interest margin was also reduced as a result of the Company's accrual of
servicing fees totaling approximately $1.2 million to AutoBond
AcceptanceCorporation("AutoBond") for monthly servicing fees for the period of
February 1999 through June 1999.
The net (loss) gain on sale of investments and trading activities for the
nine months ended September 30, 1999 decreased to a $13.8 million loss, as
compared to a $6.3 million gain for the same period in 1998. The net (loss) gain
on sale of investments and trading activities for the three months ended
September 30, 1999 decreased to a $7.3 million loss, as compared to a $1.4
million loss for the same period in 1998. The decrease for both the three and
nine months ended September 30, 1999 is primarily the result of a $8.2 million
writedown for the permanent impairment of certain securities and a $0.9 million
writedown on the permanent impairment of certain other investments during the
three months ended September 30, 1999. In addition, the Company had a $5.8
million loss related to the sale or writedown of $67.4 million of commercial
loans and a $2.7 million loss primarily related to the write-off of hedge
positions on $64.4 million of commercial loan commitments during the nine months
ended September 30, 1999. The Company also had a $1.2 million loss on the sale
of $18.5 million of securities during the nine months ended September 30, 1999.
These decreases were partially offset by $4.2 million of realized gains on
various derivative trading positions entered into during the nine months ended
September 30, 1999. The net (loss) gain on sale of investments and trading
activities for the three months ended September 30, 1998 was primarily the
result of net losses of $8.1 million on various trading positions closed during
the three months ended September 30, 1998. This loss was partially offset by
sale of securities and collateralized bonds with an aggregate principal balance
of $220.9 million during the three months ended September 30, 1998, for an
aggregate net gain of $6.7 million. The net (loss) gain on sale of investments
and trading activities for the nine months ended September 30, 1998 was
primarily the result of net gains recognized of $8.6 million on the sale of
securities and collateralized bonds with an aggregate principal balance of
$274.2 million during the nine months ended September 30, 1998. These gains were
partially offset by the net losses recognized of $2.2 million on trading
positions entered into during the nine months ended September 30, 1998.
Net administrative fees and expenses to DHI decreased $1.2 million, or 7%,
to $15.6 million in the nine months ended September 30, 1999. This decrease is
primarily the result of decreased origination volume of the Company's commercial
loan production operations.
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 to 1.32% and 1.26% for the three and nine
months ended September 30, 1999 from 1.11% and 1.16% for the same periods in
1998. This increase was primarily due to a reduction in premium amortization
expense, which decreased from $6.3 million and $21.8 million for the three and
nine months ended September 30, 1998, respectively to $3.4 million and $14.0
million for the same periods in 1999. The overall yield on interest-earning
assets increased to 7.60% for the three months ended September 30, 1999 from
7.50% for the three months ended September 30, 1998. The overall yield on
interest-earnings assets decreased to 7.36% for the nine months ended September
30, 1999 from 7.57% for the same period in 1998. The cost of interest-bearing
liabilities decreased to 6.28% and 6.10% for the three and nine months ended
September 30, 1999, respectively, from 6.39% and 6.41% for the three and nine
months ended September 30, 1998, respectively.
Individually, the net interest spread on collateral for collateralized
bonds increased 35 basis points, from 96 basis points for the nine months ended
September 30, 1998 to 131 basis points for the same period in 1999. This
increase was primarily due to lower premium amortization caused by decreased
prepayments during the nine months ended September 30, 1999 compared to the same
period in 1998. The net interest spread on securities decreased 212 basis
points, from 199 basis points for the nine months ended September 30, 1998 to a
negative 13 basis points for the nine months ended September 30, 1999. This
decrease was primarily the result of the sale of certain higher coupon
collateral during the third quarter of 1998. In addition, certain assets were
placed on non-accrual status during the third quarter of 1998. The net interest
spread on other investments increased 31 basis points, from 131 basis points for
the nine months ended September 30, 1998, to 162 basis points for the same
period in 1999, due to a higher interest rate paid in 1999 by Dynex Residential,
Inc. ("DRI"), an operating subsidiary of DHI, to Dynex REIT in conjunction with
DRI's note payable to Dynex REIT related to the Company's single family model
home purchase and leaseback business, effective as of January 1, 1999. The net
interest spread on loans held for securitization decreased 24 basis points, from
279 basis points for the nine months ended September 30, 1998, to 255 basis
points for the same period in 1999. This decrease is primarily attributable to
the funding of lower coupon collateral during the nine months ended September
30, 1999.
Interest Income and Interest-Earning Assets
Average interest-earning assets declined to $4.6 billion for the three
months ended September 30, 1999, a decrease of approximately 18% from $5.6
billion of average interest-earning assets during the same period of 1998. This
decrease in average interest-earning assets was primarily the result of $1.6
billion of principal payments during the twelve months ended September 30, 1999.
In addition, $180.4 million of investments were sold during the same period.
These decreases were partially offset by loan originations of $860.7 million for
the twelve months ended September 30, 1999. In addition, Dynex REIT purchased
$72.4 million of securities and $198.3 million of other investments during the
twelve months ended September 30, 1999. Total interest income decreased
approximately 17%, from $104.5 million for the three months ended September 30,
1998 to $86.7 million for the same period of 1999. This decrease in total
interest income was due to the decline in average interest-earnings assets.
Overall, the yield on interest-earning assets increased to 7.60% for the three
months ended September 30, 1999 from 7.50% for the three months ended September
30, 1998, due to lower premium amortization caused by decreased collateral
prepayments.
On a quarter to quarter basis, average interest-earning assets remained
relatively flat at $4.6 billion for the quarter ended September 30, 1999 when
compared with the quarter ended June 30, 1999. During the quarter ended
September 30, 1999, principal payments totaled $262.3 million. This decrease was
offset by $236.4 million of loans funded through the production operations.
Total interest income for the quarter ended September 30, 1999 was $86.7 million
versus $84.0 million for the quarter ended June 30, 1999. This increase in total
interest income was due primarily to lower premium amortization caused by
decreased prepayments and an increase in the six-month LIBOR which increased 31
basis points during the third quarter of 1999.
Earning Asset Yield
($ in millions)
Approximately $1.8 billion of the investment portfolio as of September 30,
1999 is comprised of loans or securities that have coupon rates which adjust
over time (subject to certain periodic and lifetime limitations) in conjunction
with changes in short-term interest rates. Approximately 64% of the ARM loans
underlying the ARM securities and collateral for collateralized bonds are
indexed to and reset based upon the level of six-month LIBOR; approximately 27%
are indexed to and reset based upon the level of the one-year Constant Maturity
Treasury (CMT) index. The following table presents a breakdown, by principal
balance, of the Company's collateral for collateralized bonds and ARM and fixed
mortgage securities by type of underlying loan. This table excludes other
derivative and residual securities, other securities, other investments and
loans held for securitization.
Investment Portfolio Composition (1)
($ 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, premiums
on the collateral for collateralized bonds, ARM securities, fixed-rate mortgage
securities and other securities at September 30, 1999 were $45.4 million, or
approximately 1.18% of the aggregate investment portfolio. The decrease of the
net premium from $60.7 million at June 30, 1990 to $45.4 million at September
30, 1999 was due primarily to the addition of one series of collateralized bond
during the third quarter of 1999 with a net discount of $11.6 million. Of this
$45.4 million, $35.5 million relates to the premium on multifamily and
commercial mortgage loans that have prepayment lockouts or yield maintenance for
at least seven years. Amortization expense as a percentage of principal paydowns
has increased from 1.05% for the three months ended September 30, 1998 to 1.40%
for the same period in 1999, primarily due to the multifamily and commercial
securitization during the fourth quarter of 1998. The principal prepayment rate
for the Company (indicated in the table below as "CPR Annualized Rate") was
approximately 28% for the three months ended September 30, 1999, which was a
decrease from 40% one year ago. CPR or "constant prepayment rate" is a measure
of the annual prepayment rate on a pool of loans. Excluded from this table are
the Company's loans held for securitization, which are carried at a net discount
of $6.2 million at September 30, 1999.
Premium Basis and Amortization
($ in millions)
Interest Expense and Cost of Funds
Dynex REIT's largest expense is the interest cost on borrowed funds. Funds
to finance the investment portfolio are borrowed primarily 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. Dynex REIT 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 they relate.
Average borrowed funds decreased from $5.4 billion for the three months ended
September 30, 1998 to $4.3 billion for the same period in 1999. This decrease
resulted primarily from the decline in interest-earning assets of $1.0 billion
during the twelve months ended September 30, 1999 and the paydown of the related
borrowings. For the three months ended September 30, 1999, interest expense
decreased to $66.8 million from $86.0 million for the three months ended
September 30, 1998, while the average cost of funds decreased to 6.28% for the
three months ended September 30, 1999 compared to 6.39% for the same period in
1998. The decreased average cost of funds for the third quarter of 1999 compared
to the third quarter of 1998 was mainly a result of a decrease in the one-month
LIBOR rate during the fourth quarter of 1998.
Cost of Funds
($ in millions)
Interest Rate Agreements
As part of the asset/liability management process for its investment
portfolio, Dynex REIT may enter into interest rate agreements such as interest
rate caps, 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
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 cash flow and to provide income and capital
appreciation to Dynex REIT 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
loan production operations as generally these agreements are used to hedge
interest rate risk related to 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. 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)
(Notional Amounts 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 September 30, 1999, net
hedging expense amounted to $0.97 million compared to $1.09 million and $1.92
million for the quarters ended June 30, 1999 and September 30 1998,
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 net interest rate agreement
expense decreased for the three months ended September 30, 1999 compared to the
same period in 1998, primarily due to the Company entering into $1.1 billion of
new interest rate agreements during the third quarter of 1998. Due to a decline
in Treasury yields during the fourth quarter of 1998, the Company terminated
$1.2 billion of interest rate agreements for a total loss of $10.1 million.
Also, the Company terminated $102.2 million of interest rate swap agreements for
a total loss of $0.8 million during the nine months ended September 30, 1999 as
the collateral which the interest rate swap was hedging was amortizing at a
faster rate than the original swap. This loss is being amortized into interest
income over the estimated remaining life of the collateral as a yield
adjustment. The decrease was also due to the expiration of $235 million of
interest rate caps in January 1999.
Net Interest Rate Agreement Expense
($ in millions)
Fair Value
The fair value of the available-for-sale portion of the investment
portfolio as of September 30, 1999, as measured by the net unrealized loss on
investments available-for-sale, was $28.4 million below its cost basis, which
represents a $25.3 million decrease from December 31, 1998. At December 31,
1998, the fair value of the investment portfolio was $3.1 million below its
amortized cost basis. This decrease in the portfolio's value is primarily
attributable to prepayments on the portfolio, an increase of 50 basis points in
the targeted Fed Funds rate and the approximate 1% increase in long-term
interest rates during 1999.
Credit Exposures
The Company securitizes its loan production into collateralized bonds or
pass-through securitization structures. With either structure, the Company may
use overcollateralization, subordination, reserve funds, bond insurance,
mortgage pool insurance or any combination of the foregoing as a form of credit
enhancement. With all forms of credit enhancement, the Company may retain a
limited portion of the direct credit risk after securitization.
The following table summarizes the aggregate principal amount of collateral
for collateralized bonds and pass-through securities outstanding; the maximum
direct credit exposure retained by the Company (represented by the amount of
overcollateralization pledged and subordinated securities rated below BBB owned
by the Company), net of the credit reserves maintained by the Company for such
exposure; and the actual credit losses incurred for each quarter. The table
excludes any risks related to representations and warranties made on loans
funded by the Company and securitized in mortgage pass-through securities
generally funded prior to 1995. This table also excludes any credit exposure on
loans held for securitization (which will be included as the loans are
securitized), funding notes and other investments. The increase in net credit
exposure as a percentage of the outstanding loan principal balance from 2.98% at
September 30, 1998 to 4.93% at September 30, 1999 is related primarily to the
credit exposure retained by the Company on its commercial securitization issued
during December 1998 and its single family and manufactured housing
securitizations issued during March 1999 and September 1999.
Credit Reserves and Actual Credit Losses
($ 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 has decreased to 1.95% at September 30,
1999 from 2.12% at September 30, 1998. 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 September 30, 1999, management believes the credit reserves are sufficient to
cover anticipated losses which may occur as a result of current delinquencies
presented in the table below.
Delinquency Statistics (1)
The following table summarizes the credit ratings for collateral for
collateralized bonds and securities held in the investment portfolio. This table
excludes $14.0 million of other derivative and residual securities (as the risk
on such securities is primarily prepayment-related, not credit-related), other
investments and loans held for securitization. This table also excludes the
funding notes, aggregating $104.4 million which are not rated. The balance of
the investments rated below A are net of credit reserves and discounts. All
balances exclude the related mark-to-market adjustment on such assets. At
September 30, 1999, securities with a credit rating of AA or better were $3.3
billion, or 89.2% of the total.
Investments by Credit Rating (1)
($ in millions)
General and Administrative Expenses
General and administrative expenses and net administrative fees and
expenses to DHI ("collectively, G&A expense") consist of expenses incurred in
conducting the production activities and managing the investment portfolio, as
well as various other corporate expenses. G&A expense decreased $1.5 million
from $7.7 million for the three months ending September 30, 1998 to $6.3 million
for the three months ending September 30, 1999. This decrease is primarily the
result of decreased origination volume of the Company's commercial loan
production operations. The Company expects overall G&A expense levels to
decrease as a result of the sale of the model home business and the anticipated
sale of the manufactured housing business.
The following table summarizes the ratio of G&A expense to average
interest-earning assets and the ratios of G&A expense to average total equity.
Operating Expense Ratios
Net Income and Return on Equity
Net income decreased from $6.5 million for the three months ended September
30, 1998 to $0.3 million for the three months ended September 30, 1999. Net
income available to common shareholders decreased from $3.3 million for the
three months ended September 30, 1998 to a $2.9 million loss for the same period
in 1999. Return on common equity (excluding the impact of the net unrealized
gain on investments available-for-sale) decreased from 3.7% for the three months
ended September 30, 1998 to a negative 3.5% for the three months ended September
30, 1999. The decrease in the return on common equity is primarily a result of
the decline in net income available to common shareholders from the quarter
ended September 30, 1998 to the same period in 1999 and the issuance of new
common shares during the second half of 1998.
Components of Return on Equity
($ in thousands)
Dividends and Taxable Income
Dynex REIT has 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. Dynex REIT
may issue additional common stock, preferred stock or other securities in the
future in order to fund growth in its operations, growth in its investment
portfolio or for other purposes.
Dynex REIT intends to declare and pay out as dividends 100% of its taxable
income over time. Dynex REIT's current practice is to declare quarterly
dividends; however, no dividends on its common stock have been declared since
September 1998. Generally, Dynex REIT strives to declare a quarterly dividend
which will result in the distribution of most or all of the taxable income
earned during the applicable year. At the time of the dividend announcement,
however, the total level of taxable income for the quarter is unknown.
Additionally, Dynex REIT has considerations other than the desire to pay out
most of its taxable earnings, which may take precedence when determining the
level of dividends. The Company believes that any dividends paid in 1999 will
not be a return of capital. The Company has not yet completed its analysis of
taxable earnings for the three and nine months ended September 30, 1999.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards 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. It
requires that an entity recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments
at fair value. If certain conditions are met, a derivative may be specifically
designated as (a) a hedge of the exposure to changes in the fair value of a
recognized asset or liability or an unrecognized firm commitment, (b) a hedge of
the exposure to variable cash flows of a forecasted transaction, or (c) a hedge
of the foreign currency exposure of a net investment in a foreign operation, an
unrecognized firm commitment, an available-for-sale security, or a
foreign-currency-denominated forecasted transaction. In June 1999, the Financial
Accounting Standards Board issued Statement of Financial Accounting Standards
No. 137, "Accounting for Derivative Instruments and Hedging Activities -
Deferral of the Effective Date of FASB Statement No, 133" ("FAS No. 137"). FAS
No. 137 amends FAS No. 133 to defer its effective date to all fiscal quarters of
all fiscal years beginning after June 15, 2000. The Company is in the process of
determining the impact of adopting FAS No. 133.
Year 2000
The Company is dependent upon purchased, leased, and internally-developed
software to conduct certain operations. In addition, the Company relies upon
certain counterparties such as banks and loan servicers who are also highly
dependent upon computer systems. The Company recognizes that some computer
software may incorrectly recognize dates beyond December 31, 1999. The ability
of the Company and its counterparties to correctly operate computer software in
the Year 2000 is critical to the Company's operations.
The Company uses several major and minor computer systems to conduct its
business operations. The computer systems deemed most important to the Company's
ability to continue operations are as follows:
The internally-developed loan origination system for manufactured housing
operations
The internally-developed loan origination and asset management system for
commercial loans
The internally-developed investment portfolio analytics, securitization,
and securities administration software
The purchased servicing system for commercial loans
The purchased servicing system for single family and manufactured housing
loans
The purchased general ledger accounting system
In addition, the Company is involved in data interchange with a number of
counterparties in the normal course of business. Each system or interface that
the Company relies on is being tested and evaluated for Year 2000 compliance.
The Company has contacted all of its key software vendors to determine
their Year 2000 readiness. The Company has received documentation from each of
the vendors providing assurances of Year 2000 compliance:
Baan/CODA, vendor of the general ledger accounting system, has provided
confirmation that their current software release is fully Year 2000 compliant.
Synergy Software, vendor of the commercial loan servicing system, has
provided confirmation that the current release of their software is fully Year
2000 compliant. The Company has installed and performed testing on this version
with no issues discovered.
Interlinq Software, vendor of the single family and manufactured housing
loan servicing software, has provided assurance that their software is Year 2000
compliant.
All software developed internally by the Company was designed to be Year
2000 compliant. Nevertheless, the Company established a Year 2000 test-bed to
ensure that there were no design or development oversights that could lead to a
Year 2000 problem. Initial testing of all key applications was completed in
January of 1999, with only minor issues discovered and subsequently remedied.
Critical application testing was completed in June of 1999, and new or upgraded
applications will continue to be tested as required through the century date
change.
The Company has reviewed or is reviewing the Year 2000 progress of its
primary financial counterparties; these counterparties are expected to be in
compliance. The Company, as master servicer of certain securities, is in the
process of assessing the Year 2000 readiness of its external servicers, to
ensure that these parties will be able to correctly remit loan information and
payments after December 31, 1999.
The Company believes that, other than its exposure to financial
counterparties, its most significant risk with respect to internal or purchased
software is the software systems used to service manufactured housing loans. The
Company will not be able to service these loans without the automated system.
Should these loans go unattended for a period greater than three months, the
result could have a material adverse impact on the Company.
The Company is also at significant risk if the systems of the financial
institutions that provide the Company financing and software for cash management
services should fail. In a worst case scenario, the Company would be unable to
fund its operations or pay on its obligations for an unknown period of failure.
This would have a material adverse impact on the Company.
The Company is also at significant risk if the voice and data
communications network supplied by its provider should fail. In such an instance
the Company would be unable to originate or efficiently service its manufactured
housing loans until the problem is remedied. The Company is closely monitoring
the Year 2000 efforts of its telecommunications provider; the provider has
provided assurance that their network is fully compliant at this time.
The Company is also at significant risk should the electric utility company
for the Company's offices in Glen Allen, Virginia, fail to provide power for
several business days. In such an instance, the Company would be unable (i) to
communicate over its telecommunication systems, (ii) would be unable to process
data, and (iii) would be unable to originate or service loans until the problem
is remedied. The Company continues to monitor the Year 2000 status of its
utility provider, who currently reports 99% completion of remediation and
testing and projects 100% compliance in December 1999.
The Company uses many other systems (including systems that are not
information technology oriented), both purchased and developed internally, that
could fail to perform accurately after December 31, 1999. Management believes
that the functions performed by these systems are either non-critical or could
be performed manually in the event of failure.
The Company has substantially completed its Year 2000 remediation efforts.
Management believes that there is little possibility of a significant disruption
in business. The major risks are those related to the ability of vendors and
business partners to complete Year 2000 plans. The Company expects that those
vendors and counterparties will complete their Year 2000 compliance programs
before January 1, 2000.
The Company has incurred less than $90,000 in costs to date in carrying out
its Year 2000 compliance program. The Company estimates that it will spend less
than $100,000 in total. Costs could increase in the event that the Company
determines that a counterparty will not be Year 2000 compliant.
The Company has developed contingency plans in the event that a
counterparty is not Year 2000 compliant.
LIQUIDITY AND CAPITAL RESOURCES
The Company finances its operations from a variety of sources. These
sources include 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 long-term (after securitization) basis.
However, market conditions over the past twelve months have reduced the
Company's access to capital. Further, if a significant decline in the market
value of the investment portfolio that is funded with recourse debt should
occur, the available liquidity from these other borrowings may be reduced. As a
result of such reduction in liquidity, the Company may be forced to sell certain
investments in order to maintain liquidity. If required, these sales could be at
prices lower than the carrying value of such assets, which could result in
losses.
In order to grow its equity base, Dynex REIT 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 Dynex REIT would likely generate without such offerings. During the
first nine months of 1999, Dynex REIT issued 1,789 shares of its common stock
pursuant to its dividend reinvestment program for preferred stockholders for net
proceeds of $29 thousand.
Certain aspects of Dynex REIT's funding strategies subject it to liquidity
risk. Liquidity risk stems in part from Dynex REIT's use of repurchase
agreements, its use of committed lines of credit with mark-to-market provisions
and the reliance on the asset-backed securitization markets for its long-term
funding needs. Liquidity risk also stems from hedge positions the Company may
take to hedge its commercial and manufactured housing loan production.
Repurchase agreements are generally provided by investment banks, and subject
Dynex REIT to margin call risk if the market value of assets pledged as
collateral for the repurchase agreements declines. Dynex REIT has established
"target equity" requirements for each type of investment pledged as collateral,
taking into account the price volatility and liquidity of each such investment.
Dynex REIT strives to maintain enough liquidity to meet anticipated margin calls
if interest rates increased up to 200 basis points in a twelve-month period.
Dynex REIT has committed lines of credit and uncommitted repurchase
facilities to finance the accumulation of assets for securitization. Dynex REIT
borrows on these lines of credit 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, Dynex
REIT's ability to acquire or fund additional assets may be substantially reduced
and it may experience losses. Dynex REIT currently has a total of $0.8 million
of committed lines of credit to finance loans held for securitization and other
investments. These borrowings are paid down as Dynex REIT securitizes or sells
assets. Generally these borrowings allow for the warehousing of assets for a
period of 180-365 days. Dynex REIT generally intends to securitize assets by
product type every 120-365 days. If there exists a dislocation or disruption in
the asset-backed market, Dynex REIT may be unable to securitize the assets, or
may only be able to securitize the assets on unfavorable terms. In such a case,
Dynex REIT would be required to repay the lines of credit with either available
liquidity or would be required to liquidate the assets or other assets to
generate liquidity. In addition, lines of credit with commercial and investment
banks may include provisions by such banks to mark the collateral to market on a
daily basis. To the extent the market value of the associated asset has declined
due to market conditions, Dynex REIT may be required to provide additional
collateral or sell the associated asset which may result in losses. During the
quarter, the Company securitized $338.3 million of manufactured housing loans at
terms that were considered unfavorable to the Company. The Company currently has
retained $20.7 million in principal of the BBB rated class from that
securitization, in addition to the overcollateralization below the BBB level.
As a part of its strategy to hedge exposure to changes in interest rates on
commercial mortgage loans funded and commitments to fund commercial mortgage
loans, Dynex REIT may enter into forward sales of Treasury futures. Such sales
are executed through third parties, which require an initial cash collateral
deposit and may require additional cash collateral deposits in the event that
movements in interest rates adversely impact the value of the futures position.
The value of the related loans or loan commitments will generally increase in
value as the futures position decreases; however, such value is generally not
recognized until the loans are securitized. In order to maintain its hedge
positions, Dynex REIT may therefore be exposed to additional cash collateral
requirements in adverse interest rate environments.
A substantial portion of the assets are pledged to secure indebtedness
incurred by Dynex REIT. Accordingly, those assets would not be available for
distribution to any general creditors or the stockholders of Dynex REIT in the
event of the liquidation, except to the extent that the value of such assets
exceeds the amount of the indebtedness they secure.
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 are 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 September 30,
1999, Dynex REIT had $3.0 billion of collateralized bonds outstanding as
compared to $3.7 billion at December 31, 1998.
Recourse Debt
Secured. At September 30, 1999, Dynex REIT had five committed credit
facilities aggregating $1.0 billion, comprised of (i) a $250 million credit
line, expiring on May 29, 2000, from a consortium of commercial banks primarily
for the warehousing of multifamily construction and permanent loans (including
providing the letters of credit for tax-exempt bonds) and manufactured housing
loans, (ii) a $400 million credit line, expiring on December 1,1999, from an
investment bank primarily for the warehousing of permanent loans on multifamily
and commercial properties and (iii) a $100 million credit line, expiring on
November 15, 1999, from an investment bank for the warehousing of the funding
notes which has been extended to January 15, 2000, (iv) a $175 million credit
line, expiring on November 15, 1999 from a consortium of commercial banks and
finance companies to fund the purchase of model homes which was paid off on
November 10, 1999, and (v) a $50 million credit line, expiring on November 15,
1999 from a finance company to fund the purchase of model homes, which was also
paid off on November 10, 1999. The Company expects to repay the $400 million
credit line maturing on December 1, 1999 from the proceeds from the sale of the
assets collateralizing the facility, or to secure an extension of the line. If
the Company is unable to secure new credit facilities or receive an extension on
the existing facilities, the Company would be in default at the respective
maturity date of such credit facility. The lines of credit also contain certain
financial covenants which Dynex REIT met as of September 30, 1999. However,
changes in asset levels or results of operations could result in the violation
of one or more covenants in the future. The Company's recourse credit facilities
generally contain provisions that a default of any facility is a default on each
of the other facilities.
The following table summarizes the committed credit facilities at September
30, 1999. At September 30, 1999, Dynex REIT had $497.9 million outstanding under
its committed credit facilities.
Committed Credit Facilities
At September 30, 1999
($ in millions)
Dynex REIT also uses repurchase agreements to finance a portion of its
investments, which generally have thirty day maturities. Repurchase agreements
allow Dynex REIT 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
September 30, 1999, outstanding obligations under all repurchase agreements
totaled $598.3 million compared to $528.3 million at December 31, 1998. The
following table summarizes the outstanding balances of repurchase agreements by
credit rating of the related assets pledged as collateral to support such
repurchase agreements. The table excludes repurchase agreements used to finance
loans held for securitization.
Repurchase Agreements by Rating of Investments Financed
($ in millions)
Increases in short-term interest rates, long-term interest rates, or market
risk could negatively impact the valuation of securities and may limit Dynex
REIT's borrowing ability or cause various lenders 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. 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 loans. In instances of a downgrade of
an insurer or the deterioration of the credit quality of the underlying
collateral, Dynex REIT 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 a result of the Company's securitization on November 12, 1999, the
amount of the repurchase agreements were reduced by approximately $285 million
for the AAA category, by approximately $43 million for the AA category, by
approximately $20 million for the A category, and by approximately $9 million
for the BBB category.
Unsecured. Since 1994, Dynex REIT 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 loans held for
securitization during the accumulation period as well as for general corporate
purposes. These notes payable had an outstanding balance at September 30, 1999
of $117.8 million. The Company has $97.3 million outstanding of its July 2002
senior notes (the "2002 Notes") and $20.5 million outstanding on notes issued in
September 1994 (the "1994 Notes"). During the nine months ended September 30,
1999, Dynex REIT extinguished $2.75 million of the 2002 Notes resulting in a
$0.6 million extraordinary gain. Effective May 15, 1999, the Company completed a
restructuring of the 1994 Notes. In return for certain covenant relief related
to the fixed-charge coverage requirements of the 1994 Notes, the Company agreed
to (i) convert the principal amortization of the 1994 Notes from annual to
monthly and (ii) shorten the remaining principal amortization period from 30
months to 16. Monthly amortization of the 1994 Notes through October 1999
approximates $2.0 million. Monthly amortization for the 1994 Notes from November
1999 through August 2000 approximates $1.7 million. The Company has received a
waiver of a covenant in the 1994 Notes until December 23, 1999. The Company
expects the noteholders to continue to provide such waiver until the notes are
paid-off in August 2000.
Total recourse debt increased from $1.0 billion for December 31, 1998 to
$1.2 billion for September 30, 1999. This increase was primarily due to the net
addition of $369.5 million of repurchase agreements as a result from Dynex REIT
calling $455.9 million of collateralized bonds during the third quarter of 1999
and the net addition of $379.6 million of notes payable resulting from
additional loan fundings during the nine months ended September 30, 1999. These
increases were partially offset by the securitization of $648.4 million of
manufactured housing loans as collateral for collateralized bonds during the
nine months ended September 30, 1999. These loans were previously financed by
$84.1 million of repurchase agreements and $256.2 million of notes payable. On
November 10, 1999, the Company completed the sale of the model home
sale/leaseback operations and paid down recourse debt of $180.9 million. On
November 12, 1999, the Company completed a securitization of approximately $388
million of previously called collateralized bonds. As a result of this
securitization, recourse debt was reduced by approximately $357 million. In
total, these two transaction resulted in recourse debt declining by
approximately $540 million since September 30, 1999.
Table 1
Components of Collateral for Collateralized Bonds
($ in thousands)
Table 2
Principal Balance of Collateral for Collateralized Bonds by Loan Type
($ in thousands)
Table 3
Collateral for Collateralized Bonds by Collateral Type
($ in thousands)
Table 4
Repricing Period for Adjustable-Rate Single family and Manufactured Housing
Collateral As of September 30, 1999
($ in thousands)
Table 5
Commercial Loan Prepayment Protection Periods (1)
As of September 30, 1999
($ in thousands)
Table 6
Margin of Single Family Loans over Indices
($ in thousands)
Table 9
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 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 commercial and 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. If such
financing is not available or the Company is unable to replace existing credit
facilities upon their maturity, the Company's future results could vary
materially with its historical results.
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, there can be no assurances that
circumstances relating either to the Company or the capital markets may limit or
preclude the ability of the Company to sell such collateralized bonds or
securities 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
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 is 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 September 30, 1999, the yield curve
had steepened, and as a result, the Company expects a decline of prepayment
rates during the fourth quarter in 1999.
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.
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 reprice within
specified periods. The Company's strategy is 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. In many instances, the investment strategy involves not only the
creation of the asset, but also structuring the related securitization or
borrowing to create a stable yield profile and reduce interest rate risk.
The Company continuously 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. Generally, the Company adds
investments to its portfolio that are designed to increase the diversification
and reduce the variability of the yield produced by the portfolio in different
interest rate environments.
The Company's Portfolio Executive Committee ("PEC"), which includes
executive management representatives, monitors and manages the interest rate
sensitivity and repricing characteristics of the balance sheet components
consistent with maintaining acceptable levels of change in both the net
portfolio value and net interest income. The Company's exposure to interest rate
risk is reviewed on a monthly basis by the PEC and quarterly by the Board of
Directors.
The Company utilizes several tools and risk management strategies to
monitor and address interest rate risk, including (i) a quarterly sensitivity
analysis using option-adjusted spread ("OAS") methodology to calculate the
expected change in net interest margin as well as the change in the market value
of various assets within the portfolio under various extreme scenarios; and (ii)
a monthly static cash flow and yield projection under 49 different scenarios.
Such tools allow the Company to continually monitor and evaluate its exposure to
these risks and to manage the risk profile of the investment portfolio in
response to changes in the market risk. While the Company may use such tools,
there can be no assurance the Company will accomplish the goal of adequately
managing the risk profile of the investment portfolio.
The Company measures the sensitivity of its net interest income 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.
The following table summarizes the Company's net interest margin
sensitivity analysis as of September 30, 1999 and June 30, 1999. 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 September 30, 1999 and June 30,
1999. 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 uses
a dynamic prepayment model that applies a Constant Prepayment Rate (CPR) ranging
from 6.0% for fixed-rate manufactured housing loans to 69.1% for single family
ARM loans indexed to the six month certificate of deposit rate. The model varies
the CPR based on the projected incentive to refinance for each loan type in any
given period. 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, the Company has made
significant changes to its assets and liabilities, and is likely to do so in the
future. Therefore, the following estimates should not be viewed as a forecast
and no assurance can be given that actual results will not vary significantly
from the analysis below.
The September 30, 1999 analysis illustrates that net interest margin is
slightly more sensitive to interest rate changes than it was at June 30, 1999.
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. Based on the projections above,
the Company is in compliance with its stated policy regarding the interest rate
sensitivity of net interest margin.
Approximately $1.8 billion of the Company's investment portfolio as of
September 30, 1999 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 64% and 27%
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.
Because of the 1% or 2% periodic cap nature of the ARM loans underlying the
ARM securities, these securities may decline in market value in a rising
interest rate environment. In a rapidly increasing rate environment, as was
experienced in 1994, a decline in value may be significant enough to impact the
amount of funds available under repurchase agreements to borrow against these
securities. In order to maintain liquidity, the Company may be required to sell
certain securities. To mitigate this potential liquidity risk, the Company
strives to maintain excess liquidity to cover any additional margin required in
a rapidly increasing interest rate environment, defined as a 3% increase in
short-term interest rates over a twelve-month time period. Liquidity risk also
exists with all other investments pledged as collateral for repurchase
agreements, but to a lesser extent.
As part of its asset/liability management process, the Company enters into
interest rate agreements such as interest rate caps and swaps and financial
futures contracts ("hedges"). These interest rate agreements are used by the
Company to help mitigate the risk to the investment portfolio of fluctuations in
interest rates that would ultimately impact net interest income. To help protect
the Company's net interest income in a rising interest rate environment, the
Company has purchased interest rate caps with a notional amount of $1.4 billion,
which help reduce the Company's exposure to interest rate risk rising above the
lifetime interest rate caps on ARM securities and loans. These interest rate
caps provide the Company with additional cash flow should the related index
increase above the contracted rates. The contracted rates on these interest rate
caps are based on one-month LIBOR, six-month LIBOR or one-year CMT. The Company
will also utilize interest rate swaps to manage its exposure to changes in
financing rates of assets and to convert floating rate borrowings to fixed rate
where the associated asset financed is fixed rate. Interest rate caps and
interest rate swaps that the Company uses to manage certain interest rate risks
represent protection for the earnings and cash flow of the investment portfolio
in adverse markets. To date, short term interest rates have not risen at the
speed or to the extent such that the protective cashflows provided by the caps
and swaps have been realized.
The Company may also utilize futures and options on futures to moderate the
risks inherent in the financing of a portion of its investment portfolio with
floating-rate repurchase agreements. The Company uses these instruments to
synthetically lengthen the terms of repurchase agreement financing, generally
from one to three or six months. Interest rate futures and option agreements
have historically provided the Company a means of essentially locking-in
borrowing costs at specified rates for specified period of time. Under these
contracts, the Company will receive additional cash flow if the underlying index
increases above contracted rates, mitigating the net interest income loss that
results from the higher repurchase agreement rates The Company will pay
additional cash flow if the underlying index decreases below contracted rates.
The Company has not utilized futures or options on futures for this purpose
since 1997, as they primarily benefit the Company when expected rates as
measured by the forward yield-curve are less than current cash market rates.
The remaining portion of the Company's investments portfolio as of
September 30, 1999, approximately $2.6 billion, is comprised of loans or
securities that have coupon rates that are either fixed or do not reset within
the next 15 months. The Company has limited its interest rate risk on such
investments through (i) the issuance of fixed-rate collateralized bonds and
notes payable, and (ii) equity, which in the aggregate totals approximately $1.9
billion as of the same date. The Company's interest rate risk is primarily
related to the rate of change in short term interest rates, not the level of
short term interest rates.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
As disclosed in previous filings, Dynex Capital, Inc. (the "Company" or
"Dynex") filed suit in February 1999 against AutoBond Acceptance Corporation
(Amex: ABD) and AutoBond Master Funding Corporation V ("Funding"), a
wholly-owned subsidiary of AutoBond , collectively "AutoBond", in Federal court
seeking declaratory relief with respect to its rights and obligations under
various agreements (the "Agreements") by and between the Company and 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. AutoBond filed suit against Dynex
in the district court of Travis County, Texas (the "Texas Court") alleging
breach of contract and other claims relating to the suspension of funding by
Dynex of retail installment contracts originated by AutoBond. Dynex has
subsequently withdrawn its suit in Federal court as the Texas Court was
proceeding on a faster time schedule.
On June 4, 1999, Dynex filed a counterclaim in the Texas Court to the
AutoBond filing alleging, among other things, that Dynex was fraudulently
induced into the Agreements, that AutoBond has breached the Agreements in the
areas of underwriting, servicing and principal payments, and that AutoBond has
breached its fiduciary duties to Dynex. In addition to the June 4, 1999
counterclaim, on June 17, 1999, Dynex filed an application in the Texas Court
asking the Texas Court to enter a temporary injunction prohibiting AutoBond from
continuing to exercise unlawful control over loan files and the servicing of
loans and ordering of AutoBond to cooperate in the transition of the servicing
and the loan files to a substitute servicer.
On August 5, 1999, the Texas Court denied AutoBond's motion for injunctive
relief against the Company pertaining to its suspension of funding by the
Company of retail installment contracts originated by AutoBond. On August 26,
1999, the Texas Court granted Dynex's motion for temporary injunction ordering
to immediately desist and refrain from continuing to act as servicer on the
retail installment contracts which collateralize funding notes funded by the
Company. AutoBond was ordered by the court to immediately transfer the servicing
of the contracts to the Company. On August 30, 1999, the Texas Court denied
AutoBond's motion for reconsideration of the temporary injunction. The servicing
of such contracts has subsequently been transferred to a third party servicer
engaged by Dynex.
The Company is still a defendant in the lawsuit filed by AutoBond in the
Texas Court relating to the funding of automobile installment contracts. The
trial is currently scheduled to begin January 24, 2000.
As of September 30, 1999, the outstanding balance of the auto loans
underlying the funding notes was $115 million and the Company's carrying value
of the funding notes was $104 million. The funding notes had a weighted-average
coupon of 7.8% and the underlying auto loan collateral had a weighted-average
coupon of 19.8%. The funding notes receive all the cash (less applicable
servicing fees) received on the auto loans until paid in full.
The Company is subject to various lawsuits as a result of its lending
activities. The Company does not anticipate that the resolution of such lawsuits
will have a material impact on the Company's financial condition.
Item 2. Changes in Securities and Use of Proceeds
The shareholders approved an amendment to the Company's Articles of
Incorporation to effect a one-for-four split of the issued and outstanding
shares of common stock which became effective August 2, 1999.
Item 3. Defaults Upon Senior Securities
Not applicable
Item 4. Submission of Matters to a Vote of Security Holders
At the Company's special meeting of shareholders held on July 26, 1999, for
which proxies were solicited pursuant to Regulation 14 under the Securities
Exchange Act of 1934, the following matter was voted upon and approved by
shareholders.
1. Approval of an amendment to the Company's Articles of Incorporation to
effect a one-for-four split of the issued and outstanding shares of common
stock. Total number of votes for and against this matter was 32,634,847 and
3,432,490, respectively. The total number of shares abstained were 673,531.
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
None
(b) Reports on Form 8-K
None
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: November 15, 1999