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DX > SEC Filings for DX > Form 10-Q on 8-Nov-2012All Recent SEC Filings

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Form 10-Q for DYNEX CAPITAL INC


8-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations

The following discussion and analysis should be read in conjunction with our unaudited consolidated financial statements and accompanying notes included in this Quarterly Report on Form 10-Q for the three months ended September 30, 2012 and our audited Annual Report on Form 10-K for the year ended December 31, 2011. References herein to "Dynex," the "Company," "we," "us," and "our" include Dynex Capital, Inc. and its consolidated subsidiaries, unless the context otherwise requires. In addition to current and historical information, the following discussion and analysis contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to our future business, financial condition or results of operations. For a description of certain factors that may have a significant impact on our future business, financial condition or results of operations, see "Forward-Looking Statements" at the end of this discussion and analysis.

EXECUTIVE OVERVIEW

Company Overview

We are an internally managed mortgage real estate investment trust, or mortgage REIT, which invests in mortgage assets on a leveraged basis. Our objective is to provide attractive risk-adjusted returns to our shareholders over the long term that are reflective of a leveraged, high quality fixed income portfolio with a focus on capital preservation. We seek to provide returns to our shareholders through regular quarterly dividends and through capital appreciation.

We were formed in 1987 and commenced operations in 1988. Beginning with our inception through 2000, our operations largely consisted of originating and securitizing various types of loans, principally single-family and commercial mortgage loans and manufactured housing loans. Since 2000, we have been an investor in Agency and non-Agency mortgage-backed securities ("MBS"). Agency MBS consist of residential MBS ("RMBS") and commercial MBS ("CMBS"), which come with a guaranty of payment by the U.S. government or a U.S. government-sponsored entity such as Fannie Mae and Freddie Mac. Non-Agency MBS (also consisting of RMBS and CMBS) have no such guaranty of payment.

Our primary source of income is net interest income, which is the excess of the interest income earned on our investments over the cost of financing these investments. Our investment strategy as approved by our Board of Directors is a diversified investment strategy that currently targets higher credit quality, shorter duration investments in Agency MBS and non-Agency MBS. Investments considered to be of higher credit quality have less or limited exposure to loss of principal while investments which have shorter durations have less exposure to changes in interest rates. We currently target an overall investment portfolio composition of 60%-80% in Agency MBS with the balance in non-Agency MBS and securitized mortgage loans. Our securitized mortgage loans are single-family and commercial mortgage loans which were originated or purchased by us during the 1990s. We are not actively originating, purchasing, or securitizing mortgage loans.

RMBS

Currently, the Company's RMBS investments are primarily Agency RMBS. Agency RMBS are comprised primarily of hybrid Agency adjustable-rate mortgage loans ("ARMs") and Agency ARMs. Hybrid Agency ARMs are MBS collateralized by hybrid adjustable-rate mortgage loans which are loans that have a fixed rate of interest for a specified period (typically three to ten years) and which then adjust their interest rate at least annually to an increment over a specified interest rate index as further discussed below. Agency ARMs are MBS collateralized by adjustable-rate mortgage loans which have interest rates that generally will adjust at least annually to an increment over a specified interest rate index. Agency ARMs also include hybrid Agency ARMs that are past their fixed-rate periods or within twelve months of their initial reset period. The Company may also invest in fixed-rate Agency RMBS from time to time.

Interest rates on the adjustable-rate mortgage loans collateralizing hybrid Agency ARMs or Agency ARMs are based on specific index rates, such as the London Interbank Offered Rate, or LIBOR, the one-year constant maturity treasury rate, or CMT, the Federal Reserve U.S. 12-month cumulative average one-year CMT, or MTA, or the 11th District Cost of Funds Index, or COFI. These loans will typically have interim and lifetime caps on interest rate adjustments, or interest rate caps, limiting the amount that the rates on these loans may reset in any given period.


CMBS

The Company's Agency and non-Agency CMBS are comprised of fixed-rate securities collateralized by first mortgage loans on multifamily properties that are typically prohibited from voluntary prepayment or have yield maintenance provisions. These features of CMBS provide the Company some measure of protection against prepayment of the investment. A portion of the Company's Agency and non-Agency CMBS also include interest only securities ("IOs") which represent the right to receive excess interest payments (but not principal cash flows) based on the underlying unpaid principal balance of the underlying pool of mortgage loans.

Investment Risk

In executing our investment strategy, we seek to balance the various risks of owning mortgage assets, such as interest rate, credit, prepayment, and liquidity risk with the earnings opportunity on the investment. We believe our strategy of investing in Agency and non-Agency MBS provides superior diversification of these risks across our investment portfolio and therefore provides ample opportunities to generate attractive risk-adjusted returns while preserving our shareholders' capital. We also believe that our shorter duration strategy will provide less volatility in our results and in our book value per common share than strategies which invest in longer duration assets with that may be more exposed to interest rate risk.

For further discussion of the Company, its operating policies and restrictions, its investment philosophy and strategy, and its financing and hedging strategy, see the Company's Annual Report on Form 10-K for the year ended December 31, 2011.

Factors that Affect Our Results of Operations and Financial Condition

The performance of our investment portfolio will depend on many factors, many of which are beyond our control. These factors include, but are not limited to, interest rates, trends of interest rates, the relative steepness of interest rate curves, prepayment rates on our investments, competition for investments, economic conditions and their impact on the credit performance of our investments, and actions taken by the U.S. government, including the U.S. Federal Reserve and the U. S. Department of the Treasury (the "Treasury").

In addition, our business model may be impacted by other factors such as the availability and cost of financing and the state of the overall credit markets.
Reductions in the availability of financing for our investments could significantly impact our business and force us to sell assets that we otherwise would not sell, potentially at losses or at amounts below their true fair value. Other factors also impacting our business include changes in regulatory requirements, including requirements to qualify for registration under the Investment Company Act of 1940 and REIT requirements.

Investing in mortgage-related securities on a leveraged basis subjects us to a number of risks which are discussed in Item 3, "Quantitative and Qualitative Disclosures about Market Risk" and in the "Liquidity and Capital Resources" section of this Item 2, including interest rate risk, prepayment and reinvestment risk, credit risk, market value risk and liquidity risk. Please see these Items for detailed discussion of these risks and the potential impact on our results of operations and financial condition.

Trends and Recent Market Impacts

The following marketplace conditions and prospective trends have impacted and may continue to impact our future results of operations and our financial condition. For additional information about risks that may be posed by these trends, please refer to Part I, Item 3, "Quantitative and Qualitative Disclosures about Market Risk" as well as Part II, Item 3, "Risk Factors" contained within this Quarterly Report on Form 10-Q for the three months ended September 30, 2012 in addition to Part I, Item 1A, "Risk Factors" of our Annual Report on Form 10-K for the year ended December 31, 2011.

Federal Reserve Monetary Policy and the Effects on Agency RMBS and Prepayments

In September 2012, the Federal Open Market Committee ("FOMC") announced "QE3" by indicating that it will purchase $40 billion per month in fixed-rate Agency RMBS, continue to reinvest principal repayments on its existing Agency RMBS portfolio, and extend the average maturity of its holdings of securities. These actions are expected to increase the FOMC's holdings


of longer-term securities by about $85 billion each month through the end of the year. The Federal Reserve expects these measures to put downward pressure on long-term interest rates. While the Federal Reserve hopes that QE3 will expedite an economic recovery, stabilize prices, reduce unemployment and restart business and household spending, there is no way of knowing what impact QE3 or any future actions by the Federal Reserve will have on the prices and liquidity of Agency RMBS or other securities in which we invest.

During the third quarter of 2012, we received principal payments on our Agency RMBS of $179.1 million. Our average constant prepayment rate, or CPR, for our Agency RMBS during the third quarter of 2012 was 23.4% versus 20.8% for the second quarter of 2012 and 21.4% for the first quarter of 2012. As of September 30, 2012, the weighted average coupon on the mortgage loans underlying our Agency RMBS was 4.22%, while the monthly average 30-year fixed mortgage rate and the 5-year hybrid ARM mortgage rate as of that date, as published by Freddie Mac, were 3.47% and 2.73%, respectively.

Generally, the lower coupons available on new mortgage loans, the actions by the Federal Reserve and the low interest rate environment should entice borrowers to refinance their mortgage loans at lower rates. Today, however, many obstacles exist to refinancing, including but not limited to, tighter lender underwriting standards, the lack of borrower's equity in the underlying real estate and the lack of an acceptable level of income. These obstacles are currently contributing to limited refinancing of loans in our Agency RMBS portfolio and are keeping prepayment speeds low relative to expectations and to historic prepayment rates in such a low interest rate environment. In an effort to increase refinancing of Agency RMBS, the U.S. Treasury created the Home Affordable Refinance Program, or HARP, which seeks to ease refinancing restrictions for high LTV borrowers. The HARP program eases underwriting requirements for lenders and qualification conditions for borrows to extend loans which qualify for inclusion in Agency RMBS.

Given the continued low interest rate environment, the changes to HARP, and the commitment by the Federal Reserve to keep long-term interest rates low, including the Federal Reserve's actions through QE3, we continue to expect somewhat elevated prepayment speeds on our Agency RMBS for the balance of 2012. As noted elsewhere, increased prepayments impact our net interest income by increasing the amortization expense on any investments we own at premiums to their par balance and lowers security yields.

Asset Spreads and Competition for Assets

Over the past few years, credit markets in the United States have generally experienced tightening credit spreads (where credit spreads are defined as the difference between yields on securities with credit risk and yields on benchmark U.S. Treasury securities). Spreads in assets that we invest in particular have tightened over the past several quarters from increased competition for these assets from lack of supply and from favorable market conditions in large part due to the Federal Reserve's involvement in the markets (as discussed above and below). Reductions in credit spreads will generally result in increased asset prices (assuming no corresponding increase in the benchmark Treasury rate) which increases our book value. However, when credit spreads tighten and asset prices increase, yields on potential new investment opportunities will decrease. On balance we have seen declining new investment yields during 2012 from tighter credit spreads and from declining benchmark Treasury rates.

Government Policy Initiatives

The U.S. government is actively seeking to support the U.S. housing market and has introduced programs such as the HARP program noted above. Changes in the HARP program initiated in the second quarter of 2012 represent continued efforts to spur refinance activity. The U.S. government has also introduced the Home Affordable Mortgage Program, or HAMP, which seeks to assist borrowers through the modification of mortgage loans to reduce the principal amount of the loan, the rate on the loan, or to extend the payment terms of the loan. We expect that the U.S. government will continue to introduce and experiment with housing programs and policies to assist the recovery of the housing market. These programs could increase prepayment rates which would result in lower yields on our Agency RMBS.

Interest Rates

The Federal Reserve continues to maintain a very accommodative monetary policy. The FOMC in September reiterated its target range for the federal funds rate (the rate at which U.S. banks may borrow from each other) at 0%-0.25%. The FOMC continues to emphasize that economic growth might not be strong enough to generate sustained improvement in labor market


conditions and that strains in global financial markets continue to pose significant downside risks to the economic outlook. The FOMC has indicated that inflation over the medium term is expected to run below the Federal Reserve's current interest rate objective of 2%. The FOMC at the same time noted that if the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Agency MBS (including through QE3 as noted above), undertake additional asset purchases, and employ other policy tools until such improvement is achieved in a context of price stability. The FOMC indicated that it expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens and noted that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

The actions by the FOMC noted above have continued to keep overall interest rates low and the Treasury yield curve relatively flat (as measured by the difference of 1.40% between the two year Treasury rate and the ten year Treasury rate as of September 30, 2012 versus 1.64% as of December 31, 2011). Asset credit spreads also remain tight despite continued economic uncertainty both domestically and abroad, in our judgment primarily due to the extraordinary involvement by the Federal Reserve in the markets. While our borrowing costs are based on short-term market rates such as LIBOR and the Federal Funds Target Rate, our asset yields more closely correlate with longer-term Treasury rates and longer-term swap rates. In general, a flat yield curve will result in reduced net interest spreads for new investments and will impact our ability to reinvest our capital on an accretive basis.

A negative impact of a flattening yield curve is the prospective reduction of our net interest spread (and the related return on our invested capital) for new investments. Since the first quarter of 2012, we have seen declining net interest spreads on our new investment purchases in part as a result of the flattening yield curve and in part as a result of reduced credit spreads discussed further below.

Financing

Our business model requires that we have access to leverage, principally through the repurchase agreement market. We access the repurchase agreement markets through relationships with broker-dealers and financial institutions. Repurchase agreement financing is uncommitted financing and as such, there can be no guarantee that we will always have access to this financing. During periods of sustained volatility in the credit markets, such as was experienced in 2008, or other disruptions to the credit and financing markets, access to repurchase agreement financing may be limited as liquidity providers reduce their exposure to the short-term funding credit markets. Repurchase agreement markets also fund many different types of assets for many different types of borrowers including MBS, asset-backed securities, commercial paper and government securities. Recent activities by the Federal Reserve, including Operation Twist, have increased the supply of these other types of assets which has increased competition for financing. Consequently, we have seen a modest increase in our repurchase agreement financing costs during the first nine months of 2012.

Regulatory Reform

In July 2010 the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") was enacted into law. This legislation aims to restore responsibility and accountability to the financial system. It remains unclear how this legislation may ultimately impact the Company (including, but not limited to, whether the Company will be required to register with, or report to, the Commodity Futures Trading Commission (the "CFTC") or a designee thereof), credit markets and the market for repurchase agreements or other borrowing facilities, the investing environment for Agency and non-Agency MBS, or interest rate swaps and other derivatives, since the rules and regulations under the Dodd-Frank Act continue to be promulgated, implemented and interpreted by the CFTC. For instance, as it is now constructed, the Dodd-Frank Act would require the Company to transact interest rate swaps in the future through a clearing exchange which would likely require the Company to post significantly more margin at the inception of an interest rate swap transaction. Currently, the Company's initial margin requirements with counterparties are de minimis. As such, the effective cost to the Company for interest rate swaps may increase in the future which could limit our ability to continue to use swaps to hedge our interest rate and market value risk.

On August 31, 2011, the SEC issued a concept release relating to the exclusion from registration as an investment company provided to mortgage companies by
Section 3(c)5(C) of the Investment Company Act of 1040 (the "1940 Act"). This release raises concerns regarding the ability of mortgage REITs to continue to rely on the exclusion in the future. In particular, the release states the SEC is concerned that certain types of mortgage-related pools today appear to resemble in many respects investment companies


such as closed-end funds and may not be the kinds of companies that were intended to be excluded from regulation under the 1940 Act by Section 3(c)5(C). The outcome of the review by the SEC at this time is not determinable. For a discussion of the uncertainties and risks related to the SEC's review, please refer to "Risk Factors" contained within Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2011.

GSE Reform

On February 11, 2011, the Treasury released proposals to limit or potentially wind down the role that Fannie Mae and Freddie Mac play in the mortgage market. Similar proposals to limit or wind down the role of Fannie Mae and Freddie Mac have been proposed by a number of other parties. Any such proposals, if enacted, may have broad adverse implications for the MBS market and our business, results of operations, and financial condition. We expect such proposals to be the subject of significant discussion, and it is not yet possible to determine whether such proposals will be enacted. We do not believe the ultimate reform of Fannie Mae and Freddie Mac will occur in 2012. However, it is possible that new types of Agency MBS could be proposed and sold by Fannie Mae and Freddie Mac that are structured differently from current Agency MBS. This may have the effect of reducing the amount of available investment opportunities for the Company. No such new structures have as yet been proposed. For further discussion of the uncertainties and risks related to GSE reform, please refer to "Risk Factors" contained within Item 1A of Part II of this Quarterly Report on Form 10-Q and within Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2011.

Highlights of the Third Quarter and Fourth Quarter Outlook

During the third quarter of 2012, we reported net income of $18.4 million, or $0.34 per common share versus $18.8 million, or $0.35 per common share for the second quarter of 2012. We also reported net interest income of $19.1 million compared to $19.0 million for the second quarter of 2012 and $19.1 million for the first quarter of 2012. Our slight increase in net interest income for the third quarter of 2012 compared to the second quarter of 2012 is due to the higher average balance of our investment portfolio during the third quarter of $3,729.1 million versus $3,339.5 million for the second quarter of 2012. Partially offsetting the increase in average interest earning assets was a decline in the weighted average net interest spread to 2.00% from 2.18% for the second quarter of 2012, which is primarily the result of purchasing lower spread assets and also from interest-rate resets on our Agency ARM portfolio during the third quarter of 2012.

The following table summarizes the average annualized yield by type of MBS investment for the third quarter of 2012 and for each of the preceding four quarters:

                                                                   Three Months Ended
                                                                       March
                                 September 30, 2012   June 30, 2012   31, 2012   December 31, 2011   September 30, 2011
Average annualized yields:
Agency RMBS                            2.15%              2.33%        2.70%           2.83%               2.89%
Agency CMBS (includes IOs)             4.35%              4.32%        4.05%           4.49%               4.49%
Non-Agency RMBS                        5.63%              5.60%        5.69%           6.27%               6.58%
Non-Agency CMBS (includes IOs)         5.68%              6.07%        6.52%           6.37%               6.03%
All other investments                  5.31%              4.97%        4.13%           5.74%               5.59%
Costs of financing                    (1.12)%            (1.11)%      (1.17)%         (1.20)%             (1.16)%
Net interest spread                    2.00%              2.18%        2.41%           2.56%               2.43%

Our results of operations for third quarter of 2012 included a gain of $2.1 million related to the sale of $56.1 million in Agency RMBS collateralized by reverse-mortgage securities and a gain of $1.2 million related to the sale of $15.0 million in non-Agency CMBS that were mezzanine bonds from the Freddie K Multifamily Program.

Although our targeted investment mix has been to invest 60% to 80% in Agency MBS with the balance in non-Agency MBS and securitized mortgage loans, Agency MBS allocation in recent quarters has increased outside of this range due to our recent discovery of attractive investment opportunities in Agency CMBS IO. The following table provides our asset allocation as of September 30, 2012 and as of the end of each of the four preceding financial reporting period:


                          September 30, 2012   June 30, 2012   March 31, 2012   December 31, 2011   September 30, 2011
Agency MBS                       84%                82%             81%                79%                 80%
Non-Agency MBS                   14%                15%             14%                17%                 16%
Other investments                 2%                3%               5%                4%                   4%

Our shareholders' equity increased to $617.9 million as of September 30, 2012, or $10.31 per common share, from $371.3 million, or $9.20 per common share as of December 31, 2011, and $525.1 million, or $9.66 per common share as of June 30, 2012.
The increase in shareholders' equity since June 30, 2012 resulted primarily from the issuance of 2,300,000 shares of 8.50% Series A cumulative redeemable preferred stock, an underwritten public offering that closed on August 1, 2012. We received $55.7 million in net proceeds which we used to acquire additional investments consistent with our investment strategy and for general corporate purposes. Additionally, our shareholders' equity has increased since June 30, 2012 because of a net increase in accumulated other comprehensive income of $34.4 million. The increase in accumulated other comprehensive income was due to an increase in fair value of available for sale investments of $41.6 million, partially offset by a reduction in the fair value of our interest rate swaps by $(7.2) million. These securities increased in fair value from changing market expectations on performance of these securities and their liquidity which we believe may be related to the perceived improvement in economic conditions in the U.S. and stabilizing conditions in the Eurozone.

As of December 31, 2011, we had an estimated net operating loss ("NOL") carryfoward of $143.0 million. As a result of our common stock offering in February 2012, we have incurred an "ownership change" under Section 382 of the Internal Revenue Code ("Section 382"). In general, if a company incurs an ownership change under Section 382, the company's ability to utilize an NOL carryforward to offset its taxable income (and, in our case, after taking the REIT distribution requirements into account), becomes limited to a certain amount per year. For purposes of Section 382, an ownership change occurs if over a rolling three-year period, the percentage of the company stock owned by 5% or greater shareholders has increased by more than 50 percentage points over the lowest percentage of common stock owned by such shareholders during the three-year period. Based on management's analysis and expert third-party advice, which necessarily includes certain assumptions regarding the characterization under Section 382 of our use of capital raised by us, we determined that the ownership change under Section 382 will limit our ability to use our NOL carryforward to offset our taxable income to an estimated maximum amount of $13.4 million per year. The NOL carryforward expires substantially beginning in 2019.

We believe that the outlook for our business model is favorable given the economic backdrop, despite the uncertainty regarding government policy and its potential effects on prepayments of our investments, the impact on our portfolio from asset purchases by the Federal Reserve under QE3, and the uncertainty in Europe and its potential impact on the U.S. credit markets. In recent quarters we have expanded our investment portfolio to include Agency CMBS IO and non-Agency CMBS and CMBS IO given the attractive risk-adjusted return and prepayment protection profile of these investments. With respect to non-Agency . . .

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