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DX > SEC Filings for DX > Form 10-K on 4-Mar-2014All Recent SEC Filings

Show all filings for DYNEX CAPITAL INC

Form 10-K for DYNEX CAPITAL INC


4-Mar-2014

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

The following discussion should be read in conjunction with our financial statements and the related notes included in Item 8. "Financial Statements and Supplementary Data" in this Annual Report on Form 10-K. This discussion is presented in five sections:
Executive Overview
Financial Condition
Results of Operations
Liquidity and Capital Resources
Forward-Looking Statements This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors including, but not limited to, those disclosed in Item 1A. "Risk Factors" elsewhere in this Annual Report on Form 10-K and in other documents filed with the SEC and otherwise publicly disclosed. Please refer to "Forward-Looking Statements" contained within this Item 7 for additional information. This discussion also contains non-GAAP financial measures. Please refer to Item 6 of this Annual Report on Form 10-K for reconciliations of these non-GAAP measures and additional information about why management believes these non-GAAP measures are useful for shareholders.

EXECUTIVE OVERVIEW

Please refer to Item 1 of Part 1 of this Annual Report on Form 10-K for a complete description of our business including our operating policies, investment philosophy and strategy, financing and hedging strategies, and other important information.

Highlights for the Fiscal Year and the Fourth Quarter of 2013

During 2013, fixed income markets experienced periods of high volatility as a result of large fluctuations in interest rates during the year. At the beginning of 2013, the two-year and ten-year Treasury rates were 0.25% and 1.76%, respectively; these rates touched a low of 0.20% and 1.63%, respectively, and ended the year at 0.38% and 3.03%, respectively. Most of the volatility can be attributed to the changes in market expectations with respect to Federal Reserve purchases of assets under its Large Scale Asset Purchase (LSAP) program (discussed further below). Despite the volatility, we continued to focus on our strategy of investing in high quality, shorter duration Agency and non-Agency RMBS and CMBS. While we experienced a decline in our book value per common share as a result of declines in the market value of our MBS during the year, we generated a return on common equity of 11.5% based on net income to common shareholders of $60.2 million, and an adjusted return on common equity of 12.2% based on core net operating income to common shareholders of $63.8 million. Our net interest income increased by 12% in 2013 due primarily to a larger interest earning asset base and lower borrowing costs, partially offset by lower weighted average yields on our investment assets. Overall, our net interest spread for 2013 was 1.95% versus 2.13% for 2012, reflecting the lower weighted average yields from investments made in 2013.


Management believes the events contributing to the market volatility included market reaction to the the Federal Reserve reducing its bond purchases under its LSAP program (also referred to as "QE3") which triggered global de-risking in virtually all asset classes. In 2013 the Federal Reserve reduced its LSAP program by $10 billion per month which it has continued so far in 2014. We believe that economic fundamentals are uncertain and that the U.S. economy cannot withstand sustained higher interest rates. As a result, we anticipate that the Federal Reserve will continue to keep the targeted federal funds rate very low for an extended period as discussed further below in "Trends and Recent Market Impacts". We believe that the Federal Reserve will continue its reductions in its QE3 bond purchase program in 2014 which may result in periods of volatility in asset prices as interest rates rise and credit market spreads adjust to the reduced purchases by the Federal Reserve (which has dominated the purchases of fixed rate Agency MBS and Treasury securities since the inception of QE3).

During the fourth quarter of 2013, we were selective in making investments given the environment. We also repositioned our hedging instruments and increased our modeled duration gap (a measure of the sensitivity of our investments and derivative instruments to changes in interest rates) during the quarter, which ended 2013 at the higher end of our 0.5-1.5 years target range. Our investments and derivative instruments are most sensitive to changes in rates on one-to-three year maturities, as compared to further out the yield curve. One-to-three year rates are generally more sensitive to changes in the targeted federal funds rate. Finally we began extending repurchase agreement maturities (in particular in terms greater than 120 days) given the declining cost and greater availability of longer-term borrowing.

During 2013 we continued to make investments in CMBS and CMBS IO. The CMBS market has rebounded since 2008 with better underwriting, more credit enhancement supporting our investment, and broader investor participation. We believe that fundamentals are still positive in commercial real estate, particularly multifamily, given demographic fundamentals and attitude shifts. In addition, multifamily trends are supported by declining vacancies and increasing rents.

Effective June 30, 2013, we voluntarily discontinued hedge accounting for all interest rate swaps which we previously designated as cash flow hedges under GAAP. This decision to discontinue cash flow hedge accounting was made to facilitate our ability to more effectively manage the maturity dates of our repurchase agreements. Changes in the fair value of interest rate swaps and other derivative instruments are reported in our consolidated statements of net income as "loss on derivative instruments, net" and are no longer be reported in shareholders' equity through accumulated other comprehensive income (loss).

Trends and Recent Market Impacts

There are certain conditions and prospective trends in the marketplace that have impacted our current financial condition and results of operations and which may continue to impact us in the future. The following provides a discussion of conditions and trends that had significant developments during 2013 or are new conditions and trends that are important to our financial condition and results of operations.

Federal Reserve Monetary Policy

The Federal Open Market Committee ("FOMC") continues its purchase of U.S. Treasury and fixed-rate Agency MBS under its asset purchase program known as "QE3". The FOMC as of the date of this Annual Report on Form 10-K is purchasing $65 billion per month in securities down from a high of $85 billion per month in 2013. The FOMC has reduced its purchases of Treasury and Agency MBS as a result of perceived improvements in the underlying strength of the broader economy as evidenced by continued improvement in economic activity and labor market conditions. The FOMC has reiterated its commitment to maintaining a highly accommodative stance of monetary policy for a considerable time after the QE3 asset purchase program ends and the economic recovery strengthens. The FOMC has pledged to keep the target range for the federal funds rate at 0%-0.25% and indicated that it anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6.5%, inflation between one and two years ahead is projected to be no more than a half percentage point above the FOMC's 2% longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the FOMC stated that it will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. Market participants are currently forecasting an end to asset purchases by the FOMC in 2014 and an increase in the targeted federal funds rate sometime in the second quarter of 2015.


Asset Spreads and Competition for Assets

Over the past several 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 securities and that reflects the relative riskiness of the securities versus the benchmark). Changes in credit spreads result from the expansion or contraction of the perceived riskiness of an investment versus its benchmark. Spreads on MBS had tightened throughout the first half of 2013 from increased competition for these assets due to lack of supply, favorable market conditions in large part due to the Federal Reserve's involvement in the markets, and substantial amounts of capital raised by mortgage REITs and other market participants. Reductions in credit spreads resulted in an increase in asset prices which increased our book value. During the second half of 2013, credit spreads widened on MBS due to the Federal Reserve's actions with respect to QE3 (discussed above), expectations that interest rates would be increasing for the foreseeable future, and the overall lack of liquidity in the markets. The following table provides various estimated market credit spreads on categories of assets owned by the Company as well as other market credit spreads as of the end of each quarter in 2013:

                                     December 31,
     (amounts in basis points)           2013          September 30, 2013       June 30, 2013       March 31, 2013
Hybrid ARM 5/1 (2.0% coupon) spread
to Treasuries                               30                      40                  45                   18
Hybrid ARM 10/1 (2.5% coupon)
spread to Treasuries                        76                      80                  75                   34
Agency CMBS spread to interest rate
swaps                                       58                      72                  92                   59
'A'-rated CMBS spread to interest
rate swaps                                 220                     255                 287                  205
Agency CMBS IO spread to Treasuries        165                     200                 200                  115

As noted in the table above, market credit spreads widened dramatically in the second quarter of 2013. Market credit spreads decreased over the balance of the year, but ended the year wider than in the first quarter of 2013. Most of the spread widening occurred at the same time interest rates were rapidly rising after comments by Federal Reserve officials regarding the possible reduction in its QE3 purchase program. Spread widening negatively impacted our book value from declining fair values on our MBS but provided us an opportunity to acquire assets at higher yields. Spreads have continued to tighten into 2014.

GSE Reform

Policy makers in Washington DC continue to debate the future of Fannie Mae and Freddie Mac's participation in the U.S. mortgage market. Several bills have been introduced in the U.S. Senate and the U.S. House of Representatives regarding the reform and/or dissolution of the GSEs. Any changes to the structure of the GSEs, or the revocations of their charters, 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. While we expect GSE reform to be a multi-year process, it is possible that new types of Agency MBS could be proposed and sold by Fannie Mae and Freddie Mac in the near term that are structured differently from current Agency MBS. This may have the effect of reducing the amount of available investment opportunities for the Company. For further discussion of the uncertainties and risks related to GSE reform, please refer to "Risk Factors" contained within Part I, Item 1A of this Annual Report on Form 10-K.

Regulatory Uncertainty

Certain rules recently adopted or proposed by regulators of financial institutions require such financial institutions to maintain minimum amounts of capital relative to its assets. One such proposal was made in June 2013 by the Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency to strengthen the leverage ratio standards for the largest, most systemically significant U.S. banking organizations defined as bank holding companies with more than $700 billion in consolidated total assets or $10 trillion in assets under custody. Under the proposal, these entities would be required to maintain a tier 1 capital leverage buffer of at least 2 percent above the minimum supplementary leverage ratio requirement of 3 percent, for a total of 5 percent. Such amount is in excess of current required capital levels for these institutions and could force reductions in overall leverage, including repurchase agreement financing, by these institutions in order to comply with the leverage ratio requirement, which could in turn limit the amount available for us to borrow or could increase our overall cost of financing.


There are various other recently adopted or proposed rules that could impact all regulated financial institutions in ways that may impact our ability to access financing.

In addition, the Federal Reserve has expressed concern over the generally unregulated nature of short-term wholesale funding markets including the repurchase agreement markets. Various suggestions have been made including capital surcharges as well as money market mutual fund reform (money market mutual funds are large supplier of liquidity to the repurchase markets). The outcome of any of these suggestions are uncertain but any capital surcharges or other reductions in repurchase agreement availability could have a material effect on the availability and cost of financing.

CRITICAL ACCOUNTING POLICIES

The discussion and analysis of our financial condition and results of operations are based in large part upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities. We base these estimates and judgments on historical experience and assumptions believed to be reasonable under current facts and circumstances. Actual results, however, may differ from the estimated amounts we have recorded.
Critical accounting policies are defined as those that require management's most difficult, subjective or complex judgments, and which may result in materially different results under different assumptions and conditions. The following discussion provides information on our accounting policies that require the most significant management estimates, judgments, or assumptions, or that management believes includes the most significant uncertainties, and are considered most critical to our results of operations or financial position.

Fair Value Measurements. As defined in ASC Topic 820, the fair value of a financial instrument is the exchange price in an orderly transaction between market participants to sell an asset or transfer a liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or liability. ASC Topic 820 provides a consistent definition of fair value which focuses on exit price and prioritizes, within a measurement of fair value, the use of market-based inputs over entity-specific inputs. In addition, ASC Topic 820 provides a framework for measuring fair value and establishes a three-level hierarchy for fair value measurements based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. Please refer to Note 9 of the Notes to the Consolidated Financial Statements contained in this Annual Report on Form 10-K for a description of this hierarchy.
Our Agency MBS, as well a majority of our non-Agency MBS, are substantially similar to securities that either are currently actively traded or have been recently traded in their respective market. Their fair values are derived from an average of multiple pricing services and dealer quotes. Pricing services and dealers will have access to observable market information through their trading desks. We typically receive a total of three to six prices from pricing services and brokers for each of our securities; prices obtained from brokers are not binding on either the broker or us. Management does not adjust the prices received, but, for securities on which we receive five or more prices, the high and low prices are excluded from the calculation of the average price. In addition, management reviews the prices received for each security by comparing those prices to actual purchase and sale transactions, our internally modeled prices that are calculated based on observable market rates and credit spreads, and the prices that our borrowing counterparties use in financing the our securities. For any security for which significant variations in price exist (from other external prices received or from our internal price), management may exclude such prices from the calculation of the average price. The decision to exclude any price from use in the calculation of the fair values used in our consolidated financial statements is reviewed and approved by management independent of the pricing process. The average of the remaining prices received is used for the fair values included in our consolidated financial statements. If the price of a security is obtained from quoted prices for similar instruments or model-derived valuations whose inputs are observable, the security is classified as a level 2 security. If the inputs are unobservable, the security would be classified as a level 3 security.

As of December 31, 2013, less than 15% of our non-Agency MBS (and less than 2% of our total MBS) are comprised of securities for which there are not substantially similar securities that trade frequently, and therefore, estimates of fair value for


those level 3 securities are based primarily on management's judgment. Management determines the fair value of those securities by discounting the estimated future cash flows derived from cash flow models using assumptions that are confirmed to the extent possible by third party dealers or other pricing indicators. Significant inputs into those pricing models are level 3 in nature due to the lack of readily available market quotes. Information utilized in those pricing models include the security's credit rating, coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected credit losses, and credit enhancement as well as certain other relevant information. Generally, level 3 assets are most sensitive to the default rate and severity assumptions. Significant changes in any of these inputs in isolation would result in a significantly different fair value measurement, and accordingly, there is no assurance that our estimates of fair value are indicative of the amounts that would be realized on the ultimate sale or exchange of these assets.

Amortization of Investment Premiums. We amortize premiums and accrete discounts associated with the purchase of our MBS into interest income over the projected lives of our securities, including contractual payments and estimated prepayments, using the effective yield method. Estimates and judgments related to future levels of prepayments are critical to this determination, and they are difficult for management to predict. With respect to both RMBS and CMBS, mortgage prepayment expectations can change based on how changes in current and projected interest rates impact a borrower's likelihood of refinancing as well as other factors, including but not limited to real estate prices, borrowers' credit quality, changes in the stringency of loan underwriting practices, and lending industry capacity constraints. With respect to RMBS, modifications to existing programs such as HARP, or the implementation of new programs can have a significant impact on the rate of prepayments. Further, GSE buyouts of loans in imminent risk of default, loans that have been modified, or loans that have defaulted will generally be reflected as prepayments on our securities and increase the uncertainty around management's estimates. We utilize a third party service to assist in estimating prepayment rates on all MBS. We review these estimates monthly and compare the results to any available market consensus prepayment speeds. We also consider historical prepayment rates and current market conditions to assess the reasonableness of the prepayment rates estimated by the third party service. Actual and anticipated prepayment experience is reviewed monthly and effective yields adjusted for differences between the previously estimated future prepayments and the amounts actually received as well as changes in estimated future prepayments.
Other-than-Temporary Impairments. When the fair value of an available-for-sale security is less than its amortized cost as of the reporting date, the security is considered impaired. We assess our securities for impairment on at least a quarterly basis and determine if the impairments are either temporary or "other-than-temporary" in accordance with ASC Topic 320-10. Accounting literature does not define what it considers an other-than-temporary impairment ("OTTI") to be; however, it does state that an OTTI does not mean permanent impairment. The literature does provide some examples of factors which may be indicative of an OTTI, such as: (a) the length of time and extent to which market value has been less than cost; (b) the financial condition and near-term prospects of the issuer; and (c) the intent and ability of the holder to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value.
We assess our ability to hold any Agency MBS or non-Agency MBS with an unrealized loss until the recovery in its value. Our ability to hold any such MBS is based on the amount of the unrealized loss and significance of the related investment as well as our current leverage and anticipated liquidity. Although Fannie Mae and Freddie Mac are not explicitly backed by the full faith and credit of the United States, given their guarantee and commitments for support received from the Treasury as well as the credit quality inherent in Agency MBS, we do not typically consider any of the unrealized losses on our Agency MBS to be credit-related. For our non-Agency MBS, we review the credit ratings of these MBS and the seasoning of the mortgage loans collateralizing these securities as well as the estimated future cash flows which include any projected losses in order to evaluate whether we believe any portion of the unrealized loss at the reporting date is related to credit losses. The determination as to whether an OTTI exists as well as its amount is subjective, as such determinations are based not only on factual information available at the time of assessment but also on management's estimates of future performance and cash flow projections. As a result, the timing and amount of any OTTI may constitute a material estimate that is susceptible to significant change. Our expectations with respect to our securities in an unrealized loss position may change over time, given, among other things, the dynamic nature of markets and other variables. For example, although we believe that the conservatorship of Fannie Mae and Freddie Mac has further strengthened their creditworthiness, there can be no assurance that these actions will be adequate for their needs. Accordingly, if these government actions are inadequate and the GSEs continue to suffer losses or cease to exist, our view of the credit worthiness of our Agency MBS could materially change, which may affect our assessment of OTTI for Agency MBS in future periods. Future sales or changes in our expectations with respect to Agency or non-Agency


securities in an unrealized loss position could result in us recognizing other-than-temporary impairment charges or realizing losses on sales of MBS in the future.

                              FINANCIAL CONDITION

We invest primarily in Agency and non-Agency MBS, including RMBS, CMBS and CMBS
IO securities. Agency MBS have a guaranty of principal payment by an agency of
the U.S. government or a GSE such as Fannie Mae and Freddie Mac. Non-Agency MBS
have no such guaranty of payment. The following tables provide information
regarding our asset allocation based on fair value as of December 31, 2013 and
as of the end of each of the four preceding quarters:
                                       September
                  December 31, 2013     30, 2013     June 30, 2013   March 31, 2013   December 31, 2012
Agency MBS              85.5%            86.3%           85.9%           84.9%              83.6%
Non-Agency MBS          13.1%            12.3%           12.6%           13.6%              14.6%
Other investments       1.4%              1.5%           1.5%             1.5%              1.8%



                                      September
                 December 31, 2013     30, 2013     June 30, 2013   March 31, 2013   December 31, 2012
RMBS                   67.3%            68.5%           67.9%           65.0%              62.9%
CMBS                   17.7%            17.2%           17.4%           19.3%              20.8%
CMBS IO                15.0%            14.3%           14.7%           15.7%              16.3%

Agency MBS

Our investments in Agency RMBS are collateralized primarily by ARMs and hybrid
ARMs. Our investments in Agency CMBS and CMBS IO are collateralized by fixed
rate mortgage loans which generally have some form of prepayment protection
provisions (such as prepayment lock-outs) or prepayment compensation provisions
(such as yield maintenance or prepayment penalties).

Activity related to our Agency MBS for the year ended December 31, 2013 is as
follows:
(amounts in thousands)              RMBS           CMBS        CMBS IO (1)         Total
Balance as of January 1, 2013   $ 2,571,337     $ 354,142     $    567,180     $ 3,492,659
Purchases                         1,067,754        35,415          138,323       1,241,492
Principal payments                 (847,275 )      (5,235 )              -        (852,510 )
Sales                                (4,496 )     (36,311 )       (161,550 )      (202,357 )
Change in net unrealized gain       (61,982 )     (12,322 )        (10,134 )       (84,438 )
Net premium amortization            (33,188 )      (4,188 )        (73,492 )      (110,868 )
Balance as of December 31, 2013 $ 2,692,150     $ 331,501     $    460,327     $ 3,483,978

(1) Amounts shown for CMBS IO represent premium only and exclude underlying notional values.

Overall, our investment in Agency MBS as of December 31, 2013 remained relatively unchanged compared to December 31, 2012. The bulk of our purchases during the year were Agency RMBS while the bulk of our asset sales were in . . .

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