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 quarterly period ended SeptemberJune 30, 20172020
or
o
☐		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)
Virginia52-1549373
(State or other jurisdiction of(I.R.S. Employer
incorporation or organization)(IRS Employer Identification No.)
4991 Lake Brook Drive, Suite 100 Glen Allen, Virginia23060-9245
Glen Allen,Virginia23060-9245
(Address of principal executive offices)(Zip Code)
(804)217-5800
(804) 217-5800
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:
Title of each classTrading Symbol(s)Name of each exchange on which registered
Common Stock, par value $.01 per shareDXNew York Stock Exchange
7.625% Series B Cumulative Redeemable Preferred Stock, par value $0.01 per shareDXPRBNew York Stock Exchange
6.900% Series C Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock, par value $0.01 per shareDXPRCNew York Stock Exchange

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 90 days.
Yes          x☒         No           o☐


Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes           x☒             No           o☐


Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filero☐Accelerated filerx☒
Non-accelerated filer
o (Do not check if a smaller reporting company)
☐		Smaller reporting companyo☐
Emerging growth companyo☐


If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  o☐


Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes           o☐           No            x☒


On OctoberJuly 31, 2017,2020, the registrant had 53,219,28623,140,617 shares outstanding of common stock, $0.01 par value, 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 StatementsPage
PART I.
FINANCIAL INFORMATION
Item 1.
Financial Statements
Consolidated Balance Sheets as of SeptemberJune 30, 20172020 (unaudited) and December 31, 20162019
1
Consolidated Statements of Comprehensive Income (Loss) for the three and ninesix months ended September
June 30, 20172020 (unaudited) and SeptemberJune 30, 20162019 (unaudited)
2
Consolidated StatementStatements of Shareholders' Equity for the ninesix months ended September
June 30, 20172020 and June 30, 2019 (unaudited)
3
Consolidated Statements of Cash Flows for the ninesix months ended September
June 30, 20172020 (unaudited) and SeptemberJune 30, 20162019 (unaudited)
45
Notes to the Unaudited Consolidated Financial Statements
56
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
2123
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
4946
Item 4.
Controls and Procedures
5451
PART II.
OTHER INFORMATION
Item 1.Legal Proceedings
Item 1.51
Legal Proceedings
55
Item 1A.
Risk Factors
Item 1A.52
Risk Factors
55
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
5552
Item 3.
Defaults Upon Senior Securities
5552
Item 4.
Mine Safety Disclosures
5552
Item 5.
Other Information
Item 5.52
Other Information
55
Item 6.
Exhibits
Item 6.54
Exhibits
56
SIGNATURES
5755







i

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS


DYNEX CAPITAL, INC.
CONSOLIDATED BALANCE SHEETS
(amounts in thousands except share data)
 September 30, 2017 December 31, 2016
ASSETS(unaudited) 
Mortgage-backed securities (including pledged of $2,714,312 and $3,150,610, respectively)$2,921,444
 $3,212,084
Mortgage loans held for investment, net16,523
 19,036
Cash and cash equivalents117,702
 74,120
Restricted cash43,987
 24,769
Derivative assets368
 28,534
Receivable for securities sold13,435
 —
Principal receivable on investments3,359
 11,978
Accrued interest receivable19,267
 20,396
Other assets, net7,193
 6,814
Total assets$3,143,278
 $3,397,731
    
LIABILITIES AND SHAREHOLDERS’ EQUITY

  
Liabilities: 
  
Repurchase agreements$2,519,230
 $2,898,952
Payable for unsettled securities77,357
 —
Non-recourse collateralized financing5,706
 6,440
Derivative liabilities133
 6,922
Accrued interest payable2,720
 3,156
Accrued dividends payable11,620
 12,268
Other liabilities2,413
 2,809
 Total liabilities2,619,179
 2,930,547
 

  
Shareholders’ equity: 
  
Preferred stock, par value $.01 per share; 50,000,000 shares authorized; 5,665,101 and 4,571,937 shares issued and outstanding, respectively ($141,628 and $114,298 aggregate liquidation preference, respectively)$135,828
 $110,005
Common stock, par value $.01 per share, 200,000,000 shares authorized;
51,262,350 and 49,153,463 shares issued and outstanding, respectively
513
 492
Additional paid-in capital742,845
 727,369
Accumulated other comprehensive income (loss)5,886
 (32,609)
Accumulated deficit(360,973) (338,073)
 Total shareholders' equity524,099
 467,184
 Total liabilities and shareholders’ equity$3,143,278
 $3,397,731
See notes to the unaudited consolidated financial statements.


DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(UNAUDITED)
(amounts in thousands except per share data)
 Three Months Ended Nine Months Ended
 September 30, September 30,
 2017 2016 2017 2016
Interest income$23,103
 $21,135
 $70,378
 69,040
Interest expense9,889
 6,068
 26,122
 18,478
  Net interest income13,214
 15,067
 44,256
 50,562
        
Gain (loss) on derivative instruments, net5,993
 2,409
 (9,634) (62,153)
Loss on sale of investments, net(5,211) —
 (10,628) (4,238)
Fair value adjustments, net23
 34
 63
 86
Other (loss) income, net(109) 545
 (150) 898
General and administrative expenses:    

  
Compensation and benefits(2,070) (1,736) (6,356) (5,829)
Other general and administrative(1,529) (1,619) (5,620) (5,288)
Net income (loss)10,311
 14,700
 11,931
 (25,962)
Preferred stock dividends(2,808) (2,294) (7,885) (6,882)
Net income (loss) to common shareholders$7,503
 $12,406
 $4,046
 $(32,844)
        
Other comprehensive income:    

  
Unrealized gain on available-for-sale investments, net$981
 $769
 $28,087
 $61,260
Reclassification adjustment for loss on sale of investments, net5,211
 —
 10,628
 4,238
Reclassification adjustment for de-designated cash flow hedges(48) (99) (220) (152)
Total other comprehensive income6,144
 670
 38,495
 65,346
Comprehensive income to common shareholders$13,647
 $13,076
 $42,541
 $32,502
        
Net income (loss) per common share-basic and diluted$0.15
 $0.25
 $0.08
 $(0.67)
Weighted average common shares-basic and diluted49,832
 49,147
 49,411
 49,102
 June 30, 2020December 31, 2019
ASSETS(unaudited)
Cash and cash equivalents$147,243  $62,582  
Restricted cash59,150  71,648  
Receivable for securities sold, pledged to counterparties156,047  —  
Mortgage-backed securities (including pledged of $3,391,112 and $5,024,625 respectively), at fair value3,496,925  5,188,163  
Mortgage loans held for investment (includes $7,366 and $8,857 at fair value, respectively); see Note 17,366  9,405  
Derivative assets7,926  4,290  
Accrued interest receivable16,620  26,209  
Other assets, net6,351  8,307  
Total assets$3,897,628  $5,370,604  
LIABILITIES AND SHAREHOLDERS’ EQUITY 
Liabilities:  
Repurchase agreements$3,314,991  $4,752,348  
Payable for unsettled securities—  6,180  
Non-recourse collateralized financing1,282  2,733  
Derivative liabilities4,208  974  
Accrued interest payable907  15,585  
Accrued dividends payable5,735  6,280  
Other liabilities3,036  3,516  
 Total liabilities$3,330,159  $4,787,616  
Shareholders’ equity:  
Preferred stock, par value $0.01 per share; 50,000,000 shares authorized; 7,248,330 and 6,788,330 shares issued and outstanding, respectively ($181,208 and $169,708 aggregate liquidation preference, respectively)$174,709  $162,807  
Common stock, par value $0.01 per share, 90,000,000 shares authorized;
23,140,617 and 22,945,993 shares issued and outstanding, respectively
231  229  
Additional paid-in capital858,451  858,347  
Accumulated other comprehensive income81,731  173,806  
Accumulated deficit(547,653) (612,201) 
 Total shareholders’ equity567,469  582,988  
 Total liabilities and shareholders’ equity$3,897,628  $5,370,604  
See notes to the unaudited consolidated financial statements.



1

DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTSTATEMENTS OF SHAREHOLDERS’ EQUITYCOMPREHENSIVE INCOME (LOSS)
(UNAUDITED)(unaudited)
($amounts in thousands)thousands except per share data)
Three Months EndedSix Months Ended
June 30,June 30,
 2020201920202019
Interest income$19,853  $43,748  $59,676  $83,706  
Interest expense4,850  30,813  26,952  57,089  
  Net interest income15,003  12,935  32,724  26,617  
Loss on derivative instruments, net(8,563) (117,535) (204,130) (179,233) 
Gain (loss) on sale of investments, net193,099  (10,360) 277,882  (10,360) 
Fair value adjustments, net332  (16) (40) (29) 
Other operating (expense) income, net(222) 256  (645) 25  
General and administrative expenses:
Compensation and benefits(2,736) (1,747) (4,898) (3,645) 
Other general and administrative(2,075) (2,518) (4,534) (4,574) 
Net income (loss)194,838  (118,985) 96,359  (171,199) 
Preferred stock dividends(3,253) (3,206) (7,094) (6,265) 
Preferred stock redemption charge—  —  (3,914) —  
Net income (loss) to common shareholders$191,585  $(122,191) $85,351  $(177,464) 
Other comprehensive income:
Unrealized gain on available-for-sale investments, net$28,052  $100,767  $185,807  $187,399  
Reclassification adjustment for (gain) loss on sale of investments, net(193,099) 10,360  (277,882) 10,360  
Reclassification adjustment for de-designated cash flow hedges—  —  —  (165) 
Total other comprehensive (loss) income(165,047) 111,127  (92,075) 197,594  
Comprehensive income (loss) to common shareholders$26,538  $(11,064) $(6,724) $20,130  
Net income (loss) per common share-basic and diluted$8.31  $(4.98) $3.71  $(7.49) 
Weighted average common shares-basic and diluted23,057  24,541  23,010  23,681  
 Preferred Stock Common Stock 
Additional
Paid-in
Capital
 
Accumulated
Other
Comprehensive
(Loss) Income
 
Accumulated
Deficit
 Total Shareholders' Equity
 SharesAmountSharesAmount
Balance as of December 31, 20164,571,937
$110,005
 49,153,463
$492
 $727,369
 $(32,609) $(338,073) $467,184
Stock issuance1,093,164
25,884
 2,048,288
21
 14,474
 —
 —
 40,379
Restricted stock granted, net of amortization—
—
 138,166
1
 1,565
 —
 —
 1,566
Adjustments for tax withholding on share-based compensation—
—
 (77,567)(1) (520) —
 —
 (521)
Stock issuance costs—
(61) —
—
 (43) —
 —
 (104)
Net income—
—
 —
—
 —
 —
 11,931
 11,931
Dividends on preferred stock—
—
 —
—
 —
 —
 (7,885) (7,885)
Dividends on common stock—
—
 —
—
 —
 —
 (26,946) (26,946)
Other comprehensive income—
—
 —
—
 —
 38,495
 —
 38,495
Balance as of September 30, 20175,665,101
$135,828
 51,262,350
$513
 $742,845
 $5,886
 $(360,973) $524,099
See notes to the unaudited consolidated financial statements.

2


DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(unaudited)
($ in thousands)
Preferred StockCommon StockAdditional
Paid-in
Capital		Accumulated
Other
Comprehensive
Income (Loss)		Accumulated
Deficit		Total Shareholders’ Equity
SharesAmountSharesAmount
Balance as of
December 31, 2019		6,788,330  $162,807  22,945,993  $229  $858,347  $173,806  $(612,201) $582,988  
Cumulative effect of change in accounting principle—  —  —  —  —  —  (548) (548) 
Stock issuance4,460,000  107,988  —  —  —  —  —  107,988  
Redemption of preferred stock(4,000,000) (96,086) —  —  —  —  (3,914) (100,000) 
Restricted stock granted, net of amortization—  —  67,511  1  306  —  —  307  
Repurchase of common stock—  —  (18,782) —  (206) —  —  (206) 
Adjustments for tax withholding on share-based compensation—  —  (12,744) —  (235) —  —  (235) 
Stock issuance costs—  —  —  —  (9) —  —  (9) 
Net loss—  —  —  —  —  —  (98,479) (98,479) 
Dividends on preferred stock—  —  —  —  —  —  (3,841) (3,841) 
Dividends on common stock—  —  —  —  —  —  (10,330) (10,330) 
Other comprehensive income—  —  —  —  —  72,972  —  72,972  
Balance as of
March 31, 2020		7,248,330  $174,709  22,981,978  $230  $858,203  $246,778  $(729,313) $550,607  
Restricted stock granted, net of amortization—  —  172,782  1  422  —  —  423  
Repurchase of common stock—  —  (14,143) —  (166) —  —  (166) 
Stock issuance costs—  —  —  —  (8) —  —  (8) 
Net income—  —  —  —  —  —  194,838  194,838  
Dividends on preferred stock—  —  —  —  —  —  (3,253) (3,253) 
Dividends on common stock—  —  —  —  —  —  (9,925) (9,925) 
Other comprehensive income—  —  —  —  —  (165,047) —  (165,047) 
Balance as of
June 30, 2020		7,248,330  $174,709  23,140,617  $231  $858,451  $81,731  $(547,653) $567,469  
Balance as of December 31, 20185,954,594  $142,883  20,939,073  $209  $818,861  $(35,779) $(399,021) $527,153  
Stock issuance213,468  5,015  3,109,047  31  53,841  —  —  58,887  
Restricted stock granted, net of amortization—  —  50,821  1  297  —  —  298  
Adjustments for tax withholding on share-based compensation—  —  (16,231) —  (296) —  —  (296) 
Stock issuance costs—  —  —  —  (212) —  —  (212) 
Net loss—  —  —  —  —  —  (52,214) (52,214) 
Dividends on preferred stock—  —  —  —  —  —  (3,059) (3,059) 
Dividends on common stock—  —  —  —  —  —  (12,350) (12,350) 
Other comprehensive income—  —  —  —  —  86,467  —  86,467  
3

Preferred StockCommon StockAdditional
Paid-in
Capital		Accumulated
Other
Comprehensive
Income (Loss)		Accumulated
Deficit		Total Shareholders’ Equity
SharesAmountSharesAmount
Balance as of
March 31, 2019		6,168,062  $147,898  24,082,710  $241  $872,491  $50,688  $(466,644) $604,674  
Stock issuance346,068  8,173  547,071  5  9,874  —  —  18,052  
Restricted stock granted, net of amortization—  —  17,183  —  296  —  —  296  
Stock issuance costs—  —  —  —  (28) —  —  (28) 
Net loss—  —  —  —  —  —  (118,985) (118,985) 
Dividends on preferred stock—  —  —  —  —  —  (3,206) (3,206) 
Dividends on common stock—  —  —  —  —  —  (13,292) (13,292) 
Other comprehensive income—  —  —  —  —  111,127  —  111,127  
Balance as of
June 30, 2019		6,514,130  $156,071  24,646,964  $246  $882,633  $161,815  $(602,127) $598,638  
See notes to the unaudited consolidated financial statements.
4

DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)(unaudited)
($ in thousands)
Nine Months EndedSix Months Ended
September 30, June 30,
2017 2016 20202019
Operating activities:   Operating activities:  
Net income (loss)$11,931
 $(25,962)Net income (loss)$96,359  $(171,199) 
Adjustments to reconcile net income (loss) to cash provided by operating activities: 
  
Adjustments to reconcile net income (loss) to cash provided by operating activities: 
Decrease in accrued interest receivable1,129
 3,263
Decrease (increase) in accrued interest receivableDecrease (increase) in accrued interest receivable9,589  (4,273) 
(Decrease) increase in accrued interest payable(436) 420
(Decrease) increase in accrued interest payable(14,678) 5,599  
Loss on derivative instruments, net9,634
 62,153
Loss on derivative instruments, net204,130  179,233  
Loss on sale of investments, net10,628
 4,238
(Gain) loss on sale of investments, net(Gain) loss on sale of investments, net(277,882) 10,360  
Fair value adjustments, net(63) (86)Fair value adjustments, net40  29  
Amortization of investment premiums, net122,621
 112,418
Amortization of investment premiums, net63,789  63,239  
Other amortization and depreciation, net983
 1,186
Other amortization and depreciation, net959  707  
Stock-based compensation expense1,567
 2,066
Stock-based compensation expense731  593  
Increase in other assets and liabilities, net(1,905) (2,060)
Change in other assets and liabilities, netChange in other assets and liabilities, net432  642  
Net cash and cash equivalents provided by operating activities156,089
 157,636
Net cash and cash equivalents provided by operating activities83,469  84,930  
Investing activities: 
  
Investing activities:  
Purchase of investments(772,590) (96,816)Purchase of investments(2,818,863) (2,100,712) 
Principal payments received on investments248,298
 337,719
Principal payments received on investments249,766  195,061  
Proceeds from sales of investments792,984
 94,033
Proceeds from sales of investments4,226,321  432,552  
Principal payments received on mortgage loans held for investment, net2,641
 3,709
Distributions received from limited partnership—
 10,835
Net receipts (payments) on derivatives, including terminations11,743
 (24,483)
Principal payments received on mortgage loans held for investmentPrincipal payments received on mortgage loans held for investment1,519  1,199  
Net payments on derivatives, including terminationsNet payments on derivatives, including terminations(210,712) (174,023) 
Other investing activities(214) (105)Other investing activities—  (1,348) 
Net cash and cash equivalents provided by investing activities282,862
 324,892
Net cash and cash equivalents provided by (used in) investing activitiesNet cash and cash equivalents provided by (used in) investing activities1,448,031  (1,647,271) 
Financing activities: 
  
Financing activities:  
Borrowings under repurchase agreements60,229,426
 19,293,243
Borrowings under repurchase agreements23,686,649  60,627,601  
Repayments of repurchase agreement borrowings and FHLB advances(60,609,148) (19,661,384)
Repayments of repurchase agreement borrowingsRepayments of repurchase agreement borrowings(25,124,006) (59,080,133) 
Principal payments on non-recourse collateralized financing(747) (1,443)Principal payments on non-recourse collateralized financing(1,467) (386) 
Proceeds from issuance of preferred stock25,884
 —
Proceeds from issuance of preferred stock107,988  13,188  
Proceeds from issuance of common stock14,495
 102
Proceeds from issuance of common stock—  63,751  
Cash paid for redemption of preferred stockCash paid for redemption of preferred stock(100,000) —  
Cash paid for stock issuance costs(61) —
Cash paid for stock issuance costs—  (185) 
Cash paid for repurchases of common stock—
 (310)
Cash paid for common stock repurchasesCash paid for common stock repurchases(372) —  
Payments related to tax withholding for stock-based compensation(521) (485)Payments related to tax withholding for stock-based compensation(235) (296) 
Dividends paid(35,479) (39,285)Dividends paid(27,894) (38,553) 
Net cash and cash equivalents used in financing activities(376,151) (409,562)
Net cash and cash equivalents (used in) provided by financing activitiesNet cash and cash equivalents (used in) provided by financing activities(1,459,337) 1,584,987  
   
Net increase in cash, cash equivalents, and restricted cash62,800
 72,966
Net increase in cash, cash equivalents, and restricted cash72,163  22,646  
Cash, cash equivalents, and restricted cash at beginning of period98,889
 85,125
Cash, cash equivalents, and restricted cash at beginning of period134,230  88,704  
Cash, cash equivalents, and restricted cash at end of period$161,689
 $158,091
Cash, cash equivalents, and restricted cash at end of period$206,393  $111,350  
Supplemental Disclosure of Cash Activity: 
  
Supplemental Disclosure of Cash Activity:  
Cash paid for interest$26,766
 $18,185
Cash paid for interest$41,613  $51,650  
See notes to the unaudited consolidated financial statements.

5


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)

NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES


Organization


Dynex Capital, Inc., ("Company" (“Company”) was incorporated in the Commonwealth of Virginia on December 18, 1987 and commenced operations in February 1988. The Company is an internally managed mortgage real estate investment trust, or mortgage REIT, which primarily earns income from investing on a leveraged basis in debt securities, the majority of which are specified pools of Agency and non-Agency mortgage-backed securities (“MBS”) consisting of commercial MBS (“CMBS”), residential MBS (“RMBS”), commercial MBS (“CMBS”) and CMBS interest-only ("IO"(“IO”) securities thatand non-Agency MBS, which consist mainly of CMBS IO. Agency MBS have a guaranty of principal payment by a U.S. government-sponsored entity (“GSE”) such as Fannie Mae and Freddie Mac which are in conservatorship and are currently supported by a senior preferred stock purchase agreement from U.S. Treasury. Non-Agency MBS are issued or guaranteed by the U.S. Government or U.S. Government sponsored agencies ("Agency MBS")non-governmental enterprises and MBS issued by others ("non-Agency MBS"). Wedo not have a guaranty of principal payment. The Company also investinvests in other types of mortgage-related securities, such as to-be-announced securities (“TBA”TBAs” or “TBA securities”).

Impact of COVID-19

As a result of the economic, health and market turmoil brought about by the coronavirus (“COVID-19”) forward contractspandemic, fixed income and equity markets experienced severe disruption during mid-March of 2020. The disruption resulted in a substantial rally in interest rates and a decline in fair value of securities in which the Company invests, which led to significant demands on liquidity from margin calls from derivative and repurchase agreement counterparties. The Agency MBS market largely stabilized in late March after the Federal Reserve announced that it would purchase Agency RMBS and CMBS as well as U.S. Treasuries in the amounts needed to support smooth market functioning. In addition, the U.S. Congress passed the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act to provide economic relief to individuals, businesses, state and local governments, and the health care system. The Company has not sought assistance under the CARES Act for its business or operations. Economic relief under the purchaseCARES Act includes mortgage loan forbearance and modification programs to qualifying borrowers who may have difficulty making their loan payments and individual states have adopted similar policies addressing loan payments, rent payments, foreclosures and evictions. The Company is not able to predict the impact these policies may have on its investments at this time. The impact of forbearance on the Company’s MBS could range from immaterial to significant depending on actual losses incurred on underlying loans as well as future public policy choices, and actions by the GSEs, their regulator the Federal Housing Finance Authority ("FHFA"), the Federal Reserve, and federal and state governments. There can be no assurance as to how these and other actions by the U.S. government will affect the efficiency, liquidity and stability of the financial and mortgage markets. To the extent the financial or salemortgage markets do not respond favorably to any of generic (also referredthese actions, or such actions do not function as intended, our business, results of operations and financial condition may be materially adversely affected.

While market conditions have improved since the first quarter of 2020 as a result of actions by the Federal Reserve and the passage of economic stimulus packages such as the CARES Act, economic activity has not returned to pre-pandemic levels and a resurgence in cases of COVID-19 threatens further recovery. The Company continues to monitor servicers’ reporting of delinquencies on loans underlying its investments as "non-specified") poolsan increase in defaults could lead to loss of Agency MBS.premiums should servicers become unable to advance or losses become severe enough to impact the senior tranches of the securitizations in which the Company is invested.


Basis of Presentation


The accompanying unaudited consolidated financial statements of Dynex Capital, Inc.the Company and its subsidiaries (together, “Dynex” or, as appropriate, the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to the Quarterly Report on Form 10-Q and Article 10, Rule 10-01 of Regulation S-X promulgated by the Securities and Exchange Commission (the “SEC”). Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all significant adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation of the consolidated financial statements have been included.included; however, uncertainty over the continuing impact that COVID-19 will have on the global economy and on the Company’s business makes any estimates and assumptions as of June 30, 2020 inherently less certain than they would be absent the current and potential impacts of
6

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)

COVID-19. Operating results for the three and six months ended SeptemberJune 30, 20172020 are not necessarily indicative of the results that may be expected for any other interim periods or for the entire year ending December 31, 2017.2020. The unaudited consolidated financial statements included herein should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 20162019 (the “2019 Form 10-K”) filed with the SEC.


All references to common shares, per common share amounts, and restricted stock have been adjusted to reflect the
effect of the Company’s 1-for-3 reverse stock split effected on June 20, 2019 for all periods presented.

Consolidation and Variable Interest Entities
 
The consolidated financial statements include the accounts of the Company and the accounts of its majority owned subsidiaries and variable interest entities ("VIE"(“VIE”) for which it is the primary beneficiary. As a primary beneficiary, the Company has both the power to direct the activities that most significantly impact the economic performance of the VIE and a right to receive benefits or absorb losses of the entity that could be potentially significant to the VIE. The Company is required to reconsider its evaluation of whether to consolidate a VIE each reporting period, based upon changes in the facts and circumstances pertaining to the VIE. The Company consolidates certain trusts through which it has securitized mortgage loans as a result of not meeting the sale criteria under GAAP at the time the financial assets were transferred to the trust. All intercompany accounts and transactions have been eliminated in consolidation.


The Company consolidates a VIE if the Company is determined to be the VIE’s primary beneficiary, which is defined as the party that has both: (i) the power to control the activities that most significantly impact the VIE’s financial performance and (ii) the right to receive benefits or absorb losses that could potentially be significant to the VIE. The Company reconsiders its evaluation of whether to consolidate a VIE on an ongoing basis, based on changes in the facts and circumstances pertaining to the VIE.

The Company consolidates a securitization trust, which has residential mortgage loans included in “mortgage loans held for investment” on its consolidated balance sheet, of which a portion is pledged as collateral for one remaining bond recorded as “non-recourse collateralized financing” on its consolidated balance sheet. The Company owns the subordinate class in the trust and has been deemed the primary beneficiary.

Though the Company invests in Agency and non-Agency MBS which are generally considered to be interests in VIEs, the Company does not consolidate these entities because it does not meet the criteria necessary to be deemed a primary beneficiary.

Use of Estimates
 
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenue and expenses during the reported period. Actual results could differ from those estimates. The most significant estimates used by management include, but are not limited to, amortization of premiums and discounts and fair value measurements of its investments, and other-than-temporary impairments.investments. These items are discussed further below within this note to the consolidated financial statements.




Income Taxes


The Company has elected to be taxed as a real estate investment trust ("REIT"(“REIT”) under the Internal Revenue Code of 1986 and the corresponding provisions of state law. To qualify as a REIT, the Company must meet certain tests including investing in primarily real estate-related assets and the required distribution of at least 90% of its annual REIT taxable income to stockholdersshareholders after consideration of its net operating loss ("NOL"(“NOL”) carryforward and not including taxable income retained in its taxable subsidiaries. As a REIT, the Company generally will not be subject to federal income tax on the amount of its income or capital gains that is distributed as dividends to shareholders.


The Company assesses its tax positions for all open tax years and determines whether the Company has any material unrecognized liabilities in accordance with Accounting Standards Codification ("ASC") Topic 740. The Companyand records these liabilities, if any, to the extent they are deemed more likely than not to have been incurred.


7

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)

Net Income (Loss) Per Common Share


The Company calculates basic net income (loss) per common share by dividing net income (loss) to common shareholders for the period by weighted-average shares of common stock outstanding for that period. The Company did not have any potentially dilutive securities outstanding during the three or nineand six months ended SeptemberJune 30, 20172020 or SeptemberJune 30, 2016.2019.


Holders of unvested shares of the Company'sCompany’s issued and outstanding restricted common stock are eligible to receive non-forfeitable dividends. As such, these unvested shares are considered participating securities as per ASC Topic 260-10 and therefore are included in the computation of basic net income (loss) per common share using the two-class method. Upon vesting, restrictions on transfer expire on each share of restricted stock, and each such share of restricted stock represents one unrestricted share of common stock.


Because the Company's 8.50% Series A Cumulative Redeemable Preferred Stock (the “Series A Preferred Stock”) andCompany’s 7.625% Series B Cumulative Redeemable Preferred Stock (the “Series B Preferred Stock”) and its 6.900% Series C Cumulative Redeemable Preferred Stock (the “Series C Preferred Stock”) (collectively, the “Preferred Stock”) are redeemable at the Company'sCompany’s option for cash only and may convert into shares of common stock only upon a change of control of the Company (and subject to other circumstances) as described in Article IIIB and Article IIIC of the Company’s Articles of Amendment to the Restated Articles of Incorporation (the “Restated Articles of Incorporation, as amended”), the effect of those shares and their related dividends is excluded from the calculation of diluted net income (loss) per common share.


Cash and Cash Equivalents


Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less.less as well as unrestricted demand deposits at highly rated financial institutions. The Company’s cash balances fluctuate throughout the year and may exceed Federal Deposit Insurance Company insured limits from time to time. Although the Company bears risk to amounts in excess of those insured by the FDIC, it does not anticipate any losses as a result.


Restricted Cash


Restricted cash consists of cash the Company has pledged to cover initial and variation margin with its financing and certain derivative counterparties.

The Company early adopted Accounting Standards Update ("ASU") No. 2016-18, Statement of Cash Flows (Topic 230) - Restricted Cash, which requires amounts generally described as restricted cash or restricted cash equivalents to be included with cash and cash equivalents when reconciling the beginning of period and end of period total amounts shown on the statement of cash flows. Because this ASU is to be applied retrospectively to each period presented, "net cash and cash equivalents used in financing activities" on the Company's consolidated statement of cash flows for the nine months ended September 30, 2016 now omits "increase in restricted cash" previously reported in the Quarterly Report on Form 10-Q for that period, and that increase is now included within "net increase in cash, cash equivalents, and restricted cash" for that period in order to conform to the current period's presentation.


The following table provides a reconciliation of cash, cash equivalents, and restricted cash reported on the Company's consolidated balance sheet as of SeptemberJune 30, 20172020 that sum to the total of the same such amounts shown on the Company'sCompany’s consolidated statement of cash flows for the ninesix months ended SeptemberJune 30, 2017:2020:

June 30, 2020
Cash and cash equivalents$147,243 
Restricted cash59,150 
Total cash, cash equivalents, and restricted cash shown on consolidated statement of cash flows$206,393 

  September 30, 2017
Cash and cash equivalents $117,702
Restricted cash 43,987
Total cash, cash equivalents, and restricted cash shown on consolidated statement of cash flows $161,689


Mortgage-Backed Securities
 
The Company's investments in Agency and non-Agency RMBS, CMBS, and CMBS IO securitiesCompany’s MBS are designated as available-for-sale ("AFS"(“AFS”) and are recorded at fair value on the Company'sCompany’s consolidated balance sheet. Changes in unrealized gain (loss) on the Company'sCompany’s MBS are reported in other comprehensive income ("OCI"(“OCI”) until itthe investment is sold matures, or is determined to be other than temporarily impaired.matures. Although the Company generally intends to hold its AFS securities until maturity, it may sell any of these securities as part of the overall management of its business. Upon the sale of an AFS security, any unrealized gain or loss is reclassified out of accumulated other comprehensive income ("AOCI"(“AOCI”) into net income as a realized "gain“gain (loss) on sale of investments, net"net” using the specific identification method.


The fair value of the Company’s MBS pledged as collateral against repurchase agreements and derivative instruments are included in MBSis disclosed parenthetically on the Company’s consolidated balance sheets with the fair value of the MBS pledged as collateral disclosed parenthetically.sheets.


8

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)

Interest Income, Premium Amortization, and Discount Accretion.Interest income on MBS is accrued based on the outstanding principal balance (or notional balance in the case of interest-only, or "IO",“IO” securities) and their contractual terms. Premiums andor discounts onassociated with the Company'spurchase of Agency MBS as well as any non-Agency MBS rated 'AA'‘AA’ and higher at the time of purchase are amortized or accreted into interest income over the expectedprojected life of such securities using the effective yield method, and adjustments to premium amortization and discount accretion are made for actual cash payments. The Company may also adjust premium amortization and discount accretion for changes in projected future cash payments. The Company'sCompany’s projections of future cash payments are based on input and analysis received from external sources and internal models and include assumptions about the amount and timing of loan prepayment rates, fluctuations in interest rates, credit losses, and other factors. On at least a quarterly basis, the Company reviews and makes any necessary adjustments to its cash flow projections and updates the yield recognized on these assets.

The Company does not estimate future prepayments on its fixed-rate Agency RMBS.

The Company holds certaincurrently hold any non-Agency MBS that hadwere purchased at a discount with credit ratings of less than 'AA' at the time of purchase‘AA’ or were not rated by any of the nationally recognized credit rating agencies. A portionagencies at the time of these non-Agency MBS were purchased at discounts to their par value, which management does not believe to be substantial. The discount is accreted into income over the security's expected life based on management's estimate of the security's projected cash flows. Future changes in the timing of projected cash flows or differences arising between projected cash flows and actual cash flows received may result in a prospective change in the effective yield on those securities.purchase.


Determination of MBS Fair Value.The Company estimates the fair value of the majority of its MBS based upon prices obtained from third-party pricing services and broker quotes. The remainder of the Company'sCompany’s MBS are valued by discounting the estimated future cash flows derived from cash flow models that utilize information such as the security'ssecurity’s coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected losses, and credit enhancements as well as certain other relevant information. ReferPlease refer to Note 5 for further discussion of MBS fair value measurements.


Other-than-Temporary Impairment. AnAllowance for Credit Losses.The Company recently adopted Accounting Standards Codification Topic 326, Financial Instruments - Credit Losses. On at least a quarterly basis, the Company evaluates any MBS is considered impaired when itswith a fair value is less than its amortized cost. The Company evaluates all of its impaired MBScost for other-than-temporary impairments ("OTTI") on at least a quarterly basis. An impairment is considered other-than-temporary if: (1) the Company intends to sell the MBS; (2) it is more likely than not that the Company will be required to sell the MBS before its fair value recovers; or (3) the Company does not expect to recover the full amortized cost basis of the MBS.credit losses. If either of the first two conditions is met, the entire amount of the impairment is recognized in earnings. If the impairment is solely due to the inability to fully recover the amortized cost basis, the security is further analyzed to quantify any credit loss, which is the difference between the present value of cash flows expected to be collected on the MBS andis less than its amortized cost. Thecost, the difference is recorded as an allowance for credit loss if any, is thenthrough net income up to and not exceeding the amount that the amortized cost exceeds current fair value. Subsequent changes in credit loss estimates are recognized in earnings whilein the balance of impairment related to other factors is recognizedperiod in other comprehensive income.


Followingwhich they occur. Because the recognition of an OTTI through earnings, a new cost basis is established for the security. Any subsequent recoveries in fair value may be accreted back into the amortized cost basismajority of the MBSCompany’s investments are higher credit quality and most are guaranteed by a GSE, the Company is not likely to have an allowance for credit losses recorded on a prospective basis through interest income. Please see Note 2 for additional information related to the Company's evaluation for OTTI.its consolidated balance sheet.


Repurchase Agreements
 
The Company'sCompany’s repurchase agreements, which are used to finance its purchases of MBS, are accounted for as secured borrowings under which the Company pledges its securities as collateral to secure a loan, which is equal in value to a specified percentage of the estimated fair value of the pledged collateral. The Company retains beneficial ownership of the pledged collateral. At the maturity of a repurchase agreement, the Company is required to repay the loan and concurrently receives back its pledged collateral from the lender or, with the consent of the lender, the Company may renew the agreement at the then prevailing financing rate. A repurchase agreement lender may require the Company to pledge additional collateral in the event of a decline in the fair value of the collateral pledged. Repurchase agreement financing is recourse to the Company and the assets pledged. Most of the Company’s repurchase agreements are based on the September 1996 version of the Bond Market Association Master Repurchase Agreement, which generally provides that the lender, as buyer, is responsible for obtaining collateral valuations from a generally recognized source agreed to by both the Company and the lender, or, in an instance when such source is not available, the value determination is made by the lender.


9

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)

Derivative Instruments


The Company'sCompany’s derivative instruments include interest rate swaps, futures, options, and forward contracts for the purchase or sale of generic Agency RMBS on a non-specified pool basis, commonly referred to as "TBA securities" or "TBA contracts".to-be-announced (“TBA”) securities. Derivative instruments are accounted forreported at thetheir fair value of their unit of account. Derivative instrumentson the Company’s consolidated balance sheet as derivative assets if in a gain position are reportedor as derivative assets and derivative instrumentsliabilities if in a loss position, are reported as derivative liabilities onat the Company's consolidated balance sheet.end of the period reported. All periodic interest benefits/costs and changes in fair value of derivative instruments, including gains and losses realized upon termination, maturity, or settlement are recorded in "gain“gain (loss) on derivative instruments, net"net” on the Company'sCompany’s consolidated statement of comprehensive income.income (loss). Cash receipts and payments related to derivative instruments are classified in the investing activities section of ourthe consolidated statements of cash flows in accordance with the underlying nature or purpose of the derivative transactions.


OurGenerally, the Company enters into pay-fixed interest rate swaps, which involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the interest rate swap agreements are privately negotiatedwithout exchange of the underlying notional amount. From time to time the Company may also enter into receive-fixed interest rate swaps that involve the receipt of fixed-rate amounts from a counterparty in exchange for the over-the-counter ("OTC") market andCompany making variable-rate payments over the majoritylife of thesethe interest rate swap without exchange of the underlying notional amount. The Company’s interest rate swap agreements are centrally cleared through the Chicago Mercantile Exchange ("CME"(“CME”) with the rest being subject to bilateral agreements between the Company and the swap counterparty.. The Company'sCompany’s CME cleared swaps require that the Company post initial margin as determined by the CME,collateral, and in addition, variation margin is exchanged, typically in cash, for changes in the fair value of the CME cleared swaps. Beginning in January 2017, as a result of a change in the CME's rulebook, theThe exchange of variation margin for CME cleared swaps is legally considered to be the settlement of the derivative itself as opposed to a pledge of collateral. Accordingly, beginning in 2017, the Company accounts for the daily exchange of variation margin associated with its CME cleared interest rate swaps as a direct increase or decrease to the carrying value of the related derivative asset or liability.

The carryingCompany may also enter into long and short positions in U.S. Treasury futures contracts. U.S. Treasury futures are valued based on exchange pricing with daily margin settlements. The Company realizes gains or losses on these contracts upon expiration at an amount equal to the difference between the current fair value of CME clearedthe underlying asset and the contractual price of the futures contract. Unlike interest rate swaps, the Company does not treat the daily margin exchanges for its U.S. Treasury futures as legal settlement of the instrument.

The Company currently holds put options on U.S. Treasury futures which provide the Company'sCompany the right, but not an obligation, to buy U.S. Treasury futures at a predetermined notional amount and stated term in the future. Put options on U.S. Treasury futures are valued based on exchange pricing without daily exchanges of margin amounts. The Company records the premium paid for the option contract as a derivative asset on its consolidated balance sheets issheet and adjusts the unsettledbalance for changes in fair value of those instruments.through “gain (loss) on derivative instruments” until the option is exercised or the contract expires. The Company may also purchase options for interest rate swaps (“interest rate swaptions”) which are accounted for similarly.


A TBA security is a forward contract (“TBA contract”) for the purchase (“long position”) or sale (“short position”) of a genericnon-specified Agency MBS at a predetermined price with certain principal and interest terms and certain types of collateral, but the particular Agency securities to be delivered are not identified until shortly before the TBA settlement date. The Company executes TBA dollar roll transactions which effectively delay the settlement of a forward purchase of a TBA Agency RMBS by entering into an offsettingaccounts for long and short position (referred to as a "pair off"), net settling the paired-off positions in cash, and simultaneously entering a similar TBA contract for a later settlement date. TBA securities purchased for a forward settlement month are generally priced at a discount relative to TBA securities sold for settlement in the current month. This discount, often referred to as “drop income” is the economic equivalent of net interest income on the underlying Agency securities over the roll period (interest income less implied financing cost).

The Company accounts for TBA securitiesTBAs as derivative instruments because the Company cannot assert that it is probable at inception and throughout the term of an individual TBA contracttransaction that its settlement will result in physical delivery of the underlying Agency RMBS or that the individual TBA contracttransaction will not settle in the shortest time period possible.



Please refer to Note 4 for additional information regarding the Company'sCompany’s derivative instruments as well as Note 5 for information on how the fair value of these instruments are calculated.


10

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)

Share-Based Compensation


Pursuant to the Company’s 20092020 Stock and Incentive Plan (the “2020 Plan”), the Company may grant share-based compensation to eligible employees, non-employee directors or consultants or advisersadvisors to the Company, including restricted stock awards, stock options, stock appreciation rights, dividend equivalent rights, performance shares, andunits, restricted stock units.units, and performance cash awards. The Company'sCompany’s restricted stock currently issued and outstanding under this plan may be settled only in shares of its common stock, and therefore are treated as equity awards with their fair value measured at the grant date and recognized as compensation cost over the requisite service period with a corresponding credit to shareholders'shareholders’ equity. The requisite service period is the period during which an employeea participant is required to provide service in exchange for an award, which is equivalent to the vesting period specified in the terms of the time-based restricted stock award. None of the Company'sCompany’s restricted stock awards have performance basedperformance-based conditions. The Company does not currently have any share-based compensation issued or outstanding other than restricted stock issued to its employees, officers, and directors.


Contingencies


In the normal course of business, there may be various lawsuits, claims, and other contingencies pending against the Company. On a quarterly basis, the Company evaluates whether to establish provisions for estimated losses from those matters. The Company recognizes a liability for a contingent loss when: (a) the underlying causal event has occurred prior to the balance sheet date; (b) it is probable that a loss has been incurred; and (c) there is a reasonable basis for estimating that loss. A liability is not recognized for a contingent loss when it is only possible or remotely possible that a loss has been incurred, however, possible contingent losses shall be disclosed. If the contingent loss (or an additional loss in excess of any accrual) is at least a reasonable possibility and material, then the Company discloses a reasonable estimate of the possible loss or range of loss, if such reasonable estimate can be made. If the Company cannot make a reasonable estimate of the possible material loss, or range of loss, then that fact is disclosed.


RecentAs previously disclosed in the 2019 Form 10-K, the receiver (the “Receiver”) for one of the plaintiffs awarded damages in a judgment (the "DCI Judgment") against Dynex Commercial, Inc. ("DCI"), a subsidiary of a former affiliate of the Company, filed a separate claim in May 2018 against the Company seeking payment of the damages awarded in connection with the DCI Judgment, alleging that the Company breached a litigation cost sharing agreement, as amended (the "Agreement"), that was initially entered into by the Company and DCI in December 2000. On November 21, 2019, the U.S. District Court, Northern District of Texas ("Northern District Court") granted in part and denied in part summary judgment on the Receiver’s claim and the Company’s claim for offset and recoupment. The Northern District Court found that the Company breached the Agreement and therefore must pay damages to the Receiver. The Northern District Court simultaneously granted the Company’s motion for summary judgment finding that DCI also breached the Agreement and that the Company can recover amounts due to it from DCI under the Agreement. The Receiver subsequently filed a claim for damages with the Northern District Court of approximately $12,600, while the Company filed claims for damages ranging from $13,300 to $30,600, including interest. The Receiver filed objections (the "Objections") with the Northern District Court to, among other things, the Company recovering amounts incurred prior to entry into the Agreement and amounts incurred under the Agreement after January 31, 2006, including interest, which is the date that DCI’s corporate existence ceased under Virginia law. The Company has disputed, among other things, that the Receiver's Objections are not supportable under Virginia law and has further refined its damages claim to range from $13,300 based on simple interest to $17,800 based on a combination of simple and compound interest, which the Company believes is supportable under Virginia law. There have been no material developments in this matter during the three months ended June 30, 2020. After consultation with litigation counsel, the Company believes, based upon information currently available and its evaluation of Virginia law, that the likelihood of loss is not probable, and given the range of potential claims for damages by the Company to offset the Receiver's claims, the amount of possible loss cannot be reasonably estimated, and therefore, no contingent liability has been recorded.

11

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)

Recently Issued and Adopted Accounting Pronouncements


The Company reviews all Accounting Standards Updates (“ASU”) issued by the Financial Accounting Standards Board ("FASB"(“FASB”) on at least a quarterly basis to evaluate applicability and significance of any impact on its financial condition and results of operations. There were no accounting pronouncements issued ASU No. 2017-08, Receivables-Nonrefundable Fees and Other Costs, which shortensduring the amortization period for certain callable debt securities held at a premium, requiring the premium to be amortized to the earliest call date. The amendments in this ASUsix months ended June 30, 2020 that are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018 and early adoption is permitted. The amendments in this Update should be applied using the modified-retrospective transition approach and will require disclosures for the change in accounting principle. The Company does not expect this ASUexpected to have a material impact on the Company's consolidatedCompany’s financial statements.condition or results of operations.


FASB issuedAs of January 1, 2020, the Company elected the fair value option for its mortgage loans held for investment pursuant to the provisions of ASU No. 2017-12, Derivatives and Hedging2019-05, Financial Instruments—Credit Losses (Topic 815):326) Targeted ImprovementsTransition Relief, which was issued in May of 2019. Management chose to Accountingelect the fair value option for Hedging Activities, which contains significant amendments to hedge accounting withits mortgage loans because the main objective of better aligning an entity’s risk management activities and financial reporting for hedging relationships through changes to both the designation and measurement guidance for qualifying hedging relationships and the presentation of hedge results. To meet that objective, the amendments expand and refine hedge accounting for both non-financial and financial risk components and align the recognition and presentationmajority of the effectsCompany’s investments are represented on its consolidated balance sheet at fair value. The election of the hedging instrument and the hedged itemfair value option resulted in the financial statements. This ASU also includes certain targeted improvementsa cumulative adjustment of $(548) to ease the application of current guidance related to the assessment of hedge effectiveness as well as changes to current disclosure requirements. The amendments in this ASU are effective for public business entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years, and early adoption is permitted. All transition requirements and elections will be applied to hedging relationships existingretained earnings on the date of adoption. The effect of adoption will be reflectedits consolidated balance sheet as of the beginning of the fiscal year of adoption, and the amended presentation and disclosure guidance is required only prospectively.January 1, 2020. The Company does not currently apply hedgeexpect its election of the fair value option for its mortgage loans to have a material impact on its future consolidated financial statements.

In March 2020, FASB issued ASU 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting, which provides optional expedients and exceptions to GAAP requirements for modifications on debt instruments, leases, derivatives, and other contracts, related to the expected market transition from LIBOR, and certain other floating rate benchmark indices to alternative reference rates. ASU 2020-04 generally considers contract modifications related to reference rate reform to be an event that does not require contract remeasurement at the modification date nor a reassessment of a previous accounting butdetermination. The guidance in ASU 2020-04 is evaluating the impactoptional and may be elected over time, through December 31, 2022, as reference rate reform activities occur. The Company does not believe this ASU wouldwill have a material impact on its consolidated financial statements if the Company elects to adopt hedge accounting in the future.statements.




NOTE 2 – MORTGAGE-BACKED SECURITIES
 
The majority of the Company'sCompany’s MBS are pledged as collateral for the Company's secured borrowings.Company’s repurchase agreements. The following tables present the Company’s MBS by investment type (including securities pending settlement) as of the dates indicated:
 June 30, 2020
 ParNet Premium (Discount)Amortized CostGross Unrealized GainGross Unrealized LossFair Value
Agency RMBS$2,248,752  $67,589  $2,316,341  $40,465  $—  $2,356,806  
Agency CMBS655,935  6,518  662,453  39,507  (1) 701,959  
CMBS IO (1)
—  435,271  435,271  5,731  (4,332) 436,670  
Non-Agency other1,732  (600) 1,132  403  (45) 1,490  
Total MBS:$2,906,419  $508,778  $3,415,197  $86,106  $(4,378) $3,496,925  
(1) The notional balance for Agency CMBS IO and non-Agency CMBS IO was $13,007,113 and $9,577,721 respectively, as of June 30, 2020.
 December 31, 2019
 ParNet Premium (Discount)Amortized CostGross Unrealized GainGross Unrealized LossFair Value
Agency RMBS$2,563,684  $55,770  $2,619,454  $69,082  $(462) $2,688,074  
Agency CMBS1,890,186  15,414  1,905,600  93,763  (6) 1,999,357  
CMBS IO (1)
—  488,145  488,145  11,760  (863) 499,042  
Non-Agency other1,938  (780) 1,158  552  (20) 1,690  
Total MBS:$4,455,808  $558,549  $5,014,357  $175,157  $(1,351) $5,188,163  
12

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)

 September 30, 2017
 Par Net Premium (Discount) Amortized Cost Gross Unrealized Gain Gross Unrealized Loss Fair Value 
WAC (1)
CMBS:             
Agency$1,302,237
 $12,688
 1,314,925
 $6,187
 $(13,623) 1,307,489
 2.99%
Non-Agency40,780
 (4,452) 36,328
 2,877
 —
 39,205
 5.48%
 1,343,017
 8,236
 1,351,253
 9,064
 (13,623) 1,346,694
  
CMBS IO (2):
             
Agency—
 394,380
 394,380
 7,592
 (164) 401,808
 0.63%
Non-Agency—
 322,735
 322,735
 6,254
 (330) 328,659
 0.61%
 —
 717,115
 717,115
 13,846
 (494) 730,467
  
RMBS:             
Agency fixed-rate522,099
 19,163
 541,262
 —
 (1,903) 539,359
 3.52%
Agency adjustable-rate294,254
 11,011
 305,265
 1,263
 (2,746) 303,782
 3.05%
Non-Agency1,113
 —
 1,113
 49
 (20) 1,142
 6.75%
 817,466
 30,174
 847,640
 1,312
 (4,669) 844,283
  
             

Total AFS securities:$2,160,483
 $755,525
 $2,916,008
 $24,222
 $(18,786) $2,921,444
  
(1)The weighted average coupon ("WAC") is the gross interest rate of the security weighted by the outstanding principal balance (or by notional balance in the case of an IO security).
(2)The notional balance for Agency CMBS IO and non-Agency CMBS IO was $14,253,392 and $11,061,377, respectively, as of September 30, 2017.
(1) The notional balance for the Agency CMBS IO and non-Agency CMBS IO was $13,404,824 and $9,799,629, respectively, as of December 31, 2019.
 December 31, 2016
 Par Net Premium (Discount) Amortized Cost Gross Unrealized Gain Gross Unrealized Loss Fair Value 
WAC (1)
CMBS:             
Agency$1,152,586
 $13,868
 $1,166,454
 $6,209
 $(28,108) $1,144,555
 3.12%
Non-Agency79,467
 (6,718) 72,749
 5,467
 —
 78,216
 4.72%
 1,232,053
 7,150
 1,239,203
 11,676
 (28,108) 1,222,771
  
CMBS IO (2):
             
Agency—
 411,737
 411,737
 3,523
 (3,362) 411,898
 0.67%
Non-Agency—
 346,155
 346,155
 1,548
 (5,055) 342,648
 0.61%
 —
 757,892
 757,892
 5,071
 (8,417) 754,546
  
RMBS:             
Agency adjustable-rate$1,157,258
 $57,066
 $1,214,324
 $2,832
 $(15,951) $1,201,205
 3.05%
Non-Agency33,572
 (24) 33,548
 64
 (50) 33,562
 3.58%
 1,190,830
 57,042
 1,247,872
 2,896
 (16,001) 1,234,767
  



   

 

   

  
Total AFS securities:$2,422,883
 $822,084
 $3,244,967
 $19,643
 $(52,526) $3,212,084
 



(1)The WAC is the gross interest rate of the pool of mortgages underlying the security weighted by the outstanding principal balance (or by notional balance in the case of an IO security).
(2)The notional balance for the Agency CMBS IO and non-Agency CMBS IO was $13,106,912 and $10,884,964, respectively, as of December 31, 2016.


Actual maturities of MBS are affected by the contractual lives of the underlying mortgage collateral, periodic payments of principal, prepayments of principal, and the payment priority structure of the security; therefore, actual maturities are generally shorter than the securities' stated contractual maturities.


The following table presents information regarding the sales included in "loss"gain on sale of investments, net" on the Company'sCompany’s consolidated statements of comprehensive income (loss) for the periods indicated:

Three Months EndedThree Months EndedSix Months Ended
September 30,June 30,June 30,
2017 20162020201920202019
Proceeds Received Realized Gain (Loss) Proceeds Received Realized Gain (Loss)Proceeds ReceivedRealized Gain (Loss)Proceeds ReceivedRealized Gain (Loss)Proceeds ReceivedRealized Gain (Loss)Proceeds ReceivedRealized Gain (Loss)
Agency RMBS$393,502
 $(5,160) $—
 $—
Agency RMBS$371,106  $11,729  $205,493  $(3,953) $2,188,456  $75,823  $205,493  $(3,953) 
Agency CMBS13,433
 (51) —
 —
Agency CMBS2,020,228  181,370  213,198  (6,493) 2,193,912  202,059  213,198  (6,493) 
Agency CMBS IOAgency CMBS IO—  —  13,861  86  —  —  13,861  86  
$406,935
 $(5,211) $—
 $—
$2,391,334  $193,099  $432,552  $(10,360) $4,382,368  $277,882  $432,552  $(10,360) 
       
Nine Months Ended
September 30,
2017 2016
Proceeds Received Realized Gain (Loss) Proceeds Received Realized Gain (Loss)
Agency RMBS$716,560
 $(12,392) $54,178
 $(3,010)
Agency CMBS206,993
 523
 —
 —
Non-Agency CMBS35,705
 1,199
 33,640
 (1,228)
Non-Agency RMBS16,407
 42
 —
 —
$975,665
 $(10,628) $87,818
 $(4,238)


Included in the table above are securities sold with an amortized cost of $152,363 which were unsettled as of June 30, 2020 and were pledged as collateral for repurchase agreement borrowings of $144,910. The sale proceeds of $156,047 to be received for the unsettled portion are recorded as “receivable for securities sold” on the Company’s consolidated balance sheet as of June 30, 2020.

The following table presents certain information for those MBSthe AFS securities in an unrealized loss position as of the dates indicated:
 June 30, 2020December 31, 2019
Fair ValueGross Unrealized Losses# of SecuritiesFair ValueGross Unrealized Losses# of Securities
Continuous unrealized loss position for less than 12 months:    
Agency MBS$87,603  $(2,304) 26$215,792  $(1,139) 27
Non-Agency MBS98,246  (1,926) 4713,607  (146) 7
Continuous unrealized loss position for 12 months or longer:
Agency MBS$1,225  $(128) 3$75,745  $(35) 2
Non-Agency MBS107  (20) 41,099  (31) 5
 September 30, 2017 December 31, 2016
 Fair Value Gross Unrealized Losses # of Securities Fair Value Gross Unrealized Losses # of Securities
Continuous unrealized loss position for less than 12 months:           
Agency MBS$1,377,438
 $(13,201) 76 $1,738,094
 $(38,469) 133
Non-Agency MBS38,979
 (151) 6 205,484
 (2,773) 48
            
Continuous unrealized loss position for 12 months or longer:           
Agency MBS$206,045
 $(5,236) 17 $427,405
 $(8,952) 72
Non-Agency MBS15,749
 (199) 11 81,660
 (2,332) 26


BecauseThe unrealized losses on the Company’s MBS are not credit related, therefore the Company’s allowance for credit losses was $0 as of June 30, 2020. The unrealized losses are a result of declines in market prices driven by significant spread widening. The principal related to Agency MBS is guaranteed by the government-sponsored entities Fannie Mae and Freddie Mac which have the implicit guarantee of the U.S. government, the Company does not consider any of the unrealized


losses on its Agency MBS to be credit related.Mac. Although the unrealized losses are not credit related, the Company assesses its ability and intent to hold any Agency MBS with an unrealized loss until the recovery in its value in accordance with GAAP. This assessment is based on the amount of the unrealized loss and significance of the related investment as well as the Company’s leverage and liquidity position. Based on this analysis,In addition, for its non-Agency MBS the Company has determined that the unrealized losses on its Agency MBS as of September 30, 2017 and December 31, 2016 were temporary.

The Company reviews any non-Agency MBS in an unrealized loss position to evaluate whether any decline in fair value represents an OTTI. The evaluation includes a review of the credit ratings, of the non-Agency MBS, the credit characteristics of the mortgage loans collateralizing these securities, and the estimated future cash flows including projected collateral losses. The Company performed this evaluation for its non-Agency MBS
13

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in an unrealized loss position and has determined that there have not been any adverse changes in the timing or amount of estimated future cash flows that necessitate a recognition of OTTI amounts as of September 30, 2017 or December 31, 2016.thousands except share data)




NOTE 3 – REPURCHASE AGREEMENTS

The Company’s repurchase agreements outstanding as of SeptemberJune 30, 20172020 and December 31, 20162019 are summarized in the following tables:
 June 30, 2020December 31, 2019
Collateral Type
Balance (1)
Weighted
Average Rate		Fair Value of
Collateral Pledged		BalanceWeighted
Average Rate		Fair Value of
Collateral Pledged
Agency RMBS$2,308,446  0.27 %$2,427,267  $2,594,645  1.96 %$2,647,638  
Agency CMBS654,001  0.28 %695,578  1,735,848  1.98 %1,901,452  
Agency CMBS IO225,191  1.12 %265,342  255,912  2.30 %282,522  
Non-Agency CMBS IO127,353  1.40 %155,288  165,943  2.67 %193,013  
Total repurchase agreements$3,314,991  0.38 %$3,543,475  $4,752,348  2.01 %$5,024,625  
  September 30, 2017 December 31, 2016
Collateral Type Balance 
Weighted
Average Rate
 
Fair Value of
Collateral Pledged
 Balance 
Weighted
Average Rate
 
Fair Value of
Collateral Pledged
Agency CMBS $1,188,230
 1.31% $1,250,575
 $1,005,726
 0.82% $1,095,002
Non-Agency CMBS 15,625
 2.14% 18,365
 66,881
 1.63% 77,840
Agency CMBS IO 336,187
 2.06% 389,637
 346,892
 1.57% 407,481
Non-Agency CMBS IO 279,981
 2.15% 327,976
 291,199
 1.67% 341,139
Agency RMBS 695,841
 1.31% 727,727
 1,157,302
 0.82% 1,191,147
Non-Agency RMBS —
 —% —
 26,149
 1.98% 31,952
Securitization financing bond 3,366
 2.58% 3,723
 4,803
 2.00% 5,278
Total repurchase agreements $2,519,230
 1.51% $2,718,003
 $2,898,952
 1.03% $3,149,839


The amounts for fair value of collateral pledged in the table above as of June 30, 2020 include securities sold but not settled, which are recorded as “receivable for securities sold” on the consolidated balance sheet and for which the Company had $144,910 of repurchase agreement borrowings outstanding as of June 30, 2020. The Company also had $0 and $6,180 payable to counterparties as of June 30, 2020 and December 31, 2019, respectively, for purchases pending settlement as of those respective dates.

The following table provides information on the remaining term to maturity and original term to maturity for the Company'sCompany’s repurchase agreements as of the periodsdates indicated:
June 30, 2020December 31, 2019
Remaining Term to MaturityBalanceWeighted
Average Rate		WAVG Original Term to MaturityBalanceWeighted
Average Rate		WAVG Original Term to Maturity
Less than 30 days$1,875,520  0.40 %26  $2,078,185  2.12 %34  
30 to 90 days1,439,471  0.35 %32  2,674,163  1.93 %52  
Total$3,314,991  0.38 %29  $4,752,348  2.01 %45  
  September 30, 2017 December 31, 2016
Remaining Term to Maturity Balance WAVG Original Term to Maturity Balance WAVG Original Term to Maturity
Less than 30 days $1,725,518
 36
 $2,480,213
 58
30 to 90 days 793,712
 89
 418,739
 87
Total $2,519,230
 53
 $2,898,952
 63


The following table lists the counterparties with whom the Company had over 10% of its shareholders' equity at risk (defined as the excess of collateral pledged over the borrowings outstanding):
  September 30, 2017
Counterparty Name Balance Weighted Average Rate Equity at Risk
Wells Fargo Bank, N. A. and affiliates $349,965
 2.10% $57,992


Of the amount outstanding with Wells Fargo Bank, N.A. and affiliates, $343,780 is under a committed repurchase facility which has an aggregate maximum borrowing capacity of $400,000 and is scheduled to mature on May 12, 2019, subject to early termination provisions contained in the master repurchase agreement. The facility is collateralized primarily by CMBS IO, and its weighted average borrowing rate as of September 30, 2017 was 2.10%.

As of SeptemberJune 30, 2017,2020, the Company had repurchase agreement amounts outstanding with 1819 of its 3437 available repurchase agreement counterparties. The Company'sCompany had $645,231 outstanding and $46,872, or approximately 8%, of equity at risk with JP Morgan Chase at a weighted average borrowing rate of 0.39%. The Company did not have more than 10% of its equity at risk with any of its other counterparties as of June 30, 2020. The Company has a committed repurchase facility with Wells Fargo that has an aggregate maximum borrowing capacity of $250,000, of which it had $137,301 outstanding at a weighted average borrowing rate of 1.04% as of June 30, 2020. The facility is available to the Company until its maturity date of June 11, 2021.

The Company’s counterparties, as set forth in the master repurchase agreement with the counterparty, require the Company to comply with various customary operating and financial covenants, including, but not limited to, minimum net worth and earnings, maximum declines in net worth in a given period, and maximum leverage requirements as well as maintaining the Company'sCompany’s REIT status. In addition, some of the agreements contain cross default features, whereby default under an agreement with one lender simultaneously causes default under agreements with other lenders. To the extent that the Company fails to comply with the covenants contained in these financing agreements or is otherwise found to be in default under the terms of such agreements, the counterparty has the right to accelerate amounts due under the master repurchase
14

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)

agreement. The Company believes it was in full compliance with all covenants in master repurchase agreements under which there were amounts outstanding as of SeptemberJune 30, 2017.2020.


The Company's repurchase agreements are subject to underlying agreements with master netting or similar arrangements, which provide for the right of offset in the event of default or in the event of bankruptcy of either party to the transactions. The Company reports its repurchase agreements to these arrangements on a gross basis. The following tables present information regarding the Company's repurchase agreements as if the Company had presented them on a net basis as of SeptemberJune 30, 20172020 and December 31, 2016:2019:
Gross Amount of Recognized LiabilitiesGross Amount Offset in the Balance SheetNet Amount of Liabilities Presented in the Balance Sheet
Gross Amount Not Offset in the Balance Sheet (1)
Net Amount
Financial Instruments Posted as CollateralCash Posted as Collateral
June 30, 2020
Repurchase agreements$3,314,991  $—  $3,314,991  $(3,314,991) $—  $—  
December 31, 2019
Repurchase agreements$4,752,348  $—  $4,752,348  $(4,752,348) $—  $—  
 Gross Amount of Recognized Liabilities Gross Amount Offset in the Balance Sheet Net Amount of Liabilities Presented in the Balance Sheet 
Gross Amount Not Offset in the Balance Sheet (1)
 Net Amount
Financial Instruments Posted as Collateral Cash Posted as Collateral
September 30, 2017           
Repurchase agreements$2,519,230
 $—
 $2,519,230
 $(2,519,230) $—
 $—
            
December 31, 2016:           
Repurchase agreements$2,898,952
 $—
 $2,898,952
 $(2,898,952) $—
 $—
(1)Amounts disclosed for collateral received by or posted to the same counterparty include cash and the fair value of MBS up to and not exceeding the net amount of the asset or liability presented in the balance sheet. The fair value of the actual(1) Amounts disclosed for collateral received by or posted to the same counterparty include cash and the fair value of MBS up to and not exceeding the net amount of the repurchase agreement liability presented in the balance sheet. The fair value of the total collateral received by or posted to the same counterparty may exceed the amounts presented.


Please see Note 4 for information related to the Company'sCompany’s derivatives, which are also subject to underlying agreements with master netting or similar arrangements.


NOTE 4 – DERIVATIVES


     The Company's derivative instruments includeTypes and Uses of Derivatives Instruments
Interest Rate Derivatives. Prior to the end of the first quarter of 2020, the Company primarily used interest rate swaps and TBA securities. The Company utilizes interest rate swaps to economically hedge a portion of its exposure to interest rate risk in orderas economic hedges to mitigate declines in book value resulting from fluctuations in the fair value of the Company's assets from changing interest rates and to protect some portion of the Company's earnings from rising interest rates.rates; however, the Company substantially reduced its notional balance of interest rate swaps late in the first quarter of 2020 due to the significant reduction of its MBS portfolio. In addition, counterparties began expanding initial margin requirements for interest rate swaps. The Company investsadded short positions in U.S. Treasury futures and increased its holdings of put options on U.S. Treasury futures as these derivative instruments are viewed by management as more liquid and having more favorable margin requirements versus interest rate swaps.

TBA Transactions. The Company purchases TBA securities as a means of investing in non-specified fixed-rate Agency RMBS and may also periodically sell TBA securities as a means of economically hedging its book value exposure to Agency RMBS as well as earnings exposure from rising financing costs. The Company holds long and short positions in TBA securities forby executing a series of transactions, commonly referred to as “dollar roll” transactions, which effectively delay the settlement of a forward purchase or sale(or sale) of a non-specified Agency RMBS onby entering into an offsetting TBA position, net settling the paired-off positions in cash, and simultaneously entering into an identical TBA long (or short) position with a non-specified pool basis.later settlement date. TBA securities purchased (or sold) for a forward settlement date are forward contracts which are accounted for as derivative instruments; however, management viewsgenerally priced at a discount relative to TBA securities settling in the current month. This discount, often referred to as “drop income” represents the economic equivalent of investingnet interest income (interest income less implied financing cost) on the underlying Agency security from trade date to settlement date. The Company accounts for all TBAs (whether net long or net short positions, or collectively “TBA dollar roll positions”) as derivative instruments because it cannot assert that it is probable at inception and throughout the term of an individual TBA transaction that its settlement will result in and financing genericphysical delivery of the underlying Agency fixed-rate RMBS, throughor that the repurchase agreement markets. Please refer to Note 1individual TBA transaction will not settle in the shortest period possible.

15

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)

Loss on Derivative Instruments, Net

The table below provides detail of the Company’s “loss on derivative instruments, net” by type of derivative for information related to the Company's accounting policy for its derivative instruments.periods indicated:
Three MonthsSix Months Ended
June 30,June 30,
Type of Derivative Instrument2020201920202019
Interest rate swaps$(1,672) $(124,213) $(183,852) $(195,978) 
Interest rate swaptions—  —  (573) —  
Futures(10,928) (102) (19,377) (211) 
Options on U.S. Treasury futures(6,680) —  (17,406) —  
TBA securities - long positions8,688  6,780  27,119  16,956  
TBA securities - short positions2,029  —  (10,041) —  
Loss on derivative instruments, net$(8,563) $(117,535) $(204,130) $(179,233) 

The table below summarizes information about the fair value by type of derivative instrument on the Company'sCompany’s consolidated balance sheets as of the dates indicated:

Type of Derivative InstrumentBalance Sheet LocationPurposeJune 30, 2020December 31, 2019
Options on U.S. Treasury futuresDerivative assetsEconomic hedging$3,168  $2,883  
Interest rate swaptionsDerivative assetsEconomic hedging—  573  
TBA securities - long positionsDerivative assetsInvesting4,758  834  
Total derivatives assets$7,926  $4,290  
U.S. Treasury futuresDerivative liabilitiesEconomic hedging$(4,208) $—  
TBA securities - short positionsDerivative liabilitiesEconomic hedging—  (974) 
Total derivatives liabilities$(4,208) $(974) 



Interest Rate Swaps

The Company has interest rate swap agreements outstanding with various counterparties that are centrally cleared through the CME. As explained in Note 1, the exchange of variation margin for CME cleared interest rate swaps is legally considered to be the settlement of the derivative itself as opposed to a pledge of collateral. Because the Company accounts for this daily exchange of variation margin for its CME cleared interest rate swaps as an increase or decrease to the carrying value of the related derivative asset or liability, the fair value of the interest rate swaps nets to $0 on the Company’s
16

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)

    September 30, 2017 December 31, 2016
Type of Derivative Instruments Balance Sheet Location Fair Value 
Fair Value (1)
Interest rate swaps Derivative assets $368
 $28,534
TBA securities Derivative assets —
 —
    $368
 $28,534
       
Interest rate swaps Derivative liabilities $—
 $(6,922)
TBA securities Derivative liabilities (133) —
    $(133) $(6,922)
consolidated balance sheet. The Company had net settlement amounts of $(2,866) and $(9,265) in variation margin for its interest rate swaps as of June 30, 2020 and December 31, 2019, respectively.
(1)
Refer to Note 1 regarding information on a change in the CME rulebook. Amounts reported on the consolidated balance sheet as of September 30, 2017 for its interest rate swaps reflect the netting of the derivative asset or liability with the related collateral received or posted, respectively. The net amounts comparable to September 30, 2017 for the derivative asset and derivative liabilities as of December 31, 2016 were $104 and $(576), respectively.


The following tables present information about the Company'sCompany’s interest rate swaps as of the dates indicated:
June 30, 2020December 31, 2019
Weighted-AverageWeighted-Average
Years to Maturity:Notional AmountPay RateLife Remaining (in Years)Notional AmountPay RateLife Remaining (in Years)
< 3 years$50,000  1.35 %0.3$2,860,000  1.58 %1.5
>3 and < 6 years—  — %—  700,000  1.43 %4.7
>6 and < 10 years425,000  0.69 %9.9545,000  1.78 %9.4
>10 years—  — %—  120,000  2.84 %27.7
Total$475,000  0.76 %9.0$4,225,000  1.62 %3.8
  September 30, 2017
    Weighted-Average:  
Years to Maturity: 
Net Notional Amount (1)
 
Pay Rate (2)
 Life Remaining (in Years) Fair Value
< 3 years
 $3,110,000
 1.39% 0.9 $368
>3 and < 6 years
 1,160,000
 1.66% 4.2 —
>6 and < 10 years
 1,175,000
 2.45% 8.1 —
Total $5,445,000
 1.68% 3.2 $368
         
  December 31, 2016
    Weighted-Average:  
Years to Maturity: 
Net Notional Amount (1)
 
Pay Rate (2)
 Life Remaining (in Years) Fair Value
< 3 years
 $595,000
 0.73% 2.3 $4,348
>3 and < 6 years
 1,185,000
 1.47% 4.3 8,631
>6 and < 10 years
 1,250,000
 2.42% 8.9 8,633
Total $3,030,000
 1.58% 5.3 $21,612

(1)The net notional amounts included in the tables above represent pay-fixed interest rate swaps, net of receive-fixed interest rate swaps and include $2,425,000 and $2,725,000 of pay-fixed forward starting interest rate swaps as of September 30, 2017 and December 31, 2016, respectively.
(2) Excluding forward starting pay-fixed interest rate swaps,U.S. Treasury Futures and Options

The following table presents information about the weighted average pay rate was 1.34%Company’s U.S. Treasury futures and 0.73%options outstanding as of the dates indicated:
Cost BasisFair ValueNotional Amount
As of June 30, 2020:
Options on U.S. Treasury futures (1)
$20,622  $3,168  $1,425,000  
U.S. Treasury futures - short positionsn/a(4,208) 1,225,000  
As of December 31, 2019:
Options on U.S. Treasury futures (2)
$4,359  $2,883  $1,350,000  
Pay-fixed interest rate swaptions (2)
6,180  573  750,000  
(1) All futures and options outstanding as of June 30, 2020 will expire in September 30, 2017 andof 2020.
(2) All options outstanding as of December 31, 2016, respectively.2019 expired during the first quarter of 2020.


TBA Securities

The following table summarizes information about the Company's TBA securities as of September 30, 2017:the dates indicated:

June 30, 2020December 31, 2019
Long PositionsShort PositionsLong PositionsShort Positions
Implied market value (1)
$1,290,078  $—  $442,161  $(520,117) 
Implied cost basis (2)
1,285,320  —  441,327  (519,143) 
Net carrying value (3)
$4,758  $—  $834  $(974) 


(1) Implied market value represents the estimated fair value of the underlying Agency MBS as of the date indicated.
(2) Implied cost basis represents the forward price to be paid for the underlying Agency MBS as of the date indicated.
(3) Net carrying value is the amount included on the consolidated balance sheets within “derivative assets (liabilities)” and represents the difference between the implied market value and the implied cost basis of the TBA security as of the date indicated.

17

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)

  September 30, 2017
  
Notional Amount (1)
 
Cost Basis (2)
 
Market Value (3)
 
Net Carrying Value (4)
30-year 4.0% TBA securities $650,000
 $683,813
 $683,680
 $(133)
Volume of Activity
(1)Notional amount represents the par value (or principal balance) of the underlying Agency MBS.
(2)Cost basis represents the forward price to be paid for the underlying Agency MBS as if settled.
(3)Market value is the current fair value of the TBA contract and represents the estimated fair value of the underlying Agency security as of the end of the period.
(4)Net carrying value represents the difference between the market value and the cost basis of the TBA contract as of the end of the period and is included on the consolidated balance sheets within "derivative assets (liabilities)".


The tables below summarize changes in ourthe Company’s derivative instruments for the periodsperiod indicated:
Type of Derivative InstrumentNotional Amount as of December 31, 2019AdditionsSettlements,
Terminations,
or Pair-Offs		Notional Amount as of June 30, 2020
Interest rate swaps$4,225,000  $2,915,000  $(6,665,000) $475,000  
Interest rate swaptions750,000  —  (750,000) —  
U.S. Treasury futures - short positions—  2,212,600  (3,437,600) (1,225,000) 
Options on U.S. Treasury futures1,350,000  3,425,000  (3,350,000) 1,425,000  
TBA - long positions435,000  5,311,000  (4,496,000) 1,250,000  
TBA - short positions500,000  3,017,000  (3,517,000) —  
Type of Derivative Instrument Notional Amount as of December 31, 2016 Additions 
Settlements,
Terminations,
or Pair-Offs
 Notional Amount as of September 30, 2017
Receive-fixed interest rate swaps $425,000
 $—
 $(325,000) $100,000
Pay-fixed interest rate swaps 3,455,000
 3,010,000
 (920,000) 5,545,000
TBA securities —
 3,814,000
 (3,164,000) 650,000


Offsetting
The table below provides detail of the Company's "gain (loss) on derivative instruments, net" by type of derivative for the periods indicated:
  Three Months Ended Nine Months Ended
  September 30, September 30,
Type of Derivative Instrument 2017 2016 2017 2016
Receive-fixed interest rate swaps $(99) $(2,976) $746
 $11,301
Pay-fixed interest rate swaps (611) 2,555
 (18,799) (59,912)
TBA securities 6,703
 —
 8,419
 —
Eurodollar futures —
 2,830
 —
 (13,542)
Gain (loss) on derivative instruments, net $5,993
 $2,409
 $(9,634) $(62,153)

There is a net unrealized gain of $450 remaining in AOCI on the Company's consolidated balance sheet as of September 30, 2017 which represents the activity related to interest rate swap agreements while they were previously designated as cash flow hedges, and this amount will be recognized in the Company's net income as an adjustment to "interest expense" over the remaining contractual life of the agreements. The Company estimates a credit of $210 will be reclassified to net income as a reduction of "interest expense" within the next 12 months.

A portion of the Company's interest rate swaps were entered into under bilateral agreements which contain cross-default provisions with other agreements between the parties. In addition, these bilateral agreements contain financial and operational covenants similar to those contained in our repurchase agreements as described in Note 3. The Company was in compliance with all covenants with respect to bilateral agreements under which interest rate swaps were entered into as of September 30, 2017.

The Company's derivatives are subject to underlying agreements with master netting or similar arrangements, which provide for the right of offset in the event of default or in the event of bankruptcy of either party to the transactions. The Company reports its derivative assets and liabilities subject to these arrangements on a gross basis. The following tables present information regarding those derivative assets and liabilities subject to such arrangements as if the Company had presented them on a net basis as of SeptemberJune 30, 20172020 and December 31, 2016:2019:



Offsetting of Assets
Gross Amount of Recognized AssetsGross Amount Offset in the Balance SheetNet Amount of Assets Presented in the Balance Sheet
Gross Amount Not Offset in the Balance Sheet (1)
Net Amount
Financial Instruments Received as CollateralCash Received as Collateral
June 30, 2020
Options on U.S. Treasury futures$3,168  —  $3,168  $—  $—  $3,168  
TBA - long positions4,758  —  4,758  —  —  4,758  
Derivative assets$7,926  $—  $7,926  $—  $—  $7,926  
December 31, 2019
Interest rate swaptions$573  $—  $573  $—  $—  $573  
Options on U.S. Treasury futures2,883  —  2,883  —  —  2,883  
TBA - long positions834  —  834  (380) —  454  
Derivative assets$4,290  $—  $4,290  $(380) $—  $3,910  

18

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)

 Offsetting of Assets
 Gross Amount of Recognized Assets Gross Amount Offset in the Balance Sheet Net Amount of Assets Presented in the Balance Sheet 
Gross Amount Not Offset in the Balance Sheet (1)
 Net Amount
Financial Instruments Received as Collateral Cash Received as Collateral
September 30, 2017           
Interest rate swaps$368
 $—
 $368
 $—
 $—
 $368
TBA securities—
 —
 —
 —
 —
 —
Derivative assets$368
 $—
 $368
 $—
 $—
 $368
December 31, 2016:           
Interest rate swaps$28,534
 $—
 $28,534
 $(6,449) $(22,085) $—
TBA securities—
 —
 —
 —
 —
 —
Derivative assets$28,534
 $—
 $28,534
 $(6,449) $(22,085) $—
Offsetting of Liabilities
Gross Amount of Recognized LiabilitiesGross Amount Offset in the Balance SheetNet Amount of Liabilities Presented in the Balance Sheet
Gross Amount Not Offset in the Balance Sheet (1)
Net Amount
Financial Instruments Posted as CollateralCash Posted as Collateral
June 30, 2020
U.S. Treasury futures$(4,208) —  $(4,208) $—  $4,208  $—  
TBA - short positions—  —  —  —  —  —  
Derivative liabilities$(4,208) $—  $(4,208) $—  $4,208  $—  
December 31, 2019
TBA - short positions$(974) —  $(974) $380  —  $(594) 
Derivative liabilities$(974) $—  $(974) $380  $—  $(594) 

(1) Amounts disclosed for collateral received by or posted to the same counterparty include cash and the fair value of MBS up to and not exceeding the net amount of the derivative asset or liability presented in the balance sheet. The fair value of the total collateral received by or posted to the same counterparty may exceed the amounts presented. Please refer to the consolidated balance sheets for the total cash posted as collateral, which is recorded as "restricted cash," and the total fair value of financial instruments pledged as collateral for derivatives and repurchase agreements, which is shown parenthetically.
 Offsetting of Liabilities
 Gross Amount of Recognized Liabilities Gross Amount Offset in the Balance Sheet Net Amount of Liabilities Presented in the Balance Sheet 
Gross Amount Not Offset in the Balance Sheet (1)
 Net Amount
Financial Instruments Posted as Collateral Cash Posted as Collateral
September 30, 2017           
Interest rate swaps$—
 $—
 $—
 $—
 $—
 $—
TBA securities133
 —
 133
 —
 (63) 70
Derivative liabilities$133
 $—
 $133
 $—
 $(63) $70
            
December 31, 2016:           
Interest rate swaps$6,922
 $—
 $6,922
 $(6,913) $—
 $9
TBA securities—
 —
 —
 —
 —
 —
Derivative liabilities$6,922
 $—
 $6,922
 $(6,913) $—
 $9
(1)Amounts disclosed for collateral received by or posted to the same counterparty include cash and the fair value of MBS up to and not exceeding the net amount of the asset or liability presented in the balance sheet. The fair value of the actual collateral received by or posted to the same counterparty may exceed the amounts presented.
Please see Note 3 for information related to the Company'sCompany’s repurchase agreements, which are also subject to underlying agreements with master netting or similar arrangements.


NOTE 5 – FAIR VALUE OF FINANCIAL INSTRUMENTS
 
ASC Topic 820 defines fairFair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC Topic 820 clarifies that fairFair value should beis based on the assumptions market participants would use when pricing an asset or liability and also requires an entity to considerconsiders all aspects of nonperformance risk, including the entity'sentity’s own credit standing, when measuring fair value of a liability. ASC Topic 820 established a valuation hierarchy of three levels as follows:
 
•Level 1 – Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities as of the measurement date.


•Level 2 – Inputs include quoted prices in active markets for similar assets or liabilities; quoted prices in inactive markets for identical or similar assets or liabilities; or inputs either directly observable or indirectly observable through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.
•Level 3 – Unobservable inputs are supported by little or no market activity. The unobservable inputs represent management’s best estimate of how market participants would price the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.
The Company reviews the classification of its financial instruments within the fair value hierarchy on a quarterly basis, and management may conclude that its financial instruments should be reclassified to a different level in the future if a change in type of inputs occurs. 


The following table presents the fair value of the Company’s financial instruments segregated by the hierarchy level of the fair value estimate that are measured at fair value on a recurring basisthe Company’s consolidated balance sheet by their valuation hierarchy levels as of the dates indicated:
19

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)

 September 30, 2017
 Fair Value Level 1 - Unadjusted Quoted Prices in Active Markets Level 2 - Observable Inputs Level 3 - Unobservable Inputs
Assets:       
Mortgage-backed securities$2,921,444
 $—
 $2,913,877
 $7,567
Interest rate swaps368
 —
 368
 —
Total assets carried at fair value$2,921,812
 $—
 $2,914,245
 $7,567
Liabilities: 
  
  
  
TBA securities133
 —
 133
 —
Total liabilities carried at fair value$133
 $—
 $133
 $—
        
 December 31, 2016
 Fair Value Level 1 - Unadjusted Quoted Prices in Active Markets Level 2 - Observable Inputs Level 3 - Unobservable Inputs
Assets:       
Mortgage-backed securities$3,212,084
 $—
 $3,201,157
 $10,927
Interest rate swaps28,534
 —
 28,534
 —
Total assets carried at fair value$3,240,618
 $—
 $3,229,691
 $10,927
Liabilities:       
Interest rate swaps$6,922
 $—
 $6,922
 $—
Total liabilities carried at fair value$6,922
 $—

$6,922
 $—
June 30, 2020December 31, 2019
 Fair ValueLevel 1Level 2Level 3Fair ValueLevel 1Level 2Level 3
Assets carried at fair value:    
MBS$3,496,925  $—  $3,495,435  $1,490  $5,188,163  $—  $5,186,473  $1,690  
Mortgage loans held for investment7,366  —  —  7,366  —  —  —  —  
Derivative assets:
Options on U.S. Treasury futures3,168  3,168  —  —  2,883  2,883  —  —  
Interest rate swaptions—  —  —  —  573  —  573  —  
TBA securities-long positions4,758  —  4,758  —  834  —  834  —  
Total assets carried at fair value$3,512,217  $3,168  $3,500,193  $8,856  $5,192,453  $2,883  $5,187,880  $1,690  
Liabilities carried at fair value:
TBA-short positions$—  $—  $—  $—  $974  $—  $974  $—  
U.S. Treasury futures4,208  4,208  —  —  —  —  —  —  
Total liabilities carried at fair value$4,208  $4,208  $—  $—  $974  $—  $974  $—  


The fair value measurements for a majority of the Company's MBS are considered Level 2. These Level 2 securitieswhen there are substantially similar to securities that either are actively tradedtrading or havefor which there has been recently tradedrecent trading activity in their respective markets. The Company determines the fair value of its Level 2 securities based on prices received from the Company's primary pricing service as well as other pricing services and brokers. The Company evaluates the third partythird-party prices it receives to assess their reasonableness. Although the Company does not adjust third partythird-party prices, they may be excluded from use in the determination of a security's fair value if they are significantly different from other observable market data. In valuing a security, the primary pricing service uses either a market approach, which uses observable prices and other relevant information that is generated by


market transactions of identical or similar securities, or an income approach, which uses valuation techniques to convert future amounts to a single, discounted present value amount. The Company also reviews the assumptions and inputs utilized in the valuation techniques of its primary pricing service. Examples of these observable inputs and assumptions include market interest rates, credit spreads, and projected prepayment speeds, among other things.

The fair value of interest rate swaps are measured using the income approach with the primary input being the forward interest rate swap curve, which is considered an observable input, and thus their fair values are considered Level 2 measurements as of September 30, 2017 and December 31, 2016. The fair value of TBA securities are estimated using methods similar those used to fair value the Company's Level 2 MBS.


The Company owns certain non-Agency MBS forand mortgage loans that are considered Level 3 assets because there has been no recent trading activity of similar instruments upon which there are not sufficiently recent trades of substantially similar securities, and their fair value measurements are thus considered Level 3.can be measured. The Company determines the fair value of itsfor these Level 3 securitiesassets is measured by discounting the estimated future cash flows derived from cash flow models using significant inputs which are determined by the Company when market observable inputs are not available. 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. The Company used a constant prepayment rate assumption of 10%, default rate of 2%, loss severity of 20%, and a discount rate of 7.0% in measuring the fair value of its Level 3 assets as of June 30, 2020. Significant changes in any of these inputs in isolation may result in a significantly different fair value measurement. Level 3 assets are generally most sensitive to the default rate and severity assumptions.


The activity of the instruments measured at fair value on a recurring basis usingCompany’s Level 3 inputsassets during the three and six months ended June 30, 2020 is presented in the following tabletable:

20

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)

Three Months EndedSix Months Ended
June 30, 2020June 30, 2020
Other Non-Agency MBSMortgage LoansOther Non-Agency MBSMortgage Loans
Balance as of beginning of period$1,562  $7,922  $1,690  $9,405  
Change in fair value (1)
(57) 359  (174) (501) 
Principal payments(101) (904) (206) (1,519) 
Accretion (amortization)86  (11) 180  (19) 
Balance as of end of period$1,490  $7,366  $1,490  $7,366  
(1) Change in fair value for other non-Agency MBS is recorded as unrealized gain (loss) in “other comprehensive income”. Change in fair value for mortgage loans is recorded as unrealized gain (loss) in “fair value adjustments, net“ and the amount shown for the period indicated:
 Level 3 Fair Value
 Non-Agency CMBS Non-Agency RMBS Total
Balance as of December 31, 2016$9,669
 $1,258
 $10,927
Unrealized loss included in OCI (1)
(1,422) 16
 (1,406)
Principal payments(3,896) (133) (4,029)
Accretion2,075
 —
 2,075
Balance as of September 30, 2017$6,426
 $1,141
 $7,567
(1)Amount included in "unrealized gain on available-for-sale investments, net" on consolidated statements of comprehensive income (loss).



The following table presentssix months ended June 30, 2020 is net of cumulative adjustment of $(548) made to the amortized cost as of December 31, 2019 as a summary of the carrying value and estimated fair valuesresult of the Company’s financial instruments aselection of the dates indicated:fair value option for its mortgage loans effective January 1, 2020.


The fair value of interest rate swaps is measured using the income approach with the primary input being the forward interest rate swap curve, which is considered an observable input, and thus their fair values are considered Level 2 measurements. All of the Company’s interest rate swap agreements are centrally cleared through the CME. Please refer to Note 1 for information regarding the exchange of variation margin being legally considered as settlement of the derivative as opposed to a pledge of collateral. U.S. Treasury futures and options on U.S. Treasury futures are valued based on closing exchange prices on these contracts and are classified accordingly as Level 1 measurements. Unlike its interest rate swaps, the Company does not treat the exchange of variation margin for its U.S. Treasury futures as legal settlement of the instrument. The fair value of interest rate swaptions is based on the fair value of the underlying interest rate swap and time remaining until its expiration. The fair value of TBA securities is estimated using methods similar those used to fair value the Company’s Level 2 MBS.


 September 30, 2017 December 31, 2016
 Carrying Value Fair Value Carrying Value Fair Value
Assets:       
Mortgage-backed securities$2,921,444
 $2,921,444
 $3,212,084
 $3,212,084
Mortgage loans held for investment, net (1)
16,523
 13,674
 19,036
 15,971
Derivative assets368
 368
 28,534
 28,534
Liabilities: 
  
  
  
Repurchase agreements (2)
$2,519,230
 $2,519,230
 $2,898,952
 $2,898,952
Non-recourse collateralized financing (1)
5,706
 5,722
 6,440
 6,357
Derivative liabilities133
 133
 6,922
 6,922
(1)The Company determines the fair value of its mortgage loans held for investment, net and its non-recourse collateralized financing using internally developed cash flow models with inputs similar to those used to estimate the fair value of the Company's Level 3 non-Agency MBS.
(2)The carrying value of repurchase agreements generally approximates fair value due to their short term maturities.

NOTE 6 – SHAREHOLDERS'SHAREHOLDERS’ EQUITY AND SHARE-BASED COMPENSATION


Preferred Stock

Stock. The Company's articles of incorporation authorize the issuance of up to 50,000,000 shares of preferred stock, par value $0.01 per share, of which the Company'sshare. The Company’s Board of Directors has designated 8,000,0006,600,000 shares for issuance as 6.900% Series C Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock and sold 4,460,000 of such shares during the first quarter of 2020 through a public offering for which it received proceeds of $107,988, net of $3,512 in broker commissions and other expenses. The Company used the proceeds to redeem all 2,300,000 outstanding shares of its 8.50% Series A Preferred Stock at an aggregate redemption price of approximately $25.35 per share, which included accumulated and 7,000,000unpaid dividends declared as of the redemption date March 14, 2020. The Company also used the proceeds to partially redeem 1,700,000 shares of its 7.625% Series B Preferred Stock (the Series A Preferred Stockat an aggregate redemption price of approximately $25.32 per share, which included accumulated and the Series B Preferred Stock collectively, the "Preferred Stock"). The Company had 2,300,000 shares of its Series A Preferred Stock and 3,365,101 shares of its Series B Preferred Stock issued and outstandingunpaid dividends declared as of Septemberthe redemption date March 16, 2020. The excess of the $25.00 liquidation price per share over the carrying value of the preferred stock redeemed resulted in a charge of $(3,914) to net income to common shareholders for the six months ended June 30, 2017 compared to 2,300,000 shares of Series A Preferred Stock and 2,271,937 shares of Series B Preferred Stock as of December 31, 2016.2020.


The Preferred Stock has no stated maturity, is not subject to any sinking fund or mandatory redemption, and will remain outstanding indefinitely unless redeemed or otherwise repurchased or converted into common stock pursuant to the terms of the Preferred Stock. The Company'sCompany had 2,788,330 shares of its Series AB Preferred Stock remaining as of June 30, 2020, which may be redeemed in whole, or in part, at any time and from time to time at the Company's option at a cash redemption price of $25.00 per share plus any accumulated and unpaid dividends. Except under certain limited circumstances described in Article IIIC of the Company’s Restated Articles of Incorporation, as amended, the Company may not redeem the Series BC Preferred Stock prior to April 30, 2018.15, 2025. On or after April 30, 2018,that date, the Company's Series BC Preferred Stock may be redeemed in whole, or in part, at any time and from time to time at the Company's option at a cash redemption price of $25.00 per share plus any accumulated and unpaid dividends.
21

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)

Because the Preferred Stock is redeemable only at the option of the issuer, it is classified as equity on the Company'sCompany’s consolidated balance sheet.

The Series A Preferred Stock pays a cumulative cash dividend equivalent to 8.50% of the $25.00 liquidation preference per share each year and the Series B Preferred Stock pays a cumulative cash dividend equivalent to 7.625% of the $25.00 liquidation preference per share each year. The Series C Preferred stock pays a cumulative cash dividend equivalent to 6.900% of the $25.00 liquidation preference per share each year until April 15, 2025 upon which date and thereafter, the Company will pay cumulative cash dividends at a percentage of the $25.00 liquidation value per share equal to an annual floating rate of three-month LIBOR plus a spread of 5.461%. The Company paid its regular quarterly dividends on itsdividend of $0.4765625 per share of Series B Preferred Stock for the third quarterand $0.43125 per share of Series C Preferred Stock on October 16, 2017July 15, 2020 to shareholders of record as of OctoberJuly 1, 2017.2020.

Common Stock
Stock. The Company declared a third quarterfollowing table summarizes information regarding monthly dividend declarations on the Company’s common stock dividend of $0.18 per share that was paid on October 31, 2017 to shareholders of record as of October 3, 2017.during the six months ended June 30, 2020:
Six Months Ended
June 30, 2020
Declaration DateAmount DeclaredRecord DatePayment Date
January 13, 2020$0.15 January 24, 2020February 3, 2020
February 14, 20200.15 February 24, 2020March 2, 2020
March 10, 20200.15 March 23, 2020April 1, 2020
April 8, 20200.15 April 22, 2020May 1, 2020
May 12, 20200.15 May 22, 2020June 1, 2020
June 10. 20200.13 June 22, 2020July 1, 2020
2009
Stock and Incentive Plan. OfPlans. The Company’s Board adopted the 2,500,000 shares of common stock authorized for issuance under its 20092020 Stock and Incentive Plan, which was approved by the Company’s shareholders on June 9, 2020. The 2020 Plan, which replaced the Company’s 2018 Stock and Incentive Plan (the “2018 Plan”), reserves for issuance up to 2,300,000 common shares for eligible employees, non-employee directors, consultants, and advisors to the Company had 785,962 available for issuance asto be granted in the form of September 30, 2017.stock options, restricted stock, restricted stock units, stock appreciation rights, performance units, and performance cash awards. Awards previously granted under the 2018 Plan or any other prior equity plan will remain outstanding and valid in accordance with their terms, but no new awards will be granted under the 2018 Plan or any other prior equity plan. Total stock-based compensation expense recognized by the Company for the three and ninesix months ended SeptemberJune 30, 20172020 was $388$424 and $1,567,$731, respectively, compared to $623$296 and $2,066$593 for the three and ninesix months ended SeptemberJune 30, 2016,2019, respectively.


The following table presents a rollforward of the restricted stock activity for the periods indicated:
Six Months Ended
June 30,
 20202019
SharesWeighted Average Grant Date Fair Value Per ShareSharesWeighted Average Grant Date Fair Value Per Share
Restricted stock outstanding as of beginning of period119,213  $18.56  113,904  $19.19  
Restricted stock granted240,293  13.88  67,997  18.09  
Restricted stock vested(65,749) 18.61  (62,688) 19.20  
Restricted stock outstanding as of end of period293,757  $14.72  119,213  $18.56  
 Three Months Ended
 September 30,
 2017 2016
 Shares Weighted Average Grant Date Fair Value Per Share Shares Weighted Average Grant Date Fair Value Per Share
Restricted stock outstanding as of beginning of period353,103
 $7.01
 561,089
 $7.54
Restricted stock granted—
 —
 —
 —
Restricted stock vested—
 —
 —
 —
Restricted stock outstanding as of end of period353,103
 $7.01
 561,089
 $7.54
        
 Nine Months Ended
 September 30,
 2017 2016
 Shares Weighted Average Grant Date Fair Value Per Share Shares Weighted Average Grant Date Fair Value Per Share
Restricted stock outstanding as of beginning of period553,396
 $7.55
 696,597
 $8.54
Restricted stock granted138,166
 6.76
 214,878
 6.28
Restricted stock vested(338,459) 7.80
 (350,386) 8.76
Restricted stock outstanding as of end of period353,103
 $7.01
 561,089
 $7.54


As of SeptemberJune 30, 2017,2020, the grant date fair value of the Company’s remaining nonvested restricted stock is $1,505$3,863 which will be amortized into compensation expense over a weighted average period of 1.52.4 years.


22
NOTE 7 – SUBSEQUENT EVENTS


Management has evaluated events and circumstances occurring as of and through the date this Quarterly Report on Form 10-Q was filed with the SEC and made available to the public and has determined that there have been no significant events or circumstances that qualify as a "recognized" subsequent event as defined by ASC Topic 855.

Management has determined that the following significant event, which occurred subsequent to September 30, 2017 and before the date this Quarterly Report on Form 10-Q was filed with the SEC and made available to the public, qualifies as a "nonrecognized" subsequent event as defined by ASC Topic 855:

The Company has received $14,078 in net proceeds from at-the-market issuances of 1,956,936 shares of its common stock since September 30, 2017 and $2,169 in net proceeds from at-the-market issuance of 89,313 shares of Series B Preferred Stock.



ITEM 2.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with our unaudited financial statements and the accompanying notes included in Part 1,I, Item 1. “Financial Statements” in this Quarterly Report on Form 10-Q and our audited financial statements and the accompanying notes included in Part II, Item 8 in our Annual Report on Form 10-K for the year ended December 31, 2016.2019 (the “2019 Form 10-K”). 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.


For more information about our business including our operating policies, investment philosophy and strategy, financing and hedging strategies, and other important information, please refer to Part I, Item 1 of our Annual Report on2019 Form 10-K for the year ended December 31, 2016.10-K.


EXECUTIVE OVERVIEW


Company Overview

We areDynex Capital, Inc. is an internally managed mortgage real estate investment trust, or mortgage REIT, which primarily invests in residential and commercial mortgage-backed securities (“MBS”) on a leveraged basis. Our common stock is traded on the New York Stock Exchange ("NYSE")We finance our investments principally with borrowings under the symbol "DX".repurchase agreements. 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 primarily through the payment of regular quarterly dividends and also potentially through capital appreciation.appreciation of our investments.


WeMarket Conditions and Recent Activity

Markets stabilized in the second quarter of 2020 after a volatile first quarter due to strong intervention by the Federal Reserve and the economic relief provided by the CARES Act. As markets adjusted to these policies, credit spreads on risk assets rallied and U.S. Treasury interest rates settled into a tighter range and ended the second quarter virtually unchanged from March 31, 2020. Funding markets were also have two series of preferred stock outstanding,more stable in the second quarter compared to the prior quarter. While there has not been a direct impact from COVID-19 on our 8.50% Series A Cumulative Redeemable Preferred Stock (the "Series A Preferred Stock") which is tradedoperations other than the need to shift to a remote work environment, the impact on the NYSE underU.S. and the symbol "DXPRA",global economy from COVID-19 continues to have the potential to materially disrupt cash flows on U.S. real estate, and in particular rents on multifamily and commercial real estate which could impact our 7.625% Series B Cumulative Redeemable Preferred Stock (the "Series B Preferred Stock") which is traded on the NYSE under the symbol "DXPRB".
We invest inAgency CMBS and Agency and non-Agency mortgage-backed securities (“MBS”) consistingCMBS IO securities. Asset prices do not necessarily reflect these conditions as markets are currently expecting a reasonably rapid recovery in economic activity. This could change quickly as the cases in COVID-19 have re-spiked in July.

Against this backdrop, we sold $1.8 billion of residential MBS (“RMBS”), commercial MBS (“CMBS”)Agency CMBS early in the second quarter, realizing a gain of $181.4 million. At the end of April, we had reduced our investment portfolio down to approximately $2.2 billion and CMBS interest-only ("IO") securities. Agency MBS have a guaranty of principal payment by an agencyleverage to approximately 3.9 times shareholders’ equity. As markets stabilized, over the balance of the U.S. government or a U.S. government-sponsored entity ("GSE") such as Fannie Mae and Freddie Mac. Non-Agency MBS have no such guaranty of payment. Our investments in non-Agency MBS are generally higher quality senior or mezzanine classes (typically rated 'A' or better by one or more of the nationally recognized statistical rating organizations) because they are typically more liquid (i.e., they are more easily converted into cash either through sales or pledges as collateral for repurchase agreement borrowings) and have less exposure to credit losses than lower-rated non-Agency MBS.

We invest and manage our capital pursuant to Operating Policies approved by our Board of Directors. We use leverage to enhance the returns on our invested capital by pledging our investments as collateral for borrowings such as repurchase agreements as discussed further below. We also use derivative instruments to attempt to mitigate our exposure to adverse changes in interest rates as discussed further below.

RMBS. Ourquarter, we added Agency RMBS and TBA securities to replace the Agency CMBS we sold and increased leverage including TBA securities to 8.1x at June 30, 2020. Given the potential for cash flow disruptions as noted above, we believe that Agency RMBS offer a better risk adjusted return at this point. With a smaller average balance of investments include MBS collateralized by fixed-rate mortgage loansduring the second quarter, we reduced our monthly dividend from $0.15 per common share to $0.13 per common share in June. We expect core net operating income to outpace the dividend in the third quarter given our expectation of owning a larger earning asset base and lower funding costs on balance versus the first quarter of 2020.



The charts below show the highest and lowest U.S. Treasury and swap rates during the quarter ended June 30, 2020 as well as adjustable-rate mortgage loans ("ARMs"), which have interestthe rates that generally adjust at least annually to an increment over a specified interest rate index. Agency ARMs also include hybrid adjustable-rate mortgage loans ("hybrid ARMs"), which are loans that have a fixed rateas of interest for a specified period (typically three to ten years)June 30, 2020 and then adjust their interest rate at least annually to an increment over a specified interest rate index. Substantially all of our ARMs reset based on the one-year LIBOR index. We sold the majority of our non-Agency RMBSDecember 31, 2019: 

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Second Quarter 2020 Results

Our book value per common share increased $0.62 during the second quarter of 20172020 primarily because these investments were within a year of their maturity. We are not currently re-investing capital into non-Agencyspread tightening on Agency RMBS, dueAgency CMBS, and CMBS IO. The resulting increase in fair value of our MBS was the primary component of our overall comprehensive income to the lackcommon shareholders of available securities of this type with attractive risk-adjusted returns.



In$26.5 million for the second quarter of 2017, we began entering into forward contracts2020. We monetized gains of $193.1 million on a portion of our CMBS and RMBS, which drove the majority of our net income to common shareholders of $191.6 million for the purchasesecond quarter of TBA securities as a means of investing in and financing non-specified fixed-rate Agency RMBS. A TBA security is a forward contract2020. Net interest spread increased for the purchase or sale of a fixed-rate Agency MBS at a predetermined price with certain principal and interest terms and certain types of collateral, butsecond quarter compared to the particular Agency securitiesfirst quarter due to be delivered are not identified until shortly before the TBA settlement date. Thelower financing for TBA securities is implied through our use of TBA dollar roll transactions whereby we enter into an offsetting short position, net settle the paired-off positions in cash, and simultaneously enter into a similar TBA contract for a later settlement date. TBA securities purchased for a forward settlement month are generally priced at a discount relative to TBA securities sold for settlement in the current month. This discount, often referred to as “drop income,” is the economic equivalent ofcosts while net interest income declined primarily due to a lower average balance of interest earning assets. The lower average balance resulted from sales of investments late in the first


quarter of 2020 when the Company monetized gains on the underlying Agency securities over the roll period (interest income less implied financing cost). We account for TBA securities as derivative instruments because we cannot assert that it is probable at inception and throughout the termmost of an individual TBA contract that its settlement will result in physical delivery of the underlying Agency RMBS orand reduced its leverage as asset prices began to fall during the individual TBA contract will not settle inmarket's initial response to the shortest time period possible.COVID-19 pandemic. During June, the proceeds from the first and second quarter sales were mostly re-invested back into Agency RMBS.


CMBS. The majority of our CMBS investments are fixed-rate Agency-issued securities backed by multifamily housing loans. The remainder of our CMBS portfolio contains both Agency and non-Agency issued securities backed by other commercial real estate property types such as office building, retail, hospitality, and health care. Loans underlying CMBS generally are geographically diverse, are fixed-rate, mature in eight to eighteen years and have amortization terms of up to 30 years. Typically these loans have some form of prepayment protection provisions (such as prepayment lock-out) or prepayment compensation provisions (such as yield maintenance or prepayment penalty). Yield maintenance and prepayment penalty requirements are intended to create an economic disincentive for the loans to prepay.

CMBS IO. CMBS IO are interest-only securities issued as part of a CMBS securitization and represent the right to receive a portion of the monthly interest payments (but not principal cash flows) on the unpaid principallower average balance of assets drove the underlying pooldecline of commercial mortgage loans. We invest$(3.2) million in both Agency-issued and non-Agency issued CMBS IO. The loans collateralizing CMBS IO pools are very similar in composition to the pools of loans that generally collateralize CMBS as discussed above. Since CMBS IO securities have no principal associated with them, the interest payments received are based on the unpaid principal balance of the underlying pool of mortgage loans, which is often referred to as the notional amount. Most loans in these securities have some form of prepayment protection from early repayment including absolute loan prepayment lock-outs, loan prepayment penalties, or yield maintenance requirements similar to CMBS described above. There are no prepayment protections, however, if the loan defaults and is partially or wholly repaid earlier as a result of loss mitigation actions taken by the underlying loan servicer, and therefore yields on CMBS IO investments are dependent upon the underlying loan performance. Because Agency-issued MBS generally contain higher credit quality loans, Agency CMBS IO are expected to have a lower risk of default than non-Agency CMBS IO. Our CMBS IO investments are investment grade-rated with the majority rated 'AAA' by at least one of the nationally recognized statistical rating organizations.

Financing. We finance our investments primarily through the use of uncommitted repurchase agreements which are provided principally by major financial institutions and broker-dealers. We pledge our MBS as collateral to secure the amounts borrowed from our counterparties. These repurchase agreements generally have original terms to maturity of overnight to six months, though in some instances we may enter into longer-dated maturities depending on market conditions. We pay interest on our repurchase agreement borrowings at a rate usually based on a spread to LIBOR and fixed for the term of the borrowing. Borrowings under these repurchase agreements are renewable at the discretion of our lenders and do not contain guaranteed roll-over terms. One of our repurchase agreement lenders provides a committed repurchase agreement financing facility to us with an aggregate borrowing capacity of $400.0 million that expires in May 2019.

TBA dollar roll transactions require us to post initial margin (though typically the amount is less than the initial margin amount for repurchase agreements) and variation margin for fluctuations in fair value of the TBA securities. These dollar roll transactions have an implied financing rate which changes with market conditions, expected prepayment speeds, and the underlying demand for Agency RMBS in a given delivery period.

Hedging. We currently use interest rate swaps to hedge our exposure to changes in interest rates. Such exposure results from our ownership of hybrid and fixed-rate investments that are financed with repurchase agreements which have significantly shorter maturities than the weighted average life of these investments. Changes in interest rates can impact the market value of our investments and our net interest income, thereby ultimately impacting book value per common share. We frequently adjust


our hedging portfolio based on our expectation of future interest rates, including the absolute level of rates and the slope of the yield curve versus market expectations.

Factors that Affect Our Results of Operations and Financial Condition

Our financial performance is driven principally by the performance of our investment portfolio and related financing and hedging activity. Management focuses on net interest income, net income, comprehensive income, book value per common share, and core net operating income to common shareholders, (aa non-GAAP measure) as measurementsmeasure. In addition, net periodic interest benefit from interest rate swaps declined $(2.2) million from the prior quarter to a net periodic interest cost of our financial performance. $(0.1 million), which was partially offset by an increase of $1.4 million in drop income from TBA dollar roll positions compared to the prior quarter.

Current Outlook
Our financial performance may bemacroeconomic opinion for the long-term has not changed. We believe the global economy remains fragile and vulnerable to sudden exogenous shocks. The global economy is largely supported by central banks and global debt continues to increase excessively. Our current short-term view, however, has been impacted by multiple factors, including but not limitedthe health crisis, the resulting economic crisis, and a host of new policy risks that have been introduced in order to macroeconomic conditions, geopolitical conditions, central banksupport the global economy. Though the Federal Reserve has taken action to support the financial markets, and government policy, the absolute level of interest ratesCongress and the relative slopeU.S. Treasury have passed the CARES Act, we believe the efficacy and outcome of interest rate curves, changesthese actions are unknown and the risk for policy mistakes is very high. Measures of market volatility currently are low, however, notwithstanding the spike in COVID-19 cases in the U.S. and somewhat softening economic indicators.

As noted above, we expect that we will out earn our $0.13 per common share monthly dividend in the third quarter with the favorable funding environment. This outlook assumes we do not rapidly reduce our investment portfolio from an exogenous event as occurred in March. The risk of such an event remains high, but we have constructed our investment portfolio so that we remain flexible and can quickly de-lever our balance sheet. We believe we are in a strong position of liquidity and leverage that will allow us to evaluate the market expectations of future interest rates, actualenvironment for the best risk and estimated future prepayment ratesreturn opportunities without undue pressure on our investments, competitionbalance sheet and capital position. We maintain our belief that the demographics behind the housing sector continue to support our investment thesis of investing in high quality, highly liquid U.S.-based housing assets. We continue to take a balanced and measured approach to our strategy, so that we are prepared to manage our business under a variety of scenarios.

Other Factors Impacting Our Financial Condition and Results of Operations

In recent filings, we have discussed the potential for investments, economic conditions and their impact on the credit performanceupcoming cessation of our investments, and market required yieldsLIBOR as reflected by market spreads. All of these factors are influenced by market forces beyond our control and may be exacerbated during periods of market volatility.

Our performance may also be impacted by other factors such as the availability and cost of financing and the state of the overall credit markets. Reductions in or limitations of financing for our investments could force us to sell assets, potentially at losses particularly if there is a period of stress in the funding markets as was experienced“benchmark” rate by the industry during the 2008 financial crisis. Other factors that could alsoend of 2021 to impact our business include changes in regulatory requirements, including requirementsand results of operations. Please refer to qualify for registration under the 1940 Act and REIT requirements.

We believe that regulatory impacts on financial institutions, manyPart II, Item 1A, "Risk Factors" of which are our trading and financing counterparties, continue to pose a threat to the overall liquidity in the capital markets. Restrictions on market-making activities of large U.S. financial institutions could result in reduced liquidity in times of market stress. The Federal Reserve has begun curtailing its reinvestment of principal payments received on its Agency RMBS and U.S. Treasury portfolios, which could result in volatile asset prices. Other foreign central bank asset purchases have also favorably impacted asset prices in the U.S., including securities in which we invest. Finally, the market liquidity of our investments and the financing markets could be negatively impacted if the Federal Reserve's Federal Open Market Committee (or "FOMC") suddenly changes market expectations of the target Federal Funds Rate or takes other actions which have the effect of tightening monetary policy.

To complement the performance of our investment portfolio, we regularly review our existing operations to determine whether our investment strategy or business model should change, including through a change in our investment portfolio, our targeted investments, and our risk position. We may also consider reallocating our capital resources to other assets or portfolios that better align with our long-term strategy, expanding our capital base, or merger, acquisition, or divestiture opportunities. We analyze and evaluate potential business opportunities that we identify or are presented to us that might be a strategic fit for our investment strategy or asset allocation or otherwise maximize value for our shareholders. Pursuing such an opportunity or transaction could require us to issue additional equity or debt securities.

For further discussion of the risks inherent in our business model, please see "Liquidity and Capital Resources" within this Item 2 and in Part I, Item 3 of this Quarterly Report on Form 10-Q as well as in Item 1A, "Risk Factors" of Part I of our Annual Report on Form 10-K for the year ended December 31, 2016.

Market Conditions and Recent Activity
Market volatility remained largely subdued during the third quarter of 2017 and as a result credit spreads modestly tightened or held steady across most asset classes. As of September 30, 2017, market credit spreads in general and in sectors in which we invest were at or near their tightest levels in the last year. Credit spreads for fixed-rate Agency RMBS have lagged other sectors which we believe reflects market concerns over the announced balance sheet reduction by the Federal Reserve and in our view continues to make these securities the most attractive risk-adjusted return in the market. We also believe that the macroeconomic environment continues to be supportive for RMBS and CMBS. In particular, two major central banks (the Bank of Japan and the European Central Bank) continue to inject liquidity through large scale asset purchases supporting valuations across sectors.



Interest rates were largely unchanged during the quarter but traded in a fairly wide range generally in response to shifting economic data. As expected by the markets, the FOMC increased the target Federal Funds Rate by 0.25% in June 2017 and has now increased the target Federal Funds Rate a full 1.00% to a current targeted range of 1.00% - 1.25% since December 2015. The chart below shows the highest and lowest rates during the three months ended September 30, 2017March 31, 2020 as well as the rates asItem 1, “Business” in our 2019 Form 10-K for more detailed information. Though our significant reduction of September 30, 2017 and June 30, 2017 for the indicated U.S. Treasury securities:
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The interest rate swap curve was slightly higher duringswaps in our hedging portfolio has reduced the quarter and volatility was reasonably muted. The chart below shows the highest and lowest swap rates during the three months ended September 30, 2017 as well as the swap rates as of September 30, 2017 and June 30, 2017:
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In general, global fundamentals have improved; however, we continue to view the economic environment as fragile for a number of reasons, including high levels of global debt, the uncertain geopolitical environment, and the uncertain regulatory environment, including potential shifts in Federal Reserve policy that could result from leadership changes at the Federal Reserve. We believe these conditions can create an environment of intermittent volatility, and there is potential for a rapid reversal in current monetary policy in the U.S. Given this backdrop, we will continue to invest in high credit quality and highly liquid assets for the near term. We also are mindful of potential developments that could impact our view. In particular, changes in inflation or in the expectation of future inflation or performance could cause a sharp increase in volatility and changes in monetary policy.

Highlights of the Third Quarter of 2017

During the third quarter of 2017, we continuedtransition to sell lower yielding hybrid ARMs and reallocate capital into 30-year fixed-rate Agency RMBS through the purchase of specified pools and TBA securities. Given the challenging risk environment that currently exists globally,alternative reference rates, we are focusing on fixed-rate Agency RMBS because their higher liquidity gives us the abilitycontinuing to readjustdevelop a plan to facilitate an orderly transition to alternative reference rates for our risk position more rapidly than other asset classes. Management believes that risk-adjusted returns on fixed-rate Agency RMBS are more favorable than other asset classes, particularly if credit spreads widen in the future. Furthermore, prepayments on fixed-rate Agency RMBS are more predictable than adjustable-rate Agency RMBS, which currently have higher risk of prepayment in the flat yield curve environment.

Comprehensive income to common shareholders of $0.27 per common share for the third quarter of 2017 was comprised of net income to common shareholders of $0.15 per common shareremaining interest rate swaps and other comprehensive income ("OCI") of $0.12 per common share, which resulted primarily from the favorablefinancial instruments. Our transition plan includes steps to evaluate exposure, review contracts, assess impact of credit spread tightening on the fair value of the majority of MBS as mentioned previously. In the second quarter, comprehensive income to commonour business, processes and technology and define a communication strategy with shareholders, was $0.05 per common share consisting of net loss to common shareholders of ($0.20) per common shareregulators and other comprehensive income ("OCI") of $0.25 per common share. Net interest income for the third quarter of 2017 declined approximately 18% compared to the second quarter of 2017stakeholders. We will also be assessing how our financial instruments may be indirectly impacted as a result of increasing short-term interest rates, a modest decline in average interest earning assets,modifications made by third parties to LIBOR-based loans underlying our MBS and a decrease in prepayment penalty compensation from CMBS. The decline in net interest income was more than offset by gainsother investments.




on derivative instruments (both TBAs and interest rate swaps) which increased from losses on derivative instruments incurred during the second quarter of 2017.

Core net operating income to common shareholders (a non-GAAP measure) was $0.19 per common share for the third quarter of 2017, the same as the second quarter. Drop income from TBA dollar roll transactions and lower net periodic interest costs from interest rate swaps offset higher borrowing costs and lower prepayment penalty compensation. Please see "Non-GAAP Financial Measures" at the end of this "Executive Overview" for additional important information about non-GAAP measures.
Book value per common share increased $0.08 to $7.46 as of September 30, 2017 from June 30, 2017 primarily because our investments outperformed our hedges as a result of tightening credit spreads. Economic return on book value was 3.5% for the third quarter of 2017 and 11.4% for the first nine months of 2017. Economic return on book value is calculated by dividing (i) the sum of dividends declared per common share and the change in book value per common share by (ii) beginning book value per common share.

Management Outlook

The environment remains conducive to generating net interest income from high quality investments due to low realized volatility and a benign outlook for central bank withdrawal of stimulus. We believe that fixed-rate Agency MBS continue to offer the most attractive relative return currently and will be the predominant marginal use of our capital for the foreseeable future. We expect to maintain leverage including TBA securities at cost as if settled at levels modestly higher than where they were at the end of the third quarter of 2017, but we remain concerned about sudden spikes in market volatility and may quickly reduce leverage should conditions warrant. Global central bank policies are the dominating factors for interest rates and credit spreads, and global central banks are seeking to minimize market volatility to encourage recovery in global economic growth. Should market volatility increase, our book value is likely to decline, but we would view this volatility as a potential investment opportunity given our views of expected central bank behavior. Our expectation is that our net interest spread should remain relatively flat for the fourth quarter of 2017, and that performance beyond the fourth quarter of 2017 will be highly dependent on Federal Reserve monetary policy and our hedging strategy.

Longer term we continue to believe that the outlook for our business model is very positive. Demographic trends in the U.S. are driving a significant increase in household formation, creating more demand in multifamily and single-family housing. As government participation in the housing market shrinks, there will be an increased need for private capital and expertise in the housing finance system. Global demographic aging trends are driving demand for assets that generate income. Fundamentally, this supports the assets in which we invest and also could be a source of capital for us to potentially grow our portfolio. We also intend to capitalize on opportunities for investing capital as government and regulatory policies shift while realizing that such shifts may occur over a period of several years. We will also continue seeking ways to diversify funding sources if the regulatory environment becomes more favorable, and we will also actively manage our hedge instruments to attempt to mitigate the impact on our costs of funds if the Federal Funds rate continues to increase.

Non-GAAP Financial Measures


In addition to the Company's operating results presented in accordance with GAAP, the information presented within Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Quarterly Report on Form 10-Q contains the following non-GAAP financial measures: core net operating income to common shareholders (including per common share), adjusted interest expense, adjusted net interest income and the related metrics adjusted cost of funds andmetric adjusted net interest spread. Management views core net operating income to common shareholders as an estimate of the net interest earnings and drop income from our investments after operating expenses and preferred stock dividends. In addition to the reconciliation set forth below, which derives core net operating income to common shareholders from GAAP net income to common shareholders as the nearest GAAP equivalent measure, core net operating income to common shareholders can also be determined by adjusting net interest income to include interest rate swap periodic interest costs, drop income on TBA securities, general and administrative expenses (GAAP), and preferred dividends. Management includes drop income in core net operating income to common shareholders and in adjusted net interest income because TBA securities are viewed by management as economically equivalent to holding and financing Agency RMBS using short-term repurchase agreements. Management also includes periodic interest costs from its interest rate swaps, which are included in "gain (loss) on derivative instruments" on the


Company's consolidated statements of comprehensive income, in adjusted net interest expense and in adjusted net interest income because interest rate swaps are used by the Company to economically hedge the Company's borrowing costs from repurchase agreements, and including periodic interest costs from interest rate swaps is a helpful indicator of the Company’s total cost of financing in addition to GAAP interest expense. Because these measures are used in the Company's internal analysis of financial and operating performance, management believes that they provide greater transparency to our investors of management's view of our economic performance. Management also believes the presentation of these measures, when analyzed in conjunction with the Company's GAAP operating results, allows investors to more effectively evaluate and compare the performance of the Company to that of its peers. Because these


peers, although the Company's presentation of its non-GAAP financial measures include or exclude, as applicable, certain items usedmay not be comparable to compute GAAPother similarly-titled measures of other companies. Reconciliations of core net operating income to common shareholders GAAPand adjusted net interest income orto the related GAAP financial measures are provided below and within “Results of Operations”.

Management views core net operating income to common shareholders as an estimate of the Company’s financial performance based on the effective yield of its investments, net of financing costs and other normal recurring operating income/expense, net. In addition to the non-GAAP reconciliation set forth below, which derives core net operating income to common shareholders from GAAP comprehensive income (loss) to common shareholders, core net operating income to common shareholders can also be determined by adjusting net interest income to include interest rate swap periodic interest benefit/cost, drop income on TBA securities, general and administrative expenses, and preferred dividends. Drop income generated by TBA dollar roll positions, which is included in "gain (loss) on derivatives instruments, net" on the Company's consolidated statements of comprehensive income, is included in core net operating income and in adjusted net interest income because management views drop income as the economic equivalent of net interest income (interest income less implied financing cost) on the underlying Agency security from trade date to settlement date. Management also includes interest rate swap periodic interest benefit/cost, which is also included in "gain (loss) on derivatives instruments, net", in adjusted net interest income because interest rate swaps are used by the Company to economically hedge the impact of changing interest rates on its borrowing costs from repurchase agreements, and therefore represent a cost of financing in addition to GAAP interest expense,expense. However, these non-GAAP financialmeasures do not provide a full perspective on our results of operations, and therefore, their usefulness is limited. For example, these non-GAAP measures do not include gains or losses from available-for-sale investments, changes in fair value of and costs of terminating interest rate swaps, as well as realized and unrealized gains or losses from other instruments used by management to economically hedge the impact of changing interest rates on the fair value of its portfolio and book value per common share. As a result, these non-GAAP measures should be considered as a supplement to, and not as a substitute for, the Company's GAAP results as reported on its consolidated statements of comprehensive income.

Three Months Ended
($ in thousands, except per share amounts)June 30, 2020March 31, 2020
Comprehensive income (loss) to common shareholders$26,538  $(33,262) 
Less:
Change in fair value of available for sale investments(28,052) (157,755) 
Change in fair value of derivative instruments, net (1)
10,252  198,370  
Preferred stock redemption charge to common shareholders—  3,914  
Fair value adjustments, net(332) 372  
Core net operating income to common shareholders$8,406  $11,639  
Weighted average common shares23,056,812  22,963,084  
Comprehensive income (loss) per common share$1.15  $(1.45) 
Core net operating income per common share$0.36  $0.51  
(1) Amount includes unrealized gains and losses from changes in fair value of derivatives and realized gains and losses on terminated derivatives and excludes net periodic interest benefit on effective interest rate swaps outstanding during the period.

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Three Months Ended
($ in thousands)June 30, 2020March 31, 2020
Net interest income$15,003  $17,721  
Add: TBA drop income (1)
1,796  739  
Add: net periodic interest (cost) benefit (2)
(107) 2,064  
Adjusted net interest income$16,692  $20,524  
Other operating expense, net(222) (423) 
General and administrative expenses(4,811) (4,621) 
Preferred stock dividends(3,253) (3,841) 
Core net operating income to common shareholders$8,406  $11,639  
(1) TBA drop income is calculated by multiplying the notional amount of the TBA dollar roll positions by the difference in price between two TBA securities with the same terms but different settlement dates. The impact of TBA drop income on adjusted net interest spread includes the implied average funding cost of TBA dollar roll transactions during the periods indicated.
(2) Amount represents net periodic interest benefit/cost of effective interest rate swaps outstanding during the period and excludes realized and unrealized gains and losses from changes in fair value of derivatives.


FINANCIAL CONDITION

Investment Portfolio

Our investment portfolio as of June 30, 2020 was $4.8 billion including TBA securities, an increase of over 50% versus March 31, 2020 and within 10% of the size of our portfolio as of December 31, 2019. We remain primarily invested in Agency fixed-rate investments which have more a more favorable risk-return profile and higher liquidity in the current
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macroeconomic environment due to their lower credit risk versus other types of MBS. The following chart compares the composition of our MBS portfolio including TBA securities as of the dates indicated:
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(1) Includes TBA positions at their implied market value as if settled which are accounted for as “derivative assets (liabilities)” on our consolidated balance sheet.


RMBS.The majority of our Agency RMBS are pass-through securities collateralized primarily by pools of fixed-rate single-family mortgage loans. Monthly payments of principal and interest made by the individual borrowers on the mortgage loans underlying the pools are "passed through" to the security holders, after deducting GSE or U.S. Government agency guarantee and servicer fees. In general, mortgage pass-through certificates distribute cash flows from the underlying collateral on a pro-rata basis among the security holders. Security holders also receive guarantor advances of principal and interest for delinquent loans in the mortgage pools.

Since December 31, 2019, we have shifted our RMBS portfolio into lower coupon investments to mitigate the risk of loss of premiums due to early prepayment given the lower interest rate environment. The following tables compare our fixed-rate Agency RMBS investments including TBA dollar roll positions as of the dates indicated:

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June 30, 2020
Par
Amortized Cost/
Implied Cost
Basis (1)(3)
Fair
Value (2)(3)
Weighted Average
Coupon
Loan Age
(in months) (4)
3 Month
CPR (4)(5)
Estimated Duration (6)
30-year fixed-rate:($ in thousands)
2.0%$790,107  $808,631  $812,199  2— %5.50
2.5%1,003,210  1,039,921  1,052,948  41.2 %3.80
4.0%455,435  467,789  491,659  2629.4 %2.21
TBA 2.0%500,000  509,691  511,084  n/an/a4.51
TBA 2.5%500,000  517,891  520,830  n/an/a1.33
15-year fixed-rate:
TBA 2.0%250,000  257,738  258,164  n/an/a2.46
Total$1,495,542  $1,534,158  $1,562,022  8  6.8 %5.92  
December 31, 2019
Par
Amortized Cost/
Implied Cost
Basis (1)(3)
Fair
Value (2)(3)
Weighted Average
Coupon
Loan Age
(in months) (4)
3 Month
CPR (4)(5)
Estimated Duration (6)
30-year fixed-rate:($ in thousands)
2.5%$110,610  $109,341  $109,409  3  — %5.15  
3.0%307,380  310,486  314,159  25  9.4 %4.04  
3.5%538,551  549,735  562,921  11  10.9 %2.64  
4.0%1,352,730  1,384,913  1,429,547  20  23.5 %2.28  
4.5%254,413  264,979  272,037  13  29.9 %1.55  
TBA 2.5%135,000  133,059  133,513  n/an/a5.10  
TBA 3.0%300,000  308,268  308,648  n/an/a1.90  
TBA 4.0%(500,000) (519,143) (520,117) n/an/a1.28  
Total 30-year fixed-rate$2,498,684  $2,541,638  $2,610,117  17  18.9 %2.91  
(1) Implied cost basis of TBAs represents the forward price to be paid (received) for the underlying Agency MBS.
(2) Fair value of TBAs is the implied market value of the underlying Agency security as of the end of the period.
(3) TBAs are included on the consolidated balance sheet within “derivative assets/liabilities” at their net carrying value which is the difference between their implied market value and implied cost basis. Please refer to Note 4 of the Notes to the Unaudited Consolidated Financial Statements for additional information.
(4) TBAs are excluded from this calculation as they do not have a defined weighted-average loan balance or age until mortgages have been assigned to the pool.
(5) Constant prepayment rate (“CPR”) represents the 3-month CPR of Agency RMBS held as of date indicated. Securities with no prepayment history are excluded from this calculation.
(6) Duration measures the sensitivity of a security's price to the change in interest rates and represents the percent change in price of a security for a 100-basis point increase in interest rates. We calculate duration using third-party financial models and empirical data. Different models and methodologies can produce different estimates of duration for the same securities.


CMBS. The majority of our Agency CMBS are backed by multifamily housing loans. Loans underlying CMBS are generally fixed-rate with scheduled principal payments generally assuming a 30-year amortization period, but typically requiring balloon payments on average approximately 10 years from origination. These loans typically have some form of prepayment protection provisions, such as yield maintenance or defeasance provisions, which provide us compensation if
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underlying loans prepay prior to us earning our expected return on our investment. Yield maintenance and prepayment penalty requirements are intended to create an economic disincentive for the loans to prepay, which makes the fair value of CMBS less costly to hedge relative to RMBS.

The following table presents information about our CMBS investments (including securities pending settlement) by year of origination as of the dates indicated:
June 30, 2020December 31, 2019
($ in thousands)Par ValueAmortized Cost
Months to Estimated Maturity (1)
WAC (2)
Par ValueAmortized Cost
Months to Estimated Maturity (1)
WAC (2)
Year of Origination:
Prior to 2009$12,967  $12,712  275.60 %$13,441  $13,080  305.74 %
2009 to 201216,200  16,957  435.05 %28,141  29,153  344.99 %
2013 to 201411,183  11,391  503.37 %11,294  11,528  593.65 %
2015156,489  157,966  763.30 %175,219  177,023  872.86 %
2016—  —  —— %19,910  19,742  1092.62 %
201750,781  51,219  943.08 %340,638  342,158  1013.07 %
2018—  —  —— %330,180  329,984  1273.68 %
201929,502  29,897  1493.05 %972,646  983,435  1343.27 %
2020379,951  382,850  1271.80 %—  —  —— %
$657,073  $662,992  1082.50 %$1,891,469  $1,906,103  1203.30 %
(1) Months to estimated maturity is an average weighted by the amortized cost of the investment.
(2) The weighted average coupon (“WAC”) is the gross interest rate of the security weighted by the outstanding principal balance.


CMBS IO. We invest in both Agency-issued and non-Agency issued CMBS IO which are interest-only securities issued as part of a CMBS securitization and represent the right to receive a portion of the monthly interest payments (but not principal cash flows) on the unpaid principal balance of the underlying pool of commercial mortgage loans, commonly referred to as the notional amount. The weighted average interest rate for our CMBS IO was 0.64% as of June 30, 2020 and 0.65% as of December 31, 2019. The loans collateralizing Agency-issued CMBS IO pools are similar in composition to the
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pools of loans that collateralize CMBS as discussed above. Non-Agency issued CMBS IO are backed by loans secured by a number of different property types which are shown in the table below as of June 30, 2020:

June 30, 2020
($ in thousands)Fair ValuePercentage of Portfolio
Property Type:
Retail$45,815  27.8 %
Office34,987  21.2 %
Multifamily30,106  18.3 %
Hotel21,766  13.2 %
Mixed use10,715  6.5 %
Other (1)
21,371  13.0 %
Total non-Agency CMBS IO$164,760  100.0 %
(1) Other property types collateralizing non-Agency CMBS IO do not comprise more than 5% individually.

Yields on CMBS IO securities are dependent upon the performance of the underlying loans. Similar to CMBS described above, the Company receives prepayment compensation as most loans in these securities have some form of prepayment protection from early repayment. Our return on these investments may be negatively impacted, however, by involuntary prepayments including defaults, foreclosures, or liquidations resulting in amounts being partially or wholly repaid prior to its contractual maturity date because of loss mitigation actions taken by the underlying loan servicer. Since the economic impacts of COVID-19 began in March, servicers are reporting an increase in delinquencies on loans underlying our non-Agency CMBS IO. The increase in delinquencies has been primarily in the retail and hotel sectors.

In order to manage our exposure to credit performance, we have generally invested in senior tranches of these securities where we have evaluated the credit profile of the underlying loan pool and can monitor credit performance. As of June 30, 2020 and December 31, 2019, approximately 62% of our CMBS IO are Agency-issued securities which generally contain higher credit quality loans that are expected to have a lower risk of default than non-Agency CMBS IO. In addition, becausethe majority of our non-Agency CMBS IO investments are investment grade-rated with the majority rated ‘AAA’ by at least one of the nationally recognized statistical rating organizations. All of our non-Agency CMBS IO were originated prior to 2017, the majority of which we believe have had underlying property value appreciation, and the weighted average life of contractual cash flows remaining on our non-Agency CMBS IO is 25 months. Considering these characteristics of our non-Agency CMBS IO and the actions taken by servicers so far to work with borrowers through various relief measures, we have not all companiesseen evidence of and do not currently expect a material adverse effect on our future cash flows for non-Agency CMBS IO. However, the ultimate impact of COVID-19 on the global economy and on the loans underlying any of our securities remains uncertain and cannot be predicted at this time.

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The following table presents our CMBS IO investments by year of origination as of June 30, 2020:
AgencyNon-Agency
($ in thousands)Amortized CostFair Value
Remaining WAL (1)
Amortized CostFair Value
Remaining WAL (1)
Year of Origination:
2010-2012$19,270  $19,348  10  $5,379  $5,525  9  
201329,382  30,414  15  13,639  13,578  16  
201429,462  30,148  22  59,856  59,866  21  
201536,778  38,265  27  59,975  59,708  28  
201625,564  26,200  32  18,421  17,805  16  
201728,537  28,931  43  8,509  8,278  36  
20183,968  3,986  63  —  —  —  
201993,152  91,309  61  —  —  —  
20203,379  3,309  54  —  —  —  
$269,492  $271,910  39  $165,779  $164,760  25  
(1) Remaining weighted average life (“WAL”) represents an estimate of the number of months of contractual cash flows remaining for the investments by year of origination.


Repurchase Agreements
We use identical calculations,leverage to enhance the Company's presentationreturns on our invested capital by pledging our investments as collateral for borrowings primarily through the use of uncommitted repurchase agreements with major financial institutions and broker-dealers. Repurchase agreements generally have original terms to maturity of overnight to six months, though in some instances we may enter into longer-dated maturities depending on market conditions. We pay interest on our repurchase agreement borrowings at a rate usually based on a spread to a short-term interest rate such as LIBOR and fixed for the term of the borrowing.
Please refer to Note 3 of the Notes to the Unaudited Consolidated Financial Statements contained within this Quarterly Report on Form 10-Q as well as “Results of Operations” and “Liquidity and Capital Resources” contained within this Item 7 for additional information relating to our repurchase agreement borrowings.

Derivative Assets and Liabilities

We use derivative instruments to economically hedge our exposure to adverse changes in interest rates resulting from our ownership of primarily fixed-rate investments financed with short-term repurchase agreements. Changes in interest rates can impact net interest income, the market value of our investments, and book value per common share. We regularly monitor and frequently adjust our hedging portfolio in response to many factors including, but not limited to, changes in our investment portfolio as well as our expectation of future interest rates, including the absolute level of rates and the slope of the yield curve versus market expectations. Please refer to “Quantitative and Qualitative Disclosures about Market Risk” in Part I, Item 3 of this Quarterly Report on Form 10-Q for more information.
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Prior to the end of the first quarter of 2020, we primarily used interest rate swaps to hedge a portion of our earnings and book value exposure to fluctuations in interest rates. Because we sold a substantial portion of our Agency RMBS when interest rates rallied, we terminated the majority of our interest rate swaps. We partially replaced these terminated hedges by increasing our options on U.S. Treasury futures and adding short positions in U.S. Treasury futures. Although we were substantially re-invested into Agency RMBS by the end of the second quarter, we have not entered into additional interest rate swaps to hedge interest earnings given our expectations of low stable funding rates on repurchase agreement borrowings in the near term. Our focus is on the impact of changing interest rates on our book value and management believes U.S. Treasury futures and options are more effective as hedges as they have better liquidity and more favorable margin requirements than interest rate swaps. Please refer to Note 4 of the Notes to the Unaudited Consolidated Financial Statements for details on our interest rate derivative instruments as of June 30, 2020 and December 31, 2019.



RESULTS OF OPERATIONS

The discussion below includes both GAAP and non-GAAP financial measures maythat management utilizes in its internal analysis of financial and operating performance. Please read the section “Non-GAAP Financial Measures” at the end of “Executive Overview” contained in Item 2 of this Quarterly Report on Form 10-Q for additional important information about these measures.


Net Interest Income for the Three Months Ended June 30, 2020 Compared to the Three Months Ended June 30, 2019

The following table presents certain information about our interest-earning assets and interest-bearing liabilities and their performance for the three months ended June 30, 2020 and June 30, 2019:
Three Months Ended
June 30,
20202019
($ in thousands)Interest Income/Expense
Average Balance (1)(2)
Effective Yield/
Cost of
Funds (3)(4)
Interest Income/Expense
Average Balance (1)(2)
Effective Yield/
Cost of
Funds (3)(4)
Interest-earning assets:
Agency RMBS$9,605  $1,632,531  2.35 %$25,456  $2,949,516  3.45 %
Agency CMBS4,700  720,048  2.58 %11,665  1,463,427  3.15 %
CMBS IO (5)
5,313  448,572  4.05 %4,886  492,314  3.78 %
Non-Agency MBS and other investments (6)
235  9,613  7.26 %1,741  12,088  4.82 %
Total:$19,853  $2,810,764  2.70 %$43,748  $4,917,345  3.43 %
Interest-bearing liabilities: (7)
4,850  $2,582,230  0.74 %$30,813  $4,566,160  2.67 %
Net interest income/net interest spread$15,003  1.96 %$12,935  0.76 %
(1) Average balance for assets is calculated as a simple average of the daily amortized cost and excludes unrealized gains and losses as well as securities pending settlement if applicable.
(2) Average balance for liabilities is calculated as a simple average of the daily borrowings outstanding during the period.
(3) Effective yield is calculated by dividing the sum of gross interest income and scheduled premium amortization/discount accretion (both of which are annualized for any reporting period less than 12 months) and prepayment compensation and premium amortization/discount accretion adjustments (collectively, "prepayment adjustments"), which are not be comparable to other similarly-titled measuresannualized, by the average balance of other companies.asset type outstanding during the reporting period.

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Schedules reconciling adjusted(4) Cost of funds is calculated by dividing annualized interest expense by the total average balance of borrowings outstanding during the period with an assumption of 360 days in a year.
(5) Includes Agency and non-Agency issued securities.
(6) Interest income for non-Agency and other investments includes $0.6 million of interest income from cash and cash equivalents for the three months ended June 30, 2019. Average balance and yield excludes cash and cash equivalents.
(7) Interest-bearing liabilities consist primarily of repurchase agreement borrowings.

Rate/Volume Analysis. The following table presents the estimated impact on our net interest income due to changes in rate (effective yield/cost of funds) and changes in volume (average balance) of our interest-earning assets and interest-bearing liabilities for the periods indicated:
Three Months Ended
June 30, 2020 Compared to June 30, 2019
Increase (Decrease) Due to Change InTotal Change in Interest Income/Expense
($ in thousands)RateVolume
Prepayment Adjustments (1)
Interest-earning assets:
Agency RMBS$(4,483) $(11,368) $—  $(15,851) 
Agency CMBS(1,054) (5,928) 17  (6,965) 
CMBS IO (2)
111  (404) 720  427  
Non-Agency MBS and other investments(21) (632) (853) (1,506) 
Change in interest income$(5,447) $(18,332) $(116) $(23,895) 
Change in interest expense(12,580) (13,383) —  (25,963) 
Total net change in net interest income$7,133  $(4,949) $(116) $2,068  
(1) Prepayment adjustments represent effective interest amortization adjustments related to changes in actual prepayment speeds and prepayment compensation, net of amortization adjustments for CMBS and CMBS IO and are not annualized in the calculation of effective yield.
(2) Includes Agency and non-Agency issued securities.

Net interest income increased for the three months ended June 30, 2020 compared to the three months ended June 30, 2019 because the decline in interest expense exceeded the decline in interest income. The decline in interest income is due primarily to a smaller average balance of lower yielding investments for the second quarter of 2020 compared to the same period in the prior year. The decline in interest expense was due to a smaller average balance of borrowings at a lower financing rate for the second quarter of 2020 compared to the same period in 2019. Management expects net interest income to increase in the third quarter of 2020 compared to the second quarter of 2020 as the average balance of our investment portfolio on which we earn interest income is expected to increase and we anticipate financing costs to remain low.

Net Interest Income for the Six Months Ended June 30, 2020 Compared to the Six Months Ended June 30, 2019

The following table presents certain information about our interest-earning assets and interest-bearing liabilities and their performance for the six months ended June 30, 2020 and June 30, 2019:
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Six Months Ended
June 30,
20202019
($ in thousands)Interest Income/Expense
Average Balance (1)(2)
Effective Yield/
Cost of
Funds (3)(4)
Interest Income/Expense
Average Balance (1)(2)
Effective Yield/
Cost of
Funds (3)(4)
Interest-earning assets:
Agency RMBS$28,895  $2,073,379  2.79 %$49,090  $2,794,017  3.52 %
Agency CMBS19,922  1,309,637  3.00 %20,797  1,332,700  3.10 %
CMBS IO (5)
9,968  461,988  4.03 %11,282  505,020  4.10 %
Non-Agency MBS and other investments (6)
891  9,944  7.83 %2,537  12,571  15.63 %
Total:$59,676  $3,854,948  3.02 %$83,706  $4,644,308  3.49 %
Interest-bearing liabilities: (7)
$26,952  $3,642,871  1.46 %$57,089  $4,252,190  2.67 %
Net interest income/net interest spread$32,724  1.56 %$26,617  0.82 %
(1) Average balance for assets is calculated as a simple average of the daily amortized cost and excludes unrealized gains and losses as well as securities pending settlement if applicable.
(2) Average balance for liabilities is calculated as a simple average of the daily borrowings outstanding during the period.
(3) Effective yield is calculated by dividing the sum of gross interest income and scheduled premium amortization/discount accretion (both of which are annualized for any reporting period less than 12 months) and prepayment compensation and premium amortization/discount accretion adjustments (collectively, "prepayment adjustments"), which are not annualized, by the average balance of asset type outstanding during the reporting period.
(4) Cost of funds is calculated by dividing annualized interest expense by the total average balance of borrowings outstanding during the period with an assumption of 360 days in a year.
(5) Includes Agency and non-Agency issued securities.
(6) Interest income for non-Agency and other investments includes $0.5 million and $1.1 million interest income from cash and cash equivalents for the six months ended June 30, 2020 and June 30, 2019, respectively. Average balance and yields excludes cash and cash equivalents.
(7) Interest-bearing liabilities consist primarily of repurchase agreement borrowings.

Rate/Volume Analysis. The following table presents the estimated impact on our net interest income due to changes in rate (effective yield/cost of funds) and changes in volume (average balance) of our interest-earning assets and interest-bearing liabilities for the periods indicated:
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Six Months Ended
June 30, 2020 Compared to June 30, 2019
Increase (Decrease) Due to Change InTotal Change in Interest Income/Expense
($ in thousands)RateVolume
Prepayment Adjustments (1)
Interest-earning assets:
Agency RMBS$(7,580) $(12,698) $83  $(20,195) 
Agency CMBS(694) (362) 181  (875) 
CMBS IO (2)
(794) 23  (543) (1,314) 
Non-Agency MBS and other investments(716) (92) (838) (1,646) 
Change in interest income$(9,784) $(13,129) $(1,117) $(24,030) 
Change in interest expense(21,962) (8,161) (14) (30,137) 
Total net change in net interest income$12,178  $(4,968) $(1,103) $6,107  
(1) Prepayment adjustments represent effective interest amortization adjustments related to changes in actual prepayment speeds and prepayment compensation, net of amortization adjustments for CMBS and CMBS IO and are not annualized in the calculation of effective yield.
(2) Includes Agency and non-Agency issued securities.

Net interest income increased for the six months ended June 30, 2020 compared to the six months ended June 30, 2019 because the decline in interest expense exceeded the decline in interest income. The decline in interest income is due primarily to a smaller average balance of lower yielding investments and lower income from prepayment compensation for the second quarter of 2020 compared to the same period in the prior year. The decline in interest expense was due to a smaller average balance of borrowings at a lower financing rate for the second quarter of 2020 compared to the same period in 2019.

Adjusted Net Interest Income for the Three and Six Months Ended June 30, 2020 Compared to the Three and Six Months Ended June 30, 2019

Management includes drop income from TBA dollar roll positions and net periodic interest benefit of interest rate swaps in a non-GAAP financial measure “adjusted net interest income” when evaluating the economic performance of its investments and financings. Please refer to “Non-GAAP Financial Measures” at the end of “Executive Overview” of this Item 2 of this Quarterly Report on Form 10-Q for additional information.
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Three Months Ended
June 30,
20202019
($ in thousands)AmountRateAmountRate
Net interest income$15,003  1.96 %$12,935  0.76 %
Add: TBA drop income (1) (2)
1,796  0.02 %1,282  (0.04)%
Add: net periodic interest (cost) benefit (3)
(107) (0.02)%3,553  0.31 %
Adjusted net interest income$16,692  1.96 %$17,770  1.03 %
Six Months Ended
June 30,
20202019
AmountRateAmountRate
Net interest income$32,724  1.56 %$26,617  0.82 %
Add: TBA drop income (1) (2)
2,535  — %3,245  (0.03)%
Add: net periodic interest benefit (3)
1,957  0.10 %7,450  0.35 %
De-designated cash flow hedge accretion (4)
—  — %(165) (0.01)%
Adjusted net interest income$37,216  1.66 %$37,147  1.13 %

(1) TBA drop income is calculated by multiplying the notional amount of the TBA dollar roll positions by the difference in price between two TBA securities with the same terms but different settlement dates.
(2) The impact of TBA drop income on adjusted net interest spread includes the implied average funding cost of TBA dollar roll transactions during the periods indicated.
(3) Amount represents net periodic interest cost/benefit of effective interest rate swaps outstanding during the period and excludes realized and unrealized gains and losses from changes in fair value of derivatives.
(4) Amount recorded as a portion of "interest expense" in accordance with GAAP related to the accretion of the balance remaining in accumulated other comprehensive loss as a result of the Company's discontinuation of cash flow hedge accounting effective June 30, 2013.

Management expects adjusted net interest income to increase in the third quarter of 2020 as we expect an increase in the average balance of our investment portfolio on which we earn interest income and, as mentioned previously, we expect financing costs to remain low for the near term.


Gain (Loss) on Sale of Investments, Net

We sell our investments in the ordinary course of business as we manage our risk, capital and liquidity profiles, and as we reallocate capital to various investments. When interest rates rallied early to mid-March of 2020 as the markets initially responded to the COVID-19 pandemic, we chose to realize gains on our Agency RMBS as asset prices began to fall and we de-levered our balance sheet. We used a portion of those proceeds to re-invest in Agency CMBS, but retained the majority of the proceeds to increase our liquidity. During the three months ended June 30, 2020, we sold the majority of our Agency CMBS in order to realize gains as asset premiums increased and to shift our portfolio allocation back to predominantly Agency RMBS. As of the end of June 2020, we had substantially re-invested proceeds received from these sales. None of our investment sales during the six months ended June 30, 2020 or June 30, 2019 were made under duress. The following tables provide information related to our realized gains (losses) on sales of investments for the periods indicated (1):
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Three Months Ended
June 30,
20202019
($ in thousands)Amortized cost basis soldGain (loss) on sale of investments, netAmortized cost basis soldGain (loss) on sale of investments, net
Agency RMBS$359,377  $11,729  $209,446  $(3,953) 
Agency CMBS1,838,858  181,370  219,691  (6,493) 
Agency CMBS IO—  —  13,775  86  
$2,198,235  $193,099  $442,912  $(10,360) 
Six Months Ended
June 30,
20202019
($ in thousands)Amortized cost basis soldGain (loss) on sale of investments, netAmortized cost basis soldGain (loss) on sale of investments, net
Agency RMBS$2,112,633  $75,823  $209,446  $(3,953) 
Agency CMBS1,991,853  202,059  219,691  (6,493) 
Agency CMBS IO—  —  13,775  86  
$4,104,486  $277,882  $442,912  $(10,360) 
(1) Information regarding unrealized gains (losses) on investments during the periods indicated are included under "Results
of Operations-Other Comprehensive Income (Loss)" within this Item 2.


Loss on Derivative Instruments, Net

Changes in the fair value of derivative instruments and net periodic interest benefits/costs are impacted by changing market interest rates and adjustments that we may make to our hedging positions in any given period. Because of the changes made to our derivatives portfolio from one reporting period to the next, results of any given reporting period are generally not comparable to results of another.
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The following table provides information on our financial instruments accounted for as derivative instruments for the periods indicated:
Three Months EndedSix Months Ended
June 30,June 30,
($ in thousands)2020201920202019
Interest rate derivatives:
Interest rate swaps:
Net periodic interest (cost) benefit$(107) $3,553  $1,957  $7,450  
Change in fair value (1)
(1,565) (127,766) (185,809) (203,428) 
Total interest rate swap loss, net(1,672) (124,213) (183,852) (195,978) 
Interest rate swaptions:
Change in fair value (1)
—  —  (573) —  
Futures:
Change in fair value (1)
(10,928) (102) (19,377) (211) 
Total interest rate derivative loss, net(12,600) (124,315) (203,802) (196,189) 
TBA dollar roll positions:
Change in fair value (2)
8,921  5,498  14,543  13,711  
TBA drop income (3)
1,796  1,282  2,535  3,245  
Total TBA dollar roll gain, net10,717  6,780  17,078  16,956  
Options on U.S. Treasury futures
Change in fair value (1)
(6,680) —  (17,406) —  
Total loss on derivative instruments, net$(8,563) $(117,535) $(204,130) $(179,233) 
(1) Changes in fair value for interest rate derivatives and options include unrealized gains (losses) from current and forward starting derivative instruments and realized gains (losses) from terminated derivative instruments.
(2) Changes in fair value for TBA dollar roll positions include unrealized gains (losses) from open TBA contracts and realized gains (losses) on paired off or terminated positions.
(3) TBA drop income represents a portion of the change in fair value and is calculated by multiplying the notional amount of the net TBA dollar roll positions by the difference in price between two TBA securities with the same terms but different settlement dates.

We typically use interest rate swaps to hedge the impact of changing interest rates on our repurchase agreement borrowings and the fair value of our Agency RMBS. Because we had substantial sales of Agency RMBS in early March and interest rates rallied, we chose to terminate the majority of our interest rate swaps before the end of the first quarter as noted previously. In addition, we continue to expect more stable repurchase agreement financing rates relative to the recent past, further reducing our need to use interest rate swaps as economic hedges of interest rate risk on our net interest earnings for the near term. As a result of these terminations, our net periodic interest benefit from interest rate swaps for the three and six months ended June 30, 2020 decreased to a net cost of $(0.1) million and net benefit of $2.0 million, respectively, compared to net benefits of $3.6 million and $7.5 million for the three and six months ended June 30, 2019, respectively. This decline was also partially due to a decrease of 30 and 9 basis points in our average net receive rate for the three and six months ended June 30, 2020 compared to the same periods in 2019. The table below shows our interest rate swap hedge position as a percentage of our average repurchase agreement borrowings and long TBAs outstanding and details about our net receive rates for the periods indicated:
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Three Months EndedSix Months Ended
June 30,June 30,
($ in thousands)2020201920202019
Average repurchase agreement borrowings outstanding$2,580,296  $4,562,992  $3,640,653  $4,248,909  
Average TBA long positions outstanding - at cost (1)
424,453  579,353  403,082  650,414  
Average borrowings and TBA long positions outstanding3,004,749  5,142,345  4,043,735  4,899,323  
Average notional amount of interest rate swaps outstanding350,824  4,765,220  1,614,613  4,461,685  
Ratio of average interest rate swaps to average borrowings and TBA long positions outstanding (1)
0.10.9  0.40.9  
Average interest rate swap pay-fixed rate(0.93)%(2.33)%(1.48)%(2.35)%
Average interest rate swap receive-floating rate0.80 %2.60 %1.71 %2.67 %
Average interest rate swap net (pay) receive rate(0.13)%0.27 %0.23 %0.32 %
(1) We include TBA long positions in this ratio because we use interest rate swaps to hedge a portion of the impact of changing interest rates on the fair value and implied financing cost of our TBA long positions and our repurchase agreement financing costs. This ratio calculation does not include TBA net short positions which the Company may also use to hedge the impact of changing interest rates on its specified pools of Agency RMBS and TBA long positions.

Changes in fair value of our derivative instruments consist of unrealized gains (losses) on instruments held as of the end of the period and realized gains (losses) from instruments terminated or paired off during the period. The following tables provide information regarding realized gains (losses) on derivative instruments for the periods indicated:
Three Months Ended
June 30,
20202019
($ in thousands)Realized Gain (Loss)NotionalRealized Gain (Loss)Notional
Interest rate swaps$—  $—  $(132,738) $2,935,000  
U.S. Treasury futures-short positions(15,158) 477,500  —  —  
Options on U.S. Treasury futures(10,812) 1,700,000  —  —  
TBA long positions3,930  2,156,000  12,461  2,455,000  
TBA short positions(3,173) 2,702,000  —  —  
Total$(25,213) $7,035,500  $(120,277) $5,390,000  
Six Months Ended
June 30,
20202019
Realized Gain (Loss)NotionalRealized Gain (Loss)Notional
Interest rate swaps$(183,773) $6,065,000  $(139,532) $3,810,000  
Interest rate swaptions(1,934) 750,000  —  —  
U.S. Treasury futures-net short positions(15,168) 475,000  (1,327) 50,000  
Options on U.S. Treasury futures(13,234) 3,350,000  —  —  
TBA long positions23,196  4,496,000  22,958  5,320,000  
TBA short positions(11,016) 3,517,000  —  —  
Total$(201,929) $18,653,000  $(117,901) $9,180,000  

40

Please refer to “Liquidity and Capital Resources” for information regarding recognition of deferred tax hedge losses for terminated derivative instruments.

General and Administrative Expenses

General and administrative expenses increased $0.5 million and $1.2 million for the three and six months ended June 30, 2020 compared to the three and six months ended June 30, 2019 due primarily to an increase in the accrual for incentive compensation related to changes to the executive compensation plan and an increase in the expected achievement of goals on which the bonuses are based.

LIQUIDITY AND CAPITAL RESOURCES
 Our primary sources of liquidity include borrowings under repurchase arrangements and monthly principal and interest payments we receive on our investments. Additional sources may also include proceeds from the sale of investments, equity offerings, and payments received from counterparties from interest rate swap agreements and other derivative instruments. We use our liquidity to purchase investments and to pay our operating expenses and dividends on our common and preferred stock. We also use our liquidity to meet margin requirements for our repurchase agreements and derivative transactions, including TBA contracts, under the terms of the related agreements. We may also use liquidity to repurchase shares of our common stock periodically.
Our liquidity fluctuates based on our investment activities, our financing and capital raising activities, and changes in the fair value of our investments and derivative instruments. We seek to maintain sufficient liquidity to support our operations and to meet our anticipated liquidity demands, including potential margin calls (or “haircuts” as described in our 2019 Form 10-K). Our most liquid assets include unrestricted cash and cash equivalents and unencumbered Agency RMBS, CMBS, and CMBS IO which were $242.1 million as of June 30, 2020 compared to $224.0 million as of December 31, 2019.
We perform sensitivity analysis on our liquidity based on changes in the fair value of our investments due to, among other things, changes in the absolute level of interest rates and the shape of the yield curve, credit spreads, lender haircuts, and prepayment speeds as well as changes in the fair value of our derivative instruments due to changes in the absolute level of interest rates and the shape of the yield curve. In performing this analysis, we will also consider the current state of the fixed income markets and the repurchase agreement markets in order to determine if market forces such as supply-demand imbalances or structural changes to these markets could change the liquidity of MBS or the availability of financing. The objective of our analysis is to assess the adequacy of our liquidity to withstand potential adverse events, such as the current pandemic. We may change our leverage targets based on market conditions and our perceptions of the liquidity of our investments.

As we noted in our Quarterly Report on Form 10-Q for the three months ended March 31, 2020, prices on our investments declined during the latter half of the first quarter as a result of the market’s initial response to the COVID-19 pandemic. Though we experienced margin calls from our lenders, we were able to fund all margin calls and increased collateral requirements on a timely basis and entered the second quarter in a strong position of liquidity. As noted in “Executive Overview” of this Quarterly Report on Form 10-Q, price volatility declined during the second quarter of 2020 and asset prices improved as a result of the Federal Reserve’s announcement of purchase programs. As such, we have substantially re-invested our capital and ended the second quarter with leverage of 8.1 times shareholders’ equity.

Our weighted average haircut for borrowings collateralized with CMBS IO increased to 16.1% as of June 30, 2020 compared to 12.8% as of December 31, 2019 as certain repurchase agreement counterparties have increased their related GAAPrequired haircut for CMBS IO between 5% and 10% since the onset of the pandemic. Our weighted average haircut for borrowings collateralized with Agency CMBS or RMBS remained relatively unchanged at 4.8% as of June 30, 2020.

 Our repurchase agreement borrowings are principally uncommitted with terms renewable at the discretion of our lenders and have short-term maturities. As such, we attempt to maintain unused capacity under our existing repurchase agreement credit lines with multiple counterparties, which helps protect us in the event of a counterparty's failure to renew existing repurchase agreements. We were able to renew repurchase agreement borrowings during the six months ended
41

June 30, 2020 without exception. In addition, and as part of our continuous evaluation of counterparty risk, we reduced our exposure to favor broker dealer subsidiaries of regulated financial measuresinstitutions whom we believe are provided within "Results of Operations". better capitalized entities.

The following table presents a reconciliationinformation regarding the balances of our repurchase agreement borrowings for the periods indicated:
Repurchase Agreements
($ in thousands)Balance Outstanding As of
Quarter End		Average Balance Outstanding For the Quarter EndedMaximum Balance Outstanding During the Quarter Ended
June 30, 2020$3,314,991  $2,580,296  $4,408,106  
March 31, 20204,408,106  4,701,010  4,917,731  
December 31, 20194,752,348  4,806,826  4,891,341  
September 30, 20194,872,869  4,955,825  5,191,378  
June 30, 20194,815,452  4,562,992  4,815,452  
March 31, 20194,252,893  3,931,335  4,266,684  

The counterparties with whom we have the greatest amounts of equity at risk may vary significantly during any given period due to the short-term and generally uncommitted nature of the repurchase agreement borrowings. Equity at risk represents the potential loss to the Company if the counterparty is unable or unwilling to return collateral securing the repurchase agreement borrowing at its maturity. As of June 30, 2020, the Company had repurchase agreement amounts outstanding with 19 of its 37 available repurchase agreement counterparties. Please refer to Note 3 of the Notes to the Unaudited Consolidated Financial Statements for information regarding counterparties with whom we have the greatest amount of equity at risk as of June 30, 2020.

We have various financial and operating covenants in certain of our repurchase agreements including, among other things, requirements that we maintain minimum shareholders' equity (usually a set minimum, or a percentage of the highest amount of shareholders' equity since the date of the agreement), limits on maximum decline in shareholders' equity (expressed as a percentage decline in any given period), limits on maximum leverage (as a multiple of shareholders' equity), and requirements to maintain our status as a REIT and to maintain our listing on the New York Stock Exchange. Violations of one or more of these covenants could result in the lender declaring an event of default which would result in the termination of the repurchase agreement and immediate acceleration of amounts due thereunder. In addition, some of the agreements contain cross default features, whereby default with one lender simultaneously causes default under agreements with other lenders. Violations could also restrict us from paying dividends or engaging in other transactions that are necessary for us to maintain our REIT status.

We monitor and evaluate on an ongoing basis the impact these customary financial covenants may have on our operating and financing flexibility. Currently, we do not believe we are subject to any covenants that materially restrict our financing flexibility. Although the recent market disruption caused by the global response to the COVID-19 pandemic has resulted in the industry issues described above, we were in full compliance with our debt covenants as of June 30, 2020, and we are not aware of any circumstances which could potentially result in our non-compliance in the foreseeable future.

Derivative Instruments

We are party to certain types of financial instruments that are accounted for as derivative instruments including interest rate swaps, futures, options, and long and short positions in TBA securities. Certain of these derivative instruments may require us to post initial margin at inception and daily variation margin based on subsequent changes in their fair value. In the case of interest rate swaps, our clearing counterparty has the right to require higher initial margin in volatile market conditions. The collateral posted as margin by us is typically in the form of cash or Agency MBS. Counterparties may have to post variation margin to us. Generally, as interest rates decline, we will be required to post collateral with counterparties on
42

our interest rate derivatives and vice versa as interest rates increase. As of June 30, 2020, we had cash of $59.2 million posted as collateral under these agreements.
Our TBA contracts are subject to master securities forward transaction agreements published by the Securities Industry and Financial Markets Association as well as supplemental terms and conditions with each counterparty. Under the terms of these agreements, we may be required to pledge collateral to, or have the right to receive collateral from, our counterparties when initiated or in the event the fair value of our TBA contracts declines. Declines in the fair value of TBA contracts are generally related to such factors as rising interest rates, increases in expected prepayment speeds, or widening spreads. Our TBA contracts generally provide that valuations for our TBA contracts and any pledged collateral are to be obtained from a generally recognized source agreed to by both parties. However, in certain circumstances, our counterparties have the sole discretion to determine the value of the TBA contract and any pledged collateral. In such instances, our counterparties are required to act in good faith in making determinations of value. In the event of a margin call, we must generally provide additional collateral on the same business day.

Dividends

As a REIT, we are required to distribute to our shareholders amounts equal to at least 90% of our REIT taxable income for each taxable year after consideration of our tax NOL carryforwards, the majority of which expire by the end of this year. We generally fund our dividend distributions through our cash flows from operations. If we make dividend distributions in excess of our operating cash flows during the period, whether for purposes of meeting our REIT distribution requirements or other strategic reasons, those distributions are generally funded either through our existing cash balances or through the return of principal from our investments (either through repayment or sale). Please refer to Item 1A, “Risk Factors” of our Quarterly Report on Form 10-Q for the three months ended March 31, 2020 as well as the following sections of our 2019 Form 10-K for additional important information regarding dividends declared on our taxable income:

•"Federal Income Tax Considerations" within Part I, Item 1, "Business”
•Part II, Item 5, "Market For Registrant's Common Equity, Related Stockholder Matters, and Issuer
Purchases of Equity Securities"

There may be differences between taxable income and GAAP net income (loss)due to common shareholderstiming differences in the recognition of certain revenues and expenses including, for example, losses we realize from terminating derivatives prior to their maturity, which occurs as part of our portfolio and hedge management activities. Deferred tax hedge losses on terminated derivative instruments are recognized over the original periods designated by those terminated derivatives. If any of our deferred tax hedge losses result in dividend distributions to our core net operatingshareholders in excess of REIT taxable income, the excess dividends distributed will be considered a return of capital to common shareholders for the periods presented:shareholder. The following table provides the tax hedge losses as of the dates indicated that have already been recognized in our GAAP earnings but which will reduce taxable income over the next twelve years:
Tax Year of Recognition of Hedge LossesJune 30, 2020December 31, 2019
($ in thousands)
2020$65,346  $37,954  
202152,364  28,370  
2022 and thereafter259,017  127,347  
$376,727  $193,671  


43

 Three Months Ended
($ in thousands, except per share amounts)September 30, 2017 June 30, 2017
GAAP net income (loss) to common shareholders$7,503
 $(10,073)
Less:   
Accretion of de-designated cash flow hedges (1)
(48) (73)
Change in fair value of derivative instruments, net (2)
(3,222) 15,801
Loss on sale of investments, net5,211
 3,709
Fair value adjustments, net(23) (30)
Core net operating income to common shareholders$9,421
 $9,334
 
 
Weighted average common shares outstanding49,832
 49,218
Core net operating income per common share$0.19
 $0.19
(1)Included in GAAP interest expense and relates to the accretion of the balance remaining in accumulated other comprehensive income as a result of our discontinuation of cash flow hedge accounting effective June 30, 2013.
(2)Amount represents net realized and unrealized gains and losses on derivatives and excludes net periodic interest costs related to these instruments.

Contractual Obligations and Other Matters

There have been no material changes in our contractual obligations since December 31, 2019. As of June 30, 2020, we do not believe that any off-balance sheet arrangements exist that are reasonably likely to have a material effect on our current or future financial condition, results of operations, or liquidity other than as discussed above. In addition, we do not have any material commitments for capital expenditures and have not obtained any commitments for funds to fulfill any capital obligations.

RECENT ACCOUNTING PRONOUNCEMENTS

There were no accounting pronouncements issued during the six months ended June 30, 2020 that are expected to have a material impact on the Company’s financial condition or results of operations. Please refer to Note 1 of the Notes to the Unaudited Consolidated Financial Statements contained within Item 1 of this Quarterly Report on Form 10-Q for additional information.

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 our consolidated 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. 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 relate to fair value measurements, amortization of investment premiums, and other-than-temporary impairments. Our critical accounting policies are discussed in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of


Operations” of our Annual Report on2019 Form 10-K for the year ended December 31, 2016 under “Critical Accounting Policies”.Policies.” There have been no significant changes in our critical accounting policies during the three and six months ended SeptemberJune 30, 2017.2020.



FINANCIAL CONDITION

Throughout the nine months ended September 30, 2017, we have been deploying available capital into specified and generic fixed-rate Agency RMBS and Agency CMBS. These assets generally have longer durations and higher yields than other assets of similar credit quality which management believes offer better risk-adjusted returns in the current environment. In addition, prepayments on fixed-rate Agency RMBS are more predictable than adjustable-rate Agency RMBS, which currently have a higher risk of prepayment in the flat yield curve environment. The following charts show the composition of our investment portfolio as of September 30, 2017 compared to December 31, 2016:

a3q17form10-_chartx57296.jpga3q17form10-_chartx58269.jpg
(1)Includes TBA securities, which are accounted for as "derivative assets (liabilities)" on our consolidated balance sheet, at their if-settled cost basis as of the end of the period.

The following table details the activity related to our MBS portfolio during the nine months ended September 30, 2017:
 Agency CMBS Agency RMBS 
CMBS IO
(2)
 
Non-Agency Other (3)
 Total
($ in thousands) 
30-Year Fixed (1)
 Adjustable-Rate   
Balance as of December 31, 2016$1,144,555
 $—
 $1,201,205
 $754,546
 $111,778
 $3,212,084
Purchases234,094
 544,050
 —
 71,803
 —
 849,947
Principal payments(45,217) (1,549) (172,650) —
 (20,263) (239,679)
Sales(37,215) (1,111) (727,841) —
 (50,871) (817,038)
(Amortization) accretion(3,587) (128) (8,568) (112,580) 2,279
 (122,584)
Change in fair value14,859
 (1,903) 11,636
 16,698
 (2,576) 38,714
Balance as of September 30, 2017$1,307,489
 $539,359
 $303,782
 $730,467
 $40,347
 $2,921,444
(1)Does not include TBA securities accounted for as "derivative assets (liabilities)" on our consolidated balance sheet.
(2)Includes Agency and non-Agency issued securities.


(3)Includes non-Agency CMBS and RMBS.

We sold over 50% of our investments in adjustable-rate Agency RMBS since December 31, 2016 as we expect these assets to underperform other asset classes in the current flat yield curve environment. During the same period, we also sold the majority of our non-Agency RMBS because these investments were generally within a year of their expected maturity. We also sold approximately half of our non-Agency CMBS investments because their risk-adjusted returns were lower relative to other assets.

The following table provides a summary of the amortized cost and fair value of our investment portfolio as of the periods indicated:
  September 30, 2017 December 31, 2016
  Amortized Cost Fair Value Amortized Cost Fair Value
RMBS:   
    
Agency RMBS, 30 year fixed-rate $541,262
 $539,359
 $—
 $—
TBA securities, 30 year fixed-rate (1)
 683,813
 683,680
 —
 —
Agency RMBS - adjustable rate 305,265
 303,782
 1,214,324
 1,201,205
Non-Agency RMBS 1,113
 1,142
 33,548
 33,562
  1,531,453
 1,527,963
 1,247,872
 1,234,767
CMBS and CMBS IO:        
Fixed-rate Agency CMBS $1,314,925
 $1,307,489
 $1,166,454
 $1,144,555
Non-Agency CMBS 36,328
 39,205
 72,749
 78,216
Agency CMBS IO 394,380
 401,808
 411,737
 411,898
Non-Agency CMBS IO 322,735
 328,659
 346,155
 342,648
  2,068,368
 2,077,161
 1,997,095
 1,977,317
         
Total MBS portfolio including TBA securities $3,599,821
 $3,605,124
 $3,244,967
 $3,212,084
(1)TBA securities are accounted for as "derivative assets (liabilities)" on our consolidated balance sheet at their net carrying value which represents the difference between the market value and the cost basis of the TBA contract as of the end of the period.

CMBS

Because Agency CMBS are guaranteed by the GSEs with respect to return of principal, our credit exposure is limited to any unamortized premium remaining on those securities. Non-Agency CMBS are not guaranteed and therefore our entire investment is exposed to credit losses from the underlying loans collateralizing the CMBS. The following table presents the par value, amortized cost, and weighted average months to estimated maturity of our CMBS investments as of the dates indicated by year of origination:
 September 30, 2017 December 31, 2016
($ in thousands)Par Value Amortized Cost 
Months to Estimated Maturity (1)
 Par Value Amortized Cost 
Months to Estimated Maturity (1)
Year of Origination:           
2008 and prior$41,058
 $37,869
 38 $57,771
 $53,161
 34
2009 to 2012135,326
 138,475
 26 193,061
 198,916
 33
2013 to 201420,324
 20,701
 85 42,760
 43,176
 95
2015661,113
 664,321
 102 683,680
 687,214
 111
2016254,375
 256,161
 113 254,781
 256,736
 122
2017230,821
 233,728
 119 —
 —
 —
 $1,343,017
 $1,351,255
 97 $1,232,053
 $1,239,203
 97
(1)Months to estimated maturity is an average weighted by the amortized cost of the investment.


As of September 30, 2017, the majority of the collateral underlying our non-Agency CMBS is comprised of multifamily properties. The portion of our non-Agency CMBS collateralized with single-family rental properties were sold during the second quarter of 2017. The collateral underlying our non-Agency CMBS investments is geographically dispersed in order to mitigate exposure to any particular region of the country. The U.S. state with the largest percentage of collateral underlying our non-Agency CMBS was Maryland at 23% as of September 30, 2017 and Texas at 16.0% as of December 31, 2016.

CMBS IO

Income earned from CMBS IO is based on interest payments received on the underlying commercial mortgage loan pools. Our return on these investments may be negatively impacted by any change in scheduled cash flows such as modifications of the mortgage loans or involuntary prepayments including defaults, foreclosures, and liquidations on or of the underlying mortgage loans prior to its contractual maturity date. In order to manage our exposure to credit performance, we generally invest in senior tranches of these securities and where we have evaluated the credit profile of the underlying loan pool and can monitor credit performance. In addition, to address changes in market fundamentals and the composition of mortgage loans collateralizing an investment, we consider the year of origination of the loans underlying CMBS IO in our selection of investments. The following table presents our CMBS IO investments as of September 30, 2017 by year of origination:
 September 30, 2017 December 31, 2016
($ in thousands)Amortized Cost Fair Value 
Remaining WAL  (1)
 Amortized Cost Fair Value 
Remaining WAL  (1)
Year of Origination:           
2010$7,157
 $7,364
 15
 $9,456
 $9,858
 19
201127,848
 29,353
 20
 35,130
 36,897
 23
201277,728
 79,667
 23
 102,378
 103,675
 27
2013109,705
 111,451
 29
 128,891
 129,011
 33
2014179,440
 182,447
 36
 201,802
 200,260
 39
2015177,176
 180,448
 41
 198,016
 194,886
 45
201684,943
 86,048
 48
 82,219
 79,959
 87
201753,118
 53,689
 54
 —
 —
 —
 $717,115
 $730,467
 37
 $757,892
 $754,546
 42
(1) Remaining weighted average life ("WAL") represents an estimate of the number of months of interest earnings remaining for the investments by year of origination.

Approximately 67% of the collateral underlying our non-Agency CMBS IO is comprised of retail, office, and multifamily properties as of September 30, 2017, and there have been no material changes to the characteristics or distribution of collateral type underlying these securities since December 31, 2016. The collateral underlying our non-Agency CMBS IO investments is geographically dispersed in order to mitigate exposure to any particular region of the country. The U.S. state with the largest percentage of collateral underlying our non-Agency CMBS IO was California at 14% as of September 30, 2017, unchanged compared to December 31, 2016.

RMBS

In addition to purchasing specified pools of fixed-rate Agency RMBS, we also utilize TBA contracts to purchase generic pools of fixed-rate Agency RMBS. Although these instruments are accounted for as derivatives, management views TBA securities as the economic equivalent of investing in and financing generic fixed-rate Agency RMBS through the repurchase agreement market and, therefore, evaluates the economics of these transactions in its assessment of the performance of its Agency RMBS portfolio. The following table provides information on our Agency RMBS investments including TBA securities as of September 30, 2017:


  September 30, 2017
        Weighted Average Based on Par
Coupon Par 
Fair
Value (1)(3)
 
Amortized Cost/Cost Basis (2)(3)
 
Loan
Balance (4)
 
Loan Age
(in months)
 (4)
 
3 Month CPR (4)(5)
 
Duration (6)
($ in thousands)              
30-year fixed-rate:              
3.0% $248,773
 $249,981
 $250,632
 $233,336
 10
 2.5% 6.34
4.0% 273,326
 289,378
 290,630
 240,621
 2
 —% 4.38
TBA 4.0% 650,000
 683,680
 683,813
 n/a n/a n/a 3.32
Total 30-year fixed-rate $1,172,099
 $1,223,039
 $1,225,075
 $237,150
 6
 1.2% 4.21
               
Adjustable-rate:              
3.1% (7)
 $294,254
 $303,782
 $305,265
 $270,208
 72
 17.1% 2.21
               
Total Agency RMBS (including TBA securities) $1,466,353
 $1,526,821
 $1,530,340
 $249,066
 30
 6.9% 3.81
(1)Fair value of TBA securities is the current market value of the TBA contract and represents the estimated fair value of the underlying Agency security as of the end of the period.
(2)Cost basis of TBA securities represents the forward price to be paid for the underlying Agency MBS as if settled.
(3)The net carrying value of TBA securities, which is the difference between the market value and the cost basis of the TBA securities, was $(0.1) million as of September 30, 2017 and is included on the consolidated balance sheet within "derivative liabilities".
(4)TBAs are excluded from this calculation as they do not have a defined weighted-average loan balance or age until mortgages have been assigned to the pool.
(5)Constant prepayment rate ("CPR") represents the 3-month CPR of Agency RMBS held as of date indicated. Securities with no prepayment history are excluded from this calculation.
(6)Duration is used to measure the market price volatility as interest rates change using dollar value of one basis point ("DV01") methodology.
(7)Coupon of adjustable-rate Agency RMBS represents the weighted average coupon based on amortized cost.

We did not have any investments in specified or non-specified pools of fixed-rate Agency RMBS as of December 31, 2016.
As mentioned previously, we have been reallocating capital away from adjustable-rate RMBS given the likelihood these investments will underperform in the current flat yield curve environment. We have been allowing and will continue to allow this portion of our portfolio to liquidate either on its own through payoffs or by selling when attractive bids are available. The following table provides information on our adjustable-rate RMBS by months to interest rate reset as of the dates indicated:
 September 30, 2017 December 31, 2016
($ in thousands)Par Value Amortized Cost Fair Value Par Value Amortized Cost Fair Value
Adjustable-rate Agency RMBS by MTR:           
0-12 MTR$47,126
 $48,440
 $49,580
 $335,476
 $355,069
 $353,887
13-36 MTR2,875
 3,057
 3,030
 225,272
 237,642
 235,137
37-60 MTR157,359
 164,286
 162,810
 151,578
 160,948
 157,945
Greater than 60 MTR86,894
 89,482
 88,362
 444,932
 460,665
 454,236
Total adjustable-rate Agency RMBS$294,254
 $305,265
 $303,782
 $1,157,258
 $1,214,324
 $1,201,205



Derivative Assets and Liabilities
We use interest rate swaps to hedge our earnings and book value exposure to fluctuations in interest rates. We regularly monitor and adjust our hedging portfolio in response to many factors including, but not limited to, changes in our investment portfolio, shifts in the yield curve, and our expectations with respect to the future path of interest rates and interest rate volatility.     
We also utilize TBA contracts as a means of investing in and financing fixed-rate Agency RMBS. These forward contracts are accounted for as derivative instruments because the Company cannot assert that it is probable at inception and throughout the term of an individual TBA contract that its settlement will result in physical delivery of the underlying Agency RMBS or the individual TBA contract will not settle in the shortest time period possible. Please refer to "RMBS" above for additional information about TBAs.

    The following graphs present the effective notional balance outstanding and net weighted average pay-fixed rate for our interest rate swaps for the periods indicated:

a1q17form10-_chartx30150a02.jpg
a1q17form10-_chartx32398a02.jpg


During the nine months ended September 30, 2017, we added interest rate swaps with a combined notional of $3.0 billion at a weighted average net pay-fixed rate of 1.80% and we terminated $1.1 billion in interest rate swaps with a weighted average net pay-fixed rate of 0.69%. Additionally, we had $0.2 million of interest rate swaps mature during the nine months ended September 30, 2017 with a weighted average net pay-fixed rate 0.92%. Our adjustments to the hedging portfolio were made in response to many market factors including, but not limited to, changes in our investment allocations, investing in TBA securities, shifts in the yield curve, and expectations with respect to the future path of interest rates and interest rate volatility, which is discussed further in "Quantitative and Qualitative Disclosures about Market Risk" in Item 3 of this Quarterly Report on Form 10-Q.
The following table summarizes the activity related to our interest rate swaps during the nine months ended September 30, 2017:
 Nine Months Ended
($ in thousands)September 30, 2017
Balance as of December 31, 2016 (1)
$21,612
Net receipt on termination(3,126)
Periodic net cash payments(3,364)
Settlement of variation margin (2)
3,300
Change in fair value(14,955)
Accrued interest payable(3,099)
Balance as of September 30, 2017 (1)
$368
(1)Represents the net amount recorded in "derivative assets (liabilities)" on the Company's consolidated balance sheets as of period indicated and excludes amounts related to TBA contracts which are also recorded in "derivative assets (liabilities)".
(2)As of January 2017 margin requirements from fluctuations in fair value of the Company's cleared interest rate swaps are settled daily with the Chicago Mercantile Exchange ("CME").

Repurchase Agreements
The majority of our repurchase agreement borrowings are collateralized with Agency MBS which have historically had lower liquidity risk than non-Agency MBS. The following table presents the amount pledged and leverage against the fair value of our non-Agency MBS investments by credit rating as of September 30, 2017 and December 31, 2016:


 September 30, 2017 December 31, 2016
($ in thousands)Fair Value Amount Pledged Related Borrowings Fair Value Amount Pledged Related Borrowings
Non-Agency CMBS:           
AAA$—
 $—
 $—
 $35,405
 $35,313
 $32,266
AA14,013
 —
 —
 14,127
 14,105
 11,665
A18,366
 18,365
 15,625
 18,614
 18,549
 15,831
Below A/Not Rated6,826
 —
 —
 10,070
 9,873
 7,119
   $39,205
 $18,365
 $15,625
 $78,216
 $77,840
 $66,881
            
Non-Agency CMBS IO:           
AAA$273,308
 $273,302
 $232,717
 $290,092
 $289,608
 $246,412
AA44,474
 43,797
 37,694
 46,986
 45,995
 40,026
A753
 753
 663
 —
 —
 —
Below A/Not Rated10,124
 10,124
 8,907
 5,570
 5,536
 4,761
 $328,659

$327,976
 $279,981
 $342,648
 $341,139
 $291,199
            
Non-Agency RMBS:           
Below A/Not Rated$1,142
 $—
 $—
 $33,562
 $31,952
 $26,149
 $1,142
 $—
 $—
 $33,562
 $31,952
 $26,149

Please refer to Note 3 of the Notes to the Unaudited Consolidated Financial Statements contained within this Quarterly Report on Form 10-Q as well as "Interest Expense and Cost of Funds" within "Results of Operations" and “Liquidity and Capital Resources” contained within this Item 2 for additional information relating to our borrowings.


Shareholder's Equity

Shareholder's equity increased approximately 12% during the first nine months of 2017 primarily due to an increase of $38.5 million in the fair value of MBS, which is recorded in accumulated other comprehensive income. The increase in the fair value of MBS since December 31, 2016 resulted primarily from credit spread tightening. The following table provides the accumulated unrealized holding gains (losses) by type of MBS and the remaining balance of de-designated cash flow hedges as of the periods indicated:
($ in thousands)September 30, 2017 December 31, 2016
Agency CMBS$(7,436) $(22,295)
Non-Agency CMBS2,877
 5,467
Agency CMBS IO7,428
 161
Non-Agency CMBS IO5,924
 (3,507)
Agency RMBS(3,386) (13,119)
Non-Agency RMBS29
 14
De-designated cash flow hedges450
 670
Accumulated other comprehensive income (loss)$5,886
 $(32,609)

During the nine months ended September 30, 2017, we issued 1,093,164 shares of Series B Preferred Stock under our preferred stock ATM program at a discount of approximately 5% to the liquidation value of $25.00 per share. Cash proceeds were $25.9 million, net of 2% broker commissions and other fees. On March 31, 2017, the Company entered into an amended and restated equity distribution agreement pursuant to which the Company may offer and sell up to 7,416,520 shares of common stock of the Company from time to time through its sales agent in at-the-market ("ATM") offerings. We issued 2,027,857 shares of common stock pursuant to this agreement during the nine months ended September 30, 2017 at a discount of approximately


5% to book value of $7.46 per common share at September 30, 2017. We are using the cash proceeds from these capital raises in combination with repurchase agreement borrowings to purchase additional interest earning assets for our investment portfolio.


RESULTS OF OPERATIONS

The discussions below provide information on items on our consolidated statements of comprehensive income. These discussions include both GAAP and non-GAAP financial measures which management utilizes in its internal analysis of financial and operating performance. Please read the section "Non-GAAP Financial Measures" at the end of "Executive Overview" in Part 1, Item 2 of this Quarterly Report on Form 10-Q for additional important information about these measures.

Interest Income and Effective Yields on MBS
Interest income includes gross interest earned from the coupon rate on the securities, premium amortization and discount accretion, and other interest income resulting from prepayment penalty income or other yield maintenance items on CMBS and CMBS IO securities. Effective yields are calculated by dividing the sum of gross interest income and scheduled premium amortization/discount accretion (both of which are annualized for any reporting period less than 12 months) and prepayment compensation and premium amortization/discount accretion adjustments (collectively, "prepayment adjustments"), which are not annualized, by the average balance of investments outstanding during the reporting period. The following table presents details on average balances, interest income, and effective yields of MBS for the periods indicated:
 Three Months Ended
 September 30,
 2017 2016
($ in thousands)Amount Yield Amount Yield
CMBS:       
Coupon and scheduled amortization$9,976
 2.90 % $7,903
 3.19 %
Prepayment adjustments (1)
176
 0.01 % (154) (0.02)%
 $10,152
 2.91 % $7,749
 3.17 %
Average balance (2)
$1,352,681
 

 $974,240
 

        
CMBS IO:

      
Coupon and scheduled amortization$6,841
 3.73 % $6,895
 3.81 %
Prepayment adjustments (1)
1,209
 0.16 % 546
 0.07 %
 $8,050
 3.89 % $7,441
 3.88 %
Average balance (2)
$734,282
   $724,859
  
        
RMBS:

      
Coupon and scheduled amortization$4,693
 2.19 % $6,689
 1.92 %
Prepayment adjustments (1)
(124) (0.01)% (982) (0.07)%
 $4,569
 2.18 % $5,707
 1.85 %
Average balance (2)
$856,705
 

 $1,390,401
  
 

      
Total MBS interest income and effective yield:$22,771
 2.94 % $20,897
 2.75 %
        
Total average balance (2):
$2,943,668
   $3,089,500
  
        
 Nine Months Ended
 September 30,
 2017 2016
 Amount Yield Amount Yield
CMBS:       
Coupon and scheduled amortization$28,991
 2.93 % $24,241
 3.23 %
Prepayment adjustments (1)
2,255
 0.17 % 1,016
 0.10 %


 $31,246
 3.10 % $25,257
 3.33 %
Average balance (2)
$1,308,811
 

 $990,440
  
 

      
CMBS IO:

   

  
Coupon and scheduled amortization$21,059
 3.75 % $21,279
 3.79 %
Prepayment adjustments (1)
3,619
 0.48 % 1,363
 0.18 %
 $24,678
 4.23 % $22,642
 3.97 %
Average balance (2)
$749,343
 

 $748,097
  
        
RMBS:

   

 

Coupon and scheduled amortization$15,341
 2.02 % $21,525
 1.91 %
Prepayment adjustments (1)
(1,753) (0.17)% (1,104) (0.07)%
 $13,588
 1.84 % $20,421
 1.84 %
Average balance (2)
$1,014,283
 

 $1,499,309
  
 

   

  
Total MBS interest income and effective yield:$69,512
 2.96 % $68,320
 2.79 %
        
Total average balance (2):
$3,072,437
   $3,237,846
  
(1)Prepayment adjustments represent effective interest amortization adjustments related to changes in actual and projected prepayment speeds for RMBS and prepayment compensation, net of amortization for CMBS and CMBS IO.
(2)Average balances are calculated as a simple average of the daily amortized cost and exclude unrealized gains and losses as well as securities pending settlement if applicable.

Interest income and effective yields on our total MBS portfolio for the three and nine months ended September 30, 2017 increased due to higher prepayment penalty income from CMBS and CMBS IO and lower premium amortization adjustments on RMBS compared to the three and nine months ended September 30, 2016. Interest income and effective yields on MBS also increased overall as a result of our shift in investment strategy to higher yielding fixed-rate securities over the past twelve months. The following tables present the estimated impact of changes in average balances, yields, and prepayment adjustments on interest income by type of MBS for the periods indicated:
 Three Months Ended
 September 30, 2017 vs. September 30, 2016
 Increase (Decrease) in Interest Income Due to Change In
($ in thousands) Average Balance Coupon and Scheduled Amortization 
Prepayment Adjustments (1)
CMBS$2,402
 $2,013
 $59
 $330
CMBS IO609
 134
 (188) 663
RMBS(1,137) (2,069) 74
 858
Total$1,874
 $78
 $(55) $1,851
        
 Nine Months Ended
 September 30, 2017 vs. September 30, 2016
 Increase (Decrease) in Interest Income Due to Change In
($ in thousands) Average Balance Coupon and Scheduled Amortization 
Prepayment Adjustments (1)
CMBS$5,989
 $4,800
 $(50) $1,239
CMBS IO2,036
 57
 (277) 2,256
RMBS(6,833) (6,488) 304
 (649)
Total$1,192
 $(1,631) $(23) $2,846


(1)Prepayment adjustments represent effective interest amortization adjustments related to changes in actual and projected prepayment speeds for RMBS and prepayment compensation, net of amortization for CMBS and CMBS IO.

Interest income from CMBS increased for the three and nine months ended September 30, 2017 compared to the three and nine months ended September 30, 2016 due to a higher average balance and higher prepayment penalty income while the effective yield earned on our CMBS portfolio was lower for three and nine months ended September 30, 2017 due primarily to lower average coupons on our current CMBS portfolio versus the same periods in the prior year.

Interest income and effective yield for CMBS IO for the three and nine months ended September 30, 2017 increased compared to the three and nine months ended September 30, 2016 due to an increase in prepayment penalty income for the three and nine months ended September 30, 2017 versus the same periods in 2016.
Interest income declined on RMBS for the three and nine months ended September 30, 2017 primarily due to a decrease in the average balance of approximately (38)% and (32)% for the three and nine months ended September 30, 2017, respectively, compared to the same periods in 2016. The increase of 33 basis points in the effective yield on RMBS for the three months ended September 30, 2017 compared to the same period in 2016 is due to the addition of $544.1 million in specified pools of 30-year fixed-rate Agency RMBS during the third quarter of 2017. Because these fixed-rate securities are newer issues, they have higher coupons than the adjustable-rate RMBS we have sold since September 30, 2016. Premium amortization was lower for the three and nine months ended September 30, 2017 as a result of the sales of adjustable-rate RMBS. The rate at which we amortize the premiums on adjustable-rate Agency RMBS is impacted by actual and forecasted prepayments, which is measured by the constant prepayment rate ("CPR"). The following graph shows our actual 3 month average CPRs for our adjustable-rate Agency RMBS for the periods indicated:
a1q17form10-_chartx19534a02.jpg

Premium amortization on our fixed-rate Agency RMBS is adjusted when actual prepayments are received. The CPR for our fixed-rate Agency RMBS was 1.3% for the third quarter of 2017. We do not forecast prepayments on our fixed-rate Agency RMBS.         

Interest Expense and Cost of Funds

The following table summarizes the components of interest expense as well as average balances and cost of funds for the periods indicated:


 Three Months Ended Nine Months Ended
 September 30, September 30,
($ in thousands)2017 2016 2017 2016
Interest expense on repurchase agreement borrowings$9,910
 $5,800
 $26,269
 $17,440
Interest expense on FHLB advances—
 343
 —
 1,118
Accretion of de-designated cash flow hedges (1)
(48) (99) (220) (152)
Non-recourse collateralized financing27
 24
 73
 72
Total interest expense$9,889
 $6,068
 $26,122
 $18,478
 

   

  
Average balance of repurchase agreements$2,616,250
 $2,536,562
 $2,736,834
 $2,623,225
Average balance of FHLB advances—
 263,000
 —
 308,022
Average balance of non-recourse collateralized financing5,817
 7,386
 6,058
 7,892
Average balance of borrowings$2,622,067
 $2,806,948
 $2,742,892
 $2,939,139
Cost of funds (2)
1.48% 0.85% 1.26% 0.83%
(1)Amount recorded in accordance with GAAP related to accretion of the balance remaining in accumulated other comprehensive income as a result of our discontinuation of cash flow hedge accounting effective June 30, 2013.
(2)Cost of funds is calculated by dividing annualized interest expense by the total average balance of borrowings outstanding during the period.

The following table presents the estimated impact of the change in average balances and borrowing rates of secured borrowings and other differences in interest expense for the comparative periods presented:
($ in thousands)Three Months Ended September 30, 2017 vs. September 30, 2016 Nine Months Ended September 30, 2017 vs. September 30, 2016
Change in borrowing rates on repurchase agreements and FHLB advances$4,169
 $8,927
Change in average balance of repurchase agreements and FHLB advances(402) (1,216)
Decrease (increase) in accretion of de-designated cash flow hedges51
 (68)
Decrease in non-recourse collateralized financing and other interest expense3
 1
Total change in interest expense$3,821
 $7,644

Increases in interest expense for the three and nine months ended September 30, 2017 compared to the same periods in 2016 were due to higher borrowing rates on our repurchase agreements. Our borrowing rates are based primarily on one-month LIBOR which has increased approximately 70 basis points since September 30, 2016.

Adjusted Interest Expense

Because we use derivative instruments as economic hedges of our interest rate risk exposure, management considers net periodic interest costs from derivative instruments to be an additional cost of financing investments. As such, management uses the non-GAAP financial measure "adjusted interest expense" which includes the net periodic interest costs of our effective derivative instruments excluded from GAAP interest expense. Please read the section "Non-GAAP Financial Measures" at the end of "Executive Overview" in Part 1, Item 2 of this Quarterly Report on Form 10-Q for additional information. The table below presents the reconciliation of GAAP interest expense to our adjusted interest expense for the periods indicated:
 Three Months Ended Nine Months Ended
 September 30, September 30,
($ in thousands)2017 2016 2017 2016
Interest expense$9,889
 $6,068
 $26,122
 $18,478
Add: net periodic interest costs of derivative instruments (1)
1,131
 155
 3,099
 2,321
Less: de-designated hedge accretion (2)
48
 99
 220
 152
Adjusted interest expense$11,068
 $6,322
 $29,441
 $20,951


1)Amounts represent net periodic interest costs on effective interest rate swaps outstanding during the period and exclude termination costs and changes in fair value.
(2)Amount recorded as a portion of "interest expense" in accordance with GAAP related to accretion of the balance remaining in accumulated other comprehensive income as a result of our discontinuation of cash flow hedge accounting effective June 30, 2013.

Of the $1.1 million and $3.1 million in net periodic interest costs incurred during the three and nine months ended September 30, 2017, respectively, $0.8 million and $1.3 million, respectively, relates to interest rate swaps we added to our hedging portfolio in order to mitigate the potential impact of changing interest rates on our TBA securities.

Net Interest Income and Net Interest Spread

The tables below present net interest income and net interest spread for our interest-earning assets and interest-bearing liabilities for the periods indicated:.
 Three Months Ended
 September 30,
 2017 2016
($ in thousands)Amount Yield Amount Yield
Interest income$23,103
 2.95% $21,135
 2.75%
Interest expense9,889
 1.48% 6,068
 0.85%
Net interest income/spread13,214
 1.47% 15,067
 1.90%
        
Average interest earning assets (1)
$2,960,595
   $3,110,884
  
Average balance of borrowings (2)
$2,622,067
   $2,806,948
  
        
 Nine Months Ended
 September 30,
 2017 2016
($ in thousands)Amount Yield Amount Yield
Interest income$70,378
 2.97% $69,040
 2.80%
Interest expense26,122
 1.26% 18,478
 0.83%
Net interest income/spread$44,256
 1.71% $50,562
 1.97%
        
Average interest earning assets (1)
$3,090,313
   $3,260,510
  
Average balance of borrowings (2)
$2,742,892
   $2,939,139
  
(1)Average balances are calculated as a simple average of the daily amortized cost and exclude unrealized gains and losses as well as securities pending settlement if applicable.
(2)Average balances are calculated as a simple average of the daily borrowings outstanding for both repurchase agreement and non-recourse collateralized financing.

Net interest income and net interest spread declined due to higher borrowing costs during the three and nine months ended September 30, 2017 compared to the respective periods in 2016. Higher borrowings costs were partially mitigated by an increase in interest income for the three and nine months ended September 30, 2017 compared to the respective periods in 2016, which resulted from replacing lower yielding adjustable-rate RMBS with higher yielding fixed-rate MBS during the past twelve months. Please refer to "Interest Income and Effective Yields" and "Interest Expense and Cost of Funds" for additional information.

Adjusted Net Interest Income

Drop income from TBA securities and net periodic interest costs from interest rate swaps effective during the period are included in "gain (loss) on derivatives instruments, net" on the Company's consolidated statements of comprehensive income. Drop income is the difference in price between the near settling TBA contract and the price for the same contract with a later settlement date. Management believes drop income represents the economic equivalent of net interest income (interest income less implied financing cost) on the underlying Agency security from trade date to settlement date. Management also views net periodic interest costs from interest rate swaps used to hedge interest rate risk as an additional cost of using repurchase agreements


to finance its investments. As such, management includes drop income from TBA securities and net periodic interest costs from interest rate swaps in a non-GAAP financial measure "adjusted net interest income". The following table reconciles adjusted net interest income to GAAP net interest income for the periods indicated:
 Three Months Ended Nine Months Ended
 September 30, September 30,
($ in thousands)2017 2016 2017 2016
Net interest income$13,214
 $15,067
 $44,256
 $50,562
Add: drop income3,902
 —
 5,253
 —
Add: net periodic interest costs (1)
(1,131) (155) (3,099) (2,321)
Less: de-designated hedge accretion (2)
(48) (99) (220) (152)
Adjusted net interest income$15,937
 $14,813
 $46,190
 $48,089
(1)Amounts represent net periodic interest costs on effective interest rate swaps outstanding during the period and exclude termination costs and changes in fair value.
(2)Amount recorded in accordance with GAAP related to accretion of the balance remaining in accumulated other comprehensive income as a result of our discontinuation of cash flow hedge accounting effective June 30, 2013.

Loss on Derivative Instruments, Net

The following table provides information on the components of our "loss on derivative instruments, net" for the periods indicated:
  Three Months Ended
  September 30,
($ in thousands) 2017 2016
Type of Derivative Instrument Net Periodic Interest Costs 
Change in
Fair Value (1)(2)
 Total Net Periodic Interest Costs 
Change in Fair Value (1)
 Total
Interest rate swaps $(1,131) $421
 $(710) $(155) $(266) $(421)
TBA securities —
 6,703
 6,703
 —
 —
 —
Eurodollar futures —
 —
 —
 —
 2,830
 2,830
Loss on derivative instruments, net $(1,131) $7,124
 $5,993
 $(155) $2,564
 $2,409
             
  Nine Months Ended
  September 30,
  2017 2016
Type of Derivative Instrument Net Periodic Interest Costs 
Change in
Fair Value (1)(2)
 Total Net Periodic Interest Costs 
Change in Fair Value (1)
 Total
Interest rate swaps $(3,099) $(14,954) $(18,053) $(2,321) $(46,290) $(48,611)
TBA securities —
 8,419
 8,419
 —
 —
 —
Eurodollar futures —
 —
 —
 —
 (13,542) (13,542)
Loss on derivative instruments, net $(3,099) $(6,535) $(9,634) $(2,321) $(59,832) $(62,153)
(1)Changes in fair value for interest rate swaps and Eurodollar futures include unrealized gains (losses) from current and forward starting derivative instruments and realized gains (losses) from terminated derivative instruments.
(2)Change in fair value for TBA securities includes unrealized gains (losses) from open TBA contracts and realized gains (losses) on terminated positions.

Changes in the fair value of interest rate swaps and Eurodollar futures and net periodic interest costs are impacted by changing market interest rates in any given period. In addition, because we continually monitor our hedge positioning and make changes based on our investment portfolio and related financings, management's view of the future path of interest rates, and where


we believe hedges will be most effective in relation to our capital allocation and interest rate risk, gains and losses on derivative instruments will also fluctuate based on the notional amount, maturity, and interest rate of the derivative instruments held during the period. Because of the changes made to our hedging portfolio from one reporting period to the next, results of any given reporting period are generally not comparable to results of another.

During the three months ended September 30, 2017, the fair value of our interest rate swaps increased $0.4 million as a result of higher swap rates (as shown in the Swap Rate Range graph under “Market Conditions and Recent Activity” within "Executive Overview"). Because we are "short" interest rate swaps (i.e., we pay a fixed rate of interest and receive a floating rate of interest based primarily on 3 month LIBOR), increases in swap rates result in increases in the fair value of the interest rate swaps. During the quarter, we also terminated interest rate swaps on which we paid net proceeds of $0.7 million.
For the nine months ended September 30. 2017, the fair value of interest rate swaps declined $15.0 million also as a result of lower swap rates during that period, specifically on the long end of the swap curve. Declines in fair value for the nine months ended September 30, 2016 were largely unfavorable as compared to the same periods in 2017 as a result of a larger declines in rates along the entire swap curve as well as changes in the composition of the hedging portfolio.
Net periodic interest costs for the three and nine months ended September 30, 2017 were higher than the same periods in 2016 due to a larger average notional balance of effective interest rate swaps outstanding at higher weighted-average pay-fixed rates as shown in the following table for the periods indicated:
 Three Months Ended Nine Months Ended
 September 30, September 30,
($ in thousands)2017 2016 2017 2016
Average notional balance$2,668,478
 $305,000
 $2,011,355
 $549,617
Weighted average net pay-fixed rate1.37% 0.64% 1.30% 1.06%

As mentioned previously, we execute TBA dollar roll transactions which effectively delay the settlement of a forward purchase of an Agency RMBS by entering into an offsetting short position (referred to as a "pair off"), net settling the paired-off positions in cash, and simultaneously entering a similar TBA contract for a later settlement date. TBA securities purchased for a forward settlement month are generally priced at a discount relative to TBA securities sold for settlement in the current month. This discount, often referred to as “drop income” is the economic equivalent of net interest income on the underlying Agency securities over the roll period (interest income less implied financing cost). The average if-settled cost basis of the TBA securities, which represents the basis on which we earned drop income during the three and nine months ended September 30, 2017, and the related drop income are presented in the following table:
  Three Months Ended Nine Months Ended
  September 30, 2017 September 30, 2017
($ in thousands) Average Cost Basis 
Drop
Income (1)
 Average Cost Basis 
Drop
Income (1)
TBA securities:        
3.0% 30-year $119,528
 $563
 $69,539
 $960
4.0% 30-year 677,956
 3,339
 287,298
 4,293
Total TBA securities $797,484
 $3,902
 $356,837
 $5,253
(1)Drop income is recognized in "gain (loss) on derivatives, net" on our consolidated statements of comprehensive income.

Loss on Sale of Investments, Net

Sales of our investments occur in the ordinary course of business as we manage our risk, capital and liquidity profiles, and as we reallocate capital to various investments. As mentioned previously, we have been reallocating our capital from adjustable-rate Agency RMBS to generic and specified pools of fixed-rate Agency RMBS, which we believe to be more liquid and less vulnerable to loss in book value from credit spread widening versus other investments in the current macroeconomic environment. The following tables provide information related to our loss on sale of investments, net for the periods indicated:


 Three Months Ended
 September 30,
 2017 2016
($ in thousands)Amortized cost basis sold Gain (loss) on sale of investments, net Amortized cost basis sold Gain (loss) on sale of investments, net
Agency RMBS$398,662
 $(5,160) $—
 $—
Agency CMBS13,484
 (51) —
 —
 $412,146
 $(5,211) $—
 $—
        
 Nine Months Ended
 September 30,
 2017 2016
($ in thousands)Amortized cost basis sold Gain (loss) on sale of investments, net Amortized cost basis sold Gain (loss) on sale of investments, net
Agency RMBS$728,952
 $(12,392) $57,188
 $(3,010)
Agency CMBS206,470
 523
 —
 —
Non-Agency CMBS34,506
 1,199
 34,868
 (1,228)
Non-Agency RMBS16,365
 42
 —
 —
 $986,293
 $(10,628) $92,056
 $(4,238)

General and Administrative Expenses

Compensation and benefits expense was $0.3 million and $0.5 million higher for the three and nine months ended September 30, 2017 compared to the same periods in 2016 primarily due to the timing of bonus expense accrual and the related payments. Other general and administrative expenses were $0.5 million higher for the nine months ended September 30, 2017 compared to the same period in 2016 due primarily to higher legal expenses related to a lawsuit filed in 2017 which is discussed in more detail in Item 1 of Part II of this Quarterly Report on Form 10-Q.

Other Comprehensive Income

The following table provides detail on the changes in fair value by type of MBS which are recorded as unrealized gains (losses) in other comprehensive income on our consolidated statements of operations for the periods indicated:
 Three Months Ended Nine Months Ended
 September 30, September 30,
($ in thousands)2017 2016 2017 2016
Agency CMBS$2,334
 $(1,226) $14,859
 $40,093
Non-Agency CMBS(403) (377) (2,591) 2,036
Agency CMBS IO1,032
 1,616
 7,268
 4,187
Non-Agency CMBS IO1,101
 2,131
 9,431
 5,832
Agency RMBS2,120
 (1,765) 9,734
 12,548
Non-Agency RMBS8
 390
 14
 802
   Unrealized gain on available-for-sale investments$6,192
 $769
 $38,715
 $65,498

Credit spreads tightened during the three months ended September 30, 2017 and September 30, 2016 which increased the fair value of MBS in our portfolio during those periods and more than offset the impact of slightly higher interest rates during those same periods. The increase in fair value of MBS of $38.7 million during the nine months ended September 30, 2017 was primarily due to credit spread tightening during the period. The increase in fair value of MBS of $65.5 million during the nine


months ended September 30, 2016 was primarily due to declining interest rates during the period, which favorably impacted the longer duration investments such as Agency CMBS.

LIQUIDITY AND CAPITAL RESOURCES
 Our primary sources of liquidity include borrowings under repurchase arrangements and monthly principal and interest payments we receive on our investments. Additional sources may also include proceeds from the sale of investments, equity offerings, and payments received from counterparties from interest rate swap agreements. We use our liquidity to purchase investments and to pay our operating expenses and dividends on our common and preferred stock. We also use our liquidity to post initial margin and variation margin on our repurchase agreements and derivative transactions, including TBA contracts, when required under the terms of the related agreements. We may also use liquidity to repurchase shares of our stock.
Our liquid assets fluctuate based on our investment activities, our financing and capital raising activities, and changes in the fair value of our MBS and derivative instruments. We seek to maintain sufficient liquidity to support our operations and to meet our anticipated liquidity demands, including potential margin calls from lenders (as discussed further below). We measure, manage, and forecast our liquidity on a daily basis. Our available liquid assets include unrestricted cash and cash equivalents, unencumbered Agency MBS, and certain unencumbered non-Agency MBS that can be pledged as collateral for margin calls or converted reasonably quickly into cash. As of September 30, 2017, our available liquid assets were $239.2 million, which consisted of unrestricted cash and cash equivalents of $117.7 million and unencumbered Agency MBS of $121.5 million, compared to $138.1 million as of December 31, 2016. Unencumbered Agency MBS excludes purchases and sales of MBS pending settlement. The increase in available liquid assets since December 31, 2016 is primarily due to our shift in investment mix.

We perform sensitivity analysis on our liquidity based on changes in the fair value of our investments due to changes in interest rates, credit spreads, lender haircuts, and prepayment speeds as well as changes in the fair value of our derivative instruments due to changes in interest rates. In performing this analysis we will also consider the current state of the fixed income markets and the repurchase agreement markets in order to determine if market forces such as supply-demand imbalances or structural changes to these markets could change the liquidity of MBS or the availability of financing. The objective of our analysis is to assess the adequacy of our liquidity to withstand potential adverse events. We may change our leverage targets based on market conditions and our perceptions of the liquidity of our investments.

We closely monitor our debt-to-invested equity ratio (which is the ratio of debt financing to invested equity for any investment) as part of our liquidity management process as well as our overall enterprise level debt-to-equity ratio. We also monitor the ratio of our available liquidity to outstanding repurchase agreement borrowings, which fluctuates due to changes in the fair value of collateral we have pledged to our lenders. On an enterprise level basis, our current operating policies limit our total liabilities-to-shareholders' equity to 8 times our shareholders' equity. Including our TBA position at cost (if settled), which was $683.8 million as of September 30, 2017, our leverage was 6.3 times shareholders' equity. The financing for TBA securities is implied through our use of TBA dollar roll transactions whereby we enter into an offsetting TBA contract and net settle the paired off position in cash. It is possible under certain market conditions that it may be uneconomical for us to roll our TBA contracts into future months, which may result in us having to take physical delivery of the underlying securities. Because under those circumstances we would have to fund our total purchase commitment with cash or other financing sources, which may impact our liquidity position, management includes our TBA position at cost (if settled) in evaluating the Company's leverage.

The following table presents information regarding the balances of our repurchase agreement borrowings and our net TBA position for the periods indicated:
 Repurchase Agreements 
Net TBA Position (1)
($ in thousands)Balance Outstanding As of Quarter End Average Balance Outstanding For the Quarter Ended Maximum Balance Outstanding During the Quarter Ended Balance Outstanding As of Quarter End Average Balance Outstanding For the Quarter Ended
September 30, 2017$2,519,230
 $2,616,250
 $2,801,418
 $683,813
 $745,270
June 30, 20172,540,759
 2,753,019
 2,826,005
 416,312
 305,720
March 31, 20172,825,945
 2,843,733
 2,913,617
 —
 —
December 31, 20162,898,952
 2,768,769
 2,938,745
 —
 —
September 30, 20162,478,278
 2,536,562
 2,599,491
 —
 —


(1)Balance outstanding as of quarter end and average balance outstanding for the quarter ended for net TBA position are reported at cost (as if settled).

Repurchase Agreements

 Our repurchase agreement borrowings are generally renewable at the discretion of our lenders without guaranteed roll-over terms. Given the short-term and uncommitted nature of most of our repurchase agreement financing, we attempt to maintain unused capacity under our existing repurchase agreement credit lines with multiple counterparties which helps protect us in the event of a counterparty's failure to renew existing repurchase agreements either with favorable terms or at all. As of September 30, 2017, we had repurchase agreement borrowings outstanding with 18 of our 34 available repurchase agreement counterparties at a weighted average borrowing rate of 1.51% compared to 1.03% as of December 31, 2016. Our repurchase agreement borrowings generally carry a rate of interest based on a spread to an index such as LIBOR.

For our repurchase agreement borrowings, we are required to post and maintain margin to the lender (i.e., collateral in excess of the repurchase agreement financing) in order to support the amount of the financing. This excess collateral is often referred to as a "haircut" (and which we also refer to as equity at risk). As the collateral pledged is generally MBS, the fair value of the collateral can fluctuate with changes in market conditions. If the fair value of the collateral falls below the haircut required by the lender, the lender has the right to demand additional margin, or collateral, to increase the haircut back to the initial amount. These demands are typically referred to as "margin calls". Declines in the value of investments occur for any number of reasons including but not limited to changes in interest rates, changes in ratings on an investment, changes in actual or perceived liquidity of the investment, or changes in overall market risk perceptions. Additionally, values in Agency RMBS will also decline from the payment delay feature of those securities. Agency RMBS have a payment delay feature whereby Fannie Mae and Freddie Mac announce principal payments on Agency RMBS but do not remit the actual principal payments and interest for 20 days in the case of Fannie Mae and 40 days in the case of Freddie Mac. Because these securities are financed with repurchase agreements, the repurchase agreement lender generally makes a margin call for an amount equal to the product of their advance rate on the repurchase agreement and the announced principal payments on the Agency RMBS. This causes a temporary use of our liquidity to meet the margin call until we receive the principal payments and interest 20 to 40 days later. 

The following table presents the weighted average minimum haircut contractually required by our counterparties for MBS pledged as collateral for our repurchase agreement borrowings as of the dates indicated:
 September 30, 2017 June 30, 2017 March 31, 2017 December 31, 2016 September 30, 2016
Agency CMBS and RMBS5.0% 5.0% 5.0% 5.0% 5.1%
Non-Agency CMBS and RMBS15.0% 18.0% 15.8% 16.3% 17.0%
CMBS IO15.0% 15.0% 15.3% 15.4% 15.4%

The counterparties with whom we have the greatest amounts of equity at risk may vary significantly during any given period due to the short-term and generally uncommitted nature of the repurchase agreement borrowings. Equity at risk is defined as the amount pledged as collateral to the counterparty in excess of the borrowed amount outstanding. This equity at risk represents the potential loss to the Company if the counterparty is unable or unwilling to return collateral securing the repurchase agreement borrowing at its maturity. The following tables present the counterparties with whom we had greater than 5% of our equity at risk as of September 30, 2017 and December 31, 2016:
 September 30, 2017
($ in thousands)Amount Outstanding Equity at Risk
Well Fargo Bank, N.A. and affiliates$349,965
 $57,992
JP Morgan Securities, LLC270,883
 30,803
 $620,848
 $88,795


 December 31, 2016
($ in thousands)Amount Outstanding Equity at Risk
Well Fargo Bank, N.A. and affiliates$342,160
 $62,041
South Street Financial Corporation597,394
 38,770
JP Morgan Securities, LLC212,921
 35,658
 $1,152,475
 $136,469

The following table discloses our repurchase agreement amounts outstanding and the value of the related collateral pledged by geographic region of our counterparties as of September 30, 2017 and December 31, 2016:
 September 30, 2017 December 31, 2016
($ in thousands)Amount Outstanding Market Value of Collateral Pledged Amount Outstanding Market Value of Collateral Pledged
North America$1,685,493

$1,840,749
 $2,105,337
 $2,309,391
Asia521,832

548,717
 421,991
 443,098
Europe311,905

328,537
 371,624
 397,351
 $2,519,230
 $2,718,003
 $2,898,952
 $3,149,840

Certain of our repurchase agreement counterparties require us to comply with various operating and financial covenants. The financial covenants include requirements that we maintain minimum shareholders' equity (usually a set minimum, or a percentage of the highest amount of shareholders' equity since the date of the agreement), maximum decline in shareholders' equity (expressed as a percentage decline in any given period), and limits on maximum leverage (as a multiple of shareholders' equity). Operating requirements include, among other things, requirements to maintain our status as a REIT and to maintain our listing on the NYSE. Violations of one or more of these covenants could result in the lender declaring an event of default which would result in the termination of the repurchase agreement and immediate acceleration of amounts due thereunder. In addition, some of the agreements contain cross default features, whereby default with one lender simultaneously causes default under agreements with other lenders. Violations could also restrict us from paying dividends or engaging in other transactions that are necessary for us to maintain our REIT status.

We monitor and evaluate on an ongoing basis the impact these customary financial covenants may have on our operating and financing flexibility. Currently, we do not believe we are subject to any covenants that materially restrict our financing flexibility.

Derivative Instruments

Our derivative instruments may require us to post initial margin at inception and variation margin based on subsequent changes in the fair value of the derivatives. The collateral posted as margin by us is typically in the form of cash or Agency MBS. Generally, as interest rates decline due to market changes, we will be required to post collateral with counterparties on our pay-fixed derivative instruments and receive collateral from our counterparties on our receive-fixed derivative instruments, and vice versa as interest rates increase. As of September 30, 2017, we had cash of $44.0 million posted as initial margin under these agreements.

As of September 30, 2017, approximately $160 million of the Company's interest rate swaps were entered into under bilateral agreements which contain cross-default provisions with other agreements between the parties. In addition, these bilateral agreements contain financial and operational covenants similar to those contained in our repurchase agreements, as described above. Currently, we do not believe we are subject to any covenants that materially restrict our hedging flexibility.
Our TBA contracts are subject to master securities forward transaction agreements published by the Securities Industry and Financial Markets Association as well as supplemental terms and conditions with each counterparty. Under the terms of these agreements, we may be required to pledge collateral to our counterparty when initiated or in the event the fair value of our TBA contracts declines and such counterparty demands collateral through a margin call. Declines in the fair value of TBA contracts are generally related to such factors as rising interest rates, increases in expected prepayment speeds, or widening spreads. Our TBA contracts generally provide that valuations for our TBA contracts and any pledged collateral are to be obtained from a generally recognized source agreed to by both parties. However, in certain circumstances, our counterparties have the sole discretion to determine the value of the TBA contract and any pledged collateral. In such instances, our counterparties are required to act in


good faith in making determinations of value. In the event of a margin call, we must generally provide additional collateral on the same business day.

Dividends

As a REIT, we are required to distribute to our shareholders amounts equal to at least 90% of our REIT taxable income for each taxable year after consideration of our tax NOL carryforwards. We generally fund our dividend distributions through our cash flows from operations. If we make dividend distributions in excess of our operating cash flows during the period, whether for purposes of meeting our REIT distribution requirements or other strategic reasons, those distributions are generally funded either through our existing cash balances or through the return of principal from our investments (either through repayment or sale). 

We have a net operating tax loss ("NOL") carryforward that we could use to offset our REIT taxable income distribution requirement. This NOL carryforward had an estimated balance of approximately $89.8 million as of September 30, 2017. We also have deferred tax hedge losses on terminated derivative instruments, which will be recognized over the original periods being hedged by those terminated derivatives. These losses have already been recognized in our GAAP earnings but will reduce taxable income over the next ten years as noted in the following table:
($ in thousands)Tax Hedge Loss Deduction
2017$21,542
201821,175
201916,937
2020 - 202612,383
 $72,037

If any of the deferred tax hedge losses for the years noted in the table above result in dividend distributions to our shareholders in excess of REIT taxable income, the excess dividends distributed will be considered a return of capital to the shareholder. As of September 30, 2017, we estimated that approximately 75% of our common stock dividends declared during the nine months ended September 30, 2017 will represent a return of capital to shareholders and not a distribution of REIT taxable income, principally as a result of the amount of the tax hedge loss deduction.

Contractual Obligations
The following table summarizes our contractual obligations by payment due date as of September 30, 2017:
($ in thousands) Payments due by period
Contractual Obligations: Total < 1 year 1-3 years 3-5 years > 5 years
Repurchase agreements (1)
 $2,557,279
 $2,557,279
 $—
 $—
 $—
Non-recourse collateralized financing (2)
 5,786
 1,669
 2,199
 1,207
 711
Operating lease obligations 544
 214
 330
 —
 —
Total $2,563,609
 $2,559,162
 $2,529
 $1,207
 $711
(1) Includes estimated interest payments calculated using interest rates in effect as of September 30, 2017.
(2) Amounts shown are for principal only and exclude interest obligations as those amounts are not significant. Non-recourse collateralized financing represents securitization financing that is payable solely from loans and securities pledged as collateral. Payments due by period were estimated based on the principal repayments forecasted for the underlying loans and securities, substantially all of which is used to repay the associated financing outstanding.

Other Matters

As of September 30, 2017, we do not believe that any off-balance sheet arrangements exist that are reasonably likely to have a material effect on our current or future financial condition, results of operations, or liquidity other than as discussed above. In addition, we do not have any material commitments for capital expenditures and have not obtained any commitments for funds to fulfill any capital obligations.

RECENT ACCOUNTING PRONOUNCEMENTS


Please refer to Note 1 to the Notes to the Unaudited Consolidated Financial Statements contained in this Quarterly Report on Form 10-Q for information regarding recently issued accounting pronouncements.


FORWARD-LOOKING STATEMENTS
 
Certain written statements in this Quarterly Report on Form 10-Q that are not historical facts constitute “forward-looking statements” within the meaning of Section 27A of the 1933 Act and Section 21E of the Exchange Act. Statements in this report addressing expectations, assumptions, beliefs, projections, future plans and strategies, future events, developments that we expect or anticipate will occur in the future, and future operating results, capital management, and dividend policy are forward-looking statements. Forward-looking statements are based upon management’s beliefs, assumptions, and expectations as of the date of this report regarding future events and operating performance, taking into account all information currently available to us, and are applicable only as of the date of this report. Forward-looking statements generally can be identified by use of words such as “believe”, “expect”, “anticipate”, “estimate”, “plan”, “may”, “will”, “intend”, “should”, “could” or similar expressions. We caution readers not to place undue reliance on our forward-looking statements, which are not historical facts and may be based on projections, assumptions, expectations, and anticipated events that do not materialize. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statement whether as a result of new information, future events, or otherwise.


Forward-looking statements in this Quarterly Report on Form 10-Q may include, but are not limited to:to statements about:


•Our business and investment strategy including our ability to generate acceptable risk-adjusted returns and our target investment allocations;allocations, and our views on the future performance of MBS and other investments;
•Our views on conditions in the investment, credit, and derivatives markets;
44

•Our views on the effect of actual or proposed actions of the U.S. Federal Reserve, and the FOMC, or other central banks with respect to monetary policy (including the targeted Federal Funds Rate), and the potential impact of these actions on interest rates, inflation or unemployment;
•The effect of regulatory initiatives of the Federal Reserve (including the FOMC), other financial regulators, and other financial regulators;central banks;
•Our financing strategy including our target leverage ratios, our use of TBA dollar roll transactions, and anticipated trends in financing costs, and our hedging strategy including changes to the derivative instruments to which we are a party, and changes to government regulation of hedging instruments and our use of these instruments;
•Our investment portfolio composition and target investments;
•Our investment portfolio performance, including the fair value, yields, and forecasted prepayment speeds of our investments;
•The impact of COVID-19 on the economy, as well as certain actions taken by federal, state and local governments in response to the pandemic, on delinquencies in loans underlying our investments;
•Our liquidity and ability to access financing, and the anticipated availability and cost of financing;
•Our capital stock repurchase activity andincluding the impact of stock issuances and repurchases;
•The amount, timing, and funding of future dividends;
•Our use of and restrictions on using our tax NOL carryforward;
•The status of pending litigation;
•The competitive environment in the future, including competition for investments and the availability of financing;
•Estimates of future interest expenses, including related to the Company'sCompany’s repurchase agreements and derivative instruments;
•The status and effect of legislative reforms and regulatory rule-making or review processes, and the status of reform efforts and other business developments in the repurchase agreement financing market;
•Market, industry and economic trends, and how these trends and related economic data may impact the behavior of market participants and financial regulators; and
•Market interest rates and market spreads.spreads; and

•Possible future effects of the COVID-19 pandemic.

Forward-looking statements are inherently subject to risks, uncertainties and other factors that could cause our actual results to differ materially from historical results or from any results expressed or implied by such forward-looking statements. Not all of these risks and other factors are known to us. New risks and uncertainties arise over time, and it is not possible to predict those events or how they may affect us. The projections, assumptions, expectations or beliefs upon which the forward-looking statements are based can also change as a result of these risks or other factors. If such a risk or other factor materializes in future periods, our business, financial condition, liquidity and results of operations may vary materially from those expressed or implied in our forward-looking statements.




While it is not possible to identify all factors, some of the factors that may cause actual results to differ from historical results or from any results expressed or implied by forward-looking statements, or that may cause our projections, assumptions, expectations or beliefs to change, some of those factors include the following:


•the risks and uncertainties referenced in this Quarterly Report on Form 10-Q, particularlyespecially those set forth under and incorporated by reference into Part II, Item 1A, “Risk Factors”;, and in particular the potential adverse effects of the ongoing COVID-19 pandemic and any governmental or societal responses thereto,
•our ability to find suitable reinvestment opportunities;
•changes in domestic economic conditions;
•changes in interest rates and interest rate spreads, including the repricing of interest-earning assets and interest-bearing liabilities;
•our investment portfolio performance particularly as it relates to cash flow, prepayment rates and credit performance;
•the impact on markets and asset prices from changes in the Federal Reserve's balance sheet normalization process throughReserve’s policies regarding the reduction in its holdingspurchases of Agency RMBS, Agency CMBS, and U.S. TreasuriesTreasuries;
45

•actual or anticipated changes in Federal Reserve monetary policy;policy or the monetary policy of other central banks;
•adverse reactions in U.S. financial markets related to actions of foreign central banks or the economic performance of foreign economies including in particular China, Japan, the European Union, and the United Kingdom;
•uncertainty concerning the long-term fiscal health and stability of the United States;
•the cost and availability of financing, including the future availability of financing due to changes to regulation of, and capital requirements imposed upon, financial institutions;
•the cost and availability of new equity capital;
•changes in our use of leverage;
•changes to our investment strategy, operating policies, dividend policy or asset allocations;
•the quality of performance of third-party servicer providers of our loans and loans underlying our securities;
•the level of defaults by borrowers on loans we have securitized;
•changes in our industry;
•increased competition;
•changes in government regulations affecting our business;
•changes or volatility in the repurchase agreement financing markets and other credit markets;
•changes to the market for interest rate swaps and other derivative instruments, including changes to margin requirements on derivative instruments;
•uncertainty regarding continued government support of the U.SU.S. financial system and U.S. housing and real estate markets;markets, or to reform the U.S. housing finance system including the resolution of the conservatorship of Fannie Mae and Freddie Mac;
•the composition of the Board of Governors of the Federal Reserve System;
ownership shifts under Section 382 that further limit the use of our tax NOL carryforward;•systems failures or cybersecurity incidents; and
•exposure to current and future claims and litigation.




ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK


Market risk is the exposure to losses resulting from changes in market factors. Our business strategy exposes us to a variety of market risks, including interest rate, spread, prepayment, reinvestment, credit, and liquidity risks. These risks can and do cause fluctuations in our liquidity, comprehensive income and book value as discussed below.


Interest Rate Risk


Investing in interest-rate sensitive investments such as MBS and TBA securities subjects us to interest rate risk. Interest rate risk results from investing in securities that have a fixed coupon or when the coupon may not immediately adjust for changes in interest rates. Interest rate risk also results from the mismatch between the duration of our assets versus the duration of our liabilities and hedges. With respect to MBS, mismatch in duration is usually the result of interest-rate reset or maturity dates and differing cash flow profiles of our assets versus our liabilities. Borrowing costs on our liabilities are generally based on prevailing short-term market rates and reset more frequently than interest rates on our assets. Changes in interest rates and changes in the forward curve also impact the market value of our investment portfolio and our derivative instruments (including TBA securities and interest rate swaps).


The measures of an instrument's price sensitivity to interest rate fluctuations are its duration and convexity. Duration measures the percentage change in projected market value of our investments and derivative instruments given a change in interest rates. The duration of our RMBS and TBA securities tend to increase when interest rates rise and decrease when interest rates fall, which is commonly referred to as negative convexity. This occurs because prepayments of the mortgage loans underlying the RMBS tend to decline when interest rates rise (which extends the life of the security) and increase when interest rates fall (which shortens the life of the security). The fair value of TBA securities react similarly to RMBS to changes in interest rates as they are based on an underlying generic pool of fixed-rate RMBS securities. CMBS and CMBS IO, however, generally have little convexity because the mortgage loans underlying the securities contain some form of prepayment protection provision (such as prepayment lock-outs) or prepayment compensation provisions (such as yield maintenance or prepayment penalties) which create an economic disincentive for the loans to prepay.

We attempt to manage our exposure to changes in interest rates that results from the duration mismatch between our assets and liabilities by entering into interest rate swaps to hedge this risk. We managehedging instruments. These instruments help offset the impact of changing interest rate risk within tolerances set by our Board of Directors. Our portfolio duration changes basedrates on the compositionmarket value of our investment portfolioassets and our hedge positions as well as market factors. We calculate our portfolio duration based on model projected cash flows, and such calculated duration can be an imprecise measure of actual interest rate risk. In the case of Agency RMBS and TBA securities, the primary input to the calculated duration is the anticipated prepayment speed of the underlying mortgage loans, which is sensitive to futurefinancing costs. Changes in interest rates and borrowers' behavior. Estimates of prepayment speeds can vary significantly by investor for the same security and therefore estimates of security and portfolio duration can vary significantly.

During a period of rising interest rates (particularly short term ratesimpact us in a flattening yield curve environment), our borrowing costs will increase faster than our asset yields, negatively impacting our net interest income.variety of ways. The amount of the impact will depend on the composition of our portfolio, our hedging strategy, the effectiveness of our hedging instruments as well as the magnitude and the duration of the increase in interest rates. In addition,

We manage interest rate risk within tolerances set by our adjustable-rate Agency RMBS resetBoard of Directors. Our hedging techniques are highly complex and are partly based on one-year LIBOR and have limitsassumed levels of prepayments of our assets. If prepayments are slower or caps onfaster than assumed, the initial, aggregate, or periodic amount that an interest rate may reset while our liabilities do not have interest rate reset caps. As of September 30, 2017, we had a positive net duration gap in our investment portfolio, which means our liabilities mature or reset sooner thanmaturity our investments and we had not fully hedged this difference. Therefore, increases in interest rates, particularly rapid increases, will negatively impactalso differ from our expectations, which could reduce the market valueeffectiveness of our investments, thereby reducinghedging strategies and may cause losses on such transactions and adversely affect our book value. In addition tocash flow. Estimates of prepayment speeds can vary significantly by investor for the information set forth in the tables below, see "Spread Risk" below for further discussionsame security, and therefore estimates of the risks to the market value of our investments. For further discussion of the reset features of our hybrid ARMs, please refer to "Financial Condition-RMBS" within Part I, Item 2 of this Quarterly Report on Form 10-Q.security and portfolio duration can vary significantly.


The table below shows the projected sensitivity of our net interest income and net periodic interest costs on our interest rate swaps; the projected sensitivity of the market value of our investments and derivative instruments (including TBA securities); and the percentage change in shareholders' equity as they existed as of the periods indicated based on an instantaneous parallel shift in market interest rates as set forth in the table below. In light of the low interest rate environment at September 30, 2017, the only declining rate scenario that we present is a downward shift of 50 basis points.
46




Changes in types of our investments, the returns earned on these investments, future interest rates, credit spreads, the shape of the yield curve, the availability of financing, and/or the mix of our investments and financings including derivative instruments may cause actual results to differ significantly from the modeled results.results shown in the tables below. There can be no assurance that assumed events used forto model the modelresults shown below will occur, or that other events will not occur, that will affect the outcomes; therefore, the modeled results shown in the tables below and all related disclosures constitute forward-looking statements.

  September 30, 2017 December 31, 2016
  Percentage Change in Percentage Change in
Parallel Shift in Interest Rates 
Market Value of Investments (1)
 Shareholders' Equity 
Net Interest Income and Net Periodic Interest Costs (2)
 
Market Value of Investments (1)
 Shareholders' Equity 
Net Interest Income and Net Periodic Interest Costs (2)
+100 (1.3)% (9.1)%
10.3% (0.6)% (4.4)% (42.4)%
+50 (0.5)% (3.7)% 5.6% (0.3)% (1.9)% (20.7)%
-50 0.3% 2.1% (7.2)% 0.2% 1.2% 18.7%
The table below shows the projected sensitivity of our net interest income and net periodic interest benefit/cost on our interest rate swaps as of the dates indicated assuming an instantaneous parallel shift in interest rates:
(1)Includes changes in market value of our investments and derivative instruments, including TBA securities, but excludes changes in market value of our financings because they are not carried at fair value on our balance sheet. The projections for market value do not assume any change in credit spreads.
(2)Includes changes in net interest income as well as net periodic interest costs on our interest rate swaps recorded in "gain (loss) on derivatives instruments, net".

Projected Change in Net Interest Income and Net Periodic Interest Benefit/Cost Due To
Decrease in Interest Rates ofIncrease in Interest Rates of
50 Basis Points25 Basis Points25 Basis Points50 Basis Points
June 30, 2020
(1)
1.7 %(7.2)%(15.3)%
December 31, 20192.3 %1.3 %(2.2)%(4.8)%
(1) Model used for projected results cannot assume financing rates less than 0%.

The projected impactsensitivity to changes in interest rates on our net interest related earnings in an increasingincome and net periodic interest rate environment changedbenefit/cost from a projected decline as of December 31, 2016 to a projected increase as of September 30, 2017 because we made adjustments to our hedging portfolio during the nine months ended September 30, 2017. When the yield curve flattened during the second quarter of 2017, we entered into approximately $1.0 billion of interest rate swaps shown in order to "lock-in"the table above as of June 30, 2020 has increased since December 31, 2019 because we terminated the majority of our financing costs over the near term in an attempt to avoid potential volatility in our net interest earnings. We also entered into additional interest rate swaps late in the first quarter of 2020 due to hedge the significant rally in interest rates. Given current FOMC monetary policy, management anticipates more stable funding costs in the near-term, and as such, we have shifted our interest rate risk relatedhedging strategy to include options and futures with the principal intention of capital preservation.

The table below shows the projected sensitivity of the market value of our TBA securities we began investingfinancial instruments(1) and the percentage change in duringshareholders’ equity assuming an instantaneous parallel shift in market interest rates as of the second quarterdates indicated:
47

June 30, 2020
Decrease in Interest Rates ofIncrease in Interest Rates of
100 Basis Points50 Basis Points50 Basis Points100 Basis Points
Type of
Instrument (1)
% of Market Value% of Total Equity% of Market Value% of Total Equity% of Market Value% of Total Equity% of Market Value% of Total Equity
RMBS0.8 %5.2 %0.9 %5.3 %(1.6)%(9.9)%(3.6)%(22.3)%
CMBS0.9 %5.7 %0.7 %4.5 %(0.8)%(4.6)%(1.5)%(9.0)%
CMBS IO0.1 %0.7 %0.1 %0.7 %(0.2)%(1.0)%(0.3)%(1.9)%
TBAs0.2 %1.2 %0.3 %1.5 %(0.7)%(4.2)%(1.7)%(10.4)%
Interest rate hedges(2.3)%(14.0)%(2.1)%(13.0)%3.0 %18.7 %6.7 %41.3 %
Total(0.2)%(1.2)%(0.1)%(0.9)%(0.2)%(1.0)%(0.4)%(2.3)%
December 31, 2019
Decrease in Interest Rates byIncrease in Interest Rates by
100 Basis Points50 Basis Points50 Basis Points100 Basis Points
Type of
Instrument (1)
% of Market Value% of Total Equity% of Market Value% of Total Equity% of Market Value% of Total Equity% of Market Value% of Total Equity
RMBS0.4 %3.8 %0.5 %4.2 %(0.9)%(7.8)%(2.1)%(18.3)%
CMBS3.3 %29.1 %1.6 %14.2 %(1.5)%(13.5)%(3.0)%(26.4)%
CMBS IO0.3 %2.4 %0.1 %1.1 %(0.1)%(1.1)%(0.2)%(2.2)%
TBAs0.1 %1.0 %0.1 %0.5 %(0.1)%(0.5)%(0.1)%(1.1)%
Interest rate hedges(3.0)%(26.5)%(1.5)%(13.2)%2.3 %20.8 %5.2 %46.5 %
Total1.1 %9.8 %0.8 %6.8 %(0.3)%(2.1)%(0.2)%(1.5)%
(1)Changes in market value of 2017.our financings are excluded because they are not carried at fair value on our balance sheet. The projections for market value do not assume any change in credit spreads.

Management also considers changes in the shape of the interest rate curves in assessing and managing portfolio interest rate risk. Often interest rates do not move in a parallel fashion from quarter to quarter. The table below shows the percentage change in projected market value of our investment portfolio net of derivativefinancial instruments(1) for instantaneous changes in the shape of the U.S. Treasury ("UST"(“UST”) curve (with similar changes to the interest rate swap curves) as of the periodsdates indicated:
June 30, 2020December 31, 2019
Basis Point Change inPercentage Change inPercentage Change in
2-year UST10-year UST
Market Value of
Investments (1)
Shareholders’
Equity
Market Value of
Investments (1)
Shareholders’ Equity
+25+50(0.2)%(1.0)%(0.3)%(2.9)%
+50+25(0.3)%(1.6)%(0.2)%(1.9)%
+50+100(0.5)%(2.9)%(0.4)%(3.4)%
-2500.3 %2.1 %— %(0.3)%
-25-75(0.1)%(0.5)%1.0 %9.0 %
-50-100.3 %1.6 %0.1 %1.0 %
(1)Includes changes in market value of our investments and derivative instruments, including TBA securities, but excludes changes in market value of our financings which are not carried at fair value on our balance sheet due to their short-term maturities. The projections for market value do not assume any change in credit spreads.
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  September 30, 2017 December 31, 2016
Basis Point Change in Percentage Change in
2-year UST 10-year UST 
Market Value of Investments (1)
 Shareholders' Equity 
Market Value of Investments (1)
 Shareholders' Equity
+25 +50 (0.5)% (3.6)% 0.1% 0.5%
+25 +0 (0.1)% (0.6)% (0.4)% (2.5)%
+50 +25 (0.3)% (2.3)% (0.5)% (3.2)%
+50 +100 (1.2)% (8.1)% 0.1% 0.4%
-10 -50 (0.2)% 1.5% (0.3)% (2.3)%
(1)Includes changes in market value of our investments and derivative instruments, including TBA securities, but excludes changes in market value of our financings because they are not carried at fair value on our balance sheet. The projections for market value do not assume any change in credit spreads.






Spread Risk


Spread risk is the risk of loss from an increase in the market spread between the yield on an investment versus its benchmark index. Changes in market spreads represent the market's valuation of the perceived riskiness of an asset relative to risk-free rates, and widening spreads reduce the market value of our investments as market participants require additional yield to hold riskier assets. Market spreads could change based on macroeconomic or systemic factors as well as the factors specific to a particular security such as prepayment performance or credit performance. Other factors that could impact credit spreads include technical issues such as supply and demand for a particular type of security or FOMC monetary policy. Likewise, most of our investments are fixed-rate or reset in rate over a period of time, and as interest rates rise, we would expect the market value of these investments to decrease. We do not hedge spread risk given the complexity of hedging credit spreads and the lack of liquid instruments available to use as hedges.


Fluctuations in spreads typically vary based on the type of investment. Sensitivity to changes in market spreads is derived from models that are dependent on various assumptions, and actual changes in market value in response to changes in market spreads could differ materially from the projected sensitivity if actual conditions differ from these assumptions.


The Company's exposure to changes to market spreads did not materially shift as of June 30, 2020 versus December 31, 2019. The table below is an estimateshows the projected sensitivity of the percentage change in projected market value of our investments (including TBA securities)(1) given the indicated change in market spreads as of the periodsdates indicated:
June 30, 2020December 31, 2019
Percentage Change inPercentage Change in
Basis Point Change in Market Spreads
Market Value of Investments (1)
Shareholders’ Equity
Market Value of Investments (1)
Shareholders’ Equity
+20/+50 (2)
(1.5)%(9.1)%(1.2)%(11.1)%
+10(0.7)%(4.3)%(0.6)%(5.2)%
-100.7 %4.3 %0.6 %5.4 %
-20/-50 (2)
1.5 %9.1 %1.3 %11.6 %
Basis Point Change in Market Spreads 
Percentage Change in Projected
Market Value of Investments
  September 30, 2017 December 31, 2016
+50 (2.6)% (2.2)%
+25 (1.3)% (1.1)%
-25 1.3% 1.1%
-50 2.6% 2.3%
(1) Includes changes in market value of our MBS investments, including TBA securities.

(2) Assumes a 20-basis point shift in Agency and non-Agency RMBS and CMBS and a 50-basis point shift in Agency
and non-Agency CMBS IO.

Prepayment and Reinvestment Risk


Prepayment risk is the risk of an early, unscheduled return of principal on an investment. We are subject to prepayment risk from premiums paid on investments, which are amortized as a reduction in interest income using the effective yield method under GAAP. Our comprehensive income and book value per common share may also be negatively impacted by prepayments if the fair value materially exceeds the par balance of the underlying security. Principal prepayments on our investments are influenced by changes in market interest rates and a variety of economic, geographic, government policy, and other factors beyond our control.control, including GSE policy with respect to loan forbearance and delinquent loan buy-outs.


Loans underlying our CMBS and CMBS IO securities typically have some form of prepayment protection provisions (such as prepayment lock-outs) or prepayment compensation provisions (such as yield maintenance or prepayment penalties). Yield maintenance and prepayment penalty requirements are intended to create an economic disincentive for the loans to prepay; however, the amount of the prepayment penalty required to be paid may decline over time, and as loans age, interest rates decline, or market values of collateral supporting the loans increase, prepayment penalties may lessen as an economic disincentive to the borrower. Generally, our experience has been that prepayment lock-out and yield maintenance provisions result in stable prepayment performance from period to period. There are no prepayment protections, however, if the loan defaults and is partially or wholly repaid earlier as a result of loss mitigation actions taken by the underlying loan servicer. Historically, we have experienced low default rates on loans underlying CMBS and CMBS IO.

Because CMBS IO consist of rights to interest on the underlying commercial mortgage loan pools and do not have rights to principal payments on the underlying loans, prepayment risk on these securities would beis particularly acute without these prepayment protection provisions. CMBS IOThere are no prepayment protectionprotections if the loan defaults and compensation provisions varyis partially or wholly repaid earlier as a result of loss mitigation actions taken by issuer of the security (i.e. Freddie Mac, Fannie Mae, Ginnie Mae, or non-Agency). The majority of our Agency CMBS IO are issued by Freddie Mac and these securities generally have initial prepayment lock-outs followed by a defeasance period which on average extends to within six months of the stated maturities of the underlying loans. Non-Agency CMBS IO generally have prepayment protectionloan servicer. The slowdown in the form of prepayment lock-outs and defeasance provisions. The following table details the fair value of our CMBS IO portfolio by issuer as ofeconomic activity experienced at the end of the periods indicated:


($ in thousands)September 30, 2017 December 31, 2016
Fannie Mae$11,200
 $18,957
Freddie Mac390,608
 392,941
Non-Agency CMBS IO328,659
 342,648
 $730,467
 $754,546

Prepayments onfirst quarter and beginning of the second quarter as a result of the COVID-19 pandemic, as well as certain actions taken by federal, state and local governments in response, could lead to an increase in defaults in loans underlying our RMBS generally accelerateCMBS IO, particularly loans in a declining interest rate environment,non-Agency CMBS IO securities which are collateralized by income
49

producing properties such as retail shopping centers, office buildings, multifamily apartments and hotels. Over the last several years, we have not experienced material defaults on CMBS IO loans age,in our portfolio; however, the ultimate impact on the economy and with respectcommercial real estate performance and market values from the COVID-19 pandemic, and correspondingly loan defaults, is currently unknown. Please refer to ARMS, as the loans near their respective interest rate reset dates, particularly the initial reset date, or if expectations are that interest rates will rise in the future. Our prepayment models anticipate an acceleration of prepayments in these events. To the extent the actual prepayments exceed our modeled prepayments, or, with respect to adjustable-rate RMBS, if we change our future prepayment expectations, we will record adjustments to our premium amortization which may negatively impact our net interest income. In addition, changes in market expectations of prepayments could impact the fair value of our RMBS.“Financial Condition-CMBS IO” for additional information.

As an indication of our prepayment risk on our RMBS portfolio, the following table summarizes information for our Agency RMBS portfolio regarding the net premium and weighted average coupon by months to reset ("MTR") or until maturity in the case of fixed-rate securities as of the end of the past four quarters:     
 September 30, 2017 June 30, 2017 March 31, 2017 December 31, 2016
($ in thousands)Net Premium WAC Net Premium WAC Net Premium WAC Net Premium WAC
0-12 MTR$1,313
 3.44% $7,637
 3.36% $17,671
 3.24% $19,593
 3.17%
13-36 MTR182
 4.52% 3,278
 3.14% 7,307
 3.07% 12,369
 3.18%
37-60 MTR6,928
 3.16% 11,074
 3.07% 11,651
 3.38% 10,441
 3.51%
> 60 MTR2,588
 2.58% 7,085
 2.57% 11,744
 2.68% 14,663
 2.73%
30-year fixed-rate19,163
 3.52% —
 —% —
 —% —
 —%
Total$30,174
 3.35% $29,074
 2.98% $48,373
 3.04% $57,066
 3.05%
Par balance$816,353
   $715,015
   $1,033,735
   $1,157,258
  
Premium, net as a % of par value3.7%   4.1%   4.7%   4.9%  


We seek to manage our prepayment risk on our MBS by diversifying our investments, seeking investments which we believe will have superior prepayment performance, and investing in securities which have some sort of prepayment prohibition or yield maintenance (as is the case with CMBS and CMBS IO). With respect to RMBS, when we invest in RMBS at a premium to the security'ssecurity’s par value, we tend to favor securities in which we believe the underlying borrowers have some disincentive to refinance as a result of the size of each loan'sloan’s principal balance, credit characteristics of the borrower, or geographic location of the property, among other factors.

We are also subject to reinvestment risk as a result of the prepayment, repayment and sales of our investments. In order to maintain our investment portfolio size and our earnings, we need to reinvest capital received from these events into new interest-earning assets or TBA securities. If we are unable to find suitable reinvestment opportunities or if yields on assets in which we reinvest are lower than yields on existing assets, our results and cash flows could be negatively impacted. In addition, based on market conditions, our leverage, and our liquidity profile, we may decide to not reinvest the cash flows we receive from our investment portfolio even when attractive reinvestment opportunities are available, or we may decide to reinvest in assets with lower yield but greater liquidity. If we retain rather than reinvest capital or if we invest it in lower yielding assets for liquidity reasons, the size of our investment portfolio and the amount of income generated by our investment portfolio will likely decline.



Credit Risk


Credit risk is the risk that we will not receive all contractual amounts due on investments that we own due to default by the borrower or due to a deficiency in proceeds from the liquidation of the collateral securing the obligation. Credit losses on loans could result in lower or negative yields on our investments.

Agency RMBS and Agency CMBS have credit risk to the extent that Fannie Mae or Freddie Mac fails to remit payments on the MBS for which they have issued a guaranty of payment. Given the improved financial performance and conservatorship of these entities and the continued support of the U.S. government, we believe this risk is low. Since

As noted above, Agency and non-Agency CMBS IO represent the right to excess interest and not principal on the underlying loans, theseloans. These securities are exposed to the loss of investment basis in the event a loan collateralizing the security liquidates without paying yield maintenance or prepayment penalty, whichpenalty. This will typically occursoccur when an involuntarily liquidatingthe underlying loan repays all or a portionis in default and proceeds from the disposition of its related principal balance.

Wethe loan collateral are exposedinsufficient to pay the prepayment consideration. To mitigate credit risk on our non-Agency securities and we attempt to mitigate our credit risk through asset selection and by purchasing higher quality non-Agency MBS. Our non-Agency MBS are typically investment grade rated securities which we believe will have strong credit performance. We do not currently seek to purchase heavily discounted, credit sensitive MBS. The majority of our non-Agency securities are CMBS and CMBS IO and the return we earn on these securities is dependent on the credit performance of the underlying commercial loans. In particular, since investmentsinvesting in CMBS IO, pay interest fromwe invest in primarily AAA-rated securities in senior tranches, which means we receive the underlying commercial mortgage loan pools, returns generallyhighest payment priority and are more negatively impacted by liquidations of loansthe last to absorb losses in the underlying loan pool. Please refer to "Financial Condition-Repurchase Agreements" within Item 2event of this Quarterly Report on Form 10-Q for information regarding the credit ratings on our non-Agency MBS.

a shortfall in cash flows.
 
Liquidity Risk


We have liquidity risk principally from the use of recourse repurchase agreements to finance our ownership of securities. In general, our repurchase agreements provide a source of uncommitted short-term financing for longer-term assets, thereby creating a mismatch between the maturities of the asset and the associated financing. Our repurchase agreements are renewable at the discretion of our lenders and do not contain guaranteed roll-over terms. If we fail to repay the lender at maturity, the lender has the right to immediately sell the collateral and pursue us for any shortfall if the sales proceeds are inadequate to cover the repurchase agreement financing. In addition, declines in the market value of our investments pledged as collateral for repurchase agreement borrowings may result in counterparties initiating margin calls for additional collateral .collateral.


Our use of TBA dollar roll transactionslong positions as a means of investing in and financing Agency RMBS also exposes us to liquidity risk in the event that we are unable to roll or terminate our TBA dollar roll transactionscontracts prior to their settlement date. If we are unable to roll or terminate our TBA dollar roll transactions,long positions, we could be required to take physical delivery of the underlying securities and settle our obligations for cash, which could negatively impact our liquidity position or force us to sell assets under adverse conditions if financing is not available to us on acceptable terms.


For further information, including how we attempt to mitigate liquidity risk and monitor our liquidity position and in particular, during the current economic crisis, please refer to “Liquidity and Capital Resources” in Part I, Item 2 of this Quarterly Report on Form 10-Q.



Reinvestment Risk


We are subject to reinvestment risk as a result of the prepayment, repayment and sales of our investments. In order to maintain our investment portfolio size and our earnings, we need to reinvest capital received from these events into new interest-earning assets or TBA securities. Market yields on new investments are substantially lower than the investments we sold in March. As such, we expect new assets that we add at lower yields than the investments sold will lower our interest
50

income in the near future. In addition, based on market conditions, our leverage, and our liquidity profile, we may decide to not reinvest the cash flows we receive from our investment portfolio even when attractive reinvestment opportunities are available, or we may decide to reinvest in assets with lower yield but greater liquidity. If we retain capital or pay dividends to return capital to shareholders rather than reinvest capital, or if we invest capital in lower yielding assets for liquidity reasons, the size of our investment portfolio and the amount of income generated by our investment portfolio will likely decline.
ITEM 4.CONTROLS AND PROCEDURES
ITEM 4. CONTROLS AND PROCEDURES

Disclosure controlsControls and procedures.Procedures


Our management evaluated, with the participation of our Principal Executive Officer and Principal Financial Officer, the effectiveness of our disclosure controls and procedures, as defined in Exchange Act Rule 13a-15(e), as of the end of the period covered by this report. Based on that evaluation, our Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures were effective as of SeptemberJune 30, 20172020 to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Principal Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.


Changes in internal controlInternal Control over financial reporting.Financial Reporting


Our management is also responsible for establishing and maintaining adequate internal control over financial reporting as defined in Exchange Act Rule 13a-15(f). There were no changes in our internal control over financial reporting during the three months ended SeptemberJune 30, 20172020 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.




PART II. OTHER INFORMATION

PART II.OTHER INFORMATION
ITEM 1.LEGAL PROCEEDINGS
From timeITEM 1. LEGAL PROCEEDINGS

With respect to time,the litigation filed by Basic Capital Management, Inc., et al. (the “DCI Plaintiffs”) against the Company and its subsidiaries are parties to various legal proceedings. As of September 30, 2017, neither the Company nor any of its subsidiaries were a party to any material legal proceedings.

There have been no material changes during the three months ended September 30, 2017 with respect to the garnishment action related to DCI Commercial, Inc. (“DCI”), a former affiliate of the Company and formerly known as Dynex Commercial, Inc., regarding the activities of DCI while it was an operating subsidiary of an affiliate of the Company discussed in the Company’s Annual Report on2019 Form 10-K (the “DCI Litigation”), on March 5, 2020 the Company filed its response to the DCI Plaintiffs’ opening brief in the United States Court of Appeals for the yearFifth Circuit. Oral argument has been tentatively scheduled by the Court for the week of August 31, 2020. There have been no other material developments in this matter during the three months ended June 30, 2020. With respect to the claim filed by the receiver for one of the DCI Plaintiffs in the DCI Litigation against the Company seeking payment of $11.3 million, alleging that the Company breached a litigation cost sharing agreement, as amended, entered into initially in December 31, 2016, or the suit against2000 between the Company and DCI, as co-defendants,which is also discussed in the Company’s Quarterly Report on2019 Form 10-Q for10-K (the "Receiver Litigation”), there were no material developments during the quarterthree months ended June 30, 2017. 2020.

The Company records a contingent liability when, in the opinion of management, it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. After consultation with litigation counsel, the Company believes, based upon information currently available and its evaluation of Texas and Virginia law, as applicable, that the likelihood of loss in connection with the DCI Litigation is remote and that the likelihood of loss in connection with the Receiver Litigation is not probable, and given the range of potential claims for damages by the Company to offset the Receiver's claims, the amount of possible loss in the Receiver Litigation cannot be reasonably estimated and, therefore, no contingent liability has been recorded for either matter.

The Company believes that the above matters will be resolved without a material adverse effect on the Company’s consolidated financial statements as a whole. The outcome, however, of any legal proceeding, including the above matters, cannot be predicted with certainty. As such, no assurances can be given that the Company will be successful in its defense of these actions on the merits or otherwise. If the Company is not successful in its defense efforts, the resolution of these matters could have a material adverse effect on the Company’s consolidated financial statements in a given future reporting period.
51


Other than as previously disclosed in the Company's periodic reports,described above, to the Company’s knowledge, there are no pending or threatened legal proceedings, the resolution of which, in management’s opinion, individually or in the aggregate, wouldcould have a material adverse effect on the Company’s results of operations or financial condition.




ITEM 1A.  RISK FACTORS


Risks and uncertainties identified in our forward-looking statements contained in this Quarterly Report on Form 10-Q together with those previously disclosed in the AnnualQuarterly Report on Form 10-K10-Q for the yearthree months ended DecemberMarch 31, 20162020 or those that are presently unforeseen could result in significant adverse effects on our financial condition, results of operations and cash flows. See “Forward-Looking Statements” contained in Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” within this Quarterly Report on Form 10-Q as well as Part I,II, Item 1A, “Risk Factors” in our AnnualQuarterly Report on Form 10-K for the year ended December 31, 2016, and Part II, Item 1A, "Risk Factors" in our Quarterly Reports on Form 10-Q for the quartersthree months ended March 31, 2017 and June 30, 2017.2020.



ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS


Issuer Purchases of Equity Securities


TheOn April 14, 2020, the Company has beenwas authorized by its Board of Directors to repurchasespend up to $40 million of itsto repurchase outstanding shares of common stock through DecemberMarch 31, 2018.2022. The April 2020 authorization superseded the prior repurchase authorization in its entirety. Subject to applicable securities laws and the terms of the Series AB Preferred Stock designation and the Series BC Preferred Stock, designation, both of which are contained in our Articles of Incorporation, future repurchases of common stock will be made at times and in amounts as the Company deems appropriate, provided that the repurchase price per share is less than the Company's estimate of the current net book value of a share of common stock. Repurchases may be suspended or discontinued at any time. DuringThe following table summarizes repurchases of our common stock that occurred during the three months ended SeptemberJune 30, 20172020:

Total Number of SharesAverage Price Paid per ShareTotal Number of Shares Purchased as Part of Publicly Announced Plans or ProgramsMaximum Number (or Approximate Dollar Value) of Shares that May Yet Be Purchased Under the Plans or Programs
($ in thousands)
April 1 - 30, 2020—  $—  —  $40,000  
May 1 - 31, 202014,143  11.72  14,143  39,834  
June 1 - 30, 2020—  —  —  39,834  
14,143  $—  14,143  

On April 14, 2020, the Company did notwas also authorized by its Board of Directors to spend up to $40 million to repurchase anyoutstanding shares of common stock under this repurchase authorization.Preferred Stock through March 31, 2022.



ITEM 3. DEFAULTS UPON SENIOR SECURITIES


None.


ITEM 4. MINE SAFETY DISCLOSURES
         
None.

52


ITEM 5. OTHER INFORMATION


None.

53





ITEM 6. EXHIBITS


Exhibit No.Description
3.1
Restated Articles of Incorporation, effective June 2, 2014 (incorporated herein by reference to Exhibit 3.1 to Dynex's Registration Statement on Form S-8 filed September 17, 2014).
3.23.1.1
Articles of Amendment of the Restated Articles of Incorporation, effective June 20, 2019 (incorporated herein by reference to Exhibit 3.1.1 to Dynex's Registration Statement on Form 8-A12B/A filed June 24, 2019).
3.1.2
Articles of Amendment to the Restated Articles of Incorporation, effective February 18, 2020 (incorporated herein by reference to Exhibit 3.2 to Dynex's Registration Statement on Form 8-A12B filed February 18, 2020).
3.2
Amended and Restated Bylaws, of the Company, effective as of May 16, 2017June 9, 2020 (incorporated herein by reference to Exhibit 3.2 to Dynex’s QuarterlyCurrent Report on Form 10-Q8-K filed August 8, 2017)on June 9, 2020).
10.23.44.1
Amendment No. 4 to Master Repurchase and Securities Contract dated asSpecimen of May 12, 2017 between Issued Holdings Capital Corporation, Dynex Capital, Inc. (as guarantor) and Wells Fargo Bank, N.A.Common Stock Certificate (incorporated herein by reference to Exhibit 10.23.44.1 to Dynex's Quarterly Report on Form 10-Q for the quarter ended September 30, 2019).
4.3
Specimen of 7.625% Series B Cumulative Redeemable Preferred Stock Certificate (incorporated herein by reference to Exhibit 4.1 to Dynex’s Current Report on Form 8-K filed April 16, 2013).
4.4
Specimen of 6.900% Series C Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock Certificate (incorporated herein by reference to Exhibit 4.4 to Dynex's Registration Statement on Form 8-A filed February 18, 2020).
10.40
Dynex Capital, Inc. Annual Cash Incentive Plan (effective as of January 1, 2020) (incorporated herein by reference to Exhibit 10.40 to Dynex’s Current Report on Form 8-K filed May 17, 2017)1, 2020).
10.3410.41
Amended and Restated Equity Distribution Agreement between Dynex Capital, Inc. 2020 Stock and JMP Securities LLC, dated March 31, 2017Incentive Plan, effective as of June 9, 2020 (incorporated herein by reference to Exhibit 10.3410.41 to Dynex'sDynex’s Current Report on Form 8-K filed April 3, 2017)June 9, 2020).
12.110.41.1
Statement Regarding ComputationForm of Ratio of Earnings to Fixed ChargesRestricted Stock Agreement for Non-Employee Directors (approved June 9, 2020) under the Dynex Capital, Inc. 2020 Stock and Ratio of Earnings to Combined Fixed Charges and Preferred Stock DividendsIncentive Plan (filed herewith).
31.1
Certification of principal executive officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).

31.2
Certification of principal financial officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).

32.1
Certification of principal executive officer and principal financial officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).

101The following materials from Dynex Capital, Inc.'s Quarterly Report on Form 10-Q for the three months ended SeptemberJune 30, 2017,2020, formatted in XBRL (ExtensibleiXBRL (Inline Extensible Business Reporting Language), filed herewith: (i) Consolidated Balance Sheets, (unaudited), (ii) Consolidated Statements of Comprehensive Income (unaudited)(Loss), (iii) Consolidated StatementStatements of Shareholders'Shareholders’ Equity, (unaudited), (iv) Consolidated Statements of Cash Flows, (unaudited), and (v) Notes to the Unaudited Consolidated Financial Statements.
104The cover page from Dynex Capital, Inc.'s Quarterly Report on Form 10-Q for the three months ended June 30, 2020, formatted in iXBRL (Inline Extensible Business Reporting Language) (included with Exhibit 101).



54


SIGNATURES


Pursuant to the requirements of Section 13 or 15(d) 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.
Date:August 3, 2020/s/ Byron L. Boston
Byron L. Boston
Chief Executive Officer, President,
Co-Chief Investment Officer, and Director
(Principal Executive Officer)
Date:August 3, 2020DYNEX CAPITAL, INC.
Date:November 3, 2017/s/ Byron L. Boston
Byron L. Boston
Chief Executive Officer, President,
Co-Chief Investment Officer, and Director
(Principal Executive Officer)
Date:November 3, 2017/s/ Stephen J. Benedetti
Stephen J. Benedetti
Executive Vice President, Chief Financial Officer and Chief Operating Officer
(Principal Financial Officer)







55