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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
|X| Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarter ended June 30, 2003
|_| Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
DYNEX CAPITAL, INC.
(Exact name of registrant as specified in its charter)
Commission file number 1-9819
Virginia 52-1549373
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
4551 Cox Road, Suite 300, Glen Allen, Virginia 23060-6740
(Address of principal executive offices) (Zip Code)
(804) 217-5800
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past ninety days.
|X| Yes |_| No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). |_| Yes |X| No
As of July 31, 2003, the registrant had 10,873,903 shares of common stock
outstanding with a par value of $.01 per share, which is the registrant's only
class of common stock.
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DYNEX CAPITAL, INC.
FORM 10-Q
INDEX
Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets at June 30, 2003
and December 31, 2002 (unaudited)..................................1
Condensed Consolidated Statements of Operations for the three
and six months ended June 30, 2003 and 2002 (unaudited) ..........2
Condensed Consolidated Statements of Cash Flows for
the six months ended June 30, 2003 and 2002 (unaudited) ..........3
Notes to Unaudited Condensed Consolidated Financial Statements.....4
Item 2. Management`s Discussion and Analysis of
Financial Condition and Results of Operations.....................11
Item 3. Quantitative and Qualitative Disclosures about Market Risk........21
Item 4. Controls and Procedures...........................................23
PART II. OTHER INFORMATION
Item 1. Legal Proceedings ................................................23
Item 2. Changes in Securities and Use of Proceeds.........................23
Item 3. Defaults Upon Senior Securities...................................24
Item 4. Submission of Matters to a Vote of Security Holders...............24
Item 5. Other Information.................................................25
Item 6. Exhibits and Reports on Form 8-K..................................25
SIGNATURES ..................................................................25
i
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED
BALANCE SHEETS (UNAUDITED)
(amounts in thousands except share data)
-------------------- ---- ---------------------
June 30, December 31,
2003 2002
-------------------- ---------------------
ASSETS
Cash and cash equivalents $ 13,998 $ 15,242
Other assets 5,487 4,747
-------------------- ---------------------
19,485 19,989
Investments:
Collateral for collateralized bonds:
Loans, net 1,670,793 1,818,577
Debt securities, available-for-sale 294,713 329,920
Other investments 51,469 54,322
Other loans 7,865 9,288
Securities 2,652 6,208
-------------------- ---------------------
2,027,492 2,218,315
-------------------- ---------------------
$ 2,046,977 $ 2,238,304
==================== =====================
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Collateralized bonds $ 1,852,882 $ 2,013,271
Senior notes 28,069 -
Accrued expenses and other liabilities 1,317 1,612
-------------------- ---------------------
1,882,268 2,014,883
-------------------- ---------------------
Commitments and contingencies (Note 11) - -
SHAREHOLDERS' EQUITY
Preferred stock, par value $.01 per share, 50,000,000 shares authorized:
9.75% Cumulative Convertible Series A, 493,595 and 992,038 issued and 11,274 22,658
outstanding, respectively ($16,178 and $31,353 aggregate liquidation
preference, respectively)
9.55% Cumulative Convertible Series B, 688,189 and 1,378,707 issued and 16,109 32,273
outstanding, respectively ($22,899 and $44,263 aggregate liquidation
preference, respectively)
9.73% Cumulative Convertible Series C, 684,893 and 1,383,532 issued and 19,630 39,655
outstanding, respectively ($28,045 and $54,634 aggregate liquidation
preference, respectively)
Common stock, par value $.01 per share, 100,000,000 shares authorized, 109 109
10,873,903 issued and outstanding
Additional paid-in capital 360,684 364,743
Accumulated other comprehensive loss (13,166) (17,472)
Accumulated deficit (229,931) (218,545)
-------------------- ---------------------
164,709 223,421
-------------------- ---------------------
$ 2,046,977 $ 2,238,304
==================== =====================
See notes to unaudited condensed consolidated financial statements.
1
DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED STATEMENTS
OF OPERATIONS (UNAUDITED)
(amounts in thousands except share and per share data)
------------------------------------- -------------------------------------
Three Months Ended June 30 Six Months Ended June 30
------------------------------------- -------------------------------------
2003 2002 2003 2002
---------------- ---------------- ---------------- ----------------
Interest income:
Collateral for collateralized bonds $ 35,715 $ 44,474 $ 73,470 $ 87,188
Other investments 30 44 59 55
Other loans 127 115 253 209
Securities 138 335 409 457
---------------- ---------------- ---------------- ----------------
36,010 44,968 74,191 87,909
Interest and related expense:
Collateralized bonds 27,461 31,796 55,220 63,762
Senior notes 730 941 984 1,972
Other 125 (23) 162 421
---------------- ---------------- ---------------- ----------------
28,316 32,714 56,366 66,155
---------------- ---------------- ---------------- ----------------
Net interest margin before provision for loan
losses 7,694 12,254 17,825 21,754
Provision for loan losses (18,040) (5,241) (23,884) (10,884)
---------------- ---------------- ---------------- ----------------
Net interest margin (10,346) 7,013 (6,059) 10,870
Impairment charges (200) (4,961) (2,205) (7,084)
Gain on sale of investments, net 556 77 1,010 173
Other 23 894 40 1,439
General and administrative expenses (2,151) (2,625) (4,172) (4,518)
---------------- ---------------- ---------------- ----------------
Net (loss) income (12,118) 398 (11,386) 880
Preferred stock (charge) benefit (1,214) (2,396) 9,230 (4,792)
---------------- ---------------- ---------------- ----------------
Net loss applicable to common shareholders $ (13,332) $ (1,998) $ (2,156) $ (3,912)
---------------- ---------------- ---------------- ----------------
Change in net unrealized loss during period on:
Investments classified as available-for-sale 3,486 (4,355) 5,425 (3,057)
Hedge instruments (679) 374 (1,119) 374
---------------- ---------------- ---------------- ----------------
Comprehensive loss $ (9,311) $ (3,583) $ (7,080) $ (1,803)
================ ================ ================ ================
Net loss per common share:
Basic and diluted $ (1.23) $ (0.18) $ (0.20) $ (0.36)
================ ================ ================ ================
Weighted average number of common shares
outstanding; basic and diluted 10,873,903 10,873,894 10,873,903 10,873,860
================ ================ ================ ================
See notes to unaudited condensed consolidated financial statements.
2
DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED STATEMENTS
OF CASH FLOWS (UNAUDITED)
(amounts in thousands)
-------------------------------------------------
Six Months Ended
June 30,
-------------------------------------------------
2003 2002
Operating activities:
Net (loss) income $ (11,386) $ 880
Adjustments to reconcile net (loss) income to net cash provided (used) by
operating activities:
Provision for loan losses 23,884 10,884
Impairment charges 2,205 7,084
Gain on sale of investments (1,010) (173)
Amortization and depreciation 2,904 7,209
Decrease (increase) in restricted cash 19 (18,624)
Net change in other assets, accrued expenses and other liabilities (2,285) (3,291)
---------------------- -----------------------
Net cash and cash equivalents provided by operating activities 14,331 3,969
---------------------- -----------------------
Investing activities:
Purchase of or advances on investments (1,064) (155,248)
Principal payments on collateral 156,174 251,139
Principal payments on loans 2,474 2,201
Payments received on securities and other investments 8,706 8,676
Proceeds from sales of securities and other investments 2,359 174
Other 177 (1,839)
---------------------- -----------------------
Net cash and cash equivalents provided by investing activities 168,826 105,103
---------------------- -----------------------
Financing activities:
Proceeds from issuance of bonds - 605,272
Principal payments on collateralized bonds (160,819) (676,634)
Repayment of senior notes (4,010) (11,966)
Retirement of preferred stock (19,553) -
---------------------- -----------------------
Net cash and cash equivalents used for financing activities (184,382) (83,328)
---------------------- -----------------------
Net (decrease) increase in cash and cash equivalents (1,225) 25,744
Cash and cash equivalents (excluding restricted cash) at beginning of period 15,077 7,129
---------------------- -----------------------
Cash and cash equivalents (excluding restricted cash) at end of period 13,852 32,873
Restricted cash 146 22,958
---------------------- -----------------------
Total cash and cash equivalents $ 13,998 $ 55,831
====================== =======================
Supplement disclosures of cash flow information:
Cash paid for interest $ 55,104 $ 66,721
=================================================
See notes to unaudited condensed consolidated financial statements.
3
DYNEX CAPITAL, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2003
(amounts in thousands except share and per share data)
NOTE 1 - BASIS OF PRESENTATION
The accompanying condensed consolidated financial statements have been prepared
in accordance with the instructions to Form 10-Q and do not include all of the
information and notes required by accounting principles generally accepted in
the United States of America, hereinafter referred to as "generally accepted
accounting principles," for complete financial statements. The condensed
consolidated financial statements include the accounts of Dynex Capital, Inc.
and its qualified real estate investment trust ("REIT") subsidiaries and taxable
REIT subsidiary ("Dynex" or the "Company"). All inter-company balances and
transactions have been eliminated in consolidation of Dynex.
The Company believes it has complied with the requirements for qualification as
a REIT under the Internal Revenue Code (the "Code"). To the extent the Company
qualifies as a REIT, it generally will not be subject to federal income tax on
the amount of its income or gain that is distributed as dividends to
shareholders.
In the opinion of management, all significant adjustments, consisting of normal
recurring accruals, considered necessary for a fair presentation of the
condensed consolidated financial statements have been included. The financial
statements presented are unaudited. Operating results for the three and six
months ended June 30, 2003 are not necessarily indicative of the results that
may be expected for the year ending December 31, 2003.
The preparation of financial statements, in conformity with generally accepted
accounting principles, requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenue and expenses during the reported period. Actual
results could differ from those estimates. The primary estimates inherent in the
accompanying condensed consolidated financial statements are discussed below.
The Company uses estimates in establishing fair value for its financial
instruments as discussed in Note 2.
The Company also has credit risk on certain investments in its portfolio as
discussed in Note 7. An allowance for loan losses has been estimated and
established for current existing losses based on management's judgment. The
allowance for loan losses is evaluated and adjusted periodically by management
based on the actual and projected timing and amount of credit losses. Provisions
made to increase the allowance related to credit risk are presented as provision
for loan losses in the accompanying condensed consolidated statements of
operations. The Company's actual credit losses may differ from those estimates
used to establish the allowance.
Certain reclassifications have been made to the financial statements for 2002 to
conform to the presentation for 2003.
NOTE 2 - FAIR VALUE
Securities classified as available-for-sale are carried in the accompanying
financial statements at estimated fair value. Estimates of fair value for
securities may be based on market prices provided by certain dealers. Estimates
of fair value for certain other securities are determined by calculating the
present value of the projected cash flows of the instruments using market-based
discount rates, prepayment rates and credit loss assumptions. The estimate of
fair value for securities pledged as collateral for collateralized bonds is
determined by calculating the present value of the projected cash flows of the
instruments using prepayment rate assumptions and credit loss assumptions based
on historical experience and estimated future activity, and using discount rates
commensurate with those believed would be used by third parties. Such discount
rate used in the determination of fair value of securities pledged as collateral
for collateralized bonds was 16% at June 30, 2003 and December 31, 2002.
Prepayment rate assumptions at June 30, 2003, and December 31, 2002, were
generally at a "constant prepayment rate," or CPR ranging from 30%-40% for 2003
and 30%-45% for 2002 for collateral for collateralized bonds consisting of
securities backed by single-family mortgage loans, and a CPR equivalent of 8%
4
for 2003 and 11% for 2002 for collateral for collateralized bonds consisting of
securities backed by manufactured housing loans. CPR assumptions for each year
are based in part on the actual prepayment rates experienced for the prior
six-month period and in part on management's estimate of future prepayment
activity. The loss assumptions utilized vary depending on the collateral
pledged.
NOTE 3 - NET (LOSS) INCOME PER COMMON SHARE
Net (loss) income per common share is presented on both a basic net income per
common share and diluted net (loss) income per common share basis. Diluted net
(loss) income per common share assumes the conversion of the convertible
preferred stock into common stock, using the if-converted method and stock
appreciation rights to the extent that there are rights outstanding, using the
treasury stock method, but only if these items are dilutive. The preferred stock
is convertible into one share of common stock for two shares of preferred stock.
The following table reconciles the numerator and denominator for both basic and
diluted net (loss) income per common share for the three and six months ended
June 30, 2003 and 2002.
- ----------------------------------------------------------------------------------------------------------------------------
Three Months Ended June 30, Six Months Ended June 30,
----------------------------------------------------------------------------------------------
2003 2002 2003 2002
----------------------------------------------------------------------------------------------
Weighted- Weighted- Weighted- Weighted-
Average Average Average Average
(Loss) Number (Loss) Number (Loss) Number (Loss) Number
Income Of Shares Income Of Shares Income Of Shares Income Of Shares
----------- ----------------------- ----------------------- ---------------------- -----------
Net (loss) income $(12,118) $ 398 $(11,386) $ 880
Preferred stock (charges) (1,214) (2,396) 9,230 (4,792)
benefit
------------- ----------- ----------- ----------
Net loss applicable to common
shareholders $(13,332) 10,873,903 $ (1,998) 10,873,894 $ (2,156) 10,873,903 $(3,912) 10,873,860
=========== ======================= ======================= ====================== ===========
Net loss per share:
Basic and diluted $ (1.23) $ (0.18) $ (0.20) $ (0.36)
============ ============ ============ ===========
Reconciliation of shares not
included in calculation of
earnings per share due to
antidilutive effect
Series A $ (289) 246,798 $ (580) 496,019 $ (480) 328,035 $(1,161) 496,019
Series B (403) 344,095 (806) 689,362 (671) 456,637 (1,612) 689,362
Series C (500) 342,447 (1,010) 691,766 (830) 456,313 (2,019) 691,766
Expense and incremental
shares of stock (32) 18,202 (55) 17,629 (34) 18,024 (85) 17,629
appreciation rights
----------- ----------------------- ----------------------- ---------------------- -----------
$ (1,224) 951,542 $ (2,451) 1,897,227 $ (2,015) 1,259,009 $(4,877) 1,894,776
=========== ======================= ======================= ====================== ===========
- --------------------------------------------------------------------------------
NOTE 4 - COLLATERAL FOR COLLATERALIZED BONDS
The following table summarizes the types of collateral for collateralized bonds
as of June 30, 2003 and December 31, 2002:
- --------------------------------------- -------------------- -- ----------------
June 30, December 31,
2003 2002
- --------------------------------------- -------------------- -- ----------------
Loans, at amortized cost $ 1,710,481 $ 1,844,025
Allowance for loan losses (39,688) (25,448)
- --------------------------------------- -------------------- -- ----------------
Loans, net 1,670,793 1,818,577
Debt securities, at fair value 294,713 329,920
- --------------------------------------- -------------------- -- ----------------
$ 1,965,506 $ 2,148,497
- --------------------------------------- -------------------- -- ----------------
5
The following table summarizes the amortized cost basis, gross unrealized gains
and losses and estimated fair value of debt securities pledged as collateral for
collateralized bonds as of June 30, 2003 and December 31, 2002:
- ------------------------------------------- ------------------ -----------------
June 30, December 31,
2003 2002
- ------------------------------------------- ------------------ -----------------
Debt securities, at amortized cost $ 292,136 $ 329,621
Gross unrealized gains 2,577 322
Gross unrealized losses - (23)
- ------------------------------------------- ------------------ -----------------
Estimated fair value $ 294,713 $ 329,920
- ------------------------------------------- ------------------ -----------------
The components of collateral for collateralized bonds at June 30, 2003 and
December 31, 2002 are as follows:
------------------------------------- ---------------------------------------- -- ---------------------------------------
June 30, 2003 December 31, 2002
---------------------------------------- ---------------------------------------
Loans, Debt Total Loans, Debt Total
net Securities net Securities
------------------------------------- ------------- ------------ ------------- ------------- ------------ ------------
Collateral $1,647,308 $289,084 $1,936,392 $1,791,679 $325,819 $2,117,498
Funds held by trustees 130 269 399 140 515 655
Accrued interest receivable 10,674 1,749 12,423 11,741 2,120 13,861
Unamortized premiums and discounts,
net 12,681 1,034 13,715 15,017 1,167 16,184
Unrealized gain, net - 2,577 2,577 - 299 299
------------------------------------- ------------- ------------ ------------- ------------- ------------ ------------
$1,670,793 $294,713 $1,965,506 $1,818,577 $329,920 $2,148,497
------------------------------------- ------------- ------------ ------------- -- ------------- ------------ ------------
NOTE 5 - OTHER INVESTMENTS
The following table summarizes the Company's other investments as of June 30,
2003 and December 31, 2002:
- -------------------------------------------------------------- --------------- -- ------------------
June 30, 2003 December 31, 2002
--------------- ------------------
Delinquent property tax receivables and securities $ 56,755 $ 61,572
Discount recorded as adjustment to other comprehensive loss (10,195) (12,640)
--------------- ------------------
Amortized cost basis of receivables, net 46,560 48,932
Real estate owned 4,895 5,251
Other 14 139
- -------------------------------------------------------------- --------------- ------------------
$ 51,469 $ 54,322
- -------------------------------------------------------------- --------------- -- ------------------
Delinquent property tax receivables and securities have been classified as
non-accrual, and all cash collections on such receivables are applied against
the principal balance of the Company's investment. During the six months ended
June 30, 2003, the Company collected an aggregate $5,850, including net sales
proceeds from related real estate owned. The Company also amortized $2,444 of
discount on the carrying value of the delinquent property tax receivables as a
reduction to accumulate other comprehensive loss. Delinquent property tax
securities included in Other Investments are classified as held-to-maturity and
are carried at amortized cost.
6
NOTE 6 - SECURITIES
The following table summarizes Dynex's amortized cost basis of securities
classified as held-to-maturity and fair value of securities classified as
available-for-sale, as of June 30, 2003 and December 31, 2002:
- --------------------------------------------------------------------------------
June 30, December 31,
2003 2002
- --------------------------------------------------------------------------------
Securities:
Fixed-rate mortgage securities, available-for-sale $ 978 $ 1,268
Mortgage-related securities, available-for-sale 410 3,770
- --------------------------------------------------------------------------------
1,388 5,038
Gross unrealized gains 306 935
Gross unrealized losses (153) (1,409)
- --------------------------------------------------------------------------------
Securities, available-for-sale 1,541 4,564
Asset-backed security, held-to-maturity 1,111 1,644
- --------------------------------------------------------------------------------
$ 2,652 $ 6,208
- --------------------------------------------------------------------------------
NOTE 7 - ALLOWANCE FOR LOAN LOSSES
The Company reserves for credit risk where it has exposure to losses on loans in
its investment portfolio. The following table summarizes the aggregate activity
for the allowance for loan losses of principal on investments for the six months
ended June 30, 2003 and 2002:
- ---------------------------------- ---------------------------------------------
Six Months Ended June 30,
- ---------------------------------- ---------------------------------------------
2003 2002
- ---------------------------------- ----------------------- ---------------------
Allowance at beginning of year $ 25,472 $ 22,147
Provision for loan losses 23,884 10,884
Credit losses, net of recoveries (9,645) (11,513)
- ---------------------------------- ----------------------- ---------------------
Allowance at end of year $ 39,711 $ 21,518
- ---------------------------------- ----------------------- ---------------------
The Company continues to experience unfavorable results in its manufactured
housing loan portfolio in terms of elevated delinquencies and loss severity on
repossessed units. For the six months ended June 30, 2003, the Company added
$23,884 in provisions for loan losses, substantially all of which relates to the
manufactured housing loan portfolio. Included in this amount is $14,400 in
provision for loan losses recorded in June 2003 specifically for currently
existing credit losses within outstanding manufactured housing loans that are
current as to payment but which the Company has determined to be impaired.
Previously, the Company had not considered current loans to be impaired under
generally accepted accounting principles and therefore had not previously
provide for these loans. Continued worsening trends in both the industry as a
whole and the Company's pools of manufactured housing loans prompted the Company
to prepare extensive analysis on these pools of loans. The Company has not
originated any new manufactured housing loans since 1999, and has extensive
empirical data on the historical performance of this static pool of loans. The
Company analyzed performance and default activity for loans that were current at
various points in time over the last 36 months, and based on that analysis,
identified default trends on these loans. The Company also considered current
market conditions in this analysis, with the expectation that these market
conditions would continue for the foreseeable future. Given this new observable
data, the Company now believes the inclusion of amounts in the provision for
loan losses for loans which are current as to payment is an appropriate
application of the definition of impairment within generally accepted accounting
principles, and has accounted for the amount as a change in accounting estimate
and accordingly recorded the amount as additional provision for loan losses.
7
NOTE 8 - SENIOR NOTES
The following table summarizes Dynex's recourse debt outstanding at June 30,
2003 and December 31, 2002:
- ------------------------------------ -------------------- ----------------------
June 30, 2003 December 31, 2002
- ------------------------------------ -------------------- ----------------------
9.50% Senior Notes (due 2/28/2005) $ 28,069 $ -
- ------------------------------------ -------------------- ----------------------
During the quarter ended March 31, 2003, the Company issued $32,079 of 9.50%
senior unsecured notes due February 2005 (the "February 2005 Senior Notes") in
connection with a tender offer on the Company's Preferred Stock. The February
2005 Senior Notes were issued in exchange for 1,156,891 shares of Series A,
Series B and Series C Preferred Stock. See Note 9 for further discussion.
Principal payments in the amount of $4,010, along with interest payments at a
rate of 9.50% per annum, are due quarterly beginning May 2003, with final
payment due on February 28, 2005. The Company at its option can prepay the
February 2005 Senior Notes in whole or in part, without penalty, at any time.
The February 2005 Senior Notes prohibit distributions on the Company's capital
stock until they are fully repaid, except distributions necessary for the
Company to maintain REIT status.
NOTE 9 - PREFERRED STOCK
As of June 30, 2003 and December 31, 2002, the total liquidation preference on
the Preferred Stock was $67,122 and $130,251, respectively, and the total amount
of dividends in arrears on Preferred Stock was $17,868 and $31,157,
respectively. Individually, the amount of dividends in arrears on the Series A,
the Series B and the Series C were $4,331 ($8.77 per Series A share), $6,039
($8.77 per Series B share) and $7,499 ($10.95 per Series C share), respectively
at June 30, 2003 and $7,544 ($7.60 per Series A share), $10,485 ($7.60 per
Series B share) and $13,128 ($9.49 per Series C share), respectively at December
31, 2002.
On February 28, 2003, the Company completed a tender offer for shares of its
Series A, Series B and Series C Preferred Stock. The Company purchased for cash
188,940 shares of its Series A Preferred Stock, 272,977 shares of its Series B
Preferred Stock and 268,792 shares of its Series C Preferred Stock for a total
cash payment of $19,286. In addition, the Company exchanged $32,079 of February
2005 Senior Notes for an additional 309,503 shares of Series A Preferred Stock,
417,541 shares of Series B Preferred Stock and 429,847 shares of Series C
Preferred Stock. The tender offer resulted in a preferred stock benefit of
$12,438 comprised of the elimination of dividends-in-arrears of $16,475 for the
shares tendered, less the premium paid on the Preferred Stock in excess of the
book value of such Preferred Stock, of $4,059.
NOTE 10 - DERIVATIVE FINANCIAL INSTRUMENTS
In June 2002, the Company entered into an interest rate swap which matures on
June 28, 2005, to mitigate its interest rate risk exposure on $100,000 in
notional value of its variable rate collateralized bonds, which finance a like
amount of fixed rate assets. Under the agreement, the Company will pay interest
at a fixed rate of 3.73% on the notional amount and will receive interest based
on One-Month LIBOR on the same amount. This contract has been treated as a cash
flow hedge with gains and losses associated with the change in the value of the
hedge being reported as a component of comprehensive income. During the six
months ended June 30, 2003, the Company recognized $388 in comprehensive loss on
this hedge instrument and incurred $630 of interest expense related to net
payments made on this position. At June 30, 2003, the aggregate accumulated
other comprehensive loss on this hedge instrument was $4,372. As the repricing
dates, interest rate indices and formulae for computing net settlements of the
interest rate swap agreement match the corresponding terms of the underlying
collateralized bonds being hedged, no ineffectiveness is assumed on this
agreement and, accordingly, any prospective gains or losses are included in
Other Comprehensive Income until such time as all interest rate swap payments
have been settled.
In October 2002, the Company entered into a synthetic three-year amortizing
interest-rate swap with an initial notional balance of approximately $80,000 and
ending in September 2005 with a $5,000 notional contract to mitigate its
exposure to rising interest rates on a portion of its variable rate
collateralized bonds, which finance a like amount of fixed rate assets. This
contract is accounted for as a cash flow hedge with gains and losses associated
with the change in the value of the hedge being reported as a component of
8
comprehensive income. At June 30, 2003, the current notional balance of the
amortizing synthetic swap was $52,000, and the remaining weighted-average
fixed-rate payable by the Company under the terms of the synthetic swap was
2.87%. During the six months ended June 30, 2003, the Company recognized $496 in
other comprehensive loss for the synthetic interest-rate swap and incurred $108
of interest expense related to net payments made on this position and $45 of
unamortized losses. At June 30, 2003 and December 31, 2002, the aggregate
accumulated other comprehensive loss on this hedge instrument was $1,037 and
$477, respectively.
The Company evaluated hedge effectiveness and determined that there was no
material ineffectiveness to reflect in earnings. Assuming no change in
Eurodollar rates from June 30, 2003, over the next twelve months, the Company
expects to reclassify $553 into earnings.
NOTE 11 - COMMITMENTS AND CONTINGENCIES
GLS Capital, Inc. ("GLS"), a subsidiary of the Company, together with the County
of Allegheny, Pennsylvania ("Allegheny County"), were defendants in a lawsuit in
the Commonwealth Court of Pennsylvania (the "Commonwealth Court"), the appellate
court of the state of Pennsylvania. Plaintiffs were two local businesses seeking
status to represent as a class, delinquent taxpayers in Allegheny County whose
delinquent tax liens had been assigned to GLS. Plaintiffs challenged the right
of Allegheny County and GLS to collect certain interest, costs and expenses
related to delinquent property tax receivables in Allegheny County, and whether
the County had the right to assign the delinquent property tax receivables to
GLS and therefore employ procedures for collection enjoyed by Allegheny County
under state statute. This lawsuit was related to the purchase by GLS of
delinquent property tax receivables from Allegheny County in 1997, 1998, and
1999. In July 2001, the Commonwealth Court issued a ruling that addressed, among
other things, (i) the right of GLS to charge to the delinquent taxpayer a rate
of interest of 12% per annum versus 10% per annum on the collection of its
delinquent property tax receivables, (ii) the charging of a full month's
interest on a partial month's delinquency; (iii) the charging of attorney's fees
to the delinquent taxpayer for the collection of such tax receivables, and (iv)
the charging to the delinquent taxpayer of certain other fees and costs. The
Commonwealth Court in its opinion remanded for further consideration to the
lower trial court items (i), (ii) and (iv) above, and ruled that neither
Allegheny County nor GLS had the right to charge attorney's fees to the
delinquent taxpayer related to the collection of such tax receivables. The
Commonwealth Court further ruled that Allegheny County could assign its rights
in the delinquent property tax receivables to GLS, and that plaintiffs could
maintain equitable class in the action. In October 2001, GLS, along with
Allegheny County, filed an Application for Extraordinary Jurisdiction with the
Supreme Court of Pennsylvania, Western District appealing certain aspects of the
Commonwealth Court's ruling. In March 2003, the Supreme Court issued its opinion
as follows: (i) the Supreme Court determined that GLS can charge delinquent
taxpayers a rate of 12% per annum; (ii) the Supreme Court remanded back to the
lower trial court the charging of a full month's interest on a partial month's
delinquency; (iii) the Supreme Court revised the Commonwealth Court's ruling
regarding recouping attorney fees for collection of the receivables indicating
that the recoupment of fees requires a judicial review of collection procedures
used in each case; and (iv) the Supreme Court upheld the Commonwealth Court's
ruling that GLS can charge certain fees and costs, while remanding back to the
lower trial court for consideration the facts of each individual case. Finally,
the Supreme Court remanded to the lower trial court to determine if the
remaining claims can be resolved as a class action. No hearing date has been set
for the issues remanded back to the lower trial court In August 2003, the
Pennsylvania legislature signed a bill amending and clarifying certain
provisions of the Pennsylvania statute governing GLS' right to the collection of
certain interest, costs and expenses. The bill is expected to be signed into
law. The law is retroactive to 1996, and amends and clarifies that as to items
(ii)-(iv) noted above by the Supreme Court, that GLS can charge a full month's
interest on a partial month's delinquency, that GLS can charge the taxpayer for
legal fees, and that GLS can charge certain fees and costs to the taxpayer at
redemption.
The Company and Dynex Commercial, Inc. ("DCI"), formerly an affiliate of the
Company and now known as DCI Commercial, Inc., are defendants in state court in
Dallas County, Texas in the matter of Basic Capital Management et al ("BCM")
versus Dynex Commercial, Inc. et al. The suit was filed in April 1999 originally
against DCI, and in March 2000, BCM amended the complaint and added the Company.
The current complaint alleges that, among other things, DCI and the Company
failed to fund tenant improvement or other advances allegedly required on
various loans made by DCI to BCM, which loans were subsequently acquired by the
Company; that DCI breached an alleged $160,000 "master" loan commitment entered
into in February 1998 and a second alleged loan commitment of approximately
$9,000; that DCI and the Company made negligent misrepresentations in connection
with the alleged $160,000 commitment; and that DCI and the Company fraudulently
induced BCM into canceling the alleged $160,000 master loan commitment in
January 1999. Plaintiff BCM is seeking damages approximating $40,000, including
approximately $36,500 for DCI's breach of the alleged $160,000 master loan
9
commitment, approximately $1,600 for alleged failure to make additional tenant
improvement advances, and approximately $1,900 for DCI's not funding the alleged
$9,000 commitment. DCI and the Company are vigorously defending the claims on
several grounds. The Company was not a party to the alleged $160,000 master
commitment or the alleged $9,000 commitment. The Company has filed a
counterclaim for damages approximating $11,000 against BCM. Commencement of the
trial of the case in Dallas, Texas is anticipated in the first quarter of 2004.
During the second quarter 2003, BCM filed suit against the Company and DCI as
third-party defendants in related litigation in the United States District Court
Eastern District of Louisiana in the matter Kelly Investment, Inc. versus BCM et
al. The Company sold certain BCM related loans on commercial properties located
in Louisiana to Kelly Investment, Inc. in 2000, and Kelly Investment, Inc.
subsequently filed suit against BCM in 2001. No date has been set for trial in
Louisiana. Claims made by BCM in the US District Court of Louisiana against the
Company and DCI are substantially similar to those being made in Dallas County,
Texas.
Although no assurance can be given with respect to the ultimate outcome of the
above litigation, the Company believes the resolution of these lawsuits, or any
other claims against the Company, will not have a material effect on the
Company's consolidated balance sheet, but could materially affect consolidated
results of operations in a given year.
NOTE 12 - RECENT ACCOUNTING PRONOUNCEMENTS
In April 2003, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards (SFAS) No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." Effective after June 30, 2003,
this Statement amends FASB Statement No. 133, "Accounting for Derivative
Instruments and Hedging Activities", to provide clarification of financial
accounting and reporting for derivative instruments, including certain
derivative instruments embedded in other contracts. In particular, this
Statement (1) clarifies under what circumstances a contract with an initial net
investment meets the characteristic of a derivative discussed in paragraph 6(b)
of Statement 133, (2) clarifies when a derivative contains a financing
component, (3) amends the definition of an underlying to conform it to language
used in FIN No. 45, "Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others," and (4)
amends certain other existing pronouncements. Those changes will result in more
consistent reporting of contracts as either derivatives or hybrid instruments.
The Company's adoption of SFAS No. 149 in June 2003 has not had a significant
impact on its financial position, results of operations, or cash flows.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity." This statement
is effective for financial instruments entered into or modified after May 31,
2003; otherwise effective at the beginning of the first interim period beginning
after June 15, 2003, except for mandatorily redeemable financial instruments of
nonpublic entities which are subject to the provisions of this Statement for the
first fiscal period beginning after December 15, 2003. This Statement amends
SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" and
SFAS No. 128, "Earnings per Share", to establishes standards outlining how to
classify and measure certain financial instruments with characteristics of both
liabilities and equity. It requires that certain financial instruments that were
previously classified as equity now be classified as a liability (or, in some
circumstances, as an asset). The Company is reviewing the implications of SFAS
No. 150 but does not believe that its adoption will have a significant impact on
its financial position, results of operations, or cash flows.
In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable Interest
Entities - an interpretation of ARB No. 51," which addresses consolidation of
variable interest entities. FIN No. 46 expands the criteria for consideration in
determining whether a variable interest entity should be consolidated by a
business entity, and requires existing unconsolidated variable interest entities
(which include, but are not limited to, Special Purpose Entities, or SPEs) to be
consolidated by their primary beneficiaries if the entities do not effectively
disperse risks among parties involved. This interpretation applies immediately
to variable interest entities created after January 31, 2003, and to variable
interest entities in which an enterprise obtains an interest after that date. It
applies in the first fiscal year or interim period beginning after June 15,
2003, to variable interest entities in which an enterprise holds a variable
interest that it acquired before February 1, 2003. The adoption of FIN No. 46
did not have a material effect on the Company's results of operations, cash
flows or financial position.
10
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Dynex Capital, Inc. was incorporated in the Commonwealth of Virginia in 1987.
References to "Dynex", or "the Company" contained herein refer to Dynex Capital,
Inc. together with its qualified real estate investment trust (REIT)
subsidiaries and taxable REIT subsidiary. Dynex is a financial services company,
which invests in loans and securities consisting of or secured by, principally
single family mortgage loans, commercial mortgage loans, manufactured housing
installment loans and delinquent property tax receivables. The loans and
securities in which the Company invests have generally been pooled and pledged
(i.e. securitized) as collateral for non-recourse bonds ("collateralized
bonds"), which provides long-term financing for such loans while limiting
credit, interest rate and liquidity risk. The Company has elected to be treated
as a REIT for federal income tax purposes under the Internal Revenue Code of
1986, as amended, and, as such, must distribute substantially all of its taxable
income to shareholders. Provided that the Company meets all of the prescribed
Internal Revenue Code requirements for a REIT, the Company will generally not be
subject to federal income tax.
The Company's primary focus in the near term is on maximizing cash flows from
its investment portfolio, opportunistically calling securities pursuant to
clean-up calls if the underlying collateral has value for the Company and
securing third-party servicing contracts to leverage its delinquent property tax
receivables platform. During the first six months of 2003, the Company's
investment portfolio generated net cash flows to the Company of $29.8 million
including $15.5 million in the second quarter. Depending on prepayment activity
on the underlying assets in the investment portfolio, collection activity on the
delinquent property tax receivable portfolio and the absolute level of
short-term interest rates which directly impacts the Company's financing costs,
the Company estimates that cash flow for the balance of 2003 will be similar to
amounts generated during the first six months of the year. The Company is
utilizing this cash flow to partially redeem $10 million of its 9.50% Senior
Notes due February 2005 early.
The Company has also agreed to principal terms for the servicing of $7.5 million
of liens on real estate for a regional utility in Pennsylvania. The Company will
be compensated based on the results of its collection efforts. Given the
existing infrastructure now in place to service the Company's investment in
property tax receivables, the incremental cost to service these liens is
marginal. The Company will seek to gain other third-party servicing contracts in
the future.
The Company also owns the right to call adjustable-rate and fixed-rate mortgage
pass-through securities previously issued and sold by the Company once the
outstanding balance of such securities reaches a call trigger, generally either
10% or less of the original amount issued or a specified date. During the
quarter ended June 30, 2003, the Company called approximately $26.5 million of
securities, and subsequently sold the underlying seasoned single-family mortgage
loan collateral at a gain of $1.0 million. The Company also initiated a call in
July 2003 resulting in the acquisition of $23 million in single-family seasoned
loan collateral and subsequently sold approximately $20 million of the loans. At
July 31, 2003, the aggregate callable balance of such securities at the time of
the projected call is approximately $60 million, relating to three securities.
For $30 million of these securities a third-party also owns the call rights and
there can be no assurances that the Company will be able to call these
securities as intended. In addition, the Company may or may not elect to call
one or more of these securities when they are eligible to call. The Company is
also exploring obtaining financing to call these securities for its investment
portfolio, but no assurances can be given as to the success of obtaining such
financing.
The Board of Directors continues to evaluate alternatives for the use of the
Company's cash flow in an effort to improve overall shareholder value. To that
end, the Board has formed a committee to review possible strategic alternatives.
Such review may include a number of alternatives, including the acquisition of a
new business. The Company has a net operating loss carryforward of approximately
$120 million which can be utilized to offset REIT distribution requirements,
other than excess inclusion income, which would allow the Company to retain
capital for investment in a new strategic alternative. In addition, the Company
could use the net operating loss carryforward to shelter taxable income from
income tax for any taxable-REIT subsidiary or for the Company itself if it were
to forego its REIT status. The committee of the Board also continues to review
various alternatives with respect to its capital structure, including the early
redemption of the Company's 9.50% Senior Notes and its remaining Preferred Stock
and associated dividends-in-arrears.
11
FINANCIAL CONDITION
(amounts in thousands except per share data)
- ---------------------------------------------------------------------- -------------------------- --------------------------
June 30, 2003 December 31, 2002
- ---------------------------------------------------------------------- -------------------------- --------------------------
Investments:
Collateral for collateralized bonds $ 1,965,506 $ 2,148,497
Other investments 51,469 54,322
Other loans 7,865 9,288
Securities 2,652 6,208
Collateralized bonds 1,852,882 2,013,271
Senior notes 28,069 -
Shareholders' equity 164,709 223,421
Common book value per share (inclusive of dividends in arrears) 8.97 8.57
- ---------------------------------------------------------------------- -------------------------- --------------------------
Collateral for collateralized bonds. As of June 30, 2003, the Company had 21
series of collateralized bonds outstanding. The collateral for collateralized
bonds decreased to $1.97 billion at June 30, 2003 compared to $2.15 billion at
December 31, 2002. This decrease of $183.0 million is primarily the result of
$156.2 million in principal paydowns on the collateral, $23.5 million of
additions to allowance for loan losses, $1.5 million of impairment charges and
$2.4 million of net premium amortization.
Other investments. Other investments at June 30, 2003 consist primarily of
delinquent property tax receivables. Other investments decreased from $54.3
million at December 31, 2002 to $51.5 million at June 30, 2003. This decrease is
primarily the result of pay-downs of delinquent property tax receivables which
totaled $5.8 million, and sales of real estate owned properties of $0.7 million.
These decreases were partially offset by the amortization of discounts of $2.3
million recorded to accumulated other comprehensive loss and additional advances
for collections of $1.3 million.
Other loans. Other loans decreased by $1.4 million from $9.3 million at December
31, 2002 to $7.9 million at June 30, 2003 principally as the result of pay-downs
during the quarter.
Securities. Securities decreased during the six months ended June 30, 2003 by
$3.5 million, to $2.7 million at June 30, 2003 from $6.2 million at December 31,
2002 due to principal payments of $3.6 million and the sale of six securities
with a book value of $1.2 million, partially offset by $1.0 million of net
discount amortization.
Collateralized bonds. Collateralized bonds decreased $160.4 million, from $2.0
billion at December 31, 2002 to $1.9 billion at June 30, 2003. This decrease was
primarily a result of principal payments received of $156.2 million on the
associated collateral pledged which were used to pay down the collateralized
bonds in accordance with the respective indentures. Additionally, for certain
securitizations, surplus cash in the amount of $4.5 million was retained within
the security structure and used to repay collateralized bonds outstanding,
instead of being released to the Company. For certain other securitizations,
surplus cash in the amount of $2.6 million was retained to cover losses, as
certain performance triggers were not met in such securitizations.
Senior notes. The $32.1 million of February 2005 Senior Notes issued in exchange
for Preferred Stock in February 2003 decreased to $28.0 million as of June 30,
2003 with the payment of the first quarterly payment of $4.0 million.
Shareholders' equity. Shareholders' equity decreased to $164.7 million at June
30, 2003 from $223.4 million at December 31, 2002. This decrease was primarily
the result of a $51.6 million retirement of preferred shares in connection with
the tender offer completed in February 2003, net loss of $11.4 million and $1.1
million of deferred losses on hedging instruments during the period. This
decrease was partially offset by a net decrease in accumulated other
comprehensive loss due to an unrealized gain on investments available-for-sale
of $5.4 million.
12
RESULTS OF OPERATIONS
- ----------------------------------------- --- ------------------------------------- --- ------------------------------------
(amounts in thousands except per share Three months ended June 30, Six months ended June 30,
information)
- ----------------------------------------- ------------------------------------- ------------------------------------
2003 2002 2003 2002
- ----------------------------------------- ---------------- ---------------- ---------------- ---------------
Net interest margin $ (10,346) $ 7,013 $ (6,059) $ 10,870
Impairment charges (200) (4,961) (2,205) (7,084)
Gain on sales of investments, net 556 77 1,010 173
General and administrative expenses (2,151) (2,625) (4,172) (4,518)
Net (loss) income (12,118) 399 (11,386) 880
Preferred stock (charge) benefit (1,214) (2,396) 9,230 (4,792)
Net loss applicable to common
shareholders (13,322) (1,998) (2,156) (3,912)
Basic and diluted net loss per common
share $(1.23) $(0.18) $(0.20) $(0.36)
- ----------------------------------------- --- ---------------- --- ---------------- --- ---------------- --- ---------------
Three and Six Months Ended June 30, 2003 Compared to Three and Six Months Ended
June 30, 2002. Net income and net loss per common share decreased during the six
months ended June 30, 2003 as compared to the same period in 2002. The decrease
in net income is primarily the result of additions of $23.9 million to
provisions for loan losses. Included in the this amount is $14,400 in provision
for loan losses recorded in June 2003 specifically for currently existing credit
losses within outstanding manufactured housing loans that are current as to
payment but which the Company has determined to be impaired. Previously, the
Company had not considered current loans to be impaired under generally accepted
accounting principles and therefore had not previously provide for these loans.
Continued worsening trends in both the industry as a whole and the Company's
pools of manufactured housing loans prompted the Company to prepare extensive
analysis on these pools of loans. The Company has not originated any new
manufactured housing loans since 1999, and has extensive empirical data on the
historical performance of this static pool of loans. The Company analyzed
performance and default activity for loans that were current at various points
in time over the last 36 months, and based on that analysis, identified default
trends on these loans. The Company also considered current market conditions in
this analysis, with the expectation that these market conditions would continue
for the foreseeable future. Given this new observable data, the Company now
believes the inclusion of amounts in the provision for loan losses for loans
which are current as to payment is an appropriate application of the definition
of impairment within generally accepted accounting principles, and has accounted
for the amount as a change in accounting estimate and accordingly recorded the
amount as additional provision for loan losses. Offsetting this decline was
decreased impairment charges of approximately $4.9 million and incremental net
gains on sales of investments of $1.0 million for the six months ended June 30,
2003 compared to the same periods in 2002. Net loss to common shareholders
decreased by $1.8 million or $0.16 per common share, mostly due to preferred
stock benefits from the tender offer completed in February 2003.
Net (loss) income decreased to ($12.1) million from $0.4 million for the three
months ended June 30, 2003 compared to the same period for 2002. In addition net
loss to common shareholders increased by $11.3 million or $1.05 per common share
during the three months ended June 30, 2003 compared to the same period for
2002. The decrease in net income and the increase in net loss to common
shareholders resulted principally from a decline in net interest margin, as
discussed below. This increased loss was partially offset by a decrease in
other-than-temporary impairment charges of $4.7 million and net gains on sales
of portfolio assets of $0.5 million compared to the same period in 2002
Net interest margin for the three and six months ended June 30, 2003 decreased
to $(10.3) million and $(6.1) million from $7.0 million and $10.9 million,
respectively for the same period in 2002. This decrease was primarily the result
of higher provision for loan losses for 2003 including the $14.4 million
addition to provision for loan losses, as discussed above. Net interest margin
was also negatively impacted during the three and six months ended June 30, 2003
by a decline in net interest spread and a decline in interest earning assets
compared to the three and six months ended June 30, 2002.
Impairment charges declined by $4.7 million and $4.9 million, respectively, for
the three months and the six months ended June 30, 2003 from the same period
last year. This decrease was primarily a result of losses recorded in the amount
of $1.9 million in 2002 on valuation adjustments on loans held-for-sale which
were not included in the SASCO 2002-9 securitization completed in April 2002 and
13
a decrease of $3.1 million related to other-than-temporary impairment charges on
a debt security comprised largely of manufactured housing loans.
General and administrative expense decreased by $0.4 million to $2.2 million and
$0.5 million to $4.2 million for the three months and six months ended June 30,
2003 compared to the same periods in 2002. Decreased personnel and contractor
costs are the primary reason for the reduction in general and administrative
expense, offset by increased legal expenses.
The following table summarizes the average balances of interest-earning assets
and their average effective yields, along with the average interest-bearing
liabilities and the related average effective interest rates, for each of the
periods presented.
Average Balances and Effective Interest Rates
- --------------------------------------------------------------------------------------------------------------------------
Three Months Ended June 30, Six Months Ended June 30,
---------------------------------------------------------------------------------------------------
2003 2002 2003 2002
---------------------------------------------------------------------------------------------------
(amounts in thousands) Average Effective Average Effective Average Effective Average Effective
Balance Rate Balance Rate Balance Rate Balance Rate
---------------------------------------------------------------------------------------------------
Interest-earning
assets: (1)
Collateral for
collateralized bonds $2,017,170 7.08% $2,381,783 7.46% $2,058,673 7.14% $2,373,888 7.34%
(2) (3)
Other loans 8,229 6.19% 14,603 3.14% 8,492 5.97% 8,785 4.76%
Securities 3,378 16.34% 3,826 35.00% 4,523 18.09% 4,583 19.94%
Cash and other
investments 14,085 0.86% 37,002 0.90% 14,621 0.80% 24,283 0.84%
---------------------------------------------------------------------------------------------------
Total
interest-earning $2,042,862 7.05% $2,437,214 7.38% $2,086,309 7.11% $2,411,539 7.29%
assets
===================================================================================================
Interest-bearing
liabilities:
Non-recourse debt (3) $1,886,827 5.64% $2,234,052 5.57% $1,926,627 5.59% $2,213,272 5.65%
Senior notes 30,699 9.51% 46,395 8.10% 20,696 9.51% 48,492 8.12%
---------------------------------------------------------------------------------------------------
Total
interest-bearing $1,917,526 5.70% $2,280,447 5.62% $1,947,323 5.63% $2,261,764 5.70%
liabilities
===================================================================================================
Net interest spread on
all investments (3) 1.35% 1.76% 1.48% 1.59%
============ ============ =========== ============
Net yield on average
interest-earning 1.68% 2.12% 1.84% 1.95%
assets (3)
============ ============ =========== ============
- --------------------------------------------------------------------------------------------------------------------------
(1) Average balances exclude adjustments made in accordance with Statement of
Financial Accounting Standards No. 115, "Accounting for Certain Investments
in Debt and Equity Securities" to record available-for-sale securities at
fair value.
(2) Average balances exclude funds held by trustees of $370 and $601 for the
three months ended June 30, 2003 and 2002, respectively, and $435 and $568
for the six months ended June 30, 2003 and 2002, respectively.
(3) Effective rates are calculated excluding non-interest related
collateralized bond expenses. If included, the effective rate on
interest-bearing liabilities would be 5.91% and 5.74% for the three months
ended June 30, 2003 and 2002, respectively, and 5.79% and 5.85% for the six
months ended June 30, 2003 and 2002, respectively, while the net yield on
average interest-earning assets would be 1.51% and 1.74% for the three
months ended June 30, 2003 and 2002, respectively, and 1.71% and 1.90% for
the six months ended June 30, 2003 and 2002, respectively.
The net interest spread decreased 41 basis points, to 135 basis points for the
three months ended June 30, 2003 from 176 basis points for the same period in
2002 (each basis point is 0.01%). The net interest spread for the six months
ended June 30, 2003 also decreased relative to the same period in 2002, to 148
basis points from 159 basis points. The decrease in the Company's net interest
spread for both periods can be generally attributed to the resetting of interest
rates on adjustable rate mortgage loans in the Company's investment portfolio
and the prepayment of higher rate loans in that portfolio which together caused
a decline in interest earning asset yield of 33 basis points and 18 basis points
for the three and six month comparative periods, respectively. The majority of
the Company's variable-rate interest-bearing liabilities are indexed relative to
One-Month LIBOR. Interest-bearing liability costs increased 8 basis points for
the three month period and decreased 7 basis points for the six-month periods
ended June 30, 2003, respectively, compared to the same period in 2002.
Interest-bearing liability costs increased 8 basis points for the three month
period primarily as a result of interest charges associated with the interest
rate swap and the amortizing synthetic interest rate swap discussed below and
the 9.50% Senior Notes issued in 2003 with a higher coupon than the 7.875%
Senior Notes retired in 2002. Interest-bearing liability costs for the six month
periods decreased 7 basis points, principally as a result of the overall lower
rate environment and the impact of the issuance of SASCO Series 2002-9 in April
2002, which lowered the Company's overall cost of funds. The Company currently
finances approximately $216 million of the fixed-rate assets with non-recourse
LIBOR based floating-rate liabilities. In June 2002, the Company, through the
use of an interest-rate swap, converted $100 million of such floating-rate
14
liabilities into fixed rate, in effect locking the spread in for that portion of
fixed rate assets financed with floating rate liabilities. Under the swap, the
Company pays a fixed rate of 3.73% and receives one-month LIBOR. In October
2002, the Company created an amortizing synthetic swap through the short sale of
a string of Eurodollar futures contracts, with an initial effective notional
balance of approximately $80 million, amortizing over a three-year period. At
June 30, 2003, the notional amount of this synthetic amortizing swap was $52
million.
The Company would expect its net interest spread on its interest-earning assets
for the balance of 2003 to continue to decrease as higher coupon loans and
securities prepay, and rates on adjustable-rate assets in the investment
portfolio continue to adjust downward. Rates on collateralized bonds should
decline as a result of the reduction of 25 basis points in the Federal Funds
target rate in June, but not enough to offset declining asset yields. The
average One-Month LIBOR rate declined to 1.26% and 1.30% for the three and six
month periods ended June 30, 2003, respectively from 1.85% for the three and six
month periods ended June 30, 2002.
Interest Income and Interest-Earning Assets. At June 30, 2003, $1.6 billion of
the investment portfolio consists of loans and securities which pay a fixed-rate
of interest, and approximately $426.4 million of the investment portfolio is
comprised of loans and securities that have coupon rates which adjust over time
(subject to certain periodic and lifetime limitations) in conjunction with
changes in short-term interest rates. The Company finances its investment
portfolio with principally non-recourse collateralized bonds. At June 30, 2003,
approximately $1.2 billion of fixed-rate bonds and $641 million of adjustable
rate bonds were outstanding. The following table presents a breakdown, by
principal balance, of the Company's collateral for collateralized bonds and ARM
and fixed mortgage securities by type of underlying loan. This table excludes
mortgage-related securities, other investments and other loans.
Investment Portfolio Composition (1)
($ in millions)
- ------------------- ------------------ ----------------- --------------------
Other Indices
LIBOR Based CMT Based Based Fixed-Rate
ARM Loans ARM Loans ARM Loans Loans Total
- ------------------- ---------------------------------------------------------
2002, Quarter 2 ... $ 452.6 $ 90.1 $ 63.8 $ 1,740.2 $ 2,346.7
2002, Quarter 3 ... 414.4 80.8 59.9 1,698.4 2,253.5
2002, Quarter 4 ... 384.6 73.2 57.0 1,650.9 2,165.7
2003, Quarter 1 ... 352.5 66.3 52.8 1,605.3 2,076.9
2003, Quarter 2 ... 316.9 59.6 49.9 1,564.9 1,991.3
- ------------------- ------ ----- ----- -------- --------
(1) Includes only the principal amount of collateral for collateralized
bonds, ARM securities and fixed-rate mortgage securities.
The average asset yield is reduced for the amortization of premiums, net of
discounts on the investment portfolio. As indicated in the table below, net
premium on the collateral for collateralized bonds, ARM securities, fixed-rate
mortgage securities at June 30, 2002, was $13.7 million, or approximately 0.69%
of the aggregate balance of collateral for collateralized bonds, ARM securities
and fixed-rate securities. The $13.7 million net premium consists of gross
collateral premiums of $35.0 million, less gross collateral discounts of $21.3
million. Of the $35.0 million in gross premiums on collateral, $26.0 million
relates to the premium on multifamily and commercial mortgage loans with a
principal balance of $770.6 million at June 30, 2003, and that have average
prepayment lockouts or yield maintenance to 2008. The net premium (i.e., gross
premium less gross discount) on such multifamily and commercial loans is $26.0
million. Amortization expense as a percentage of principal pay-downs has
increased from 1.39% for the three months ended June 30, 2002 to 1.64% for the
same period in 2003. The principal prepayment rate for the Company (indicated in
the table below as "CPR Annualized Rate") was approximately 22% for the three
months ended June 30, 2003. CPR or "constant prepayment rate" is a measure of
the annual prepayment rate on a pool of loans.
15
Premium Basis and Amortization
($ in millions)
- --------------------------------------------------------------------------------
Amortization
CPR Expense as a %
Net Amortization Annualized Principal of Principal
Premium Expense Rate Paydowns Paydowns
- --------------------------------------------------------------------------------
2002, Quarter 2 $ 18.3 $ 1.5 17% $ 108.3 1.39%
2002, Quarter 3 16.7 1.6 21% 94.5 1.70%
2002, Quarter 4 16.2 0.5 19% 95.5 0.57%
2003, Quarter 1 15.1 1.1 24% 85.4 1.32%
2003, Quarter 2 13.7 1.3 22% 81.8 1.64%
- --------------------------------------------------------------------------------
Credit Exposures. The Company invests in collateralized bonds or pass-through
securitization structures. Generally these securitization structures use
over-collateralization, subordination, third-party guarantees, reserve funds,
bond insurance, mortgage pool insurance or any combination of the foregoing as a
form of credit enhancement. The Company generally has retained a limited portion
of the direct credit risk in these securities. In most instances, the Company
retained the "first-loss" credit risk on pools of loans that it has securitized.
The following table summarizes the aggregate principal amount of collateral for
collateralized bonds and securities outstanding; the direct credit exposure
retained by the Company (represented by the amount of over-collateralization
pledged and subordinated securities owned by the Company), net of the credit
reserves and discounts maintained by the Company for such exposure; and the
actual credit losses incurred for each year.
The table excludes other forms of credit enhancement from which the Company
benefits, and based upon the performance of the underlying loans, may provide
additional protection against losses. These additional protections include loss
reimbursement guarantees with a remaining balance of $30.2 million and a
remaining deductible aggregating $0.8 million on $65.3 million of securitized
single family mortgage loans which are subject to such reimbursement agreements;
guarantees aggregating $28.7 million on $301.0 million of securitized commercial
mortgage loans, whereby losses on such loans would need to exceed the respective
guarantee amount before the Company would incur credit losses; and $208.3
million of securitized single family mortgage loans which are subject to various
mortgage pool insurance policies whereby losses would need to exceed the
remaining stop loss of at least 61% on such policies before the Company would
incur losses. During the first and second quarter 2003, the Company received a
payment of $89 thousand and established a receivable of $87 thousand,
respectively under the $30.2 million loss reimbursement guarantee.
Credit Reserves and Actual Credit Losses
($ in millions)
- ----------------------------------------------------------------------------------------------
Outstanding Loan Credit Exposure, Net Actual Credit Credit Exposure, Net to
Principal Balance of Credit Reserves Losses Outstanding Loan Balance
- ----------------------------------------------------------------------------------------------
2002, Quarter 2 $ 2,437.8 $ 114.6 $ 8.4 4.70%
2002, Quarter 3 2,340.5 110.2 8.3 4.71%
2002, Quarter 4 2,246.9 91.9 7.7 4.09%
2003, Quarter 1 2,082.3 90.1 6.2 4.33%
2003, Quarter 2 1,997.1 72.8 6.4 3.65%
- ----------------------------------------------------------------------------------------------
The following table summarizes single family mortgage loan, manufactured housing
loan and commercial mortgage loan delinquencies as a percentage of the
outstanding collateral balance for those securities in which the Company has
retained a portion of the direct credit risk. The delinquencies as a percentage
of the outstanding collateral balance have increased to 4.76% at June 30, 2003
from 4.03% at June 30, 2002 primarily due to two commercial loans which have
become delinquent and increased percentage of delinquencies on single family
mortgage loans and manufactured housing loans due primarily to the declining
balance of these loans outstanding. The Company monitors and evaluates its
exposure to credit losses and has established reserves based upon anticipated
16
losses, general economic conditions and trends in the investment portfolio. As
of June 30, 2003, management believes the level of credit reserves is
appropriate for currently existing losses.
Delinquency Statistics (1)
- --------------------------------------------------------------------------------
30 to 60 days 60 to 90 days 90 days and over
delinquent delinquent delinquent (2) Total
- --------------------------------------------------------------------------------
2002, Quarter 2 1.25% 0.59% 2.19% 4.03%
2002, Quarter 3 1.99% 0.34% 2.14% 4.47%
2002, Quarter 4 1.78% 0.64% 2.07% 4.49%
2003, Quarter 1 1.79% 0.51% 2.20% 4.50%
2003, Quarter 2 1.68% 0.50% 2.58% 4.76%
- --------------------------------------------------------------------------------
(1) Excludes other investments and loans held for sale or securitization. (2)
Includes foreclosures, repossessions and REO.
General and Administrative Expense. The following tables present a breakdown of
general and administrative expense.
- --------------------------------------------------------------------------------
Servicing Corporate/Investment Total
Portfolio Management
- --------------------------------------------------------------------------------
2002, Quarter 2 $ 1,036.8 $ 1,587.5 $ 2,624.3
2002, Quarter 3 1,122.2 1,103.7 2,225.9
2002, Quarter 4 1,221.5 1,526.9 2,748.4
2003, Quarter 1 1,146.6 874.2 2,020.8
2003, Quarter 2 1,262.3 888.3 2,150.6
- --------------------------------------------------------------------------------
Supplemental Information for Collateralized Bond Securities
The Company, through its subsidiaries, pledges collateral (i.e., single-family
mortgage loans and securities, manufactured housing mortgage loans and
securities, or commercial mortgage loans) for collateralized bond obligations
that are issued based on the pledge of such collateral. These collateralized
bonds are recourse only to the collateral pledged, and not to the Company. The
structure created by the pledge of collateral and sale of the associated
collateralized bonds is referred to hereafter as a "collateralized bond
security". The "principal balance of net investment" in a collateralized bond
security represents the principal balance of the collateral pledged less the
outstanding balance of the associated collateralized bonds owned by third
parties. This net investment is also commonly referred to as
"over-collateralization". The "amortized cost basis of net investment" is the
over-collateralization amount plus or minus collateral and collateralized bond
premiums and discounts and related costs. The Company generally has sold the
investment grade classes of the collateralized bonds to third parties, and has
retained the portion of the collateralized bond security that is below
investment grade.
The Company analyzes and values its investment in collateral for collateralized
bonds on a net investment basis. The Company estimates the fair value of its net
investment in collateralized bond securities as the present value of the
projected cash flow from the collateral, adjusted for the impact of and assumed
level of future prepayments and credit losses, less the projected principal and
interest due on the bonds owned by third parties. Below is a summary as of June
30, 2003, by each series where the fair value exceeds $0.5 million of the
Company's net investment in collateralized bond securities. The Company master
services four of its collateral for collateralized bond securities. Structured
Asset Securitization Corporation (SASCO) Series 2002-9 is master-serviced by
Wells Fargo Bank. CCA One Series 2 and Series 3 are master-serviced by Bank of
New York. Monthly payment reports for those securities master-serviced by the
Company may be found on the Company's website at www.dynexcapital.com.
The following tables show the Company's net investment in each of the securities
presented below on both a principal balance and amortized cost basis, as those
terms are defined above. The accompanying consolidated financial statements of
the Company present the collateral for collateralized bonds as an asset, and
presents the associated collateralized bond obligation as a non-recourse
liability. In addition, the Company carries only its investment in MERIT Series
11 at fair value. As a result, the table below is not meant to present the
Company's investment in collateral for collateralized bonds or collateralized
bonds in accordance with generally accepted accounting principles applicable to
the Company's transactions. See below for a reconciliation of the amounts
included in the table to the Company's consolidated financial statements.
- ---------------------------------------------------------------------------------------------------------------------------
(amounts in thousands) Principal balance
Principal balance of collateralized Principal Amortized Cost
Collateralized Bond of collateral bonds outstanding Balance of Net Basis of Net
Series (1) Collateral Type pledged to third parties Investment Investment
- ---------------------------------------------------------------------------------------------------------------------------
MERIT Series 11A Debt securities backed by
Single-family loans and
Manufactured housing loans $ 296,322 $ 258,688 $ 37,634 $ 28,434
MERIT Series 12-1 Manufactured housing loans 239,382 217,176 22,206 19,880
MERIT Series 13 Manufactured housing loans 285,883 256,555 29,328 23,733
SASCO 2002-9 Single family loans 392,154 382,380 9,774 18,437
MCA One Series 1 Commercial mortgage loans 81,113 76,394 4,719 (99)
CCA One Series 2 Commercial mortgage loans 291,971 269,867 22,104 8,511
CCA One Series 3 Commercial mortgage loans 396,493 352,469 44,024 50,677
- ---------------------------------------------------------------------------------------------------------------------------
$ 1,983,317 $ 1,813,529 $ 169,788 $ 149,573
- ---------------------------------------------------------------------------------------------------------------------------
(1) MERIT stands for MERIT Securities Corporation; MCA stands for Multifamily
Capital Access One, Inc. (now known as Commercial Capital Access One,
Inc.); and CCA stands for Commercial Capital Access One, Inc. Each such
entity is a wholly owned limited purpose subsidiary of the Company. SASCO
stands for Structured Asset Securitization Corporation.
The following table reconciles the balances presented in the table above with
the amounts included for collateral for collateralized bonds and collateralized
bonds in the accompanying consolidated financial statements.
- --------------------------------------------------------------------------------------------------------------------
(amounts in thousands) Collateral
For Collateralized Net
Collateralized Bonds Investment
Bonds
- --------------------------------------------------------------------------------------------------------------------
Principal balances per the above table $ 1,983,317 $ 1,813,529 $ 169,788
Principal balance of security excluded from above table 4,657 4,723 (66)
Recorded impairments on debt securities (11,894) - (11,894)
Premiums and discounts 13,715 26,927 (13,212)
Unrealized gain/loss 2,577 _ 2,577
Accrued interest and other 12,822 7,703 5,119
Allowance for loan losses (39,688) - (39,688)
- --------------------------------------------------------------------------------------------------------------------
Balance per consolidated financial statements $ 1,965,506 $ 1,852,882 $ 112,624
- --------------------------------------------------------------------------------------------------------------------
The following table summarizes the fair value of the Company's net investment in
collateralized bond securities, the various assumptions made in estimating value
and the cash flow received from such net investment during the six months ended
June 30, 2003. As the Company does not present its investment in collateralized
bonds on a net investment basis and carries only its investment in MERIT Series
11 at fair value, the table below is not meant to present the Company's
investment in collateral for collateralized bonds or collateralized bonds in
accordance with generally accepted accounting principles applicable to the
Company's transactions.
18
- ----------------------------------------------------------------------------------------------------------------------------
Fair Value Assumptions ($ in thousands)
------------------------------------------------------------------------
Cash flows
Collateralized Weighted-average Projected cash flow Fair value of received
Bond Series prepayment speeds Losses termination date net in 2003,
investment (1) net (2)
- ----------------------------------------------------------------------------------------------------------------------------
MERIT Series 11A 35%-40% CPR on SF 3.2% annually on Anticipated final maturity $ 30,870 $ 8,158
securities; 8% CPR MH securities in 2025
on MH securities
MERIT Series 12-1 8% CPR 3.4% annually on Anticipated final maturity 1,912 638
MH Loans in 2027
MERIT Series 13 10% CPR 4.0% annually Anticipated final maturity 1,241 723
in 2026
SASCO 2002-9 30% CPR 0.20% annually Anticipated call date in 26,609 7,573
2005
MCA One Series 1 (3) 0.8% annually Anticipated final maturity 2,470 233
in 2018
CCA One Series 2 (4) 0.80% annually Anticipated call date in 10,661 861
beginning in 2004 2012
CCA One Series 3 (4) Losses of $4,000 Anticipated call date in 17,305 1,194
in 2003, 1.2% 2009
annually beginning
in 2004
- ----------------------------------------------------------------------------------------------------------------------------
$ 91,068 $19,380
- ----------------------------------------------------------------------------------------------------------------------------
(1) Calculated as the net present value of expected future cash flows,
discounted at 16%. Expected cash flows were based on the forward LIBOR
curve as of June 30, 2003, and incorporates the resetting of the interest
rates on the adjustable rate assets to a level consistent with projected
prevailing rates. Increases or decreases in interest rates and index levels
from those used in the projection would impact the calculation of fair
value, as would differences in actual prepayment speeds and credit losses
versus the assumptions set forth above. Cash flows received by the Company
during the six months ended June 30, 2003, equal to the excess of the cash
flows received on the collateral pledged, over the cash flow requirements
of the collateralized bond security
(2) Computed at 0% CPR until maturity
(3) Computed at 0% CPR until the respective call date
The above tables illustrate the Company's estimated fair value of its net
investment in certain collateralized bond securities. In its consolidated
financial statements, the Company carries its investments at amortized cost,
except for its investment in MERIT Series 11, which it carries at estimated fair
value. Including the recorded allowance for loan losses of $39.7 million, the
Company's net investment in collateralized bond securities is approximately
$112.6 million. This amount compares to an estimated fair value, utilizing a
discount rate of 16%, of approximately $91.1 million, as set forth in the table
above.
The following table compares the fair value of these investments at various
discount rates, but otherwise using the same assumptions as set forth for the
two immediately preceding tables:
- --------------------------------------------------------------------------------
Fair Value of Net Investment
- --------------------------------------------------------------------------------
Collateralized Bond Series ..... 12% 16% 20% 25%
- -------------------------------- -------- -------- -------- --------
MERIT Series 11A ............... $ 34,370 $ 30,870 $ 28,170 $ 25,531
MERIT Series 12-1 .............. 1,789 1,912 1,960 1,956
MERIT Series 13 ................ 997 1,241 1,393 1,498
SASCO 2002-9 ................... 27,719 26,609 25,562 24,335
MCA One Series 1 ............... 3,086 2,470 2,014 1,600
CCA One Series 2 ............... 13,263 10,661 8,742 7,011
CCA One Series 3 ............... 20,588 17,305 14,643 12,004
- -------------------------------- -------- -------- -------- --------
$101,812 $ 91,068 $ 82,484 $ 73,935
- -------------------------------- -------- -------- -------- --------
19
LIQUIDITY AND CAPITAL RESOURCES
The Company has historically financed its operations from a variety of sources.
These sources have included cash flow generated from the investment portfolio,
including net interest income and principal payments and prepayments. In
addition, while the Company was actively originating loans for its investment
portfolio, the Company funded these operations through short-term warehouse
lines of credit with commercial and investment banks, repurchase agreements and
the capital markets via the asset-backed securities market (which provides
long-term non-recourse funding of the investment portfolio via the issuance of
collateralized bonds). Should the Company's future operations require access to
sources of capital such as lines of credit and repurchase agreements, the
Company believes that it would be able to access such sources.
The Company's cash flow from its investment portfolio for the three months and
six months ended June 30, 2003 was approximately $15.5 million and $29.8
million, respectively. Such cash flow is after payment of principal and interest
on the associated collateralized bonds (i.e., non-recourse debt) outstanding.
From the cash flow on its investment portfolio, the Company funds its operating
overhead costs, including the servicing of its delinquent property tax
receivables, and repays any remaining recourse debt.
The Company's cash flow from its investment portfolio is subject to fluctuation
due to changes in interest rates, repayment rates and default rates and related
losses. In a period of rapidly rising interest rates, the Company's net interest
margin and cash flow from the investment portfolio is likely to be significantly
impacted due to increased borrowing costs on variable-rate non-recourse
collateralized bonds. The Company anticipates, however, that it will have
sufficient cash flow from its investment portfolio to meet all of its
obligations.
Collateralized Bonds. Dynex, through limited-purpose finance subsidiaries, has
issued non-recourse debt in the form of collateralized bonds to fund the
majority of its investment portfolio. The obligations under the collateralized
bonds are payable solely from the collateral for collateralized bonds and are
otherwise non-recourse to Dynex. Collateral for collateralized bonds is not
subject to margin calls. The maturity of each class of collateralized bonds is
directly affected by the rate of principal prepayments on the related
collateral. Each series is also subject to redemption according to specific
terms of the respective indentures, generally on the earlier of a specified date
or when the remaining balance of the bonds equals 35% or less of the original
principal balance of the bonds. At June 30, 2003, Dynex had $1.9 billion of
collateralized bonds outstanding. Approximately $1.2 billion of the
collateralized bonds carry a fixed rate of interest, and approximately $0.6
billion carries a rate of interest which adjusts monthly based on One-Month
LIBOR.
Senior notes. On February 28, 2003, the Company issued $32.1 million of 9.50%
senior unsecured notes due February 2005 (the "February 2005 Senior Notes") in
connection with a tender offer on the Company's preferred stock. The February
2005 Senior Notes were issued in exchange for 1,156,891 shares of Series A,
Series B and Series C preferred stock. Principal payments in the amount of $4.0
million, along with interest payments at a rate of 9.50% per annum, are due
quarterly beginning May 2003, with final payment due on February 28, 2005. The
Company at its option can prepay the February 2005 Senior Notes in whole or in
part, without penalty, at any time. The February 2005 Senior Notes prohibit
distributions on the Company's capital stock until they are fully repaid, except
distributions necessary for the Company to maintain REIT status. At June 30,
2003, the outstanding balance of the Senior Notes was $28.1 million. In August
2003, the Company announced that it planned to redeem early $10 million of the
Senior Notes.
FORWARD-LOOKING STATEMENTS
Certain written statements in this Form 10-Q made by the Company, that are not
historical fact constitute "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. Such forward-looking statements may
involve factors that could cause the actual results of the Company to differ
materially from historical results or from any results expressed or implied by
such forward-looking statements. The Company cautions the public not to place
undue reliance on forward-looking statements, which may be based on assumptions
and anticipated events that do not materialize. The Company does not undertake,
and the Securities Litigation Reform Act specifically relieves the Company from,
any obligation to update any forward-looking statements.
Factors that may cause actual results to differ from historical results or from
any results expressed or implied by forward-looking statements include the
following:
20
Economic Conditions. The Company is affected by general economic conditions. The
risk of defaults and credit losses could increase during an economic slowdown or
recession. This could have an adverse effect on the performance of the Company's
securitized loan pools and on the Company's overall financial performance.
Capital Resources. Cash flows from the investment portfolio fund the Company's
operations and repayments of recourse debt, and are subject to fluctuation due
to changes in interest rates, repayment rates and default rates and related
losses.
Interest Rate Fluctuations. The Company's income and cash flow depends on its
ability to earn greater interest on its investments than the interest cost to
finance these investments. Interest rates in the markets served by the Company
generally rise or fall with interest rates as a whole. A majority of the loans
currently pledged as collateral for collateralized bonds by the Company are
fixed-rate. The Company currently finances these fixed-rate assets through
non-recourse collateralized bonds, approximately $280 million of which is
variable rate which resets monthly. Through the use of interest rate swaps and
synthetic swaps, the Company has reduced this exposure by approximately $152
million at June 30, 2003 on an amortizing basis through approximately June 2005.
In addition, a significant amount of the investments held by the Company is
adjustable-rate collateral for collateralized bonds, which generally reset on a
delayed basis and have periodic interest rate caps. These investments are
financed through non-recourse long-term collateralized bonds which reset monthly
and which have no periodic caps. In total at June 30, 2003, the Company has
approximately $640 million of adjustable-rate collateralized bonds.
The net interest spread and cash flow for the Company could decrease materially
during a period of rapidly rising short-term interest rates, despite the use of
interest-rate swaps and synthetic swaps, as a result of the monthly reset in the
rate on the adjustable-rate collateralized bonds issued by the Company.
Defaults. Defaults by borrowers on loans securitized by the Company may have an
adverse impact on the Company's financial performance, if actual credit losses
differ materially from estimates made by the Company. The allowance for losses
is calculated on the basis of historical experience and management's best
estimates. Actual default rates or loss severity may differ from the Company's
estimate as a result of economic conditions. In particular, the default rate and
loss severity on the Company's portfolio of manufactured housing loans has been
higher than initially estimated. Actual defaults on ARM loans may increase
during a rising interest rate environment. The Company believes that its
reserves are adequate for such risks on loans as of June 30, 2003.
Third-party Servicers. Third-party servicers service the majority of the
Company's investment portfolio. To the extent that these servicers are
financially impaired, the performance of the Company's investment portfolio may
deteriorate, and defaults and credit losses may be greater than estimated.
Prepayments. Prepayments by borrowers on loans securitized by the Company may
have an adverse impact on the Company's financial performance. Prepayments are
expected to increase during a declining interest rate or flat yield curve
environment. The Company's exposure to rapid prepayments is primarily (i) the
faster amortization of premium on the investments and, to the extent applicable,
amortization of bond discount, and (ii) the replacement of investments in its
portfolio with lower yield securities.
Competition. The financial services industry is a highly competitive market.
Increased competition in the market has adversely affected the Company, and may
continue to do so.
Regulatory Changes. The Company's businesses as of June 30, 2003 are not subject
to any material federal or state regulation or licensing requirements. However,
changes in existing laws and regulations or in the interpretation thereof, or
the introduction of new laws and regulations, could adversely affect the Company
and the performance of the Company's securitized loan pools or its ability to
collect on its delinquent property tax receivables.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk generally represents the risk of loss that may result from the
potential change in the value of a financial instrument due to fluctuations in
interest and foreign exchange rates and in equity and commodity prices. Market
risk is inherent to both derivative and non-derivative financial instruments,
and accordingly, the scope of the Company's market risk management extends
beyond derivatives to include all market risk sensitive financial instruments.
As a financial services company, net interest margin comprises the primary
component of the Company's earnings. Additionally, cash flow from the investment
portfolio represents the primary component of the Company's incoming cash flow.
21
The Company is subject to risk resulting from interest rate fluctuations to the
extent that there is a gap between the amount of the Company's interest-earning
assets and the amount of interest-bearing liabilities that are prepaid, mature
or re-price within specified periods. While certain investments may perform
poorly in an increasing or decreasing interest rate environment, other
investments may perform well, and others may not be impacted at all.
The Company focuses on the sensitivity of its cash flow, and measures such
sensitivity to changes in interest rates. Changes in interest rates are defined
as instantaneous, parallel, and sustained interest rate movements in 100 basis
point increments. The Company estimates its net interest margin cash flow for
the next twenty-four months assuming interest rates following the forward LIBOR
curve (based on 90-day Eurodollar futures contracts) as of June 30, 2003. Once
the base case has been estimated, cash flows are projected for each of the
defined interest rate scenarios. Those scenario results are then compared
against the base case to determine the estimated change to cash flow.
The following table summarizes the Company's net interest margin cash flow
sensitivity analysis as of June 30, 2003. This analysis represents management's
estimate of the percentage change in net interest margin cash flow given a shift
in interest rates, as discussed above. Other investments are excluded from this
analysis because they are not interest rate sensitive. The "Base" case
represents the interest rate environment as it existed as of June 30, 2003. At
June 30, 2003, both one-month LIBOR and six-month LIBOR were 1.12%. The analysis
is heavily dependent upon the assumptions used in the model. The effect of
changes in future interest rates, the shape of the yield curve or the mix of
assets and liabilities may cause actual results to differ significantly from the
modeled results. In addition, certain financial instruments provide a degree of
"optionality." The most significant option affecting the Company's portfolio is
the borrowers' option to prepay the loans. The model applies prepayment rate
assumptions representing management's estimate of prepayment activity on a
projected basis for each collateral pool in the investment portfolio. The model
applies the same prepayment rate assumptions for all five cases indicated below.
The extent to which borrowers utilize the ability to exercise their option may
cause actual results to significantly differ from the analysis. Furthermore, the
projected results assume no additions or subtractions to the Company's
portfolio, and no change to the Company's liability structure. Historically,
there have been significant changes in the Company's assets and liabilities, and
there are likely to be such changes in the future.
- ------------------------------ ---------- ---------------------------
% Change in Net
Basis Point Interest Margin
Increase (Decrease) Cash Flow From
in Interest Rates Base Case
- ------------------------------ ---------------------------
+200 (10.0)%
+100 (5.6)%
Base -
-100 7.3%
-200 9.1%
- ------------------------------ ---------- ---------------------------
Approximately $426 million of the Company's investment portfolio as of June 30,
2003 is comprised of loans or securities that have coupon rates which adjust
over time (subject to certain periodic and lifetime limitations) in conjunction
with changes in short-term interest rates. Approximately 73% and 14% of the ARM
loans underlying the Company's ARM securities and collateral for collateralized
bonds are indexed to and reset based upon the level of six-month LIBOR and
one-year CMT, respectively.
Generally, during a period of rising short-term interest rates, the Company's
net interest spread earned on its investment portfolio will decrease. The
decrease of the net interest spread results from (i) the lag in resets of the
ARM loans underlying the ARM securities and collateral for collateralized bonds
relative to the rate resets on the associated borrowings and (ii) rate resets on
the ARM loans which are generally limited to 1% every six months or 2% every
twelve months and subject to lifetime caps, while the associated borrowings have
no such limitation. As short-term interest rates stabilize and the ARM loans
reset, the net interest margin may be restored to its former level as the yields
on the ARM loans adjust to market conditions. Conversely, net interest margin
may increase following a fall in short-term interest rates. This increase may be
temporary as the yields on the ARM loans adjust to the new market conditions
after a lag period. In each case, however, the Company expects that the increase
or decrease in the net interest spread due to changes in the short-term interest
rates to be temporary. The net interest spread may also be increased or
decreased by the proceeds or costs of interest rate swap, cap or floor
agreements, to the extent that the Company has entered into such agreements.
22
The remaining portion of the Company's investment portfolio as of June 30, 2003,
approximately $1.6 billion, is comprised of loans or securities that have coupon
rates that are fixed. The Company has substantially limited its interest rate
risk on such investments through (i) the issuance of fixed-rate collateralized
bonds which approximated $1.2 billion as of June 30, 2003, and (ii)
shareholders' equity, which was $164.7 million. Overall, the Company's interest
rate risk is primarily related both to the rate of change in short term interest
rates, and to the level of short-term interest rates.
Item 4. Controls and Procedures
(a) Evaluation of disclosure controls and procedures. As required by
Rule 13a-15 under the Exchange Act, as of the end of the period covered by this
quarterly report (the "Evaluation Date"), the Company carried out an evaluation
of the effectiveness of the design and operation of the Company's disclosure
controls and procedures. This evaluation was carried out under the supervision
and with the participation of the Company's management. Based upon that
evaluation, the Company's management concluded that the Company's disclosure
controls and procedures are effective. Disclosure controls and procedures are
controls and other procedures that are designed to ensure that information
required to be disclosed in the Company's reports filed or submitted under the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the SEC's rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed in the Company's reports filed
under the Exchange Act is accumulated and communicated to management, including
the Company's management, as appropriate, to allow timely decisions regarding
required disclosures.
(b) Changes in internal controls. There were no significant changes in
the Company's internal controls or in other factors that could materially
affect, or are reasonably likely to materially affect the Company's internal
controls subsequent to the Evaluation Date, nor any significant deficiencies or
material weaknesses in such internal controls requiring corrective actions.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
GLS Capital, Inc. ("GLS"), a subsidiary of the Company, together with the County
of Allegheny, Pennsylvania ("Allegheny County"), were defendants in a lawsuit in
the Commonwealth Court of Pennsylvania (the "Commonwealth Court"), the appellate
court of the state of Pennsylvania. Plaintiffs were two local businesses seeking
status to represent as a class, delinquent taxpayers in Allegheny County whose
delinquent tax liens had been assigned to GLS. Plaintiffs challenged the right
of Allegheny County and GLS to collect certain interest, costs and expenses
related to delinquent property tax receivables in Allegheny County, and whether
the County had the right to assign the delinquent property tax receivables to
GLS and therefore employ procedures for collection enjoyed by Allegheny County
under state statute.. This lawsuit was related to the purchase by GLS of
delinquent property tax receivables from Allegheny County in 1997, 1998, and
1999. In July 2001, the Commonwealth Court issued a ruling that addressed, among
other things, (i) the right of GLS to charge to the delinquent taxpayer a rate
of interest of 12% per annum versus 10% per annum on the collection of its
delinquent property tax receivables, (ii) the charging of a full month's
interest on a partial month's delinquency; (iii) the charging of attorney's fees
to the delinquent taxpayer for the collection of such tax receivables, and (iv)
the charging to the delinquent taxpayer of certain other fees and costs. The
Commonwealth Court in its opinion remanded for further consideration to the
lower trial court items (i), (ii) and (iv) above, and ruled that neither
Allegheny County nor GLS had the right to charge attorney's fees to the
delinquent taxpayer related to the collection of such tax receivables. The
Commonwealth Court further ruled that Allegheny County could assign its rights
in the delinquent property tax receivables to GLS, and that plaintiffs could
maintain equitable class in the action. In October 2001, GLS, along with
Allegheny County, filed an Application for Extraordinary Jurisdiction with the
Supreme Court of Pennsylvania, Western District appealing certain aspects of the
Commonwealth Court's ruling. In March 2003, the Supreme Court issued its opinion
as follows: (i) the Supreme Court determined that GLS can charge delinquent
taxpayers a rate of 12% per annum; (ii) the Supreme Court remanded back to the
lower trial court the charging of a full month's interest on a partial month's
delinquency; (iii) the Supreme Court revised the Commonwealth Court's ruling
regarding recouping attorney fees for collection of the receivables indicating
that the recoupment of fees requires a judicial review of collection procedures
used in each case; and (iv) the Supreme Court upheld the Commonwealth Court's
ruling that GLS can charge certain fees and costs, while remanding back to the
lower trial court for consideration the facts of each individual case. Finally,
the Supreme Court remanded to the lower trial court to determine if the
remaining claims can be resolved as a class action. No hearing date has been set
for the issues remanded back to the lower trial court. In August 2003, the
23
Pennsylvania legislature signed a bill amending and clarifying certain
provisions of the Pennsylvania statute governing GLS' right to the collection of
certain interest, costs and expenses. The bill is expected to be signed into
law. The law is retroactive to 1996, and amends and clarifies that as to items
(ii)-(iv) noted above by the Supreme Court, that GLS can charge a full month's
interest on a partial month's delinquency, that GLS can charge the taxpayer for
legal fees, and that GLS can charge certain fees and costs to the taxpayer at
redemption.
The Company and Dynex Commercial, Inc. ("DCI"), formerly an affiliate of the
Company and now known as DCI Commercial, Inc., are defendants in state court in
Dallas County, Texas in the matter of Basic Capital Management et al ("BCM")
versus Dynex Commercial, Inc. et al. The suit was filed in April 1999 originally
against DCI, and in March 2000, BCM amended the complaint and added the Company.
The current complaint alleges that, among other things, DCI and the Company
failed to fund tenant improvement or other advances allegedly required on
various loans made by DCI to BCM, which loans were subsequently acquired by the
Company; that DCI breached an alleged $160 million "master" loan commitment
entered into in February 1998 and a second alleged loan commitment of
approximately $9 million; that DCI and the Company made negligent
misrepresentations in connection with the alleged $160 million commitment; and
that DCI and the Company fraudulently induced BCM into canceling the alleged
$160 million master loan commitment in January 1999. Plaintiff BCM is seeking
damages approximating $40 million, including approximately $37 million for DCI's
breach of the alleged $160 million master loan commitment, approximately $1.6
million for alleged failure to make additional tenant improvement advances, and
approximately $1.9 million for DCI's not funding the alleged $9 million
commitment. DCI and the Company are vigorously defending the claims on several
grounds. The Company was not a party to the alleged $160 million master
commitment or the alleged $9 million commitment. The Company has filed a
counterclaim for damages approximating $11 million against BCM. Commencement of
the trial of the case in Dallas, Texas is anticipated in the first quarter of
2004. During the second quarter 2003, BCM filed suit against the Company and DCI
as third-party defendants in related litigation in the United States District
Court Eastern District of Louisiana in the matter Kelly Investment, Inc. versus
BCM et al. The Company sold certain BCM related loans on commercial properties
located in Louisiana to Kelly Investment, Inc. in 2000, and Kelly Investment,
Inc. subsequently filed suit against BCM in 2001. No date has been set for trial
in Louisiana. Claims made by BCM in the US District Court of Louisiana against
the Company and DCI are substantially similar to those being made in Dallas
County, Texas.
Although no assurance can be given with respect to the ultimate outcome of the
above litigation, the Company believes the resolution of these lawsuits, or any
other claims against the Company, will not have a material effect on the
Company's consolidated balance sheet, but could materially affect consolidated
results of operations in a given year.
Item 2. Changes in Securities and Use of Proceeds
None
Item 3. Defaults Upon Senior Securities
See Note 9 to accompanying condensed consolidated financial statements in Part I
Item 1.
Item 4. Submission of Matters to a Vote of Security Holders
On May 30, 2003, the Annual Meeting of shareholders was held to elect the
members of the Board of Directors and to approve the continuation of Deloitte
and Touche, L.L.P..as the auditor for the Company. The following table
summarizes the results of those votes.
24
- ------------------------- ---------- ------- -------- ----------- --------------
Broker
Director For Against Withheld Abstentions Non-Votes
- ------------------------- ---------- ------- -------- ----------- --------------
Common Shares Voted
Thomas B. Akin 10,190,624 - 148,692 - -
J. Sidney Davenport 10,188,076 - 151,240 - -
Thomas H. Potts 9,530,949 - 808,367 - -
Donald B. Vaden 10,174,888 - 164,428 - -
Eric P. VonderPorten 10,212,330 - 126,986 - -
Deloitte & Touche, L.L.P. 10,228,750 67,667 - 42,899 -
- ------------------------- ---------- ------- -------- ----------- --------------
Preferred Shares Voted
Leon A. Feldman 1,576,294 - 200,977 - -
Barry Igdaloff 1,762,006 - 15,265 - -
- ------------------------- ---------- ------- -------- ----------- --------------
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
31.1 Certification of Principal Executive Officer
pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
31.2 Certification of Chief Financial Officer pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Principal Executive Officer and
Chief Financial Officer pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K
Current report on Form 8-K as filed with the Commission on May
5, 2003 providing a copy of the Dynex Capital, Inc. Press
Release dated May 5, 2003.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DYNEX CAPITAL, INC.
Dated: August 14, 2003 By: /s/ Stephen J. Benedetti
---------------------------------------
Stephen J. Benedetti
Executive Vice President
(authorized officer of registrant,
principal accounting officer)
25
Exhibit 31.1
CERTIFICATION
PURSUANT TO 17 CFR 240.13a-14
PROMULGATED UNDER
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, Stephen J. Benedetti, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Dynex Capital,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
or omit to state a material fact necessary to make the statements
made, in light of the circumstances under which such statements were
made, not misleading with respect to the period covered by this
quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e) for the
registrant and we have:
(a) designed such disclosure controls and procedures, or caused such
disclosure controls to be designed under our supervision, to ensure
that material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
(b) evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions about the
effectiveness of the disclosure controls and procedures as of the end
of the period covered by this report based on such evaluation; and
(c) disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter (the registrant's fourth
fiscal quarter in the case of an annual report) that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal control of financial reporting; and
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation of internal control over
financial reporting, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing
the equivalent function):
(a) all significant deficiencies and material weaknesses in the design or
operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant's ability to
record, process, summarize and report financial information; and
(b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
control over financial reporting; and
Date: August 14, 2003 /s/ Stephen J. Benedetti
----------------------------
Stephen J. Benedetti
Principal Executive Officer
26
Exhibit 31.2
CERTIFICATION
PURSUANT TO 17 CFR 240.13a-14
PROMULGATED UNDER
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, Stephen J. Benedetti, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Dynex Capital,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
or omit to state a material fact necessary to make the statements
made, in light of the circumstances under which such statements were
made, not misleading with respect to the period covered by this
quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e) for the
registrant and we have:
(a) designed such disclosure controls and procedures, or caused such
disclosure controls to be designed under our supervision, to ensure
that material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
(b) evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions about the
effectiveness of the disclosure controls and procedures, as of the
end of the period covered by this report based on such evaluation;
and
(c) disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter (the registrant's fourth
fiscal quarter in the case of an annual report) that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal control of financial reporting; and
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation of internal control over
financial reporting, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing
the equivalent function):
(a) all significant deficiencies and material weaknesses in the design or
operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant's ability to
record, process, summarize and report financial information; and
(b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
control over financial reporting.
Date: August 14, 2003 /s/ Stephen J. Benedetti
----------------------------
Stephen J. Benedetti
Chief Financial Officer
27
Exhibit 32.1
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report of Dynex Capital, Inc. (the "Company")
on Form 10-Q for the quarter ending June 30, 2003, as filed with the Securities
and Exchange Commission on the date hereof (the "Report"), I, Stephen J.
Benedetti, the Principal Executive Officer and the Chief Financial Officer of
the Company, certify, pursuant to and for purposes of 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to my
knowledge:
(1) The Report fully complies with the requirements of Section 13(a) or
15(d) of the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations of
the Company.
August 14, 2003 /s/ Stephen J. Benedetti
-------------------------
Stephen J. Benedetti
Principal Executive Officer
Chief Financial Officer
28