================================================================================
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 March 31, 2004
|_| 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
On April 30, 2004, the registrant had 10,873,903 shares of common stock of $.01
value outstanding, which is the registrant's only class of common stock.
================================================================================
DYNEX CAPITAL, INC.
FORM 10-Q
INDEX
Page
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of March 31, 2004
and December 31, 2003 (unaudited).......................................................1
Condensed Consolidated Statements of Operations and Comprehensive (Loss) Income
for the three months ended March 31, 2004 and 2003 (unaudited)..........................2
Condensed Consolidated Statements of Cash Flows for
the three months ended March 31, 2004 and 2003 (unaudited)..............................3
Notes to Unaudited Condensed Consolidated Financial Statements...........................4
Item 2. Management`s Discussion and Analysis of
Financial Condition and Results of Operations...........................................13
Item 3. Quantitative and Qualitative Disclosures about Market Risk..............................25
Item 4. Controls and Procedures.................................................................27
PART II OTHER INFORMATION
Item 1. Legal Proceedings..............................................................27
Item 2. Changes in Securities and Use of Proceeds......................................28
Item 3. Defaults Upon Senior Securities................................................29
Item 4. Submission of Matters to a Vote of Security Holders............................29
Item 5. Other Information..............................................................29
Item 6. Exhibits and Reports on Form 8-K...............................................29
SIGNATURE .......................................................................................30
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS, UNAUDITED
(amounts in thousands except share data)
March 31, December 31,
2004 2003
--------------- ----------------
ASSETS
Cash and cash equivalents $ 5,279 $ 7,386
Other assets 4,199 4,174
--------------- ----------------
9,478 11,560
Investments:
Securitized finance receivables:
Loans, net 1,471,819 1,518,613
Debt securities, available-for-sale 244,045 255,580
Other investments 36,315 37,903
Securities 30,008 33,275
Other loans 7,828 8,304
--------------- -----------------
1,790,015 1,853,675
--------------- -----------------
$ 1,799,493 $ 1,865,235
=============== =================
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Non-recourse securitization financing $ 1,631,260 $ 1,679,830
Repurchase agreements 21,505 23,884
Senior notes - 10,049
---------------------------------
1,652,765 1,713,763
Accrued expenses and other liabilities 1,929 1,626
--------------- -----------------
1,654,694 1,715,389
--------------- -----------------
Commitments and Contingencies (Note 12) - -
SHAREHOLDERS' EQUITY
Preferred stock, par value $.01 per share, 50,000,000 shares authorized:
9.75% Cumulative Convertible Series A, 493,595 shares issued and outstanding 11,274 11,274
($16,610 and $16,322 aggregate liquidation preference, respectively)
9.55% Cumulative Convertible Series B, 688,189 shares issued and outstanding 16,109 16,109
($23,503 and $23,100 aggregate liquidation preference, respectively)
9.73% Cumulative Convertible Series C, 684,893 shares issued and outstanding 19,631 19,631
($28,795 and $28,295 aggregate liquidation preference, respectively)
Common stock, par value $.01 per share, 100,000,000 shares authorized, 109 109
10,873,903 shares issued and outstanding
Additional paid-in capital 360,684 360,684
Accumulated other comprehensive loss (3,542) (3,882)
Accumulated deficit (259,466) (254,079)
--------------- -----------------
144,799 149,846
--------------- -----------------
$ 1,799,493 $ 1,865,235
=============== =================
See notes to unaudited condensed consolidated financial statements.
DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED STATEMENTS
OF OPERATIONS AND COMPREHENSIVE (LOSS) INCOME, UNAUDITED
(amounts in thousands except share data)
Three Months Ended
March 31,
-----------------------------------------------
2004 2003
---------------------- --------------------
Interest income:
Securitized finance receivables $ 32,886 $ 37,756
Other investments 16 1,341
Securities 559 271
Other loans 170 125
---------------------- --------------------
33,631 39,493
---------------------- --------------------
Interest and related expense:
Non-recourse securitization financing 26,872 27,760
Repurchase agreements and senior notes 242 254
Other 82 36
---------------------- --------------------
27,196 28,050
---------------------- --------------------
Net interest margin before provision for loan losses 6,435 11,443
Provision for loan losses (7,200) (5,844)
---------------------- --------------------
Net interest margin (765) 5,599
Impairment charges (1,661) (2,078)
(Loss) gain on sale of investments, net (34) 527
Other (expense) income (459) 17
General and administrative expenses (2,468) (2,021)
---------------------- --------------------
Net (loss) income (5,387) 2,044
Preferred stock (charge) benefit (1,191) 10,444
---------------------- --------------------
Net (loss) income to common shareholders (6,578) 12,488
Change in net unrealized gain/(loss) on:
Investments classified as available for sale during the period 259 626
Hedge instruments 81 (440)
---------------------- --------------------
Comprehensive (loss) income $ (5,047) $ 2,230
====================== ====================
Net (loss) income per common share:
Basic $ (0.60) $ 1.15
====================== ====================
Diluted $ (0.60) $ 1.13
====================== ====================
See notes to unaudited condensed consolidated financial statements.
DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED STATEMENTS
OF CASH FLOWS, UNAUDITED
(amounts in thousands)
Three Months Ended
March 31,
----------------------------------------
2004 2003
----------------- ------------------
Operating activities:
Net (loss) income $ (5,387) $ 2,044
Adjustments to reconcile net (loss) income to net cash provided by
operating activities:
Provision for loan losses 7,200 5,844
Impairment charges 1,661 2,078
Loss (gain) on sale of investments 34 (527)
Amortization and depreciation 1,946 832
Net change in other assets, accrued expenses and other liabilities 28 (247)
------------------ ------------------
Net cash and cash equivalents provided by operating activities 5,482 10,024
------------------ ------------------
Investing activities:
Principal payments received on securitized finance receivables 49,401 79,275
Payments received on other investments, securities and other loans 5,559 6,123
Proceeds from sales of securities and other investments 290 1,405
Purchases of other investments (318) -
Other 75 (1,228)
------------------ ------------------
Net cash and cash equivalents provided by investing activities 55,007 85,575
------------------ ------------------
Financing activities:
Principal payments on non-recourse securitization financing (50,168) (84,349)
Repayment of repurchase agreement borrowings (2,379) -
Repayment of senior notes (10,049) -
Retirement of preferred stock - (19,531)
------------------ ------------------
Net cash and cash equivalents used for financing activities (62,596) (103,880)
------------------ ------------------
Net decrease in cash and cash equivalents (2,107) (8,281)
Cash and cash equivalents at beginning of period 7,386 15,076
------------------ ------------------
Cash and cash equivalents at end of period $ 5,279 $ 6,795
================== ==================
Supplement disclosures of cash flow information:
Cash paid for interest $ 25,419 $ 27,403
================== ==================
See notes to unaudited condensed consolidated financial statements.
NOTES TO UNAUDITED Condensed CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
March 31, 2004
(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.
The Company follows the equity method of accounting for investments with
greater than 20% and less than a 50% interest in partnerships and corporate
joint ventures when it is able to influence the financial and operating policies
of the investee. For all other investments, the cost method is applied.
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 for federal income tax purposes, 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 adjustments, 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 months ended
March 31, 2004 are not necessarily indicative of the results that may be
expected for the year ending December 31, 2004. For further information, refer
to the audited consolidated financial statements and footnotes included in the
Company's Form 10-K for the year ended December 31, 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 reporting 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. 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
estimated timing and amount of currently existing credit losses. Provisions made
to increase the allowance related to credit risk are presented as provision for
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 2003 to
conform to presentation for 2004, including reclassification of certain basis
adjustments from securitized finance receivables within assets to non-recourse
securitization financing within liabilities on the balance sheet and from
interest income to interest expense on the income statement. These remaining
unamortized deferred hedging amounts were basis adjustments recorded prior to
2001 which related to financing hedges and are more appropriately recorded as
part of the related debt.
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 securitized finance receivables is
determined by calculating the present value of the projected cash flows of the
instruments, using discount rates, prepayment rate assumptions and credit loss
assumptions based on historical experience and estimated future activity, and
using discount rates commensurate with those the Company believes would be used
by third parties. The discount rate used in the determination of fair value of
securities pledged as securitized finance receivables was 16% at March 31, 2004
and December 31, 2003. Prepayment rate assumptions at March 31, 2004 and
December 31, 2003 were generally at a "constant prepayment rate," or CPR,
ranging from 30%-50% for both 2004 and 2003, for securitized finance receivables
consisting of securities backed by single-family mortgage loans, and a CPR
equivalent of 8%-9% for 2004 and 9%-10% for 2003, for securitized finance
receivables 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 for each
series of securitized finance receivables, depending on the collateral pledged.
Estimates of fair value for financial instruments are based primarily on
management's judgment. Since the fair value of the Company's financial
instruments is based on estimates, actual fair values recognized may differ from
those estimates recorded in the condensed consolidated financial statements.
NOTE 3 -- SUBSEQUENT EVENTS
On March 29, 2004, the Company initiated a recapitalization plan pursuant to an
offer to its preferred shareholders to exchange outstanding shares of Series A,
Series B, and Series C preferred stock for Senior Notes due 2007, and to convert
the remaining shares of Series A, Series B, and Series C preferred stock into a
new Series D preferred stock and common stock. The recapitalization plan
required the approval of two-thirds of the outstanding shares of each Series of
preferred stock, by Series, and the approval of a majority of the common
shareholders. Such approvals were obtained at special shareholder's meetings
held in April 2004. In addition, Series A, Series B and Series C preferred
shareholders tendered for $823 of senior notes. As a result of the approval of
the recapitalization plan, the three existing classes of Series A, Series B and
Series C preferred stock will be converted into a new Series D preferred stock
and common stock, and the accumulated dividend arrearages on those shares will
also be eliminated. The Series A, Series B, and Series C preferred stock will be
converted into a maximum 5,628,794 shares of Series D preferred stock and a
maximum 1,288,554 shares of common stock. The Series D preferred stock will have
an initial issue price of $10 per share. The conversion is expected to take
place in May 2004.
NOTE 4 -- NET (LOSS) INCOME PER COMMON SHARE
Net (loss) income per common share is presented on both a basic net (loss)
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 the basic and diluted net (loss) income per common share for the three
months ended March 31, 2004 and 2003.
------------------------------------------------- ----------------------------------------------------------------
Three Months Ended March 31,
----------------------------------------------------------------
2004 2003
------------------------------------------------- --------------------------- --- --------------------------------
Weighted- Weighted-
Average Average
Income Number of Income Number of
(loss) Shares (loss) Shares
------------- ------------- --------------- ----------------
Net (loss) income $ (5,387) $ 2,044
Preferred stock (charge) benefit (1,191) 10,444
------------- ---------------
Net (loss) income to common shareholders $ (6,578) 10,873,903 $ 12,488 10,873,903
Effect of dividends and additional shares of
preferred stock - - 1,593 1,569,882
------------- ------------- --------------- ----------------
Diluted $ (6,578) 10,873,903 $ 14,081 12,443,785
============= ============= =============== ================
Net (loss) income per share:
Basic $ (0.60) $ 1.15
============= ================
Diluted $ (0.60) $ 1.13
============= ================
Reconciliation of shares included in calculation of earnings per share due to dilutive effect:
Conversion of Series A $ - - $ 386 410,176
Conversion of Series B - - 537 570,431
Conversion of Series C - - 670 571,445
Expense and incremental shares of stock
appreciation rights - - - 17,830
------------- ------------- --------------- ----------------
$ - - $ 1,593 1,569,882
============= ============= =============== ================
Reconciliation of shares not included in calculation of earnings per share due to anti-dilutive effect:
Conversion of Series A $ 289 246,798 $ - -
Conversion of Series B 402 344,094 - -
Conversion of Series C 500 342,446 - -
Expense and incremental shares of stock
appreciation rights - 17,830 - -
------------- ------------- --------------- ----------------
$ 1,191 951,168 $ - -
============= ============= =============== ===============
------------------------------------------------------------------------------------------------------------------
NOTE 5 -- SECURITIZED FINANCE RECEIVABLES
The following table summarizes the components of securitized finance receivables
at March 31, 2004 and December 31, 2003:
- ------------------------------------------------------------------------- -------------------- -- ------------------
March 31, December 31, 2003
2004
- ------------------------------------------------------------------------- -------------------- -- ------------------
Loans, at amortized cost $ 1,517,807 $ 1,561,977
Allowance for loan losses (45,988) (43,364)
- ------------------------------------------------------------------------- -------------------- -- ------------------
Loans, net 1,471,819 1,518,613
Debt securities, at fair value 244,045 255,580
- ------------------------------------------------------------------------- -------------------- -- ------------------
$ 1,715,864 $ 1,774,193
- ------------------------------------------------------------------------- -------------------- -- ------------------
The following table summarizes the amortized cost basis, gross unrealized gains
and estimated fair value of debt securities pledged as securitized finance
receivables at March 31, 2004 and December 31, 2003:
- ----------------------------------------------------------------------- ---------------------- -- ------------------
March 31, December 31, 2003
2004
- ----------------------------------------------------------------------- ---------------------- -- ------------------
Debt securities, at amortized cost $ 243,776 $ 255,462
Gross unrealized gains 269 118
- ----------------------------------------------------------------------- ---------------------- -- ------------------
Estimated fair value $ 244,045 $ 255,580
- ----------------------------------------------------------------------- ---------------------- -- ------------------
The components of securitized finance receivables at March 31, 2004 and
December 31, 2003 are as follows:
- ------------------------------- ----------------------------------------- -----------------------------------------
March 31, 2004 December 31, 2003
- ------------------------------- ----------------------------------------- -----------------------------------------
Debt Debt
Loans, net Securities Total Loans, net Securities Total
- ------------------------------- ------------- ------------- ------------- ------------- ------------- -------------
Collateral:
Commercial $ 752,141 $ - $ 752,141 $ 758,144 $ - $ 758,144
Manufactured housing 477,425 164,891 642,316 491,230 172,847 664,077
Single-family 293,587 76,870 370,457 317,631 80,468 398,099
------------- ------------- ------------- ------------- ------------- -------------
1,523,153 241,761 1,764,914 1,567,005 253,315 1,820,320
Allowance for loan losses (45,988) - (45,988) (43,364) - (43,364)
Funds held by trustees 131 71 202 131 147 278
Accrued interest receivable 9,592 1,530 11,122 9,878 1,594 11,472
Unamortized discounts and
premiums , net (15,069) 414 (14,655) (15,037) 406 (14,631)
Unrealized gain, net - 269 269 - 118 118
- ------------------------------- ------------- ------------- ------------- ------------- ------------- -------------
$ 1,471,819 $ 244,045 $ 1,715,864 $ 1,518,613 $ 255,580 $ 1,774,193
- ------------------------------- ------------- ------------- ------------- ------------- ------------- -------------
All of the securitized finance receivables are encumbered by non-recourse
securitized financing.
NOTE 6 -- 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 on investments for the three months ended
March 31, 2004 and 2003:
- ------------------------------------------------------ -------------------------------------------------------------
Three Months Ended March 31,
- ------------------------------------------------------ -------------------------------------------------------------
2004 2003
- ------------------------------------------------------ ------------------------------ ------------------------------
Allowance at beginning of period $ 43,364 $ 25,472
Provision for loan losses 7,200 5,844
Charge-offs (4,576) (4,702)
- ------------------------------------------------------ ------------------------------ ------------------------------
Allowance at end of period $ 45,988 $ 26,614
- ------------------------------------------------------ ------------------------------ ------------------------------
An allowance for loan losses has been estimated and established for currently
existing probable losses to the extent losses are borne by the Company under the
terms of the securitization transaction. Factors considered in establishing an
allowance include current loan delinquencies, historical cure rates of
delinquent loans, and historical and anticipated loss severity of the loans as
they are liquidated. The allowance for loan losses is evaluated and adjusted
periodically by management based on the actual and estimated timing and amount
of probable credit losses, using the above factors, as well as industry loss
experience. Where loans are considered homogeneous, the allowance for losses are
established and evaluated on a pool basis. Otherwise, the allowance for losses
is established and evaluated on a loan-specific basis. Provisions made to
increase the allowance are a current period expense to operations. Generally,
the Company considers manufactured housing loans to be impaired when they are
30-days past due. The Company also provides an allowance 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 based on default
trends, current market conditions and empirical observable performance data on
the loans. Single-family loans are considered impaired when they are 60-days
past due.
Loan losses on commercial mortgage loans are estimated based on several factors
including the debt service coverage ratio and estimated loss severities for each
loan. The following table presents certain information on commercial mortgage
loans that the Company has determined to be impaired.
- ---------------------- ------------------------------ ------------------------------ ------------------------------
Amount for Which There Is Amount for Which There Is
Total Recorded Investment in a Related Allowance for No Related Allowance For
Impaired Loans Credit Losses Credit Losses
- ---------------------- ------------------------------ ------------------------------ ------------------------------
4th Quarter 2003 $ 191,484 $ 10,861 $ 180,623
1st Quarter 2004 232,371 12,061 220,310
- ---------------------- ------------------------------ ------------------------------ ------------------------------
Of the amounts included in the Recorded Investment in Impaired Loans in the
table above, approximately $112,175 and $90,088 for 2004 and 2003, respectively,
is covered by loss guarantees from a `AAA-rated' third-party insurance company.
The aggregate amount of losses covered by these guarantees is $28,739.
NOTE 7 -- OTHER INVESTMENTS
The following table summarizes the Company's other investments at March 31, 2004
and December 31, 2003:
- -------------------------------------------------------------------------- ------------------ -- ------------------
March 31, 2004 December 31, 2003
------------------ ------------------
------------------ ------------------
Delinquent property tax receivables and securities, at amortized cost $ 33,991 $ 34,939
Real estate owned 2,320 2,960
Other 4 4
- -------------------------------------------------------------------------- ------------------ ------------------
$ 36,315 $ 37,903
- -------------------------------------------------------------------------- ------------------ -- ------------------
At March 31, 2004 and December 31, 2003, the Company has real estate owned with
a current carrying value of $2,320 and $2,960, respectively, resulting from
foreclosures on delinquent property tax receivables and securities. During the
three months ended March 31, 2004 and March 31, 2003, the Company collected an
aggregate of $1,800 and $2,816, respectively, on delinquent property tax
receivables and securities, including net sales proceeds from related real
estate owned.
NOTE 8 -- 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, at March 31, 2004 and December 31, 2003:
- --------------------------------------------------- ------------------------------- -------------------------------
March 31, 2004 December 31, 2003
- --------------------------------------------------- ------------------------------- -------------------------------
Fair Effective Fair Effective
Value Interest Rate Value Interest Rate
- --------------------------------------------------- --------------- --------------- --------------- ---------------
Securities, available-for-sale:
Fixed-rate mortgage securities $ 26,500 7.9% $ 29,713 14.0%
Mortgage-related securities 50 1.1% 54 12.7%
Equity security 3,000 3,000
- --------------------------------------------------- --------------- --------------- --------------- ---------------
29,550 32,767
Gross unrealized gains 478 517
Gross unrealized losses (743) (810)
- --------------------------------------------------- --------------- --------------- --------------- ---------------
Securities, available-for-sale 29,285 32,474
Asset-backed security, held-to-maturity 723 801
- --------------------------------------------------- --------------- --------------- --------------- ---------------
$ 30,008 $ 33,275
- --------------------------------------------------- --------------- --------------- --------------- ---------------
NOTE 9 -- RECOURSE DEBT
The following table summarizes Dynex's recourse debt outstanding at March 31,
2004 and December 31, 2003:
- ----------------------------------------------------- ---------------------------- -- ---------------------------
March 31, 2004 December 31, 2003
- ----------------------------------------------------- ---------------------------- -- ---------------------------
9.50% Senior Notes (due 2/28/2005) $ - $ 10,049
Repurchase agreements 21,505 23,884
- ----------------------------------------------------- ---------------------------- -- ---------------------------
$ 21,505 $ 33,933
- ----------------------------------------------------- ---------------------------- -- ---------------------------
During the quarter ended March 31, 2004, the Company early redeemed the 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 (see Note 10).
NOTE 10 -- PREFERRED STOCK
At March 31, 2004 and December 31, 2003, the total liquidation preference on the
Preferred Stock was $68,908 and $67,717, respectively, and the total amount of
dividends in arrears on Preferred Stock was $19,655 and $18,466, respectively.
Individually, the amount of dividends in arrears on the Series A, the Series B
and the Series C were $4,765 ($9.65 per Series A share), $6,642 ($9.65 per
Series B share) and $8,248 ($12.05 per Series C share), respectively, at March
31, 2004 and $4,476 ($9.07 per Series A share), $6,240 ($9.07 per Series B
share) and $7,750 ($11.32 per Series C share), respectively, at December 31,
2003.
On March 29, 2004, the Company initiated a recapitalization plan through an
offer to its preferred shareholders to exchange outstanding shares of its Series
A, Series B, and Series C preferred stock for Senior Notes due 2007, and to
convert the remaining shares of Series A, Series B, and Series C preferred stock
into a new Series D preferred stock and common stock. As a result of the
approval of the recapitalization plan, the three existing classes of Series A,
Series B and Series C preferred stock will be converted into a new Series D
preferred stock and common stock, and the accumulated dividend arrearages on
those shares will also be eliminated. The conversion is expected to take place
in May 2004. See Note 3 for further discussion.
NOTE 11 -- 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 non-recourse securitization financing, 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 changes in the value of the hedge being
reported as a component of accumulated other comprehensive income. During the
three months ended March 31, 2004, the Company recognized $113 in other
comprehensive loss on this position and incurred $662 of interest expense
related to net payments made on this position. At March 31, 2004, the aggregate
accumulated other comprehensive loss on this hedge instrument was $2,825. 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 securitized finance receivables being hedged, no ineffectiveness
is assumed on this agreement and, accordingly, any prospective gains or losses
are included in other comprehensive income until the interest rate swap payments
are settled. Based on the forward LIBOR curve as of March 31, 2004, over the
next twelve months, the Company expects to reclassify $2,410 of this other
comprehensive loss to interest expense.
In October 2002, the Company entered into a synthetic three-year amortizing
interest-rate swap with an initial notional balance of approximately $80,000 to
mitigate its exposure to rising interest rates on a portion of its variable rate
non-recourse securitization financing, 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 accumulated other comprehensive income. At March 31, 2004, the
current notional balance of the amortizing synthetic swap was $34,000, and the
remaining weighted-average fixed-rate payable by the Company under the terms of
the synthetic swap was 3.40%. The synthetic swap amortizes through September
2005. During the three months ended March 31, 2004, the Company recognized $17
in other comprehensive loss for the synthetic interest-rate swap and incurred
$147 of interest expense related to net payments made on this position. At March
31, 2004, the aggregate accumulated other comprehensive loss was $721. The
Company evaluated hedge effectiveness and determined that there was no material
ineffectiveness to reflect in earnings. Based on the forward Eurodollar curve as
of March 31, 2004, over the next twelve months, the Company expects to
reclassify $562 into earnings.
NOTE 12 -- 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. 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 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 issues remanded back to the Trial
Court are currently on hold as the Court addresses the challenge made to the
retroactive components of the legislation. The test case being used to decide
this issue is one that is unrelated to GLS. Briefs are currently being filed on
this case.
The Company and Dynex Commercial, Inc. ("DCI"), formerly an affiliate of the
Company and now known as DCI Commercial, Inc., were defendants in state court in
Dallas County, Texas in the matter of Basic Capital Management et al
(collectively, "BCM" or "the Plaintiffs") 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 as a defendant. The complaint, which
was further amended during pretrial proceedings, alleged 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 that DCI breached
another alleged loan commitment of approximately $9,000. The trial commenced in
January 2004 and in February 2004, the jury in the case rendered a verdict in
favor of one of the plaintiffs and against the Company on the alleged breach of
the loan agreements for tenant improvements and awarded that plaintiff damages
in the amount of $253. The jury also awarded the Plaintiffs' attorneys' fees in
the amount of $2,100. The jury entered a separate verdict against DCI in favor
of BCM under two mutually exclusive damage models, for $2,200 and $25,600,
respectively. The verdict, any judgement, and the apportionment of the award of
attorneys fees between the Company and DCI, if appropriate, remains subject to
the outcome of post-judgment motions pending or to be filed with the trial
court. The Company does not believe that it has any legal responsibility for the
verdict against DCI. Plaintiffs are seeking to set-off any damages that may be
awarded against obligations to or loans held by DCI or the Company, as
applicable. The Plaintiffs may attempt to include loans which have been pledged
by the Company as securitized finance receivables in non-recourse securitization
financings. The jury found in favor of DCI on the alleged $9,000 loan
commitment, but did not find in favor of DCI for counterclaims made against BCM.
The Company (and DCI) are vigorously contesting the Plaintiffs' claims including
whether any Plaintiff is entitled to any judgement.
Although no assurance can be given with respect to the ultimate outcome of the
above litigation, the Company believes the resolution of these lawsuits will not
have a material effect on the Company's condensed consolidated balance sheet,
but could materially affect consolidated results of operations in a given year.
NOTE 13 -- RECENT ACCOUNTING PRONOUNCEMENTS
In December 2003, the Accounting Standards Executive Committee (AcSEC) of the
American Institute of Certified Professional Accountants (AICPA) issued
Statement of Position (SOP) No. 03-3, "Accounting for Certain Loans or Debt
Securities Acquired in a Transfer." SOP No. 03-3 is effective for loans acquired
in fiscal years beginning after December 15, 2004, with early adoption
encouraged. A certain transition provision applies for certain aspects of loans
currently within the scope of Practice Bulletin 6, Amortization of Discounts on
Certain Acquired Loans. SOP No. 03-3 addresses accounting for differences
between contractual cash flows and cash flows expected to be collected from an
investor's initial investment in loans or debt securities (loans) acquired in a
transfer if those differences are attributable, at least in part, to credit
quality. It includes loans acquired in business combinations and applies to all
non-governmental entities, including not-for-profit organizations. SOP No. 03-3
does not apply to loans originated by the entity. The Company is reviewing the
implications of SOP No. 03-3 but does not believe that its adoption will have a
significant impact on its financial position, results of operations or cash
flows.
In March 2004, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin (SAB) No. 105, "Application of Accounting Principles to Loan
Commitments." SAB No. 105 addresses the application of generally accepted
accounting practices which apply to loan commitments which are accounted for as
a derivative instrument and measured at fair value. The Company is reviewing the
implications of SAB No. 105 but does not believe that its adoption will have a
significant impact on its financial position, results of operations or cash
flows.
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 ("non-recourse
securitization financing"), which provides long-term financing for such loans
while limiting credit, interest rate and liquidity risk. The Company earns the
net interest spread between the interest income on the loans and securities in
its investment portfolio and the interest and other expenses associated with the
non-recourse securitization financing. The Company also collects payments from
property owners on its investment in delinquent property tax receivables. The
Company manages the cash flow on these investments to maximize shareholders'
value.
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 owns the right to call securitization financing previously issued
and sold by the Company once the outstanding balance of such securities reaches
a call trigger, generally either 35% or less of the original amount issued or a
specified date. Generally interest rates on the bonds issued in the
securitization financing increase by 0.30%-2.00% if the bonds are not redeemed
by the Company. The Company will evaluate the benefit of calling such bonds at
the time they are redeemable. These non-recourse securitization financings are
collateralized by manufactured housing loans, and certain of the bonds may have
interest rates which exceed current market rates. The Company has the right to
call such bonds by class and is contemplating calling these bonds and reissuing
them at the lower current market rates. On April 26, 2004, the Company redeemed
the senior-most bond classes with an aggregate principal balance of $154.8
million, in its Merit Series 12 securitization and reissued the bonds at a $7.4
million premium to the Company. The aggregate callable balance at the time of
the projected call of securitization financing which is expected to reach
respective call triggers during the remainder of 2004 is approximately $230
million, relating to one securitization financing structure. The Company may or
may not elect to call all or part of this securitization, or other
securitizations, when eligible to call.
On March 29, 2004, the Company initiated a recapitalization plan whereby
the Company was seeking shareholder approval to convert the Series A, Series B,
and Series C preferred stock into a new Series D preferred stock and common
stock. As part of the recapitalization plan, the Company offered to exchange
9.50% Senior Notes due 2007 for Series A, Series B and Series C preferred stock.
In April 2004, at special meetings of its shareholders, the Company's preferred
shareholders and its common shareholders approved the conversion of the existing
preferred stock into Series D preferred stock and common stock. In addition,
preferred shareholders tendered for $0.8 million of the Senior Notes. As a
result, on a preliminary basis, the Series A, Series B and Series C preferred
stock will convert into a maximum 5,628,794 shares of Series D preferred stock
and 1,288,554 shares of common stock. The Series D preferred stock will have an
issue price of $10 per share and pay $0.95 per year in dividends. All prior
dividends-in-arrears on the Series A, Series B and Series C preferred stock will
be extinguished. Interest on the senior notes and dividends on the Series D
preferred stock will begin to accrue as of April 7, 2004. On a pro forma basis,
utilizing information as of March 31, 2004, the Company's book value per common
share will increase by $0.19 per share. On a preliminary basis, assuming the
maximum number of shares of common stock are issued, common stock outstanding
after the recapitalization transaction closes will increase from 10,873,903 to
12,162,457 shares. Below is the pro-forma effect on the Company's capital
structure of the conversion and tender offer which assumes the conversion of the
maximum shares of Series D preferred stock and common stock, and assumes costs
incurred related to the implementation of the recapitalization plan and
conversion of Series A, Series B and Series C preferred stock in Series D
preferred stock and common stock of $0.4 million.
- ----------------------------------------------------------------------------------------------------------------------
March 31, 2004
-----------------------------------------------------------
(amounts in thousands) Actual Adjustment Pro-Forma
- ---------------------------------------------------------- ----------------- -- ----------------- --- ----------------
Liabilities:
Non-recourse securitization financing $ 1,631,260 $ - $ 1,631,260
Repurchase agreements 21,505 - 21,505
Senior notes - 823 823
Accrued expenses and other liabilities 1,929 - 1,929
----------------- ----------------- ----------------
1,654,694 823 1,655,517
----------------- ----------------- ----------------
Shareholders' Equity:
Series A preferred stock 11,274 (11,274) -
Series B preferred stock 16,109 (16,109) -
Series C preferred stock 19,631 (19,631) -
Series D preferred stock - 55,886 55,886
Common stock 109 13 122
Additional paid-in capital 360,684 (2,272) 358,412
Accumulated other comprehensive loss (3,542) - (3,542)
Accumulated deficit (259,466) (7,881) (267,347)
----------------- ----------------- ----------------
144,799 (1,268) 143,531
----------------- ----------------- ----------------
$ 1,799,493 $ (445) $ 1,799,048
================= ================= ================
- ----------------------------------------------------------------------------------------------------------------------
The Company believes that the successful completion of the recapitalization plan
will be instrumental in its ability to pursue strategic alternatives, access
additional sources of capital, enhance overall shareholder value, and provide
preferred shareholders with increased liquidity for their shares. Beyond the
recapitalization plan, the Company's primary focus has been and will continue to
be on maximizing cash flows from its investment portfolio and opportunistically
calling securities pursuant to clean-up calls if the underlying collateral has
value for the Company. Longer term, the Board of Directors will continue to
evaluate alternatives for the use of the Company's cash flow in an effort to
improve overall shareholder value. Such evaluation may include a number of
alternatives, including the acquisition of a new business. In addition, given
the availability of tax net operating loss carryforwards, the Company could
forego its REIT status in connection with the introduction of a new business
plan, if such business plan included activities not traditionally associated
with REITs, or that are prohibited or otherwise restricted for REITs.
CRITICAL ACCOUNTING POLICIES
The discussion and analysis of the Company's financial condition and results of
operations are based in large part upon its consolidated financial statements,
which have been prepared in conformity with accounting principles generally
accepted in the United States of America. The preparation of the financial
statements 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.
Critical accounting policies are defined as those that are reflective of
significant judgments or uncertainties, and which may result in materially
different results under different assumptions and conditions, or the application
of which may have a material impact on the Company's financial statements. The
following are the Company's critical accounting policies.
Consolidation of Subsidiaries. The consolidated financial statements represent
the Company's accounts after the elimination of inter-company transactions. The
Company follows the equity method of accounting for investments with greater
than 20% and less than a 50% interest in partnerships and corporate joint
ventures when it is able to influence the financial and operating policies of
the investee. For all other investments, the cost method is applied.
Impairments. The Company evaluates all securities in its investment portfolio
for other-than-temporary impairments. A security is generally defined to be
other-than-temporarily impaired if, for a maximum period of three consecutive
quarters, the carrying value of such security exceeds its estimated fair value
and the Company estimates, based on projected future cash flows or other fair
value determinants, that the carrying value is not likely to exceed fair value
in the foreseeable future. If an other-than-temporary impairment is deemed to
exist, the Company records an impairment charge to adjust the carrying value of
the security down to its estimated fair value. In certain instances, as a result
of the other-than-temporary impairment analysis, the recognition or accrual of
interest will be discontinued and the security will be placed on non-accrual
status.
The Company considers an investment to be impaired if the fair value of the
investment is less than its recorded cost basis. Impairments of other
investments are considered other-than-temporary when the Company determines that
the collection trends indicate the investment is not recoverable. The impairment
recognized on other investments is the difference between the book value of the
investment and the expected collections less collection costs.
Allowance for Loan Losses. The Company has credit risk on loans pledged in
securitization financing transactions and classified as securitized finance
receivables in its investment portfolio. An allowance for loan losses has been
estimated and established for currently existing probable losses to the extent
losses are borne by the Company under the terms of the securitization
transaction. Factors considered in establishing an allowance include current
loan delinquencies, historical cure rates of delinquent loans, and historical
and anticipated loss severity of the loans as they are liquidated. The allowance
for loan losses is evaluated and adjusted periodically by management based on
the actual and estimated timing and amount of probable credit losses, using the
above factors, as well as industry loss experience. Where loans are considered
homogeneous, the allowance for losses are established and evaluated on a pool
basis. Otherwise, the allowance for losses is established and evaluated on a
loan-specific basis. Provisions made to increase the allowance are a current
period expense to operations. Generally, the Company considers manufactured
housing loans to be impaired when they are 30-days past due. The Company also
provides an allowance 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 based on default trends, current market conditions
and empirical observable performance data on the loans. Single-family loans are
considered impaired when they are 60-days past due. Commercial mortgage loans
are evaluated on a loan by loans basis for impairment. Generally, commercial
mortgage loans with a debt service coverage ratio less than 1:1 are considered
impaired. Based on the specific details of a loan, loans with a debt service
coverage ratio greater than 1:1 may be considered impaired; conversely, loans
with a debt service coverage ratio less than 1:1 may not be considered impaired.
A range of loss severity assumptions are applied to these impaired loans to
determine the level of reserves necessary. Certain of the commercial mortgage
loans are covered by loan guarantees that limits the Company's exposure on these
loans. The level of allowance for loan losses required for these loans is
reduced by the amount of applicable loan guarantees. The Company's actual credit
losses may differ from those estimates used to establish the allowance.
FINANCIAL CONDITION
(amounts in thousands)
- ----------------------------------------------------------------------------------------
March 31, 2004 December 31, 2003
- -------------------------------------- ----------------------- -------------------------
Investments:
Securitized finance receivables $ 1,715,864 $ 1,774,193
Other investments 36,315 37,903
Securities 30,008 33,275
Other loans 7,828 8,304
Non-recourse securitization financing 1,631,260 1,679,830
Repurchase agreements 21,505 23,884
Senior notes - 10,049
Shareholders' equity 144,799 149,846
Common book value per share
(inclusive of dividends in arrears) $ 6.98 $ 7.55
- ----------------------------------------------------------------------------------------
Securitized finance receivables. Securitized finance receivables decreased to
$1.72 billion at March 31, 2004 compared to $1.77 billion at December 31, 2003.
This decrease of $58.3 million is primarily the result of $49.8 million in
paydowns on the collateral, $7.2 million of additions to allowance for loan
losses and $1.5 million of impairment charges, partially offset by $0.2 million
of market value changes.
Other investments. Other investments at March 31, 2004 consist primarily of
delinquent property tax receivables. Other investments decreased from $37.9
million at December 31, 2003 to $36.3 million at March 31, 2004. This decrease
is primarily the result of pay-downs of delinquent property tax receivables
which totaled $1.6 million, and sales of real estate owned properties of $0.5
million during the quarter. These decreases were partially offset by additional
advances for collections of $0.5 million.
Securities. Securities decreased during the three months ended March 31, 2004 by
$3.3 million, to $30.0 million at March 31, 2004 from $33.3 million at December
31, 2003 due to principal payments of $3.4 million, partially offset by $0.1
million of net discount write-down.
Other loans. Other loans decreased by $0.5 million from $8.3 million at December
31, 2003 to $7.8 million at March 31, 2004 as the result of paydowns during the
period.
Non-recourse securitization financing. As of March 31, 2004, the Company had 20
series of non-recourse securitization financing outstanding. Non-recourse
securitization financing decreased $48.6 million, from $1.68 billion at December
31, 2003 to $1.63 billion at March 31, 2004. This decrease was primarily a
result of principal payments received of $49.4 million on the associated finance
receivables pledged which were used to pay down the non-recourse securitization
financing in accordance with the respective indentures. Additionally, for
certain securitizations, surplus cash in the amount of $1.0 million was retained
within the security structure and used to repay non-recourse securitization
financing outstanding, instead of being released to the Company, as certain
performance triggers were not met in such securitizations. These decreases were
partially offset by amortization of discounts of $1.7 million.
Senior Notes. The February 2005 Senior Notes were early redeemed in March 2004.
Shareholders' equity. Shareholders' equity decreased to $144.8 million at March
31, 2004 from $149.8 million at December 31, 2003. This decrease was primarily
the result of a net loss of $5.4 million, partially offset by a net decrease in
accumulated other comprehensive loss due to an increase in unrealized gain on
investments available-for-sale of $0.2 million and $0.1 million of deferred
gains on hedging instruments.
RESULTS OF OPERATIONS
- -----------------------------------------------------------------------------------------------
Three Months Ended
March 31,
--------------------------------
(amounts in thousands except per share information) 2004 2003
- -----------------------------------------------------------------------------------------------
Net interest margin $ (765) $ 5,599
Impairment charges (1,661) (2,078)
(Loss) gain on sales of investments (34) 527
General and administrative expenses (2,468) (2,021)
Net (loss) income (5,387) 2,044
Net (loss) income per common share:
Basic $ (0.60) $ 1.15
Diluted $ (0.60) $ 1.13
- -----------------------------------------------------------------------------------------------
Three Months Ended March 31, 2004 Compared to Three Months Ended March 31, 2003.
The decrease in net income during the three months ended March 31, 2004 as
compared to the same period in 2003 is primarily the result of a decrease in net
interest margin of $6.4 million, and an increase in general and administrative
expense, offset by a decrease in impairment charges. In addition to this
decrease in net income, net income per common share also experienced a
significant decrease resulting from the recognition, during the three months
ended March 31, 2003, of $10.4 million of preferred stock benefit associated
with the retirement of Series A, Series B and Series C preferred shares
exchanged for senior notes and cash pursuant to a tender offer initiated by the
Company. This is in contrast to the $1.2 million of preferred dividend charges
for the three-months ended March 31, 2004.
Net interest margin for the three months ended March 31, 2004 decreased to
$(0.8) million from $5.6 million for the same period for 2003. Net interest
spread decreased from 1.68% to 1.21% for the three-month periods ended March 31,
2003 and 2004, respectively, as discussed below. Provision for losses increased
by $1.4 million from $5.8 million in 2003 to $7.2 million in the current period
due to increased actual and estimated loss experience in the Company's
manufactured housing loan portfolio.
Impairment charges consist of losses on certain debt securities. Impairment
charges for the three-month ended March 31, 2003, were $1.7 million compared to
$2.1 million for the same period in 2003. The Company did not experience, in the
three-months ended March 31, 2004, impairment losses on its investment in
delinquent property tax receivables and REO properties that it experienced
during the same period for 2003. Impairment charges for the three-months ended
March 31, 2004, were substantially all related to a security backed mostly by
manufactured housing loans. Gain on sales of investments decreased by $0.5
million in 2004 compared to 2003. Gain on sales of investments in 2003 included
the call of $8.2 million of previously issued securities, and the subsequent
sale of the underlying seasoned single-family mortgage collateral.
General and administrative expense increased to $2.5 million for the
three-months ended March 2004 from $2.0 million for the same period in 2003.
This increase was primarily the result of legal expenses associated with the BCM
litigation, as discussed in Note 12 of the Notes to Unaudited Condensed
Consolidated Financial Statements.
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. Assets that are on non-accrual status are excluded from the
table below for each period presented.
Average Balances and Effective Interest Rates
---------------------------------------------
- -------------------------------------------------------------------------------------------------------------------
Three Months Ended March 31,
----------------------------------------------------------
2004 2003
----------------------------------------------------------
Average Effective Average Effective
Balance Rate Balance Rate
----------------------------- ----------------------------
Interest-earning assets: (1)
Securitized finance receivables (2) $ 1,768,007 7.44% $ 2,069,703 7.56%
Securities 28,408 7.87% 5,668 19.13%
Cash 8,636 0.75% 15,031 1.24%
Other loans 8,227 8.25% 8,755 5.76%
Other investments 4 (13.27%) 50,618 10.23%
----------------------------- ----------------------------
Total interest-earning assets $ 1,813,282 7.42% $ 2,149,775 7.60%
============================= ============================
Interest-bearing liabilities:
Non-recourse securitization financing (3) $ 1,681,370 6.26% $ 1,962,979 5.57%
Repurchase agreements 22,773 1.45% - -%
Senior notes 6,700 9.50% 10,693 9.50%
----------------------------- ----------------------------
Total interest-bearing liabilities $ 1,710,843 6.21% $ 1,973,672 5.59%
============================= ============================
Net interest spread on all investments (3) 1.21% 1.68%
============ ============
Net yield on average interest-earning assets (3) 1.56% 2.22%
============ ============
- -------------------------------------------------------------------------------------------------------------------
<FN>
(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 $335 and $501 for the
three months ended March 31, 2004 and 2003, respectively.
(3) Effective rates are calculated excluding non-interest related
collateralized bond expenses. If included, the effective rate on
interest-bearing liabilities would be 6.36% and 6.02% for the three
months ended March 31, 2004 and 2003.
</FN>
The net interest spread decreased 47 basis points, to 1.21% for the three months
ended March 31, 2004 from 1.68% for the same period in 2003. The net yield on
average interest earning assets for the three months ended March 31, 2004 also
decreased relative to the same period in 2003, to 1.56% from 2.22%. The decline
in the Company's net interest spread can be attributed to decreasing yields on
interest-earning assets and increases in the cost of interest-bearing
liabilities. Yields on interest earning assets declined as a result of the
discontinuance of interest accrual on the Company's investment in delinquent
property tax receivables and the sale in 2003 of high yielding securities.
Interest-bearing liability costs increased by 29 basis points for the three
month period ended March 31, 2004, compared to the same period in 2003 due
primarily to adjustable-rate bonds paying down faster than fixed rate bonds. For
the three month period ended March 31, 2004, there has been a greater decline in
the effective interest-earning yield on the securitized finance receivables due
to the `reset' lag and `floors' (the loans generally adjust or `reset' every six
or twelve months and are generally limited to maximum adjustments upwards or
downwards of 1% each six months), decreases in the short-term interest rates
applicable to the approximate $327 million in single-family ARM loans that
comprise a portion of the securitized finance receivables and increased
prepayments and charge-offs of these securitized finance receivables. The
average One-Month LIBOR rate decreased to 1.10% for the three-month period ended
March 31, 2004 compared to 1.34% for the three-month period ended March 31,
2003. The average six-month LIBOR rate decreased to 1.18% for the three-month
period ended March 31, 2004 compared to 1.36% for the same period in 2003.
From March 31, 2003 to March 31, 2004, average interest-earning assets declined
$336 million, or approximately 16%. A large portion of such reduction relates to
paydowns on the Company's adjustable-rate single-family mortgage loans and
charge-offs on the Company's manufactured housing loans. The Company's portfolio
as of March 31, 2004 consists of $326.8 million of adjustable rate assets and
$1.5 billion of fixed-rate assets. The Company currently finances approximately
$198.4 million of the fixed-rate assets with non-recourse LIBOR based
floating-rate liabilities. Assuming short-term interest rates stay at or about
current levels or increase slowly, the single-family ARM loans should continue
to reset downwards in rate (subject to the floors) which will have the impact of
reducing net interest spread in future periods. If short-term interest rates
start to increase, then the downward resetting of the single-family ARM loans
will slow down and the cost of interest-bearing liabilities will start to
increase, also reducing net interest spread in future periods, depending on how
quickly the rates increase. In June 2002, the Company entered into a three-year
$100 million notional pay fixed/receive variable interest rate swap agreement to
hedge part of this fixed-rate/floating-rate interest mismatch. In October 2002,
the Company short sold a series of 90-day Eurodollar futures contracts with
initial notional amounts of $80 million and with decreasing notional amounts
through September 2005 to hedge an additional portion of this mismatch. At March
31, 2004, the notional amount of this synthetic amortizing swap was $34 million.
Interest Income and Interest-Earning Assets. At March 31, 2004, $1.5 billion of
the investment portfolio consists of loans and securities which pay a fixed-rate
of interest, and approximately $326.8 million of the investment portfolio is
comprised of loans and securities that have coupon rates which adjust over time
(subject to certain periodic and lifetime limitations) in conjunction with
changes in short-term interest rates. Approximately 71% of the ARM loans
underlying the ARM securities and securitized finance receivables are indexed to
and reset based upon the level of six-month LIBOR; approximately 14% of the ARM
loans are indexed to and reset based upon the level of the one-year Constant
Maturity Treasury (CMT) index. The following table presents a breakdown, by
principal balance, of the Company's securitized finance receivables and
securities by type of underlying loan. This table excludes mortgage-related
securities, other investments and unsecuritized loans.
Investment Portfolio Composition (1)
($ in millions)
- --------------------- ------------------ ------------------ ------------------ ------------------ ------------------
Other Indices
LIBOR Based ARM CMT Based ARM Based ARM Loans Fixed-Rate Loans
Loans Loans Total
- --------------------- ------------------ ------------------ ------------------ ------------------ ------------------
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
2003, Quarter 3 288.8 53.4 48.2 1,519.2 1,909.6
2003, Quarter 4 258.2 48.8 45.4 1,512.2 1,864.6
2004, Quarter 1 235.3 46.5 45.0 1,479.0 1,805.8
- --------------------- ------------------ ------------------ ------------------ ------------------ ------------------
(1) Only principal amounts are included.
Credit Exposures. The Company invests in non-recourse securitization financing
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 securitized
finance receivables 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 quarter presented.
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 $27.5 million and a
remaining deductible aggregating $0.8 million on $47.0 million of securitized
single family mortgage loans which are subject to such reimbursement agreements;
guarantees aggregating $28.7 million on $296.8 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 $153.6
million of securitized single family mortgage loans which are subject to various
mortgage pool insurance policies whereby losses would need to exceed the
remaining stop loss of at least 58% on such policies before the Company would
incur losses. This table excludes any credit exposure on unsecuritized loans and
other investments.
Credit Reserves and Actual Credit Losses
($ in millions)
--------------------------------------------------------------------------------------------------------------------
Credit Exposure, Net
Outstanding Credit Exposure, Actual of Credit Reserves to
Loan Principal Net of Credit Outstanding Loan
Balance Credit Reserves Losses Balance
--------------------------------------------------------------------------------------------------------------------
2003, Quarter 1 $ 2,082.3 $ 90.1 $ 6.2 4.33%
2003, Quarter 2 1,997.1 72.8 6.4 3.65%
2003, Quarter 3 1,903.7 67.6 5.7 3.55%
2003, Quarter 4 1,830.2 64.7 7.2 3.54%
2004, Quarter 1 1,775.1 54.3 6.0 3.06%
--------------------------------------------------------------------------------------------------------------------
The following table summarizes single family mortgage loan, manufactured housing
loan and commercial mortgage loan delinquencies as a percentage of the
outstanding collateral balance for those securities in which Dynex has retained
a portion of the direct credit risk. The delinquencies as a percentage of the
outstanding collateral balance have increased to 6.52% at March 31, 2004 from
4.55% at March 31, 2003. The Company monitors and evaluates its exposure to
credit losses and has established reserves based upon anticipated losses,
general economic conditions and trends in the investment portfolio. As of March
31, 2003, management believes the level of credit reserves is appropriate for
currently existing losses.
Delinquency Statistics (1)
--------------------------------------------------------------------------------------------------------------------
30 to 60 days delinquent 60 to 90 days 90 days and over
delinquent delinquent (2) Total
--------------------------------------------------------------------------------------------------------------------
2003, Quarter 1 1.73% 0.49% 2.33% 4.55%
2003, Quarter 2 1.61% 0.43% 2.79% 4.83%
2003, Quarter 3 1.55% 0.48% 2.73% 4.76%
2003, Quarter 4 1.63% 0.43% 2.62% 4.68%
2004, Quarter 1 3.40% 0.49% 2.63% 6.52%
--------------------------------------------------------------------------------------------------------------------
(1) Excludes other investments and unsecuritized loans. (2) Includes
foreclosures, repossessions and REO.
General and Administrative Expense. The following tables present a breakdown of
general and administrative expense by category and business unit.
- ----------------------------- ---------------------------- ----------------------------- ----------------------------
Servicing Corporate/Investment Total
Portfolio Management
- ----------------------------- ---------------------------- ----------------------------- ----------------------------
2003, Quarter 1 $ 1,146.6 $ 874.2 $ 2,020.8
2003, Quarter 2 1,262.3 888.3 2,150.6
2003, Quarter 3 1,240.6 884.1 2,124.7
2003, Quarter 4 1,199.4 1,136.8 2,336.2
2004, Quarter 1 1,008.9 1,459.6 2,468.5
- ----------------------------- ---------------------------- ----------------------------- ----------------------------
General and administrative expense increased to $2.5 million for the
three-months ended March 2004 from $2.0 million for the same period in 2003.
This increase was primarily the result of legal expenses associated with the BCM
litigation.
Recent Accounting Pronouncements. In December 2003, the Accounting Standards
Executive Committee (AcSEC) of the American Institute of Certified Professional
Accountants (AICPA) issued Statement of Position (SOP) No. 03-3, "Accounting for
Certain Loans or Debt Securities Acquired in a Transfer." SOP No. 03-3 is
effective for loans acquired in fiscal years beginning after December 15, 2004,
with early adoption encouraged. A certain transition provision applies for
certain aspects of loans currently within the scope of Practice Bulletin 6,
Amortization of Discounts on Certain Acquired Loans. SOP No. 03-3 addresses
accounting for differences between contractual cash flows and cash flows
expected to be collected from an investor's initial investment in loans or debt
securities (loans) acquired in a transfer if those differences are attributable,
at least in part, to credit quality. It includes loans acquired in business
combinations and applies to all non-governmental entities, including
not-for-profit organizations. SOP No. 03-3 does not apply to loans originated by
the entity. The Company is reviewing the implications of SOP No. 03-3 but does
not believe that its adoption will have a significant impact on its financial
position, results of operations or cash flows.
In March 2004, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin (SAB) No. 105, "Application of Accounting Principles to Loan
Commitments." SAB No. 105 addresses the application of generally accepted
accounting practices which apply to loan commitments which are accounted for as
a derivative instrument and measured at fair value. The Company is reviewing the
implications of SAB No. 105 but does not believe that its adoption will have a
significant impact on its financial position, results of operations or cash
flows.
Non-GAAP Information on Securitized Finance Receivables and
Non-Recourse Securitization Financing
The Company finances its securitized finance receivables through the issuance of
non-recourse securitization financing. The Company presents in its condensed
consolidated financial statements the securitized finance receivables as assets,
and the associated securitization financing as a liability. Because the
securitization financing is recourse only to the finance receivables pledged,
and is therefore not a general obligation of the Company, the risk to the
Company on its investment in securitized finance receivables is limited to its
net investment (i.e., the excess of the finance receivables pledged over the
non-recourse securitization financing). This excess is often referred to as
overcollateralization. The purpose of the information presented in this section
is to present the securitized finance receivables on a net investment basis, and
to provide estimated fair value information using various assumptions on such
net investment. In the tables below, the "principal balance of net investment"
in securitized finance receivables represents the excess of the principal
balance of the collateral pledged over the outstanding balance of the associated
non-recourse securitization financing owned by third parties. The "amortized
cost basis of net investment" is principal balance of net investment plus or
minus premiums and discounts and related costs. The Company generally has sold
the investment grade classes of the securitization financing to third parties,
and has retained the portion of the securitization financing that is below
investment grade.
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. 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.
Below is a summary as of March 31, 2004, by each series of the Company's net
investment in securitized finance receivables where the fair value exceeds $0.5
million. 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 condensed consolidated
financial statements of the Company presents the securitized finance receivables
as an asset, and presents the associated securitization financing 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 securitized finance receivables
or the non-recourse securitization financing 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
condensed consolidated financial statements.
- --------------------------------------------------------------------------------------------------------------------
(amounts in thousands) Principal
Principal Balance of Principal Amortized
Balance Collateralized Balance Cost Basis
Collateralized Of Bonds Of Of
Bond Collateral Outstanding to Net Net
Series (1) Collateral Type Pledged Third Parties Investment Investment
- --------------------------------------------------------------------------------------------------------------------
MERIT Series 11 Securities backed by $ 250,690 $ 218,005 $ 32,685 $ 23,480
single-family mortgage
and manufactured housing
loans
MERIT Series 12 Manufactured housing loans 217,522 199,369 18,153 14,114
MERIT Series 13 Manufactured housing loans 259,903 237,298 22,605 15,779
SASCO 2002-9 Single family loans 293,587 284,859 8,728 14,280
MCA Series 1 Commercial mortgage loans 79,144 74,425 4,719 241
CCA One Series 2 Commercial mortgage loans 285,676 263,572 22,104 9,916
CCA One Series 3 Commercial mortgage loans 387,321 346,375 40,946 52,347
- --------------------------------------------------------------------------------------------------------------------
$ 1,773,843 $ 1,623,903 $ 149,940 $ 130,157
- --------------------------------------------------------------------------------------------------------------------
(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 securitized finance receivables and securitization
financing in the accompanying condensed consolidated financial statements.
- ----------------------------------------------------------------------------------------------
(amounts in thousands) Securitized Non-recourse
finance securitization
receivables financing
- ----------------------------------------------------------------------------------------------
Principal balances per the above table $ 1,773,843 $ 1,623,903
Principal balance of security excluded from above table 3,520 3,497
Recorded impairments on debt securities (12,449) -
Premiums and discounts (14,655) (3,429)
Accrued interest and other 11,592 7,289
Allowance for loan losses (45,987) -
- ----------------------------------------------------------------------------------------------
Balance per condensed consolidated financial statements $ 1,715,864 $ 1,631,260
- ----------------------------------------------------------------------------------------------
The following table summarizes the fair value of a non-GAAP presentation of
the Company's net investment in securitized finance receivables, the various
assumptions made in estimating value, and the cash flow received from such net
investment during 2004. As the Company does not present its investment in
securitized finance receivables 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 securitized finance receivables or
securitization financing in accordance with generally accepted accounting
principles applicable to the Company's transactions.
- --------------------------------------------------------------------------------------------------------------------
Fair Value Assumptions ($ in thousands)
- --------------------------------------------------------------------------------------------------------------------
Collateralized Bond Weighted-average Projected cash Fair value of net Cash flows
Series prepayment speeds Losses flow termination investment (1) received in 2004,
date net (2)
- --------------------------------------------------------------------------------------------------------------------
MERIT Series 11 30%-35% CPR on SF 3.3% annually on Anticipated final $ 23,652 $ 3,336
securities; 8% MH loans maturity in 2025
CPR on MH
securities
MERIT Series 12 8% CPR 3.1% annually on Anticipated final 8,853 277
MH loans maturity in 2027
MERIT Series 13 9% CPR 3.7% annually Anticipated final 638 306
maturity in 2026
SASCO 2002-9 30% CPR 0.15% annually Anticipated call 18,851 3,017
date in 2005
MCA One Series 1 (3) 0.80% annually Anticipated final 2,659 116
maturity in 2018
CCA One Series 2 (4) 0.80% annually Anticipated call 11,094 430
date in 2012
CCA One Series 3 (4) 1.20% annually Anticipated call 18,873 525
date in 2009
- --------------------------------------------------------------------------------------------------------------------
$ 84,620 $ 8,007
- --------------------------------------------------------------------------------------------------------------------
(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 March 31, 2004, 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 would impact the calculation of fair value, as would
differences in actual prepayment speeds and credit losses versus the
assumptions set forth above.
(2) Cash flows received by the Company during the year, equal to the excess of
the cash flows received on the collateral pledged, over the cash flow
requirements of the collateralized bond security
(3) Computed at 0% CPR through June 2008 due to prepayment lockouts and yield
maintenance provisions (4) Computed at 0% CPR until the respective call
date due to prepayment lockouts and yield maintenance provisions
The above tables illustrate the Company's estimated fair value of its net
investment in securitized finance receivables. In its condensed 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. The fair value of net investment for Merit Series 12 in the above table
includes $7.4 million in proceeds which the Company received in April 2004 from
the redemption of the two most senior classes of bonds and the resale of such
bonds to a third-party. Merit Series 13, which is secured by similar collateral,
is redeemable beginning in August 2004. However, as the Company has not
determined whether it will redeem any classes from Series 13, and has not
obtained an independent valuation of the optional redemption provision for
Series 13, no value for such provision is included in the above table. Inclusive
of recorded allowance for loan losses of $46.0 million, the Company's net
investment in collateralized bond securities is approximately $84.6 million.
This amount compares to an estimated fair value, utilizing a discount rate of
16%, of approximately $84.6 million, as set forth in the table above.
The following table compares the fair value of the non-GAAP disclosure of these
investments at various discount rates, but otherwise sing 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 $ 26,452 $ 23,652 $ 21,492 $ 19,397
MERIT Series 12-1 8,837 8,853 8,833 8,777
MERIT Series 13 469 638 747 831
SASCO 2002-9 19,401 18,851 18,320 17,682
MCA One Series 1 3,293 2,659 2,182 1,742
CCA One Series 2 13,656 11,094 9,154 7,358
CCA One Series 3 22,127 18,873 16,166 13,407
- --------------------------------------------------------------------------------------------------------------------
$ 94,235 $ 84,620 $ 76,894 $ 69,194
- --------------------------------------------------------------------------------------------------------------------
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
non-recourse securitization financing). The Company's investment portfolio
continues to provide positive cash flow, which can be utilized by the Company
for reinvestment or other purposes. 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 quarter ended
March 31, 2004 was approximately $11.1 million. Such cash flow is after payment
of principal and interest on the associated non-recourse securitization
financing (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.
Senior Notes. During the quarter ended March 31, 2004, the Company redeemed all
of the 9.50% senior unsecured notes due February 2005 (the "February 2005 Senior
Notes").
Non-recourse Debt. Dynex, through limited-purpose finance subsidiaries, has
issued non-recourse debt in the form of non-recourse securitization financing to
fund the majority of its investment portfolio. The obligations under the
non-recourse securitization financing are payable solely from the securitized
finance receivables and are otherwise non-recourse to Dynex. Securitized finance
receivables is not subject to margin calls. The maturity of each class of
non-recourse securitization financing 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 March 31,
2004, Dynex had $1.6 billion of non-recourse securitization financing
outstanding.
FORWARD-LOOKING STATEMENTS
Certain written statements in this Form 10-Q made by the Company, that are not
historical fact constitute "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. Such forward-looking statements may
involve factors that could cause the actual results of the Company to differ
materially from historical results or from any results expressed or implied by
such forward-looking statements. The Company cautions the public not to place
undue reliance on forward-looking statements, which may be based on assumptions
and anticipated events that do not materialize. The Company does not undertake,
and the Securities Litigation Reform Act specifically relieves the Company from,
any obligation to update any forward-looking statements.
Factors that may cause actual results to differ from historical results or from
any results expressed or implied by forward-looking statements include the
following:
Economic Conditions. The Company is affected by 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 Company's financial
performance and the performance on the Company's securitized loan pools.
Capital Resources. Cash flows from our portfolio 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 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 securitized finance receivables by the Company are fixed-rate. The
Company currently finances these fixed-rate assets through non-recourse debt,
approximately $198 million of which is variable rate. Financing fixed rate
assets with variable rate bonds exposes the Company to reductions in income and
cash flow in a period of rising interest rates. Through the use of interest rate
swaps and synthetic swaps, the Company has reduced this exposure by
approximately $134 million at March 31, 2004 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 March 31,
2004, the Company has approximately $503 million of variable-rate collateralized
bonds.
The net interest spread for these investments could decrease materially during a
period of rapidly rising short-term interest rates, since the investments
generally have interest rates which reset on a delayed basis and have periodic
interest rate caps, whereas the related borrowing has no delayed resets or such
interest rate caps.
Defaults. Defaults by borrowers on loans retained by the Company may have an
adverse impact on the Company's financial performance, if actual credit losses
differ materially from estimates made by the Company. 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 that were delinquent as of March
31, 2004.
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 March 31, 2004 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 and cash flows. 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.
The Company monitors the aggregate cash flow, projected net yield and estimated
market value of its investment portfolio under various interest rate and
prepayment assumptions. While certain investments may perform poorly in an
increasing or decreasing interest rate environment, other investments may
perform well, and others may not be impacted at all.
The Company focuses on the sensitivity of its investment portfolio 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 over
such time period follow the forward LIBOR curve (based on 90-day Eurodollar
futures contracts) as of March 31, 2004. 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. Cash flow changes from interest rate swaps, caps,
floors or any other derivative instrument are included in this analysis.
The following table summarizes the Company's net interest margin cash flow and
market value sensitivity analyses as of March 31, 2004. These analyses
represents management's estimate of the percentage change in net interest margin
cash flow and value, expressed as a percentage change of shareholders' equity,
given a parallel 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
March 31, 2004. At March 31, 2004, one-month LIBOR was 1.09% and six-month LIBOR
was 1.16%. 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 investment portfolio and the liabilities incurred by the Company,
including non-recourse securitization financing, to finance their investments.
As a result of anticipated prepayments on assets in the investment portfolio,
there are likely to be such changes in the future.
Projected Change in Net
Basis Point Interest Margin Projected Change in Value,
Increase (Decrease) Cash Flow From Expressed as a Percentage of
in Interest Rates Base Case Shareholders' Equity
- ----------------------------------- -------------------------------- -----------------------------------
+200 (15.0)% (5.6)%
+100 (9.3)% (2.8)%
Base
-100 10.5% 3.9%
-200 15.5% 7.1%
The Company's interest rate risk is related both to the rate of change in short
term interest rates, and to the level of short-term interest rates.
Approximately $326.8 million of the Company's investment portfolio as of March
31, 2004 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 71% and 14% of the ARM
loans underlying the Company's ARM securities and securitized finance
receivables 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 securitized finance receivables
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 to item (i), the Company has substantially limited its
interest rate risk on such investments through (i) the issuance of fixed-rate
non-recourse securitization financing which approximated $1.1 billion as of
March 31, 2004, and (ii) equity, which was $144.8 million. In addition, the
Company has entered into interest rate swaps and synthetic swaps to mitigate its
interest rate risk exposure on fixed-rate investments financed with variable
rate bonds as further discussed below. As to items (ii) and (iii), as short-term
interest rates stabilize and the ARM loans reset, the net interest margin may be
partially restored as the yields on the ARM loans adjust to market conditions.
In addition, the Company has entered into an interest rate swap to mitigate its
interest rate risk exposure on $100 million in notional value of its variable
rate bonds. The swap agreement has been constructed such that 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 notional amount. The impact on
cash flows from the interest rate swap has been included in the table above for
each of the respective interest-rate scenarios. An additional approximate $34
million of floating-rate liabilities are being converted to a fixed rate through
an amortizing synthetic swap created by the short sale of a string of Eurodollar
futures contract in October 2002. The synthetic swap has an estimated duration
of 1.25 years. As of December 31, 2003, the weighted-average fixed rate cost of
the synthetic swap to the Company is 3.40%.
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. 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.
Item 4. Controls and Procedures
(a) Evaluation of disclosure controls and procedures.
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.
As of the end of the period covered by this report, the
Company carried out an evaluation of the effectiveness of the
design and operation of the Company's disclosure controls and
procedures pursuant to Rule 13a-15 under the Exchange Act.
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.
In conducting its review of disclosure controls, management
concluded that sufficient disclosure controls and procedures
did exist 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.
(b) Changes in internal controls.
The Company's management is also responsible for establishing
and maintaining adequate internal control over financial
reporting. During the Company's last fiscal quarter its real
estate owned management and collection systems were enhanced to
more reliably capture and report information on the status of
the Company's real estate owned including information necessary
to accurately compute the net realizable value of the real estate
owned and to seek verification of market values from independent
third-party sources. There were no other 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. 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 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 issues remanded back to the Trial
Court are currently on hold as the Court addresses the challenge made to the
retroactive components of the legislation. The test case being used to decide
this issue is one that is unrelated to GLS. Briefs are currently being filed on
this case.
The Company and Dynex Commercial, Inc. ("DCI"), formerly an affiliate of the
Company and now known as DCI Commercial, Inc., were defendants in state court in
Dallas County, Texas in the matter of Basic Capital Management et al
(collectively, "BCM" or "the Plaintiffs") 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 as a defendant. The complaint, which
was further amended during pretrial proceedings, alleged 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 that DCI breached
another alleged loan commitment of approximately $9 million. The trial commenced
in January 2004 and in February 2004, the jury in the case rendered a verdict in
favor of one of the plaintiffs and against the Company on the alleged breach of
the loan agreements for tenant improvements and awarded that plaintiff damages
in the amount of $0. 3 million. The jury also awarded the Plaintiffs' attorneys
fees in the amount of $2.1 million. The jury entered a separate verdict against
DCI in favor of BCM under two mutually exclusive damage models, for $2.2 million
and $25.6 million, respectively. The verdict, any judgement, and the
apportionment of the award of attorneys fees between the Company and DCI, if
appropriate, remains subject to the outcome of post-judgment motions pending or
to be filed with the trial court. The Company does not believe that it has any
legal responsibility for the verdict against DCI. Plaintiffs are seeking to
set-off any damages that may be awarded against obligations to or loans held by
DCI or the Company, as applicable. The Plaintiffs may attempt to include loans
which have been pledged by the Company as securitized finance receivables in
non-recourse securitization financings. The jury found in favor of DCI on the
alleged $9 million loan commitment, but did not find in favor of DCI for
counterclaims made against BCM. The Company (and DCI) are vigorously contesting
Plaintiffs' claims including whether any Plaintiff is entitled to any judgement.
Although no assurance can be given with respect to the ultimate outcome of the
above litigation, the Company believes the resolution of these lawsuits will not
have a material effect on the Company's condensed 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 10 to accompanying condensed consolidated financial statements in
Part I Item 1.
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
31.1 Certification of Principal Executive Officer and
Chief Financial Officer pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.
32.1 Certification of Principal Executive Officer
pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K
Current report on Form 8-K, including Item 5. "Other Events and
Regulation FD Disclosure" and Item 7. "Financial Statements,
Pro Forma Financial Information and Exhibits," Exhibit No.
99.1 as filed with the Commission on March 30, 2004 providing
a copy of the Dynex Capital, Inc. Press Release dated March 29,
2004.
Current report on Form 8-K, including Item 7. "Exhibits,"
Exhibit No. 99 as filed with the Commission on March 16,
2004 providing a copy of the Dynex Capital, Inc. Press Release
dated March 15, 2004.
Current report on Form 8-K, including Item 12, "Results of Opera-
tions and Financial Condition," Exhibit No. 99.1 as filed with the
Commission on May 12, 2004, providing a copy of the Dynex Capital,
Inc. Press Release dated May 11, 2004.
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: May 20, 2004 By: /s/ Stephen J. Benedetti
------------------------------------
Stephen J. Benedetti,
Executive Vice President
(Principal Executive Officer)