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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
|X| Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarterly period ended June 30, 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
As of July 31, 2004, the registrant had 12,162,391 shares of common stock
outstanding with a par value of $.01 per share, which is the registrant's only
class of common stock.
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DYNEX CAPITAL, INC.
FORM 10-Q
INDEX
Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets at June 30, 2004
and December 31, 2003 (unaudited)..............................................................1
Condensed Consolidated Statements of Operations and
Comprehensive Loss for the three and six months ended
June 30, 2004 and 2003 (unaudited) .............................................................2
Condensed Consolidated Statements of Cash Flows for
the six months ended June 30, 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..................................................11
Item 3. Quantitative and Qualitative Disclosures about Market Risk.....................................24
Item 4. Controls and Procedures........................................................................25
PART II. OTHER INFORMATION
Item 1. Legal Proceedings .............................................................................26
Item 2. Changes in Securities, Use of Proceeds and
Issuer Purchases of Equity Securities..........................................................27
Item 3. Defaults Upon Senior Securities................................................................27
Item 4. Submission of Matters to a Vote of Security Holders............................................27
Item 5. Other Information..............................................................................27
Item 6. Exhibits and Reports on Form 8-K...............................................................27
SIGNATURE............................................................................................................29
Exhibits.............................................................................................................30
i
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED
BALANCE SHEETS (UNAUDITED)
(amounts in thousands except share data)
-------------------- ---- ---------------------
June 30, December 31,
2004 2003
-------------------- ---------------------
ASSETS
Cash and cash equivalents $ 22,905 $ 7,386
Other assets 3,433 4,174
-------------------- ---------------------
26,338 11,560
Investments:
Securitized finance receivables:
Loans, net 1,422,878 1,518,613
Debt securities, available-for-sale 228,521 255,580
Other investments 35,258 37,903
Securities 25,007 33,275
Other loans 6,433 8,304
-------------------- ---------------------
1,718,097 1,853,675
-------------------- ---------------------
$ 1,744,435 $ 1,865,235
==================== =====================
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Non-recourse securitization financing $ 1,589,596 $ 1,679,830
Repurchase agreements 17,330 23,884
Senior notes 823 10,049
-------------------- ---------------------
1,607,749 1,713,763
Accrued expenses and other liabilities 1,325 1,626
-------------------- ---------------------
1,609,074 1,715,389
-------------------- ---------------------
Commitments and contingencies (Note 11) - -
SHAREHOLDERS' EQUITY
Preferred stock, par value $.01 per share, 50,000,000 shares authorized:
9.75% Cumulative Convertible Series A, None and 493,595 shares issued and - 11,274
outstanding (None and $16,322 aggregate liquidation preference,
respectively)
9.55% Cumulative Convertible Series B, None and 688,189 shares issued and - 16,109
outstanding (None and $23,100 aggregate liquidation preference,
respectively)
9.73% Cumulative Convertible Series C, None and 684,893 shares issued and - 19,631
outstanding (None and $28,295 aggregate liquidation preference,
respectively)
9.75% Cumulative Convertible Series D, 5,628,737 shares and none issued and 55,670 -
outstanding ($57,535 and no aggregate liquidation preference, respectively)
Common stock, par value $.01 per share, 100,000,000 shares authorized, 122 109
12,162,391 and 10,873,903 shares issued and outstanding, respectively
Additional paid-in capital 366,897 360,684
Accumulated other comprehensive income (loss) 1,438 (3,882)
Accumulated deficit (288,766) (254,079)
-------------------- ---------------------
135,361 149,846
-------------------- ---------------------
$ 1,744,435 $ 1,865,235
==================== =====================
See notes to unaudited condensed consolidated financial statements.
1
DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED STATEMENTS
OF OPERATIONS AND COMPREHENSIVE LOSS (UNAUDITED)
(amounts in thousands except share and per share data)
---------------------------------- --- ---------------------------------------
Three Months Ended June 30, Six Months Ended June 30,
---------------------------------- ---------------------------------------
2004 2003 2004 2003
--------------- --------------- ----------------- -----------------
Interest income:
Securitized finance receivables $ 32,469 $ 37,078 $ 65,355 $ 76,177
Securities 555 138 1,114 409
Other loans 163 127 333 253
Other investments 30 1,162 46 2,503
--------------- --------------- ----------------- -----------------
33,217 38,505 66,848 79,342
--------------- --------------- ----------------- -----------------
Interest and related expense:
Non-recourse securitization financing 27,555 28,824 54,427 57,927
Repurchase agreements and senior notes 83 730 325 984
Other 60 125 142 162
--------------- --------------- ----------------- -----------------
27,698 29,679 54,894 59,073
--------------- --------------- ----------------- -----------------
Net interest margin before provision for loan
losses 5,519 8,826 11,954 20,269
Provision for loan losses (8,947) (18,040) (16,147) (23,884)
--------------- --------------- ----------------- -----------------
Net interest margin (3,428) (9,214) (4,193) (3,615)
Impairment charges (7,746) (200) (9,407) (2,205)
Gain on sale of investments, net 20 556 4 1,010
Other income (expense) 216 23 (261) 40
General and administrative expenses (2,015) (2,151) (4,483) (4,172)
--------------- --------------- ----------------- -----------------
Net loss (12,953) (10,986) (18,340) (8,942)
Preferred stock benefit (charge) 2,045 (1,214) 854 9,230
--------------- --------------- ----------------- -----------------
Net (loss) income to common shareholders $ (10,908) $ (12,200) $ (17,486) $ 288
--------------- --------------- ----------------- -----------------
Change in net unrealized gain/(loss) on:
Investments classified as available-for-sale
during the period 3,056 2,355 3,315 2,981
Hedge instruments 1,924 (679) 2,005 (1,119)
--------------- --------------- ----------------- -----------------
Comprehensive loss $ (7,973) $ (9,310) $ (13,020) $ (7,080)
=============== =============== ================= =================
Net (loss) income per common share:
Basic and diluted $(0.95) $(1.12) $(1.59) $0.03
=============== =============== ================= =================
Weighted average number of common shares outstanding:
Basic and diluted 11,468,635 10,873,903 10,972,844 10,873,903
=============== =============== ================= =================
See notes to unaudited condensed consolidated financial statements.
2
DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED STATEMENTS
OF CASH FLOWS (UNAUDITED)
(amounts in thousands)
-------------------------------------------------
Six Months Ended
June 30,
-------------------------------------------------
2004 2003
---------------------- -----------------------
Operating activities:
Net loss $ (18,340) $ (8,942)
Adjustments to reconcile net loss to net cash provided by operating
activities:
Provision for loan losses 16,147 23,884
Impairment charges 9,407 2,205
Gain on sale of investments (4) (1,010)
Amortization and depreciation 3,886 5,349
Net change in other assets, accrued expenses and other liabilities 2,096 (4,711)
---------------------- -----------------------
Net cash and cash equivalents provided by operating activities 13,192 16,775
---------------------- -----------------------
Investing activities:
Principal payments received on securitized finance receivables 100,881 156,174
Payments received on other investments, securities and other loans 13,956 11,180
Proceeds from sales of securities and other investments 461 2,359
Purchase of or advances on investments (1,308) (3,508)
Other (243) 177
---------------------- -----------------------
Net cash and cash equivalents provided by investing activities 113,747 166,382
---------------------- -----------------------
Financing activities:
Principal payments on non-recourse securitization financing (101,552) (160,818)
Proceeds from issuance of bonds 7,377 -
Repayment of repurchase agreement borrowings (5,731) -
Repayment of senior notes (10,049) (4,010)
Retirement of preferred stock (1,465) (19,553)
---------------------- -----------------------
Net cash and cash equivalents used for financing activities (111,420) (184,381)
---------------------- -----------------------
Net increase (decrease) in cash and cash equivalents 15,519 (1,224)
Cash and cash equivalents at beginning of period 7,386 15,076
---------------------- -----------------------
---------------------- -----------------------
Cash and cash equivalents at end of period $ 22,905 $ 13,852
====================== =======================
Supplement disclosures of cash flow information:
Cash paid for interest $ 50,531 $ 55,104
=================================================
See notes to unaudited condensed consolidated financial statements.
3
DYNEX CAPITAL, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS June 30, 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 when it is able to
influence the financial and operating policies of the investee. For all other
investments in partnerships, 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 accruals considered necessary for a fair presentation of the condensed
consolidated financial statements have been included. The financial statements
presented are unaudited. Operating results for the three and six months ended
June 30, 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 as
discussed in Note 5. An allowance for loan losses has been estimated and
established for current existing losses based on management's judgment. The
allowance for loan losses is evaluated and adjusted periodically by management
based on the actual and projected timing and amount of credit losses. Provisions
made to increase the allowance related to credit risk are presented as provision
for loan losses in the accompanying condensed consolidated statements of
operations. The Company's actual credit losses may differ from those estimates
used to establish the allowance.
Certain reclassifications have been made to the financial statements for 2003 to
conform to the presentation for 2004.
NOTE 2 - FAIR VALUE
Securities classified as available-for-sale are carried in the accompanying
financial statements at estimated fair value. Securities are both fixed-rate and
adjustable-rate. Estimates of fair value for securities are based on market
prices provided by certain dealers, when available. Estimates of fair value for
certain other securities, including securities pledged as securitized finance
4
receivables, are determined by calculating the present value of the projected
cash flows of the instruments using market based assumptions such as the forward
yield based on the forward Eurodollar curve and estimated market spreads to
applicable indices for comparable securities, and using collateral based
assumptions such as prepayment rates and credit loss assumptions based on the
most recent performance and anticipated performance of the underlying
collateral..
NOTE 3 - NET INCOME (LOSS) PER COMMON SHARE
Net income (loss) per common share is presented on both a basic and diluted per
common share basis. Diluted net income (loss) 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 Series D preferred stock is convertible into one share of common
stock for each share of preferred stock. The Series A, Series B and Series C
preferred stock is convertible into one share of common stock for two shares of
preferred stock.
The following table reconciles the numerator and denominator for both basic and
diluted net income (loss) per common share for the three and six months ended
June 30, 2004 and 2003.
- ----------------------------------------------------------------------------------------------------------------------------
Three Months Ended June 30, Six Months Ended June 30,
----------------------------------------------------------------------------------------------
2004 2003 2004 2003
----------------------------------------------------------------------------------------------
Weighted- Weighted- Weighted- Weighted-
Average Average Average Average
(Loss) Number (Loss) Number (Loss) Number (Loss) Number
Income Of Shares Income Of Shares Income Of Shares Income Of Shares
----------- ----------------------- ----------------------- ---------------------- -----------
Net loss $ (12,953) $(10,986) $ (18,340) $ (8,942)
Preferred stock benefit 2,045 (1,214) 854 9,230
(charge)
------------- ----------- ----------- ----------
Net (loss) income to common
shareholders $ (10,908) 11,468,635 $(12,200) 10,873,903 $ (17,486) 10,972,844 $ 288 10,873,903
=========== ======================= ======================= ====================== ===========
Net (loss) income per share:
Basic and diluted $(0.95) $(1.12) $(1.59) $0.03
============ ============ ============ ===========
Reconciliation of shares not included in
calculation of earnings per share due to
anti-dilutive effect
Series A $ (48) 132,891 $ (289) 246,798 $ (337) 189,844 $ (675) 328,035
Series B (134) 185,282 (403) 344,095 (537) 264,688 (940) 456,637
Series C (167) 184,394 (500) 342,447 (666) 263,420 (1,169) 456,313
Series D (1,263) 2,659,733 - - (1,263) 1,329,866 - -
Expense and incremental
shares of stock - 21,119 - 19,933 - 21,067 - 19,933
appreciation rights
----------- ----------------------- ----------------------- ---------------------- -----------
$ (1,612) 3,183,419 $ (1,192) 953,273 $ (2,803) 2,068,885 $ (2,784) 1,260,918
=========== ======================= ======================= ====================== ===========
- ----------------------------------------------------------------------------------------------------------------------------
NOTE 4 - SECURITIZED FINANCE RECEIVABLES
The following table summarizes the types of securitized finance receivables as
of June 30, 2004 and December 31, 2003:
- ----------------------------------- -------------------- -- ----------------
June 30, December 31,
2004 2003
- ----------------------------------- -------------------- -- ----------------
Loans, at amortized cost $ 1,472,346 $1,561,977
Allowance for loan losses (49,468) (43,364)
- ----------------------------------- -------------------- -- ----------------
Loans, net 1,422,878 1,518,613
Debt securities, at fair value 228,521 255,580
- ----------------------------------- -------------------- -- ----------------
$ 1,651,399 $ 1,774,193
- ----------------------------------- -------------------- -- ----------------
5
The following table summarizes the amortized cost basis, gross unrealized gains
and losses and estimated fair value of debt securities pledged as securitized
finance receivables as of June 30, 2004 and December 31, 2003:
- ------------------------------------- ------------------ --- -------------------
June 30, December 31, 2003
2004
- ------------------------------------- ------------------ --- -------------------
Debt securities, at amortized cost $ 225,251 $ 255,462
Gross unrealized gains 3,270 118
- ------------------------------------- ------------------ --- -------------------
Estimated fair value $ 228,521 $ 255,580
- ------------------------------------- ------------------ --- -------------------
The components of securitized finance receivables at June 30, 2004 and December
31, 2003 are as follows:
- ----------------------------------------- ----------------------------------------- -----------------------------------------
June 30, 2004 December 31, 2003
- ----------------------------------------- ----------------------------------------- -----------------------------------------
Loans, net Debt Total Loans, net Debt Total
Securities Securities
- ----------------------------------------- ------------- ------------- ------------- ------------- ------------- -------------
Collateral:
Commercial $ 746,852 $ - $ 746,852 $ 758,144 $ - $ 758,144
Manufactured housing 462,742 157,861 620,603 491,230 172,847 664,077
Single-family 267,798 65,156 332,954 317,631 80,468 398,099
------------- ------------- ------------- ------------- ------------- -------------
1,477,392 223,017 1,700,409 1,567,005 253,315 1,820,320
Allowance for loan losses (49,468) - (49,468) (43,364) - (43,364)
Funds held by trustees 131 383 514 131 147 278
Accrued interest receivable 9,335 1,458 10,793 9,878 1,594 11,472
Unamortized discounts and premiums, net (14,512) 393 (14,119) (15,037) 406 (14,631)
Unrealized gain, net - 3,270 3,270 - 118 118
- ----------------------------------------- ------------- ------------- ------------- ------------- ------------- -------------
$ 1,422,878 $ 228,521 $1,651,399 $1,518,613 $ 255,580 $ 1,774,193
- ----------------------------------------- ------------- ------------- ------------- ------------- ------------- -------------
NOTE 5 - 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 six months ended June
30, 2004 and 2003:
- ---------------------------------- ---------------------------------------------
Six Months Ended June 30,
- ---------------------------------- ---------------------------------------------
2004 2003
- ---------------------------------- --------------------- -----------------------
Allowance at beginning of period $ 43,364 $ 25,472
Provision for loan losses 16,147 23,884
Credit losses, net of recoveries (10,043) (9,645)
- ---------------------------------- --------------------- -----------------------
Allowance at end of period $ 49,468 $ 39,711
- ---------------------------------- --------------------- -----------------------
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
thirty 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 sixty days past due.
6
Commercial mortgage loans are considered impaired when they are thirty days past
due, and are evaluated for impairment with the ratio of net operating income on
the underlying collateral to the required debt service falls below 1:1. Once
deemed impaired, loan losses on commercial mortgage loans are estimated based on
several factors including the net operating income and estimated capitalization
rates, or appraised value, if available. The following table presents certain
information on commercial mortgage loans that the Company has determined to be
impaired. Impaired loans at June 30, 2004 declined from December 31, 2003 based
on the repayment in full in July and August 2004 of approximately $70 million of
loans previously considered impaired, and the reclassification of loans
previously considered impaired based on the improved performance of the
underlying loan collateral, or if the loan is collateralized by low income
housing tax credit properties.
- ------------------------------- ------------------------------ ------------------------------ ------------------------------
Amount for which there is a Amount for which there is no
Recorded Investment in Related Allowance for Credit Related Allowance for Credit
Impaired Loans Losses Losses
- ------------------------------- ------------------------------ ------------------------------ ------------------------------
December 31, 2003 $ 191,484 $ 10,861 $ 180,623
June 30, 2004 80,556 16,395 64,161
- ------------------------------- ------------------------------ ------------------------------ ------------------------------
NOTE 6 - OTHER INVESTMENTS
The following table summarizes the Company's other investments as of June 30,
2004 and December 31, 2003:
- ---------------------------------------------------------------------------------- ------------------ -- ------------------
June 30, December 31,
2004 2003
------------------ ------------------
Delinquent property tax receivables and securities, at amortized cost $ 33,186 $ 34,939
Real estate owned 2,070 2,960
Other 2 4
- ---------------------------------------------------------------------------------- ------------------ ------------------
$ 35,258 $ 37,903
- ---------------------------------------------------------------------------------- ------------------ -- ------------------
At June 30, 2004 and December 31, 2003, the Company has real estate owned with a
current carrying value of $2,070 and $2,960, respectively, resulting from
foreclosures on delinquent property tax receivables and securities. During the
six months ended June 30, 2004 and 2003, the Company collected an aggregate of
$3,892 and $5,850, respectively, on delinquent property tax receivables and
securities, including net sales proceeds from related real estate owned. The
Company also accrued interest income of none and $2,444, respectively, during
such periods. Delinquent property tax securities included in other investments
are classified as held-to-maturity and are carried at amortized cost.
7
NOTE 7 - SECURITIES
The following table summarizes Dynex's amortized cost basis of securities
classified as held-to-maturity and fair value of securities classified as
available-for-sale, as of June 30, 2004 and December 31, 2003, and the effective
interest rate of these securities as of the respective period end:
- ------------------------------------------------------------ ------------------------------ --------------------------------
June 30, 2004 December 31, 2003
- ------------------------------------------------------------ ------------------------------ --------------------------------
Fair Effective Fair Effective
Value Interest Rate Value Interest Rate
- ------------------------------------------------------------ -------------- --------------- --------------- ----------------
Securities, available-for-sale:
Fixed-rate mortgage securities $ 21,592 7.88% $ 29,713 7.79%
Mortgage-related securities 46 - 54 -
Equity security, at amortized cost 3,000 3,000
- ------------------------------------------------------------ -------------- --------------- --------------- ----------------
24,638 32,767
Gross unrealized gains 366 517
Gross unrealized losses (576) (810)
- ------------------------------------------------------------ -------------- --------------- --------------- ----------------
Securities, available-for-sale 24,428 32,474
Asset-backed security, held-to-maturity 579 801
- ------------------------------------------------------------ -------------- --------------- --------------- ----------------
$ 25,007 $ 33,275
- ------------------------------------------------------------ -------------- --------------- --------------- ----------------
NOTE 8 - REPURCHASE AGREEMENTS AND SENIOR NOTES
The following table summarizes Dynex's recourse debt outstanding at June 30,
2004 and December 31, 2003:
- ----------------------------------------- ----------------- -- -----------------
June 30, 2004 December 31, 2003
- ----------------------------------------- ----------------- -- -----------------
Repurchase agreements $ 17,330 $ 23,884
9.50% Senior Notes (due 2/28/2005) - 10,049
9.50% Senior Notes (due 4/30/2007) 823 -
- ----------------------------------------- ----------------- -- -----------------
$ 18,153 $ 33,933
- ----------------------------------------- ----------------- -- -----------------
Repurchase agreements are collateralized by securities with a fair value of
$19,319 and $26,517 as of June 30, 2004, and December 31, 2003, respectively.
NOTE 9 - PREFERRED STOCK
On May 19, 2004, the Company completed a shareholder approved recapitalization
resulting in the exchange of all of its outstanding shares of its Series A,
Series B, and Series C preferred stock for $823 of Senior Notes due 2007, and
the conversion of the remaining shares of Series A, Series B, and Series C
preferred stock into 5,628,737 shares of Series D preferred stock and 1,288,488
shares of common stock. As a result of the completion of the recapitalization,
the dividend arrearage on the three existing classes of Series A, Series B and
Series C preferred stock was eliminated. The Series D preferred stock has an
issue price of $10 per share, currently pays $0.2375 per share in quarterly
dividends, and each share is convertible into one share of common stock.
As of June 30, 2004 and December 31, 2003, the total liquidation preference on
the Preferred Stock was $57,535 and $67,717, respectively. Individually, the
amount of accrued dividends on the Series D shares were $1,248 ($0.22 per Series
D share) at June 30, 2004 and dividends in arrears on the Series A, the Series
B, the Series C shares were $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.
8
NOTE 10 - DERIVATIVE FINANCIAL INSTRUMENTS
The Company has entered into an interest rate swap agreement 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 the one-month London Inter-Bank Offering Rate
("LIBOR") on the same amount. This contract has been treated as a cash flow
hedge with the changes in the value of the hedge being reported as a component
of accumulated other comprehensive income. During the six months ended June 30,
2004, the Company recognized $1,624 in other comprehensive gain on this hedge
instrument and incurred $1,328 of interest expense related to net payments made
on the interest-rate swap. At June 30, 2004, the aggregate accumulated other
comprehensive loss on this hedge instrument was $1,314. 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
securitization financing 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 June 30, 2004, over the next twelve
months, the Company expects to reclassify $1,314 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 June 30, 2004, the
current notional balance of the amortizing synthetic swap was $29,000, and the
remaining weighted-average fixed-rate payable by the Company under the terms of
the synthetic swap was 2.68%. The synthetic swap amortizes through September
2005. During the six months ended June 30, 2004, the Company recognized $367 in
other comprehensive gain for the synthetic interest-rate swap and incurred $303
of interest expense related to net payments made on this position. At June 30,
2004, the aggregate accumulated other comprehensive loss was $307. The Company
evaluated the effectiveness of this hedge in mitigating its interest rate risk
and determined that there was no material ineffectiveness to reflect in
earnings. Based on the forward Eurodollar curve as of June 30, 2004, over the
next twelve months the Company expects to reclassify $288 into earnings.
NOTE 11 - COMMITMENTS AND CONTINGENCIES
GLS Capital, Inc. ("GLS"), a subsidiary of the Company, together with the County
of Allegheny, Pennsylvania ("Allegheny County"), were defendants in a lawsuit in
the Commonwealth Court of Pennsylvania (the "Commonwealth Court"), the appellate
court of the state of Pennsylvania. Plaintiffs were two local businesses seeking
status to represent as a class, delinquent taxpayers in Allegheny County whose
delinquent tax liens had been assigned to GLS. Plaintiffs challenged the right
of Allegheny County and GLS to collect certain interest, costs and expenses
related to delinquent property tax receivables in Allegheny County, and whether
the County had the right to assign the delinquent property tax receivables to
GLS and therefore employ procedures for collection enjoyed by Allegheny County
under state statute. This lawsuit was related to the purchase by GLS of
delinquent property tax receivables from Allegheny County in 1997, 1998, and
1999. In July 2001, the Commonwealth Court issued a ruling that addressed, among
other things, (i) the right of GLS to charge to the delinquent taxpayer a rate
of interest of 12% per annum versus 10% per annum on the collection of its
delinquent property tax receivables, (ii) the charging of a full month's
interest on a partial month's delinquency; (iii) the charging of attorney's fees
to the delinquent taxpayer for the collection of such tax receivables, and (iv)
the charging to the delinquent taxpayer of certain other fees and costs. The
Commonwealth Court in its opinion remanded for further consideration to the
lower trial court items (i), (ii) and (iv) above, and ruled that neither
Allegheny County nor GLS had the right to charge attorney's fees to the
delinquent taxpayer related to the collection of such tax receivables. The
Commonwealth Court further ruled that Allegheny County could assign its rights
in the delinquent property tax receivables to GLS, and that plaintiffs could
maintain equitable class in the action. In October 2001, GLS, along with
Allegheny County, filed an Application for Extraordinary Jurisdiction with the
Supreme Court of Pennsylvania, Western District appealing certain aspects of the
Commonwealth Court's ruling. In March 2003, the Supreme Court issued its opinion
as follows: (i) the Supreme Court determined that GLS can charge delinquent
taxpayers a rate of 12% per annum; (ii) the Supreme Court remanded back to the
lower trial court the charging of a full month's interest on a partial month's
delinquency; (iii) the Supreme Court revised the Commonwealth Court's ruling
regarding recouping attorney fees for collection of the receivables indicating
that the recoupment of fees requires a judicial review of collection procedures
9
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. Specific damages related to the
issues remanded back to the Trial Court have not been determined, and the
Company believes that the ultimate outcome of this litigation will not have a
material impact on its financial condition, but may have a material impact on
reported results for the particular period presented.
The Company and Dynex Commercial, Inc. ("DCI"), formerly an affiliate of the
Company and now known as DCI Commercial, Inc., are defendants in state court in
Dallas County, Texas in the matter of Basic Capital Management, et. al. v. Dynex
Commercial, Inc., et. al. The suit was filed in April 1999, originally against
DCI. In March 2000, Basic Capital Management (hereafter "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 entered a separate verdict against DCI in favor of BCM under two
mutually-exclusive damage models, for $2,200 and $25,600, respectively. 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 jury also awarded the
plaintiffs attorneys' fees in the amount of $2,100. On June 29, 2004, after
considering post-trial motions, the presiding judge entered judgment in favor of
the Company and DCI, effectively overturning the verdicts of the jury and
dismissing damages awarded by the jury. The trial court upheld the Company and
DCI's position that the evidence and the jury verdict did not support a judgment
against the Company and DCI in the litigation. The plaintiffs have subsequently
filed motions with the trial court seeking a new trial. DCI is a former
affiliate of the Company, and the Company believes that it will have no
obligation for amounts, if any, awarded to the plaintiffs as a result of the
actions of DCI.
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 consolidated balance sheet, but could
materially affect consolidated results of operations in a given year.
NOTE 12 - RECENT ACCOUNTING PRONOUNCEMENTS
In March 2004, the Emerging Issues Task Force ("EITF") amended and ratified
previous consensus reached on EITF 03-01, "The Meaning of Other-Than-Temporary
Impairment", to introduce a three-step model to: 1) determine whether an
investment is impaired; 2) evaluate whether the impairment is
other-than-temporary; and 3) account for other-than-temporary impairments. In
part, this amendment requires companies to apply qualitative and quantitative
measures to determine whether a decline in the fair value of a security is
other-than-temporary. The amount of other-than-temporary impairments to be
recognized, if any, will be dependent on market conditions and management's
intentions and ability at the time of evaluation to hold underwater investments
until forecasted recovery in the fair value up to and beyond the adjusted cost.
This amendment is effective for financial periods beginning after June 15, 2004.
The Company has reviewed this statement and does not believe that its adoption
will have a significant impact on its financial position, results of operations
or cash flows.
10
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Dynex Capital, Inc. was incorporated in the Commonwealth of Virginia in 1987.
References to "Dynex" or "the Company" contained herein refer to Dynex Capital,
Inc. together with its qualified real estate investment trust (REIT)
subsidiaries and taxable REIT subsidiary. Dynex is a financial services company,
which invests in loans and securities consisting of or secured by, principally
single-family mortgage loans, commercial mortgage loans, manufactured housing
installment loans and delinquent property tax receivables. The loans and
securities in which the Company invests have generally been pooled and pledged
(i.e. securitized) as securitized finance receivables 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
services its delinquent property tax receivables portfolio. The Company's
primary focus is to manage cash flow on its existing investment portfolio, and
opportunistically investing its capital, primarily in securitization financing
bonds where the Company owns optional redemption rights to redeem these bonds at
par where the bonds have fair values exceeding their par price as further
discussed below.
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. 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.
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.
In addition, MERIT Series 13 reaches its optional redemption date in August
2004, and the senior-most bond classes in this securitization financing will
have an estimated aggregate principal balance of approximately $140 million. As
of the end of the second quarter, the Company estimates the value of these
senior-most bond classes to be approximately $4 million in excess of their
purchase price, and its currently attempting to structure a resecuritization of
these bonds where the Company would retain a subordinate interest of as much as
$15 million in the new securitization which would have an estimated yield of
approximately 15%. The Company's SASCO 2002-9 securitization financing is
projected to reach a call trigger during the first quarter of 2005 with an
aggregate callable balance of approximately $200 million at that time. The
Company may or may not elect to call all or part of this securitization, or
other securitizations, when eligible to call.
On May 19, 2004, the Company completed a recapitalization plan whereby the
Company converted 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 exchanged 9.50% Senior Notes due 2007 for Series A, Series B
and Series C preferred stock. The remaining Series A, Series B and Series C
preferred stock were converted into 5,628,737 shares of Series D preferred stock
and 1,288,488 shares of common stock. The Series D preferred stock had an issue
price of $10 per share and pays $0.95 per year in dividends. All prior
dividends-in-arrears on the Series A, Series B and Series C preferred stock were
extinguished. Interest on the senior notes and dividends on the Series D
preferred stock began to accrue on April 7, 2004. As a result of the
recapitalization, the Company's book value per common share decreased by $0.21
per share. Common stock outstanding after the recapitalization transaction
closed increased from 10,873,903 to 12,162,391 shares.
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
11
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. A security will be considered other-than-temporarily
impaired sooner than three consecutive quarters if the security is subject to
credit losses, and credit performance of such collateral has deteriorated and is
not anticipated to substantially recover for 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 thirty 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
12
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 sixty 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, except loans secured by low income housing tax credit properties 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. Low income housing tax credit properties are deemed impaired when such
loans are thirty days past due or if the underlying property is near the
expiration of its tax credit compliance period and the debt service coverage
ratio is below 1:1. 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 limit 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 except per share data) June 30, 2004 December 31, 2003
- ----------------------------------------------------------------------------- ----------------------- -----------------------
Investments:
Securitized finance receivables:
Loans, net $ 1,422,878 $ 1,518,613
Debt securities, available-for-sale 228,521 255,580
Other investments 35,258 37,903
Securities 25,007 33,275
Other loans 6,433 8,304
Non-recourse securitization financing 1,589,596 1,679,830
Repurchase agreements 17,330 23,884
Senior notes 823 10,049
Shareholders' equity 135,361 149,846
Book value per common share (inclusive of dividends in arrears) 6.40 7.55
- ----------------------------------------------------------------------------- ----------------------- -----------------------
Securitized finance receivables. As of June 30, 2004, the Company had 20 series
of non-recourse securitization financing outstanding. Loans, net decreased to
$1.42 billion at June 30, 2004 compared to $1.52 billion at December 31, 2003.
This decrease of $95.7 million is primarily the result of $79.6 million in
principal paydowns on the securitized finance receivables, $16.1 million of
additions to allowance for loan losses and decreases of accrued interest
receivables of $0.5 million, partially offset by $0.5 million of net premium
amortization. Debt securities decreased to $228.5 million at June 30, 2004
compared to $255.6 million at December 31, 2003. This decrease of $27.1 million
is primarily the result of $21.3 million in principal paydowns on the
securitized finance receivables, $9.1 million of impairment charges, partially
offset by $3.2 million of market value adjustments and $0.1 million of other
increases.
Other investments. Other investments at June 30, 2004 consist primarily of
delinquent property tax receivables. Other investments decreased from $37.9
million at December 31, 2003, to $35.3 million at June 30, 2004. This decrease
is primarily the result of pay-downs of delinquent property tax receivables,
which totaled $3.5 million, and sales of real estate owned properties of $0.5
million. These decreases were partially offset by additional advances for
collections of $1.8 million.
Other loans. Other loans decreased by $1.9 million from $8.3 million at December
31, 2003, to $6.4 million at June 30, 2004, principally as the result of
pay-downs during the quarter.
Securities. Securities decreased during the six months ended June 30, 2004 by
$8.3 million, to $25.0 million at June 30, 2004 from $33.3 million at December
31, 2003 due primarily to principal payments on the securities.
13
Non-recourse securitization financing. Non-recourse securitization financing
decreased $90.2 million; from $1.7 billion at December 31, 2003 to $1.6 billion
at June 30, 2004. This decrease was primarily a result of principal payments
received of $100.9 million on the associated securitized 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 $1.5 million was retained within
the security structure and used to cover losses, as certain performance triggers
were not met in such securitizations. These decreases were partially offset by
the addition of $7.4 million of premium on the call and reissue of a
securitization financing and $4.0 million of amortization of bond premium during
the six months ended June 30, 2004.
Senior notes. Of the $32.1 million of February 2005 Senior Notes issued in
exchange for Preferred Stock in February 2003, the $10.0 million remaining
balance was paid in March 2004. In conjunction with the recapitalization plan
completed in May 2004, $0.8 million of 9.50% Senior Notes due April 2007 were
issued in exchange for Series A, Series B, and Series C preferred shares.
Shareholders' equity. Shareholders' equity decreased to $135.4 million at June
30, 2004, from $149.8 million at December 31, 2003. This decrease was primarily
the result of a net loss of $18.3 million and a net decrease of $1.5 million
resulting from the issues costs of and shares tendered for senior notes in
connection with the recapitalization transaction completed in May 2004,
partially offset by a net increase in accumulated other comprehensive income of
$5.3 million. The increase in accumulated other comprehensive income is
comprised of an increase in unrealized gain on investments available-for-sale of
$3.3 million and $2.0 million of other comprehensive income from hedging
instruments during the period.
RESULTS OF OPERATIONS
- ---------------------------------------------- --- ----------------------------------- -- -----------------------------------
(amounts in thousands except per share Three months ended June 30, Six months ended June 30,
information)
- ---------------------------------------------- ----------------------------------- -----------------------------------
2004 2003 2004 2003
- ---------------------------------------------- --------------- --------------- --------------- ----------------
Net interest margin before provision for $ 5,519 $ 8,826 $ 11,954 $ 20,269
losses
Net interest margin (3,428) (9,214) (4,193) (3,615)
Impairment charges (7,746) (200) (9,407) (2,205)
Gain on sales of investments, net 20 556 4 1,010
General and administrative expenses (2,015) (2,151) (4,483) (4,172)
Net loss (12,953) (10,986) (18,340) (8,942)
Preferred stock benefit (charge) 2,045 (1,214) 854 9,230
Net (loss) income to common shareholders (10,908) (12,200) (17,486) 288
Net (loss) income per common share:
Basic $(0.95) $(1.12) $(1.59) $0.03
- ---------------------------------------------- --- --------------- --- --------------- -- --------------- -- ----------------
Three Months Ended June 30, 2004 Compared to Three Months Ended June 30, 2003.
Net loss and net (loss) income per common share decreased during the three
months ended June 30, 2004 as compared to the same period in 2003. The decrease
in net loss is primarily the result of decreased additions of $9.1 million to
provision for loan losses. Included in this reduction is $14.4 million in
provision for loan losses recorded in June 2003 specifically for currently
existing credit losses within outstanding manufactured housing loans that are
current as to payment but which the Company has determined to be impaired. As a
partial offset to the decrease in provision for loan losses, net margin before
provision for loan losses decreased by $3.3 million. Offsetting this improvement
in net income was increased impairment charges of approximately $7.7 million and
reduced net gains on sales of investments of $0.5 million for the three months
ended June 30, 2004 compared to the same periods in 2003. Net loss to common
shareholders decreased by $1.3 million or $0.17 per common share, from a loss of
$12.2 million for the three months ended June 30, 2003 to a loss of $10.9
million for the same period in 2004, mostly due to the net effect preferred
stock benefits from the recapitalization completed in May 2004 offset by a $7.6
million impairment of debt securities backed primarily by manufactured housing
loans.
14
Net interest margin for the three months ended June 30, 2004 increased to $(3.4)
million from $(9.2) million for the same period in 2003. This increase was
primarily the result of lower provision for loan losses for 2004 including the
$14.4 million addition to provision for loan losses in 2003, as discussed above.
Net interest margin was negatively impacted during the three months ended June
30, 2004 by a decline in net interest spread and a decline in interest earning
assets compared to the three months ended June 30, 2003.
Impairment charges increased by $7.6 million for the three months ended June 30,
2004 from the same period last year on debt securities pledged as securitized
finance receivables and comprised largely of manufactured housing loans.
Impairment of these debt securities is determined as the difference between the
fair value of the security, as measured by discounting the cash flows of the
security certificates utilizing prepayment and loan loss rate assumptions, at
discount rates that a market participant would use, and the book value of those
securities. The fair value of these debt securities has declined during the
second quarter 2004 as the result of an increase in losses during the quarter
which is not anticipated to improve for the foreseeable future. The Company
believes that market participants will use the higher loss rate assumptions in
evaluating the fair value of these securities.
General and administrative expense decreased slightly by $0.1 million to $2.0
million for the three months ended June 30, 2004 compared to the same period in
2003.
Six Months Ended June 30, 2004 Compared to Six Months Ended June 30, 2003. Net
loss and net loss per common share increased during the six months ended June
30, 2004 as compared to the same period in 2003. The increase in net loss is
primarily the result of decreased net interest margin, increased impairment
charges, and decreased gain on sale of investments. Additions to provision for
loan losses decreased by $7.7 million during the six months ended June 30, 2004
compared to the same period in 2003. Included in this amount is $14.4 million in
provision for loan losses recorded in June 2003 specifically for currently
existing credit losses within outstanding manufactured housing loans that are
current as to payment but which the Company has determined to be impaired. Net
income to common shareholders decreased from $0.3 million for the six months
ended June 30, 2003 to a loss of $17.5 million for the six months ended June 30,
2004, mostly due to the net effect of preferred stock benefits from the tender
offer completed in February 2003 and the recapitalization completed in May 2004
offset by a $9.1 million impairment of a debt security backed primarily by
manufactured housing loans.
Net interest margin for the six months ended June 30, 2004 decreased to $(4.2)
million from $(3.6) million for the same period in 2003. This decrease was
primarily the result of a $8.3 million decrease in net interest margin before
provision for loan losses. Net interest margin before provision for loan losses
was negatively impacted during the six months ended June 30, 2004 by a decline
in net interest spread and a decline in interest earning assets compared to the
six months ended June 30, 2003. This decline in net interest margin before
provision for loan losses was partially offset by decreased provisions for loan
losses, mostly due to the $14.4 million addition to provisions for loan losses
on current loans recorded in 2003.
Impairment charges increased by $7.2 million for the six months ended June 30,
2004 from the same period last year. This increase was primarily a result of
losses on debt securities pledged as securitized finance receivables and
comprised largely of manufactured housing loans. Impairment of these debt
securities is determined as the difference between the fair value of the
security, as measured by discounting the cash flows of the security certificates
utilizing prepayment and loan loss rate assumptions, at discount rates that a
market participant would use, and the book value of those securities. The fair
value of these debt securities has declined during the second quarter 2004 as
the result of an increase in losses during the quarter which is not anticipated
to improve for the foreseeable future. The Company believes that market
participants will use the higher loss rate assumptions in evaluating the fair
value of these securities.
General and administrative expense increased slightly by $0.3 million to $4.5
million for the six months ended June 30, 2004 compared to the same periods in
2003. This increase was primarily the result of litigation related expenses in
connection with the litigation discussed in Note 11 of the Notes to Unaudited
Condensed Consolidated Financial Statements.
15
The following table summarizes the average balances of interest-earning assets
and their average effective yields, along with the average interest-bearing
liabilities and the related average effective interest rates, for each of the
periods presented.
Average Balances and Effective Interest Rates
- --------------------------------------------------------------------------------------------------------------------------
Three Months Ended June 30, Six Months Ended June 30,
---------------------------------------------------------------------------------------------------
2004 2003 2004 2003
---------------------------------------------------------------------------------------------------
(amounts in thousands) Average Effective Average Effective Average Effective Average Effective
Balance Rate Balance Rate Balance Rate Balance Rate
---------------------------------------------------------------------------------------------------
Interest-earning
assets(1):
Securitized finance
receivables(2) (3) $1,707,230 7.61% $1,986,849 7.46% $1,737,618 7.52% $2,027,677 7.51%
Securities 24,211 7.87% 3,377 16.34% 26,310 7.87% 4,523 18.09%
Other loans 6,757 9.68% 8,298 6.13% 7,492 8.90% 8,526 5.94%
Cash and other 15,545 0.77% 61,608 7.55% 12,092 0.76% 62,716 7.98%
investments
---------------------------------------------------------------------------------------------------
Total
interest-earning $1,753,743 7.56% $2,060,132 7.48% $1,783,512 7.49% $2,103,442 7.54%
assets
==========================================================================================================================
Interest-bearing
liabilities:
Non-recourse
securitization $1,602,163 6.71% $1,863,400 6.02% $1,627,252 6.54% $1,902,524 5.96%
financing(3)
Repurchase agreements 20,103 1.40% - - 21,438 1.42% - -
Senior notes 549 9.50% 30,699 9.51% 3,624 9.50% 20,696 9.51%
---------------------------------------------------------------------------------------------------
Total
interest-bearing $1,622,815 6.64% $1,894,099 6.08% $1,652,314 6.48% $1,923,220 6.00%
liabilities
==========================================================================================================================
Net interest spread on
all investments(3) 0.92% 1.40% 1.01% 1.54%
============ ============ =========== ============
Net yield on average
interest-earning 1.41% 1.88% 1.49% 2.06%
assets(3)
============ ============ =========== ============
- --------------------------------------------------------------------------------------------------------------------------
(1) Average balances exclude adjustments made in accordance with Statement of
Financial Accounting Standards No. 115, "Accounting for Certain
Investments in Debt and Equity Securities" to record available-for-sale
securities at fair value.
(2) Average balances exclude funds held by trustees of $509 and $370 for the
three months ended June 30, 2004 and 2003, respectively, and $422 and $435
for the six months ended June 30, 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 6.83% and 6.26% for the three months
ended June 30, 2004 and 2003, respectively, and 6.64% and 6.14% for the
six months ended June 30, 2004 and 2003, respectively
The net interest spread decreased 48 basis points to 92 basis points for the
three months ended June 30, 2004, from 140 basis points for the same period in
2003 (each basis point is 0.01%). The net interest spread for the six months
ended June 30, 2004 also decreased relative to the same period in 2003, to 101
basis points from 154 basis points. The decrease in the Company's net interest
spread for both periods can be generally attributed to the resetting of interest
rates on adjustable rate mortgage loans in the Company's investment portfolio
and the prepayment of higher rate loans in that portfolio which together caused
a decline in interest earning asset yield of 47 basis points and 57 basis points
for the three and six month comparative periods, respectively. The majority of
the Company's variable-rate interest-bearing liabilities are indexed relative to
One-Month LIBOR. Interest-bearing liability costs increased 56 basis points and
48 basis points for the three and six month periods ended June 30, 2004,
respectively, primarily as a result of an adjustment of discount amortization
arising from the expected sale of eighteen loans in the commercial loan
portfolio. In addition, as two higher rated bonds paid off during the period,
more cash flowed to the lower rated bond classes in the waterfall structure,
whose interest rates are approximately 25 basis points higher. The Company
currently finances approximately $187 million of the fixed-rate assets with
non-recourse LIBOR based floating-rate liabilities. In June 2002, the Company,
through the use of an interest-rate swap, converted $100 million of such
floating-rate liabilities into fixed rate, in effect locking the spread in for
that portion of fixed rate assets financed with floating rate liabilities. Under
the swap, the Company pays a fixed rate of 3.73% and receives one-month LIBOR.
In October 2002, the Company created an amortizing synthetic swap through the
short sale of a string of Eurodollar futures contracts, with an initial
effective notional balance of approximately $80 million, amortizing over a
three-year period. At June 30, 2004, the notional amount of this synthetic
amortizing swap was $29 million.
16
The Company would expect its net interest spread on its interest-earning assets
for the balance of 2004 to continue to decrease as rates on adjustable-rate
assets in the investment portfolio continue to adjust downward and as borrowing
costs increase as the Federal Reserve continues to increase the Federal Funds
target rate going forward. The average One-Month LIBOR rate declined to 1.15%
and 1.13% for the three and six month periods ended June 30, 2004, respectively,
from 1.26% and 1.30% for the three and six month periods ended June 30, 2003.
One-Month LIBOR has increased from 1.12% at year-end 2003 to 1.37% at June 30,
2004.
Interest Income and Interest-Earning Assets. At June 30, 2004, $1.4 billion of
the investment portfolio consists of loans and securities which pay a fixed-rate
of interest, and approximately $298.5 million of the investment portfolio is
comprised of loans and securities that have coupon rates which adjust over time
(subject to certain periodic and lifetime limitations) in conjunction with
changes in short-term interest rates. The Company finances its investment
portfolio with principally non-recourse securitization financing. At June 30,
2004, approximately $1.1 billion of fixed-rate bonds and $467 million of
adjustable rate bonds were outstanding. The following table presents a
breakdown, by principal balance, of the Company's securitized finance
receivables and ARM and fixed mortgage securities by type of underlying loan.
This table excludes mortgage-related securities, other investments and other
loans.
Investment Portfolio Composition(1)
- ---------------------------- ------------------ ----------------- ------------------ ------------------- ------------------
($ in millions) Other Indices
LIBOR Based ARM CMT Based ARM Based ARM Loans Fixed-Rate Loans
Loans Loans Total
- ---------------------------- ------------------ ----------------- ------------------ ------------------- ------------------
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
2004, Quarter 2 215.8 41.9 40.8 1,443.1 1,741.6
- ---------------------------- ------------------ ----------------- ------------------ ------------------- ------------------
(1) Includes only the principal amount of securitized finance receivables, ARM
securities and fixed-rate mortgage securities.
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 year.
The table excludes other forms of credit enhancement from which the Company
benefits, and based upon the performance of the underlying loans, may provide
additional protection against losses. These additional protections include loss
reimbursement guarantees with a remaining balance of $27.5 million and a
remaining deductible aggregating $0.2 million on $40.9 million of securitized
single-family mortgage loans which are subject to such reimbursement agreements;
guarantees aggregating $21.8 million on $295.3 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 $138.6
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 62% on such policies before the Company would
incur losses. During the second quarter 2004, the Company established a
receivable of $559 thousand under the $27.5 million loss reimbursement
guarantee.
17
Credit Reserves and Actual Credit Losses
- ---------------------------------------------------------------------------------------------------------------------------
($ in millions) Credit Exposure, Net
Outstanding Loan Credit Exposure, Net to Outstanding Loan
Principal Balance of Credit Reserves Actual Credit Losses Balance
- ---------------------------------------------------------------------------------------------------------------------------
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%
2004, Quarter 2 1,716.1 48.0 8.0 2.80%
- ---------------------------------------------------------------------------------------------------------------------------
The following table summarizes single family mortgage loan, manufactured housing
loan and commercial mortgage loan delinquencies as a percentage of the
outstanding securitized finance receivables balance for those securities in
which the Company has retained a portion of the direct credit risk. The
delinquencies as a percentage of the outstanding securitized finance receivables
balance have increased to 9.97% at June 30, 2004 from 4.83% at June 30, 2003
primarily due to seventeen commercial loans which have become delinquent since
2003. Of these seventeen loans, fourteen are low income housing tax credit
("LIHTC") loans with an aggregate unpaid principal balance of $60 million which
were repaid in full in July and August 2004. The adjusted delinquency percentage
excluding these fourteen loans is 6.48%. 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 June 30, 2004, 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 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%
2004, Quarter 2 3.00% 2.09% 4.88% 9.97%
- ----------------------------------------------------------------------------------------------------------------------------
(1) Excludes other investments and loans held for sale or securitization. (2)
Includes foreclosures, repossessions and REO.
General and Administrative Expense. The following tables present a breakdown of
general and administrative expense. Included in the first and second quarter of
2004 is an aggregate $703 thousand of litigation related expense for the
litigation in Dallas County, Texas and Pittsburgh, Pennsylvania.
- -------------------------------- ------------------------------ ------------------------------ ---------------------------
($ in thousands) Servicing Corporate/Investment Total
Portfolio Management
- -------------------------------- ------------------------------ ------------------------------ ---------------------------
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
2004, Quarter 2 986.8 1,028.1 2,014.9
- -------------------------------- ------------------------------ ------------------------------ ---------------------------
18
Recent Accounting Pronouncements. In March 2004, the Emerging Issues Task
Force ("EITF") amended and ratified previous consensus reached on EITF 03-01,
"The Meaning of Other-Than-Temporary Impairment", to introduce a three-step
model to: 1) determine whether an investment is impaired; 2) evaluate whether
the impairment is other-than-temporary; and 3) account for other-than-temporary
impairments. In part, this amendment requires companies to apply qualitative and
quantitative measures to determine whether a decline in the fair value of a
security is other-than-temporary. The amount of other-than-temporary impairments
to be recognized, if any, will be dependent on market conditions and
management's intentions and ability at the time of evaluation to hold underwater
investments until forecasted recovery in the fair value up to and beyond the
adjusted cost. This amendment is effective for financial periods beginning after
June 15, 2004. The Company has reviewed this statement 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 in the tables below 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 June 30, 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.
19
- -----------------------------------------------------------------------------------------------------------------------------
(amounts in thousands) Principal
Principal balance of
balance of non-recourse
securitized securitization Amortized Cost
finance financing Principal Basis of Net
Collateralized Bond Collateral Type receivables outstanding to Balance of Net Investment
Series(1) pledged third parties Investment
- -----------------------------------------------------------------------------------------------------------------------------
MERIT Series 11A Debt securities backed by
Single-family loans and
Manufactured housing loans $ 237,466 $ 207,265 $ 30,201 $ 15,773
MERIT Series 12-1 Manufactured housing loans 210,871 194,743 16,128 5,168
MERIT Series 13 Manufactured housing loans 251,871 232,159 19,712 12,212
SASCO 2002-9 Single family loans 267,798 259,394 8,404 13,303
MCA One Series 1 Commercial mortgage loans 78,457 73,739 4,718 337
CCA One Series 2 Commercial mortgage loans 284,055 261,952 22,103 11,314
CCA One Series 3 Commercial mortgage loans 384,340 343,394 40,946 49,922
- -----------------------------------------------------------------------------------------------------------------------------
$ 1,714,858 $ 1,572,646 $ 142,212 $ 108,029
- -----------------------------------------------------------------------------------------------------------------------------
(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 non-recourse
securitization financing in the accompanying consolidated financial statements.
- -----------------------------------------------------------------------------------------------------------------------------
(amounts in thousands) Non-recourse
Securitized securitization
Finance Receivables financing
- -----------------------------------------------------------------------------------------------------------------------------
Principal balances per the above table $ 1,714,858 $ 1,572,646
Principal balance of security excluded from above table 3,074 3,369
Recorded impairments on debt securities (17,523) -
Premiums and discounts (14,119) 6,235
Unrealized gain 3,270 _
Accrued interest and other 11,307 7,346
Allowance for loan losses (49,468) -
- -----------------------------------------------------------------------------------------------------------------------------
Balance per consolidated financial statements $ 1,651,399 $ 1,589,596
- -----------------------------------------------------------------------------------------------------------------------------
The following table summarizes the fair value of the Company's net investment in
collateralized bond securities, the various assumptions made in estimating value
and the cash flow received from such net investment during the six months ended
June 30, 2004. As the Company does not present its investment in non-recourse
securitization financing 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
non-recourse securitization financing in accordance with generally accepted
accounting principles applicable to the Company's transactions.
20
- -----------------------------------------------------------------------------------------------------------------------------
Fair Value Assumptions ($ in thousands)
------------------------------------------------------------------------
Cash flows
Collateralized Weighted-average Projected cash flow Fair value of received in
Bond Series prepayment speeds Losses termination date net 2004, net(1)
investment(1)
- -----------------------------------------------------------------------------------------------------------------------------
MERIT Series 11A 35%-40% CPR on SF 3.8% annually on Anticipated final maturity $ 14,216 $ 6,540
securities; 7% CPR MH securities in 2025
on MH securities
MERIT Series 12-1 8% CPR 3.4% annually on Anticipated final maturity 1,367 544
MH Loans in 2027
MERIT Series 13 7% CPR 4.0% annually Anticipated final maturity 4,499 601
in 2026
SASCO 2002-9 30% CPR 0.10% annually Anticipated call date in 16,589 5,803
2005
MCA One Series 1 (2) 0.80% annually Anticipated final maturity 2,604 232
in 2018
CCA One Series 2 (3) 0.80% annually Anticipated call date in 12,009 867
beginning in 2004 2012
CCA One Series 3 (3) 1.2% annually Anticipated call date in 20,076 979
beginning in 2004 2009
- -----------------------------------------------------------------------------------------------------------------------------
$ 71,360 $ 15,566
- -----------------------------------------------------------------------------------------------------------------------------
(1) Calculated as the net present value of expected future cash flows,
discounted at 16%. Expected cash flows were based on the forward LIBOR
curve as of June 30, 2004, and incorporate 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. Cash flows received by the Company during the
six months ended June 30, 2004, equal to the excess of the cash flows
received on the collateral pledged, over the cash flow requirements of the
collateralized bond security.
(2) Computed at 0% CPR until maturity.
(3) Computed at 0% CPR until the respective call date.
The above tables illustrate the Company's estimated fair value of its net
investment in certain collateralized bond securities. In its consolidated
financial statements, the Company carries its investments at amortized cost,
except for its investment in MERIT Series 11, which it carries at estimated fair
value. Including the recorded allowance for loan losses of $49.5 million, the
Company's net investment in collateralized bond securities is approximately
$58.5 million. This amount compares to an estimated fair value, utilizing a
discount rate of 16%, of approximately $71.4 million, as set forth in the table
above. The difference between the $58.5 million in net investment as included in
the consolidated financial statements and the $71.4 million of estimated fair
value, is due to the differences between the estimated fair value of such net
investment and amortized cost.
The following table compares the fair value of these investments at various
discount rates, but otherwise using the same assumptions as set forth for the
two immediately preceding tables:
- -----------------------------------------------------------------------------------------------------------------------------
Fair Value of Net Investment
- -----------------------------------------------------------------------------------------------------------------------------
Collateralized Bond Series 12% 16% 20% 25%
- ------------------------------------- --------------------- --------------------- --------------------- ---------------------
MERIT Series 11A $ 15,843 $ 14,216 $ 12,900 $ 11,585
MERIT Series 12-1 1,347 1,367 1,361 1,333
MERIT Series 13 4,311 4,499 4,631 4,743
SASCO 2002-9 18,673 16,589 14,973 13,405
MCA One Series 1 3,211 2,604 2,144 1,718
CCA One Series 2 14,479 12,009 10,059 8,178
CCA One Series 3 23,377 20,076 17,307 14,459
- ------------------------------------- --------------------- --------------------- --------------------- ---------------------
$ 81,241 $ 71,360 $ 63,375 $ 55,421
- ------------------------------------- --------------------- --------------------- --------------------- ---------------------
21
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 or accumulating
assets 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). Should the
Company's future operations require access to sources of capital such as lines
of credit and repurchase agreements, the Company believes that it would be able
to access such sources.
The Company's cash flow from its investment portfolio for the three months and
six months ended June 30, 2004 was approximately $11.7 million and $22.8
million, respectively. 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
securitization financing. The Company anticipates, however, that it will have
sufficient cash flow from its investment portfolio to meet all of its
obligations.
Non-recourse securitization financing. 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 the
Company. The maturity of each class of non-recourse securitization financing is
directly affected by the rate of principal prepayments on the related collateral
and is not subject to margin call risk. Each series is also subject to
redemption according to specific terms of the respective indentures, generally
on the earlier of a specified date or when the remaining balance of the bonds
equals 35% or less of the original principal balance of the bonds. At June 30,
2004, Dynex had $1.6 billion of non-recourse securitization financing
outstanding. Approximately $1.1 billion of the non-recourse securitization
financing carry a fixed rate of interest, and approximately $467 million carries
a rate of interest, which adjusts monthly based on One-Month LIBOR.
Senior notes. In March 2004, the Company redeemed the remaining $10.0 million of
9.50% senior unsecured notes due February 2005 (the "February 2005 Senior
Notes") in preparation for implementation the Company's recapitalization plan.
In April, the Company issued $823 thousand of 9.50% Senior Notes due April 2007
in exchange for 8,890 shares of Series A preferred stock, 10,553 shares of
Series B preferred stock and 8,584 shares of Series C preferred stock. At June
30, 2004, the outstanding balance of the Senior Notes was $0.8 million.
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:
22
Economic Conditions. The Company is affected by general economic conditions. The
risk of defaults and credit losses could increase during an economic slowdown or
recession. This could have an adverse effect on the performance of the Company's
securitized loan pools and on the Company's overall financial performance.
Capital Resources. Cash flows from the investment portfolio fund the Company's
operations and repayments of recourse debt, and are subject to fluctuation due
to changes in interest rates, repayment rates and default rates and related
losses.
Interest Rate Fluctuations. The Company's income and cash flow depends on its
ability to earn greater interest on its investments than the interest cost to
finance these investments. Interest rates in the markets served by the Company
generally rise or fall with interest rates as a whole. Approximately $1.4
billion 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 securitization financing, approximately $1.1 billion is
fixed-rate and approximately $187 million of which is variable rate and resets
monthly. Through the use of interest rate swaps and synthetic swaps, the Company
has reduced this exposure by approximately $129 million at June 30, 2004 on an
amortizing basis through approximately June 2005. In addition, approximately
$298 million of the investments held by the Company are adjustable-rate
securitized finance receivables, which generally reset on a delayed basis and
have periodic interest rate caps. These investments are financed through
non-recourse long-term non-recourse securitization financing which reset monthly
and which have no periodic caps. In total at June 30, 2004, the Company has
approximately $467 million of adjustable-rate non-recourse securitization
financing.
The net interest spread and cash flow for the Company could decrease materially
during a period of rapidly rising short-term interest rates, despite the use of
interest-rate swaps and synthetic swaps, as a result of the monthly reset in the
rate on the adjustable-rate non-recourse securitization financing issued by the
Company.
Defaults. Defaults by borrowers on loans securitized by the Company may have an
adverse impact on the Company's financial performance, if actual credit losses
differ materially from estimates made by the Company. Although the Company
believes that its reserves for loan losses are adequate as of June 30, 2004, 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
adjustable-rate loans may increase during a rising interest rate environment.
Third-party Servicers. Third-party servicers service the majority of the
Company's investment portfolio. To the extent that these servicers are
financially impaired, the performance of the Company's investment portfolio may
deteriorate, and defaults and credit losses may be greater than estimated.
Prepayments. Prepayments by borrowers on loans securitized by the Company may
have an adverse impact on the Company's financial performance. Prepayments are
expected to increase during a declining interest rate or flat yield curve
environment. The Company's exposure to rapid prepayments is primarily (i) the
faster amortization of premium on the investments and, to the extent applicable,
amortization of bond discount, and (ii) the replacement of investments in its
portfolio with lower yield securities.
Competition. The financial services industry is a highly competitive market.
Increased competition in the market has adversely affected the Company, and may
continue to do so.
Regulatory Changes. The Company's businesses as of June 30, 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.
23
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk generally represents the risk of loss that may result from the
potential change in the value of a financial instrument due to fluctuations in
interest and foreign exchange rates and in equity and commodity prices. Market
risk is inherent to both derivative and non-derivative financial instruments,
and accordingly, the scope of the Company's market risk management extends
beyond derivatives to include all market risk sensitive financial instruments.
As a financial services company, net interest margin comprises the primary
component of the Company's earnings. Additionally, cash flow from the investment
portfolio represents the primary component of the Company's incoming cash flow.
The Company is subject to risk resulting from interest rate fluctuations to the
extent that there is a gap between the amount of the Company's interest-earning
assets and the amount of interest-bearing liabilities that are prepaid, mature
or re-price within specified periods. While certain investments may perform
poorly in an increasing or decreasing interest rate environment, other
investments may perform well, and others may not be impacted at all.
The Company focuses on the sensitivity of its cash flow, and measures such
sensitivity to changes in interest rates. Changes in interest rates are defined
as instantaneous, parallel, and sustained interest rate movements in 100 basis
point increments. The Company estimates its net interest margin cash flow for
the next twenty-four months assuming interest rates following the forward LIBOR
curve (based on 90-day Eurodollar futures contracts) as of June 30, 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.
The following table summarizes the Company's net interest margin cash flow
sensitivity analysis as of June 30, 2004. This analysis represents management's
estimate of the percentage change in net interest margin cash flow given a shift
in interest rates, as discussed above. Other investments are excluded from this
analysis because they are not interest rate sensitive. The "Base" case
represents the interest rate environment as it existed as of June 30, 2004. At
June 30, 2004, one-month LIBOR was 1.37% and six-month LIBOR was 1.94%. The
analysis is heavily dependent upon the assumptions used in the model. The effect
of changes in future interest rates, the shape of the yield curve or the mix of
assets and liabilities may cause actual results to differ significantly from the
modeled results. In addition, certain financial instruments provide a degree of
"optionality." The most significant option affecting the Company's portfolio is
the borrowers' option to prepay the loans. The model applies prepayment rate
assumptions representing management's estimate of prepayment activity on a
projected basis for each collateral pool in the investment portfolio. The model
applies the same prepayment rate assumptions for all five cases indicated below.
The extent to which borrowers utilize the ability to exercise their option may
cause actual results to significantly differ from the analysis. Furthermore, the
projected results assume no additions or subtractions to the Company's
portfolio, and no change to the Company's liability structure. Historically,
there have been significant changes in the Company's assets and liabilities, and
there are likely to be such changes in the future.
- ------------------------------------- ------- -------------------------------- ------ ----------------------------
Projected Change in Net
Basis Point Interest Margin Projected Change in Value,
Increase (Decrease) Cash Flow From Expressed as a Percentage
in Interest Rates Base Case of Shareholders' Equity
- ------------------------------------- -------------------------------- ----------------------------
+200 (13.2)% (6.3)%
+100 (4.0)% (2.1)%
Base - -
-100 8.3% 2.2%
-200 17.7% 4.3%
- ------------------------------------- ------- -------------------------------- ------ ----------------------------
The Company's interest rate rise is related both to the rate of change in
short-term interest rates and to the level of short-term interest rates.
Approximately $298 million of the Company's investment portfolio as of June 30,
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
adjustable rate loans underlying the Company's adjustable rate securities and
securitized finance receivables are indexed to and reset based upon the level of
six-month LIBOR and one-year CMT, respectively.
24
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
adjustable rate loans underlying the adjustable rate securities and securitized
finance receivables relative to the rate resets on the associated borrowings and
(ii) rate resets on the adjustable rate 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 (a)
the issuance of fixed-rate non-recourse securitization financing which
approximated $1.1 billion as of June 30, 2004, and (b) equity, which was $135.4
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
item (ii), 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. The remaining portion of the Company's investment
portfolio as of June 30, 2004, approximately $1.4 billion, is comprised of loans
or securities that have coupon rates that are fixed.
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, including the
Company's Principal Executive Officer and Chief Financial
Officer. 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. There were no 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.
25
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. Specific damages related to the
issues remanded back to the Trial Court have not been determined, and the
Company believes that the ultimate outcome of this litigation will not have a
material impact on its financial condition, but may have a material impact on
reported results for the particular period presented.
The Company and Dynex Commercial, Inc. ("DCI"), formerly an affiliate of the
Company and now known as DCI Commercial, Inc., are defendants in state court in
Dallas County, Texas in the matter of Basic Capital Management, et. al. v. Dynex
Commercial, Inc., et. al. The suit was filed in April 1999 originally against
DCI but in March 2000, Basic Capital Management (hereafter, "BCM" or
"Plaintiffs") 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
26
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 $.3 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 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 jury also awarded the plaintiffs attorneys
fees in the amount of $2.1 million. On June 29, 2004, after considering
post-trial motions, the presiding judge entered judgment in favor of the Company
and DCI, effectively overturning the verdicts of the jury and dismissing damages
awarded by the jury. The trial court upheld the Company and DCI's position that
the evidence and the jury verdict did not support a judgment against the Company
and DCI in the litigation. The plaintiffs have subsequently filed motions with
the trial court seeking a new trial. DCI is a former affiliate of the Company,
and the Company believes that it will have no obligation for amounts, if any,
awarded to the plaintiffs as a result of the actions of DCI.
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 consolidated balance sheet, but could
materially affect consolidated results of operations in a given year.
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchasers of Equity
Securities
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
On April 30, 2004, a special meeting of preferred and common shareholders was
held to approve several issues relative to the Company's recapitalization
transaction. The following table summarizes the results of those votes.
- ----------------------------------------------------------------------------------- ------------- ------------- --------------
FOR AGAINST ABSTAIN
- ----------------------------------------------------------------------------------- ------------- ------------- --------------
Series A Preferred Shareholders
- ----------------------------------------------------------------------------------- ------------- ------------- --------------
Approval and adoption of the amendment of the Company's Articles of
Incorporation to accomplish the Series D conversion (in connection with the
recapitalization transaction) 347,551 20,654 450
- ----------------------------------------------------------------------------------- ------------- ------------- --------------
Approval of adjournment of the Meeting. 346,928 21,053 674
- ----------------------------------------------------------------------------------- ------------- ------------- --------------
- ----------------------------------------------------------------------------------- ------------- ------------- --------------
Series B Preferred Shareholders
- ----------------------------------------------------------------------------------- ------------- ------------- --------------
Approval and adoption of the amendment of the Company's Articles of
Incorporation to accomplish the Series D conversion (in connection with the
recapitalization transaction) 498,658 17,689 307
- ----------------------------------------------------------------------------------- ------------- ------------- --------------
Approval of adjournment of the Meeting. 498,671 17,548 435
- ----------------------------------------------------------------------------------- ------------- ------------- --------------
- ----------------------------------------------------------------------------------- ------------- ------------- --------------
Series C Preferred Shareholders
- ----------------------------------------------------------------------------------- ------------- ------------- --------------
Approval and adoption of the amendment of the Company's Articles of
Incorporation to accomplish the Series D conversion (in connection with the
recapitalization transaction) 500,672 21,636 1,057
- ----------------------------------------------------------------------------------- ------------- ------------- --------------
Approval of adjournment of the Meeting. 498,533 22,462 2,370
- ----------------------------------------------------------------------------------- ------------- ------------- --------------
- ----------------------------------------------------------------------------------- ------------- ------------- --------------
Common Shareholders
- ----------------------------------------------------------------------------------- ------------- ------------- --------------
Approval of issuance of additional shares of Common Stock as provided for
by the proposed amendment to the Company's Articles of Incorporation
creating a new Series D Preferred Stock, 7,478,298 220,248 45,592
- ----------------------------------------------------------------------------------- ------------- ------------- --------------
Approval of adjournments of the Meeting. 7,330,143 367,248 46,747
- ----------------------------------------------------------------------------------- ------------- ------------- --------------
27
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
3.1 Amendment to Articles of Incorporation effective May 19, 2004.
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 and Chief
Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K
The Company furnished a report on Form 8-K, dated May 12,
2004, reporting under item 12 the issuance by the company of a
press release announcing the Company's financial results for
the quarter ended March 31, 2004.
28
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DYNEX CAPITAL, INC.
Dated: August 16, 2004 By: /s/ Stephen J. Benedetti
---------------------------------------
Stephen J. Benedetti
Executive Vice President
(authorized officer of registrant,
principal accounting officer)
29
EXHIBIT INDEX
Exhibit No.
3.1 Amendment to Articles of Incorporation effective May 19,
2004.
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 and Chief
Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
30