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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 March 31, 2005
|_| Transition Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
Commission File Number: 1-9819
DYNEX CAPITAL, INC.
(Exact name of registrant as specified in its charter)
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 90 days.
|X| Yes |_| No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). |_| Yes |X| No
On February 28, 2005, the registrant had 12,162,391 shares outstanding of common
stock, $.01 par value, 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 March 31, 2005
and December 31, 2004 (unaudited).......................................................1
Condensed Consolidated Statements of Operations and Comprehensive Loss
for the three months ended March 31, 2005 and 2004 (unaudited)..........................2
Condensed Consolidated Statements of Cash Flows for
the three months ended March 31, 2005 and 2004 (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.................................................................26
PART II OTHER INFORMATION
Item 1. Legal Proceedings.......................................................................26
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.............................28
Item 3. Defaults Upon Senior Securities.........................................................28
Item 4. Submission of Matters to a Vote of Security Holders.....................................28
Item 5. Other Information.......................................................................28
Item 6. Exhibits ...............................................................................28
SIGNATURE................................................................................................29
PART I. FINANCIAL INFORMATION
---------------------
Item 1. Financial Statements
--------------------
DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED
BALANCE SHEETS (UNAUDITED)
(amounts in thousands except share data)
March 31, December 31,
2005 2004
--------------- ----------------
ASSETS
Cash and cash equivalents $ 60,534 $ 52,522
Other assets 5,770 4,965
---------------- ---------------
66,304 57,487
Investments:
Securitized finance receivables:
Loans, net 996,076 1,036,123
Debt securities, available-for-sale 195,304 206,434
--------------- -----------------
1,191,380 1,242,557
Securities 70,033 87,706
Other investments 7,166 7,595
Other loans 5,242 5,589
--------------- -----------------
1,273,821 1,343,447
--------------- -----------------
$ 1,340,125 $ 1,400,934
=============== =================
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Non-recourse securitization financing $ 1,131,617 $ 1,177,280
Repurchase agreements 59,367 70,468
------------- --------------
1,190,984 1,247,748
Accrued expenses and other liabilities 4,277 4,420
--------------- -----------------
1,195,261 1,252,168
--------------- -----------------
Commitments and Contingencies (Note 11) - -
SHAREHOLDERS' EQUITY
9.75% Cumulative Convertible Series D Preferred stock, par value $.01 per share, 55,666 55,666
50,000,000 shares authorized, 5,628,737 shares issued and outstanding
($57,624 aggregate liquidation preference)
Common stock, par value $.01 per share, 100,000,000 shares authorized, 122 122
12,162,391 shares issued and outstanding
Additional paid-in capital 366,896 366,896
Accumulated other comprehensive income 317 3,817
Accumulated deficit (278,137) (277,735)
--------------- -----------------
144,864 148,766
--------------- -----------------
$ 1,340,125 $ 1,400,934
=============== =================
See notes to unaudited condensed consolidated financial statements.
DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED STATEMENTS
OF OPERATIONS AND COMPREHENSIVE LOSS (UNAUDITED)
(amounts in thousands except share data)
Three Months Ended
March 31,
-----------------------------------------------
2005 2004
---------------------- --------------------
Interest income:
Securitized finance receivables $ 21,997 $ 32,886
Securities 1,126 559
Other investments 672 16
Other loans 258 170
---------------------- --------------------
24,053 33,631
---------------------- --------------------
Interest and related expense:
Non-recourse securitization financing 19,101 26,872
Repurchase agreements 454 242
Other 41 82
---------------------- --------------------
19,596 27,196
---------------------- --------------------
Net interest income 4,457 6,435
Provision for loan losses (2,261) (7,200)
---------------------- --------------------
Net interest income (loss) after provision for loan losses 2,196 (765)
Impairment charges (266) (1,661)
Gain (loss) on sale of investments, net 79 (34)
Other income (expense) 417 (459)
General and administrative expenses (1,492) (2,468)
---------------------- --------------------
Net income (loss) 934 (5,387)
Preferred stock charge (1,337) (1,191)
---------------------- --------------------
Net loss to common shareholders $ (403) $ (6,578)
====================== ====================
Change in net unrealized (loss)/gain on:
Investments classified as available for sale during the period (3,883) 259
Hedge instruments 383 81
---------------------- --------------------
Comprehensive loss $ (2,566) $ (5,047)
====================== ====================
Net loss per common share:
Basic and diluted $ (0.03) $ (0.60)
====================== ====================
See notes to unaudited condensed consolidated financial statements.
DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED STATEMENTS
OF CASH FLOWS (UNAUDITED)
(amounts in thousands)
Three Months Ended
March 31,
----------------------------------------
2005 2004
------------------ ------------------
Operating activities:
Net income (loss) $ 934 $ (5,387)
Adjustments to reconcile net income (loss) to net cash provided by
operating activities:
Provision for loan losses 2,261 7,200
Impairment charges 266 1,661
(Gain) loss on sale of investments (79) 34
Amortization and depreciation 407 1,946
Net change in other assets, accrued expenses and other liabilities (900) 28
------------------ ------------------
Net cash and cash equivalents provided by operating activities 2,889 5,482
------------------ ------------------
Investing activities:
Principal payments received on securitized finance receivables 45,831 49,401
Payments received on other investments, securities, and other loans 12,624 5,559
Proceeds from sales of securities and other investments 5,168 290
Purchases of or advances on other investments (92) (318)
Other 102 75
------------------ ------------------
Net cash and cash equivalents provided by investing activities 63,633 55,007
------------------ ------------------
Financing activities:
Principal payments on non-recourse securitization financing (46,072) (50,168)
Repayment of repurchase agreement borrowings (11,101) (2,379)
Repayment of senior notes - (10,049)
Dividends paid (1,337) -
------------------ ------------------
Net cash and cash equivalents used for financing activities (58,510) (62,596)
------------------ ------------------
Net increase (decrease) in cash and cash equivalents 8,012 (2,107)
Cash and cash equivalents at beginning of period 52,522 7,386
------------------ ------------------
Cash and cash equivalents at end of period $ 60,534 $ 5,279
================== ==================
Supplement disclosures of cash flow information:
Cash paid for interest $ 18,892 $ 25,419
================== ==================
See notes to unaudited condensed consolidated financial statements.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
March 31, 2005
(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 consolidates entities in which it owns more than 50% of the voting
equity and control does not rest with others. 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 or when it is able to
influence the financial and operating policies of the investee but owns less
than 50% of the voting equity. For all other investments, the cost method is
applied.
The Company believes it has complied with the requirements for qualification as
a REIT under the Internal Revenue Code (the "Code"). To the extent the Company
qualifies as a REIT for federal income tax purposes, it generally will not be
subject to federal income tax on the amount of its income or gain that is
distributed as dividends to shareholders.
In the opinion of management, all significant adjustments, consisting of normal
recurring 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 months ended March 31,
2005 are not necessarily indicative of the results that may be expected for the
year ending December 31, 2005. Certain information and footnote disclosures
normally included in the consolidated financial statements prepared in
accordance with generally accepted accounting principles have been omitted. The
unaudited financial statements included herein should be read in conjunction
with the financial statements and notes thereto included in the Company's Annual
Report on Form 10-K for the year ended December 31, 2004, filed with the
Securities and Exchange Commission.
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. 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 receivables, are determined by calculating the present value of the
projected cash flows of the instruments using market-based assumptions such as
estimated future interest rates 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.
The Company also has credit risk on loans in its portfolio as discussed in Note
5. An allowance for loan losses has been estimated and established for currently
existing losses in the loan portfolio, which are deemed probable as to their
occurrence. 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. Provisions made to increase the allowance for loan losses are
presented as provision for losses in the accompanying condensed consolidated
statements of operations. The Company's actual credit losses may differ from
those estimates used to establish the allowance.
Certain reclassifications have been made to the financial statements for 2004 to
conform to the presentation adopted in 2005.
NOTE 2 -- SUBSEQUENT EVENTS
On April 25, 2005, the Company completed the redemption of the outstanding
classes of the SASCO 2002-9 series of securitization financing. The redeemed
bonds are held by the Company and will, therefore, remain outstanding. The
redemption was financed with approximately $25,000 of cash and $170,000 of
repurchase agreement financing.
In addition, on May 9, 2005, the Company sold certain securitized manufactured
housing loans and securities, for a net $9,000. The sale is expected to result
in the removal of approximately $372,000 in securitized finance receivable
assets, net of reserves, and $369,000 in securitization financing borrowings
from the Company's balance sheet. The Company expects to record a gain in excess
of $8,000 on the sale. These investments were considered non-core assets for the
Company.
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 following table reconciles the
numerator and denominator for both the basic and diluted net income (loss) per
common share for the three months ended March 31, 2005 and 2004.
- --------------------------------------------------------------------------------------------------------------------
Three Months Ended March 31,
2005 2004
- --------------------------------------------------------------------------------------------------------------------
Weighted-Average Weighted-
Number of Average
Income Shares Income Number of
(loss) (loss) Shares
--------------------------- --------------------------------
Net income (loss) $ 934 $ (5,387)
Preferred stock charge (1,337) (1,191)
------------- ---------------
Net loss to common shareholders $ (403) 12,162,391 $ (6,578) 10,873,903
Effect of dividends and additional shares of
preferred stock - - - -
------------- ------------- --------------- ----------------
Diluted $ (403) 12,162,391 $ (6,578) 10,873,903
============= ============= =============== ================
Net loss per share:
Basic and diluted $ (0.03) $ (0.60)
============= ================
Reconciliation of shares included in calculation of earnings per share due to
anti-dilutive effect:
Conversion of Series A preferred stock $ - - $ 289 246,798
Conversion of Series B preferred stock - - 402 344,094
Conversion of Series C preferred stock - - 500 342,446
Dividends and assumed conversion of 1,337 5,628,737 - -
Series D preferred stock
Expense and incremental shares of stock
appreciation rights - 257 - 17,830
------------- ------------- --------------- ----------------
$ 1,337 5,628,994 $ 1,191 951,168
============= ============= =============== ================
- --------------------------------------------------------------------------------------------------------------------
NOTE 4 -- SECURITIZED FINANCE RECEIVABLES
The following table summarizes the components of securitized finance receivables
at March 31, 2005 and December 31, 2004:
- --------------------------------------------------------------------------------------------------------------------
March 31, December 31, 2004
2005
- --------------------------------------------------------------------------------------------------------------------
Loans, at amortized cost $ 1,023,757 $ 1,064,137
Allowance for loan losses (27,681) (28,014)
- --------------------------------------------------------------------------------------------------------------------
Loans, net 996,076 1,036,123
Debt securities, at fair value 195,304 206,434
- --------------------------------------------------------------------------------------------------------------------
$ 1,191,380 $ 1,242,557
- --------------------------------------------------------------------------------------------------------------------
The following table summarizes the amortized cost basis, gross unrealized gains
and estimated fair value of debt securities pledged as securitized finance
receivables at March 31, 2005 and December 31, 2004:
- ----------------------------------------------------------------------------------------------------------------------
March 31, December 31, 2004
2005
- ----------------------------------------------------------------------------------------------------------------------
Debt securities, at amortized cost $ 197,125 $ 205,370
Gross unrealized (losses) gains (1,821) 1,064
- ----------------------------------------------------------------------------------------------------------------------
Estimated fair value $ 195,304 $ 206,434
- ----------------------------------------------------------------------------------------------------------------------
The components of securitized finance receivables at March 31, 2005 and December
31, 2004 are as follows:
- -------------------------------------------------------------------------------------------------------------------
March 31, 2005 December 31, 2004
- -------------------------------------------------------------------------------------------------------------------
Debt Total Loans, net Debt Total
Loans, net Securities Securities
- -------------------------------------------------------------------------------------------------------------------
Collateral:
Commercial $ 621,257 $ - $ 621,257 $ 640,090 $ - $ 640,090
Manufactured housing 193,356 144,943 338,299 198,246 149,420 347,666
Single-family 208,288 49,130 257,418 225,055 52,753 277,808
-----------------------------------------------------------------------------------
1,022,901 194,073 1,216,974 1,063,391 202,173 1,265,564
Allowance for loan losses (27,681) - (27,681) (28,014) - (28,014)
Funds held by trustees 131 119 250 130 43 173
Accrued interest receivable 6,373 205 6,578 6,548 202 6,750
Unamortized discounts and
premiums, net (5,648) 2,728 (2,920) (5,932) 2,952 (2,980)
Unrealized (loss) gain, net - (1,821) (1,821) - 1,064 1,064
- -------------------------------------------------------------------------------------------------------------------
$ 996,076 $ 195,304 $ 1,191,380 $ 1,036,123 $ 206,434 $1,242,557
- -------------------------------------------------------------------------------------------------------------------
All of the securitized finance receivables are encumbered by non-recourse
securitized financing.
NOTE 5 -- ALLOWANCE FOR LOAN LOSSES
The Company reserves for probable estimated credit losses on loans in its
investment portfolio. The following table summarizes the aggregate activity for
the allowance for loan losses for the three months ended March 31, 2005 and
2004:
- --------------------------------------------------------------------------------------------------------------------
Three Months Ended March 31,
------------------------------------------------------------
2005 2004
- --------------------------------------------------------------------------------------------------------------------
Allowance at beginning of period $ 28,014 $ 43,364
Provision for loan losses 2,261 7,200
Credit losses, net of recoveries (2,594) (4,576)
- --------------------------------------------------------------------------------------------------------------------
Allowance at end of period $ 27,681 $ 45,988
- --------------------------------------------------------------------------------------------------------------------
The following table presents certain information on commercial mortgage loans
that the Company has determined to be impaired. Impaired loans at March 31, 2005
declined from December 31, 2004 due to the repayment of approximately $8,350 of
impaired loans during the first quarter.
- --------------------------------------------------------------------------------------------------------------------
Amount For Which There Is Amount For Which There Is
Total Recorded Investment A Related Allowance For No Related Allowance For
In Impaired Loans Loan Losses Loan Losses
- --------------------------------------------------------------------------------------------------------------------
March 31, 2005 $ 56,601 $ 18,500 $ 38,101
December 31, 2004 72,431 17,379 55,052
- --------------------------------------------------------------------------------------------------------------------
NOTE 6 -- OTHER INVESTMENTS
The following table summarizes the Company's other investments at March 31, 2005
and December 31, 2004:
- --------------------------------------------------------------------------------------------------------------------
March 31, 2005 December 31, 2004
- --------------------------------------------------------------------------------------------------------------------
Delinquent property tax receivable securities, at amortized cost $ 5,736 $ 6,000
Real estate owned 1,430 1,595
- --------------------------------------------------------------------------------------------------------------------
$ 7,166 $ 7,595
- --------------------------------------------------------------------------------------------------------------------
At March 31, 2005 and December 31, 2004, the Company had real estate owned with
a current carrying value of $1,430 and $1,595, respectively. Real estate owned
is acquired from foreclosures on delinquent property tax receivables. During the
three months ended March 31, 2005 and March 31, 2004, the Company collected an
aggregate of $876 and $1,800, respectively, on delinquent property tax
receivables and securities, including net sales proceeds from related real
estate owned.
NOTE 7 -- SECURITIES
The following table summarizes the fair value of the Company's securities
classified as available-for-sale, at March 31, 2005 and December 31, 2004:
- --------------------------------------------------------------------------------------------------------------------
March 31, 2005 December 31, 2004
- --------------------------------------------------------------------------------------------------------------------
Fair Effective Fair Effective
Value Interest Rate Value Interest Rate
- --------------------------------------------------------------------------------------------------------------------
Securities, available-for-sale:
Fixed-rate mortgage securities $ 67,503 4.61% $ 79,462 4.54%
Mortgage-related securities 25 0.33% 28 0.33%
Equity security 2,530 7,438
- --------------------------------------------------------------------------------------------------------------------
70,058 86,928
Gross unrealized gains 197 852
Gross unrealized losses (222) (74)
- --------------------------------------------------------------------------------------------------------------------
$ 70,033 $ 87,706
- --------------------------------------------------------------------------------------------------------------------
NOTE 8 -- RECOURSE DEBT
The Company utilizes repurchase agreements, which are recourse to the Company,
to finance certain of its investments. The Company had $59,367 and $70,468 of
repurchase agreements outstanding as of March 31, 2005 and December 31, 2004,
respectively. The repurchase agreements were collateralized by securities with a
fair value of $65,426 and $78,491 as of March 31, 2005 and December 31, 2004,
respectively.
NOTE 9 -- PREFERRED STOCK
At March 31, 2005 and December 31, 2004, the total liquidation preference, which
includes accrued dividends payable, on the Preferred Stock was $57,624 and
$58,040, respectively. There was $1,337 ($0.2375 per share) of accrued dividends
payable on the Series D Preferred Stock as of both March 31, 2005 and December
31, 2004.
NOTE 10 -- DERIVATIVE FINANCIAL INSTRUMENTS
In June 2002, the Company entered into an interest rate swap which matures on
June 28, 2005, to mitigate its interest rate risk exposure on $100,000 in
notional value of its variable rate non-recourse securitization financing, which
finance a like amount of fixed rate assets. Under the agreement, the Company
will pay interest at a fixed rate of 3.73% on the notional amount and will
receive interest based on one-month London Inter-Bank Offering Rate ("LIBOR") on
the same amount. This contract has been treated as a cash flow hedge with
changes in the value of the hedge being reported as a component of accumulated
other comprehensive income. During the three months ended March 31, 2005, the
Company recognized $327 in other comprehensive income on this position. At March
31, 2005, the aggregate accumulated other comprehensive loss on this hedge
instrument was $165. 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. Amounts in
accumulated other comprehensive income are reclassified into earnings in the
same period during which the hedged transaction affects earnings.
In October 2002, the Company entered into a synthetic three-year amortizing
interest-rate swap (using Eurodollar Futures contracts) with an initial notional
balance of approximately $81,000 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. During 2004, the Company
determined that this instrument, which previously qualified for hedge
accounting, ceased to be effective due to a significant deterioration in the
correlation between the synthetic interest rate swap cash flow hedge and the
financing being hedged, as measured by the correlation between the three-month
Eurodollar futures and one-month LIBOR. Accordingly, the Company has
discontinued hedge accounting and reflected the changes in market value of the
hedge instrument in its statement of operations as other income (expense). The
remaining unrealized loss included in other comprehensive income at the time the
Company discontinued hedge accounting is being amortized over the remaining term
of the hedge exposure. At March 31, 2005, the aggregate accumulated other
comprehensive loss on this hedge instrument was $60. During March 2005, the
company settled the remaining three Eurodollar contracts and recognized trading
gains of $30 and interest expense of $56.
NOTE 11 -- COMMITMENTS AND CONTINGENCIES
GLS Capital, Inc. ("GLS"), a subsidiary of the Company, together with the County
of Allegheny, Pennsylvania ("Allegheny County"), were defendants in a lawsuit in
the Commonwealth Court of Pennsylvania (the "Commonwealth Court"), the appellate
court of the state of Pennsylvania. Plaintiffs were two local businesses seeking
status to represent as a class, delinquent taxpayers in Allegheny County whose
delinquent tax liens had been assigned to GLS. Plaintiffs challenged the right
of Allegheny County and GLS to collect certain interest, costs and expenses
related to delinquent property tax receivables in Allegheny County, and whether
the County had the right to assign the delinquent property tax receivables to
GLS and therefore employ procedures for collection enjoyed by Allegheny County
under state statute. This lawsuit was related to the purchase by GLS of
delinquent property tax receivables from Allegheny County in 1997, 1998, and
1999. In July 2001, the Commonwealth Court issued a ruling that addressed, among
other things, (i) the right of GLS to charge to the delinquent taxpayer a rate
of interest of 12% per annum versus 10% per annum on the collection of its
delinquent property tax receivables, (ii) the charging of a full month's
interest on a partial month's delinquency; (iii) the charging of attorney's fees
to the delinquent taxpayer for the collection of such tax receivables, and (iv)
the charging to the delinquent taxpayer of certain other fees and costs. The
Commonwealth Court in its opinion remanded for further consideration to the
lower trial court items (i), (ii) and (iv) above, and ruled that neither
Allegheny County nor GLS had the right to charge attorney's fees to the
delinquent taxpayer related to the collection of such tax receivables. The
Commonwealth Court further ruled that Allegheny County could assign its rights
in the delinquent property tax receivables to GLS, and that plaintiffs could
maintain equitable class in the action. In October 2001, GLS, along with
Allegheny County, filed an Application for Extraordinary Jurisdiction with the
Supreme Court of Pennsylvania, Western District appealing certain aspects of the
Commonwealth Court's ruling. In March 2003, the Supreme Court issued its opinion
as follows: (i) the Supreme Court determined that GLS can charge delinquent
taxpayers a rate of 12% per annum; (ii) the Supreme Court remanded back to the
lower trial court the charging of a full month's interest on a partial month's
delinquency; (iii) the Supreme Court revised the Commonwealth Court's ruling
regarding recouping attorney fees for collection of the receivables indicating
that the recoupment of fees requires a judicial review of collection procedures
used in each case; and (iv) the Supreme Court upheld the Commonwealth Court's
ruling that GLS can charge certain fees and costs, while remanding back to the
lower trial court for consideration the facts of each individual case. Finally,
the Supreme Court remanded to the lower trial court to determine if the
remaining claims can be resolved as a class action. The lower trial court had
set the hearing on the class-action status for late April 2005, but the hearing
was delayed until no earlier than June 2005. In August 2003, the Pennsylvania
legislature enacted a law 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. Subsequent to the enactment of the law, challenges
to the retroactivity provisions of the law were filed in separate cases, which
did not include GLS as a defendant. In September 2004, the Trial Court in that
litigation upheld the retroactive provisions enacted in 2003. Plaintiffs have
appealed in that case. The Company believes that the ultimate outcome of this
litigation will not have a material impact on our 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., were defendants in state court in
Dallas County, Texas in the matter of Basic Capital Management et. al.
(collectively, "BCM" or "the Plaintiffs") versus Dynex Commercial, Inc. et. al.
The suit was filed in April 1999 originally against DCI, and in March 2000, BCM
amended the complaint and added the Company as a defendant. The complaint, which
was further amended during pretrial proceedings, alleged that, among other
things, DCI and the Company failed to fund tenant improvement or other advances
allegedly required on various loans made by DCI to BCM, which loans were
subsequently acquired by the Company; that DCI breached an alleged $160,000
"master" loan commitment entered into in February 1998; and that DCI breached
another alleged loan commitment of approximately $9,000. The trial commenced in
January 2004 and in February 2004, the jury in the case rendered a verdict in
favor of one of the plaintiffs and against the Company on the alleged breach of
the loan agreements for tenant improvements and awarded that plaintiff damages
in the amount of $253. The jury also awarded the Plaintiffs' attorneys fees in
the amount of $2,100. The jury entered a separate verdict against DCI in favor
of BCM under two mutually exclusive damage models, for $2,200 and $25,600,
respectively. The 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.
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. Plaintiffs have filed an appeal. 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.
On February 11, 2005, a putative class action lawsuit was filed against the
Company, our subsidiary MERIT Securities Corporation, Stephen J. Benedetti and
Thomas H. Potts in United States District Court for the Southern District of New
York by the Teamsters Local 445 Freight Division Pension Fund. The lawsuit
purports to be a class action on behalf of purchasers of MERIT Series 13
securitization financing bonds, which are collateralized by manufactured housing
loans. The allegations include federal securities laws violations in connection
with the issuance in August 1999 by MERIT Securities Corporation of our MERIT
Series 13 bonds. The suit also alleges fraud and negligent misrepresentations in
connection with MERIT Series 13. The Company is currently evaluating the
allegations made in the lawsuit and intends to vigorously defend itself against
them.
Although no assurance can be given with respect to the ultimate outcome of the
above litigation, the Company believes the resolution of these lawsuits will not
have a material effect on the Company's condensed consolidated balance sheet,
but could materially affect consolidated results of operations in a given year.
NOTE 12 -- STOCK BASED COMPENSATION
On January 2, 2005, the Company granted 126,297 stock appreciation rights (SAR)
to certain of its employees and officers under the Dynex Capital, Inc. 2004
Stock Incentive Plan. The SARs vest over the next four years in equal annual
installments, expire on December 31, 2011 and have an exercise price of $7.81
per share, which was the market price of the stock on the grant date.
The Company has elected to follow the intrinsic value method in accounting for
its stock based compensation issued to employees and non-employee directors.
Accordingly, the Company did not recognize compensation expense upon the
issuance of its stock appreciation rights, because the term was fixed and the
exercise price equaled the market price of the underlying stock on the date of
the grant.
If the Company had applied the fair value method to SARs granted to employees
using the Black-Scholes pricing model, the Company would have recorded
approximately $16 of compensation expense resulting in pro forma net loss to
common shareholders of $419 for the first quarter of 2005, which would have had
no effect on pro forma net loss per common share on a basic and diluted basis.
NOTE 13 -- RECENT ACCOUNTING PRONOUNCEMENTS
In December 2004, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 123 (Revised 2004), Share-Based Payment (FAS 123R). This statement
supersedes APB Opinion No. 25 and its related implementation guidance. The
statement establishes standards for the accounting for transactions in which an
entity exchanges its equity instruments for goods and services. This statement
focuses primarily on accounting for transactions in which an entity obtains
employee services in share-based payment transactions. The most significant
change resulting from this statement is the requirement for public companies to
expense employee share-based payments under fair value as originally introduced
in SFAS No. 123. This statement is effective for public companies as of the
beginning of the first interim or annual reporting period that begins after
December 15, 2005. The Company will adopt this statement effective January 1,
2006. The Company presented the amount that would have been recorded in general
and administrative expense for the quarter ended March 31, 2005 if the Company
had adopted the provisions of FAS 123R in Note 12 above.
In September 2004, the FASB Board directed the FASB Staff to delay the effective
date for adoption of paragraphs 10-20 of Emerging Issues Task Force ("EITF")
Issue 03-1, "The Meaning of Other-Than-Temporary Impairment," until the issuance
of implementation guidance for debt securities that are impaired solely due to
interest rates and/or sector spreads and analyzed for other-than-temporary
impairment under paragraph 16 of EITF 03-1. The delay of the effective date for
paragraphs 10-20 of EITF 03-1 will be superseded upon final issuance of
Statement of Financial Position "FSP" EITF Issue 03-1-a. 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.
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
---------------------------------------------------------------
The following discussion and analysis of the financial condition and results of
operations of the Company for the three months ended March 31, 2005 should be
read in conjunction with the Company's Unaudited Condensed Consolidated
Financial Statements and the accompanying Notes to Unaudited Condensed
Consolidated Financial Statements included in this report.
The Company is a financial services company, which invests in loans and
securities principally consisting of, or secured by, 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 to a securitization trust
(i.e. securitized) as collateral for non-recourse bonds ("non-recourse
securitization financing"), which provides long-term financing for such loans
while limiting credit, interest rate and liquidity risk. The Company earns the
net interest spread between the interest income on the loans and securities in
its investment portfolio and the interest and other expenses associated with the
non-recourse securitization financing. The Company also collects payments from
property owners on its investment in delinquent property tax receivables.
In recent years, the Company elected to sell certain non-core assets, improving
its financial flexibility by converting investments into cash, and the Company
completed a restructuring of its equity capital while simultaneously eliminating
preferred dividends in arrears. The Company's total investment portfolio assets
over the last four quarters have declined approximately $516 million to $1.27
billion at March 31, 2005. During that time, the Company has improved its
liquidity, as cash and cash equivalents is now $60.5 million compared to $5.3
million at March 31, 2004. In 2004, the Company also restructured its preferred
stock resulting in the elimination or payment-in-kind of $18.5 million in
dividends in arrears.
In addition, on May 9, 2005, the Company sold certain securitized manufactured
housing loans and securities, for a net $9.0 million. The sale is expected to
result in the removal of approximately $372 million in securitized finance
receivable assets, net of reserves, and $369 million in securitization financing
borrowings from the Company's balance sheet. The Company expects to record a
gain on the sale in excess of $8.0 million on the sale. These investments were
considered non-core assets for the Company and contributed $981 thousand in net
interest income and $150 thousand of net cash flows for the first quarter of
2005. The Company anticipates being able to replace the income and cash flows
quickly once the Company begins to substantively reinvest its capital.
In our securitization trusts, we have retained the right to redeem outstanding
securitization financing bonds based on percentages of the original financing
that remains outstanding, or at a certain date. Securitization financing bonds
with an outstanding balance of approximately $200 million at March 31, 2005 and
secured by approximately $208 million in single-family loans were redeemed in
April 2005. The redemption of these bonds, which at the date of the redemption
had declined to $195.7 million, was financed with approximately $170.7 million
of repurchase agreement financing and $25.0 million of the Company's capital.
The Company anticipates reissuing these bonds during 2005.
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 consolidates entities in which it owns more than 50% of the voting
equity and control of the entity does not rest with others. 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 or when it is
able to influence the financial and operating policies of the investee but owns
less than 50% of the voting equity. 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 fair value will remain below the carrying value 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 generally considered to be other-than-temporary when the fair
value remains below the carrying value for three consecutive quarters. If the
impairment is determined to be other-than-temporary, an impairment charge is
recorded in order to adjust the carrying value of the investment to its
estimated value.
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. 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 is 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. Commercial mortgage loans are
evaluated on an individual basis for impairment. Generally, a commercial loan
with a debt service coverage ratio of less than one is considered impaired.
However, based on a commercial loan's details, commercial loans with a debt
service coverage ratio less than one may not be considered impaired; conversely,
commercial loans with a debt service coverage ratio greater than one may be
considered impaired. 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
the estimates used to establish the allowance.
FINANCIAL CONDITION
-------------------
Below is a discussion of the Company's financial condition.
- -------------------------------------------------------------------------------------------------------------------
(amounts in thousands except per share data) March 31, 2005 December 31, 2004
- -------------------------------------------------------------------------------------------------------------------
Investments:
Securitized finance receivables:
Loans, net $ 996,076 $ 1,036,123
Debt securities 195,304 206,434
Securities 70,033 87,706
Other investments 7,166 7,595
Other loans 5,242 5,589
Non-recourse securitization financing 1,131,617 1,177,280
Repurchase agreements 59,367 70,468
Shareholders' equity 144,864 148,766
Common book value per share $ 7.28 $ 7.60
- -------------------------------------------------------------------------------------------------------------------
Securitized finance receivables. Securitized finance receivables decreased to
$1.19 billion at March 31, 2005 compared to $1.24 billion at December 31, 2004.
This decrease of $51.2 million is primarily the result of $44.6 million of
paydowns on the collateral, $2.3 million of additions to the allowance for loan
losses, $3.4 million of cash payments received applied to principal, $2.1
million of net interest accretion and $2.9 million of unrealized losses on a
debt security.
Securities. Securities decreased during the three months ended March 31, 2005 by
$17.7 million, to $70.0 million at March 31, 2005 from $87.7 million at December
31, 2004 due to principal payments of $11.9 million, the sale of $4.9 million of
equity securities and a net $0.8 million decrease in the fair value of
available-for-sale securities.
Other investments. Other investments at March 31, 2005 consist primarily of a
security collateralized by delinquent property tax receivables. Other
investments decreased from $7.6 million at December 31, 2004 to $7.2 million at
March 31, 2005. This decrease is primarily the result of pay-downs and proceeds
from sales of real estate owned properties which together totaled of $0.8
million during the quarter and other than temporary impairment charges of $0.1
million. These decreases were partially offset by interest accruals of $0.4
million on the security and additional advances for collections of $0.1 million.
Other loans. Other loans decreased by $0.4 million from $5.6 million at December
31, 2004 to $5.2 million at March 31, 2005 as the result of pay-downs during the
period.
Non-recourse securitization financing. Non-recourse securitization financing
decreased $45.7 million, from $1.18 billion at December 31, 2004 to $1.13
billion at March 31, 2005. This decrease was primarily a result of principal
payments received of $44.6 million on the associated finance receivables pledged
which were used to pay down the non-recourse securitization financing in
accordance with the respective indentures. Additionally, for certain
securitizations, surplus cash in the amount of $1.6 million was retained within
the security structure and used to repay non-recourse securitization financing
outstanding, instead of being released to the Company, as certain performance
triggers were not met in such securitizations. These decreases were partially
offset by amortization of discounts of $0.7 million.
Repurchase Agreements. Repayments of repurchase agreements of $11.1 million
reduced the outstanding balance to $59.4 million as of March 31, 2005 compared
to $70.5 million as of December 31, 2004.
Shareholders' equity. Shareholders' equity decreased to $144.9 million at March
31, 2005 from $148.8 million at December 31, 2004. This decrease was primarily
the result of a net decrease in accumulated other comprehensive income of $3.9
million on investments available-for-sale and preferred stock dividends of $1.3
million. These decreases were partially offset by net income of $0.9 million and
$0.4 million of deferred gains on hedging instruments.
RESULTS OF OPERATIONS
- -----------------------------------------------------------------------------------------------
Three Months Ended
March 31,
--------------------------------
(amounts in thousands except per share information) 2005 2004
- -----------------------------------------------------------------------------------------------
Net interest income $ 4,457 $ 6,435
Net interest income (loss) after provision for loan losses 2,196 (765)
Impairment charges (266) (1,661)
General and administrative expenses (1,492) (2,468)
Net income (loss) 934 (5,387)
Net loss per common share:
Basic and diluted $ (0.03) $ (0.60)
- -----------------------------------------------------------------------------------------------
Three Months Ended March 31, 2005 Compared to Three Months Ended March 31, 2004.
The increase in net income and decrease in net loss per common share during the
three months ended March 31, 2005 as compared to the same period in 2004 is
primarily the result of a $4.9 million decrease in provision for loan losses,
and $1.4 million decrease in impairment charges, and a decrease in general and
administrative expense and other income (expense) of $1.9 million, offset by a
decrease net interest income of $2.0 million.
Net interest income decreased from $6.4 million to $4.5 million for the quarter
ended March 31, 2005 from the same period in 2004. Net interest income decreased
primarily as a result of a decline in overall interest earning assets and a
decline in the net interest spread earned on the investment portfolio from 1.21%
to 0.73% for the three-month periods ended March 31, 2004 and 2005,
respectively, as discussed below. Net interest income after provision for loan
losses for the three months ended March 31, 2005 increased to $2.2 million from
a loss of $0.8 million for the same period for 2004. Provision for loan losses
decreased by $4.9 million from $7.2 million in 2004 to $2.3 million in the
current period due primarily to the sale in 2004 of the Company's rights and
interests in a securitization trust containing manufactured housing loans and
the subsequent derecognition of said securitization trust. There were also no
provisions for loan losses on the Company's remaining manufactured housing loans
for the first quarter of 2005 due to their impending sale as discussed in Note 2
to the condensed financial statements.
Impairment charges for the three months ended March 31, 2004 were $0.3 million
compared to $1.7 million for the same period in 2004. The $1.4 million decrease
of impairment losses for the three-months ended March 31, 2005 compared to the
same period in 2004 reflects other than temporary impairment of its investment
in delinquent property tax receivables and REO properties in 2004 that was not
experienced in 2005.
General and administrative expense decreased to $1.5 million for the
three-months ended March 31, 2005 from $2.5 million for the same period in 2004.
This decrease was primarily the result of the reductions in compensation expense
and litigation costs incurred during the three months ended March 31, 2004 that
were not experienced in 2005.
The following table summarizes the average balances of interest-earning assets
and their average effective yields, along with the average interest-bearing
liabilities and the related average effective interest rates, for each of the
periods presented. Assets that are on non-accrual status are excluded from the
table below for each period presented.
Average Balances and Effective Interest Rates
- -------------------------------------------------------------------------------------------------------------------
Three Months Ended March 31,
----------------------------------------------------------
2005 2004
----------------------------------------------------------
Average Effective Average Effective
Balance Rate Balance Rate
--------------- ------------ --------------- ------------
Interest-earning assets:(1)
Securitized finance receivables(2) $ 1,226,852 7.17% $ 1,768,007 7.44%
Securities 72,807 5.69% 28,412 7.87%
Cash 54,200 2.21% 8,636 0.75%
Other loans 7,092 14.53% 8,227 8.25%
Other investments 7,394 20.14% - -
--------------- ------------ --------------- ------------
Total interest-earning assets $ 1,368,346 7.00% $ 1,813,282 7.42%
=============== ============ =============== ============
Interest-bearing liabilities:
Non-recourse securitization financing(3) $ 1,147,513 6.49% $ 1,681,370 6.26%
Repurchase agreements 69,216 2.62% 22,773 1.45%
Senior notes - - 6,700 9.50%
--------------- ------------ --------------- ------------
Total interest-bearing liabilities $ 1,216,729 6.27% $ 1,710,843 6.21%
=============== ============ =============== ============
Net interest spread on all investments(3) 0.73% 1.21%
============ ============
Net yield on average interest-earning assets(3)(4) 1.43% 1.56%
============ ============
- -------------------------------------------------------------------------------------------------------------------
<FN>
(1) Average balances exclude adjustments made in accordance with Statement of
Financial Accounting Standards No. 115, "Accounting for Certain
Investments in Debt and Equity Securities" to record available-for-sale
securities at fair value.
(2) Average balances exclude funds held by trustees of $233 and $335 for the
three months ended March 31, 2005 and 2004, respectively.
(3) Effective rates are calculated excluding non-interest related
collateralized bond expenses. If included, the effective rate on
interest-bearing liabilities would be 6.44% and 6.36% for the three
months ended March 31, 2005 and 2004.
(4) Net yield on average interest-earning assets reflects net interest income
excluding non-interest related collateralized bond expenses divided by
average interest earning assets for the period, annualized.
</FN>
The net interest spread decreased 48 basis points, to 0.73% for the three months
ended March 31, 2005 from 1.21% for the same period in 2004. The net yield on
average interest earning assets for the three months ended March 31, 2005 also
decreased relative to the same period in 2004, to 1.43% from 1.56%. The decline
in the Company's net interest spread can be attributed to decreasing yields on
interest-earning assets and increases in the cost of interest-bearing
liabilities. Yields on interest earning assets declined as a significant portion
of the investment portfolio has been converted to cash, as the Company acquired
in late 2004 a $60 million fixed rate security with a yield of 3.83% and as
adjustable interest earning assets continue to decline due to sales and
prepayments. Interest-bearing liability costs increased by 6 basis points for
the three month period ended March 31, 2005, compared to the same period in 2004
due primarily to increases in one-month LIBOR and the repayment in 2004 of
higher rated, lower yield bond classes. This has been moderated by an increase
in repurchase agreement financing with yields tied to one-month LIBOR. The
average One-Month LIBOR rate increased to 2.64% for the three-month period ended
March 31, 2005 compared to 1.10% for the three-month period ended March 31,
2004. The average six-month LIBOR rate decreased to 3.08% for the three-month
period ended March 31, 2005 compared to 1.18% for the same period in 2004.
The following table summarizes the amount of change in interest income and
interest expense due to changes in interest rates versus changes in volume:
- ---------------------------------------------------------------------------------------------------------------------
Three Months Ended March 31, 2005 vs.
Three Months Ended March 31, 2004
(amounts in thousands) Rate Volume Total
- ---------------------------------------------------------------------------------------------------------------------
Securitized finance receivables $ (1,148) $ (9,741) $ (10,889)
Securities (192) 668 476
Other investments 291 365 656
Other loans 114 (26) 88
- ---------------------------------------------------------------------------------------------------------------------
Total interest income (935) (8,734) (9,669)
- ---------------------------------------------------------------------------------------------------------------------
Securitization financing 472 (8,179) (7,707)
Senior notes (80) (80) (160)
Repurchase agreements 111 261 372
- ---------------------------------------------------------------------------------------------------------------------
Total interest expense 503 (7,998) (7,495)
- ---------------------------------------------------------------------------------------------------------------------
Net interest income $ (1,438) $ (736) $ (2,174)
- ---------------------------------------------------------------------------------------------------------------------
<FN>
Note: The change in interest income and interest expense due to changes in both
volume and rate, which cannot be segregated, has been allocated
proportionately to the change due to volume and the change due to rate.
This table excludes non-interest related dividends on equity securities,
securitization financing expense, other interest expense and provision
for credit losses.
</FN>
From March 31, 2004 to March 31, 2005, average interest-earning assets declined
$445 million, or approximately 25%. Approximately half of that decline resulted
from the derecognition of a securitization trust collateralized by manufactured
housing loans. Another large portion of such reduction relates to paydowns on
the Company's adjustable-rate single-family mortgage loans and manufactured
housing loans. The Company's portfolio as of March 31, 2005 consists of $231.5
million of adjustable rate assets and $1.1 billion of fixed-rate assets. The
Company currently finances approximately $216.8 million of the fixed-rate assets
with non-recourse LIBOR based floating-rate liabilities. As short-term interest
rates continue to increase, the downward resetting of the single-family ARM
loans will reverse and the cost of interest-bearing liabilities will continue to
increase, with the reduction of net interest spread in future periods depending
on how quickly the rates increase.
Interest Income and Interest-Earning Assets. At March 31, 2005, $1.1 billion of
the investment portfolio consists of loans and securities which pay a fixed-rate
of interest, and approximately $231.5 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. Approximately 69% of the ARM loans
underlying the ARM securities and securitized finance receivables are indexed to
and reset based upon the level of six-month LIBOR; approximately 14% of the ARM
loans are indexed to and reset based upon the level of the one-year Constant
Maturity Treasury (CMT) index. The Company finances its investment portfolio
with principally non-recourse securitization financing. At March 31, 2005,
approximately $740 million of fixed-rate bonds and $380 million of adjustable
rate bonds were outstanding. The following table presents a breakdown, by
principal balance, of the Company's securitized finance receivables and
securities by type of underlying loan. This table excludes mortgage-related
securities, other investments and unsecuritized loans.
Investment Portfolio Composition(1)
($ in millions)
- --------------------------------------------------------------------------------------------------------------------
Other Indices
LIBOR Based CMT Based Based ARM Fixed-Rate
ARM Loans ARM Loans Loans Loans Total
- --------------------------------------------------------------------------------------------------------------------
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
2004, Quarter 3 196.1 38.8 39.5 1,335.8 1,610.2
2004, Quarter 4 176.7 34.5 37.6 1,112.8 1,361.6
2005, Quarter 1 163.7 32.9 34.9 1,069.1 1,300.6
- --------------------------------------------------------------------------------------------------------------------
<FN>
(1) Includes only the principal amount of securitized finance receivables,
ARM securities and fixed-rate mortgage securities.
</FN>
Credit Exposures. The Company's predominate securitization structure is
non-recourse securitization financing, whereby loans and securities are pledged
to a trust, and the trust issues bonds pursuant to an indenture. 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. From an economic
point of view, the Company generally has retained a limited portion of the
direct credit risk in these securities. In many 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 certain
investments of the Company; the direct credit exposure retained by the Company
(represented by the amount of over-collateralization pledged and subordinated
securities owned by the Company), net of the credit reserves and discounts
maintained by the Company for such exposure; and the actual credit losses
incurred for each quarter presented. Credit Exposure, Net of Credit Reserves is
based on the credit risk retained by the Company for the loans and securities
pledged to the securitization trust, from an economic point of view. The table
includes any subordinated security retained by the Company. The Company's credit
exposure, net of credit reserves was substantially unchanged from 2004.
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 $26.6 million and a
remaining deductible aggregating $0.5 million on $29.3 million of securitized
single family mortgage loans which are subject to such reimbursement agreements;
guarantees aggregating $19.5 million on $200.0 million of securitized commercial
mortgage loans, whereby losses on such loans would need to exceed the respective
guarantee amount before the Company would incur credit losses; and $95.8 million
of securitized single family mortgage loans which are subject to various
mortgage pool insurance policies whereby losses would need to exceed the
remaining stop loss of at least 77% on such policies before the Company would
incur losses. This table excludes any credit exposure on unsecuritized loans and
other investments.
Credit Reserves and Actual Credit Losses
($ in millions)
- --------------------------------------------------------------------------------------------------------------------
Credit Exposure, Net
Outstanding Credit Exposure, Actual Of Credit Reserves To
Loan Principal Net Of Credit Outstanding Loan
Balance Credit Reserves Losses Balance
- --------------------------------------------------------------------------------------------------------------------
2004, Quarter 1 $ 1,775.1 $ 54.3 $ 6.0 3.06%
2004, Quarter 2 1,716.1 48.0 8.0 2.80%
2004, Quarter 3 1,613.4 39.8 6.5 2.47%
2004, Quarter 4 1,296.5 39.9 4.6 3.08%
2005, Quarter 1 1,245.8 39.4 2.6 3.16%
- --------------------------------------------------------------------------------------------------------------------
The following table summarizes single family mortgage loan, manufactured housing
loan and commercial mortgage loan delinquencies as a percentage of the
outstanding collateral balance for those securities in which the Company has
retained a portion of the direct credit risk. The delinquencies as a percentage
of the outstanding securitized finance receivables balance have decreased to
6.16% at March 31, 2005 from 6.60% at March 31, 2004 primarily due to the sale
of certain securitized finance receivable investments in the fourth quarter of
2004 where the Company had credit risk on the assets sold. The Company monitors
and evaluates its exposure to credit losses and has established reserves based
upon anticipated losses, general economic conditions and trends in the
investment portfolio. As of March 31, 2005, management believes the level of
credit reserves is appropriate for currently existing losses.
Delinquency Statistics (1)
- ---------------------------------------------------------------------------------------------------------------------
30 to 60 days 60 to 90 days 90 days and over
delinquent delinquent delinquent (2) Total
- ---------------------------------------------------------------------------------------------------------------------
2004, Quarter 1 3.46% 0.52% 2.62% 6.60%
2004, Quarter 2 3.04% 2.17% 4.85% 10.04%
2004, Quarter 3 2.53% 0.46% 4.64% 7.63%
2004, Quarter 4 1.27% 0.32% 5.38% 6.97%
2005, Quarter 1 1.35% 0.42% 4.39% 6.16%
- ---------------------------------------------------------------------------------------------------------------------
<FN>
(1) Excludes other investments and unsecuritized loans.
(2) Includes foreclosures, repossessions and REO.
</FN>
General and Administrative Expense. The following tables present a breakdown of
general and administrative expense by category and business unit.
- ---------------------------------------------------------------------------------------------------------------------
Corporate/Investment
Servicing Portfolio Management Total
- ---------------------------------------------------------------------------------------------------------------------
2004, Quarter 1 $ 1,008.9 $ 1,459.6 $ 2,468.5
2004, Quarter 2 986.8 1,028.1 2,014.9
2004, Quarter 3 930.3 916.8 1,847.1
2004, Quarter 4 557.5 859.8 1,417.3
2005, Quarter 1 525.2 966.4 1,491.6
- ---------------------------------------------------------------------------------------------------------------------
General and administrative expense decreased to $1.5 million for the
three-months ended March 2005 from $2.5 million for the same period in 2004.
This decrease was primarily the result of reduced compensation expense,
primarily in the tax lien servicing operation, and legal fees incurred in the
first quarter of 2004.
RECENT ACCOUNTING PRONOUNCEMENTS
--------------------------------
In December 2004, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 123 (Revised 2004), Share-Based Payment. This statement supersedes APB
Opinion No. 25 and its related implementation guidance. The statement
establishes standards for the accounting for transactions in which an entity
exchanges its equity instruments for goods and services. This statement focuses
primarily on accounting for transactions in which an entity obtains employee
services in share-based payment transactions. The most significant change
resulting from this statement is the requirement for public companies to expense
employee share-based payments under fair value as originally introduced in SFAS
No. 123. This statement is effective for public companies as of the beginning of
the first interim or annual reporting period that begins after June 15, 2005.
The Company will adopt this statement effective July 1, 2005 and is currently
evaluating the impact it will have on net income had the Company adopted the
provisions of SFAS No. 123, for each year presented.
In September 2004, the FASB Board directed the FASB Staff to delay the effective
date for adoption of paragraphs 10-20 of Emerging Issues Task Force ("EITF")
Issue 03-1, "The Meaning of Other-Than-Temporary Impairment," until the issuance
of implementation guidance for debt securities that are impaired solely due to
interest rates and/or sector spreads and analyzed for other-than-temporary
impairment under paragraph 16 of EITF 03-1. The delay of the effective date for
paragraphs 10-20 of EITF 03-1 will be superseded upon final issuance of
Statement of Financial Position "FSP" EITF Issue 03-1-a. 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.
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. The Company monitors and evaluates the performance of these
securitization transactions based on the Company's net investment in such
transactions, and believes the tables below will assist the investor in
understanding the Company's actual investment in these transactions, the credit
risk which the Company has retained on its investments, the performance of these
investments, and the estimated fair value of these investments based on the
assumptions set forth below.
In the tables below, the "principal balance of net investment" in securitized
finance receivables represents the excess of the principal balance of the
collateral pledged over the outstanding balance of the associated non-recourse
securitization financing owned by third parties. The "amortized cost basis of
net investment" is principal balance of net investment plus or minus premiums
and discounts and related costs. The Company generally has sold the investment
grade classes of the securitization financing to third parties, and has retained
the portion of the securitization financing that is below investment grade.
The Company estimates the fair value of its net investment in collateralized
bond securities as the present value of the projected cash flow from the
collateral, adjusted for the impact of and assumed level of future prepayments
and credit losses, less the projected principal and interest due on the bonds
owned by third parties. The Company master services three of its collateral for
collateralized bond securities. Structured Asset Securitization Corporation
(SASCO) Series 2002-9 is master-serviced by Wells Fargo Bank. CCA One Series 2
and Series 3 are master-serviced by Bank of New York. Monthly payment reports
for those securities master-serviced by the Company may be found on the
Company's website at www.dynexcapital.com.
Below is a summary as of March 31, 2005, 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 present the securitized finance receivables
as an asset, and present the associated securitization financing bond obligation
as a non-recourse liability. In addition, the Company carries only its
investment in MERIT Series 11 at fair value. As a result, the table below is not
meant to present the Company's investment in securitized finance receivables or
the non-recourse securitization financing in accordance with generally accepted
accounting principles applicable to the Company's transactions. See below for a
reconciliation of the amounts included in the table to the Company's condensed
consolidated financial statements.
- --------------------------------------------------------------------------------------------------------------------
(amounts in thousands) Principal
Principal Balance of Principal Amortized
Balance Collateralized Balance Cost Basis
Securitized Financing Of Bonds Of Of
Bond Collateral Outstanding to Net Net
Series (1) Collateral Type Pledged Third Parties Investment Investment
- --------------------------------------------------------------------------------------------------------------------
MERIT Series 11 Securities backed by $ 206,416 $ 179,842 $ 26,574 $ 15,698
single-family mortgage
and manufactured housing
loans
MERIT Series 12 Manufactured housing loans 193,356 182,567 10,789 1,068
SASCO 2002-9 Single family loans 208,288 200,417 7,871 11,406
MCA Series 1 Commercial mortgage loans 67,199 62,474 4,725 1,024
CCA One Series 2 Commercial mortgage loans 214,121 192,018 22,103 13,260
CCA One Series 3 Commercial mortgage loans 339,937 299,976 39,961 46,825
- --------------------------------------------------------------------------------------------------------------------
$ 1,229,317 $ 1,117,294 $ 112,023 $ 89,281
- --------------------------------------------------------------------------------------------------------------------
<FN>
(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
</FN>
The following table reconciles the balances presented in the table above with
the amounts included for securitized finance receivables and securitization
financing in the accompanying condensed consolidated financial statements.
- --------------------------------------------------------------------------------------------------------------------
(amounts in thousands)
Non-recourse
Securitized Securitization
Finance Receivables Financing
- --------------------------------------------------------------------------------------------------------------------
Principal balances per the above table $ 1,229,317 $ 1,117,294
Principal balance of security excluded from above table 2,480 2,542
Recorded impairments on debt securities (14,823) -
Premiums and discounts (2,920) 6,672
Accrued interest and other 5,007 5,109
Allowance for loan losses (1) (27,681) -
- --------------------------------------------------------------------------------------------------------------------
Balance per condensed consolidated financial statements $ 1,191,380 $ 1,131,617
- --------------------------------------------------------------------------------------------------------------------
<FN>
(1) Allowance for loan losses includes $15,448 for commercial loans,
$11,808 for manufactured housing loans, and $425 for single-family loans.
</FN>
The following table summarizes the fair value of the Company's net investment in
securitized finance receivables securities, the various assumptions made in
estimating value, and the cash flow received from such net investment during the
three months ended March 31, 2005. As the Company does not present its
investment in non-recourse securitization financing on a net investment basis
and carries only its investment in MERIT Series 11 at fair value, the table
below is not meant to present the Company's investment in securitized finance
receivables or non-recourse securitization financing in accordance with
generally accepted accounting principles applicable to the Company's
transactions.
- --------------------------------------------------------------------------------------------------------------------
Fair Value Assumptions ($ in thousands)
-----------------------------------------------------------------------------------------------
Projected cash Cash flows
Collateralized Bond Weighted-average flow termination Fair value of net received in 2005,
Series prepayment speeds Losses date investment (1) net (2)
- --------------------------------------------------------------------------------------------------------------------
MERIT Series 11 30% CPR on SF 4.2% annually on Anticipated final $ 8,519 (5) $ 637
securities; 8% MH loans maturity in 2025
CPR on MH
securities
MERIT Series 12 7% CPR 3.6% annually on Anticipated final 736 (5) 249
MH loans maturity in 2027
SASCO 2002-9 28% CPR 0.10% annually Anticipated call 14,573 1,388
date in 2005
MCA One Series 1 (3) 1.00% annually Anticipated final 2,751 264
maturity in 2018
CCA One Series 2 (4) 0.80% annually Anticipated call 12,764 430
date in 2010
CCA One Series 3 (4) 1.20% annually Anticipated call 22,114 104
date in 2009
- ------------------------------------------------------------------------------------------------------------------
$ 61,457 $ 3,072
- ------------------------------------------------------------------------------------------------------------------
<FN>
(1) Calculated as the net present value of expected future cash flows,
discounted at 16%. Expected cash flows were based on the forward LIBOR
curve as of March 31, 2005, 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.
(2) Cash flows received by the Company during the three months ended March
31, 2005, equal to the excess of the cash flows received on the
collateral pledged, over the cash flow requirements of the collateralized
bond security
(3) Computed at 0% CPR through June 2008 due to prepayment lockouts and yield
maintenance provisions
(4) Computed at 0% CPR until the respective call date due to prepayment
lockouts and yield maintenance provisions
(5) The Company executed an agreement subsequent to the end of the quarter to
sell certain of its interest in Merit Series 11 and Merit Series 12 for
$8.0 million and retained the servicing rights related to the Series. The
retained servicing rights were valued at approximately $2.5 million and
$0.7 million for MERIT Series 11 and 12, respectively, and was estimated
using the assumptions in the table above. See Item 2 - Management's
Discussion and Analysis of Financial Condition and Results of Operations
for additional discussion of the transaction.
</FN>
The above tables illustrate the Company's estimated fair value of its net
investment in securitized finance receivables. In its condensed consolidated
financial statements, the Company carries its investments at amortized cost,
except for its investment in MERIT Series 11, which it carries at estimated fair
value. Inclusive of recorded allowance for loan losses of $27.7 million, the
Company's net investment in collateralized bond securities is approximately
$59.8 million. This amount compares to an estimated fair value, utilizing a
discount rate of 16%, of approximately $61.5 million, as set forth in the table
above.
The following table compares the fair value of the non-GAAP disclosure of these
investments at various discount rates, but otherwise 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 $ 9,931 $ 8,519 $ 7,441 $ 6,406
MERIT Series 12-1 713 736 741 732
SASCO 2002-9 16,430 14,573 13,146 11,774
MCA One Series 1 3,295 2,751 2,323 1,908
CCA One Series 2 15,205 12,764 10,795 8,852
CCA One Series 3 25,274 22,114 19,396 16,521
- --------------------------------------------------------------------------------------------------------------------
$ 70,848 $ 61,457 $ 53,842 $ 46,193
- --------------------------------------------------------------------------------------------------------------------
LIQUIDITY AND CAPITAL RESOURCES
-------------------------------
The Company has historically financed its operations from a variety of sources.
Currently, the Company's primary source for funding its operations is
principally the cash flow generated from the investment portfolio, which
includes net interest income and principal payments and prepayments on these
investments. From the cash flow on its investment portfolio, the Company funds
its operating overhead costs, including the servicing of its delinquent property
tax receivables, repays any remaining recourse debt, and makes additional
investments. Should the Company's future operations require access to sources of
capital such as lines of credit and repurchase agreements, the Company believes
that it would be able to access such sources.
The Company's cash flow from its investment portfolio for the quarter ended
March 31, 2005 was approximately $10.8 million, inclusive of proceeds received
on the sale of investments. Such cash flow is after payment of principal and
interest on the associated non-recourse securitization financing (i.e.,
non-recourse debt) outstanding. From the cash flow on its investment portfolio,
the Company funds its operating overhead costs, including the servicing of its
delinquent property tax receivables, and repays any remaining recourse debt.
The Company's cash flow from its investment portfolio is subject to fluctuation
due to changes in interest rates, repayment rates and default rates and related
losses. In a period of rapidly rising interest rates, the Company's net interest
margin and cash flow from the investment portfolio is likely to be significantly
impacted due to increased borrowing costs on variable-rate non-recourse
collateralized bonds. The Company anticipates, however, that it will have
sufficient cash flow from its investment portfolio to meet all of its
obligations.
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 March 31,
2005, Dynex had $1.1 billion of non-recourse securitization financing
outstanding. Approximately $740 million of the non-recourse securitization
financing carries a fixed rate of interest, and approximately $380 million
carries a rate of interest, which adjusts monthly based on One-Month LIBOR.
Repurchase agreements. The Company uses repurchase agreements to finance certain
of its investments. As of March 31, 2005, the Company had $59.4 million of
repurchase agreements financing approximately $65.4 million of mortgage-backed
securities. Subsequent to the end of the first quarter, the Company financed the
redemption of the outstanding bonds of a securitization financing with
approximately $170 million of repurchase agreements, as discussed in "Item 2 -
Management's Discussion and Analysis of Financial Condition and Results of
Operations" above.
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. All statements contained in this
Item as well as those discussed elsewhere in this Report addressing the results
of operations, our operating performance, events, or developments that we expect
or anticipate will occur in the future, including statements relating to
investment strategies, net interest income growth, earnings or earnings per
share growth, and market share, as well as statements expressing optimism or
pessimism about future operating results, are forward-looking statements. The
forward-looking statements are based upon management's views and assumptions as
of the date of this Report, regarding future events and operating performance
and are applicable only as of the dates of such statements. 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.
Factors that may cause actual results to differ from historical results or from
any results expressed or implied by forward-looking statements include the
following:
Economic Conditions. The Company is affected by general economic conditions. An
increase in the risk of defaults and credit risk resulting from an economic
slowdown or recession could result in a decrease in the value of the Company's
investments and the over-collateralization associated with its securitization
transactions. As a result of the Company being heavily invested in short-term
high quality investments, a worsening economy could benefit the Company by
creating opportunities for the Company to invest in assets that become
distressed as a result of the worsening conditions. These changes could have an
effect on the Company's financial performance and the performance on the
Company's securitized loan pools.
Investment Portfolio Cash Flow. Cash flows from the investment portfolio fund
the Company's operations and repayments of outstanding debt, and are subject to
fluctuation due to changes in interest rates, repayment rates and default rates
and related losses. Cash flows from the investment portfolio are likely to
sequentially decline until the Company meaningfully begins to reinvest its
capital. There can be no assurances that the Company will be able to find
suitable investment alternatives for its capital, nor can there be assurances
that the Company will meet its reinvestment and return hurdles.
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 or exceed reserves for
losses recorded in the financial statements. The allowance for loan 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. Actual defaults on adjustable-rate
mortgage loans may increase during a rising interest rate environment. In
addition, commercial mortgage loans are generally large dollar balance loans,
and a significant loan default may have an adverse impact on the Company's
financial results.
Interest Rate Fluctuations. The Company's income and cash flow depends on its
ability to earn greater interest on its investments than the interest cost to
finance these investments. Interest rates in the markets served by the Company
generally rise or fall with interest rates as a whole. A majority of the
Company's investments, including loans and securities currently pledged as
securitized finance receivables and securities, are fixed-rate. The Company
currently finances these fixed-rate assets through non-recourse securitization
financing and repurchase agreements, approximately $380 million of which is
variable rate and resets monthly. Financing fixed-rate assets with variable-rate
bonds exposes the Company to reductions in income and cash flow in a period of
rising interest rates. Through the use of interest rate swaps and synthetic
swaps, the Company has reduced this exposure by approximately $100 million as of
March 31, 2005. In addition, a portion of the investments held by the Company
are adjustable-rate securitized finance receivables. These investments are
financed through non-recourse long-term securitization financing, which reset
monthly. The net interest spread for these investments could decrease during a
period of rapidly rising short-term interest rates, since the investments
generally have interest rates which reset on a delayed basis and have periodic
interest rate caps; the related borrowing has no delayed resets or such interest
rate caps.
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. In
addition, third-party servicers are generally obligated to advance scheduled
principal and interest on a loan if such loan is securitized, and to the extent
the third-party servicer fails to make this advance, the Company may be required
to make the advance. The actual credit losses experienced by the Company are in
large part influenced by the quality of servicing by these third-party
servicers.
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 yielding investments.
Competition. The financial services industry is a highly competitive market in
which we compete with a number of institutions with greater financial resources.
In purchasing portfolio investments and in issuing securities, we compete with
other mortgage REITs, investment banking firms, savings and loan associations,
commercial banks, mortgage bankers, insurance companies, federal agencies and
other entities, many of which have greater financial resources and a lower cost
of capital than we do. Increased competition in the market and our competitors
greater financial resources have adversely affected the Company, and may
continue to do so. Competition may also continue to keep pressure on spreads
resulting in the Company being unable to reinvest its capital at a satisfactory
risk-adjusted basis.
Regulatory Changes. The Company's businesses as of and for the quarter ended
March 31, 2005 were 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. The Company is a REIT and is required to meet certain tests in
order to maintain its REIT status as described in the earlier discussion of
"Federal Income Tax Considerations." If the Company should fail to maintain its
REIT status, it would not be able to hold certain investments and would be
subject to income taxes
Section 404 of the Sarbanes-Oxley Act of 2002. Based on the Company's expected
market capitalization at June 30, 2005, the Company anticipates that it will be
required to be compliant with the provisions of Section 404 of the
Sarbanes-Oxley Act of 2002 by December 31, 2005. Failure to be compliant may
result in doubt in the capital markets about the quality and adequacy of the
Company's internal disclosure controls. This could result in the Company having
difficulty in or being unable to raise additional capital in these markets in
order to finance its operations and future investments.
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.
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 income 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. Cash flow
from the investment portfolio includes net interest income received and returns
of invested capital. The Company is subject to interest-rate risk resulting
primarily from the use of leverage to finance its investment portfolio.
Specifically, the Company is subject to risk resulting from interest rate
fluctuations to the extent that there is a gap between the amount of
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 portfolio cash flow, and measures
such sensitivity to changes in interest rates. Changes in interest rates are
defined as instantaneous, parallel, and sustained interest rate movements in 100
basis point increments. The Company estimates its net interest margin cash flow
for the next twenty-four months assuming interest rates over such time period
follow the forward LIBOR curve (based on 90-day Eurodollar futures contracts) as
of March 31, 2005. 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 portfolio cash flow sensitivity
analysis as of March 31, 2005. This analysis represents management's estimate of
the percentage change in net interest margin cash flow given a parallel shift in
interest rates as discussed above. Certain investments, including other loans
and other investments are excluded from this analysis because they are not
interest rate sensitive or if no leverage exists relative to these investments.
The "Base Case" included in the table below represents the interest rate
environment as it existed as of March 31, 2005. At March 31, 2005, one-month
LIBOR was 2.87% and six-month LIBOR was 3.40%. 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 Of
In Interest Rates Base Case Shareholders' Equity
- --------------------------------------------------------------------------------------------------------
+200 (13.3)% (4.3)%
+100 (5.6)% (1.9)%
Base
-100 3.6% 1.5%
-200 13.1% 3.7%
The Company's interest rate risk is related both to the rate of change in short
term interest rates and to the level of short-term interest rates. Approximately
$1.1 billion of the Company's investment portfolio assets are comprised of loans
or securities that have coupon rates that are fixed, and approximately $231.5
million of the Company's investment portfolio assets are comprised of loans or
securities that have coupon rates which adjust over time. At March 31, 2005,
the Company has financed these assets with approximately $740 million of
fixed-rate securitization financing, $380 million in adjustable-rate
securitization financing, $59.4 million in repurchase agreement financing, and
the balance with equity.
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 securitization financing and (b) equity. 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 adjustable rate loans reset, the net interest margin may
be partially restored as the yields on the adjustable rate loans adjust to
market conditions.
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 over financial reporting. There were also no
significant deficiencies or material weaknesses in such
internal controls requiring corrective actions.
PART II. OTHER INFORMATION
-----------------
Item 1. Legal Proceedings
-----------------
GLS Capital, Inc. ("GLS"), a subsidiary of the Company, together with the County
of Allegheny, Pennsylvania ("Allegheny County"), were defendants in a lawsuit in
the Commonwealth Court of Pennsylvania (the "Commonwealth Court"), the appellate
court of the state of Pennsylvania. Plaintiffs were two local businesses seeking
status to represent as a class, delinquent taxpayers in Allegheny County whose
delinquent tax liens had been assigned to GLS. Plaintiffs challenged the right
of Allegheny County and GLS to collect certain interest, costs and expenses
related to delinquent property tax receivables in Allegheny County, and whether
the County had the right to assign the delinquent property tax receivables to
GLS and therefore employ procedures for collection enjoyed by Allegheny County
under state statute. This lawsuit was related to the purchase by GLS of
delinquent property tax receivables from Allegheny County in 1997, 1998, and
1999. In July 2001, the Commonwealth Court issued a ruling that addressed, among
other things, (i) the right of GLS to charge to the delinquent taxpayer a rate
of interest of 12% per annum versus 10% per annum on the collection of its
delinquent property tax receivables, (ii) the charging of a full month's
interest on a partial month's delinquency; (iii) the charging of attorney's fees
to the delinquent taxpayer for the collection of such tax receivables, and (iv)
the charging to the delinquent taxpayer of certain other fees and costs. The
Commonwealth Court in its opinion remanded for further consideration to the
lower trial court items (i), (ii) and (iv) above, and ruled that neither
Allegheny County nor GLS had the right to charge attorney's fees to the
delinquent taxpayer related to the collection of such tax receivables. The
Commonwealth Court further ruled that Allegheny County could assign its rights
in the delinquent property tax receivables to GLS, and that plaintiffs could
maintain equitable class in the action. In October 2001, GLS, along with
Allegheny County, filed an Application for Extraordinary Jurisdiction with the
Supreme Court of Pennsylvania, Western District appealing certain aspects of the
Commonwealth Court's ruling. In March 2003, the Supreme Court issued its opinion
as follows: (i) the Supreme Court determined that GLS can charge delinquent
taxpayers a rate of 12% per annum; (ii) the Supreme Court remanded back to the
lower trial court the charging of a full month's interest on a partial month's
delinquency; (iii) the Supreme Court revised the Commonwealth Court's ruling
regarding recouping attorney fees for collection of the receivables indicating
that the recoupment of fees requires a judicial review of collection procedures
used in each case; and (iv) the Supreme Court upheld the Commonwealth Court's
ruling that GLS can charge certain fees and costs, while remanding back to the
lower trial court for consideration the facts of each individual case. Finally,
the Supreme Court remanded to the lower trial court to determine if the
remaining claims can be resolved as a class action. The lower trial court had
set the hearing on the class-action status for late April 2005, but the hearing
was delayed until no earlier than June 2005. In August 2003, the Pennsylvania
legislature enacted a law 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. Subsequent to the enactment of the law, challenges
to the retroactivity provisions of the law were filed in separate cases, which
did not include GLS as a defendant. In September 2004, the Trial Court in that
litigation upheld the retroactive provisions enacted in 2003. Plaintiffs have
appealed in that case. A hearing on the class-action status is currently set for
late April 2005. We believe that the ultimate outcome of this litigation will
not have a material impact on our 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., were defendants in state court in
Dallas County, Texas in the matter of Basic Capital Management et al
(collectively, "BCM" or "the Plaintiffs") versus Dynex Commercial, Inc. et al.
The suit was filed in April 1999 originally against DCI, and in March 2000, BCM
amended the complaint and added the Company as a defendant. The complaint, which
was further amended during pretrial proceedings, alleged that, among other
things, DCI and the Company failed to fund tenant improvement or other advances
allegedly required on various loans made by DCI to BCM, which loans were
subsequently acquired by the Company; that DCI breached an alleged $160 million
"master" loan commitment entered into in February 1998; and that DCI breached
another alleged loan commitment of approximately $9 million. The trial commenced
in January 2004 and in February 2004, the jury in the case rendered a verdict in
favor of one of the plaintiffs and against the Company on the alleged breach of
the loan agreements for tenant improvements and awarded that plaintiff damages
in the amount of $0.3 million. The jury also awarded the Plaintiffs' attorneys
fees in the amount of $2.1 million. The jury entered a separate verdict against
DCI in favor of BCM under two mutually exclusive damage models, for $2.2 million
and $25.6 million, respectively. The 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. 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. Plaintiffs have
filed an appeal. 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.
On February 11, 2005, a putative class action lawsuit was filed against the
Company, our subsidiary MERIT Securities Corporation, Stephen J. Benedetti and
Thomas H. Potts in United States District Court for the Southern District of New
York by the Teamsters Local 445 Freight Division Pension Fund. The lawsuit
purports to be a class action on behalf of purchasers of MERIT Series 13
securitization financing bonds, which are collateralized by manufactured housing
loans. The allegations include federal securities laws violations in connection
with the issuance in August 1999 by MERIT Securities Corporation of our MERIT
Series 13 bonds. The suit also alleges fraud and negligent misrepresentations in
connection with MERIT Series 13. We are currently evaluating the allegations
made in the lawsuit and intend to vigorously defend ourselves against them.
Although no assurance can be given with respect to the ultimate outcome of the
above litigation, the Company believes the resolution of these lawsuits will not
have a material effect on the Company's condensed consolidated balance sheet,
but could materially affect consolidated results of operations in a given year.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
-----------------------------------------------------------
None.
Item 3. Defaults Upon Senior Securities
-------------------------------
None
Item 4. Submission of Matters to a Vote of Security Holders
---------------------------------------------------
Not applicable
Item 5. Other Information
-----------------
None
Item 6. Exhibits
--------
10.1 Asset Purchase Agreement dated September 13, 2004
(filed herewith).
31.1 Certification of Principal Executive Officer and
Chief Financial Officer pursuant to Section 302
(filed herewith).
32.1 Certification of Principal Executive Officer and
Chief Financial Officer pursuant to Section 906
(filed herewith).
SIGNATURE
---------
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DYNEX CAPITAL, INC.
Dated: May 20, 2005 By: /s/ Stephen J. Benedetti
----------------------------------------
Stephen J. Benedetti
Executive Vice President
(authorized officer of registrant and
principal accounting officer)
EXHIBIT INDEX
-------------
Exhibit No.
10.1 Asset Purchase Agreement dated September 13, 2004
31.1 Certification of Principal Executive Officer and
Chief Financial Officer pursuant to Section 302.
32.1 Certification of Principal Executive Officer and
Chief Financial Officer pursuant to Section 906.