Dynex Capital, Inc. — Q2 2013 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2013. Dynex is an internally managed mortgage REIT investing in Agency and non-Agency mortgage-backed securities (MBS), generally using repurchase-agreement financing. Unless noted otherwise, amounts below are in millions.
Financial performance
| Metric | Q2 2013 | Q2 2012 | Six months 2013 | Six months 2012 |
|---|---|---|---|---|
| Interest income | $33.9 | $27.1 | $66.9 | $53.4 |
| Net interest income | $22.4 | $19.0 | $45.0 | $38.2 |
| Net income | $31.5 | $18.8 | $51.1 | $35.3 |
| Net income attributable to common shareholders | $29.4 | $18.8 | $47.8 | $35.3 |
| Basic and diluted EPS | $0.54 | $0.35 | $0.88 | $0.68 |
| Common dividends declared per share | $0.29 | $0.29 | $0.58 | $0.57 |
Q2 net interest income increased year over year, but the overall portfolio net interest spread narrowed to 1.75% from 2.18%. Management attributed pressure to lower asset yields on newer purchases and higher financing balances; lower average financing costs partly offset this. Q2 net income also benefited from $10.8 million in net fair-value gains, including approximately $11.4 million from trading interest-rate swaps. Thus, reported earnings included a material market-valuation contribution.
For the six months, operating cash flow was $102.0 million, investing cash outflow was $656.6 million, and financing cash inflow was $528.2 million. Cash declined by $26.5 million to $29.3 million. Cash flow included $66.8 million of amortization and depreciation adjustments.
Financial position and material changes
- Total assets were $4.75 billion at June 30, versus $4.28 billion at December 31, 2012. MBS at fair value were $4.56 billion.
- Repurchase agreements rose to $4.07 billion from $3.56 billion; total liabilities were $4.14 billion. The weighted-average repurchase borrowing rate was 0.60% at quarter-end. Repurchase financing is short-term, generally uncommitted, and collateralized.
- Shareholders’ equity was $607.2 million, down from $616.7 million at year-end. Accumulated other comprehensive income shifted from $52.5 million positive to a $35.1 million loss, largely reflecting unrealized MBS valuation declines.
- Book value per common share fell $1.56, or 15%, during Q2 to $8.94. Management attributed an estimated $1.06 per-share decline to wider credit spreads and $0.50 to higher interest rates.
- Available liquid assets were $164.3 million, including $29.3 million cash, $124.4 million unencumbered Agency MBS, and $10.6 million cash collateral received. This compared with $186.0 million at year-end.
- Enterprise total liabilities-to-equity leverage was 6.8x at quarter-end, compared with 6.3x at March 31; company policy capped it at 7x. The company said it expected to reduce leverage to 6.5x or below during Q3, assuming asset prices did not remain volatile.
Management commentary, outlook, and risks
Management described Q2 as a period of extreme fixed-income market volatility. The 10-year Treasury yield rose from 1.85% at March 31 to 2.49% at June 30, while credit spreads widened. Management linked the repricing to expectations of earlier Federal Reserve tapering, market de-risking, bond-fund redemptions, and regulatory constraints. It expected spreads to remain wide in the near term amid uncertainty and reduced market liquidity. No formal earnings or dividend guidance was provided.
Effective June 30, Dynex discontinued hedge accounting for its interest-rate swaps to gain flexibility in repurchase-agreement maturity management. Future fair-value changes on those swaps will flow through earnings rather than other comprehensive income; the change did not affect Q2 results. The company also cited use of Eurodollar futures as an alternative hedge, in part because post-June 10 swap clearing requirements can require materially higher initial margin. Subsequent to quarter-end, it entered into $450 million of Eurodollar contracts and approximately $175 million of swaps.
Key risks include interest-rate and spread movements, MBS valuation volatility, prepayments and reinvestment at lower yields, leverage, margin calls, and reliance on short-term repurchase funding that lenders may not renew. A 100-basis-point instantaneous rate increase was modeled to reduce projected 24-month net interest income by 7.5% and portfolio market value by 2.1%; a 50-basis-point credit-spread widening was modeled to reduce market value by 2.2%. Management cautioned that these static scenarios may differ materially from actual outcomes.
Legal matters include a Pennsylvania tax-lien class action and litigation involving former affiliate DCI. The filing states that management did not expect the matters to materially affect consolidated financial condition or liquidity, but a resolution could affect results or cash flows in a future period. In the DCI matter, a $25.6 million award was reinstated against DCI; management said Dynex would not be obligated for amounts ultimately awarded against DCI. The company reported compliance with repurchase-agreement covenants at June 30.
Important facts for investors to verify
- How much future earnings depend on swap and other fair-value movements versus recurring net interest income.
- Whether leverage can be reduced to management’s stated Q3 target while preserving liquidity and avoiding asset sales at unfavorable prices.
- The sensitivity of book value, financing capacity, and margin requirements to continued rate and credit-spread volatility.
- Whether repurchase lenders renew financing on acceptable terms, particularly given the 6.8x leverage level and short-term funding structure.
- Subsequent-period swap and Eurodollar hedging activity, collateral requirements, and the earnings effects of discontinued hedge accounting.
- Developments in the legal proceedings, including any appeal or judgment affecting Dynex or DCI.