Dynex Capital, Inc. — Q2 2018 Form 10-Q
Reporting period: Three and six months ended June 30, 2018. Dynex is a mortgage REIT investing primarily in Agency and non-Agency residential and commercial mortgage-backed securities, financed mainly with short-term repurchase agreements. Unless otherwise noted, amounts below are in millions of dollars.
Financial performance
- Q2 net income: $15.7 million; net income attributable to common shareholders was $12.7 million, or $0.23 per diluted share. In Q2 2017, Dynex reported a $7.4 million net loss and a $10.1 million loss to common shareholders, or ($0.20) per share.
- First-half results: Net income was $60.0 million and income to common shareholders was $54.1 million, or $0.96 per share, versus $1.6 million net income and a $3.5 million loss to common shareholders in first-half 2017.
- Comprehensive income: Q2 comprehensive income to common shareholders was $3.0 million. For the first half, comprehensive loss to common shareholders was $1.1 million, reflecting $55.2 million of other comprehensive loss, primarily unrealized declines in available-for-sale securities.
- Interest earnings: Q2 net interest income was $11.7 million, down from $16.1 million a year earlier; net interest spread was 1.07% versus 1.65%. For the first half, net interest income was $25.3 million versus $31.0 million, and spread was 1.23% versus 1.74%. Higher funding costs outweighed higher asset yields. Management’s non-GAAP core net operating income was $10.4 million, or $0.18 per share, in Q2, versus $10.2 million, or $0.18 per share, in Q1 2018.
- Other earnings drivers: Q2 net derivative gains were $20.7 million versus a $15.8 million loss in Q2 2017; first-half gains were $59.0 million versus a $15.6 million loss. Investment-sale losses were $12.4 million in Q2 and $16.2 million in the first half.
- Balance sheet and leverage: Total assets were $3,082.8 million and shareholders’ equity was $542.2 million at June 30, versus $3,305.8 million and $557.1 million at year-end 2017. Repurchase-agreement borrowings were $2,515.0 million, down from $2,565.9 million; the quarter-end weighted-average repo rate rose to 2.21% from 1.67%. Leverage was 6.1 times equity including TBA dollar-roll positions at cost. The filing cites common book value of $6.93 per share at June 30.
- Liquidity and cash flow: Cash and cash equivalents were $165.1 million, with another $52.8 million restricted as collateral. Management reported $272.6 million of most-liquid assets, down from $283.9 million at year-end. First-half operating cash flow was $93.0 million, investing cash flow was $109.8 million, and financing cash flow was negative $72.0 million; cash, cash equivalents and restricted cash increased $130.8 million.
- Dividends and capital: The Q2 common dividend was $0.18 per share, paid July 31. The company issued common stock through its ATM program for $5.6 million net proceeds during the quarter; it also authorized a new ATM program for up to 10 million shares. About 80% of common dividends declared in the first half were expected to represent return of capital for tax purposes.
Material changes and management commentary
- Short-term rates rose and the yield curve flattened. Management attributed lower GAAP net interest income and spread to higher repo borrowing costs; average one-month LIBOR was 1.97% in Q2 2018 versus 1.06% a year earlier.
- The portfolio shifted toward fixed-rate Agency RMBS and away from adjustable-rate RMBS, which Dynex said carried higher prepayment risk and lower expected returns in a rising-rate environment. The investment portfolio, including TBA dollar rolls, had fair value of $3,612.8 million, down from $4,017.4 million at year-end.
- Management expected the Federal Reserve to raise its target rate likely twice more during the remainder of 2018 and anticipated further yield-curve flattening. It said hedges were positioned to help offset higher short-term funding rates. This is management’s outlook, not a quantified earnings or dividend forecast.
- After quarter-end, Dynex said it had reinvested substantially all Q2 asset-sale proceeds and increased the portfolio, including TBAs, to approximately $4.0 billion, with corresponding higher adjusted leverage.
Risks, contingencies and unusual items
- Funding and market risk: Most repo facilities are short-term, uncommitted and renewable at lenders’ discretion. Falling collateral values can trigger margin calls; failure to meet them could permit lenders to terminate agreements and sell collateral. TBA positions may also require cash settlement or physical delivery if they cannot be rolled.
- Interest-rate sensitivity: The company reported a positive net duration gap. Its model estimated that an instantaneous 100-basis-point rate increase would reduce shareholders’ equity by 8.1%; a 50-basis-point increase was estimated to reduce equity by 3.6%. These are model-based sensitivities, not forecasts.
- Asset and spread risk: Rising rates and wider spreads can reduce portfolio fair value; prepayments can affect premium amortization and CMBS IO income. Management identified uncertainty around central-bank policy, financing-market liquidity, regulation and reinvestment opportunities.
- Legal matters: A Texas suit alleging, among other claims, fraudulent transfers was dismissed in May, but plaintiffs filed an amended complaint in June adding former affiliates and a current executive. A plaintiff separately sought $11.3 million under a litigation cost-sharing agreement. Dynex said it considers the matters without merit and does not expect a material adverse effect, while acknowledging outcomes cannot be predicted.
- Other: Dynex reported compliance with repo and bilateral-derivative covenants at June 30. Management reported no significant subsequent events and no material change in internal control over financial reporting.
Key facts for investors to verify
- How rising short-term funding costs and a flattening curve affect net interest spread, hedge performance and earnings in subsequent quarters.
- Whether the post-quarter portfolio expansion and higher adjusted leverage change liquidity, margin-call exposure or book value sensitivity.
- Whether the $272.6 million liquid-asset position and access to short-term repo financing remain adequate under adverse market conditions.
- Developments in the amended litigation and the $11.3 million cost-sharing claim, including any change to management’s assessment of potential exposure.
- The sustainability of the $0.18 common dividend, considering taxable income, the $89.8 million estimated NOL carryforward and the stated return-of-capital component of recent distributions.