DYNEX CAPITAL INC quarterly report, Q3 FY2016

Dynex Capital, Inc. — Q3 2016 Form 10-Q

Reporting period: Three and nine months ended September 30, 2016. Dynex is an internally managed mortgage REIT investing on a leveraged basis in Agency and non-Agency residential and commercial mortgage-backed securities (MBS), including CMBS interest-only securities. Amounts below are in U.S. dollars; financial statement figures are in millions unless stated otherwise.

Financial performance and position

Metric	Q3 2016	Q3 2015	Nine months 2016	Nine months 2015
Interest income	$21.1	$26.1	$69.0	$74.7
Net interest income	$15.1	$20.2	$50.6	$58.0
Net income (loss) to common shareholders	$12.4	$(39.3)	$(32.8)	$(22.9)
Basic and diluted earnings (loss) per common share	$0.25	$(0.74)	$(0.67)	$(0.42)
Comprehensive income (loss) to common shareholders	$13.1	$(11.9)	$32.5	$(12.1)

Q3 GAAP net interest spread was 1.90%, versus 2.02% a year earlier; adjusted net interest spread, a non-GAAP measure including derivative periodic interest costs, was 1.87%, versus 1.91%. Nine-month adjusted spread was 1.86%, versus 1.93%.
Management’s non-GAAP core net operating income was $9.7 million, or $0.20 per common share, versus $10.5 million, or $0.21, in Q2 2016.
At September 30, total assets were $3,343.6 million and shareholders’ equity was $494.9 million. MBS fair value was $3,110.5 million, down from $3,493.7 million at year-end 2015.
Repurchase agreements were $2,478.3 million and FHLB advances were $263.0 million; total secured borrowings were $2,741.3 million, down from $3,109.4 million at December 31, 2015. Weighted-average secured borrowing cost was 0.88%, versus 0.69% at year-end.
Cash and cash equivalents were $73.4 million; restricted cash was $84.7 million. Management reported available liquid assets of $203.8 million, including $130.4 million of unencumbered Agency MBS, versus $150.3 million at year-end.
Operating cash flow for the nine months was $157.6 million; investing activities provided $324.9 million and financing activities used $443.1 million. Cash increased $39.5 million to $73.4 million.
Book value per common share was $7.76 at September 30, up $0.07 from June 30. The company declared a Q3 common dividend of $0.21 per share, payable October 31, 2016.

Material changes versus comparable periods

Q3 net income to common shareholders improved from a substantial year-earlier loss, largely reflecting a $2.4 million net derivative gain compared with a $52.7 million derivative loss in Q3 2015. For the first nine months, however, derivative losses remained high at $62.2 million, close to the $61.0 million loss in 2015.
Q3 net interest income fell $5.2 million year over year; nine-month net interest income declined $7.4 million. Management attributed the declines primarily to the smaller investment portfolio, lower prepayment penalty income, and higher borrowing costs. Portfolio yield improved, but did not offset these factors.
Average interest-earning assets for Q3 were $3,110.9 million versus $3,818.1 million a year earlier. The MBS portfolio had declined approximately 17% over the prior 12 months, based on amortized cost.
Repurchase agreement average borrowing cost rose to 0.86% in Q3 from 0.57% a year earlier. Lower average borrowing balances and reduced amortization of previously de-designated cash-flow hedges partly offset higher rates.
Nine-month other comprehensive income was $65.3 million, primarily reflecting unrealized MBS gains as interest rates declined during the period. In Q3, MBS unrealized gains were much smaller as tighter credit spreads were largely offset by rising rates.
Total liabilities to shareholders’ equity declined to 5.8 times from 6.5 times at year-end, against a stated operating-policy limit of 7 times.

Outlook, management commentary and risks

Management described Q3 markets as recovering from the late-Q2 Brexit-related rate rally: interest rates rose during Q3 and credit spreads tightened. It expected the Federal Reserve could raise its target rate in December 2016, while judging that global debt, moderate inflation and demographic trends would constrain sustained increases in longer-term rates.
Management said it had added investments with combined book value over $266 million in Q4 through the filing date. It expected modest portfolio growth and a modest increase in leverage, and planned more active hedge management. It had also added forward-starting swaps after quarter-end to mitigate some rate exposure. These are expectations, not guarantees.
The company’s FHLB membership was subject to termination under the 2016 FHFA rule. Its remaining $263.0 million advance matured and was repaid in October 2016, with replacement financing through repurchase agreements at a higher rate than the prior 0.51% FHLB rate.
Management’s modeled instantaneous parallel-rate scenarios at September 30 estimated that a 100-basis-point increase would reduce market value by 1.4% and adjusted net interest income by 35.3%; a 50-basis-point increase would reduce them by 0.6% and 17.2%, respectively. These are model estimates, exclude credit-spread changes and may differ materially from actual outcomes.
Key risks include interest-rate and curve movements, prepayments and reinvestment, credit and market-value losses, short-term uncommitted repo funding, lender margin calls, counterparty concentration, and regulatory changes that could restrict financing liquidity. Most repurchase financing was short term; the weighted-average remaining repo maturity was 18 days. The company reported covenant compliance at quarter-end.
Management identified fair-value estimates, investment-premium amortization and impairment judgments as critical accounting areas. It reported no material change in critical accounting policies, no material off-balance-sheet arrangements, and no legal proceeding expected to materially adversely affect consolidated financial condition or liquidity, though proceedings could affect results or cash flows in a future period.

Important facts for investors to verify

Whether Q4 asset growth, higher leverage and new forward-starting swaps occurred as management expected, and their effect on earnings, book value and liquidity.
How the October repayment of FHLB advances and replacement repo financing affected funding costs and lender exposure.
Whether prepayments, borrowing costs and the expected rate environment continue to pressure net interest income and dividend coverage.
The assumptions behind rate-sensitivity estimates, including curve shape, prepayments, credit spreads, financing availability and hedge effectiveness.
Changes in available liquidity, collateral haircuts, margin requirements and repo-counterparty concentration, given the short-term and generally uncommitted nature of funding.
The continuing status of legal proceedings and the use of tax NOL and deferred hedge-loss deductions. The filing estimated that approximately 70% of 2016 common dividends would be return of capital for tax purposes.