DYNEX CAPITAL INC quarterly report, Q2 FY2020

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Dynex Capital, Inc. — Q2 2020 Form 10-Q

Reporting period: Three and six months ended June 30, 2020. Amounts below are in U.S. dollars; financial statement amounts are converted from thousands to millions unless stated otherwise.

Business context

Dynex is an internally managed mortgage REIT investing primarily on a leveraged basis in residential and commercial mortgage-backed securities (MBS), financed mainly through repurchase agreements. In Q2, markets stabilized after the March disruption, supported by Federal Reserve actions. Dynex sold substantial Agency CMBS, realized gains, and redeployed capital into Agency RMBS and TBA securities.

Key financial results and position

  • Q2 earnings: Net income was $194.8 million; net income attributable to common shareholders was $191.6 million, or $8.31 per diluted share, compared with a $122.2 million common-shareholder loss, or $4.98 per share, in Q2 2019. The Q2 2020 result was substantially driven by $193.1 million in realized gains on investment sales, rather than recurring operations.
  • Interest income and spread: Interest income was $19.9 million versus $43.7 million; interest expense was $4.9 million versus $30.8 million. Net interest income rose to $15.0 million from $12.9 million, and reported net interest spread increased to 1.96% from 0.76%.
  • Derivatives and comprehensive income: Q2 net derivative loss was $8.6 million, compared with $117.5 million in Q2 2019. Other comprehensive loss was $165.0 million, reflecting, among other items, reclassification of realized sale gains. Comprehensive income to common shareholders was $26.5 million versus a loss of $11.1 million.
  • Core operating measure: Management’s non-GAAP core net operating income to common shareholders was $8.4 million, or $0.36 per share, down from $11.6 million, or $0.51 per share, in Q1 2020. The company cautions that this measure excludes investment gains and losses and other items and is not a substitute for GAAP results.
  • Six-month results: Net income was $96.4 million versus a $171.2 million loss in the first half of 2019; common-shareholder net income was $85.4 million versus a $177.5 million loss. Net interest income increased to $32.7 million from $26.6 million, while net derivative losses were $204.1 million versus $179.2 million.
  • Assets, debt and equity: At June 30, total assets were $3.90 billion, MBS fair value was $3.50 billion, repurchase-agreement borrowings were $3.31 billion, and shareholders’ equity was $567.5 million. At December 31, 2019, these were $5.37 billion, $5.19 billion, $4.75 billion, and $583.0 million, respectively. Management reported quarter-end leverage of 8.1x equity, including TBA securities.
  • Liquidity and cash flow: Cash and cash equivalents were $147.2 million and restricted cash was $59.2 million. The company reported $242.1 million of most liquid assets, including unrestricted cash and unencumbered securities. For the first half, operating cash flow was $83.5 million, investing cash flow was $1.45 billion, and financing cash flow was negative $1.46 billion; cash, cash equivalents and restricted cash increased $72.2 million.
  • Dividends and capital: The common monthly dividend was reduced from $0.15 to $0.13 per share for June. In Q1, Dynex issued $108.0 million of Series C preferred stock net of issuance costs, redeemed all Series A and part of Series B preferred stock, and recorded a $3.9 million redemption charge to common shareholders.

Material changes versus comparable periods

  • Q2 earnings reversed the prior-year loss, principally because of large realized gains on securities sold. Q2 2020 investment-sale gains were $193.1 million, versus a $10.4 million loss in Q2 2019.
  • The portfolio and financing base contracted sharply during the Q1 market shock, then were rebuilt during Q2. Management said the portfolio, including TBAs, increased more than 50% from March 31 and was within 10% of its December 2019 size at quarter-end.
  • Repurchase funding cost declined: the weighted-average rate on quarter-end repos was 0.38%, versus 2.01% at December 31, 2019. Repo borrowings were lower than year-end, although leverage had risen to 8.1x equity by June 30.
  • Dynex substantially reduced interest-rate swap notional from $4.225 billion at year-end to $475 million at June 30, shifting more hedging toward Treasury futures and options, which management viewed as more liquid and having more favorable margin requirements.
  • Q2 book value per common share increased $0.62, according to management, primarily due to spread tightening and higher MBS fair values.

Outlook, risks and unusual items

  • Management expected core operating income to exceed the $0.13 monthly common dividend in Q3, citing a larger expected earning-asset base and low funding costs. This outlook assumes no sudden event requiring rapid portfolio reduction; it is not a formal earnings guarantee.
  • COVID-19 remains a material uncertainty. Management noted increased delinquencies on loans underlying non-Agency CMBS IO, particularly in retail and hotel sectors, and said future impacts on cash flows and collateral losses cannot be predicted. It reported no CARES Act assistance for its operations.
  • Liquidity exposure includes short-term, generally uncommitted repo financing, margin calls, and TBA settlement or roll risk. CMBS IO repo haircuts increased to a weighted average 16.1% from 12.8% at year-end; the Agency RMBS/CMBS weighted average haircut was 4.8%. Dynex said it met Q1 margin calls, renewed repos during the first half, and was in covenant compliance at June 30.
  • Interest-rate, spread, prepayment, credit and reinvestment risks remain significant. Management warned that lower yields on new investments may reduce future interest income and that spread widening can reduce portfolio value. Its modeled sensitivity indicates a 100-basis-point rate increase would reduce total equity by 2.3%, assuming the stated model conditions and no spread change.
  • Dynex described its long-term economic outlook as fragile and cited policy uncertainty and the July resurgence in COVID-19 cases. The filing also discusses the planned LIBOR transition; the company was developing a transition plan.
  • Litigation includes the DCI matter and a related receiver claim. The company recorded no contingent liability, assessing loss as remote for the DCI litigation and not probable for the receiver matter; outcomes remain uncertain.

Important facts for investors to verify

  1. Whether recurring core earnings and cash generation support the common dividend after excluding realized gains and other non-recurring market effects.
  2. Whether COVID-related delinquencies, especially in retail and hotel collateral, lead to material losses or reduced CMBS IO cash flows.
  3. Whether repo counterparties continue to renew financing on acceptable terms and whether margin calls or higher haircuts constrain liquidity or leverage.
  4. How portfolio growth, 8.1x leverage and reduced swap hedging affect book value and earnings under changes in rates, spreads and prepayments.
  5. Whether the Q3 earnings outlook is achieved and how the common dividend, preferred obligations, litigation and LIBOR transition develop.