Dynex Capital, Inc. — Q1 2019 Form 10-Q
Reporting period: Three months ended March 31, 2019; balance-sheet comparisons are to December 31, 2018. Amounts below are U.S. dollars; financial statement amounts are converted from thousands to millions where indicated.
Business context
Dynex is an internally managed mortgage REIT that invests primarily in Agency and non-Agency residential and commercial mortgage-backed securities, using repurchase-agreement borrowing and derivatives to finance and hedge its portfolio. Its stated objective is long-term risk-adjusted returns, with capital preservation and regular dividends.
Key financial results and position
| Metric | Q1 2019 / March 31, 2019 | Comparison |
|---|---|---|
| Interest income | $40.0 million | $25.2 million in Q1 2018 |
| Interest expense | $26.3 million | $11.6 million in Q1 2018 |
| Net interest income | $13.7 million | $13.6 million in Q1 2018 |
| Net income (loss) | $(52.2) million; $(55.3) million attributable to common shareholders | $44.3 million net income and $41.4 million to common shareholders in Q1 2018 |
| Net income (loss) per common share | $(0.81) | $0.74 in Q1 2018 |
| Comprehensive income (loss) to common shareholders | $31.2 million | $(4.1) million in Q1 2018 |
| Net interest spread | 0.84% | 1.34% in Q1 2018 |
| Core net operating income, non-GAAP | $12.1 million, or $0.18 per common share | $10.9 million, or $0.18 per share, in Q4 2018 |
| Total assets | $5.04 billion | $3.89 billion at December 31, 2018 |
| Mortgage-backed securities | $4.84 billion fair value | $3.75 billion at December 31, 2018 |
| Repurchase agreements | $4.25 billion | $3.27 billion at December 31, 2018 |
| Shareholders’ equity | $604.7 million | $527.2 million at December 31, 2018 |
| Cash and cash equivalents; restricted cash | $55.9 million; $86.8 million | Combined balance of $142.7 million at quarter-end |
| Operating cash flow | $40.3 million provided | $41.9 million provided in Q1 2018 |
| Investing / financing cash flow | $(1.01) billion used / $1.02 billion provided | Investing outflow primarily reflected investment purchases |
Material changes and drivers
- Derivative instruments produced a net loss of $61.7 million in Q1 2019, versus a $38.4 million gain in Q1 2018. The 2019 loss was primarily associated with lower longer-term swap rates and a decline in the fair value of pay-fixed interest rate swaps.
- Available-for-sale investment marks generated $86.6 million of unrealized gains in other comprehensive income, principally as MBS values benefited from declining longer-term interest rates and tighter credit spreads. This offset the derivative loss in comprehensive results; it did not eliminate the GAAP net loss.
- Net interest income was nearly unchanged year over year: higher asset income was largely offset by greater borrowing balances and higher financing costs. The reported net interest spread fell 50 basis points year over year.
- Book value per common share rose to $6.24 from $6.02 at year-end. Including the $0.18 first-quarter dividend, management reported a 6.6% quarterly total economic return on book value per common share. Issuance of more than 9.3 million common shares raised $53.9 million net and reduced book value per share by approximately $0.05.
- Management reported leverage of 8.5 times shareholders’ equity when TBA dollar-roll positions are included at cost, up from 8.0 times at year-end. Repurchase-agreement borrowings increased to $4.25 billion; their quarter-end weighted-average rate was 2.78%, versus 2.69% at year-end.
Outlook, risks and unusual items
- Management expected interest rates to remain relatively range-bound for the rest of 2019, with the 10-year U.S. Treasury generally within a broader 2%–4% range and potentially below 3.5%. It noted that short-term rate inversion and rates near the lower end of its expected range created headwinds for earnings and stated that Dynex might not fully earn its dividend in the near term. These are management expectations, not guaranteed results.
- Management expected leverage to continue increasing as it planned further Agency MBS investment, and believed the yield curve could steepen over the intermediate term, supporting improved spreads. It also cited higher expected Agency RMBS prepayments and reduced benefit from swaps as near-term pressures.
- Key exposures include interest-rate and spread movements, prepayments and reinvestment, credit performance, and liquidity. Most repurchase financing is short-term, uncommitted, and renewable at lenders’ discretion; collateral declines can trigger margin calls. Failure to meet calls or refinance could force asset sales. Derivatives and TBA positions also require collateral and can create liquidity demands.
- Dynex was evaluating the exchange of some or all Freddie Mac RMBS for Uniform Mortgage-Backed Securities ahead of the June 3, 2019 Single Security Initiative. It reported no indication from repo counterparties at the time that financing or liquidity on existing Freddie Mac securities would be impaired.
- Two previously disclosed legal matters involving former affiliate DCI remained pending. The company described the claims as baseless and said it intended to defend them; it believed resolution would not materially adversely affect the company, while acknowledging outcomes could not be predicted with certainty.
- The company reported compliance with repurchase-agreement covenants at quarter-end. It also reported an estimated $89.8 million tax net operating loss carryforward, expected to begin substantially expiring in 2020. No significant subsequent events were identified through filing.
Most important facts for investors to verify
- Whether core operating earnings and cash generation can sustain common and preferred dividends, given management’s warning that the common dividend may not be fully earned near term.
- How repo borrowing costs, short-term funding access, collateral haircuts, margin requirements, and leverage evolve, particularly in a stressed market.
- Whether net interest spread and swap economics improve or remain pressured by the yield curve, prepayments, and funding rates.
- How much book value and reported earnings continue to fluctuate with MBS marks and derivative fair-value changes; core net operating income is a non-GAAP measure and excludes significant valuation movements.
- The financing, operational, and liquidity effects of the UMBS transition and the eventual outcomes of the pending DCI-related litigation.