DYNEX CAPITAL INC quarterly report, Q2 FY2016

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Dynex Capital, Inc. — Q2 2016 Form 10-Q

Reporting period: Three and six months ended June 30, 2016; interim financial statements are unaudited. Dynex is an internally managed mortgage REIT investing in residential and commercial mortgage-backed securities (MBS) using leverage. Unless noted otherwise, amounts are in millions of dollars.

Financial results and position

  • Q2 earnings: Interest income was $22.8 and interest expense $6.1, producing net interest income of $16.7. A $16.3 net derivative loss and $0.3 investment-sale loss contributed to a $3.2 GAAP net loss and a $5.5 loss attributable to common shareholders, or $(0.11) per share.
  • Six-month results: Net interest income was $35.5; net derivative losses were $64.6. GAAP net loss was $40.7 and loss attributable to common shareholders was $45.3, or $(0.92) per share.
  • Comprehensive income: Q2 comprehensive income attributable to common shareholders was $17.4, including $22.9 of other comprehensive income (primarily unrealized MBS gains). For the six months, comprehensive income was $19.4, including $64.7 of other comprehensive income.
  • Core net operating income, a non-GAAP measure: Q2 was $10.5, or $0.21 per share, versus $10.8, or $0.22 per share, in Q1 2016. Management says it views comprehensive income as a more complete measure of performance than GAAP net income because GAAP net income includes derivative fair-value changes but excludes MBS fair-value changes.
  • Margins and funding costs: Q2 GAAP net interest spread was 1.94%, versus 1.97% in Q2 2015; adjusted spread was 1.87%, versus 1.86%. For the first six months, adjusted spread was 1.85%, versus 1.92% in 2015. Q2 cost of funds rose to 0.83% from 0.66% a year earlier, mainly reflecting higher repo rates.
  • Balance sheet at June 30: Total assets were $3,469; MBS were $3,209. Total liabilities were $2,978 and shareholders’ equity $492. Repurchase agreements were $2,600 and FHLB advances $263. Secured borrowings declined about 8% from year-end 2015; liabilities were 6.1 times equity, down from 6.5 times.
  • Liquidity and cash flow: Available liquid assets were $181.6, comprising $96.9 unrestricted cash and $84.7 unencumbered Agency MBS; restricted cash was $83.7. Six-month operating cash flow was $106.2, investing cash flow provided $263.5, and financing activities used $306.8. Management reported compliance with financing covenants.
  • Shareholder returns and book value: Book value per common share was $7.69, near $7.71 at the start of 2016. The company maintained its $0.21 quarterly common dividend. It estimated $15.9 of common dividends declared in the first half would be treated as return of capital for tax purposes, principally due to deferred tax hedge losses.

Material changes versus comparable periods

  • Q2 net loss attributable to common shareholders of $5.5 contrasted with income of $28.2 in Q2 2015. The six-month common-shareholder loss of $45.3 contrasted with income of $16.4 in the first half of 2015.
  • Six-month net interest income declined to $35.5 from $37.7 in 2015, as the smaller average portfolio and higher borrowing costs outweighed improved asset yields. Interest income was $47.9 versus $48.6, while interest expense rose to $12.4 from $10.9.
  • Six-month derivative losses increased to $64.6 from $8.2 in 2015, with management attributing most of the fair-value decline to falling interest rates. Conversely, lower rates and reduced credit-market volatility supported Q2 MBS unrealized gains.
  • The portfolio and financing balance contracted as principal collections and asset-sale proceeds were used to repay borrowings rather than reinvest. MBS fair value fell to $3,208.7 from $3,493.7 at year-end 2015. Cash increased to $96.9 from $33.9.

Outlook, risks and unusual items

  • Management considered the low-rate environment supportive of continued net interest income, while emphasizing disciplined risk management and capital allocation. It expected intermittent market volatility and believed a significant near-term rise in U.S. rates was limited, with potential further yield-curve flattening. These are management expectations, not formal earnings guidance.
  • The company maintained a long-duration portfolio and hedge position and said it might further reduce hedges and add duration if rates rise. It reduced leverage and built liquidity in anticipation of volatility. Modeled sensitivities at June 30 indicated a parallel +100-basis-point rate shift could reduce market value by 1.3% and adjusted net interest income by 31.5%; a +50-basis-point shift was modeled to reduce adjusted net interest income by 15.2%. These estimates depend on assumptions and are not forecasts.
  • A 2016 FHFA rule requires the captive insurance subsidiary to terminate FHLB membership by February 2017. Its remaining $263.0 of advances was due in October 2016 and could not be renewed. Management said it expected to replace the funding without difficulty, but replacement availability and cost remain relevant risks.
  • Most repo financing is short-term, uncommitted, and renewable at lenders’ discretion; declines in collateral values can trigger margin calls. The company cited interest-rate, prepayment, credit-spread, counterparty, liquidity, and financing-market risks. It also noted regulatory changes could reduce repo-market capacity.
  • Legal proceedings were not expected, based on current knowledge, to have a material adverse effect on consolidated financial condition or liquidity; resolution could affect results or cash flows in a future period. No material changes to previously reported proceedings were noted.
  • The company reported no material changes in internal control over financial reporting and concluded disclosure controls were effective as of June 30, 2016.

Important facts for investors to verify

  • Whether recurring net interest earnings and the $0.21 common dividend are sustainable, distinguishing GAAP losses, management’s non-GAAP core measure, and tax treatment of distributions.
  • The drivers and potential volatility of derivative marks, MBS fair values, book value, and the disclosed interest-rate and credit-spread sensitivity estimates.
  • How the $263 million FHLB advance is refinanced or repaid in October 2016, and the cost and availability of short-term repo funding and collateral liquidity.
  • Whether leverage reduction and available liquid assets remain adequate under market stress, margin calls, or reduced financing availability.
  • Portfolio credit quality, prepayment behavior, and valuation assumptions for non-Agency and Level 3 MBS, including the effect of changes in collateral performance and market liquidity.