Dynex Capital, Inc. — Form 10-Q Summary
Reporting period: Quarter and nine months ended September 30, 2017. Dynex is an internally managed mortgage REIT investing in Agency and non-Agency residential and commercial mortgage-backed securities, generally using repurchase-agreement financing and interest-rate derivatives. Amounts below are in U.S. dollars; financial statement amounts are in millions unless stated otherwise.
Financial performance and position
| Metric | Q3 2017 | Comparable period |
|---|---|---|
| Interest income | $23.1 | $21.1 in Q3 2016 |
| Interest expense | $9.9 | $6.1 in Q3 2016 |
| Net interest income | $13.2 | $15.1 in Q3 2016 |
| Net interest spread | 1.47% | 1.90% in Q3 2016 |
| Net income | $10.3 | $14.7 in Q3 2016 |
| Net income to common shareholders | $7.5; $0.15 per common share | $12.4; $0.25 per share in Q3 2016 |
| Comprehensive income to common shareholders | $13.6; $0.27 per share | $13.1 in Q3 2016 |
- For the first nine months, net income was $11.9 million, versus a $26.0 million net loss in 2016; income to common shareholders was $4.0 million, versus a $32.8 million loss.
- Nine-month net interest income was $44.3 million versus $50.6 million; net interest spread was 1.71% versus 1.97%.
- Management’s non-GAAP core net operating income was $0.19 per common share in Q3, unchanged from Q2 2017. This is not a GAAP earnings measure.
- Operating cash flow was $156.1 million for the first nine months. Cash, cash equivalents and restricted cash totaled $161.7 million at quarter-end, including $44.0 million of restricted cash.
- At September 30, total assets were $3.14 billion, including $2.92 billion of mortgage-backed securities; total liabilities were $2.62 billion and shareholders’ equity was $524.1 million. Equity rose about 12% from year-end 2016, primarily reflecting $38.5 million of other comprehensive income from increased MBS fair values.
- Repurchase agreements totaled $2.52 billion, at a 1.51% weighted-average rate, compared with $2.90 billion at 1.03% at December 31, 2016. Including TBA securities at cost as if settled, leverage was 6.3 times shareholders’ equity; the stated operating-policy limit for total liabilities to equity is 8 times.
- Available liquid assets were $239.2 million, comprising $117.7 million of unrestricted cash and $121.5 million of unencumbered Agency MBS, up from $138.1 million at year-end 2016.
- Book value per common share was $7.46 at September 30, up $0.08 from June 30. Economic return on book value was 3.5% for Q3 and 11.4% for the first nine months.
Material changes and notable items
- Dynex shifted portfolio exposure away from adjustable-rate Agency RMBS and certain non-Agency securities toward fixed-rate Agency RMBS and Agency CMBS. The MBS portfolio declined to $2.92 billion from $3.21 billion at year-end, while TBA positions at cost reached $683.8 million.
- Higher short-term borrowing costs weighed on spread income: Q3 cost of funds rose to 1.48% from 0.85% a year earlier, as management cited higher repo rates associated primarily with rising LIBOR. Q3 net interest income also declined about 18% from Q2, reflecting higher short-term rates, somewhat lower average interest-earning assets and less CMBS prepayment-penalty compensation.
- Q3 derivative gains of $6.0 million, including TBA-related gains, and $6.1 million of other comprehensive income helped offset the lower net interest income. The company recorded a $5.2 million Q3 realized loss on investment sales; nine-month realized losses were $10.6 million.
- During the first nine months, Dynex issued approximately 1.09 million Series B preferred shares for $25.9 million net proceeds and approximately 2.03 million common shares through its ATM program. After quarter-end, it reported an additional $14.1 million of net common-stock ATM proceeds and $2.2 million from Series B preferred-stock issuance.
- The third-quarter common dividend was $0.18 per share, paid October 31, 2017. Management estimated about 75% of common dividends declared during the first nine months would be treated as return of capital, principally due to tax hedge-loss deductions.
Outlook, risks and contingencies
- Management expected fixed-rate Agency MBS to remain its principal marginal use of capital and expected leverage, including TBAs at cost, to be modestly higher than at quarter-end, subject to reducing leverage if market conditions warranted. It expected net interest spread to remain relatively flat in Q4 2017; results thereafter were described as highly dependent on Federal Reserve policy and hedging decisions. These are management expectations, not quantified earnings guidance.
- Management cited potential volatility from Federal Reserve balance-sheet reduction and policy shifts, geopolitical and regulatory uncertainty, and possible changes in inflation. Key business risks include interest-rate and spread movements, prepayments, credit performance, refinancing and margin calls, and the availability and cost of short-term, generally uncommitted repo financing.
- The company reported a positive net duration gap and incomplete hedging. Its modeled instantaneous +100-basis-point parallel rate shift implied a 9.1% decrease in shareholders’ equity; a +50-basis-point spread widening implied a 2.6% decrease in projected investment market value. These are model estimates, not forecasts.
- Dynex reported compliance with financing and derivative covenants at quarter-end. It stated that no material legal proceedings were pending, while noting previously disclosed litigation and higher year-to-date legal expense related to a lawsuit filed in 2017. No material change in the previously reported matters was described for the quarter.
- Management concluded disclosure controls were effective as of September 30, 2017, with no material quarterly change in internal control over financial reporting. It reported no significant recognized subsequent events.
Important facts for investors to verify
- Whether the portfolio shift toward fixed-rate Agency assets and TBA positions sustains returns as financing costs and Federal Reserve policy change.
- The effect of rising repo rates, short-term lender renewals, collateral haircuts and potential margin calls on net interest income and liquidity.
- How the 6.3-times leverage measure, which includes TBAs at cost as if settled, compares with the company’s financing and risk limits under stressed conditions.
- The basis for the $7.46 book value per common share and the impact of subsequent ATM stock issuance on per-share value and dilution.
- Dividend sustainability, including the difference between GAAP earnings, non-GAAP core income and taxable income; confirm the final tax characterization of distributions.
- The status and potential financial impact of previously disclosed litigation, and whether legal costs or outcomes change.