Dynex Capital, Inc. — Q3 2015 Form 10-Q
Reporting period: Three and nine months ended September 30, 2015. Dynex is an internally managed mortgage REIT investing in leveraged Agency and non-Agency residential and commercial mortgage-backed securities (MBS). Financial amounts below are in U.S. dollars; “million” and “billion” are used for readability.
Financial performance and position
- Q3 results: Net loss attributable to common shareholders was $39.3 million, or $0.74 per diluted share, versus net income of $28.6 million, or $0.52 per share, in Q3 2014. Comprehensive loss attributable to common shareholders was $11.9 million, or $0.22 per share, versus comprehensive income of $14.1 million.
- Nine-month results: Net loss attributable to common shareholders was $22.9 million, or $0.42 per share, compared with net income of $17.3 million, or $0.32 per share, in the prior-year period. Comprehensive loss was $12.1 million versus comprehensive income of $67.5 million.
- Interest income and margins: Q3 interest income was $26.1 million and net interest income was $20.2 million, compared with $26.0 million and $19.9 million, respectively, in Q3 2014. GAAP net interest spread was 2.02% versus 2.03%; adjusted net interest spread, including derivative interest costs, was 1.91% versus 1.93%. For the nine months, net interest income declined to $58.0 million from $61.1 million.
- Core net operating income: A non-GAAP measure, it was $12.5 million, or $0.24 per share, in Q3, versus $13.8 million, or $0.25 per share, in Q3 2014. Nine-month core net operating income was $36.5 million, or $0.67 per share, versus $41.7 million, or $0.76 per share.
- Balance sheet and leverage: Total assets were $3.93 billion at September 30, 2015, versus $3.69 billion at year-end 2014. Shareholders’ equity was $527.8 million, down from $607.3 million. Book value was $8.19 per common share, down from $9.02 at year-end. Total liabilities were $3.40 billion; repurchase agreements were $3.06 billion and FHLB advances were $255 million. Total liabilities were 6.4 times equity, versus 5.1 times at year-end.
- Portfolio: MBS fair value was $3.74 billion, up from $3.52 billion at year-end. Management shifted capital from Agency RMBS toward CMBS, including Agency CMBS, to reduce RMBS prepayment exposure. CMBS fair value rose to $1.17 billion from $543 million; RMBS fell to $1.78 billion from $2.21 billion.
- Cash flow and liquidity: For the nine months, operating cash flow was $162.5 million, investing cash outflow was $374.5 million, and financing cash inflow was $180.6 million. Cash and cash equivalents ended at $12.6 million, down from $43.9 million at year-end. Management reported available liquid assets of $149.0 million, principally $12.6 million of unrestricted cash and $136.3 million of unencumbered Agency MBS; an additional $11.4 million of unencumbered non-Agency MBS was considered less liquid.
- Dividends and repurchases: The company paid $46.7 million in dividends during the first nine months. It repurchased 4.38 million common shares for $31.1 million during that period, including 3.52 million shares in Q3 at an average $6.92 per share. A $0.24-per-share Q3 common dividend was declared for payment in October.
Material changes and unusual items
- Q3 losses chiefly reflected derivatives underperforming the MBS portfolio as rates declined and credit spreads widened. Derivative instruments generated a $52.7 million Q3 loss, including a $47.5 million fair-value loss attributed to falling rates, while unrealized MBS gains contributed $26.7 million to other comprehensive income.
- Nine-month derivative losses were $61.0 million, including $56.6 million from fair-value changes. Management cited spread widening and basis risk—the imperfect relationship between asset values and related hedges—as factors in the portfolio’s performance.
- Agency RMBS prepayment speeds increased: the reported CPR was 18.8% in Q3 versus 16.7% in Q2. Higher speeds increased premium amortization and weighed on RMBS yields.
- Interest expense declined year over year for the nine-month period, in part because amortization of previously de-designated cash flow hedges was lower. General and administrative expenses increased to $13.4 million from $11.9 million, primarily due to legal and consulting expenses.
- FHLB advances were a new funding source in 2015. At quarter-end Mackinaw had $255 million outstanding at a 0.20% rate, all due within 30 days, against pledged Agency MBS and cash.
Outlook, risks, and contingencies
- Management expected the Federal Reserve’s first rate increase to be delayed, while acknowledging that higher short-term rates could raise borrowing costs and reduce net interest income, spreads, and potentially the common dividend. The filing provides no formal earnings or dividend guidance.
- Management maintained a positive duration gap, describing the portfolio as more sensitive to rising than falling rates, and identified credit-spread widening as its largest book-value risk. It continued to favor multifamily Agency CMBS, Agency and non-Agency CMBS IO, and selected re-performing or non-performing loan securities.
- Financing depends substantially on short-term, generally uncommitted repurchase agreements, which may not renew and can require additional collateral after market-value declines. Market stress, reduced lender capacity, margin calls, higher rates, and regulatory changes could pressure liquidity or force asset sales. Repurchase borrowings had an 18-day weighted-average remaining maturity.
- A proposed FHFA rule could make Mackinaw ineligible for FHLB membership. If adopted, outstanding advances could become repayable promptly; inability to replace that financing could require collateral liquidation and harm liquidity. The company reported compliance with financing covenants at quarter-end.
- In a Texas garnishment action, plaintiffs alleged Dynex was a successor to former affiliate Dynex Commercial and sought to reach a judgment against that affiliate. Dynex’s motion to dismiss was pending. The company said it believed existing legal proceedings would not materially adversely affect consolidated financial condition or liquidity, but outcomes could affect results or cash flows in a future period.
- Management stated that it had identified no material off-balance-sheet arrangements or significant subsequent events. It reported effective disclosure controls and no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether the $149.0 million of reported available liquidity is adequate given short-term repo maturities, collateral requirements, and the $78.2 million of restricted cash.
- Current status and consequences of the FHFA proposal for Mackinaw’s FHLB membership, including the repayment or refinancing risk on $255 million of advances.
- Subsequent book value, leverage, and dividend coverage, especially given the Q3 decline in book value and the reported market and rate sensitivities.
- Whether derivative fair-value losses, widening credit spreads, and higher Agency RMBS prepayments persist, and how these affect GAAP results versus non-GAAP core net operating income.
- Developments in the pending garnishment action and any change to the company’s assessment of legal contingencies.
- Reconcile non-GAAP core net operating income and adjusted spread to GAAP measures; management cautions that these measures are supplements and may not be comparable with similarly titled measures at other companies.