DYNEX CAPITAL INC annual report, FY2018

Dynex Capital, Inc. — FY2018 Form 10-K

Business and period: Mortgage REIT investing primarily in residential and commercial mortgage-backed securities, financed mainly with short-term repurchase agreements and using derivatives to hedge interest-rate exposure. This filing covers the year ended December 31, 2018; fourth-quarter results are noted separately where relevant.

Financial results and position

Metric	FY2018	FY2017
Interest income	$110.1 million	$94.5 million
Interest expense	$59.6 million	$36.2 million
Net interest income	$50.5 million	$58.3 million
Net income (loss) to common shareholders	$(4.8) million; $(0.08) per share	$23.1 million; $0.46 per share
Comprehensive income (loss) to common shareholders	$(31.9) million	$47.0 million
Core net operating income to common shareholders (non-GAAP)	$42.3 million; $0.73 per share	$37.0 million; $0.73 per share
Common dividends declared	$0.72 per share	$0.72 per share

• At year-end, total assets were $3.89 billion, shareholders’ equity $527.2 million, and book value per common share $6.02, down from $7.34 a year earlier. Mortgage-backed securities were $3.75 billion.
• Repurchase agreements totaled $3.27 billion, versus $2.57 billion at year-end 2017. Reported leverage, including TBA long positions at cost as if settled, was 8.0 times equity, up from 6.4 times.
• Net interest spread fell to 1.22% from 1.74%; adjusted net interest spread, a non-GAAP measure including TBA drop income and swap interest, was 1.48% versus 1.64%. Average cost of funds rose to 2.15% from 1.32%.
• Cash from operating activities was $180.6 million. Investing activities used $869.3 million, while financing activities provided $690.3 million; cash, cash equivalents and restricted cash increased by $1.5 million. Year-end unrestricted cash was $34.6 million and restricted cash was $54.1 million.
• Management reported $210.8 million of most liquid assets, including unrestricted cash and unencumbered securities, down from $283.9 million. The year-end weighted-average repo rate was 2.69%, versus 1.67% in 2017; 17 of 36 available repo counterparties were lenders.

Material changes and fourth-quarter developments

• Higher short-term rates increased financing costs faster than asset yields. Annual interest expense rose $23.4 million, exceeding the $15.5 million increase in interest income; net interest income declined $7.8 million.
• Widening credit spreads and higher rates reduced asset values, contributing to a $27.1 million other comprehensive loss and most of the $1.32 annual decline in book value per common share. Net unrealized losses on MBS were $50.2 million; realized losses on TBA dollar-roll positions were $10.7 million.
• Fourth-quarter net loss to common shareholders was $81.5 million, or $1.34 per share; comprehensive loss was $31.4 million. The quarter included a net derivative loss of $82.0 million and net interest income of $13.0 million, compared with $14.1 million in fourth-quarter 2017.
• Core net operating income increased to $42.3 million from $37.0 million, while core net operating income per share remained $0.73. Management attributed the improvement principally to a $5.8 million net periodic interest benefit on swaps (versus a $3.4 million cost in 2017) and higher TBA drop income.
• The portfolio shifted further toward fixed-rate Agency RMBS: year-end investment allocation was approximately 65% 30-year Agency RMBS, including TBA dollar rolls, and 23% Agency CMBS. CMBS IO fell to approximately 11% of the portfolio; the company said it had not actively purchased these securities during 2018.

Outlook, risks and unusual items

• No quantified earnings, spread, book-value or dividend guidance was provided. Management described a lower-return environment and expected interest rates to remain in a narrower range, while stating that MBS could continue to offer attractive leveraged returns in 2019. These views are forward-looking and uncertain.
• Management said volatility had moderated and spreads had tightened early in 2019, improving book value since year-end. In January 2019, the company raised approximately $46.1 million net by issuing 8.05 million common shares, with proceeds intended for investment in assets offering higher expected returns.
• Key risks include high leverage; short-term, generally uncommitted repo financing and margin calls; interest-rate, spread, prepayment, reinvestment, credit and liquidity risk; imperfect hedging; TBA settlement and margin requirements; and potential changes to Federal Reserve policy, GSE support, housing-finance rules and LIBOR.
• Common dividends were $0.72 per share for 2018. Approximately 78% of common dividends declared were characterized as return of capital for tax purposes, principally because of tax hedge-loss deductions. The company has not established a minimum dividend.
• Litigation related to former affiliate DCI remains a contingency. A Texas federal court dismissed an amended complaint on January 25, 2019, but plaintiffs could amend it; a separate claim seeks $11.3 million under a litigation cost-sharing agreement. The company disputes the claims and stated it expects no material adverse effect, while acknowledging outcomes cannot be assured. A $11.4 million receivable from DCI was fully reserved because DCI has no current assets.
• The company reported compliance with repo and swap covenants at year-end. Its financial statements received an unqualified audit opinion, and the auditor also gave an unqualified opinion on internal control over financial reporting.

Important facts for investors to verify

• How 2019 funding costs, asset yields and hedges affect net interest spread and recurring earnings, particularly as repo financing reprices.
• Whether reported liquidity and available financing can withstand collateral-value declines, margin calls, repo nonrenewals and any need to settle TBA positions.
• Whether book value recovers or declines further as interest rates and MBS credit spreads move, and how much of any change reflects hedging versus unhedged spread risk.
• The sustainability and tax characterization of the $0.72 common dividend relative to cash generation, taxable income and capital needs.
• Post-year-end share issuance effects on per-share book value and earnings, and developments in the DCI-related lawsuits and cost-sharing claim.