Dynex Capital, Inc. — Q2 2017 Form 10-Q
Reporting period: Three and six months ended June 30, 2017. The unaudited filing was signed August 8, 2017. Dynex is a mortgage REIT investing primarily in leveraged Agency and non-Agency residential and commercial mortgage-backed securities (MBS).
Financial performance
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Interest income | $24.9m | $22.8m | $47.3m | $47.9m |
| Net interest income | $16.1m | $16.7m | $31.0m | $35.5m |
| Net income (loss) | $(7.4)m | $(3.2)m | $1.6m | $(40.7)m |
| Net income (loss) to common shareholders | $(10.1)m | $(5.5)m | $(3.5)m | $(45.3)m |
| Basic and diluted loss per common share | $(0.20) | $(0.11) | $(0.07) | $(0.92) |
| Net interest spread | 1.65% | 1.94% | 1.74% | 1.99% |
| Cost of funds | 1.25% | 0.83% | 1.15% | 0.82% |
Q2 comprehensive income to common shareholders was $2.3m, including $12.4m of other comprehensive income (OCI). The GAAP derivative loss was $15.8m and the investment-sale loss was $3.7m. Management’s non-GAAP core net operating income to common shareholders was $9.3m, or $0.19 per share, versus $7.4m, or $0.15, in Q1 2017; this is not a year-over-year comparison.
Financial position, cash flow and liquidity
- At June 30, 2017, total assets were $3.06bn, including $2.86bn of MBS; shareholders’ equity was $497.3m. Total liabilities were $2.56bn, primarily $2.54bn of repurchase-agreement borrowings, compared with $2.90bn of repo debt at year-end 2016.
- Management reported total liabilities at 5.2 times shareholders’ equity, down from 6.3 times at year-end. Including the implied financing of TBA positions, adjusted leverage was 6.0 times, up from 5.8 times at March 31. The company’s stated leverage limit is 8 times equity.
- Available liquid assets were $218.5m: $100.9m unrestricted cash and $117.6m unencumbered Agency MBS. Restricted cash was $45.4m. Repo borrowings had a 1.47% weighted-average rate and a 19-day weighted-average remaining term. The company reported compliance with financing covenants.
- For the six months, operating activities provided $103.0m cash, investing activities provided $309.2m and financing activities used $385.5m; cash increased $26.7m to $100.9m. Operating cash flow includes significant noncash adjustments, including $81.2m of investment-premium amortization.
- Book value per common share was $7.38 at June 30, down $0.14 from March 31 but up $0.20 from December 31. Economic return on book value was 0.5% for Q2 and 7.8% for the first half, including dividends and change in book value.
Material changes and management commentary
- Dynex shifted capital from variable-rate and hybrid-ARM exposure toward fixed-rate Agency RMBS, including $400m notional of 30-year TBA contracts initiated in Q2. It also sold most of its non-Agency RMBS, which were generally near expected maturity, and approximately half of its non-Agency CMBS backed by single-family rental properties.
- Management said Q2 net interest income increased about 8.3% from Q1, helped by discount accretion and CMBS prepayment compensation, but partly offset by higher funding costs. The year-over-year Q2 net interest spread narrowed as borrowing costs rose faster than asset yields.
- Series B preferred shares outstanding increased by 776,721 through an at-the-market issuance, raising $18.2m net of fees. The company declared a Q2 common dividend of $0.18 per share, paid July 28, 2017. The preferred shares carry annual stated rates of 8.50% (Series A) and 7.625% (Series B).
- Management expects the portfolio and leverage to grow during the remainder of 2017, with fixed-rate RMBS viewed as offering relatively attractive risk-adjusted returns. It plans to continue managing hedges and seeking diversified funding. The filing provides no numerical earnings or dividend guidance.
Risks, contingencies and unusual items
- Management cited tight credit spreads, elevated asset prices, potential market volatility, Federal Reserve balance-sheet reduction and further rate increases. A rapid rate or yield-curve move, spread widening, faster prepayments, credit deterioration, or reduced repo availability could hurt earnings, book value or liquidity.
- Most repo financing is short-term, uncommitted and renewable at lenders’ discretion; collateral declines can trigger margin calls. TBA positions add off-balance-sheet leverage and may require cash settlement or additional collateral if rolling becomes uneconomical.
- A Dallas County lawsuit seeks to enforce a $46.5m judgment entered against former affiliate DCI against Dynex, alleging fraudulent asset transfers and related claims. Dynex considers the suit baseless and expects no material adverse effect, but states that an unsuccessful defense could materially affect results in a quarter. No clear loss estimate or accrual is provided in the filing text.
- The company said approximately 71% of common dividends declared in the first half were estimated to represent return of capital, principally due to tax hedge-loss deductions. It reported an estimated $89.8m tax NOL carryforward.
- Management found disclosure controls effective at quarter-end and reported no material change in internal control over financial reporting during Q2. No other significant subsequent event was reported.
Important facts for investors to verify
- Whether the fixed-rate/TBA portfolio shift improves risk-adjusted returns without creating excessive leverage, settlement or margin-liquidity risk.
- How rising repo rates and hedging costs affect net interest spread, core earnings and the sustainability of common and preferred dividends.
- Changes in book value, portfolio duration and sensitivity to interest rates and credit spreads; modeled sensitivities are estimates and exclude spread changes in the rate scenarios.
- Developments in the DCI-related lawsuit, including any change in Dynex’s assessment, potential exposure or required accrual.
- The company’s continued compliance with repo covenants, access to counterparties and available liquidity, particularly during market stress.