Dynex Capital, Inc. — Q3 2011 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2011. Amounts below are in millions, except per-share data. The filing is unaudited. Dynex is a leveraged mortgage REIT investing primarily in Agency and non-Agency mortgage-backed securities (MBS).
Financial performance and position
| Metric | Q3 2011 | Q3 2010 | Nine months 2011 | Nine months 2010 |
|---|---|---|---|---|
| Interest income | $21.1 | $11.7 | $59.7 | $34.5 |
| Net interest income | $14.6 | $8.4 | $42.3 | $23.5 |
| Net income | $1.5 | $7.0 | $25.4 | $19.8 |
| Net income per common share, diluted | $0.04 | $0.33 | $0.67 | $1.00 |
| Dividends declared per common share | $0.27 | $0.25 | $0.81 | $0.94 |
Q3 net interest spread was 2.43%, down from 2.98% in Q3 2010 and slightly below 2.45% in Q2 2011. Net income included an $8.2 million litigation settlement and related-cost charge, a $2.0 million non-cash charge on redemption of non-recourse financing, and $1.3 million of additional Agency MBS premium amortization due to higher forecast prepayments. Comprehensive loss was $6.8 million in Q3, including $8.3 million of other comprehensive loss, principally from cash flow hedge valuation changes.
At September 30, total assets were $2,633.7 million, liabilities $2,264.2 million, and shareholders’ equity $369.5 million. Investment assets included $2,072.1 million of Agency MBS, $403.7 million of non-Agency MBS, and $118.7 million of securitized mortgage loans. Repurchase agreements were $2,053.7 million, versus $1,234.2 million at year-end 2010; reported overall leverage was 6.1 times equity, up from 4.6 times. Book value was $9.15 per share, down from $9.59 at June 30, 2011.
For the first nine months, operating activities generated $53.6 million of cash, investing used $945.0 million, and financing provided $882.7 million. Cash declined $8.7 million to $10.2 million. Management also reported $189.1 million of unencumbered cash and unpledged Agency MBS as liquidity; this is broader than cash on the balance sheet.
Material changes and management outlook
- Portfolio expansion was funded in part by a first-quarter common-stock offering that generated $90.5 million net and by equity placement proceeds. Agency MBS rose to 80% of the investment portfolio, above the 50%–70% target; management expected to increase non-Agency holdings to move toward that mix.
- Management raised its forecast for Agency RMBS prepayments to 28% CPR over the next 12 months, citing lower rates, proposed HARP changes, and Federal Reserve policy. Faster prepayments could accelerate premium amortization and reduce yields.
- The company’s target portfolio duration was 0.5–1.5 years. Its modeled sensitivity to an instantaneous 100-basis-point rate increase was a 4.9% decline in projected net interest income and a 1.2% decline in projected market value; these estimates rely on assumptions and a static portfolio.
- Management described investment opportunities as attractive but highlighted uncertainty from the yield curve, credit spreads, European markets, government policy, and financing availability. It expected the Federal Funds Target Rate to remain at 0%–0.25% through mid-2013, as then indicated by the FOMC.
Risks, contingencies, and unusual items
- Funding and liquidity: Repurchase financing is short-term, uncommitted, subject to renewal and margin calls, and generally recourse. The company had $2.1 billion of repo borrowings, with a weighted-average rate of 0.43%; the average original repo term was 45 days. Market-value declines or lenders’ refusal to renew could force asset sales.
- Covenant: A counterparty covenant breach occurred because the litigation accrual pushed liabilities above six times equity. The counterparty amended the limit to seven times equity; the filing says no debt was accelerated and no cross-defaults were triggered.
- Litigation: Dynex recorded $8.2 million for the Teamsters securities class action and had agreed in principle to pay $7.5 million into escrow, subject to a definitive agreement and court approval. The company denied wrongdoing. Other disclosed proceedings included the Allegheny County and Basic Capital matters; outcomes remained uncertain.
- Rate hedges: Interest-rate swap notional was $1.022 billion, with $28.8 million of derivative liabilities at quarter-end. The company had pledged Agency MBS worth $30.7 million as swap collateral. It estimated a further $10.6 million of hedge-related amounts would increase interest expense over the next 12 months.
- Regulatory and market risks: The filing identifies potential effects of Operation Twist, HARP and GSE reform, Dodd-Frank implementation, and an SEC review of the mortgage-company exemption under Investment Company Act Section 3(c)(5)(C). A change in that exemption could require operational changes or asset sales.
- Subsequent counterparty event: MF Global Holdings filed for bankruptcy protection on October 31, 2011. Dynex said it had no borrowings outstanding with MF Global, Inc. at that time and no direct exposure to its liquidation.
Important facts for investors to verify
- Whether the proposed $7.5 million Teamsters settlement received final court and class approval, and whether costs differed from the recorded estimate.
- Whether leverage, repo access, counterparty concentration, and unencumbered liquidity remained adequate amid market stress and potential margin calls.
- Whether Agency RMBS prepayments approached the 28% CPR forecast and how that affected premium amortization, net interest spread, and earnings.
- How book value and swap collateral requirements changed as interest rates and MBS credit spreads moved.
- Whether the SEC’s Section 3(c)(5)(C) review or other regulatory developments changed Dynex’s ability to operate under its existing structure.