DYNEX CAPITAL INC - Annual Report: 2006 (Form 10-K)
UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
DC 20549
FORM
10-K
(Mark
One)
þ
ANNUAL
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
For
the
fiscal year ended December 31, 2006
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT
OF 1934
Commission
file number 1-9819
DYNEX
CAPITAL, INC.
(Exact
name of registrant as specified in its charter)
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Virginia
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52-1549373
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(State
or other jurisdiction of incorporation or organization)
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(I.R.S.
Employer Identification No.)
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4551
Cox Road, Suite 300, Glen Allen, Virginia
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23060-6740
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(Address
of principal executive offices)
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(Zip
Code)
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Registrant’s
telephone number, including area code (804) 217-5800
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Securities
registered pursuant to Section 12(b) of the Act:
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Title
of each class
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Name
of each exchange on which registered
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Common
Stock, $.01 par value
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New
York Stock Exchange
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Series
D 9.50% Cumulative Convertible Preferred Stock,
$.01
par value
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New
York Stock Exchange
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Securities
registered pursuant to Section 12(g) of the
Act:
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None
(Title
of
class)
Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined
in
Rule 405 of the Securities Act.
Yes o No þ
Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or 15(d) of the Act.
Yes o No þ
Indicate
by check mark whether the registrant (1) has filed all reports required to
be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements
for
the past 90 days.
Yes þ No o
Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this
Form 10-K. o
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of “accelerated
filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
one):
Large
accelerated filer o Accelerated
filer o Non-accelerated
filer þ
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act).
Yes o No þ
As
of
June 30, 2006, the aggregate market value of the voting stock held by
non-affiliates of the registrant was approximately $66,263,355 based on a
closing sales price on the New York Stock Exchange of $6.84.
Common
stock outstanding as of February 28, 2007 was 12,131,262 shares.
DOCUMENTS
INCORPORATED BY REFERENCE
Portions
of the Definitive Proxy Statement expected to be filed pursuant to Regulation
14A within 120 days from December 31, 2006, are incorporated by reference
into Part III.
DYNEX
CAPITAL, INC.
2006
FORM 10-K ANNUAL REPORT
TABLE
OF CONTENTS
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Page
Number
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PART
I.
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Item
1.
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Business
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1
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Item
1A.
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Risk
Factors
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4
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Item
1B.
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Unresolved
Staff Comments
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8
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Item
2.
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Properties
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8
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Item
3.
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Legal
Proceedings
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8
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Item
4.
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Submission
of Matters to a Vote of Security Holders
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10
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PART
II.
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Item
5.
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Market
for Registrant’s Common Equity and Related Stockholder Matters
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10
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Item
6.
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Selected
Financial Data
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12
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Item
7.
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Management’s
Discussion and Analysis of Financial Condition and Results of
Operations
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13
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Item
7A.
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Quantitative
and Qualitative Disclosures about Market Risk
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31
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Item
8.
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Financial
Statements and Supplementary Data
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32
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Item
9.
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Changes
in and Disagreements with Accountants on Accounting and Financial
Disclosure
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32
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Item
9A.
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Controls
and Procedures
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33
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Item
9B.
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Other
Information
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33
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PART
III.
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Item
10.
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Directors,
Executive Officers and Corporate Governance
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33
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Item
11.
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Executive
Compensation
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33
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Item
12.
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Security
Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters
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33
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Item
13.
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Certain
Relationships and Related Transactions, and Director
Independence
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34
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Item
14.
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Principal
Accounting Fees and Services
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34
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PART
IV.
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Item
15.
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Exhibits,
Financial Statement Schedules
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34
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SIGNATURES
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36
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i
PART
I
In
this annual report on Form 10-K, we refer to Dynex Capital, Inc. and its
subsidiaries as “we,” “us,” “Dynex,” or “the Company,” unless specifically
indicated otherwise.
ITEM
1. BUSINESS
GENERAL
Dynex
Capital, Inc., together with its subsidiaries, is a specialty finance company
organized as a mortgage real estate investment trust (REIT) that invests in
loans and fixed income securities consisting principally of single-family
residential and commercial mortgage loans. We finance these loans and securities
through a combination of non-recourse securitization financing, repurchase
agreements, and equity. We employ financing in order to increase the overall
yield on our invested capital. Our ownership of these investments, and the
use
of leverage, exposes us to certain risks, including, but not limited to, credit
risk, interest-rate risk, margin call risk, and prepayment risk, which are
discussed in more detail in ITEM 1A - RISK FACTORS.
We
own
both investment grade (credit rating of “BBB-” or higher) and non-investment
grade investments. As it relates to our current investment portfolio, our
ownership of non-investment grade securities is generally in the form of the
first-loss or subordinate classes of securitization trusts. In securitization
trusts, loans and securities are pledged to a trust, and the trust issues bonds
(referred to as non-recourse securitization financing) pursuant to an indenture.
We have typically been the sponsor of the trust and have retained the
lowest-rated bond classes in the trust, often referred to as subordinate bonds
or overcollateralization. While all of the loans collateralizing the trust
are
consolidated in our financial statements, the performance of our investment
depends on the performance of the subordinate bonds and overcollateralization
we
retained. The overall performance of the our retained interests in these trusts
is principally dependent on the credit performance of the underlying assets.
Most of the investments which we own were originated by us and are considered
highly seasoned.
In
recent
years, our focus has been on deleveraging our balance sheet, converting non-core
assets to cash while reducing our exposure to credit risk and increasing our
investable capital. In order to deleverage our balance sheet, we sold certain
non-core assets (i.e., assets that we no longer consider part of our core
investment strategy), such as manufactured housing loans and a delinquent
property tax receivable portfolio, and contributed our interests in a commercial
mortgage loan securitization trust to a joint venture in which we own slightly
less than 50%. As a result, since 2004, we have had an overall reduction in
investments of $934 million, reduced our net credit exposure on non-investment
grade investments by $17.5 million and our leverage ratio has declined from
4.4x
to 2.4x at December 31, 2005 and 2006, respectively.
As
we
have sold investments or investments have otherwise paid-down, as mentioned
above, we have not found compelling investment opportunities in REIT eligible
assets with what we believe to be reasonable risk-adjusted returns. This has
primarily been a result of:
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·
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inversion
of the yield curve, making it more difficult for us to earn net interest
income on leveraged investments;
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·
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low
risk premiums on these assets, resulting in lower risk-adjusted returns;
and
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·
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competition
for these assets, primarily from hedge funds, financial institutions,
foreign investors, other REITS and money
managers.
|
Given
the
continued challenging investment environment for traditional REIT investments,
we are actively seeking opportunities to partner with others in order to
leverage our capital and expertise. We have also retained an investment advisor
to assist us in identifying potential partners and other investment
opportunities.
In
light
of the lack of compelling investment opportunities, we used some of our
investable capital to redeem approximately $14 million, or 25%, of our then
outstanding 9.50% Series D Preferred Stock in January 2006. We also repurchased
32,560 shares of our common stock during 2006, under a stock repurchase plan
approved by our Board of Directors, which authorizes us to repurchase up to
one
million shares of our common stock.
1
As
a
REIT, we are required to distribute to stockholders as dividends at least 90%
of
our taxable income, which is our income as calculated for tax, after
consideration of any tax net operating loss (NOL) carrryforwards. However,
unlike other mortgage REITs, our required REIT income distributions are likely
to be limited well into the future due to the reduction of our future taxable
income by our tax net operating loss (NOL) carryforwards, which were an
estimated $153 million at December 31, 2006, although we have not finalized
our
2006 federal income tax return. As a result, we anticipate being able to invest
our capital and compound the returns on an essentially tax-free basis for the
foreseeable future. Over the long-term this will allow us to increase our book
value per common share while potentially utilizing a lower risk investment
strategy than some of our competitors would have to utilize in order to achieve
similar results.
We
were
incorporated in the Commonwealth of Virginia in 1987, and began operations
in
1988.
BUSINESS
MODEL AND STRATEGY
As
a
mortgage REIT, we seek to generate net interest income from our investment
portfolio. We seek investment assets which have an acceptable rate of return.
We
earn the excess of the interest income on our investment assets over the costs
of the financing of those assets. The net interest income on our existing
investment portfolio is directly impacted by the credit performance of the
underlying loans and securities, and to a lesser extent, by the level of
prepayments of the underlying loans and securities, and by changes in interest
rates. Net interest income is also dependent on our investment strategy and
the
reinvestment rate for our investable capital. We intend to invest in assets,
and
structure the financing of these assets, in such a way that will generate
reasonably stable net interest income in a variety of prepayment, interest
rate
and credit environments. Our business model and strategy have inherent risks,
a
discussion of these risks is provided in ITEM 1A - RISK FACTORS
below.
We
have
an investment policy which governs the allocation of capital between short-term,
highly liquid investments, investment grade fixed income investments,
subordinate and credit sensitive investments, and strategic investments.
Strategic investments are investments in equity and equity-like securities
of
other companies, including other mortgage REITs. Strategic investments may
or
may not be qualifying investments for the respective REIT tests described in
Federal
Income Tax Considerations below.
Our
capital allocations are reviewed annually by the Board of Directors, and are
adjusted for a variety of factors, including, but not limited to, the current
investment climate, the current interest-rate environment, competition, and
our
desire for capital preservation.
In
the
current investment environment, we believe that expanding our ability to source
and analyze investments through joint ventures and other arrangements with
qualified partners is the best means to identify compelling investment
opportunities. Towards this goal, we have entered into a joint venture with
DBAH
Capital, LLC, which is an affiliate of Deutsche Bank AG, and hired Sandler
O’Neill & Partners, LLP (Sandler O’Neill) to expand our access to investment
opportunities. We continue to seek additional opportunities to partner with
other mortgage REITs, hedge funds, money mangers, Wall Street firms and
specialty finance companies to further leverage our resources. We continue
to
evaluate investment opportunities generated internally, as well as through
our
relationship with our business partners. While the investment environment has
recently improved, reflected by increasing risk premiums on assets, there can
be
no assurances that acceptable risk-adjusted investment opportunities will be
found.
Our
tax
NOL carryforwards limit the distributions we would otherwise be required to
make
in order to maintain our REIT status; however, our Series D Preferred Stock
requires the payment of a quarterly dividend. If the Series D Preferred Stock
dividend is not paid for a period of two consecutive quarters, the Series D
Preferred Stock will automatically convert into senior notes. While we will
regularly evaluate whether to pay dividends on our common stock, it is currently
our intention to not distribute any net income to common shareholders, that
absent our NOL carryforwards we would be required to distribute, in order to
organically grow our investment portfolio and book value. At December 31, 2006,
common book value was $94.3 million or $7.78 per common share. By utilizing
our
NOL carryforwards of approximately $153 million as of December 31, 2006 to
offset distributions of REIT taxable income to common shareholders that would
otherwise be required, we could increase common book value by $153 million
to
approximately $247 million, or more than $20 per common share, before we would
be required to make a distribution to our common shareholders. We have not
yet
finalized our tax results for 2006, but we anticipate utilizing a small amount
(less than 1%) of our NOL carryforward to offset ordinary taxable income in
excess of the Series D Preferred Stock dividends paid during 2006. Although
we
do not foresee any issues with our ability to use our NOL carryforwards to
offset future taxable income, there are circumstances that could restrict our
2
ability
to do so, which include restrictions based on changes in our ownership. While
we
are retaining amounts that otherwise would be distributed to shareholders,
we
believe that this will enhance overall common shareholder value over the longer
term.
COMPETITION
The
financial services industry in which we compete is a highly competitive industry
with a number of institutions with greater financial resources. In making
investments and financing those investments, we compete with other mortgage
REITs, specialty finance companies, investment banking firms, savings and loan
associations, commercial banks, mortgage bankers, insurance companies, federal
agencies, foreign investors, and other entities, many of which have greater
financial resources and a lower cost of capital than we do. Increased
competition in the market and our competitors’ greater financial resources have
driven down returns on investments and have adversely impacted our ability
to
invest our capital on an acceptable risk-adjusted basis, and may continue to
do
so for the foreseeable future.
AVAILABLE
INFORMATION
Our
website address is www.dynexcapital.com.
Our
annual reports on Form 10-K, our quarterly reports on Form 10-Q and our current
reports on Form 8-K, and amendments to those reports, filed or furnished
pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are
made available, as soon as reasonably practicable after such material is
electronically filed with or furnished to the Securities and Exchange
Commission, free of charge through our website.
We
have
adopted a Code of Conduct that applies to all of our employees, officers and
directors. Our Code of Conduct is also available, free of charge, on our
website, along with our Audit Committee Charter, our Nominating and Corporate
Governance Committee Charter, and our Compensation Committee Charter. We will
post on our website any amendments to the Code of Conduct or waivers from its
provisions, if any, which are applicable to any of our directors or executive
officers.
FEDERAL
INCOME TAX CONSIDERATIONS
We
believe that we have complied with the requirements for qualification as a
REIT
under the Internal Revenue Code (the “Code”). The REIT rules generally require
that a REIT invest primarily in real estate-related assets, that our activities
be passive rather than active and that we distribute annually to our
shareholders substantially all of our taxable income, after certain deductions,
including deductions for NOL carryforwards. We could be subject to income tax
if
we failed to satisfy those requirements or if we acquired certain types of
income-producing real property. For the foreseeable future, we intend to offset
taxable income with our NOL carryforwards, enabling us to retain the taxable
income generated for reinvestment opportunities and our future growth.
We
use
the calendar year for both tax and financial reporting purposes. There may
be
differences between taxable income and income computed in accordance with
generally accepted accounting principles in the United States of America
(“GAAP”). These differences primarily arise from timing differences in the
recognition of revenue and expense for tax and GAAP purposes. We currently
have
tax operating loss carryforwards of approximately $153 million, which expire
between 2019 and 2025. We also had excess inclusion income of $1.9 million
from
our ownership of certain residual investments. Excess inclusion income cannot
be
offset by NOL carryforwards, so in order to meet REIT distribution requirements,
we must distribute all of our excess inclusion income.
Failure
to satisfy certain Code requirements could cause us to lose our status as a
REIT. If we failed to qualify as a REIT for any taxable year, we may be subject
to federal income tax (including any applicable alternative minimum tax) at
regular corporate rates and would not receive deductions for dividends paid
to
shareholders. We could, however, utilize our NOL carryforward to offset any
taxable income. In addition, given the size of our NOL carryforward, we could
pursue a business plan in the future in which we would voluntarily forego our
REIT status. If we lost or otherwise surrendered our status as a REIT, we could
not elect REIT status again for five years. Several of our investments in
securitization finance receivables have ownership restrictions limiting their
ownership to REITs. Therefore, if we chose to forego our REIT status, we would
have to sell these investments or otherwise provide for REIT ownership of these
investments.
3
We
also
have a taxable REIT subsidiary (TRS), which has a NOL carryforward of
approximately $4 million. The TRS has limited operations, and, accordingly,
we
have established a full valuation allowance for the related deferred tax
asset.
Qualification
as a REIT
Qualification
as a REIT requires that we satisfy a variety of tests relating to our income,
assets, distributions and ownership. The significant tests are summarized
below.
Sources
of Income.
To
continue qualifying as a REIT, we must satisfy two distinct tests with respect
to the sources of our income: the “75% income test” and the “95% income test.”
The 75% income test requires that we derive at least 75% of our gross income
(excluding gross income from prohibited transactions) from certain real
estate-related sources. In order to satisfy the 95% income test, 95% of our
gross income for the taxable year must consist of either income that qualifies
under the 75% income test or certain other types of passive income.
If
we
fail to meet either the 75% income test or the 95% income test, or both, in
a
taxable year, we might nonetheless continue to qualify as a REIT, if our failure
was due to reasonable cause and not willful neglect and the nature and amounts
of our items of gross income were properly disclosed to the Internal Revenue
Service. However, in such a case we would be required to pay a tax equal to
100%
of any excess non-qualifying income.
Nature
and Diversification of Assets.
At the
end of each calendar quarter, three asset tests must be met by us. Under the
75%
asset test, at least 75% of the value of our total assets must represent cash
or
cash items (including receivables), government securities or real estate assets.
Under the “10% asset test,” we may not own more than 10% of the outstanding
voting securities of any single non-governmental issuer, provided such
securities do not qualify under the 75% asset test or relate to taxable REIT
subsidiaries. Under the “5% asset test,” ownership of any stocks or securities
that do not qualify under the 75% asset test must be limited, in respect of
any
single non-governmental issuer, to an amount not greater than 5% of the value
of
the total assets of us.
If
we
inadvertently fail to satisfy one or more of the asset tests at the end of
a
calendar quarter, such failure would not cause us to lose our REIT status,
provided that (i) we satisfied all of the asset tests at the close of a
preceding calendar quarter and (ii) the discrepancy between the values of
our assets and the standards imposed by the asset tests either did not exist
immediately after the acquisition of any particular asset or was not wholly
or
partially caused by such an acquisition. If the condition described in clause
(ii) of the preceding sentence was not satisfied, we still could avoid
disqualification by eliminating any discrepancy within 30 days after the close
of the calendar quarter in which it arose.
Ownership.
In
order to maintain our REIT status, we must not be deemed to be closely held
and
must have more than 100 shareholders. The closely held prohibition requires
that
not more than 50% of the value of our outstanding shares be owned by five or
fewer persons at anytime during the last half of our taxable year. The more
than
100 shareholders rule requires that we have at least 100 shareholders for 335
days of a twelve-month taxable year. In the event that we failed to satisfy
the
ownership requirements we would be subject to fines and be required to take
curative action to meet the ownership requirements in order to maintain our
REIT
status.
EMPLOYEES
As
of
December 31, 2006, including our subsidiaries, we had 17 employees. Our
relationship with our employees is good. None of our employees are covered
by
any collective bargaining agreements, and we are not aware of any union
organizing activity relating to our employees. Effective February 28, 2007,
GLS
Capital Services, Inc., our tax lien servicing subsidiary, headquartered in
Pittsburgh, Pennsylvania, ceased operations and the five employees there were
terminated.
ITEM
1A. RISK FACTORS
Our
business is subject to various risks, including the risks described below.
Our
business, operating results and financial condition could be materially and
adversely affected by any of these risks. Please note that additional risks
not
presently known to us or that we currently deem immaterial may also impair
our
business and operations.
4
Our
ownership of certain subordinate interests in securitization trusts subjects
us
to credit risk on the underlying loans, and we provide for loss reserves on
these loans as required under GAAP.
As
the
result of our ownership of the overcollateralization portion of the
securitization trust, the predominant risk to us in our investment portfolio
is
credit risk. Credit risk is the risk of loss to us from the failure by a
borrower (or the proceeds from the liquidation of the underlying collateral)
to
fully repay the principal balance and interest due on a loan. A borrower’s
ability to repay and the value of the underlying collateral could be negatively
influenced by economic and market conditions. These conditions could be global,
national, regional or local in nature. Upon securitization of the pool of loans
or securities backed by loans, the credit risk retained by us from an economic
point of view is generally limited to the overcollateralization tranche of
the
securitization trust. We provide for estimated losses on the gross amount of
loans pledged to securitization trusts included in our financial statements
as
required by GAAP. In some instances, we may also retain subordinated bonds
from
the securitization trust, which increases our credit risk above the
overcollateralization tranche from an economic perspective. We provide reserves
for existing losses based on the current performance of the respective pool
or
on an individual loan basis. If losses are experienced more rapidly, due to
declining property performance, market conditions or other factors, than we
have
provided for in our reserves, we may be required to provide for additional
reserves for these losses.
Certain
investments employ internal structural leverage as a result of the
securitization process, and are
in the most subordinate position in the capital structure, which magnifies
the
potential impact of adverse events on our cash flows and reported results.
Many
of
the loans that we own have been pledged to securitization trusts which employ
a
high degree of internal structural leverage and concentrated credit, interest
rate, prepayment, or other risks. We have generally retained the most
subordinate classes of the securitization trust. As a result of these factors,
net interest income and cash flows on our investments will vary based on the
performance of the assets pledged to the securitization trust. In particular,
should assets meaningfully underperform as to delinquencies, defaults, and
credit losses, it is possible that cash flows which may have otherwise been
paid
to us as a result of our ownership of the subordinate interests may be retained
within the securitization trust. No amount of risk management or mitigation
can
change the variable nature of the cash flows and financial results generated
by
concentrated risks in our investments. None of our existing securities at
December 31, 2006 have reached these predetermined levels, but such levels
could
be reached in the future.
Our
efforts to manage credit risk may not be successful in limiting delinquencies
and defaults in underlying loans or losses on our
investments.
Despite
our efforts to manage credit risk, there are many aspects of credit that we
cannot control. Third party servicers provide for the primary and special
servicing of our loans. We have a risk management function, which oversees
the
performance of these services and provides limited asset management
capabilities. Our risk management operations may not be successful in limiting
future delinquencies, defaults, and losses. The securitizations in which we
have
invested may not receive funds that we believe are due from mortgage insurance
companies and other counter-parties. Loan servicing companies may not cooperate
with our risk management efforts, or such efforts may be ineffective. Service
providers to securitizations, such as trustees, bond insurance providers, and
custodians, may not perform in a manner that promotes our interests. The value
of the properties collateralizing residential loans may decline. The value
of
properties collateralizing commercial mortgage loans may decline. The frequency
of default, and the loss severity on loans upon default, may be greater than
we
anticipated. If loans become “real estate owned” (REO), servicing companies will
have to manage these properties and may not be able to sell them. Changes in
consumer behavior, bankruptcy laws, tax laws, and other laws may exacerbate
loan
losses. In some states and circumstances, the securitizations in which we invest
have recourse as owner of the loan against the borrower’s other assets and
income in the event of loan default; however, in most cases, the value of the
underlying property will be the sole source of funds for any recoveries.
We
may be unable to invest in new assets with attractive yields, and yields on
new
assets in which we do invest may not generate attractive yields, resulting
in a
decline in our earnings per share over time.
Our
existing investments have been declining as we have sold investments or assets
have otherwise paid down. The yields on the new investments purchased have
generally been lower than the yield on those assets sold or repaid, due to
lower
5
overall
interest rates and more competition for these assets. We have generally been
unable to find investments which have acceptable risk adjusted yields. As a
result, our net interest income has been declining, and may continue to decline
in the future, resulting in lower earnings per share over time. In order to
maintain our investment portfolio size and our earnings, we need to reinvest
a
portion of the cash flows we receive into new interest earning assets. We have
been investing our available capital in short duration high credit quality
assets and will continue to do so until the risk adjusted yields on available
investments are more attractive.
Prepayments
of principal on our investments, and the timing of prepayments, may impact
our
reported earnings and our cash flows.
We
own
many of our securitization finance receivables and have issued associated
securitization financing bonds at premiums or discounts to their principal
balances. Prepayments of principal on loans and the associated bonds, whether
voluntary or involuntary, impact the amortization of premiums and discounts
under the effective yield method of accounting that we use for GAAP accounting.
Under the effective yield method of accounting, we recognize yields on our
assets and effective costs of our liabilities based on assumptions regarding
future cash flows. Variations in actual cash flows from those assumed as a
result of prepayments, and subsequent changes in future cash flow expectations
will cause adjustments in yields on assets and costs of liabilities which could
contribute to volatility in our future results.
In
a
period of declining interest rates, loans and securities in the investment
portfolio will generally prepay more rapidly (to the extent that such loans
are
not prohibited from prepayment), which may result in additional amortization
of
asset premium. In a flat yield curve environment (i.e.,
when
the spread between the yield on the one-year Treasury security and the yield
on
the ten-year Treasury security is less than 1.0%), adjustable rate mortgage
loans and securities tend to rapidly prepay, causing additional amortization
of
asset premium. In addition, the spread between our funding costs and asset
yields may compress, causing a further reduction in our net interest
income.
We
finance a portion of our investment portfolio with short-term recourse
repurchase agreements which subjects us to margin calls if the assets pledged
subsequently decline in value.
We
finance a portion of our investments, primarily high credit-quality, liquid
securities, with recourse repurchase agreements. These arrangements require
us
to maintain a certain level of collateral for the related borrowings. If the
collateral should fall below the required level, the repurchase agreement lender
could initiate a margin call. This would require that we either pledge
additional collateral acceptable to the lender or repay a portion of the debt
in
order to meet the margin requirement. Should we be unable to meet a margin
call,
we may have to liquidate the collateral or other assets quickly. Because a
margin call and quick sale could result in a lower than otherwise expected
and
attainable sale price, we may incur a loss on the sale of the
collateral.
We
may be subject to the risks associated with inadequate or untimely services
from
third-party service providers, which may harm our results of
operations.
Our
loans
and loans underlying securities are serviced by third-party service providers.
As with any external service provider, we are subject to the risks associated
with inadequate or untimely services. Many borrowers require notices and
reminders to keep their loans current and to prevent delinquencies and
foreclosures. A substantial increase in our delinquency rate that results from
improper servicing or loan performance in general could harm our ability to
securitize our real estate loans in the future and may have an adverse effect
on
our earnings.
Interest
rate fluctuations can have various negative effects on us, and could lead to
reduced earnings and/or increased earnings
volatility.
Our
investment portfolio today is substantially match-funded, and overall we are
largely insulated from material risks related to rising, or declining, interest
rates. In the past however, we have been exposed to material changes in
short-term interest rates, and depending on future investments, may again be
exposed to these changes. Certain of our current investments and contemplated
future investments are adjustable-rate loans and securities which have interest
rates which reset semi-annually or annually, based on an index such as the
one-year constant maturity treasury or the six-month London Interbank Offered
Rate (LIBOR). These investments may be financed with borrowings which reset
monthly, based upon one-month LIBOR. In a rising rate environment, net interest
income earned on these investments may be reduced, as the interest cost for
the
funding sources could increase more rapidly than the interest earned on the
associated asset financed. In a
6
declining
interest-rate environment, net interest income may be enhanced as the interest
cost for the funding sources decreases more rapidly than the interest earned
on
the associated assets. To the extent that assets and liabilities are both
fixed-rate or adjustable rate with corresponding payment dates, interest-rate
risk may be mitigated.
Our
reported income depends on accounting conventions and assumptions about the
future that may change.
Accounting
rules for our assets, and for the various aspects of our current and future
business change from time to time. Changes in GAAP, or the accepted
interpretation of these accounting principles, can affect our reported income,
earnings, and shareholders’ equity. Interest income on our assets, and interest
expense on our liabilities, may in part be based on estimates of future events.
These estimates can change in a manner that harms our results or can
demonstrate, in retrospect, that revenue recognition in prior periods was too
high or too low. We use the effective yield method of GAAP accounting for many
of our investments. We calculate projected cash flows for each of these assets
incorporating assumptions about the amount and timing of credit losses, loan
prepayment rates, and other factors. The yield we recognize for GAAP purposes
generally equals the discount rate that produces a net present value for actual
and projected cash flows that equals our GAAP basis in that asset. We change
the
yield recognized on these assets based on actual performance and as we change
our estimates of future cash flows. The assumptions that underlie our projected
cash flows and effective yield analysis may prove to be overly optimistic,
or
conversely, overly conservative. In these cases, our GAAP yield on the asset,
or
cost of the liability may change, leading to changes in our reported GAAP
results.
Failure
to qualify as a REIT would adversely affect our dividend distributions and
could
adversely affect the value of our securities.
We
believe that we have met all requirements for qualification as a REIT for
federal income tax purposes and we intend to continue to operate so as to
qualify as a REIT in the future. However, many of the requirements for
qualification as a REIT are highly technical and complex and require an analysis
of factual matters and an application of the legal requirements to such factual
matters in situations where there is only limited judicial and administrative
guidance. Thus, no assurance can be given that the Internal Revenue Service
or a
court would agree with our conclusion that we have qualified as a REIT or that
future changes in our factual situation or the law will allow us to remain
qualified as a REIT. If we failed to qualify as a REIT for federal income tax
purposes and did not meet the requirements for statutory relief, we could be
subject to federal income tax at regular corporate rates on our income and
we
could possibly be disqualified as a REIT for four years thereafter. Failure
to
qualify as a REIT could force us to sell certain of our investments, possibly
at
a loss, and could adversely affect the value of our common stock.
Maintaining
REIT status may reduce our flexibility to manage our
operations.
To
maintain REIT status, we must follow certain rules and meet certain tests.
In
doing so, our flexibility to manage our operations may be reduced. For
instance:
|
· If
we make frequent asset sales from our REIT entities to persons deemed
customers, we could be viewed as a “dealer,” and thus subject to 100%
prohibited transaction taxes or other entity level taxes on income
from
such transactions.
|
|
|
· Compliance
with the REIT income and asset rules may limit the type or extent
of
hedging that we can undertake.
|
|
|
· Our
ability to own non-real estate related assets and earn non-real estate
related income is limited. Our ability to own equity interests in
other
entities is limited. If we fail to comply with these limits, we may
be
forced to liquidate attractive assets on short notice on unfavorable
terms
in order to maintain our REIT status.
|
|
|
· Our
ability to invest in taxable subsidiaries is limited under the REIT
rules.
Maintaining compliance with this limit could require us to constrain
the
growth of our taxable REIT affiliates in the future.
|
|
|
· Meeting
minimum REIT dividend distribution requirements could reduce our
liquidity. Earning non-cash REIT taxable income could necessitate
our
selling assets, incurring debt, or raising new equity in order to
fund
dividend distributions.
|
|
|
· Stock
ownership tests may limit our ability to raise significant amounts
of
equity capital from one source.
|
7
We
may fail to properly conduct our operations so as to avoid falling under the
definition of an investment company pursuant to the Investment Company Act
of
1940.
We
also
conduct our operations so as to avoid falling under the definition of an
investment company pursuant to the Investment Company Act of 1940. If we were
determined to be an investment company, our ability to use leverage would be
substantially reduced, and our ability to conduct business may be impaired.
Under the current interpretation of the staff of the Securities and Exchange
Commission (“SEC”), in order to be exempted from regulation as an investment
company, a REIT must, among other things, maintain at least 55% of its assets
directly in qualifying real estate interests. In satisfying this 55%
requirement, a REIT may treat mortgage-backed securities issued with respect
to
an underlying pool to which it holds all issued certificates as qualifying
real
estate interests. If the SEC or its staff adopts a contrary interpretation
of
such treatment, the REIT could be required to sell a substantial amount of
these
securities or other non-qualified assets under potentially adverse market
conditions.
We
are dependent on certain key personnel.
We
have
only one Executive Officer, Stephen J. Benedetti, who serves as our Executive
Vice President and Chief Operating Officer. We currently do not have a Chief
Executive Officer, President, or Chief Financial Officer. Mr. Benedetti
previously served as our Chief Financial Officer. Mr. Benedetti has been with
us
since 1994 and has extensive knowledge of us, our operations, and our current
investment portfolio. He also has extensive experience in managing a portfolio
of mortgage-related investments and as an executive officer of a publicly-traded
mortgage REIT. The loss of Mr. Benedetti could have an adverse effect on our
operations.
ITEM
1B. UNRESOLVED STAFF COMMENTS
There
are
no unresolved comments from the SEC Staff.
ITEM
2.
PROPERTIES
Our
executive and administrative offices and operations offices are both located
in
Glen Allen, Virginia, on properties leased by us. The address is 4551 Cox Road,
Suite 300, Glen Allen, Virginia 23060. As of December 31, 2006, we leased 8,244
square feet. The term of the lease runs to May 2008 but may be renewed at our
option for three additional one-year periods at substantially similar
terms.
We
believe that our property is maintained in good operating condition and is
suitable and adequate for our purposes.
ITEM
3.
LEGAL PROCEEDINGS
We
and
our subsidiaries may be involved in certain litigation matters arising in the
ordinary course of businesses. Although the ultimate outcome of these matters
cannot be ascertained at this time, and the results of legal proceedings cannot
be predicted with certainty, we believe, based on current knowledge, that the
resolution of these matters will not have a material adverse effect on our
financial position or results of operations. Information on litigation arising
out of the ordinary course of business is described below.
One
of
our subsidiaries, GLS Capital, Inc. (“GLS”), and the County of Allegheny,
Pennsylvania (“Allegheny County”), are defendants in a class action lawsuit
filed in 1997 in the Court of Common Pleas of Allegheny County, Pennsylvania
(the “Court of Common Pleas”). Plaintiffs allege that GLS illegally
charged the taxpayers of Allegheny County certain attorney fees, costs and
expenses, and interest, in the collection of delinquent property tax receivables
owned by GLS. Plaintiffs were seeking class certification status, and in
October 2006, the Court of Common Pleas certified the class action status of
the
litigation. In its Order certifying the class action, the Court of Common Pleas
left open the possible decertification of the class if the fees, costs and
expenses charged by GLS are in accordance with public policy considerations
8
as
well
as Pennsylvania statute and relevant ordinance. The Company successfully
sought the stay of this action pending the outcome of other litigation before
the Pennsylvania Supreme Court in which GLS is not directly involved but has
filed an Amicus brief in support of the defendants. Several of the
allegations in that lawsuit are similar to those being made against GLS in
this
litigation. Plaintiffs have not enumerated its damages in this matter, and
we
believe that the ultimate outcome of this litigation will not have a material
impact on our financial condition, but may have a material impact on our
reported results for the particular period presented.
Dynex
Capital, Inc. and Dynex Commercial, Inc. (“DCI”), formerly our affiliate and now
known as DCI Commercial, Inc., are appellees (or “respondents”) in the Court of
Appeals for the Fifth Judicial District of Texas at Dallas, related to the
matter of Basic Capital Management et al (collectively, “BCM” or “the
Plaintiffs”) versus Dynex Commercial, Inc. et al. The appeal seeks to
overturn a judgment from a lower court in our and DCI’s favor which denied
recovery to Plaintiffs and to have a judgment entered in favor of Plaintiffs
based on a jury award for damages, all of which was set aside by the trial
court
as discussed further below. In the alternative, Plaintiffs are seeking a
new trial. The appeal relates to a suit filed against us and DCI in 1999,
alleging, among
other things, that DCI and Dynex Capital, Inc. failed to fund tenant improvement
or other advances allegedly required on various loans made by DCI to BCM, which
loans were subsequently acquired by us; that DCI breached an alleged $160
million “master” loan commitment entered into in February 1998; and that DCI
breached another alleged loan commitment of approximately $9 million. The
original trial commenced in January 2004, and, in February 2004, the jury in
the
case rendered a verdict in favor of one of the Plaintiffs and against us on
the
alleged breach of the loan agreements for tenant improvements and awarded that
Plaintiff damages in the amount of $0.25 million. The jury entered a separate
verdict against DCI in favor of BCM under two mutually exclusive damage models,
for $2.2 million and $25.6 million, respectively. The jury found in favor of
DCI
on the alleged $9 million loan commitment, but did not find in favor of DCI
for
counterclaims made against BCM. The jury also awarded the Plaintiffs attorneys’
fees in the amount of $2.1 million. After considering post-trial motions, the
presiding judge entered judgment in favor of us and DCI, effectively overturning
the verdicts of the jury and dismissing damages awarded by the jury. DCI is
a
former affiliate of ours, and we believe that we will have no obligation for
amounts, if any, awarded to the Plaintiffs as a result of the actions of DCI.
The
Court
of Appeals heard
oral arguments in this matter in April 2006 but has not yet rendered its
decision.
We
and
MERIT Securities Corporation, a subsidiary, are defendants in a putative class
action complaint alleging violations of the federal securities laws in the
United States District Court for the Southern District of New York (“District
Court”) by the Teamsters Local 445 Freight Division Pension Fund ("Teamsters").
The complaint was filed on February 11, 2005, and purports to be a class action
on behalf of purchasers between February 2000 and May 2004 of MERIT Series
12
and MERIT Series 13 securitization financing bonds (the “Bonds”), which are
collateralized by manufactured housing loans. The complaint seeks
unspecified damages and alleges, among other things, misrepresentations in
connection with the issuance of and subsequent reporting on the Bonds. The
complaint initially named our former president and our current Chief Operating
Officer as defendants. On February 10, 2006, the District Court dismissed the
claims against our former president and our current Chief Operating Officer,
but
did not dismiss the claims against us or MERIT (“together, the Corporate
Defendants”). The Corporate Defendants moved to certify an interlocutory appeal
of this order to the United States Court of Appeals for the Second Circuit
(“Second Circuit”). On June 2, 2006, the District Court granted the Corporate
Defendants’ motion. On September 14, 2006, the Second Circuit granted the
Corporate Defendants’ petition to accept the certified order for interlocutory
appeal. On March 2, 2007, the parties completed briefing in the Second Circuit
and are awaiting oral argument. We have evaluated the allegations made in the
complaint and believes them to be without merit and intends to vigorously defend
itself against them
Although
no assurance can be given with respect to the ultimate outcome of the above
litigation, the Company believes the resolution of these lawsuits will not
have
a material effect on our consolidated balance sheet but could materially affect
our consolidated results of operations in a given year or period.
9
ITEM
4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No
matters were submitted to a vote of our shareholders during the fourth quarter
of 2006.
PART
II
|
ITEM
5.
|
MARKET
FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER
MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES
|
Our
common stock is traded on the New York Stock Exchange under the trading symbol
“DX”. The common stock was held by approximately 732 holders of record and
beneficial holders who hold common stock in street name as of December 31,
2006.
During the last two years, the high and low closing stock prices and cash
dividends declared on common stock were as follows:
|
High
|
Low
|
Dividends
Declared
|
||||||||
|
2006:
|
||||||||||
|
First
quarter
|
$
|
6.98
|
$
|
6.50
|
$
|
-
|
||||
|
Second
quarter
|
$
|
6.99
|
$
|
6.57
|
$
|
-
|
||||
|
Third
quarter
|
$
|
7.45
|
$
|
6.60
|
$
|
-
|
||||
|
Fourth
quarter
|
$
|
7.16
|
$
|
6.72
|
$
|
-
|
||||
|
2005:
|
||||||||||
|
First
quarter
|
$
|
8.08
|
$
|
7.12
|
$
|
-
|
||||
|
Second
quarter
|
$
|
7.69
|
$
|
7.10
|
$
|
-
|
||||
|
Third
quarter
|
$
|
7.75
|
$
|
6.85
|
$
|
-
|
||||
|
Fourth
quarter
|
$
|
7.24
|
$
|
6.70
|
$
|
-
|
||||
Any
dividends declared by the Board of Directors have generally been for the purpose
of maintaining our REIT status, and in compliance with requirements set forth
at
the time of the issuance of the Series D Preferred Stock. The stated quarterly
dividend on Series D Preferred Stock is $0.2375 per share. In accordance with
the terms of the Series D Preferred Shares, if we fail to pay two consecutive
quarterly preferred dividends or if we fail to maintain consolidated
shareholders’ equity of at least 200% of the aggregate issue price of the Series
D Preferred Stock, then these shares automatically convert into a new series
of
9.50% senior unsecured notes. Dividends for the preferred stock must be fully
paid before dividends can be paid on common stock. We do not anticipate paying
dividends on our common stock in the foreseeable future given our ability to
offset future taxable income with our net operating loss carryforwards.
We
repurchased 32,560 shares of common stock during 2006 at a cost of $220
thousand. There were no repurchases of our common stock during the fourth
quarter of 2006.
10
STOCK
PERFORMANCE GRAPH
The
following graph demonstrates a five year comparison of cumulative total returns
for shares of Common Stock, the Standard & Poor’s 500 Stock Index (“S&P
500”), and the Bloomberg Mortgage REIT Index. The table below assumes $100 was
invested at the close of trading on December 31, 2001 in the shares of
Common Stock, S&P 500, and the Bloomberg Mortgage REIT Index.
Comparative
Five-Year Total Returns (1)
Dynex
Capital, Inc., S&P 500, and Bloomberg Mortgage REIT Index
(Performance
Results through December 31, 2006)
|
Cumulative
Total Stockholder Returns as of December 31,
|
|||||||||||||||||||
|
Index
|
2001
|
2002
|
2003
|
2004
|
2005
|
2006
|
|||||||||||||
|
Dynex
Capital Inc.
|
$
|
100.00
|
$
|
230.48
|
$
|
290.48
|
$
|
372.38
|
$
|
328.57
|
$
|
337.62
|
|||||||
|
S&P
500 (1)
|
$
|
100.00
|
$
|
77.90
|
$
|
100.25
|
$
|
111.15
|
$
|
116.61
|
$
|
135.03
|
|||||||
|
Bloomberg
Mortgage REIT Index (1)
|
$
|
100.00
|
$
|
122.96
|
$
|
162.21
|
$
|
205.58
|
$
|
172.72
|
$
|
206.10
|
|||||||
|
(1)
|
Cumulative
total return assumes reinvestment of dividends. The source of this
information is Bloomberg and Standard & Poor’s. The factual material
is obtained from sources believed to be
reliable.
|
11
ITEM
6. SELECTED FINANCIAL DATA
The
following table presents selected financial information and should be read
in
conjunction with the audited consolidated financial statements.
|
Years
ended December 31,
|
2006
|
2005
|
2004
|
2003
|
2002
|
|||||||||||
|
(amounts
in thousands except share and per share data)
|
||||||||||||||||
|
Net
interest income(1)
|
$
|
11,087
|
$
|
11,889
|
$
|
23,281
|
$
|
38,971
|
$
|
49,153
|
||||||
|
Net
interest income after recapture of (provision for) loan losses(2)
|
11,102
|
6,109
|
4,818
|
1,889
|
20,670
|
|||||||||||
|
Impairment
charges(3)
|
(60
|
)
|
(2,474
|
)
|
(14,756
|
)
|
(16,355
|
)
|
(18,477
|
)
|
||||||
|
Equity
in loss of joint venture
|
(852
|
)
|
-
|
-
|
-
|
-
|
||||||||||
|
Loss
on capitalization of joint venture
|
(1,194
|
)
|
-
|
-
|
-
|
-
|
||||||||||
|
(Loss)
gain on sale of investments
|
(183
|
)
|
9,609
|
14,490
|
1,555
|
(150
|
)
|
|||||||||
|
Other
income (expense)
|
617
|
2,022
|
(179
|
)
|
436
|
1,397
|
||||||||||
|
General
and administrative expenses
|
(4,521
|
)
|
(5,681
|
)
|
(7,748
|
)
|
(8,632
|
)
|
(9,493
|
)
|
||||||
|
Net
income (loss)
|
$
|
4,909
|
$
|
9,585
|
$
|
(3,375
|
)
|
$
|
(21,107
|
)
|
$
|
(9,360
|
)
|
|||
|
Net
income (loss) to common shareholders
|
$
|
865
|
$
|
4,238
|
$
|
(5,194
|
)
|
$
|
(14,260
|
)
|
$
|
(18,946
|
)
|
|||
|
Net
income (loss) per common share:
|
||||||||||||||||
|
Basic
& diluted
|
$
|
0.07
|
$
|
0.35
|
$
|
(0.46
|
)
|
$
|
(1.31
|
)
|
$
|
(1.74
|
)
|
|||
|
Dividends
declared per share:
|
||||||||||||||||
|
Common
|
$
|
-
|
$
|
-
|
$
|
-
|
$
|
-
|
$
|
-
|
||||||
|
Series
A and B Preferred
|
$
|
-
|
$
|
-
|
$
|
-
|
$
|
0.8775
|
$
|
0.2925
|
||||||
|
Series
C Preferred
|
$
|
-
|
$
|
-
|
$
|
-
|
$
|
1.0950
|
$
|
0.3651
|
||||||
|
Series
D Preferred
|
$
|
0.9500
|
$
|
0.9500
|
$
|
0.6993
|
$
|
-
|
$
|
-
|
||||||
|
December
31,
|
2006
|
2005
|
2004
|
2003
|
2002
|
|||||||||||
|
Investments(4)
|
$
|
403,566
|
$
|
756,409
|
$
|
1,343,448
|
$
|
1,853,675
|
$
|
2,185,746
|
||||||
|
Total
assets(4)
|
466,557
|
805,976
|
1,400,934
|
1,865,235
|
2,205,735
|
|||||||||||
|
Securitization
financing(4)
|
211,564
|
516,578
|
1,177,280
|
1,679,830
|
1,980,702
|
|||||||||||
|
Repurchase
agreements and senior notes
|
95,978
|
133,315
|
70,468
|
33,933
|
-
|
|||||||||||
|
Total
liabilities(4)
|
330,019
|
656,642
|
1,252,168
|
1,715,389
|
1,982,314
|
|||||||||||
|
Shareholders’
equity
|
136,538
|
149,334
|
148,766
|
149,846
|
223,421
|
|||||||||||
|
Number
of common shares outstanding
|
12,131,262
|
12,163,391
|
12,162,391
|
10,873,903
|
10,873,903
|
|||||||||||
|
Average
number of common shares
|
12,140,452
|
12,163,062
|
11,272,259
|
10,873,903
|
10,873,871
|
|||||||||||
|
Book
value per common share
|
$
|
7.78
|
$
|
7.65
|
$
|
7.60
|
$
|
7.55
|
$
|
8.57
|
||||||
(1) Net
interest income declined due to a reduction in our investment portfolio
resulting from sales, transfer of assets and the receipt of principal. The
interest earning investment portfolio averaged $644 million in 2006, $1,039
million in 2005 and $1,658 million in 2004,
(2) Net
interest income after provision for loan losses has increased due to asset
sales
and lower loan loss provisions associated with improved performance of
commercial mortgage loans and the derecognition in 2006 of a securitization
trust backed by commercial loans.
(3) Impairment
charges have declined as a result of the sale of certain underperforming
securities and the stabilization in the value of our delinquent tax lien
investment.
(4) Declines
have been due to the sale and derecognition of investments, receipt of principal
on investments we continue to hold and the derecognition of a securitization
trust backed by commercial mortgage loans during 2006.
12
ITEM
7. MANAGEMENT’S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
SUMMARY
Dynex
Capital, Inc., together with its subsidiaries, is a specialty finance company
organized as a real estate investment trust (REIT) that invests in loans and
securities consisting principally of single-family residential and commercial
mortgage loans. We finance these loans and securities through a combination
of
non-recourse securitization financing, repurchase agreements, and equity. We
employ leverage in order to increase the overall yield on our invested capital.
We seek to generate net interest income (i.e., interest income on investments
in
excess of the cost of financing these assets), which provides acceptable returns
on our invested capital on a risk adjusted basis.
In
recent
years, we have elected to sell certain non-core assets, including investments
in
manufactured housing loans and delinquent property tax receivable portfolios,
as
well as to contribute certain of our interests in a commercial mortgage loan
securitization trust to a joint venture, in order to reduce our exposure to
credit risk on these assets, increase our capital available for new investments,
and strengthen our balance sheet by reducing our overall leverage. Our emphasis
on strengthening the balance sheet and developing investment partnerships,
through joint venture and other means, has been in anticipation of redeploying
our invested capital in more compelling investment opportunities. Given the
continued flat treasury yield curve and the challenging reinvestment environment
in traditional mortgage REIT investment opportunities, we were not able to
make
any significant deployments of our capital during the year. We anticipate that
our recently established joint venture with an affiliate of Deutsche Bank AG
and
the hiring of Sandler O’Neill should assist us in identifying and gaining access
to more compelling investment opportunities in the near future. We believe
that
our strategy of not investing our capital when we do not believe there is an
adequate risk adjusted return has continued to serve our shareholders well
and
protect shareholder value.
We
have
an investment policy which governs the allocation of capital between short-term,
highly liquid investments, investment grade fixed income investments,
subordinate and credit sensitive investments, and strategic investments.
Strategic investments are investments in equity and equity-like securities
of
other companies, including other mortgage REITs. We anticipate making additional
strategic investments in 2007 while using our capital in the interim to pay
down
recourse debt or to invest only in short-term, highly liquid
investments.
During
2006, we earned net income of $4.9 million, and net income to common
shareholders of $0.9 million. Because of differences between GAAP income and
taxable income, we expect to report taxable income in excess of our book net
income but have not yet finalized the tax calculations. We expect to utilize
our
tax NOL carryforwards to offset any taxable income in excess of the Series
D
Preferred Stock dividends paid during 2006 that we would otherwise be required
to distribute and not to make any distribution to common
shareholders.
On
January 9, 2006, we redeemed 1,407,198 shares of the Series D Preferred Stock,
which represented approximately 25% of the then outstanding shares, for
approximately $14.1 million in cash, which represented a redemption price of
$10
per share and $33,000 of preferred dividends that had accrued on those shares
through the redemption date.
We
also
began repurchasing our common shares during the first quarter of 2006 under
the
stock repurchase plan authorized by our Board of Directors. We repurchased
32,560 shares of our outstanding common stock during 2006 at an average cost
of
$6.75 per share and may repurchase up to an additional 979,700 shares under
the
current Board authorization. Subject to the applicable securities laws and
the
terms of the Series D Preferred Stock designation, future repurchases of common
stock will be made at times and in amounts as the Company deems appropriate
and
may be suspended or discontinued at any time.
During
2006, we entered into a joint venture with an affiliate of Deutsche Bank, A.G.
In connection with the formation of the joint venture, we contributed our
interests in $279.0 million of securitized finance receivables (backed by
commercial mortgage loans) which had been pledged to a trust and secured $254.5
million in securitization financing. As a result of the contribution, we
derecognized these amounts from our consolidated balance sheet, and recognized
a
loss of $1.2
13
million
on the transfer of our interests, which had a fair value of approximately $22.0
million when contributed, to the joint venture. Also in connection with the
formation of the joint venture, we agreed to remit cash flows that we receive
on
an additional $182.4 million in securitized finance receivables, which
collateralizes $165.7 million in securitization financing, by recording an
investment in the joint venture and a corresponding liability of $16.3 million
on the date of contribution to reflect this commitment. The $182.4 million
in
securitized finance receivables and the $165.7 million in securitization
financing will continue to be carried in our financial statements. In return
for
the contributions discussed above, we received a 49.875% interest in the joint
venture, an amount equal to that received by the Deutsche Bank affiliate. Our
aggregate initial investment in the joint venture was $38.3 million. We view
this joint venture as a means of diversifying our risk in the investments
contributed to the joint venture, and also as a means of partnering on equal
terms with a much larger organization, which has greater resources and capital
and access to more investment opportunities than we currently do. We believe
that we have largely completed our efforts to diversify our investment portfolio
and do not currently anticipate any additional significant asset sales.
FINANCIAL
CONDITION
Comparative
balance sheet information is set forth in the tables below:
|
December
31,
|
|||||||
|
(amounts
in thousands except per share data)
|
2006
|
2005
|
|||||
|
Investments:
|
|||||||
|
Securitized
finance receivables
|
$
|
346,304
|
$
|
722,152
|
|||
|
Investment
in joint venture
|
37,388
|
-
|
|||||
|
Securities
|
13,143
|
24,908
|
|||||
|
Other
investments
|
2,802
|
4,067
|
|||||
|
Other
loans
|
3,929
|
5,282
|
|||||
|
Securitization
financing
|
211,564
|
516,578
|
|||||
|
Repurchase
agreements
|
95,978
|
133,315
|
|||||
|
Obligation
under payment agreement
|
16,299
|
-
|
|||||
|
Shareholders’
equity
|
136,538
|
149,334
|
|||||
|
Book
value per common share (inclusive of preferred stock liquidation
preference)
|
$
|
7.78
|
$
|
7.65
|
|||
Securitized
Finance Receivables
Securitized
finance receivables include loans secured
by single-family residential and commercial mortgage properties. Securitized
finance receivables decreased to $346.3 million at December 31, 2006
from
$722.2 million at December 31, 2005. This decrease of $375.9 million is
primarily the result of derecognition of $279.0 million of receivables which
were contributed to a joint venture and principal repayments of $93.9 million.
Principal repayments resulted from normal principal amortization of the
underlying loan and loan prepayments due to the favorable interest rate and
real
estate environment.
Investment
in Joint
Venture
We
formed
a joint venture with an affiliate of Deutsche Bank, A.G. in which we have a
49.875% interest during the third quarter of 2006. As discussed above, in
exchange for our interest in the joint venture, we contributed our interests
in
one pool of commercial mortgage loans and executed an agreement with the joint
venture that requires us to remit the cash flows we receive on our interests
in
a second pool of commercial mortgage loans to the joint venture. Our initial
investment in joint venture upon its formation was $38.3 million, which has
been
reduced by $0.9 million for our proportionate share of the joint venture’s
losses through December 31, 2006. The joint venture’s loss was primarily related
to an impairment charge recorded on its investment in commercial mortgage backed
securities.
14
Securities
Securities
are predominantly investment grade single-family residential agency and
non-agency mortgage securities. Securities decreased to $13.1 million at
December 31, 2006
compared
to $24.9 million at December 31, 2005,
primarily as a result of the receipt of principal payments of $11.9 million.
Other
Investments
Other
investments at December 31, 2006
and 2005
consist primarily of a security collateralized by delinquent property tax
receivables and the related real estate owned. Other investments decreased
to
$2.8 million at December 31, 2006
from
$4.1 million at December 31, 2005. This decrease of $1.3 million resulted from
payments of $0.7 million received in 2006 and applied against the carrying
value
of the investment and the sale of $0.5 million of related real estate
owned.
Securitization
Financing
Non-recourse
securitization financing decreased to $211.6 million at December 31,
2006
from
$516.6 million at December 31, 2005. This decrease was primarily a result of
the
derecognition of $253.1 million of non-recourse securitization financing as
a
result of the contribution of the associated securitized finance receivables
to
the joint venture, principal payments of $48.3 million, and
premium amortization of approximately $3.3 million.
Repurchase
Agreements
During
2006, we made net payments of $37.3 million on the repurchase agreement
borrowings resulting in a balance of $96.0 million at December 31,
2006.
Obligation
Under
Payment Agreement
Our
obligation under payment agreement relates to our entry into an agreement that
requires us to remit the cash flows we receive on our interests in a commercial
mortgage loan securitization trust to the joint venture. We contributed this
agreement to the joint venture as part of its initial capitalization in exchange
for a portion of our interest in the joint venture and recorded a liability
of
$16.2 million upon its contribution. The change in the balance from the
contribution date to December 31, 2006 was a result of payments made to the
joint venture under the agreement of $437.6 thousand less the amortization
of
the related discount.
Shareholders’
Equity
Shareholders’
equity decreased from $149.3 million at December 31, 2005 to $136.5 million
at
December 31, 2006.
The
decrease resulted primarily from the redemption of 25% of the then outstanding
shares of Series D Preferred Stock during the first quarter of 2006 for $14.1
million, the repurchase of $0.2 of common stock and dividends declared on the
shares of Series D Preferred Stock of $4.0 million. These decreases were offset
by net income of $4.9 million, and a change in accumulated other comprehensive
income of $0.5 million on certain available-for-sale investments.
Supplemental
Discussion of Investments
We
evaluate and manage our investment portfolio in large part based on our net
capital invested in that particular investment. Net capital invested is
generally defined as the cost basis of the investment net of the associated
financing for that investment. For securitized finance receivables, because
the
securitization financing is recourse only to the finance receivables pledged
and
is, therefore, not our general obligation, the risk on our investment in
securitized finance receivables from an economic point of view is limited to
our
net retained investment in the securitization trust.
15
Below
is
the net basis of our investments as of December 31, 2006. Included in the table
is an estimate of the fair value of our net investment. The fair value of our
net investment in securitized finance receivables is based on the present value
of the projected cash flow from the collateral, adjusted for the impact and
assumed level of future prepayments and credit losses, less the projected
principal and interest due on the securitization financing bonds owned by third
parties. The fair value of securities is based on quotes obtained from
third-party dealers, or, as is the case for the majority of our investments,
calculated by discounting estimated future cash flows at market rates. For
securities and other investments, we may employ leverage to enhance our overall
returns on our net capital invested in these particular assets.
|
December
31, 2006
|
|||||||||||||
|
(amounts
in thousands)
|
Amortized
cost
basis
|
Financing
|
Net
basis
|
Fair
value
of
net basis
|
|||||||||
|
Securitized
finance receivables: (1)
|
|||||||||||||
|
Single
family mortgage loans
|
$
|
118,226
|
$
|
95,978
|
$
|
22,248
|
$
|
22,965
|
|||||
|
Commercial
mortgage loans
|
232,573
|
211,564
|
21,009
|
20,466
|
|||||||||
|
Allowance
for loan losses
|
(4,495
|
)
|
-
|
(4,495
|
)
|
-
|
|||||||
|
346,304
|
307,542
|
38,762
|
43,431
|
||||||||||
|
Securities:
(2)
|
|||||||||||||
|
Investment
grade single-family
|
10,874
|
-
|
10,874
|
11,145
|
|||||||||
|
Non-investment
grade single-family
|
359
|
-
|
359
|
552
|
|||||||||
|
Equity
and other
|
1,280
|
-
|
1,280
|
1,446
|
|||||||||
|
12,513
|
-
|
12,513
|
13,143
|
||||||||||
|
Investment
in joint venture(3)
|
37,388
|
-
|
37,388
|
36,520
|
|||||||||
|
Obligation
under payment agreement(1)
|
-
|
16,299
|
(16,299
|
)
|
(16,541
|
)
|
|||||||
|
Other
loans and investments(2)
|
6,690
|
-
|
6,690
|
7,507
|
|||||||||
|
Net
unrealized gain
|
671
|
-
|
671
|
-
|
|||||||||
|
Total
|
$
|
403,566
|
$
|
323,841
|
$
|
79,725
|
$
|
84,060
|
|||||
|
(1)
|
Fair
values for securitized finance receivables and the obligation under
payment agreement are based on discounted cash flows using assumptions
set
forth in the table below, inclusive of amounts invested in redeemed
securitization financing bonds.
|
|
(2)
|
Fair
values of securities are based on dealer quotes, if available. Where
dealer quotes are not available, fair values are calculated as the
net
present value of expected future cash flows, discounted at 16%. Expected
cash flows for both securitized finance receivables and securities
were
based on the forward LIBOR curve as of December 31, 2006, and incorporate
the resetting of the interest rates on the adjustable rate assets
to a
level consistent with projected prevailing rates. Increases or decreases
in interest rates and index levels from those used would impact the
calculation of fair value, as would differences in actual prepayment
speeds and credit losses versus the assumptions set forth
above.
|
|
(3)
|
Fair
value for investment in joint venture represents Dynex’s share of the
joint assets valued using methodologies and assumptions consistent
with
note 1 above.
|
16
The
following table summarizes the assumptions used in estimating fair value for
our
net investment in securitized finance receivables and the cash flow related
to
those net investments during 2006.
|
Fair
Value Assumptions
|
||||||||||||||||
|
Loan
type
|
Weighted-average
prepayment
speeds
|
Losses
|
Weighted-
average
discount
rate(5)
|
Projected
cash
flow
termination
date
|
(amounts
in thousands)
2006
Cash Flows (1)
|
|||||||||||
|
Single-family
mortgage loans
|
30%
CPR
|
0.2%
annually
|
16%
|
|
Anticipated
final maturity 2024
|
$
|
3,080
|
|||||||||
|
Commercial
mortgage loans(2)
|
(3)
|
|
0.8%
annually
|
16%
|
|
(4)
|
|
$
|
2,342
|
|||||||
(1) Represents
the excess of the cash flows received on the collateral pledged over the cash
flow required to service the related securitization financing.
(2) Includes
loans pledged to two different securitization trusts.
(3) Assumed
CPR speeds generally are governed by underlying pool characteristics, prepayment
lock-out provisions, and yield maintenance provisions. Loans currently
delinquent in excess of 30 days are assumed liquidated in six months at a loss
amount that is calculated for each loan based on its specific
facts.
(4) Cash
flow termination dates are modeled based on the repayment dates of the loans
or
optional redemption dates of the underlying securitization financing
bonds.
(5) Represents
management’s estimate of the market discount rate that would be used by a third
party in valuing these or similar assets.
The
following table presents the Net Basis of Investments included in the “Estimated
Fair Value of Net Investment” table above by their rating classification.
Investments in the unrated and non-investment grade classification primarily
include other loans that have not been given a rating but that are substantially
seasoned and performing loans. Securitization over-collateralization generally
includes the excess of the securitized finance receivable collateral pledged
over the outstanding bonds issued by the securitization trust.
|
December
31,
|
|||||||
|
(amounts
in thousands)
|
2006
|
2005
|
|||||
|
Cash
and cash equivalents
|
$
|
56,880
|
$
|
45,235
|
|||
|
Investments:
|
|||||||
|
AAA
rated and agency MBS fixed income securities
|
$
|
20,876
|
$
|
36,223
|
|||
|
AA
and A rated fixed income securities
|
2,777
|
6,480
|
|||||
|
Unrated
and non-investment grade
|
8,924
|
11,781
|
|||||
|
Securitization
over-collateralization
|
9,760
|
52,032
|
|||||
|
Investment
in joint venture
|
37,388
|
-
|
|||||
|
$
|
79,725
|
$
|
106,516
|
||||
Supplemental
Discussion of Common Equity Book Value
We
believe that our shareholders, as well as shareholders of other companies in
the
mortgage REIT industry, consider book value per common share an important
measure. Our reported book value per common share is based on the carrying
value
our assets and liabilities as recorded in the consolidated financial statements
in accordance with generally accepted accounting principles. A substantial
portion of our assets are carried on a historical, or amortized, cost basis
and
not at estimated fair value. The table included in the “Supplemental Discussion
of Investments” section above compares the amortized cost basis of our
investments to their estimated fair value based on assumptions set forth in
the
table.
We
believe that book value per common share, adjusted to reflect the carrying
value
of investments at their fair value (hereinafter referred to as “Adjusted Common
Equity Book Value”), is also a meaningful measure for our shareholders,
representing effectively our estimated going-concern value. The following table
calculates Adjusted Common Equity Book Value and Adjusted Common Equity Book
Value per share using the estimated fair value information contained in the
“Estimated Fair Value of Net Investment” table above. The amounts set forth in
the table in the Adjusted Common Equity
17
Book
Value column include all of our assets and liabilities at their estimated fair
values, and exclude any value attributable to our tax net operating loss
carryforwards and other matters that might impact our value.
|
December
31, 2006
|
|||||||
|
(amounts
in thousands)
|
Book
Value
|
Adjusted
Book Value
|
|||||
|
Total
investment assets (per table above)
|
$
|
79,725
|
$
|
84,060
|
|||
|
Cash
and cash equivalents
|
56,880
|
56,880
|
|||||
|
Other
assets and liabilities, net
|
(67
|
)
|
(67
|
)
|
|||
|
136,538
|
140,873
|
||||||
|
Less:
Preferred stock liquidation preference
|
(42,215
|
)
|
(42,215
|
)
|
|||
|
Common
equity book value and adjusted book value
|
$
|
94,323
|
$
|
98,658
|
|||
|
Common
equity book value per share and adjusted book value per
share
|
$
|
7.78
|
$
|
8.13
|
|||
Comparative
information on our results of operations is provided in the tables
below:
|
Year
Ended December 31,
|
||||||||||
|
(amounts
in thousands except per share information)
|
2006
|
2005
|
2004
|
|||||||
|
Net
interest income
|
$
|
11,087
|
$
|
11,889
|
$
|
23,281
|
||||
|
Recapture
of (provision for) loan losses
|
15
|
(5,780
|
)
|
(18,463
|
)
|
|||||
|
Net
interest income after recapture of (provision for) loan
losses
|
11,102
|
6,109
|
4,818
|
|||||||
|
Equity
in loss of joint venture
|
(852
|
)
|
-
|
-
|
||||||
|
Loss
on capitalization of joint venture
|
(1,194
|
)
|
-
|
-
|
||||||
|
Impairment
charges
|
(60
|
)
|
(2,474
|
)
|
(14,756
|
)
|
||||
|
(Loss)
gain on sales of investments
|
(183
|
)
|
9,609
|
14,490
|
||||||
|
Other
income (expense)
|
617
|
2,022
|
(179
|
)
|
||||||
|
General
and administrative expenses
|
(4,521
|
)
|
(5,681
|
)
|
(7,748
|
)
|
||||
|
Net
income (loss)
|
4,909
|
9,585
|
(3,375
|
)
|
||||||
|
Preferred
stock charge
|
(4,044
|
)
|
(5,347
|
)
|
(1,819
|
)
|
||||
|
Net
income (loss) to common shareholders
|
$
|
865
|
$
|
4,238
|
$
|
(5,194
|
)
|
|||
|
Basic
& diluted net income (loss) per common share
|
$
|
0.07
|
$
|
0.35
|
$
|
(0.46
|
)
|
|||
|
Dividends
declared per share:
|
||||||||||
|
Common
|
$
|
-
|
$
|
-
|
$
|
-
|
||||
|
Series
D Preferred
|
$
|
0.9500
|
$
|
0.9500
|
$
|
0.6993
|
||||
2006
Compared to 2005
Net
income decreased in 2006 by $4.7 million, to $4.9 million from $9.6 million
in
2005, as a result of a decrease in (loss) gain on sales of investments of $9.8
million primarily due to gains recognized in 2005 on the sale and derecognition
of two securitization trusts backed by manufactured housing loans for which
there were no comparable transactions in 2006. Net income also declined from
reductions in net interest income of $0.8 million, and a $1.4 million decrease
in other income. These decreases in net income were partially offset by a $5.8
million decrease in recapture of (provision for) loan losses, a decrease in
impairment charges of $2.4 million, and a $1.2 million decrease in general
and
administrative expenses.
Net
income to common shareholders decreased by $3.4 million in 2006 from $4.2
million in 2005 to $0.9 million in 2006. The decrease in net income to common
shareholders was due to the above mentioned decrease in net income of $4.7
million, offset by a decrease in preferred stock charge of $1.3 million.
18
Net
interest income for the year ended December 31, 2006 decreased to $11.1 million,
or 6.7%, from $11.9 million for the same period in 2005. This decline is a
result of a decline in average interest-earning assets, primarily related to
the
derecognition of $279.0 million of securitized finance receivables and the
related securitization financing as a result of the contribution of our
interests in a pool of commercial mortgage loans to a joint venture during
2006.
This decline in average interest-earning assets was partially offset by an
increase in the net interest spread on interest-earning assets. Net interest
spread on non-cash investments increased to 0.59% in 2006 from 0.35% in 2005.
The increase in net interest spread is due to unexpected prepayment of
commercial loans in 2006 and interest rates on single family loans that reset
during 2006 while rates on the associated financing remained flat during the
year. See further discussion below as to changes in the net interest spread
on
our investment portfolio during 2006.
Net
interest income after provision for loan losses increased as a result of a
decline in the provision for loan losses of $5.8 million from 2005 to 2006.
The
decrease in provision for loan losses was due primarily to an increase in
reserves in 2005 for a large commercial loan that became delinquent in 2005;
whereas, there were no new significant delinquent commercial loans in 2006.
There was a small amount provided for loan losses on single-family loans of
$0.4
million during 2006 as these loans continue to season.
Impairment
charges decreased from $2.5 million in 2005 to $0.1 million in 2006. Impairment
charges for 2005 included $1.7 million on a debt security collateralized by
delinquent property tax receivables.
We
recognized a loss of $1.2 million for 2006 on the capitalization of a joint
venture related to our contribution of a commercial loan securitization to
the
joint venture, and the creation of an obligation under payment agreement in
connection with the formation of the joint venture as discussed above under
“Financial Condition.” The contribution of our interests in this securitization
resulted in the derecognition of approximately $279.0 million of securitized
finance receivables and $253.1 million of related securitization
financing.
General
and administrative expense decreased by $1.2 million from $5.7 million to $4.5
million for the year ended December 31, 2005 and 2006, respectively. General
and
administrative expenses decreased during 2006 primarily due to a reduction
of
$0.6 million in legal and litigation expenses defending ourselves in various
suits and a decrease in salary and benefits related to reductions in staffing
at
our tax lien servicing operation in Pennsylvania.
We
reported a preferred stock charge of $4.0 million for the year ended December
31, 2006, which represents an decrease of $1.3 million from the $5.3 million
reported for the year ended December 31, 2005. The preferred stock charge for
2006 decreased due to the redemption of 1,407,198 shares of Series D Preferred
Stock in January 2006, which represented 25% of the then outstanding shares
of
such stock, which is the only class of our preferred stock
outstanding.
2005
Compared to 2004
Net
income increased in 2005 by $13.0 million, to $9.6 million in 2005 from a loss
of $3.4 million in 2004, as a result of a decrease in provision for loan losses
of $12.7 million, decreased impairment charges of $12.3 million, decreased
general and administrative expenses of $2.1 million and $2.0 million of other
income. These increases in income were partially offset by a decrease of net
interest income of $11.4 million and a decrease in gain on sales of investments
of $4.9 million. Net income to common shareholders increased by $9.4 million
in
2005, from a loss of $5.2 million in 2004 to income of $4.2 million in 2005.
The
increase in net income to common shareholders was due to increased net income
of
$9.6 million, offset by an increase in preferred stock charges of $3.5 million.
Net
interest income for the year ended December 31, 2005 decreased to $11.9 million,
from $23.3 million for the same period in 2004. Net interest income decreased
$11.4 million, or 48.9%, as a result of a decline in average interest-earning
assets and a decrease in the net interest spread on interest-earning assets.
Average interest earning assets decreased in 2005 due to the sale of
investments, including $370.1 million of securitized finance receivables, $7.3
million of equity securities and $1.7 million of other loans. Net interest
spread was 0.39% in 2005 versus 1.09% in 2004, and decreased in 2005 as a result
of sales and prepayments of higher coupon assets, the proceeds of which have
been reinvested in lower-yielding cash equivalents, and also decreased due
in
part to increasing borrowing costs from both increasing LIBOR rates and
repayment of lower-cost securitization financing bonds pursuant to the terms
of
the securitization trust. See further discussion below as to changes in the
net
interest spread on our investment portfolio during 2005.
19
Net
interest income after provision for loan losses increased as a result of the
decline of the provision for loan losses in 2005 compared to 2004 of $12.7
million. Provision for loan losses decreased to $5.8 million in 2005, from
$18.5
million in 2004. The decrease of $12.7 million from 2004 was primarily due
to
the sale in late 2004 and early 2005 of our investment in manufactured housing
loans. Provision for manufactured housing loan losses decreased by $15.4 million
in 2005 while commercial and single family loan loss reserve provisions
increased by $2.1 million and $0.7 million, respectively.
Impairment
charges decreased from $14.8 million in 2004 to $2.5 million in 2005. Impairment
charges for 2004 included $9.1 million on manufactured housing loan securities
and $4.9 million on delinquent property tax receivable securities. No impairment
charges were recorded on manufactured housing securities as a result of their
sale in 2005. Impairment charges in 2005 included $1.7 million on a debt
security collateralized by delinquent property tax receivables.
Gain
on
sale of investments for 2005 resulted primarily from a net gain of $8.2 million
recognized on the sale of our interests in securitization trusts collateralized
primarily by manufactured housing loans and securities backed by manufactured
housing loans, for cash proceeds of $8.0 million. The sale of our
interests in those securitizations resulted in the de-recognition of
approximately $367.2 million of securitized finance receivables and $363.9
million of related securitization financing. We also recorded a gain of
$1.4 million on the sale of approximately $2.0 million in mezzanine loans for
net proceeds of $3.4 million.
General
and administrative expense decreased by $2.0 million from $7.7 million to $5.7
million for the year ended December 31, 2004 and 2005, respectively. General
and
administrative expenses decreased during 2005 with the sale in October 2004
of
the Ohio delinquent property tax receivable servicing operation and through
continued downsizing in the operation. General and administrative expenses
in
2004 included $1.0 million of litigation related expenses versus $0.8 million
in
2005. General and administrative expenses in 2005 included approximately $291
increase in professional fees related to the audit of our 2004 financial
statements and the subsequent termination of our independent accounting firm.
We
reported a preferred stock charge of $5.3 million for the year ended December
31, 2005, which represents an increase of $3.5 million from the $1.8 million
reported for the year ended December 31, 2004. Preferred stock charge for 2005
includes a full year’s dividend on the Series D preferred stock. In 2004,
dividends on the preferred stock outstanding was partially offset by the
preferred stock benefit resulting from the recapitalization completed in
2004.
20
Average
Balances and Effective Interest Rates
The
following table summarizes the average balances of interest-earning assets
and
their average effective yields, along with the average interest-bearing
liabilities and the related average effective interest rates, for each of the
periods presented. Assets that are on non-accrual status are excluded from
the
table below for each period presented.
|
Year
ended December 31,
|
|||||||||||||||||||
|
2006
|
2005
|
2004
|
|||||||||||||||||
|
(amounts
in thousands)
|
Average
Balance
|
Effective
Rate
|
Average
Balance
|
Effective
Rate
|
Average
Balance
|
Effective
Rate
|
|||||||||||||
|
Interest-earning
assets(1):
|
|||||||||||||||||||
|
Securitized
finance receivables(2)(3)
|
$
|
586,113
|
7.88%
|
|
$
|
931,777
|
7.19%
|
|
$
|
1,601,553
|
7.41%
|
|
|||||||
|
Other
interest-bearing assets
|
23,823
|
8.86%
|
|
83,767
|
5.31%
|
|
32,304
|
8.28%
|
|
||||||||||
|
Total
interest-earning assets
|
$
|
609,936
|
7.92%
|
|
$
|
1,015,544
|
7.10%
|
|
$
|
1,633,857
|
7.43%
|
|
|||||||
|
Interest-bearing
liabilities:
|
|||||||||||||||||||
|
Non-recourse securitization
financing(3)
|
$
|
401,050
|
8.08%
|
|
$
|
735,910
|
7.40%
|
|
$
|
1,499,772
|
6.40%
|
|
|||||||
|
Repurchase
agreements
|
114,252
|
5.12%
|
|
151,328
|
3.59%
|
|
21,040
|
1.75%
|
|
||||||||||
|
Senior
notes
|
-
|
-%
|
|
-
|
-%
|
|
2,020
|
9.90%
|
|
||||||||||
|
Total
interest-bearing liabilities
|
$
|
515,302
|
7.42%
|
|
$
|
887,238
|
6.75%
|
|
$
|
1,522,832
|
6.34%
|
|
|||||||
|
Net
interest spread(3)
|
0.50%
|
|
0.35%
|
|
1.09%
|
|
|||||||||||||
|
Net
yield on average interest-earning assets(3)
|
1.64%
|
|
1.20%
|
|
1.51%
|
|
|||||||||||||
|
Cash
and cash equivalents
|
$
|
40,881
|
4.93%
|
|
$
|
29,962
|
2.56%
|
|
$
|
24,529
|
1.37%
|
|
|||||||
|
Net
yield on average interest-earning assets(3),
including
cash and cash equivalents
|
1.84%
|
|
1.24%
|
|
1.51%
|
|
|||||||||||||
(1) Average
balances exclude adjustments made in accordance with SFAS No. 115, “Accounting
for Certain Investments in Debt and Equity Securities,” to record available for
sale securities at fair value.
(2) Average
balances exclude funds held by trustees of $172, $218 and $342 for the years
ended December 31, 2006, 2005 and 2004, respectively.
(3) Effective
rates are calculated excluding non-interest related non-recourse securitization
financing expenses and provision for credit losses.
2006
compared to 2005
The
net
interest spread for the year ended December 31, 2006 increased to 50 basis
points from 35 basis points for the year ended December 31, 2005. This increase
in the net interest spread is due to non-recurring income on liquidated and
delinquent commercial loans in 2006. In addition during 2006, the increases
in
the average rate on the securitization financing, which were financing
variable-rate single family loans, slowed while interest rates on the loans
reset higher during the year, which helped increase the net interest spread.
The
overall yield on interest-earning assets, excluding cash and cash equivalents,
increased to 7.92% for the year ended December 31, 2006 from 7.10% for the
same
period in 2005 primarily as a result of an increase of approximately 150 basis
points in the weighted average coupon on our securitized single-family mortgage
loans, the majority of which have an adjustable rate based on LIBOR, and as
a
result of the derecognition of $279.0 million in commercial mortgage loans
contributed to a joint venture during 2006. The effective rate on
interest-bearing liabilities increased from 6.75% to 7.42% as a result of the
overall increase in market interest rates. Approximately 20% of our
interest-bearing liabilities reprice monthly and are indexed to one-month LIBOR,
which averaged 5.10% for 2006, compared to 3.39% for 2005. The effect of
increasing market rates was muted by the derecognition of approximately $253.1
million of non-recourse securitization financing, which was financing a pool
of
commercial mortgage loans our interests in which were contributed to a joint
venture.
2005
compared to 2004
The
net
interest spread for the year ended December 31, 2005 decreased to 35 basis
points from 109 basis points for the year ended December 31, 2004. This decrease
in the net interest spread is due to declining yields on interest-earning
assets, due principally to decreased interest income as a result of the sale
of
approximately $370.1 million of securitized finance receivables during the
second quarter of 2005 and the sale of approximately $219.2 million in
receivables during the fourth quarter of 2004. The net interest spread
contribution for the receivables sold was 2 basis points and 18 basis points
for
21
the
three
and twelve month periods ended December 31, 2005 and 18 basis points and 37
basis points, respectively during the three and twelve month periods ended
December 31, 2004. The proceeds from the sale of these investments have
generally been invested in cash and short-term securities. In addition during
2005, the securitization financing that backed variable-rate single family
loans
was replaced with LIBOR-based repurchase agreement financing, which is recourse
to us, and which carries a weighted average spread to LIBOR of 10 basis points.
The securitization financing had an effective spread to LIBOR of 32 basis
points. The net interest spread reflects the reduce yield on increased
investments in cash and cash equivalents and also reflects the amortization
of
premiums and discounts on both the assets and the liabilities.
The
overall yield on interest-earnings assets, excluding cash and cash equivalents,
decreased to 7.10% for the year ended December 31, 2005 from 7.43% for the
same
period in 2004. The overall yield declined by 33 basis points as higher rate
loans continued to be prepaid during the period. In addition to declining asset
yields, interest-bearing liability costs increased from 6.34% to 6.75% as a
result of the overall increase in market interest rates, including LIBOR rates,
and the repayment of lower-cost securitization financing bonds pursuant to
the
terms of the securitization trust. Approximately 20% of our interest-bearing
liabilities re-price monthly and are indexed to one-month LIBOR, which averaged
3.39% for 2005, compared to 1.50% for 2004.
Rates
and Volume
The
following table summarizes the amount of change in interest income and interest
expense due to changes in interest rates versus changes in volume:
|
2006
to 2005
|
2005
to 2004
|
||||||||||||||||||
|
(amounts
in thousands)
|
Rate
|
Volume
|
Total
|
Rate
|
Volume
|
Total
|
|||||||||||||
|
Securitized
finance receivables
|
$
|
5,973
|
$
|
(26,805
|
)
|
$
|
(20,832
|
)
|
$
|
(3,409
|
)
|
$
|
(48,202
|
)
|
$
|
(51,611
|
)
|
||
|
Other
interest-bearing assets
|
1,161
|
(4,103
|
)
|
(2,942
|
)
|
(785
|
)
|
3,161
|
2,376
|
||||||||||
|
Total
interest income
|
7,134
|
(30,908
|
)
|
(23,774
|
)
|
(4,194
|
)
|
(45,041
|
)
|
(49,235
|
)
|
||||||||
|
Securitization
financing
|
4,577
|
(26,675
|
)
|
(22,098
|
)
|
13,195
|
(54,776
|
)
|
(41,581
|
)
|
|||||||||
|
Senior
notes
|
-
|
-
|
-
|
(100
|
)
|
(100
|
)
|
(200
|
)
|
||||||||||
|
Repurchase
agreements
|
2,096
|
(1,591
|
)
|
505
|
460
|
4,601
|
5,061
|
||||||||||||
|
Total
interest expense
|
6,673
|
(28,266
|
)
|
(21,593
|
)
|
13,555
|
(50,275
|
)
|
(36,720
|
)
|
|||||||||
|
Net
interest income
|
$
|
461
|
$
|
(2,642
|
)
|
$
|
(2,181
|
)
|
$
|
(17,749
|
)
|
$
|
5,234
|
$
|
(12,515
|
)
|
|||
Note: The
change in interest income and interest expense due to changes in both volume
and
rate, which cannot be segregated, has been allocated proportionately to the
change due to volume and the change due to rate. This table excludes
non-interest related securitization financing expense, other interest expense
and provision for credit losses.
Credit
Exposures
As
discussed in ITEM 1A - RISK FACTORS above, the predominate risk in our
investment portfolio today is credit risk (i.e., the risk that we will not
receive all amounts contractually due us on an investment as a result of a
default by the borrower and the resulting deficiency in proceeds from the
liquidation of the collateral securing the obligation). In many instances,
we
retained the “first-loss” credit risk on pools of loans and securities that we
have securitized. In addition to our retained interests in certain
securitizations, we also have credit risk on approximately $8.9 million of
unrated or non-investment grade securities and loans.
The
following table summarizes the aggregate principal amount of our investments
in
securitized finance receivables and subordinate securities; the direct credit
exposure retained by us from those investments (represented by the amount of
over-collateralization pledged and subordinated securities owned by us), net
of
the credit reserves and discounts maintained by us for such exposure; and the
actual credit losses incurred for each year. Our credit exposure, net of credit
reserves has sequentially decreased from year-to-year as a result of the sale
and derecognition of investments, and as a result of additional provisions
for
loan losses on loans where we have credit risk. From 2004 to 2006, we sold
assets or assets were otherwise paid down by $935 million, resulting in the
reduction of our credit exposure by $17.5 million.
22
Credit
Reserves and Actual Credit Losses
(amounts
in millions)
|
Outstanding
Loan Principal Balance
|
Credit
Exposure, Net of Credit Reserves
|
Actual
Credit
Losses
|
Credit
Exposure, Net of Credit Reserves to Outstanding Loan
Balance
|
||||||||||
|
2004
|
$
|
1,296.5
|
$
|
39.9
|
$
|
25.1
|
3.08
|
%
|
|||||
|
2005
|
$
|
751.1
|
$
|
28.9
|
$
|
3.6
|
3.85
|
%
|
|||||
|
2006
|
$
|
361.3
|
$
|
22.4
|
$
|
7.2
|
6.20
|
%
|
|||||
Delinquencies
as a percentage of all outstanding securitized finance receivables balance
have
decreased to 4.4% at December 31, 2006 from 7.0% at December 31, 2005 primarily
as a result of certain commercial loans that were delinquent in 2005 being
paid-off during 2006 and the continued strong performance of the residential
real estate market. We monitor and evaluate our exposure to credit losses and
have established reserves based upon anticipated losses, general economic
conditions and trends in the investment portfolio. At December 31, 2006,
management believes the level of credit reserves is appropriate for currently
existing losses. The following tables summarize single-family mortgage loan
and
commercial mortgage loan delinquencies as a percentage of the outstanding
commercial securitized finance receivables balance for those securities in
which
we have retained a portion of the direct credit risk.
Single
family mortgage loan delinquencies as a percentage of the outstanding loan
balance increased by approximately 2.3% to 9.84% at December 31, 2006 from
7.50%
at December 31, 2005. The increase in delinquencies occurred in loans whose
losses are covered by pool insurance, while delinquencies on non-pool insured
loans actually decreased from 2005 to 2006.
Single-Family
Loan Delinquency Statistics
|
December
31,
|
30
to 59 days
delinquent
|
60
to 89 days
delinquent
|
90
days and over
delinquent
(1)
|
Total
|
|
2004
|
4.30%
|
1.06%
|
3.35%
|
8.71%
|
|
2005
|
4.28%
|
0.62%
|
2.60%
|
7.50%
|
|
2006
|
4.90%
|
1.89%
|
3.05%
|
9.84%
|
For
commercial mortgage loans, the delinquencies as a percentage of the outstanding
securitized finance receivables balance have decreased to 1.36% at December
31,
2006 from 6.90% at December 31, 2005 primarily due to eight delinquent
commercial loans which resolved during 2006 and the derecognition of one of
our
three commercial mortgage loan securitizations also in 2006 which had two
significant delinquent loans at December 31, 2005.
Commercial
Mortgage Loan Delinquency Statistics (1)
|
December
31,
|
30
to 59 days
delinquent
|
60
to 89 days
delinquent
|
90
days and over
delinquent
(1)
|
Total
|
|
2004
|
-%
|
-%
|
7.96%
|
7.96%
|
|
2005
|
-%
|
0.25%
|
6.65%
|
6.90%
|
|
2006
|
-%
|
-%
|
1.36%
|
1.36%
|
(1) Includes
foreclosures and real estate owned.
23
CRITICAL
ACCOUNTING POLICIES
The
discussion and analysis of our financial condition and results of operations
are
based in large part upon our consolidated financial statements, which have
been
prepared in conformity with accounting principles generally accepted in the
United States of America. The preparation of the financial statements requires
management to make estimates and assumptions that affect the reported amounts
of
assets and liabilities and disclosure of contingent assets and liabilities
at
the date of the financial statements and the reported amounts of revenue and
expenses during the reported period. Actual results could differ from those
estimates.
Critical
accounting policies are defined as those that are reflective of significant
judgments or uncertainties, and which may result in materially different results
under different assumptions and conditions, or the application of which may
have
a material impact on our financial statements. The following are our critical
accounting policies.
Consolidation
of Subsidiaries. The
consolidated financial statements represent our accounts after the elimination
of inter-company transactions. We consolidate entities in which we own more
than
50% of the voting equity and control of the entity does not rest with others.
We
follow the equity method of accounting for investments with greater than 20%
and
less than a 50% interest in partnerships and corporate joint ventures or when
we
are able to influence the financial and operating policies of the investee
but
own less than 50% of the voting equity. For all other investments, the cost
method is applied.
Securitization.
We
have
securitized loans and securities in a securitization financing transaction
by
transferring financial assets to a wholly owned trust, and the trust issues
non-recourse bonds pursuant to an indenture. Generally, we retain some form
of
control over the transferred assets, and/or the trust is not deemed to be a
qualified special purpose entity. In instances where the trust is deemed not
to
be a qualified special purpose entity, the trust is included in our consolidated
financial statements. A
transfer of financial assets in which we surrender control over those assets
is
accounted for as a sale to the extent that consideration other than beneficial
interests in the transferred assets is received in exchange. For
accounting and tax purposes, the loans and securities financed through the
issuance of bonds in a securitization financing transaction are treated as
our
assets, and the associated bonds issued are treated as our debt as
securitization financing. We may retain certain of the bonds issued by the
trust, and we generally will transfer collateral in excess of the bonds issued.
This excess is typically referred to as over-collateralization. Each
securitization trust generally provides us with the right to redeem, at our
option, the remaining outstanding bonds prior to their maturity
date.
Impairments.
We
evaluate all securities in our investment portfolio for other-than-temporary
impairments. A security is generally defined to be other-than-temporarily
impaired if, for a maximum period of three consecutive quarters, the carrying
value of such security exceeds its estimated fair value and we estimate, based
on projected future cash flows or other fair value determinants, that the fair
value will remain below the carrying value for the foreseeable future. If an
other-than-temporary impairment is deemed to exist, we record an impairment
charge to adjust the carrying value of the security down to its estimated fair
value. In certain instances, as a result of the other-than-temporary impairment
analysis, the recognition or accrual of interest will be discontinued and the
security will be placed on non-accrual status.
We
consider an investment to be impaired if the fair value of the investment is
less than its recorded cost basis. Impairments of other investments are
generally considered to be other-than-temporary when the fair value remains
below the carrying value for three consecutive quarters. If the impairment
is
determined to be other-than-temporary, an impairment charge is recorded in
order
to adjust the carrying value of the investment to its estimated
value.
Allowance
for Loan Losses.
We have
credit risk on loans pledged in securitization financing transactions and
classified as securitized finance receivables in our investment portfolio.
An
allowance for loan losses has been estimated and established for currently
existing probable losses. Factors considered in establishing an allowance
include current loan delinquencies, historical cure rates of delinquent loans,
and historical and anticipated loss severity of the loans as they are
liquidated. The allowance for loan losses is evaluated and adjusted periodically
by management based on the actual and estimated timing and amount of probable
credit losses, using the above factors, as well as industry loss experience.
Where loans are considered homogeneous, the allowance for losses is established
and evaluated on a pool basis. Otherwise, the allowance for losses is
established and evaluated on a loan-specific basis. Provisions made to increase
the allowance are a current period expense to operations. Single-family loans
are considered impaired when they are 60-days past due. Commercial mortgage
loans are evaluated on an individual basis for impairment. Generally, a
commercial loan with a debt service coverage ratio of less than one is
considered impaired. However, based on a commercial loan’s details, commercial
24
loans
with a debt service ratio less than one may not be considered impaired;
conversely, commercial loans with a debt service coverage ratio greater than
one
may be considered impaired. Certain of the commercial mortgage loans are covered
by loan guarantees that limit our exposure on these loans. The level of
allowance for loan losses required for these loans is reduced by the amount
of
applicable loan guarantees. Our actual credit losses may differ from the
estimates used to establish the allowance.
Low-income
housing tax credit (LIHTC) properties account for 85% of Dynex’s commercial loan
portfolio. Section 42 of the tax code provides tax credits to investors in
projects to construct or substantially rehabilitate properties that provide
housing for qualifying low income families. Property owners must comply with
income and rental restrictions over a minimum 15-year compliance period and
in
return, they are entitled to receive a tax credit of 4% to 9% (a
dollar-for-dollar reduction of federal taxes) for each taxable year over a
period of 10 years. If a property owner fails to maintain compliance with the
tax credit restrictions, the owner would face the partial recapture of tax
credits already taken. In addition, a property owner is incented to support
poorly performing properties because a default on a mortgage loan that leads
to
a foreclosure would result in the prior owner losing any future tax credits
and
the recapture of any tax credits already taken. For these reasons, we believe
that qualifying tax credit properties will be supported by the property owner
through its 15-year compliance period. These properties are monitored and loan
loss reserve requirements reflect any poorly performing property which is
nearing the end of that compliance period. Loans on LIHTC properties account
for
approximately $190,500 of the $225,500 of commercial loan collateral. The deal
structures in which the LIHTC loans reside maintain an interest in the
properties covered by the loan. Possible loan losses would be mitigated by
the
value of the underlying collateral. All commercial loan properties are monitored
for performance and loan loss provisions are made for those loans that are
considered to be likely to incur a loss.
LIQUIDITY
AND CAPITAL RESOURCES
We
have
historically financed our operations from a variety of sources. Our primary
source of funding for our operations today is the cash flow generated from
the
investment portfolio, which includes net interest income and principal payments
and prepayments on these investments. From the cash flow on our investment
portfolio, we fund our operating overhead costs, including the servicing of
our
delinquent property tax receivables, pay the dividend on the Series D preferred
stock and service the remaining recourse debt. Our investment portfolio
continues to provide positive cash flow, which can be utilized by us for
reinvestment or other purposes. We have primarily utilized our cash flow during
2006 to pay down repurchase agreement financing and redeem a portion of our
Series D Preferred Stock. Relative to others in our industry, our capital base
is less leveraged, and we have much greater financial flexibility and
resources.
The
cash
flow from our investment portfolio for the year and quarter ended December
31,
2006 was approximately $34.0 million and $5.8 million, respectively, excluding
proceeds from the sales of investments and the above refunding of repurchase
agreements. Such cash flow is after payment of principal and interest on the
associated securitization financing (i.e.,
non-recourse debt) outstanding. We also sold investments in 2006 which generated
net cash proceeds of $3.3 million.
Excluding
any cash flow derived from the sale or re-securitization of assets and assuming
that short-term interest rates remain stable, we anticipate that, absent
reinvestment of our capital in higher yielding investments, the cash flow from
our investment portfolio will continue to decline in 2007 compared to 2006
as
the investment portfolio continues to pay down. We do, however, anticipate,
that
we will have sufficient cash flow from our investment portfolio to meet all
of
our obligations on both a short-term and long-term basis.
Our
cash
flow from our investment portfolio is subject to fluctuation due to changes
in
interest rates, repayment rates and default rates and related losses. We
currently have a substantial portion of our available capital invested in cash
or highly liquid, short-term instruments. At December 31, 2006, this amount
was
$56.9 million, which represents a significant portion of our overall equity
capital base. We intend to maintain high levels of liquidity for the foreseeable
future given the lack of compelling reinvestment opportunities as a result
of
the absolute low level of interest rates, the flat yield curve, and the
historically tight spreads on fixed income instruments.
25
We
redeemed 25% of our Series D Preferred Stock in January 2006. This redemption
reduced the Series D Preferred Stock outstanding by approximately $14.1 million,
saving us approximately $1.3 million in dividends annually. The Board of
Directors of Dynex also approved the redemption of up to one million shares
of
common stock of Dynex upon completion of the redemption of the Series D
Preferred Stock. We may also redeem additional shares of our common stock if
alternative uses of the capital are not available and if accretive to book
value
per common share.
Through
limited-purpose finance subsidiaries, we have issued non-recourse debt in the
form of non-recourse securitization financing to fund the majority of our
investment portfolio. The obligations under the securitization financing are
payable solely from the securitized finance receivables and are otherwise
non-recourse to us. The maturity of each class of securitization financing
is
directly affected by the rate of principal prepayments on the related collateral
and is not subject to margin call risk. Each series is also subject to
redemption according to specific terms of the respective indentures, generally
on the earlier of a specified date or when the remaining balance of the bonds
equals 35% or less of the original principal balance of the bonds. At December
31, 2006, we have $211.6 million of non-recourse securitization financing
outstanding, all of which carries a fixed rate of interest.
In
2005,
securitization financing bonds were redeemed with cash and repurchase agreement
financing secured by the bonds. As a result of paydowns on the associated
securitized finance receivables, the remaining balance of the securitization
financing bonds at the end of 2006 was $108.7 million, which was financed with
cash of $12.7 million and repurchase agreement financing of approximately $96.0
million. As the redeemed bonds have not been legally extinguished, we could
reissue these bonds, generating estimated proceeds in excess of $108.7 million,
which would be used to repay the repurchase agreement financing, and the balance
of which would increase our cash and cash equivalents.
Contractual
Obligations and Commitments
The
following table shows expected cash payments on our contractual obligations
as
of December 31, 2006 for the following time periods:
|
Payments
due by period
|
||||||||||||||||
|
Contractual
Obligations(1)
|
Total
|
<
1 year
|
1-3
years
|
3-5
years
|
>
5 years
|
|||||||||||
|
Long-Term
Debt Obligations:(2)
|
||||||||||||||||
|
Non-recourse
securitization financing(3)
|
$
|
317,808
|
$
|
44,118
|
$
|
84,116
|
$
|
148,964
|
$
|
40,610
|
||||||
|
Repurchase
agreements
|
95,978
|
95,978
|
-
|
-
|
-
|
|||||||||||
|
Operating
lease obligations
|
209
|
145
|
64
|
-
|
-
|
|||||||||||
|
Mortgage
servicing obligations
|
3,980
|
414
|
933
|
569
|
2,064
|
|||||||||||
|
Obligation
under payment agreement(4)
|
22,422
|
1,542
|
4,147
|
16,733
|
-
|
|||||||||||
|
Total
|
$
|
440,397
|
$
|
142,197
|
$
|
89,260
|
$
|
166,266
|
$
|
42,674
|
||||||
|
(1)
|
As
the master servicer for certain of the series of non-recourse
securitization financing securities which we have issued, and certain
loans which have been securitized but for which we are not the master
servicer, we have an obligation to advance scheduled principal and
interest on delinquent loans in accordance with the underlying servicing
agreements should the primary servicer fail to make such advance.
Such
advance amounts are generally repaid in the same month as they are
made,
or shortly thereafter, and the contractual obligation with respect
to
these advances is excluded from the above
table.
|
|
(2)
|
Amounts
presented for Long-Term Debt Obligations include estimated principal
and
interest on the related
obligations.
|
|
(3)
|
Securitization
financing is non-recourse to us as the bonds are payable solely from
loans
and securities pledged as securitized finance receivables. Payments
due by
period were estimated based on the principal repayments forecast
for the
underlying loans and securities, substantially all of which is used
to
repay the associated securitization financing
outstanding.
|
|
(4)
|
We
entered an agreement to contribute to a joint venture all of the
net
cashflows from our interests in a pool of securitized commercial
mortgage
loans. By agreement, the joint venture is scheduled to dissolve no
later
than 2011.
|
Off-Balance
Sheet Arrangements
We
do not
believe that any off-balance sheet arrangements exist that are reasonably likely
to have a material current or future effect on our financial condition, changes
in financial condition, revenues or expenses, results of operations, liquidity,
capital expenditures or capital resources.
26
Selected
Quarterly Results
The
following tables present our unaudited selected quarterly results for 2006
and
2005.
Summary
of Selected Quarterly Results (unaudited)
(amounts
in thousands except share and per share data)
|
Year
Ended December 31, 2006
|
First
Quarter
|
Second
Quarter
|
Third
Quarter
|
Fourth
Quarter
|
|||||||||
|
Operating
results:
|
|||||||||||||
|
Total
interest income
|
$
|
14,766
|
$
|
14,192
|
$
|
13,000
|
$
|
8,491
|
|||||
|
Net
interest income after provision for loan losses
|
2,407
|
2,543
|
3,102
|
3,050
|
|||||||||
|
Net
income (loss)
(2)
|
1,213
|
1,615
|
(215
|
)
|
2,297
|
||||||||
|
Basic
and diluted net income (loss) per common share
|
0.01
|
0.05
|
(0.10
|
)
|
0.11
|
||||||||
|
Cash
dividends declared per common share
|
-
|
-
|
-
|
-
|
|||||||||
|
Average
interest-earning assets
(4)
|
764,682
|
713,000
|
588,306
|
375,152
|
|||||||||
|
Average
borrowed funds
|
635,877
|
609,813
|
502,842
|
316,388
|
|||||||||
|
Net
interest spread on interest-earning assets
(3)
|
(0.13
|
)%
|
0.14
|
%
|
0.83
|
%
|
2.00
|
%
|
|||||
|
Average
asset yield
|
7.59
|
%
|
7.68
|
%
|
8.39
|
%
|
8.28
|
%
|
|||||
|
Net
yield on average interest-earning assets(1)
|
1.18
|
%
|
1.22
|
%
|
1.90
|
%
|
2.95
|
%
|
|||||
|
Cost
of funds
|
7.72
|
%
|
7.54
|
%
|
7.56
|
%
|
6.28
|
%
|
|||||
|
Year
Ended December
31, 2005
|
First
Quarter
|
Second
Quarter
|
Third
Quarter
|
Fourth
Quarter
|
|||||||||
|
Operating
results:
|
|||||||||||||
|
Total
interest income
|
$
|
24,053
|
$
|
18,533
|
$
|
15,717
|
$
|
16,092
|
|||||
|
Net
interest income after provision for loan losses
|
2,196
|
2,068
|
992
|
853
|
|||||||||
|
Net
income (loss)
|
935
|
9,594
|
(1,899
|
)
|
955
|
||||||||
|
Basic
net (loss) income per common share
|
(0.03
|
)
|
0.68
|
(0.27
|
)
|
(0.03
|
)
|
||||||
|
Diluted
net (loss) income per common share
|
(0.03
|
)
|
0.54
|
(0.27
|
)
|
(0.03
|
)
|
||||||
|
Cash
dividends declared per common share
|
-
|
-
|
-
|
-
|
|||||||||
|
Average
interest-earning assets (4)
|
1,320,065
|
1,031,024
|
884,336
|
817,944
|
|||||||||
|
Average
borrowed funds
|
1,214,329
|
909,881
|
745,776
|
678,966
|
|||||||||
|
Net
interest spread on interest-earning assets
(3)
|
0.88
|
%
|
0.25
|
%
|
0.22
|
%
|
(0.23
|
)%
|
|||||
|
Average
asset yield
|
7.17
|
%
|
7.09
|
%
|
7.04
|
%
|
7.13
|
%
|
|||||
|
Net
yield on average interest-earning assets (1)
|
1.39
|
%
|
1.05
|
%
|
1.26
|
%
|
1.01
|
%
|
|||||
|
Cost
of funds
|
6.29
|
%
|
6.84
|
%
|
6.82
|
%
|
7.37
|
%
|
|||||
(1) Computed
as net interest margin excluding non-interest non-recourse securitization
financing expenses divided by average interest earning assets.
(2) The
decrease in net income during the third quarter of 2006 relates primarily to
loss of approximately $1.2 million recognized on the transfer of $279.0 million
of commercial mortgage loans to a joint venture and the derecognition of the
related non-recourse securitization financing of $254.5
million.
(3) The
negative net interest spread on interest-earning assets resulted from the impact
of certain commercial loans being on non-accrual and an increase in amortization
expense related to deferred costs on our commercial securitizations resulting
from higher than anticipated prepayments on those
securitizations.
(4) Excludes
cash and cash equivalents.
27
FORWARD-LOOKING
STATEMENTS
Certain
written statements in this Form 10-K
made by
Dynex that are not historical fact constitute “forward-looking statements”
within the meaning of Section 27A of the Securities Act of 1933, as amended,
and
Section 21E of the Securities Exchange Act of 1934, as amended. All statements
contained in this Item as well as those discussed elsewhere in this Report
addressing the results of operations, our operating performance, events, or
developments that we expect or anticipate will occur in the future, including
statements relating to investment strategies, net interest income growth,
earnings or earnings per share growth, and market share, as well as statements
expressing optimism or pessimism about future operating results, are
forward-looking statements. The forward-looking statements are based upon
management’s views and assumptions as of the date of this Report, regarding
future events and operating performance and are applicable only as of the dates
of such statements. Such forward-looking statements may involve factors that
could cause our actual results to differ materially from historical results
or
from any results expressed or implied by such forward-looking statements. Dynex
cautions the public not to place undue reliance on forward-looking statements,
which may be based on assumptions and anticipated events that do not
materialize.
Factors
that may cause actual results to differ from historical results or from any
results expressed or implied by forward-looking statements include the
following:
Reinvestment. Asset
yields today are generally lower than those assets sold or repaid, due to lower
overall interest rates and more competition for these assets as investment
assets have repaid or been sold. We have generally been unable to find
investments which have acceptable risk adjusted yields. As a result, our net
interest income has been declining, and may continue to decline in the future,
resulting in lower earnings per share over time. In order to maintain our
investment portfolio size and our earnings, we need to reinvest a portion of
the
cash flows we receive into new interest earning assets. If we are unable to
find
suitable reinvestment opportunities, the net interest income on our investment
portfolio and investment cash flows could be negatively impacted.
Economic
Conditions.
We are
affected by general economic conditions. An increase in the risk of defaults
and
credit risk resulting from an economic slowdown or recession could result in
a
decrease in the value of our investments and the over-collateralization
associated with its securitization transactions. As a result of our being
heavily invested in short-term high quality investments, a worsening economy,
however, could also benefit us by creating opportunities for us to invest in
assets that become distressed as a result of the worsening conditions. These
changes could have an effect on our financial performance and the performance
on
our securitized loan pools.
Investment
Portfolio Cash Flow.
Cash
flows from the investment portfolio fund our operations, the preferred stock
dividend, and repayments of outstanding debt, and are subject to fluctuation
due
to changes in interest rates, repayment rates and default rates and related
losses, particularly given the high degree of internal structural leverage
inherent in our securitized investments. Based on the performance of the
underlying assets within the securitization structure, cash flows which may
have
otherwise been paid to us as a result of our ownership interest may be retained
within the structure. Cash flows from the investment portfolio are likely to
sequentially decline until we meaningfully begin to reinvest our capital. There
can be no assurances that we will find suitable investment alternatives for
our
capital, nor can there be assurances that we will meet our reinvestment and
return hurdles.
Defaults.
Defaults
by borrowers on loans we securitized may have an adverse impact on our financial
performance, if actual credit losses differ materially from our estimates or
exceed reserves for losses recorded in the financial statements. The allowance
for loan losses is calculated on the basis of historical experience and
management’s best estimates. Actual default rates or loss severity may differ
from our estimate as a result of economic conditions. Actual defaults on
adjustable-rate mortgage loans may increase during a rising interest rate
environment. In addition, commercial mortgage loans are generally large dollar
balance loans, and a significant loan default may have an adverse impact on
our
financial results. Such impact may include higher provisions for loan losses
and
reduced interest income if the loan is placed on non-accrual.
28
Interest
Rate Fluctuations.
Our
income and cash flow depends on our ability to earn greater interest on our
investments than the interest cost to finance these investments. Interest rates
in the markets served by us generally rise or fall with interest rates as a
whole. Approximately $259 million of our investments, including loans and
securities currently pledged as securitized finance receivables and securities,
are fixed-rate and approximately $101 million of our investments are variable
rate. We currently finance these fixed-rate assets through $212 million of
fixed
rate securitization financing and $96 million of variable rate repurchase
agreements. The net interest spread for these investments could decrease during
a period of rapidly rising short-term interest rates, since the investments
generally have interest rates which reset on a delayed basis and have periodic
interest rate caps; the related borrowing has no delayed resets or such interest
rate caps.
Third-party
Servicers.
Our
loans
and loans underlying securities are serviced by third-party service providers.
As with any external service provider, we are subject to the risks associated
with inadequate or untimely services. Many borrowers require notices and
reminders to keep their loans current and to prevent delinquencies and
foreclosures. A substantial increase in our delinquency rate that results from
improper servicing or loan performance in general could harm our ability to
securitize our real estate loans in the future and may have an adverse effect
on
our earnings.
Prepayments.
Prepayments by borrowers on loans we securitized may have an adverse impact
on
our financial performance. Prepayments are expected to increase during a
declining interest rate or flat yield curve environment. Our exposure to rapid
prepayments is primarily (i) the faster amortization of premium on the
investments and, to the extent applicable, amortization of bond discount, and
(ii) the replacement of investments in its portfolio with lower yielding
investments.
Competition.
The
financial services industry is a highly competitive market in which we compete
with a number of institutions with greater financial resources. In purchasing
portfolio investments and in issuing securities, we compete with other mortgage
REITs, investment banking firms, savings and loan associations, commercial
banks, mortgage bankers, insurance companies, federal agencies and other
entities, many of which have greater financial resources and a lower cost of
capital than we do. Increased competition in the market and our competitors
greater financial resources have adversely affected Dynex, and may continue
to
do so. Competition may also continue to keep pressure on spreads resulting
in us
being unable to reinvest our capital on an acceptable risk-adjusted
basis.
Regulatory
Changes.
Our
businesses as of and for the year ended December 31, 2006 were not subject
to
any material federal or state regulation or licensing requirements. However,
changes in existing laws and regulations or in the interpretation thereof,
or
the introduction of new laws and regulations, could adversely affect us and
the
performance of our securitized loan pools or our ability to collect on our
delinquent property tax receivables. We are a REIT and are required to meet
certain tests in order to maintain our REIT status as described in the earlier
discussion of “Federal Income Tax Considerations.” If we should fail to maintain
our REIT status, we would not be able to hold certain investments and would
be
subject to income taxes.
Section
404 of the Sarbanes-Oxley Act of 2002.
We
anticipate that we will be required to be compliant with the provisions of
Section 404 of the Sarbanes-Oxley Act of 2002 as of December 31, 2007. Failure
to be compliant may result in doubt in the capital markets about the quality
and
adequacy of our internal disclosure controls. This could result in our having
difficulty in or being unable to raise additional capital in these markets
in
order to finance our operations and future investments.
Other.
The
following risks, which are discussed in more detail in ITEM 1A - RISK FACTORS
above, could also affect our results of operations, financial condition and
cash
flows:
|
·
|
Our
ownership of certain subordinate interests in securitization trusts
subjects us to credit risk on the underlying loans, and we provide
for
loss reserves on these loans as required under GAAP.
|
|
·
|
Certain
investments employ internal structural leverage as a result of the
securitization process, and are in the most subordinate position
in the
capital structure, which magnifies the potential impact of adverse
events
on our cash flows and reported results.
|
|
·
|
Our
efforts to manage credit risk may not be successful in limiting
delinquencies and defaults in underlying loans or losses on our
investments.
|
|
·
|
We
may be unable to invest in new assets with attractive yields, and
yields
on new assets in which we do invest may not generate attractive yields,
resulting in a decline in our earnings per share over
time.
|
29
|
·
|
Prepayments
of principal on our investments, and the timing of prepayments, may
impact
our reported earnings and our cash
flows.
|
|
·
|
We
finance a portion of our investment portfolio with short-term recourse
repurchase agreements which subjects us to margin calls if the assets
pledged subsequently decline in
value.
|
|
·
|
We
may be subject to the risks associated with inadequate or untimely
services from third-party service providers, which may harm our results
of
operations.
|
|
·
|
Interest
rate fluctuations can have various negative effects on us, and could
lead
to reduced earnings and/or increased earnings
volatility.
|
|
·
|
Our
reported income depends on accounting conventions and assumptions
about
the future that may change.
|
|
·
|
Failure
to qualify as a REIT would adversely affect our dividend distributions
and
could adversely affect the value of our
securities.
|
|
·
|
Maintaining
REIT status may reduce our flexibility to manage our
operations.
|
|
·
|
We
may fail to properly conduct our operations so as to avoid falling
under
the definition of an investment company pursuant to the Investment
Company
Act of 1940.
|
|
·
|
We
are dependent on certain key
personnel.
|
RECENT
ACCOUNTING PRONOUNCEMENTS
In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities.” SFAS 159 permits entities to choose
to measure many financial instruments, and certain other items, at fair value.
SFAS 159 applies to reporting periods beginning after November 15, 2007. We
are
currently evaluating the potential impact on adoption of SFAS 159.
In
September 2006, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value
Measurements”, which defines fair value, establishes a framework for measuring
fair value in generally accepted accounting principles and expands disclosures
about fair value measurements. SFAS 157 is effective for fiscal years
beginning after November 15, 2007 and all interim periods within those
fiscal years. Earlier application is permitted provided that the reporting
entity has not yet issued interim or annual financial statements for that fiscal
year. The Company is currently evaluating the impact, if any, that SFAS 157
may have on the Company’s financial statements.
In
June
2006, the FASB issued Interpretation (“FIN”) No. 48, “Accounting for Uncertainty
in Income Taxes”. FIN 48 prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return. The new FASB standard
also provides guidance on derecognition, classification, interest and penalties,
accounting in interim periods, disclosure, and transition. The provisions of
FIN
48 are effective for fiscal years beginning December 15, 2006. The Company
does
not expect that the adoption of FIN 48 will have a material impact on the
Company’s financial statements.
In
February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid
Instruments”, an amendment to SFAS 133 and SFAS 140. Among other things, SFAS
155: (i) permits fair value remeasurement for any hybrid financial instrument
that contains an embedded derivative that otherwise would require bifurcation;
(ii) clarifies which interest-only strips and principal-only strips are not
subject to the requirements of SFAS 133; (iii) establishes a requirement to
evaluate interests in securitized financial assets to identify interests that
are freestanding derivatives or that are hybrid financial instruments that
contain an embedded derivative requiring bifurcation; (iv) clarifies that
concentrations of credit risk in the form of subordination are not embedded
derivatives; and (v) amends SFAS 140 to eliminate the prohibition on a
qualifying special-purpose entity from holding a derivative financial instrument
that pertains to a beneficial interest other than another derivative financial
instrument. SFAS 155 is effective for all financial instruments acquired,
issued, or subject to a remeasurement (new basis) event occurring after the
beginning of an entity’s first fiscal year beginning after September 15, 2006.
At initial application of SFAS 155, the fair value election provided for in
paragraph 4(c) may be applied for hybrid financial instruments that were
bifurcated under paragraph 12 of SFAS 133 prior to the initial application
of
SFAS 155.
In
January 2007, the FASB provided a scope exception under SFAS 155 for securitized
interests that only contain an embedded derivative that is tied to the
prepayment risk of the underlying prepayable financial assets, and for which
the
investor does not control the right to accelerate the settlement. If a
securitized interest contains any other embedded derivative (for example,
an inverse floater), then it would be subject to the bifurcation tests in SFAS
133, as would securities purchased at a significant premium. Following the
issuance of the scope exception by the FASB, changes in the market value
30
of
the
Company’s investment securities would continue to be made through other
comprehensive income, a component of stockholders’ equity. The Company does not
expect that the January 1, 2007 adoption of SFAS 155 will have a material impact
on the Company’s financial position, results of operations or cash flows.
However, to the extent that certain of the Company’s future investments in
securitized financial assets do not meet the scope exception adopted by the
FASB, the Company’s future results of operations may exhibit volatility if such
investments are required to be bifurcated or marked to market value in their
entirety through the income statement, depending on the election made by the
Company.
In
September 2006, the Securities and Exchange Commission (“SEC”) Staff issued
Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior
Year Misstatements when Quantifying Misstatements in Current Year Financial
Statements”, which addresses how the effects of prior year uncorrected financial
statement misstatements should be considered in current year financial
statements. The SAB requires registrants to quantify misstatements using both
balance sheet and income statement approaches and to evaluate whether either
approach results in quantifying an error that is material in light of relative
quantitative and qualitative factors. The requirements of SAB 108 are effective
for annual financial statements covering the first fiscal year ending after
November 15, 2006. The Company’s adoption of SAB 108 during the year ended
December 31, 2006 had no impact on the Company’s financial statements.
ITEM
7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK
Market
risk generally represents the risk of loss that may result from the potential
change in the value of a financial instrument due to fluctuations in interest
and foreign exchange rates and in equity and commodity prices. Market risk
is
inherent to both derivative and non-derivative financial instruments, and
accordingly, the scope of our market risk management extends beyond derivatives
to include all market risk sensitive financial instruments. As a financial
services company, net interest income comprises the primary component of our
earnings and cash flows. We are subject to risk resulting from interest rate
fluctuations to the extent that there is a gap between the amount of our
interest-earning assets and the amount of interest-bearing liabilities that
are
prepaid, mature or re-price within specified periods.
We
monitor the aggregate cash flow, projected net yield and estimated market value
of our investment portfolio under various interest rate and prepayment
assumptions. While certain investments may perform poorly in an increasing
or
decreasing interest rate environment, other investments may perform well, and
others may not be impacted at all.
We
focus
on the sensitivity of our investment portfolio cash flow, and measure such
sensitivity to changes in interest rates. Changes in interest rates are defined
as instantaneous, parallel, and sustained interest rate movements in 100 basis
point increments. We estimate our net interest income cash flow for the next
twenty-four months assuming interest rates over such time period follow the
forward LIBOR curve (based on 90-day Eurodollar futures contracts) as of
December 31, 2006. Once the base case has been estimated, cash flows are
projected for each of the defined interest rate scenarios. Those scenario
results are then compared against the base case to determine the estimated
change to cash flow. Cash flow changes from interest rate swaps, caps, floors
or
any other derivative instrument are included in this analysis.
The
following table summarizes our net interest income cash flow and market value
sensitivity analyses as of December 31, 2006. These analyses represent
management’s estimate of the percentage change in net interest margin cash flow
and value expressed as a percentage change of shareholders’ equity, given a
parallel shift in interest rates, as discussed above. Other investments are
excluded from this analysis because they are not considered interest rate
sensitive. The “Base” case represents the interest rate environment as it
existed as of December 31, 2006. At December 31, 2006, one-month LIBOR was
5.32% and six-month LIBOR was 5.37%. The analysis is heavily dependent upon
the
assumptions used in the model. The effect of changes in future interest rates,
the shape of the yield curve or the mix of assets and liabilities may cause
actual results to differ significantly from the modeled results. In addition,
certain financial instruments provide a degree of “optionality.” The most
significant option affecting our portfolio is the borrowers’ option to prepay
the loans. The model applies prepayment rate assumptions representing
management’s estimate of prepayment activity on a projected basis for each
collateral pool in the investment portfolio. The model applies the same
prepayment rate assumptions for all five cases indicated below. The extent
to
which borrowers utilize the ability to exercise their option may cause actual
results to significantly differ from the analysis. Furthermore, the projected
results assume no additions or subtractions to our portfolio,
31
and
no
change to our liability structure. Historically, there have been significant
changes in our investment portfolio and the liabilities incurred by us. As
a
result of anticipated prepayments on assets in the investment portfolio, there
are likely to be such changes in the future.
|
Projected
Change in Net Interest Margin Cash Flow From Base
Case
|
Projected
Change in Value, Expressed as a Percentage of Shareholders’
Equity
|
|||||
|
Basis
Point Increase (Decrease) in Interest Rates
|
Excluding
Cash and Cash Equivalents
|
Including
Cash and Cash Equivalents
|
||||
|
+200
|
(3.9)%
|
12.0%
|
(0.3)%
|
|||
|
+100
|
(0.7)%
|
6.8%
|
(0.0)%
|
|||
|
Base
|
-
|
-
|
-
|
|||
|
-100
|
0.7%
|
(6.8)%
|
0.0%
|
|||
|
-200
|
4.5%
|
(11.6)%
|
0.3%
|
|||
Our
interest rate risk is related both to the rate of change in short term interest
rates and to the level of short-term interest rates. Approximately $259 million
of our investment portfolio is comprised of loans or securities that have coupon
rates that are fixed. Approximately $101 million of our investment portfolio
as
of December 31, 2006 was comprised of loans or securities that have coupon
rates
which adjust over time (subject to certain periodic and lifetime limitations)
in
conjunction with changes in short-term interest rates. Approximately 68%, 11%
and 11% of the adjustable-rate loans underlying our securitized finance
receivables are indexed to and reset based upon the level of six-month LIBOR,
one-year constant maturity treasury rate (CMT) and prime rate,
respectively.
Generally,
during a period of rising short-term interest rates, our net interest income
earned and the corresponding cash flow on our investment portfolio will
decrease. The decrease of the net interest spread results from
(i) fixed-rate loans and investments financed with variable-rate debt, (ii)
the lag in resets of the adjustable-rate loans underlying the securitized
finance receivables relative to the rate resets on the associated borrowings,
and (iii) rate resets on the adjustable-rate loans which are generally
limited to 1% every six months or 2% every twelve months and subject to lifetime
caps, while the associated borrowings have no such limitation. As to item (i),
we have substantially limited our interest rate risk by match funding fixed
rate
assets and variable rate assets. As to items (ii) and (iii), as short-term
interest rates stabilize and the adjustable-rate loans reset, the net interest
margin may be partially restored as the yields on the adjustable-rate loans
adjust to market conditions.
Net
interest income may increase following a fall in short-term interest rates.
This
increase may be temporary as the yields on the adjustable-rate loans adjust
to
the new market conditions after a lag period. The net interest spread may also
be increased or decreased by the proceeds or costs of interest rate swap, cap
or
floor agreements, to the extent that we have entered into such
agreements.
ITEM
8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our
consolidated financial statements and the related notes, together with the
Report of the Independent Registered Public Accounting Firm thereon, are set
forth on pages F-1 through F-27 of this Form 10-K.
|
ITEM
9.
|
CHANGES
IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE
|
Not
applicable.
32
ITEM
9A. CONTROLS AND PROCEDURES
(a) Evaluation
of disclosure controls and procedures.
Disclosure
controls and procedures are controls and other procedures that are designed
to
ensure that information required to be disclosed in our reports filed or
submitted under the Exchange Act is recorded, processed, summarized and reported
within the time periods specified in the SEC’s rules and forms. Disclosure
controls and procedures include, without limitation, controls and procedures
designed to ensure that information required to be disclosed in our reports
filed under the Exchange Act is accumulated and communicated to management,
including our management, as appropriate, to allow timely decisions regarding
required disclosures.
As
of the
end of the period covered by this annual report, we carried out an evaluation
of
the effectiveness of the design and operation of our disclosure controls and
procedures pursuant to Rule 13a-15 under the Exchange Act. This evaluation
was
carried out under the supervision and with the participation of our management,
including our Principal Executive Officer and Principal Financial Officer.
Based
upon that evaluation, our management concluded that our disclosure controls
and
procedures are effective.
In
conducting its review of disclosure controls, management concluded that
sufficient disclosure controls and procedures did exist to ensure that
information required to be disclosed in our reports filed or submitted under
the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the SEC’s rules and forms.
(b) Changes
in internal controls.
Our
management is also responsible for establishing and maintaining adequate
internal control over financial reporting. There were no changes in our internal
controls or in other factors during the fourth quarter of 2006 that materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting. There were also no significant deficiencies or
material weaknesses in such internal controls requiring corrective
actions.
ITEM
9B.
OTHER INFORMATION
None.
PART
III
ITEM
10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The
information required by Item 10 is included in our proxy statement for its
2006
Annual Meeting of Shareholders (the “2007 Proxy Statement”) in the Election of
Directors, Corporate Governance and the Board of Directors, Ownership of Stock
and Management of the Company and Executive Compensation sections and is
incorporated herein by reference.
ITEM
11.
EXECUTIVE COMPENSATION
The
information required by Item 11 is included in the 2007 Proxy Statement in
the
Management of the Company and Executive Compensation section and is incorporated
herein by reference.
|
ITEM
12.
|
SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
STOCKHOLDER MATTERS
|
The
information required by Item 12 is included in the 2007 Proxy Statement in
the
Ownership of Stock and Management of the Company and Executive Compensation
sections and is incorporated herein by reference.
33
ITEM
13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The
information required by Item 13 is included in the 2007 Proxy Statement in
the
Corporate Governance and the Board of Directors and Management of the Company
and Executive Compensation sections and is incorporated herein by
reference.
ITEM
14.
PRINCIPAL ACCOUNTING FEES AND SERVICES
The
information required by Item 14 is included in the 2007 Proxy Statement in
the
Audit Information section and is incorporated herein by reference.
PART
IV
ITEM
15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a) Documents
filed as part of this report:
|
1.
and 2.
|
Financial
Statements and Schedules
The
information required by this section of Item 15 is set forth in the
Consolidated Financial Statements and Report of Independent Registered
Public Accounting Firm beginning at page F-1 of this Form 10-K.
The index to the Financial Statements is set forth at page F-2 of
this
Form 10-K.
|
|
3.
|
Exhibits
|
|
Number
|
Exhibit
|
|
3.1
|
Articles
of Incorporation of the Registrant, as amended, effective as of February
4, 1988. (Incorporated herein by reference to Dynex’s Amendment No. 1 to
the Registration Statement on Form S-3 (No. 333-10783) filed March
21,
1997.)
|
|
3.2
|
Amended
and Restated Bylaws of the Registrant. (Incorporated by reference
to
Dynex’s Current Report on Form 8-K filed June 21, 2006.)
|
|
3.3
|
Amendment
to Articles of Incorporation, effective December 29, 1989. (Incorporated
herein by reference to Dynex’s Amendment No. 1 to the Registration
Statement on Form S-3 (No. 333-10783) filed March 21, 1997.)
|
|
3.4
|
Amendment
to Articles of Incorporation, effective October 9, 1996. (Incorporated
herein by reference to the Registrant’s Current Report on Form 8-K, filed
October 15, 1996.)
|
|
3.5
|
Amendment
to Articles of Incorporation, effective October 19, 1992. (Incorporated
herein by reference to Dynex’s Amendment No. 1 to the Registration
Statement on Form S-3 (No. 333-10783) filed March 21,
1997.)
|
|
3.6
|
Amendment
to Articles of Incorporation, effective April 25, 1997. (Incorporated
herein by reference to Dynex’s Quarterly Report on Form 10-Q for the
quarter ended March 31, 1997.)
|
34
|
3.7
|
Amendment
to Articles of Incorporation, effective June 17, 1998. (Incorporated
herein by reference to Dynex’s Annual Report on Form 10-K for the year
ended December 31, 2004.)
|
|
3.8
|
Amendment
to Articles of Incorporation, effective August 2, 1999. (Incorporated
herein by reference to Dynex’s Annual Report on Form 10-K for the year
ended December 31, 2004.)
|
|
3.9
|
Amendment
to Articles of Incorporation, effective May 19, 2004. (Incorporated
herein
by reference to Dynex’s Quarterly Report on Form 10-Q for the quarter
ended June 30, 2004.)
|
|
3.10
|
Amendments
to the Bylaws of Dynex. (Incorporated herein by reference to Dynex’s
Annual Report on Form 10-K for the year ended December 31, 2002,
as
amended.)
|
|
10.1
|
Dynex
Capital, Inc. 2004 Stock Incentive Plan. (Incorporated herein by
reference
to Dynex’s Annual Report on Form 10-K for the year ended December 31,
2004.)
|
|
10.2
|
Form
of Stock Option Agreement for Non-Employee Directors under the Dynex
Capital, Inc. 2004 Stock Incentive Plan. (Incorporated herein by
reference
to Dynex’s Quarterly Report on Form 10-Q for the quarter ended June 30,
2005.)
|
|
10.3
|
Form
of Stock Appreciation Rights Agreement for Senior Executives under
the
Dynex Capital, Inc. 2004 Stock Incentive Plan. (Incorporated herein
by
reference to Dynex’s Quarterly Report on Form 10-Q for the quarter ended
June 30, 2005.)
|
|
10.4
|
Limited
Liability Company Agreement of Copperhead Ventures, LLC dated September
8,
2007 (portions of this exhibit have been omitted pursuant to a request
for
confidential treatment). (Incorporated herein by reference to Dynex’s
Quarterly Report on Form 10-Q for the quarter ended September 30,
2006.)
|
|
21.1
|
List
of consolidated entities of Dynex (filed herewith).
|
|
23.1
|
Consent
of BDO Seidman, LLP (filed herewith).
|
|
23.2
|
Consent
of Deloitte & Touche, LLP (filed herewith).
|
|
31.1
|
Certification
of Principal Executive Officer and Principal Financial Officer pursuant
to
Section 302 of the Sarbanes-Oxley Act of 2002 (filed
herewith).
|
|
32.1
|
Certification
of Principal Executive Officer and Chief Financial Officer pursuant
to
Section 906 of the Sarbanes-Oxley Act of 2002 (filed
herewith).
|
(b) Exhibits:
See Item
15(a)(3) above.
(c) Financial
Statement Schedules:
None.
35
SIGNATURES
Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the Registrant has duly caused this report to be signed on its behalf
by
the undersigned, thereunto duly authorized.
|
DYNEX
CAPITAL, INC.
|
||
|
(Registrant)
|
||
|
April
2, 2007
|
/s/
Stephen J. Benedetti
|
|
|
Stephen
J. Benedetti, Executive Vice President
|
||
Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has
been
signed below by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.
|
Signature
|
Capacity
|
Date
|
|
/s/
Stephen J. Benedetti
|
Principal
Executive Officer
|
April
2, 2007
|
|
Stephen
J. Benedetti
|
Principal
Financial Officer
|
|
|
/s/
Jeffrey L. Childress
|
Principal
Accounting Officer
|
April
2, 2007
|
|
Jeffrey
L. Childress
|
||
|
/s/
Thomas B. Akin
|
Director
|
April
2, 2007
|
|
Thomas
B. Akin
|
||
|
/s/
Leon A. Felman
|
Director
|
April
2, 2007
|
|
Leon
A. Felman
|
||
|
/s/
Barry Igdaloff
|
Director
|
April
2, 2007
|
|
Barry
Igdaloff
|
||
|
/s/
Daniel K. Osborne
|
Director
|
April
2, 2007
|
|
Daniel
K. Osborne
|
||
|
/s/
Eric P. Von der Porten
|
Director
|
April
2, 2007
|
|
Eric
P. Von der Porten
|
||
36
DYNEX
CAPITAL, INC.
CONSOLIDATED
FINANCIAL STATEMENTS AND
REPORT
OF
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
For
Inclusion in Form 10-K
Annual
Report Filed with
Securities
and Exchange Commission
December
31, 2006
F
-
1
DYNEX
CAPITAL, INC.
INDEX
TO FINANCIAL STATEMENTS
Consolidated
Financial Statements:
|
Page
|
||
|
Report
of Independent Registered Public Accounting Firm for the Years ended
December 31, 2006 and 2005
|
F-3
|
|
|
Report
of Independent Registered Public Accounting Firm for the Year ended
December 31, 2004
|
F-4
|
|
|
Consolidated
Balance Sheets December 31, 2006 and 2005
|
F-5
|
|
|
Consolidated
Statements of Operations -- Years ended December 31, 2006, 2005 and
2004
|
F-6
|
|
|
Consolidated
Statements of Shareholders’ Equity -- Years ended December 31, 2006, 2005
and 2004
|
F-7
|
|
|
Consolidated
Statements of Cash Flows -- Years ended December 31, 2006, 2005 and
2004
|
F-8
|
|
|
Notes
to Consolidated Financial Statements
|
F-9
|
F
-
2
REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To
the
Board of Directors and Stockholders of
Dynex
Capital, Inc.
Glen
Allen, Virginia
We
have
audited the accompanying consolidated balance sheets of Dynex Capital, Inc.
(“Dynex”) as of December 31, 2006 and 2005 and the related consolidated
statements of operations, shareholders’ equity, and cash flows for the years
then ended. These financial statements are the responsibility of Dynex’s
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. Dynex is not required to have,
nor
were we engaged to perform, an audit of its internal control over financial
reporting. Our
audits included consideration of internal control over financial reporting
as a
basis for designing audit procedures that are appropriate in the circumstances
but not for the purpose of expressing an opinion on the effectiveness of Dynex’s
internal control over financial reporting. Accordingly, we express no such
opinion. An audit includes examining, on a test basis, evidence supporting
the
amounts and disclosures in the financial statements, assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In
our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Dynex at December 31, 2006
and 2005, and the results of its operations and its cash flows for the years
then ended, in conformity with accounting principles generally accepted in
the
United States of America.
BDO
SEIDMAN LLP
Richmond,
Virginia
February
12, 2007
F
-
3
REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To
the
Board of Directors and Stockholders of
Dynex
Capital, Inc.
Glen
Allen, Virginia
We
have
audited the accompanying consolidated statements of operations, shareholders'
equity, and cash flows for the year ended December 31, 2004 of Dynex Capital,
Inc. and subsidiaries (the “Company”). These financial statements are the
responsibility of the Company’s management. Our responsibility is to express an
opinion on the financial statements based on our audit.
We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that
we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The Company is not required
to
have, nor were we engaged to perform, an audit of its internal control over
financial reporting. Our
audit
included consideration of internal control over financial reporting as a
basis
for designing audit procedures that are appropriate in the circumstances
but not
for the purpose of expressing an opinion on the effectiveness of the Company’s
internal control over financial reporting. Accordingly, we express no such
opinion. An audit includes examining, on a test basis, evidence supporting
the
amounts and disclosures in the financial statements, assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that
our
audit provides a reasonable basis for our opinion.
In
our
opinion, the Company’s consolidated financial statements referred to above
present fairly, in all material respects, the results of their operations
and
their cash flows for year ended December 31, 2004, in conformity with accounting
principles generally accepted in the United States of
America.
DELOITTE
& TOUCHE LLP
Princeton,
New Jersey
April
7,
2005
F
-
4
CONSOLIDATED
BALANCE SHEETS
DYNEX
CAPITAL, INC.
December
31, 2006 and 2005
(amounts
in thousands except share data)
|
2006
|
2005
|
||||||
|
ASSETS
|
|||||||
|
Cash
and cash equivalents
|
$
|
45,235
|
|||||
|
Other
assets
|
6,111
|
4,332
|
|||||
|
62,991
|
49,567
|
||||||
|
Investments:
|
|||||||
|
Securitized
finance receivables, net
|
346,304
|
722,152
|
|||||
|
Investment
in joint venture
|
37,388
|
-
|
|||||
|
Securities
|
13,143
|
24,908
|
|||||
|
Other
investments
|
2,802
|
4,067
|
|||||
|
Other
loans
|
3,929
|
5,282
|
|||||
|
403,566
|
756,409
|
||||||
|
$
|
466,557
|
$
|
805,976
|
||||
|
LIABILITIES
AND SHAREHOLDERS’ EQUITY
|
|||||||
|
LIABILITIES
|
|||||||
|
Securitization
financing
|
$
|
211,564
|
$
|
516,578
|
|||
|
Repurchase
agreements secured by securitization financing
|
95,978
|
133,315
|
|||||
|
Obligation
under payment agreement
|
16,299
|
-
|
|||||
|
Other
liabilities
|
6,178
|
6,749
|
|||||
|
330,019
|
656,642
|
||||||
|
Commitments
and Contingencies (Note 15)
|
|||||||
|
SHAREHOLDERS’
EQUITY
|
|||||||
|
Preferred
stock, par value $.01 per share,
|
|||||||
|
50,000,000
shares authorized:
|
|||||||
|
9.5%
Cumulative Convertible Series D,
|
|||||||
|
4,221,539
and 5,628,737 shares issued and outstanding, respectively
|
41,749
|
55,666
|
|||||
|
($43,218
and $57,624 aggregate liquidation preference,
respectively)
|
|||||||
|
Common
stock, par value $.01 per share, 100,000,000 shares
authorized,
|
|||||||
|
12,131,262
and 12,163,391 shares issued and outstanding, respectively
|
121
|
122
|
|||||
|
Additional
paid-in capital
|
366,637
|
366,903
|
|||||
|
Accumulated
other comprehensive income
|
663
|
140
|
|||||
|
Accumulated
deficit
|
(272,632
|
)
|
(273,497
|
)
|
|||
|
136,538
|
149,334
|
||||||
|
|
$
|
466,557
|
$
|
805,976
|
|||
See
notes to consolidated financial statements.
F
-
5
CONSOLIDATED
STATEMENTS OF OPERATIONS
DYNEX
CAPITAL, INC.
Years
ended December 31, 2006, 2005 and 2004
(amounts
in thousands except share data)
|
2006
|
2005
|
2004
|
||||||||
|
Interest
income:
|
||||||||||
|
Securitized
finance receivables
|
$
|
68,387
|
$
|
118,647
|
||||||
|
Securities
|
1,558
|
3,885
|
2,535
|
|||||||
|
Other
investments
|
2,015
|
1,369
|
335
|
|||||||
|
Other
loans
|
636
|
754
|
706
|
|||||||
|
50,449
|
74,395
|
122,223
|
||||||||
|
Interest
and related expense:
|
||||||||||
|
Non-recourse
securitization financing
|
33,172
|
57,166
|
98,271
|
|||||||
|
Repurchase
agreements and senior notes
|
5,933
|
5,428
|
567
|
|||||||
|
Obligation
under payment agreement
|
489
|
-
|
-
|
|||||||
|
Other
|
(232
|
)
|
(88
|
)
|
104
|
|||||
|
39,362
|
62,506
|
98,942
|
||||||||
|
Net
interest income
|
11,087
|
11,889
|
23,281
|
|||||||
|
Recapture
of (provision for) loan losses
|
15
|
(5,780
|
)
|
(18,463
|
)
|
|||||
|
Net
interest income after recapture of (provision for) loan
losses
|
11,102
|
6,109
|
4,818
|
|||||||
|
Impairment
charges
|
(60
|
)
|
(2,474
|
)
|
(14,756
|
)
|
||||
|
Equity
in loss of joint venture
|
(852
|
)
|
-
|
-
|
||||||
|
Loss
on capitalization of joint venture
|
(1,194
|
)
|
-
|
-
|
||||||
|
(Loss)
gain on sale of investments, net
|
(183
|
)
|
9,609
|
14,490
|
||||||
|
General
and administrative expenses
|
(4,521
|
)
|
(5,681
|
)
|
(7,748
|
)
|
||||
|
Other
income (expense)
|
617
|
2,022
|
(179
|
)
|
||||||
|
Net
income (loss)
|
4,909
|
9,585
|
(3,375
|
)
|
||||||
|
Preferred
stock charge
|
(4,044
|
)
|
(5,347
|
)
|
(1,819
|
)
|
||||
|
Net
income (loss) to common shareholders
|
$
|
865
|
$
|
4,238
|
$
|
(5,194
|
)
|
|||
|
Net
income (loss) per common share :
|
||||||||||
|
Basic
and diluted
|
$
|
0.07
|
$
|
0.35
|
$
|
(0.46
|
)
|
|||
See
notes to consolidated financial statements.
F
-
6
CONSOLIDATED
STATEMENTS OF SHAREHOLDERS’ EQUITY
DYNEX
CAPITAL, INC.
Years
ended December 31, 2006, 2005, and 2004
(amounts
in thousands except share data)
|
Preferred
Stock
|
Common
Stock
|
Additional
Paid-in
Capital
|
Accumulated
Other
Comprehensive
(Loss) Income
|
Accumulated
Deficit
|
Total
|
||||||||||||||
|
Balance
at January 1, 2004
|
$
|
47,014
|
$
|
109
|
$
|
360,684
|
$
|
(3,882
|
)
|
$
|
(254,079
|
)
|
$
|
149,846
|
|||||
|
Comprehensive
income:
|
|||||||||||||||||||
|
Net
loss - 2004
|
-
|
-
|
-
|
-
|
(3,375
|
)
|
(3,375
|
)
|
|||||||||||
|
Change
in net unrealized gain on:
|
|||||||||||||||||||
|
Investments
classified as available for sale
|
-
|
-
|
-
|
4,681
|
-
|
4,681
|
|||||||||||||
|
Hedge
instruments
|
-
|
-
|
-
|
3,018
|
-
|
3,018
|
|||||||||||||
|
Total
comprehensive income
|
4,324
|
||||||||||||||||||
|
Recapitalization
|
8,652
|
13
|
6,212
|
-
|
(16,345
|
)
|
(1,468
|
)
|
|||||||||||
|
Dividends
on preferred stock
|
-
|
-
|
-
|
-
|
(3,936
|
)
|
(3,936
|
)
|
|||||||||||
|
Balance
at December 31, 2004
|
55,666
|
122
|
366,896
|
3,817
|
(277,735
|
)
|
148,766
|
||||||||||||
|
Comprehensive
income:
|
|||||||||||||||||||
|
Net
income - 2005
|
-
|
-
|
-
|
-
|
9,585
|
||||||||||||||
|
Change
in net unrealized gain/(loss) on:
|
|||||||||||||||||||
|
Investments
classified as available for sale
|
-
|
-
|
-
|
(4,286
|
)
|
-
|
(4,286
|
)
|
|||||||||||
|
Hedge
instruments
|
-
|
-
|
-
|
609
|
-
|
609
|
|||||||||||||
|
Total
comprehensive income
|
5,908
|
||||||||||||||||||
|
Issuance
of common stock
|
-
|
-
|
7
|
-
|
-
|
7
|
|||||||||||||
|
Dividends
on preferred stock
|
-
|
-
|
-
|
-
|
(5,347
|
)
|
(5,347
|
)
|
|||||||||||
|
Balance
at December 31, 2005
|
55,666
|
122
|
366,903
|
140
|
(273,497
|
)
|
149,334
|
||||||||||||
|
Comprehensive
income:
|
|||||||||||||||||||
|
Net
income - 2006
|
-
|
-
|
-
|
-
|
4,909
|
4,909
|
|||||||||||||
|
Change
in net unrealized gain/(loss) on:
|
|||||||||||||||||||
|
Investments
classified as available for sale, net
|
-
|
-
|
-
|
523
|
-
|
523
|
|||||||||||||
|
Total
comprehensive income
|
5,432
|
||||||||||||||||||
|
Redemption
of preferred stock
|
(13,917
|
)
|
-
|
(155
|
)
|
-
|
-
|
(14,072
|
)
|
||||||||||
|
Conversion
of preferred stock for common stock
|
-
|
-
|
4
|
-
|
-
|
4
|
|||||||||||||
|
Repurchase
of common stock
|
-
|
(1
|
)
|
(219
|
)
|
-
|
-
|
(220
|
)
|
||||||||||
|
Stock
option issuance
|
-
|
-
|
104
|
-
|
-
|
104
|
|||||||||||||
|
Dividends
on preferred stock
|
-
|
-
|
-
|
-
|
(4,044
|
)
|
(4,044
|
)
|
|||||||||||
|
Balance
at December 31, 2006
|
$
|
41,749
|
$
|
121
|
$
|
366,637
|
$
|
663
|
$
|
(272,632
|
)
|
$
|
136,538
|
||||||
See
notes to consolidated financial statements.
F
-
7
CONSOLIDATED
STATEMENTS OF CASH FLOWS
DYNEX
CAPITAL, INC.
Years
ended December 31, 2006, 2005
and
2004
(amounts
in thousands except share data)
|
2006
|
2005
|
2004
|
||||||||
|
Operating
activities:
|
||||||||||
|
Net
income (loss)
|
$
|
9,585
|
$
|
(3,375
|
)
|
|||||
|
Adjustments
to reconcile net income (loss) to cash provided by
operating
activities:
|
||||||||||
|
(Recapture
of) provision for loan loss
|
(15
|
)
|
5,780
|
18,463
|
||||||
|
Equity
in loss of joint venture
|
852
|
-
|
-
|
|||||||
|
Loss
on capitalization of joint venture
|
1,194
|
-
|
-
|
|||||||
|
Impairment
charges
|
60
|
2,474
|
14,756
|
|||||||
|
Loss
(gain) on sale of investments
|
183
|
(9,609
|
)
|
(14,490
|
)
|
|||||
|
Amortization
and depreciation
|
(538
|
)
|
2,607
|
3,726
|
||||||
|
Stock
based compensation expense
|
104
|
-
|
-
|
|||||||
|
Net
change in other assets and other liabilities
|
676
|
1,500
|
3,953
|
|||||||
|
Net
cash and cash equivalents provided by operating
activities
|
7,425
|
12,337
|
23,033
|
|||||||
|
Investing
activities:
|
||||||||||
|
Principal
payments received on investments
|
93,945
|
144,532
|
286,212
|
|||||||
|
Purchase
of securities and other investments
|
(17,221
|
)
|
(56,246
|
)
|
(71,468
|
)
|
||||
|
Payments
received on securities, other investments and loans
|
28,819
|
117,264
|
21,601
|
|||||||
|
Proceeds
from sales of securities and other investments
|
3,348
|
15,321
|
32,066
|
|||||||
|
Other
|
(385
|
)
|
168
|
180
|
||||||
|
Net
cash and cash equivalents provided by investing
activities
|
108,506
|
221,039
|
268,591
|
|||||||
|
Financing
activities:
|
||||||||||
|
Proceeds
from issuance of securitization financing
|
-
|
-
|
7,377
|
|||||||
|
Principal
payments on securitization financing
|
(48,283
|
)
|
(102,510
|
)
|
(286,330
|
)
|
||||
|
Redemption
of securitization financing
|
-
|
(195,653
|
)
|
-
|
||||||
|
Repayment
of senior notes
|
-
|
-
|
(10,872
|
)
|
||||||
|
(Repayment
of) borrowings under repurchase agreements, net
|
(37,337
|
)
|
62,847
|
46,584
|
||||||
|
Redemption
of preferred stock
|
(14,068
|
)
|
-
|
(648
|
)
|
|||||
|
Repurchase
of common stock
|
(220
|
)
|
-
|
-
|
||||||
|
Dividends
paid
|
(4,378
|
)
|
(5,347
|
)
|
(2,599
|
)
|
||||
|
Net
cash and cash equivalents used for financing activities
|
(104,286
|
)
|
(240,663
|
)
|
(246,488
|
)
|
||||
|
Net
increase (decrease) in cash and cash equivalents
|
11,645
|
(7,287
|
)
|
45,136
|
||||||
|
Cash
and cash equivalents at beginning of year
|
45,235
|
52,522
|
7,386
|
|||||||
|
Cash
and cash equivalents at end of year
|
$
|
56,880
|
$
|
45,235
|
$
|
52,522
|
||||
See
notes to consolidated financial statements.
F
-
8
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
DYNEX
CAPITAL, INC.
December
31, 2006, 2005, and 2004
(amounts
in thousands except share and per share data)
NOTE
1 - BASIS OF PRESENTATION
Basis
of Presentation
The
accompanying consolidated financial statements have been prepared in accordance
with the instructions to Form 10-K and include all of the information and notes
required by accounting principles generally accepted in the United States of
America, hereinafter referred to as “generally accepted accounting principles,”
for complete financial statements. The consolidated financial statements include
the accounts of Dynex Capital, Inc. and its qualified real estate investment
trust (“REIT”) subsidiaries and taxable REIT subsidiary (“Dynex” or the
“Company”). All inter-company balances and transactions have been eliminated in
consolidation of Dynex.
Dynex
believes it has complied with the requirements for qualification as a REIT
under
the Internal Revenue Code (the “Code”). As such, Dynex believes that it
qualifies as a REIT, and it generally will not be subject to federal income
tax
on the amount of its income or gain that is distributed as dividends to
shareholders.
Dynex
uses estimates in establishing fair value for its securities as discussed in
Note 2.
Dynex
also has credit risk on certain investments in its portfolio as discussed in
Note 4. An allowance for loan losses has been estimated and established for
currently existing losses based on management’s judgment. The allowance for loan
losses is evaluated and adjusted periodically by management based on the actual
and estimated timing and amount of currently existing credit losses. Provisions
made to increase the allowance related to credit risk are presented as provision
for loan losses in the accompanying consolidated statements of operations.
Dynex’s actual credit losses may differ from those estimates used to establish
the allowance.
Certain
amounts for 2004 and 2005 have been reclassified to conform to the presentation
adopted in 2006.
NOTE
2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Consolidation
of Subsidiaries
The
consolidated financial statements represent Dynex’s accounts after the
elimination of inter-company transactions. Dynex consolidates entities in which
it owns more than 50% of the voting equity and control does not rest with
others. Dynex follows the equity method of accounting for investments with
greater than 20% and less than a 50% interest in partnerships and corporate
joint ventures or when it is able to influence the financial and operating
policies of the investee but owns less than 50% of the voting equity. For all
other investments, the cost method is applied.
Federal
Income Taxes
Dynex
believes it has complied with the requirements for qualification as a REIT
under
the Internal Revenue Code (the “Code”). As such, Dynex believes that it
qualifies as a REIT for federal income tax purposes, and it generally will
not
be subject to federal income tax on the amount of its income or gain that is
distributed as dividends to shareholders. Dynex uses the calendar year for
both
tax and financial reporting purposes. There may be differences between taxable
income and income computed in accordance with accounting principles generally
accepted in the United States of America (“GAAP”).
F
-
9
Investments
Securitized
Finance Receivables.
Securitized finance receivables consist of loans or securities pledged to
support the repayment of non-recourse securitization financing issued by Dynex
and recourse repurchase agreement financing collateralized by the securitization
financing bonds redeemed in 2005. Certain securitized finance receivables are
reported at amortized cost. An allowance has been established for currently
existing losses on such loans. Securities pledged, if any, are reported at
estimated fair value. Securitized finance receivables can only be sold subject
to the lien of the respective securitization financing indenture.
Investment
in Joint Venture.
The
Company accounts for its investment in joint venture using the equity method
as
it does not exercise control over significant asset decisions such as buying,
selling or financing nor is it the primary beneficiary under Financial
Interpretation No. 46R. Under the equity method, the Company increases its
investment for its proportionate share of net income and contributions to the
joint venture and decreases its investment balance by recording its
proportionate share of net loss and distributions.
The
Company periodically reviews its investment in joint venture for other than
temporary declines in market value. Any decline that is not expected to be
recovered in the next twelve months is considered other than temporary, and
an
impairment charge is recorded as a reduction to the carrying value of the
investment. No impairment charges were recognized with respect to the Company’s
investment in joint venture.
Other
Investments.
Other
investments include unsecuritized delinquent property tax receivables,
securities backed by delinquent property tax receivables, and real estate owned.
The unsecuritized delinquent property tax receivables are carried at amortized
cost. Securities
backed by delinquent property tax receivables are classified as
available-for-sale and are carried at estimated fair value.
Other
investments also include real estate owned acquired through, or in lieu of,
foreclosure in connection with the servicing of the delinquent tax lien
receivables portfolio. Such investments are considered held for sale and are
initially recorded at fair value less cost to sell (“net realizable value”) at
the date of foreclosure, establishing a new cost basis. Subsequent to
foreclosure, management periodically performs valuations and adjusts the
property to the lower of cost and net realizable value. Revenue and expenses
related to and changes in the valuation of the real estate owned are included
in
other income (expense).
Securities.
Securities
include debt and equity securities, which are considered available-for-sale
under SFAS No. 115 and are reported at fair value, with unrealized gains and
losses excluded from earnings and reported as accumulated other comprehensive
income. The basis used to determine the gain or loss on any debt and equity
securities sold is the specific identification method and average cost method,
respectively.
Other
loans.
Other
loans are carried at amortized cost.
Interest
Income.
Interest
income is recognized when earned according to the terms of the underlying
investment and when, in the opinion of management, it is collectible. For loans,
the accrual of interest is discontinued when, in the opinion of management,
the
interest is not collectible in the normal course of business, when the loan
is
significantly past due or when the primary servicer of the loan fails to advance
the interest and/or principal due on the loan. For securities and other
investments, the accrual of interest is discontinued when, in the opinion of
management, it is probable that all amounts contractually due will not be
collected. Loans are considered past due when the borrower fails to make a
timely payment in accordance with the underlying loan agreement, inclusive
of
all applicable cure periods. All interest accrued but not collected for
investments that are placed on a non-accrual status or are charged-off is
reversed against interest income. Interest on these investments is accounted
for
on the cash-basis or cost-recovery method, until qualifying for return to
accrual status. Investments are returned to accrual status when all the
principal and interest amounts contractually due are brought current and future
payments are reasonably assured.
F
-
10
Premiums,
Discounts and Hedging Basis Adjustments
Premiums
and discounts on investments and obligations are amortized into interest income
or expense, respectively, over the life of the related investment or obligation
using the effective yield method. Hedging basis adjustments on associated debt
obligations are amortized over the expected remaining life of the debt
instrument. If the indenture for a particular debt obligation provides for
a
step-up of interest rates on the optional redemption date for that obligation
and Dynex has the ability and intent to exercise its call option, then premiums,
discounts, and deferred hedging losses are amortized to that optional redemption
date. Otherwise, these amounts are amortized over the estimated remaining life
of the obligation.
Debt
Issuance Costs
Costs
incurred in connection with the issuance of debt are deferred and amortized
over
the estimated lives of their respective debt obligations using the effective
yield method.
Derivative
Financial Instruments
On
occasion, Dynex may enter into interest rate swap agreements, interest rate
cap
agreements, interest rate floor agreements, financial forwards, financial
futures and options on financial futures (“Interest Rate Agreement”) to manage
its sensitivity to changes in interest rates. These interest rate agreements
are
intended to provide income and cash flow to offset potential reduced net
interest income and cash flow under certain interest rate environments. At
the
inception of the Interest Rate Agreement, these instruments are designated
as
either hedge positions or trading positions using criteria established in SFAS
No. 133, “Accounting for Derivative Instruments and Hedging Activities” (as
amended). If, at the inception of the Interest Rate Agreement, formal
documentation is prepared that describes the risk being hedged, identifies
the
hedging instrument and the means to be used for assessing the effectiveness
of
the hedge and if it can be demonstrated that the hedging instrument will be
highly effective at hedging the risk exposure, the derivative instrument will
be
designated as a cash flow hedge position. Otherwise, the Interest Rate Agreement
will be classified as a trading position.
For
Interest Rate Agreements designated as cash flow hedges, Dynex evaluates the
effectiveness of these hedges against the financial instrument being hedged.
The
effective portion of the hedge relationship on an interest rate agreement
designated as a cash flow hedge is reported in accumulated other comprehensive
income, and the ineffective portion of such hedge is reported in income. Amounts
in accumulated other comprehensive income are reclassified into earnings in
the
same period during which the hedged transaction affects earnings. Derivative
instruments are carried at fair value in the financial statements of
Dynex.
As
a part
of Dynex’s interest rate risk management process, Dynex may be required
periodically to terminate hedge instruments. Any basis adjustments or changes
in
the fair value of hedges recorded in other comprehensive income are recognized
into income or expense in conjunction with the original hedge or hedged
exposure.
If
the
underlying asset, liability or commitment is sold or matures, the hedge is
deemed partially or wholly ineffective, or the criteria that was executed at
the
time the hedge instrument was entered into no longer exists, the interest rate
agreement no longer qualifies as a designated hedge. Under these circumstances,
such changes in the market value of the interest rate agreement are recognized
in current income.
For
interest rate agreements entered into for trading purposes, realized and
unrealized changes in fair value of these instruments are recognized in the
consolidated statements of operations as trading income or loss in the period
in
which the changes occur or when such trade instruments are settled. Amounts
receivable from counter-parties, if any, are included on the consolidated
balance sheets in other assets.
F
-
11
Cash
Equivalents
Cash
and
cash equivalents include cash on hand and highly liquid investments with
original maturities of three months or less. The Company has cash and cash
equivalents on deposit at individual financial institutions that are in excess
of federally insured amounts.
Net
Income Per Common Share
Net
income per common share is presented on both a basic net income per common
share
and diluted net income per common share basis. Diluted net income per common
share assumes the conversion of the convertible preferred stock into common
stock, using the if-converted method, and stock appreciation rights, using
the
treasury stock method, but only if these items are dilutive. Each share of
preferred stock is convertible into one share of common stock.
Use
of Estimates
The
preparation of financial statements, in conformity with accounting principles
generally accepted in the United States of America, requires management to
make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date
of
the financial statements and the reported amounts of revenue and expenses during
the reported period. Actual results could differ from those estimates. The
primary estimates inherent in the accompanying consolidated financial statements
are discussed below.
Fair
Value. Securities
classified as available-for-sale are carried in the accompanying financial
statements at estimated fair value. Estimates of fair value for securities
may
be based on market prices provided by certain dealers. Estimates of fair value
for certain other securities are determined by calculating the present value
of
the projected cash flows of the instruments using estimates of market-based
discount rates, prepayment rates and credit loss assumptions. The estimate
of
fair value for securities pledged as securitized finance receivables is
determined by calculating the present value of the projected cash flows of
the
instruments, using discount rates, prepayment rate assumptions and credit loss
assumptions based on historical experience and estimated future activity, and
using discount rates commensurate with those Dynex believes would be used by
third parties in a market purchase.
Estimates
of fair value for financial instruments are based primarily on management’s
judgment. Since the fair value of Dynex’s financial instruments
is based
on estimates, actual fair values recognized may differ from those estimates
recorded in the consolidated financial statements. The fair value of all
financial instruments is presented in Note 10.
Allowance
for Loan Losses. An
allowance for loan losses has been estimated and established for currently
existing probable losses for loans in Dynex’s investment portfolio. Factors
considered in establishing an allowance include current loan delinquencies,
historical cure rates of delinquent loans, and historical and anticipated loss
severity of the loans as they are liquidated. The factors differ by loan type
(e.g., single family versus commercial) and collateral type (e.g., multifamily
versus office). The allowance for losses is evaluated and adjusted periodically
by management based on the actual and estimated timing and amount of probable
credit losses, using the above factors, as well as industry loss experience.
Where loans are considered homogeneous, the allowance for losses are established
and evaluated on a pool basis. Otherwise, the allowance for losses is
established and evaluated on a loan-specific basis. Provisions made to increase
the allowance are charged as a current period expense. Single-family loans
are
considered impaired when they are 60-days past due. Commercial mortgage loans
are evaluated on an individual basis for impairment. Commercial mortgage loans
are secured by income-producing real estate and are evaluated for impairment
when the debt service coverage ratio on the loan is less than 1:1. Certain
of
the commercial mortgage loans are covered by loan guarantees that limit Dynex’s
exposure on these loans.
F
-
12
Impairments.
Dynex
evaluates all securities in its investment portfolio for other-than-temporary
impairments. A security is generally defined to be other-than-temporarily
impaired if, for a maximum period of three consecutive quarters, the carrying
value of such security exceeds its estimated fair value and Dynex estimates,
based on projected future cash flows or other fair value determinants, that
the
fair value will remain below the carrying value for the foreseeable future.
If
an other-than-temporary impairment is deemed to exist, Dynex records an
impairment charge to adjust the carrying value of the security down to its
estimated fair value. In certain instances, as a result of the
other-than-temporary impairment analysis, the recognition or accrual of interest
will be discontinued and the security will be placed on non-accrual status.
Securities normally are not placed on non-accrual status if the servicer
continues to advance on the impaired loans in the security.
Dynex
considers an investment to be impaired if the fair value of the investment
is
less than its recorded cost basis. Impairments of other investments are
generally considered to be other-than-temporary when the fair value remains
below the carrying value for three consecutive quarters. If the impairment
is
determined to be other-than-temporary, an impairment charge is recorded in
order
to adjust the carrying value of the investment to its estimated
value.
Mortgage
Servicing Rights.
Dynex
retains the primary servicing rights for certain of its loans, and subcontracts
the performance of the primary servicing to unrelated third parties. The
mortgage servicing rights are amortized in proportion to and over the period
of
the estimated net servicing loss.
Contingencies.
In the
normal course of business, there are various lawsuits, claims, and contingencies
pending against the Company. In accordance with SFAS No. 5, Accounting
for Contingencies,
we have
established provisions for estimated losses from pending claims, investigations
and proceedings. Although the ultimate outcome of the various matters cannot
be
ascertained at this point, it is the opinion of management, after consultation
with counsel, that the resolution of the foregoing matters will not have a
material adverse effect on the financial condition of the Company, taken as
a
whole, such resolution may, however, have a material effect on the results
of
operations or cash flows in any future period, depending on the level of income
for such period.
Securitization
Transactions
Dynex
has
securitized loans and securities in a securitization financing transaction
by
transferring financial assets to a wholly owned trust, and the trust issues
non-recourse bonds pursuant to an indenture. Generally, Dynex retains some
form
of control over the transferred assets, and/or the trust is not deemed to be
a
qualified special purpose entity. In instances where the trust is deemed not
to
be a qualified special purpose entity, the trust is included in the consolidated
financial statements of Dynex. A
transfer of financial assets in which Dynex surrenders control over those assets
is accounted for as a sale to the extent that consideration other than
beneficial interests in the transferred assets is received in exchange.
For
accounting and tax purposes, the loans and securities financed through the
issuance of bonds in a securitization financing transaction are treated as
assets of Dynex, and the associated bonds issued are treated as debt of Dynex
as
securitization financing. Dynex may retain certain of the bonds issued by the
trust, and Dynex generally will transfer collateral in excess of the bonds
issued. This excess is typically referred to as over-collateralization. Each
securitization trust generally provides Dynex the right to redeem, at its
option, the remaining outstanding bonds prior to their maturity
date.
Recent
Accounting Pronouncements
In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities.” SFAS 159 permits entities to choose
to measure many financial instruments, and certain other items, at fair value.
SFAS 159 applies to reporting periods beginning after November 15, 2007. The
Company is currently evaluating the potential impact on adoption of SFAS 159.
F
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13
In
September 2006, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value
Measurements”, which defines fair value, establishes a framework for measuring
fair value in generally accepted accounting principles and expands disclosures
about fair value measurements. SFAS 157 is effective for fiscal years
beginning after November 15, 2007 and all interim periods within those
fiscal years. Earlier application is permitted provided that the reporting
entity has not yet issued interim or annual financial statements for that fiscal
year. The Company is currently evaluating the impact, if any, that SFAS 157
may have on the Company’s financial statements.
In
June
2006, the FASB issued Interpretation (“FIN”) No. 48, “Accounting for Uncertainty
in Income Taxes”. FIN 48 prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return. The new FASB standard
also provides guidance on derecognition, classification, interest and penalties,
accounting in interim periods, disclosure, and transition. The provisions of
FIN
48 are effective for fiscal years beginning December 15, 2006. The Company
does
not expect that the adoption of FIN 48 will have a material impact on the
Company’s financial statements.
In
February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid
Instruments”, an amendment to SFAS 133 and SFAS 140. Among other things, SFAS
155: (i) permits fair value remeasurement for any hybrid financial instrument
that contains an embedded derivative that otherwise would require bifurcation;
(ii) clarifies which interest-only strips and principal-only strips are not
subject to the requirements of SFAS 133; (iii) establishes a requirement to
evaluate interests in securitized financial assets to identify interests that
are freestanding derivatives or that are hybrid financial instruments that
contain an embedded derivative requiring bifurcation; (iv) clarifies that
concentrations of credit risk in the form of subordination are not embedded
derivatives; and (v) amends SFAS 140 to eliminate the prohibition on a
qualifying special-purpose entity from holding a derivative financial instrument
that pertains to a beneficial interest other than another derivative financial
instrument. SFAS 155 is effective for all financial instruments acquired,
issued, or subject to a remeasurement (new basis) event occurring after the
beginning of an entity’s first fiscal year beginning after September 15, 2006.
At initial application of SFAS 155, the fair value election provided for in
paragraph 4(c) may be applied for hybrid financial instruments that were
bifurcated under paragraph 12 of SFAS 133 prior to the initial application
of
SFAS 155.
In
January 2007, the FASB provided a scope exception under SFAS 155 for securitized
interests that only contain an embedded derivative that is tied to the
prepayment risk of the underlying prepayable financial assets, and for which
the
investor does not control the right to accelerate the settlement. If a
securitized interest contains any other embedded derivative (for example,
an inverse floater), then it would be subject to the bifurcation tests in SFAS
133, as would securities purchased at a significant premium. Following the
issuance of the scope exception by the FASB, changes in the market value of
the
Company’s investment securities would continue to be made through other
comprehensive income, a component of stockholders’ equity. The Company does not
expect that the January 1, 2007 adoption of SFAS 155 will have a material impact
on the Company’s financial position, results of operations or cash flows.
However, to the extent that certain of the Company’s future investments in
securitized financial assets do not meet the scope exception adopted by the
FASB, the Company’s future results of operations may exhibit volatility if such
investments are required to be bifurcated or marked to market value in their
entirety through the income statement, depending on the election made by the
Company.
In
September 2006, the Securities and Exchange Commission (“SEC”) Staff issued
Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior
Year Misstatements when Quantifying Misstatements in Current Year Financial
Statements”, which addresses how the effects of prior year uncorrected financial
statement misstatements should be considered in current year financial
statements. The SAB requires registrants to quantify misstatements using both
balance sheet and income statement approaches and to evaluate whether either
approach results in quantifying an error that is material in light of relative
quantitative and qualitative factors. The requirements of SAB 108 are effective
for annual financial statements covering the first fiscal year ending after
November 15, 2006. The Company’s adoption of SAB 108 during the year ended
December 31, 2006 had no impact on the Company’s financial statements.
F
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14
NOTE
3 - SECURITIZED FINANCE RECEIVABLES
The
following table summarizes the components of securitized finance receivables
as
of December 31, 2006 and 2005.
|
2006
|
2005
|
||||||
|
Collateral:
|
|||||||
|
Commercial
mortgage loans
|
$
|
225,463
|
$
|
570,199
|
|||
|
Single-family
mortgage loans
|
116,060
|
161,058
|
|||||
|
341,523
|
731,257
|
||||||
|
Funds
held by trustees, including funds held for defeasance
|
7,351
|
6,648
|
|||||
|
Accrued
interest receivable
|
2,380
|
5,114
|
|||||
|
Unamortized
discounts and premiums, net
|
(455
|
)
|
(1,832
|
)
|
|||
|
Loans,
at amortized cost
|
350,799
|
741,187
|
|||||
|
Allowance
for loan losses
|
(4,495
|
)
|
(19,035
|
)
|
|||
|
$
|
346,304
|
$
|
722,152
|
||||
All
of
the securitized finance receivables are encumbered by securitization financing
(see Note 8).
Single-family
mortgage loans includes $1,518 of loans in foreclosure and $2,321 of loans
which
are 90+ days delinquent and still accruing interest. Commercial mortgage loans
includes one loan with an unpaid principal balance of $3,170, which was placed
on non-accrual during 2006.
During
2006, $279,003 of securitized finance receivables backed by commercial mortgage
loans were derecognized in conjunction with the formation of a joint venture
(see Note 11).
NOTE
4 - ALLOWANCE FOR LOAN LOSSES
Dynex
provides an allowance for losses where it has exposure to losses on loans in
its
securitized finance receivables portfolio. The allowance for loan losses is
included in securitized finance receivables in the accompanying consolidated
balance sheets. The following table summarizes the aggregate activity for the
allowance for loan losses for the years ended December 31, 2006,
2005 and 2004:
|
2006
|
2005
|
2004
|
||||||||
|
Allowance
at beginning of year
|
$
|
19,035
|
$
|
28,014
|
$
|
43,364
|
||||
|
(Recapture
of) provision for loan losses
|
(15
|
)
|
5,780
|
18,463
|
||||||
|
Credit
losses, net of recoveries
|
(4,172
|
)
|
(3,450
|
)
|
(17,651
|
)
|
||||
|
Loans
sold/transferred
|
(10,353
|
)
|
(11,309
|
)
|
(16,162
|
)
|
||||
|
Allowance
at end of year
|
$
|
4,495
|
$
|
19,035
|
$
|
28,014
|
||||
The
loans
sold/transferred amount of $10,353 in 2006 represents the allowance associated
with the loans that were derecognized in connection with the initial formation
of a joint venture. (See Note 11). The transfers of $11,309 and $16,162 in
2005
and 2004, respectively, relate to the sale of the Company’s interest in three
securitization trusts and the related loans, primarily manufactured housing.
F
-
15
The
following table presents certain information on commercial mortgage loans that
Dynex has determined to be impaired. The decline from 2005 to 2006 relates
to
the derecognition of loans during 2006 as discussed in Note 11.
|
Total
Recorded Investment in Impaired Loans
|
Amount
for Which There is a Related Allowance for Credit
Losses
|
Amount
for Which There is no Related Allowance for Credit
Losses
|
||||||||
|
2005
|
$
|
54,558
|
$
|
21,609
|
$
|
32,949
|
||||
|
2006
|
13,266
|
4,107
|
9,159
|
|||||||
Loans
secured by low-income housing tax credit (LIHTC) properties account for $190,500
of Dynex’s commercial loan portfolio. Section 42 of the tax code provides tax
credits to investors in projects to construct or substantially rehabilitate
properties that provide housing for qualifying low income families. Property
owners must comply with income and rental restrictions over a minimum 15-year
compliance period and in return, they are entitled to receive a tax credit
of 4%
to 9% (a dollar-for-dollar reduction of federal taxes) for each taxable year
over a period of 10 years. If a property owner fails to maintain compliance
with
the tax credit restrictions, or if the property is subject to a change in
ownership as a result of foreclosure, then the owner would face the partial
recapture of tax credits already taken. Dynex believes that the existence of
the
tax credit, and the prospect for recapture, provides incentive for the owner
to
maintain and support the property.
NOTE
5 - SECURITIES
The
following table summarizes Dynex’s amortized cost basis and fair value of
securities, all of which are classified as available-for-sale, as of December
31, 2006 and 2005, and the related average effective interest rates at December
31, 2006 and 2005:
|
2006
|
2005
|
||||||||||||
|
Value
|
Effective
Interest Rate
|
Value
|
Effective
Interest Rate
|
||||||||||
|
Securities,
available-for-sale at amortized cost:
|
|||||||||||||
|
Fixed-rate
mortgage securities
|
$
|
11,362
|
7.22%
|
|
$
|
22,900
|
6.14%
|
|
|||||
|
Other
securities
|
-
|
320
|
|||||||||||
|
Equity
securities
|
1,151
|
1,602
|
|||||||||||
|
12,513
|
24,822
|
||||||||||||
|
Gross
unrealized gains
|
636
|
332
|
|||||||||||
|
Gross
unrealized losses
|
(6
|
)
|
(246
|
)
|
|||||||||
|
Securities,
available-for-sale at fair value
|
$
|
13,143
|
$
|
24,908
|
|||||||||
Investment
activity.
During
2006, Dynex purchased approximately $2,388 of common stock of five publicly
traded REITs. The Company sold its investment in four of those REITs during
2006
generating proceeds of $2,471, gains of $137 and losses of $505.
Unrealized
gain/loss on securities.
The
unrealized gains and losses at December 31, 2006 were primarily related to
the
Company’s investment in fixed-rate mortgage securities. The unrealized losses
represent temporary declines in value.
F
-
16
NOTE
6 - OTHER INVESTMENTS
The
following table summarizes the Company’s other investments at December 31, 2006
and 2005:
|
2006
|
2005
|
||||||
|
Delinquent
property tax receivables and security
|
$
|
2,227
|
$
|
3,220
|
|||
|
Real
estate owned
|
575
|
847
|
|||||
|
$
|
2,802
|
$
|
4,067
|
||||
The
balance of the delinquent property tax security includes an unrealized gain
of
$41 and $55 as of December 31, 2006 and 2005, respectively.
At
December 31, 2006 and 2005, Dynex had real estate owned with a current carrying
value of $575 and $847, respectively, resulting from foreclosures on delinquent
property tax receivables. Cash collections on all delinquent property tax
receivables, including proceeds from sales of real estate owned, amounted to
$1,412 and $3,039 during 2006 and 2005, respectively.
NOTE
7 - OTHER LOANS
The
following table summarizes Dynex’s carrying basis for other loans at December
31, 2006 and 2005, respectively.
|
2006
|
2005
|
||||||
|
Single-family
mortgage loans
|
$
|
3,345
|
$
|
4,825
|
|||
|
Multifamily
and commercial mortgage loans participations
|
962
|
995
|
|||||
|
4,307
|
5,820
|
||||||
|
Unamortized
discounts
|
(378
|
)
|
(538
|
)
|
|||
|
$
|
3,929
|
$
|
5,282
|
||||
NOTE
8 - SECURITIZATION FINANCING
Dynex,
through limited-purpose finance subsidiaries, has issued bonds pursuant to
indentures in the form of non-recourse securitization financing. Each series
of
securitization financing may consist of various classes of bonds, either at
fixed or variable rates of interest. Dynex, on occasion, may retain bonds at
issuance, or redeem bonds and hold such bonds outstanding for possible future
issuance. Payments received on securitized finance receivables and any
reinvestment income thereon is used to make payments on the securitization
financing (see Note 3). The obligations under the securitization financings
are
payable solely from the securitized finance receivables and are otherwise
non-recourse to Dynex. The stated maturity date for each class of bonds is
generally calculated based on the final scheduled payment date of the underlying
collateral pledged. The actual maturity of each class will be directly affected
by the rate of principal prepayments on the related collateral. Each series
is
also subject to redemption at Dynex’s option according to specific terms of the
respective indentures. As a result, the actual maturity of any class of a series
of securitization financing is likely to occur earlier than its stated maturity.
Dynex
redeemed a series of securitization financing bonds, financing such redemption
with cash and repurchase agreement financing. Because the redeemed bonds are
held by a subsidiary of Dynex that is distinct from the bond’s issuer, to which
the bonds are a liability, the bonds are eliminated in the consolidated
financial statements but remain outstanding. These bonds have a current unpaid
balance of $108,681. See Note 9 for further discussion.
All
of
the other securitization financing bonds retained at December 31, 2006 and
2005
are considered non-investment grade and had balances of $16,576 and $27,417,
respectively. As the limited-purpose finance subsidiaries issuing the bonds
are
included in the consolidated financial statements of Dynex, such retained bonds
are eliminated in the consolidated financial statements.
F
-
17
The
components of non-recourse securitization financing along with certain other
information at December 31, 2006 and 2005 are summarized as
follows:
|
2006
|
2005
|
||||||||||||
|
Bonds
Outstanding
|
Range
of
Interest
Rates
|
Bonds
Outstanding
|
Range
of
Interest
Rates
|
||||||||||
|
Fixed-rate
classes
|
$
|
206,478
|
6.6%
- 8.8%
|
|
$
|
509,923
|
6.6%
- 8.8%
|
|
|||||
|
Accrued
interest payable
|
1,428
|
3,438
|
|||||||||||
|
Deferred
costs
|
(2,848
|
)
|
(16,912
|
)
|
|||||||||
|
Unamortized
net bond premium
|
6,506
|
20,129
|
|||||||||||
|
$
|
211,564
|
$
|
516,578
|
||||||||||
|
Range
of stated maturities
|
2024-2027
|
2009-2028
|
|||||||||||
|
Estimated
weighted average life
|
3.5
years
|
3.5
years
|
|||||||||||
|
Number
of series
|
2
|
3
|
|||||||||||
At
December 31, 2006, the weighted-average effective rate of the fixed rate
classes was 6.9%. The average effective rate of interest for securitization
financing was 8.1%, 7.4%, and 6.4%, for the years ended December 31, 2006,
2005,
and
2004, respectively.
NOTE
9 - REPURCHASE AGREEMENTS
The
Company uses repurchase agreements, which are recourse to the Company, to
finance certain of its investments. The Company had repurchase agreements of
$95,978 and $133,315, at December 31, 2006 and 2005, respectively. The
repurchase agreements mature monthly and have a weighted average rate of 0.10%
over one-month LIBOR (5.42% at December 31, 2006). All of the amounts
outstanding under repurchase agreements are collateralized by securitization
bonds with a fair value of $106,639 at December 31, 2006, and which pay interest
at a blended rate of one-month LIBOR plus 0.10%.
NOTE
10 - FAIR VALUE AND ADDITIONAL INFORMATION ABOUT FINANCIAL
INSTRUMENTS
SFAS
No.
107, “Disclosures about Fair Value of Financial Instruments” requires the
disclosure of the estimated fair value of financial instruments. The following
table presents the recorded basis and estimated fair values of Dynex’s financial
instruments as of December 31, 2006
and
2005:
|
2006
|
2005
|
||||||||||||
|
Recorded
Basis
|
Fair
Value
|
Recorded
Basis
|
Fair
Value
|
||||||||||
|
Assets:
|
|||||||||||||
|
Securitized
finance receivables, net
|
$
|
346,304
|
$
|
369,984
|
$
|
722,152
|
$
|
761,287
|
|||||
|
Other
investments
|
2,802
|
2,802
|
4,067
|
4,067
|
|||||||||
|
Securities
|
13,143
|
13,143
|
24,908
|
24,908
|
|||||||||
|
Other
loans
|
3,929
|
4,705
|
5,282
|
6,040
|
|||||||||
|
Liabilities:
|
|||||||||||||
|
Securitization
financing
|
211,564
|
230,575
|
516,578
|
556,610
|
|||||||||
|
Repurchase
agreements
|
95,978
|
95,978
|
133,315
|
133,315
|
|||||||||
|
Obligation
under payment agreement
|
16,299
|
16,541
|
-
|
-
|
|||||||||
F
-
18
Estimates
of fair value for securitized finance receivables are determined by calculating
the present value of the projected cash flows of the instruments, using discount
rates, prepayment rate assumptions and credit loss assumptions based on
historical experience and estimated future activity, and using discount rates
commensurate with those Dynex believes would be used by third parties.
Prepayment rate assumptions for each year are based in part on the actual
prepayment rates experienced for the prior six-month period and in part on
management’s estimate of future prepayment activity. The loss assumptions
utilized vary for each series of securitized finance receivables, depending
on
the collateral pledged. Estimates of fair value for other investments are
determined by calculating the present value of the projected net cash flows,
inclusive of the estimated cost to service these investments. Estimates of
fair
value for securities are based principally on market prices provided by certain
dealers. Fair value for securitization financing is determined based on
estimated current market rates for similar instruments. Since estimates of
fair
value for the obligation under payment agreement is based on cashflows generated
by certain securitized finance receivables, the discount rate, prepayment rate
and credit loss assumptions are consistent with those used to value the
securitized finance receivables.
NOTE
11 - INVESTMENT IN JOINT VENTURE
On
September 15, 2006, Issued Holdings Capital Corporation (“IHCC”), a wholly-owned
subsidiary of Dynex, DBAH Capital, LLC, an affiliate of Deutsche Bank, A.G.,
and
Dartmouth Investments, LLP formed a joint venture, Copperhead Ventures, LLC,
in
which the parties’ interests are 49.875%, 49.875% and 0.25%, respectively.
In
connection with the formation and initial capitalization of the joint venture,
the Company contributed its interests in a pool of securitized commercial
mortgage loans issued by a subsidiary of the Company, and additionally agreed
under a payment agreement (included in the consolidated financial statements
as
“obligation under payment agreement”) to make payments to the joint venture
based on cash flows received by the Company from its interests in a second
pool
of securitized commercial mortgage loans.
The
Company’s interests contributed to the joint venture included three subordinate
commercial mortgage-backed securities and the redemption rights for all of
the
outstanding non-recourse securitization financing bonds issued by that trust.
The contribution of these interests resulted in derecognition of securitization
finance receivables of $279,003 and the related securitization financing of
$254,454, the recognition of $1,354 of accrued interest on a loan contributed
to
the joint venture to which the Company retained the right to receive and the
recognition of a loss of $1,194 for the year ended December 31,
2006.
With
respect to the payment agreement, the Company has the right to repurchase the
payment agreement from the joint venture under certain circumstances at its
then
fair value, and the Company has the right of first refusal should the joint
venture decide to sell the agreement in the future. The Company has recorded
an
investment in and a liability to the joint venture equal to the estimated fair
value of the future estimated cash flows of the trust. The difference between
the gross cash flows and the recorded liability is amortized into interest
expense using the effective interest method. The carrying value of the
obligation under payment agreement is $16,299 at December 31, 2006, and the
estimated fair value of such agreement is $16,541.
The
total
fair value of the consideration contributed by the Company for its interest
in
the joint venture was $37,281, which exceeded its proportionate share of the
net
assets of the joint venture at formation by $967. This difference is recorded
in
investment in joint venture is being amortized over the estimated life of the
joint venture as a charge to the Company’s equity in the earnings or loss of the
joint venture.
The
Company accounts for its investment in the joint venture using the equity
method, under which it recognizes its proportionate share of the joint ventures
earnings or loss and changes in accumulated other comprehensive income. The
Company recorded a loss of $852 for its interest in the net loss of the joint
venture and $8 for the decrease in accumulated other comprehensive income of
the
joint venture for the year ended December 31, 2006. The joint venture’s loss
related to the impairment of one of the joint venture’s commercial mortgage
backed securities due to an increase in the estimate of the loss on the
liquidation of a foreclosed loan collateralizing the security.
F
-
19
The
following tables presents the financial condition and results of operations
for
the joint venture as of and for the year ended December 31, 2006.
|
Condensed
Statement of Operations
|
||||
|
Interest
income
|
$
|
1,611
|
||
|
Interest
expense
|
-
|
|||
|
Impairment
|
(3,664
|
)
|
||
|
Trading
gains
|
589
|
|||
|
Net
loss
|
$
|
(1,508
|
)
|
|
|
Condensed
Balance Sheet
|
||||
|
Total
assets
|
$
|
73,219
|
||
|
Total
liabilities
|
-
|
|||
|
Total
equity
|
$
|
73,219
|
||
The
Company’s equity in the net loss of the joint venture of $852 represents our
proportionate share (49.875%) of the net loss of the joint venture and
approximately $100 of amortization related to the difference between the fair
value of the consideration contributed by the Company to form the joint venture
and its initial interest in the net assets of the joint venture.
NOTE
12 - INCOME (LOSS) PER SHARE
The
following table reconciles the numerator and denominator for both the basic
and
diluted EPS for the years ended December 31, 2006, 2005, and 2004.
|
2006
|
2005
|
2004
|
|||||||||||||||||
|
Income
(loss)
|
Weighted-Average
Number of Shares
|
Income
(loss)
|
Weighted-Average
Number of Shares
|
Income
(loss)
|
Weighted-Average
Number
of
Shares
|
||||||||||||||
|
Net
income (loss)
|
$
|
4,909
|
$
|
9,585
|
$
|
(3,375
|
)
|
||||||||||||
|
Preferred
stock charge
|
(4,044
|
)
|
(5,347
|
)
|
(1,819
|
)
|
|||||||||||||
|
Net
income (loss) available to common shareholders
|
$
|
865
|
12,140,452
|
$
|
4,238
|
12,163,062
|
$
|
(5,194
|
)
|
11,272,259
|
|||||||||
|
Net
income (loss) per share:
|
|||||||||||||||||||
|
Basic
and diluted
|
$
|
0.07
|
$
|
0.35
|
$
|
(0.46
|
)
|
||||||||||||
|
Dividends
and potentially anti-dilutive common shares assuming conversion of
preferred stock:
|
|||||||||||||||||||
|
Series
A
|
$
|
-
|
-
|
$
|
-
|
-
|
$
|
337
|
94,403
|
||||||||||
|
Series
B
|
-
|
-
|
-
|
-
|
537
|
131,621
|
|||||||||||||
|
Series
C
|
-
|
-
|
-
|
-
|
666
|
130,990
|
|||||||||||||
|
Series
D
|
4,044
|
4,256,237
|
5,347
|
5,628,737
|
3,936
|
3,491,047
|
|||||||||||||
|
Expense
and incremental shares of stock appreciation rights and
options
|
-
|
81,180
|
-
|
64
|
-
|
21,045
|
|||||||||||||
|
$
|
4,044
|
4,337,417
|
$
|
5,347
|
5,628,801
|
$
|
5,476
|
3,869,106
|
|||||||||||
F
-
20
NOTE
13 - PREFERRED AND COMMON STOCK
The
following table presents a summary of Dynex’s issued and outstanding preferred
stock:
|
Issue
Price
|
Dividends
Paid Per Share
|
||||
|
Cumulative
Convertible Preferred Stock
|
Per
share
|
2006
|
2005
|
2004
|
|
|
Series
D 9.50% (“Series D”)
|
$10.00
|
$0.9500
|
$0.9500
|
$0.6993
|
|
Dynex
is
authorized to issue up to 50,000,000 shares of preferred stock. For all series
issued, dividends are cumulative from the date of issue and are payable
quarterly in arrears. The dividends are equal, per share, to the greater of
(i) the per quarter base rate of $0.2375 for Series D, or (ii) the
quarterly dividend declared on Dynex’s common stock. One share of Series D
preferred stock is convertible at any time at the option of the holder into
one
share of common stock. The series is redeemable by Dynex at any time, in whole
or in part, (i) at a rate of one share of preferred stock for one share of
common stock, plus accrued and unpaid dividends, provided that for 20 trading
days within any period of 30 consecutive trading days, the closing price of
the
common stock equals or exceeds the issue price, or (ii) for cash at the
issue price, plus any accrued and unpaid dividends.
In
the
event of liquidation, the holders of this series of preferred stock will be
entitled to receive out of the assets of Dynex, prior to any such distribution
to the common shareholders, the issue price per share in cash, plus any accrued
and unpaid dividends. For purposes of determining net income (loss) to common
shareholders used in the calculation of earnings (loss) per share, preferred
stock charge includes the current period dividend accrual amount for the
Preferred Stock outstanding for the years ended December 31, 2006, 2005 and
2004
of $4,044, $5,347, and $3,936, respectively. If Dynex fails to pay dividends
for
two consecutive quarters or if Dynex fails to maintain consolidated
shareholders’ equity of at least 200% of the aggregate issue price of the Series
D preferred stock, then these shares automatically convert into a new series
of
9.50% senior notes. Shareholder’s equity at December 31, 2006 was 323% of the
aggregate issue price of the outstanding Series D preferred shares at that
date.
The
following table presents the changes in the number of preferred and common
shares outstanding:
|
Preferred
Shares
|
Common
|
||||||||||||||||||
|
Series
A
|
Series
B
|
Series
C
|
Series
D
|
Total
|
Shares
|
||||||||||||||
|
January
1, 2004
|
493,595
|
688,189
|
684,893
|
-
|
1,866,677
|
10,873,903
|
|||||||||||||
|
Recapitalization
|
(493,595
|
)
|
(688,189
|
)
|
(684,893
|
)
|
5,628,737
|
3,762,060
|
1,288,488
|
||||||||||
|
December
31, 2004
|
-
|
-
|
-
|
5,628,737
|
5,628,737
|
12,162,391
|
|||||||||||||
|
Grant
|
-
|
-
|
-
|
-
|
-
|
1,000
|
|||||||||||||
|
December
31, 2005
|
-
|
-
|
-
|
5,628,737
|
5,628,737
|
12,163,391
|
|||||||||||||
|
Redemption
|
-
|
-
|
-
|
(1,406,767
|
)
|
(1,406,767
|
)
|
-
|
|||||||||||
|
Conversion
|
-
|
-
|
-
|
(431
|
)
|
(431
|
)
|
431
|
|||||||||||
|
Repurchase
|
-
|
-
|
-
|
-
|
-
|
(32,560
|
)
|
||||||||||||
|
December
31, 2006
|
-
|
-
|
-
|
4,221,539
|
4,221,539
|
12,131,262
|
|||||||||||||
On
January 9, 2006, the Company paid approximately $14,105 to redeem 1,406,767
shares of its Series D Preferred Stock. In addition, certain Series D Preferred
Stock shareholders elected to convert 431 shares of Series D Preferred Stock
to
common shares rather than have their shares redeemed. After the redemption
and
conversion, there were 4,221,539 shares of Series D Preferred Stock outstanding.
The Company also announced a common stock repurchase program under which it
may
repurchase up to one million shares of its common stock.
During
2006, the Company repurchased 32,560 shares of common stock at a
weighted-average price of $6.75 per share under a stock repurchase plan
authorized by the Company’s Board of Directors in 2005. The Company is
authorized to repurchase, subject to the applicable securities laws and the
terms of the Series D Preferred Stock designation, up to an additional 967,440
shares of common stock under the current plan. Any future repurchases of common
stock will be made at times and in amounts as deemed appropriate by the Company,
and the plan may be suspended or discontinued at any time.
F
-
21
NOTE
14 - EMPLOYEE BENEFITS
Stock
Incentive Plan
Pursuant
to Dynex’s 2004 Stock Incentive Plan, as approved by the shareholders at Dynex’s
2005 annual shareholders’ meeting (the “Stock Incentive Plan”), Dynex may grant
to eligible officers, directors and employees stock options, stock appreciation
rights (“SARs”) and restricted stock awards. An aggregate of 1,500,000 shares of
common stock is available for distribution pursuant to the Employee Incentive
Plan. Dynex may also grant dividend equivalent rights (“DERs”) in connection
with the grant of options or SARs.
Effective
January 1, 2006, Dynex adopted Statement of Financial Accounting Standards
No.
123 (revised 2004), “Share-Based Payment, (SFAS 123(R)) using the
modified-prospective-transition method. Under this transition method,
compensation cost in 2006 includes cost for options granted prior to but not
vested as of December 31, 2005, and options vested in 2006. Therefore results
for prior periods have not been restated.
On
January 2, 2005, Dynex granted 126,297 stock appreciation rights (SAR) to
certain of its employees and officers under the Stock Incentive Plan. The SARs
vest over the next four years in equal annual installments, expire on December
31, 2011 and have an exercise price of $7.81 per share, which was the market
price of the stock on the grant date. Compensation cost was measured as the
change in fair value of the SAR contract during the period.
On
June
17, 2005, Dynex granted options to acquire an aggregate of 40,000 shares of
common stock to the members of its Board of Directors under the Stock Incentive
Plan. The options have an exercise price of $8.46 per share, which represents
110% of the closing stock price on the grant date, expire on June 17, 2010
and
were fully vested when granted.
On
January 12, 2006, Dynex granted 77,000 SARs to certain of its employees and
officers
under
the Stock Incentive Plan. The SARs vest over the next four years in equal annual
installments, expire on December 31, 2012 and have an exercise price of $6.61
per share, which was the market price of the stock on the grant date.
On
June
16, 2006, the Company granted options to acquire an aggregate of 35,000 shares
of common stock to the members of its Board of Directors under the Stock
Incentive Plan, which had a fair value of approximately $64 on the grant date.
The options have an exercise price of $7.43 per share, which represents 110%
of
the closing stock price on the grant date, expire on June 16, 2011, and were
fully vested when granted.
Dynex
incurred compensation expense of $244, none and $13 for SARs and options related
to the Stock Incentive Plan during 2006, 2005 and 2004,
respectively.
The
following table presents a summary of the SAR and option activity for the Stock
Incentive Plan for the year ended December 31, 2006:
|
SARs
|
Stock
Options
|
||||||||||||
|
Number
Of Shares
|
Weighted
Average Exercise Price
|
Number
Of Shares
|
Weighted
Average Exercise Price
|
||||||||||
|
Shares
outstanding at beginning of year
|
126,297
|
$
|
7.81
|
40,000
|
$
|
8.46
|
|||||||
|
Shares
granted
|
77,000
|
6.61
|
35,000
|
7.43
|
|||||||||
|
Shares
forfeited or redeemed
|
-
|
-
|
-
|
-
|
|||||||||
|
Shares
exercised
|
-
|
-
|
-
|
-
|
|||||||||
|
Shares
outstanding at end of year
|
203,297
|
7.36
|
75,000
|
7.98
|
|||||||||
|
Shares
vested and exercisable
|
31,574
|
$
|
7.81
|
75,000
|
$
|
7.98
|
|||||||
F
-
22
The
weighted-average grant-date fair value of SARs granted during the years ended
December 31, 2006, 2005 and 2004, was $3.69, $5.98 and none, respectively.
No
SARs were either exercised or paid during the period reported. The aggregate
intrinsic value of SARs shares outstanding at December 31, 2006 and fully vested
SARs shares was $(54) and $(23). The weighted average remaining contractual
term
was 52 months and 60 months respectively.
The
weighted-average grant-date fair value of options granted during the years
ended
December 31, 2006, 2005 and 2004, was $2.09, $1.76 and none, respectively.
No
options were either exercised or paid during the period reported. All option
shares are fully vested at the time of the grant. The aggregate intrinsic value
of options shares outstanding and fully vested options shares at December 31,
2006 was $(67). The weighted average remaining contractual term was 42 months
and 54 months respectively.
The
fair
value of each SAR or option award is estimated on the date of grant using the
Black-Scholes option valuation model that uses the assumptions noted in the
table below. Expected volatilities are based on implied volatilities from traded
options on the Company’s stock, historical volatility of the Company’s stock,
and other factors. The Company uses historical data to estimate option exercise
and employee termination within the valuation model; separate groups of
employees that have similar historical exercise behavior are considered
separately for valuation purposes. SARs are assumed to be exercised at the
midpoint between the later of their vesting date and the current reporting
date.
The risk-free rate for periods within the contractual life of the option is
based on the U.S. Treasury yield curve in effect at the time of
grant.
The
option awards to the directors of the Company were treated as equity awards.
The
share options will be settled by the issuance of shares of common stock only,
are not mandatorily redeemable, and have no market, performance or service
conditions that must be met for the shares to be earned. The grant date fair
value was recorded as equity.
|
SARs
Granted
|
Options
Granted
|
||||||||||||
|
January
3, 2005
|
January
12, 2006
|
June
17, 2005
|
June
16, 2006
|
||||||||||
|
Expected
volatility
|
14.6%-17.8
|
%
|
17.2%-22.9
|
%
|
20.8
|
%
|
21.8
|
%
|
|||||
|
Weighted-average
volatility
|
16.1
|
%
|
19.4
|
%
|
20.8
|
%
|
21.8
|
%
|
|||||
|
Expected
dividends
|
0
|
%
|
0
|
%
|
0
|
%
|
0
|
%
|
|||||
|
Expected
term (in months)
|
35
|
45
|
26
|
30
|
|||||||||
|
Risk-free
rate
|
4.68
|
%
|
4.68
|
%
|
4.80
|
%
|
5.11
|
%
|
|||||
The
share
options issued to certain of the Company’s directors will be settled with new
shares issued for the purpose.
Employee
Savings Plan
Dynex
provides an Employee Savings Plan under Section 401(k) of the Internal Revenue
Code. The Employee Savings Plan allows eligible employees to defer up to 25%
of
their income on a pretax basis. Dynex matches the employees’ contribution, up to
6% of the employees’ eligible compensation. Dynex may also make discretionary
contributions based on the profitability of Dynex. The total expense related
to
Dynex’s matching and discretionary contributions in 2006, 2005, and 2004 was
$78, $94 and $122, respectively. Dynex does not provide post employment or
post
retirement benefits to its employees.
401(k)
Overflow Plan
During
1997, Dynex adopted a non-qualifying overflow plan which covers employees who
have contributed to the Employee Savings Plan the maximum amount allowed under
the Internal Revenue Code. The excess contributions are made to the overflow
plan on an after-tax basis. However, Dynex partially reimburses employees for
the effect of the contributions being made on an after-tax basis. Dynex matches
the employee’s contribution up to 6% of the employee’s eligible compensation.
There was no reimbursement expense in 2006, 2005 or 2004.
F
-
23
NOTE
15 - COMMITMENTS AND CONTINGENCIES
As
of
December 31, 2006, Dynex is obligated under non-cancelable operating leases
with
expiration dates through 2008. Rent and lease expense under those leases was
$136, $186, and $473, respectively in 2006, 2005,
and
2004.
In
connection with the formation and initial capitalization of the joint venture,
the Company contributed its interests in a pool of securitized commercial
mortgage loans, and additionally agreed under a payment agreement (included
in
the consolidated financial statements as “obligation under payment agreement”)
to make payments to the joint venture based on cash flows received by the
Company from its interests in a second pool of securitized commercial mortgage
loans. The Company has the right to repurchase the payment agreement from the
joint venture under certain circumstances at its then fair value, and the
Company has the right of first refusal should the joint venture decide to sell
the agreement in the future. The Company has recorded an investment in and
a
liability to the joint venture equal to the estimated fair value of the future
estimated cash flows of the trust. The difference between the gross cash flows
and the recorded liability is amortized into interest expense using the
effective interest method. The carrying value of the obligation under payment
agreement is $16,299 at December 31, 2006, and the estimated fair value of
such
agreement is $16,541.
The
future minimum lease payments under non-cancelable leases are as follows:
|
Years
Ending December 31,
|
Leases
|
|||
|
2007
|
$
|
145
|
||
|
2008
|
64
|
|||
|
2009
|
-
|
|||
|
2010
|
-
|
|||
|
2011
and thereafter
|
-
|
|||
|
Total
|
$
|
209
|
||
NOTE
16 - LITIGATION
Dynex
and
its subsidiaries may be involved in certain litigation matters arising in the
ordinary course of businesses. Although the ultimate outcome of these matters
cannot be ascertained at this time, and the results of legal proceedings cannot
be predicted with certainty, management believes, based on current knowledge,
that the resolution of these matters will not have a material adverse effect
on
the Company’s financial position or results of operations. Information on
litigation arising out of the ordinary course of business is described
below.
One
of
the Company’s subsidiaries, GLS Capital, Inc. (“GLS”), and the County of
Allegheny, Pennsylvania (“Allegheny County”), are defendants in a class action
lawsuit filed in 1997 in the Court of Common Pleas of Allegheny County,
Pennsylvania (the “Court of Common Pleas”). Plaintiffs allege that GLS
illegally charged the taxpayers of Allegheny County certain attorney fees,
costs
and expenses, and interest, in the collection of delinquent property tax
receivables owned by GLS. Plaintiffs were seeking class certification
status, and in October 2006, the Court of Common Pleas certified the class
action status of the litigation. In its Order, the Court of Common Pleas left
open the possible decertification of the class if the fees, costs and
expenses charged by GLS are in accordance with public policy considerations
as
well as Pennsylvania statute and relevant ordinance. The Company
successfully sought the stay of this action pending the outcome of other
litigation before the Pennsylvania Supreme Court in which GLS is not directly
involved but has filed an Amicus brief in support of the defendants.
Several of the allegations in that lawsuit are similar to those being made
against GLS in this litigation. Plaintiffs have not enumerated its damages
in
this matter, and management believes that the ultimate outcome of this
litigation will not have a material impact on the Company’s financial condition,
but may have a material impact on its reported results for the particular period
presented.
F
-
24
Dynex
Capital, Inc.
and
Dynex Commercial, Inc. (“DCI”), formerly an affiliate and now known as DCI
Commercial, Inc., are appellees (or “respondents”) in the Court of Appeals for
the Fifth Judicial District of Texas at Dallas, related to the matter of Basic
Capital Management et al (collectively, “BCM” or “the Plaintiffs”) versus
Dynex Commercial, Inc. et al. The appeal seeks to overturn a judgment from
a lower court in the Company’s favor and DCI which denied recovery to Plaintiffs
and to have a judgment entered in favor of Plaintiffs based on a jury award
for
damages, all of which was set aside by the trial court as further discussed
below. In the alternative, Plaintiffs are seeking a new trial. The appeal
relates to a suit filed against us and DCI in 1999, alleging, among
other things, that DCI and we failed to fund tenant improvement or other
advances allegedly required on various loans made by DCI to BCM, which loans
were subsequently acquired by us; that DCI breached an alleged $160,000 “master”
loan commitment entered into in February 1998; and that DCI breached another
alleged loan commitment of approximately $9,000. The original trial commenced
in
January 2004, and, in February 2004, the jury in the case rendered a verdict
in
favor of one of the Plaintiffs and against us on the alleged breach of the
loan
agreements for tenant improvements and awarded that Plaintiff damages in the
amount of $253. The jury entered a separate verdict against DCI in favor of
BCM
under two mutually exclusive damage models, for $2,200 and $25,600,
respectively. The jury found in favor of DCI on the alleged $9,000 loan
commitment, but did not find in favor of DCI for counterclaims made against
BCM.
The jury also awarded the Plaintiffs attorneys’ fees in the amount of $2,100.
After considering post-trial motions, the presiding judge entered judgment
in
favor of Dynex Capital, Inc. and DCI, effectively overturning the verdicts
of
the jury and dismissing damages awarded by the jury. DCI is a former affiliate
of Dynex, and management believes that Dynex will have no obligation for
amounts, if any, awarded to the Plaintiffs as a result of the actions of DCI.
The
Court
of Appeals heard
oral arguments in this matter in April 2006 but has not yet rendered its
decision.
Dynex
Capital, Inc. and MERIT Securities Corporation, a subsidiary, are defendants
in
a putative class action complaint alleging violations of the federal
securities
laws in
the United States District Court for the Southern District of New York
(“District Court”) by the Teamsters Local 445 Freight Division Pension Fund
("Teamsters"). The complaint was filed on February 11, 2005, and purports to
be
a class action on behalf of purchasers between February 2000 and May 2004 of
MERIT Series 12 and MERIT Series 13 securitization financing bonds (the
“Bonds”), which are collateralized by manufactured housing loans. The
complaint seeks unspecified damages and alleges, among other things,
misrepresentations in connection with the issuance of and subsequent reporting
on the Bonds. The complaint initially named Dynex’s former president and its
current Chief Operating Officer as defendants. On February 10, 2006, the
District Court dismissed the claims against the Company’s former president and
current Chief Operating Officer, but did not dismiss the claims against the
Company or MERIT (“Corporate Defendants”). The Corporate Defendants moved to
certify an interlocutory appeal of this order to the United States Court of
Appeals for the Second Circuit (“Second Circuit”). On June 2, 2006, the District
Court granted the Corporate Defendants’ motion. On September 14, 2006, the
Second Circuit granted the Corporate Defendants’ petition to accept the
certified order for interlocutory appeal. On March 2, 2007, the parties
completed briefing in the Second Circuit and are awaiting oral argument. The
Company has evaluated the allegations made in the complaint and believes them
to
be without merit and intends to vigorously defend itself against
them
Although
no assurance can be given with respect to the ultimate outcome of the above
litigation, the Company believes the resolution of these lawsuits will not
have
a material effect on the Company’s consolidated balance sheet but could
materially affect its consolidated results of operations in a given year or
period.
NOTE
17 - SUPPLEMENTAL CONSOLIDATED STATEMENTS OF CASH FLOWS
INFORMATION
|
Years
ended December 31,
|
||||||||||
|
2006
|
2005
|
2004
|
||||||||
|
Cash
paid for interest
|
$
|
40,932
|
$
|
61,824
|
$
|
96,473
|
||||
|
Supplemental
disclosure of non-cash activities:
|
||||||||||
|
9.75%
senior unsecured notes due April 2007 issued in connection with
recapitalization plan
|
$
|
-
|
$
|
-
|
$
|
823
|
||||
|
Formation
of joint venture with Deutsche Bank
|
$
|
38,248
|
$
|
-
|
$
|
-
|
||||
|
Conversion
of preferred shares to common shares
|
$
|
4
|
$
|
-
|
$
|
-
|
||||
F
-
25
NOTE
18 - RELATED PARTY TRANSACTIONS
Dynex
and
Dynex Commercial, Inc., now known as DCI Commercial, Inc (“DCI”) have been
jointly named in litigation regarding the activities of DCI while it was an
operating subsidiary of an affiliate of Dynex. Dynex and DCI entered into a
Litigation Cost Sharing Agreement whereby the parties set forth how the costs
of
defending against litigation would be shared, and whereby Dynex agreed to fund
all costs of such litigation, including DCI’s portion. DCI’s cumulative portion
of costs associated with litigation and funded by Dynex is $3,276 and is secured
by the proceeds of any counterclaims that DCI may receive in the litigation.
DCI
costs funded by Dynex are considered loans, and bear simple interest at the
rate
of Prime plus 8.0% per annum. At December 31, 2006, the total amount due Dynex
under the Litigation Cost Sharing Agreement, including interest, was $5,144,
which has been fully reserved by Dynex. DCI is currently wholly owned by ICD
Holding, Inc. An executive of Dynex is the sole shareholder of ICD Holding.
NOTE
19 - NON-CONSOLIDATED AFFILIATES
The
following tables summarize the financial condition and result of operations
of
Dynex’s non-consolidated affiliates, excluding the joint venture which is
presented in Note 11.
|
Condensed
Statement of Operations (Unaudited)
|
||||||||||
|
2006
|
2005
|
2004
|
||||||||
|
Total
revenues
|
$
|
2,538
|
$
|
2,538
|
$
|
2,537
|
||||
|
Total
expenses
|
$
|
1,594
|
$
|
1,729
|
$
|
1,831
|
||||
|
Net
income
|
$
|
944
|
$
|
809
|
$
|
706
|
||||
|
Condensed
Balance Sheet (Unaudited)
|
|||||||
|
2006
|
2005
|
||||||
|
Total
assets
|
$
|
15,638
|
$
|
16,103
|
|||
|
Total
liabilities
|
$
|
10,832
|
$
|
12,240
|
|||
|
Total
equity
|
$
|
4,807
|
$
|
3,863
|
|||
Dynex
has
a 99% limited partnership interest in a partnership that owns a commercial
office building located in St. Paul, Minnesota. The building is leased pursuant
to a triple-net master lease to a single-tenant. The second mortgage lender
has
a bargain purchase option to purchase the building in 2007, which, subsequent
to
December 31, 2006, they expressed their intention to exercise during the first
quarter of 2007. Rental income derived from the master lease for the term of
the
lease exactly covers the operating cash requirements on the building, including
the payment of debt service. Dynex accounts for the partnership using the cost
method. The partnership had net income of $944, $809 and $706 for the years
ended December 31, 2006, 2005
and
2004,
respectively. Due to the bargain purchase option, any increase in basis of
the
investment due to the accrual of its share of earnings of the partnership is
immediately reduced by a charge of a like amount to the same account, given
the
probability of exercise of the option by the second mortgage lender. Dynex’s
investment in this partnership amounted to $11 at December 31, 2006,
2005
and
2004.
Dynex
owns a 1% limited partnership interest in a partnership that owns a low income
housing tax credit multifamily housing property located in Texas. In May 2001,
Dynex sold a 98% limited partnership interest in a partnership to a former
director for a purchase price of $198, which was equal to its estimated fair
value. By reason of the former director’s investment in the partnership, Dynex
has guaranteed to the director the use of the low-income housing tax credits
associated with the property, proportionate to his investment, that are reported
annually to the Internal Revenue Service. The guarantee expires on April 30,
2007 when the term of the Section 42 tax credits expires. During 2006, Dynex
loaned the partnership $356. These advances are due on demand. Dynex, through
a
subsidiary has made a first mortgage loan to the partnership secured by the
property, with a current unpaid principal balance of $1,640. As Dynex does
not
have control or exercise significant influence over the operations of this
partnership, its investment and total advances of $712 at December 31, 2006
are
accounted for using the cost method.
F
-
26
NOTE
20 - SUMMARY OF QUARTERLY RESULTS (UNAUDITED)
The
following tables present Dynex’s unaudited selected quarterly results for 2006
and 2005.
|
Year
Ended December 31, 2006
|
First
Quarter
|
Second
Quarter
|
Third
Quarter
|
Fourth
Quarter
|
|||||||||
|
Operating
results:
|
|||||||||||||
|
Total
interest income
|
$
|
14,766
|
$
|
14,192
|
$
|
13,000
|
$
|
8,491
|
|||||
|
Net
interest income after provision for loan losses
|
2,407
|
2,543
|
3,102
|
3,050
|
|||||||||
|
Net
income (loss)
|
1,213
|
1,615
|
(215
|
)
|
2,297
|
||||||||
|
Basic
and diluted net income (loss) per common share
|
0.01
|
0.05
|
(0.10
|
)
|
0.11
|
||||||||
|
Cash
dividends declared per common share
|
-
|
-
|
-
|
-
|
|||||||||
|
Year
Ended December
31, 2005
|
First
Quarter
|
Second
Quarter
|
Third
Quarter
|
Fourth
Quarter
|
|||||||||
|
Operating
results:
|
|||||||||||||
|
Total
interest income
|
$
|
24,053
|
$
|
18,533
|
$
|
15,717
|
$
|
16,092
|
|||||
|
Net
interest income after provision for loan losses
|
2,196
|
2,068
|
992
|
853
|
|||||||||
|
Net
income (loss)
|
935
|
9,594
|
(1,899
|
)
|
955
|
||||||||
|
Basic
net (loss) income per common share
|
(0.03
|
)
|
0.68
|
(0.27
|
)
|
(0.03
|
)
|
||||||
|
Diluted
net (loss) income per common share
|
(0.03
|
)
|
0.54
|
(0.27
|
)
|
(0.03
|
)
|
||||||
|
Cash
dividends declared per common share
|
-
|
-
|
-
|
-
|
|||||||||
F
-
27
EXHIBIT
INDEX
|
Number
|
Exhibit
|
|
21.1
|
List
of consolidated entities of Dynex (filed herewith).
|
|
23.1
|
Consent
of BDO Seidman, LLP (filed herewith).
|
|
23.2
|
Consent
of Deloitte & Touche, LLP (filed herewith).
|
|
31.1
|
Certification
of Principal Executive Officer and Principal Financial Officer pursuant
to
Section 302 of the Sarbanes-Oxley Act of 2002 (filed
herewith).
|
|
32.1
|
Certification
of Principal Executive Officer and Chief Financial Officer pursuant
to
Section 906 of the Sarbanes-Oxley Act of 2002 (filed
herewith).
|