DYNEX CAPITAL INC - Quarter Report: 2008 March (Form 10-Q)
UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
DC 20549
FORM
10-Q
þ Quarterly Report
Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For
the quarterly period ended March 31, 2008
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)
Virginia
|
52-1549373
|
(State
or other jurisdiction of
|
(I.R.S.
Employer
|
incorporation
or organization)
|
Identification
No.)
|
4551
Cox Road, Suite 300, Glen Allen, Virginia
|
23060-6740
|
(Address
of principal executive offices)
|
(Zip
Code)
|
(804)
217-5800
(Registrant‘s
telephone number, including area code)
|
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 whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company. See the definitions of “large accelerated filer,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act. (Check one):
Large
accelerated filer
|
o
|
Accelerated
filer
|
þ
|
Non-accelerated
filer
|
o (Do
not check if a smaller reporting company)
|
Smaller reporting
company
|
o
|
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).
Yes o No þ
On April
30, 2008, the registrant had 12,169,762 shares outstanding of common stock, $.01
par value, which is the registrant’s only class of common stock.
DYNEX
CAPITAL, INC.
FORM
10-Q
INDEX
Page
|
|||
PART
I.
|
FINANCIAL
INFORMATION
|
||
Item
1.
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Financial
Statements
|
||
Condensed
Consolidated Balance Sheets at March 31, 2008 (unaudited) and December 31,
2007
|
1
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||
Condensed
Consolidated Statements of Operations and Comprehensive Income (Loss) for
the three months ended March 31, 2008 and
2007 (unaudited)
|
2
|
||
Condensed
Consolidated Statement of Shareholders’ Equity for the three months ended
March 31, 2008 (unaudited)
|
3
|
||
Condensed
Consolidated Statements of Cash Flows for the three months ended March 31,
2008 and 2007 (unaudited)
|
4
|
||
Notes
to Unaudited Condensed Consolidated Financial Statements
|
4
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||
Item
2.
|
Management’s
Discussion and Analysis of Financial Condition and Results of
Operations
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15
|
|
Item
3.
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Quantitative
and Qualitative Disclosures about Market Risk
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35
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|
Item
4.
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Controls
and Procedures
|
37
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|
PART
II.
|
OTHER
INFORMATION
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||
Item
1.
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Legal
Proceedings
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37
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|
Item
1A.
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Risk
Factors
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38
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|
Item
2.
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Unregistered
Sales of Equity Securities and Use of Proceeds
|
38
|
|
Item
3.
|
Defaults
Upon Senior Securities
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38
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|
Item
4.
|
Submission
of Matters to a Vote of Security Holders
|
38
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|
Item
5.
|
Other
Information
|
39
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|
Item
6.
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Exhibits
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39
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SIGNATURES
|
40
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PART
I. FINANCIAL INFORMATION
Item
1. Financial
Statements
DYNEX
CAPITAL, INC.
CONDENSED
CONSOLIDATED
(amounts
in thousands except share data)
March
31,
|
December
31,
|
|||||||
2008
|
2007
|
|||||||
(Unaudited)
|
||||||||
ASSETS
|
||||||||
Cash
and cash equivalents
|
$ | 37,935 | $ | 35,352 | ||||
Other
assets
|
3,770 | 5,671 | ||||||
41,705 | 41,023 | |||||||
Investments:
|
||||||||
Securitized
mortgage loans, net
|
271,537 | 278,463 | ||||||
Securities
|
58,280 | 29,231 | ||||||
Investment
in joint venture
|
13,380 | 19,267 | ||||||
Other
loans and investments
|
3,549 | 6,774 | ||||||
346,746 | 333,735 | |||||||
$ | 388,451 | $ | 374,758 | |||||
LIABILITIES
AND SHAREHOLDERS' EQUITY
|
||||||||
LIABILITIES
|
||||||||
Securitization
financing
|
$ | 200,313 | $ | 204,385 | ||||
Repurchase
agreements
|
29,556 | 4,612 | ||||||
Obligation
under payment agreement
|
11,244 | 16,796 | ||||||
Other
liabilities
|
6,972 | 7,029 | ||||||
248,085 | 232,822 | |||||||
Commitments
and Contingencies (Note 13)
|
||||||||
SHAREHOLDERS'
EQUITY
|
||||||||
Preferred
stock, par value $0.01 per share, 50,000,000 shares
authorized,
|
||||||||
9.5%
Cumulative Convertible Series D, 4,221,539 shares issued
|
||||||||
and
outstanding, ($43,218 aggregate liquidation preference)
|
41,749 | 41,749 | ||||||
Common
stock, par value $0.01 per share, 100,000,000 shares
authorized,
|
||||||||
12,169,762
and 12,136,262 shares issued and outstanding, respectively
|
122 | 121 | ||||||
Additional
paid-in capital
|
366,731 | 366,716 | ||||||
Accumulated
other comprehensive (loss) income
|
(4,916 | ) | 1,093 | |||||
Accumulated
deficit
|
(263,320 | ) | (267,743 | ) | ||||
140,366 | 141,936 | |||||||
$ | 388,451 | $ | 374,758 | |||||
See
notes to unaudited condensed consolidated financial
statements.
|
1
DYNEX
CAPITAL, INC.
OF
OPERATIONS AND COMPREHENSIVE (LOSS) INCOME (UNAUDITED)
(amounts
in thousands except share data)
Three
Months Ended
|
||||||||
March
31,
|
||||||||
2008
|
2007
|
|||||||
Interest
income:
|
||||||||
Securitized
mortgage loans
|
$ | 5,602 | $ | 7,025 | ||||
Securities
|
428 | 324 | ||||||
Cash
and cash equivalents
|
324 | 739 | ||||||
Other
loans and investments
|
129 | 127 | ||||||
6,483 | 8,215 | |||||||
Interest
and related expenses:
|
||||||||
Securitization
financing
|
3,599 | 4,096 | ||||||
Repurchase
agreements
|
54 | 1,258 | ||||||
Obligation
to joint venture under payment agreement
|
401 | 367 | ||||||
Other
|
8 | 34 | ||||||
4,062 | 5,755 | |||||||
Net
interest income
|
2,421 | 2,460 | ||||||
(Provision
for) recapture of provision for loan losses
|
(26 | ) | 523 | |||||
Net
interest income after provision for loan losses
|
2,395 | 2,983 | ||||||
Equity
in (loss) income of joint venture
|
(2,251 | ) | 630 | |||||
Gain
(loss) on sale of investments, net
|
2,093 | (6 | ) | |||||
Fair
value adjustments, net
|
4,231 | – | ||||||
Other
income (expense)
|
67 | (539 | ) | |||||
General
and administrative expenses
|
(1,216 | ) | (1,126 | ) | ||||
Net
income
|
5,319 | 1,942 | ||||||
Preferred
stock dividends
|
(1,003 | ) | (1,003 | ) | ||||
Net
income to common shareholders
|
$ | 4,316 | $ | 939 | ||||
Change
in net unrealized gain (loss) on :
|
||||||||
Investments
classified as available-for-sale
|
(2,373 | ) | 126 | |||||
Investment
in joint venture
|
(3,636 | ) | 829 | |||||
Comprehensive
(loss) income
|
$ | (690 | ) | $ | 2,897 | |||
Net
income per common share:
|
||||||||
Basic
|
$ | 0.36 | $ | 0.08 | ||||
Diluted
|
$ | 0.32 | $ | 0.08 | ||||
See
notes to unaudited condensed consolidated financial
statements.
|
2
DYNEX
CAPITAL, INC.
CONDENSED
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY (UNAUDITED)
Three-months
ended March 31, 2008
(amounts
in thousands except share data)
Preferred
Stock
|
Common
Stock
|
Additional
Paid-in
Capital
|
Accumulated
Other
Comprehensive
(Loss)
Income
|
Accumulated
Deficit
|
Total
|
|||||||||||||||||||
Balance
at December 31, 2007
|
$ | 41,749 | $ | 121 | $ | 366,716 | $ | 1,093 | $ | (267,743 | ) | $ | 141,936 | |||||||||||
Cumulative
effect of adoption of SFAS 159
|
– | – | – | – | 1,323 | 1,323 | ||||||||||||||||||
Net
income
|
– | – | – | – | 5,319 | 5,319 | ||||||||||||||||||
Other
comprehensive income (loss):
|
||||||||||||||||||||||||
Change
in market value of securities and other investments
|
– | – | – | (3,916 | ) | – | (3,916 | ) | ||||||||||||||||
Reclassification
adjustment for net gains included in net income
|
– | – | – | (2,093 | ) | – | (2,093 | ) | ||||||||||||||||
Total
comprehensive income (loss)
|
(690 | ) | ||||||||||||||||||||||
Dividends
on common stock
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– | – | – | – | (1,217 | ) | (1,217 | ) | ||||||||||||||||
Dividends
on preferred stock
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– | – | – | – | (1,002 | ) | (1,002 | ) | ||||||||||||||||
Grant
and vesting of restricted stock
|
– | 1 | 15 | – | – | 16 | ||||||||||||||||||
Balance
at March 31, 2008
|
$ | 41,749 | $ | 122 | $ | 366,731 | $ | (4,916 | ) | $ | (263,320 | ) | $ | 140,366 |
See
notes to unaudited condensed consolidated financial statements.
3
DYNEX
CAPITAL, INC.
OF
CASH FLOWS (UNAUDITED)
(amounts
in thousands)
Three
Months Ended
|
||||||||
March
31,
|
||||||||
2008
|
2007
|
|||||||
Operating
activities:
|
||||||||
Net
income
|
$ | 5,319 | $ | 1,942 | ||||
Adjustments
to reconcile net income to cash provided by operating
activities:
|
||||||||
Equity
in (loss) income of joint venture
|
2,251 | (630 | ) | |||||
Provision
for (recapture of provision for) loan losses
|
26 | (523 | ) | |||||
Gain
on sale of investments
|
(2,093 | ) | 6 | |||||
Fair
value adjustments, net
|
(4,231 | ) | – | |||||
Amortization
and depreciation
|
(264 | ) | (335 | ) | ||||
Net
change in other assets and other liabilities
|
1,912 | 1,407 | ||||||
Net
cash and cash equivalents provided by operating activities
|
2,920 | 1,867 | ||||||
Investing
activities:
|
||||||||
Principal
payments received on securitized mortgage loans
|
6,825 | 15,578 | ||||||
Purchase
of securities and other investments
|
(37,730 | ) | (5,591 | ) | ||||
Payments
received on securities and other loans and investments
|
2,581 | 2,811 | ||||||
Proceeds
from sales of securities and other investments
|
8,991 | 83 | ||||||
Other
|
85 | 937 | ||||||
Net
cash and cash equivalents (used for) provided by investing
activities
|
(19,248 | ) | 13,818 | |||||
Financing
activities:
|
||||||||
Principal
payments on securitization financing
|
(3,814 | ) | (4,657 | ) | ||||
Net
borrowings (repayments on) repurchase agreement
|
24,945 | (9,100 | ) | |||||
Proceeds
from sale of common stock
|
- | 37 | ||||||
Dividends
paid
|
(2,220 | ) | (1,002 | ) | ||||
Net
cash and cash equivalents provided by (used for) financing
activities
|
18,911 | (14,722 | ) | |||||
Net
increase in cash and cash equivalents
|
2,583 | 963 | ||||||
Cash
and cash equivalents at beginning of period
|
35,352 | 56,880 | ||||||
Cash
and cash equivalents at end of period
|
$ | 37,935 | 57,843 | |||||
See
notes to unaudited condensed consolidated financial
statements.
|
4
DYNEX
CAPITAL, INC.
March 31,
2008
(amounts
in thousands except share and per share data)
NOTE
1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of
Presentation
The
accompanying condensed consolidated financial statements have been prepared in
accordance with the instructions to Form 10-Q and do not 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 condensed
consolidated financial statements include the accounts of Dynex Capital, Inc.
and its qualified real estate investment trust ("REIT") subsidiaries and taxable
REIT subsidiary (together, “Dynex” or the “Company”). All
intercompany balances and transactions have been eliminated in
consolidation.
The
Company consolidates entities in which it owns more than 50% of the voting
equity, and control does not rest with others and variable interest entities in
which it is determined to be the primary beneficiary in accordance with
Financial Interpretation (“FIN”) 46(R). The Company 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.
The
Company believes it has complied with the requirements for qualification as a
REIT under the Internal Revenue Code of 1986, as amended (the
“Code”). To the extent the Company qualifies as a REIT for federal
income tax purposes, 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.
In the
opinion of management, all significant adjustments, consisting of normal
recurring accruals considered necessary for a fair presentation of the condensed
consolidated financial statements have been included. The financial statements
presented are unaudited. Operating results for the three months ended
March 31, 2008 are not necessarily indicative of the results that may be
expected for the year ending December 31, 2008. Certain information and footnote
disclosures normally included in the consolidated financial statements prepared
in accordance with generally accepted accounting principles have been
omitted. The unaudited financial statements included herein should be
read in conjunction with the financial statements and notes thereto included in
the Company’s Annual Report on Form 10-K for the year ended December 31, 2007,
filed with the Securities and Exchange Commission (the “SEC”).
The
preparation of financial statements, in conformity with generally accepted
accounting principles, 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 reporting
period. Actual results could differ from those
estimates. The primary estimates inherent in the accompanying
condensed consolidated financial statements are discussed below.
The
Company uses estimates in establishing fair value for its financial
instruments. Securities classified as available-for-sale are carried
in the accompanying financial statements at estimated fair value. Estimates of
fair value for securities are based on market prices provided by certain
dealers, when available. When market prices are not available, fair
value estimates are determined by calculating the present value of the projected
cash flows of the instruments using market-based assumptions such as estimated
future interest rates and estimated market spreads to applicable indices for
comparable securities, and using collateral based assumptions such as prepayment
rates and credit loss assumptions based on the most recent performance and
anticipated performance of the underlying collateral.
5
The
Company 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 the Company 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, the Company 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.
The
Company considers impairments of other investments 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.
The
Company also has credit risk on loans in its portfolio as discussed in Note
4. An allowance for loan losses has been estimated and established
for currently existing losses in the loan portfolio, which are deemed probable
as to their occurrence. 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. Provisions made to increase the
allowance for loan losses are presented as provision for losses or recapture of
provision for loan losses, in the accompanying condensed consolidated statements
of operations. The Company’s actual credit losses may differ from
those estimates used to establish the allowance.
New Accounting
Standards
In
December 2007, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards (“SFAS”) No. 160, “Noncontrolling
Interests in Consolidated Financial Statements, an amendment of ARB No.
51.” SFAS 160 addresses reporting requirements in the financial
statements of non-controlling interests to their equity share of subsidiary
investments. SFAS 160 applies to reporting periods beginning
after December 15, 2008. The Company is currently evaluating the
potential impact on adoption of SFAS 160.
In
December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS
141(R)”) which revised SFAS No. 141, “Business Combinations.” This
pronouncement is effective as of January 1, 2009. Under SFAS No. 141,
organizations utilized the announcement date as the measurement date for the
purchase price of the acquired entity. SFAS 141(R) requires
measurement at the date the acquirer obtains control of the acquiree, generally
referred to as the acquisition date. SFAS 141(R) will have a
significant impact on the accounting for transaction costs, restructuring costs,
as well as the initial recognition of contingent assets and liabilities assumed
during a business combination. Under SFAS 141(R), adjustments to the
acquired entity’s deferred tax assets and uncertain tax position balances
occurring outside the measurement period are recorded as a component of the
income tax expense, rather than goodwill. As the provisions of SFAS
141(R) are applied prospectively, the impact cannot be determined until the
transactions occur. The Company is currently evaluating the impact,
if any, that SFAS 141(R) may have on the Company’s financial
statements.
On March
20, 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative
Instruments and Hedging Activities, an amendment of FASB Statement No. 133”
(“SFAS 161”). SFAS 161 provides for enhanced disclosures about how
and why an entity uses derivatives and how and where those derivatives and
related hedged items are reported in the entity’s financial
statements. SFAS 161 also requires certain tabular formats for
disclosing such information. SFAS 161 is effective for fiscal
years and interim periods beginning after November 15, 2008 with early
application encouraged. SFAS 161 applies to all entities and all
derivative instruments and related hedged items accounted for under SFAS
133. Among other things, SFAS 161 requires disclosures of an entity’s
objectives and strategies for using derivatives by primary underlying risk and
certain disclosures about the potential future collateral or cash requirements
as a result of contingent credit-related features. The Company is
currently evaluating the impact, if any, that the adoption of SFAS 161 will have
on the Company’s financial statements.
6
NOTE
2 — NET INCOME PER COMMON SHARE
Net
income per common share is presented on both a basic and diluted 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 options, using the treasury stock method, but only
if these items are dilutive. The Series D Preferred Stock is
convertible into one share of common stock for each share of preferred
stock. The following table reconciles the numerator and denominator
for both the basic and diluted net income per common share for the three months
ended March 31, 2008 and 2007.
Three
Months Ended March 31,
|
||||||||||||||||
2008
|
2007
|
|||||||||||||||
Income
|
Weighted-Average
Common Shares
|
Income
|
Weighted-
Average
Common
Shares
|
|||||||||||||
Net
income
|
$ | 5,319 | $ | 1,942 | ||||||||||||
Preferred
stock charge
|
(1,003 | ) | (1,003 | ) | ||||||||||||
Net
income to common shareholders
|
$ | 4,316 | 12,156,887 | $ | 939 | 12,133,151 | ||||||||||
Effect
of dilutive items
|
1,003 | 4,230,105 | – | 495 | ||||||||||||
Diluted
|
$ | 5,319 | 16,386,992 | $ | 939 | 12,133,646 | ||||||||||
Net
income per share:
|
||||||||||||||||
Basic
|
$ | 0.36 | $ | 0.08 | ||||||||||||
Diluted
|
$ | 0.32 | $ | 0.08 | ||||||||||||
Reconciliation
of shares included in calculation of earnings per share due to dilutive
effect:
|
||||||||||||||||
Net
effect of dilutive:
|
||||||||||||||||
Preferred
stock
|
1,003 | 4,221,539 | – | – | ||||||||||||
Stock
options
|
– | 8,566 | – | 495 | ||||||||||||
$ | 1,003 | 4,230,105 | $ | – | 495 |
NOTE
3 — SECURITIZED MORTGAGE LOANS, NET
The
following table summarizes the components of securitized mortgage loans at March
31, 2008 and December 31, 2007.
March
31,
2008
|
December
31, 2007
|
|||||||
Securitized
mortgage loans:
|
||||||||
Commercial
mortgage loans
|
$ | 184,040 | $ | 185,998 | ||||
Single-family
mortgage loans
|
81,280 | 86,088 | ||||||
265,320 | 272,086 | |||||||
Funds
held by trustees, including funds held for defeased loans
|
7,166 | 7,225 | ||||||
Accrued
interest receivable
|
1,850 | 1,940 | ||||||
Unamortized
discounts and premiums, net
|
(54 | ) | (67 | ) | ||||
Loans,
at amortized cost
|
274,282 | 281,184 | ||||||
Allowance
for loan losses
|
(2,745 | ) | (2,721 | ) | ||||
$ | 271,537 | $ | 278,463 |
7
All of
the securitized mortgage loans are encumbered by securitization financing
bonds.
NOTE
4 — ALLOWANCE FOR LOAN LOSSES
The
allowance for loan losses is included in securitized mortgage loans, net in the
accompanying Condensed Consolidated Balance Sheets. The following
table summarizes the aggregate activity for the allowance for loan losses for
the three months ended March 31, 2008 and 2007.
Three
Months Ended March 31,
|
||||||||
2008
|
2007
|
|||||||
Allowance
at beginning of period
|
$ | 2,721 | $ | 4,495 | ||||
Provision
for (recapture of) loan losses
|
26 | (523 | ) | |||||
Charge-offs,
net of recoveries
|
(2 | ) | (434 | ) | ||||
Allowance
at end of period
|
$ | 2,745 | $ | 3,538 |
The
Company identified $12,148 of impaired commercial loans at March 31, 2008
compared to $13,792 of impaired commercial loans at December 31, 2007, none of
which were delinquent.
The
following table presents certain information on impaired securitized commercial
mortgage loans at December 31, 2007 and March 31, 2008.
Investment
in Impaired Loans
|
Reserves
on Impaired Loans
|
Investment
in Excess of Reserves
|
||||||||||
December
31, 2007
|
$ | 13,792 | $ | 2,590 | $ | 11,202 | ||||||
March
31, 2008
|
12,148 | 2,590 | 9,558 |
NOTE
5 — SECURITIES
The
following table summarizes the amortized cost basis and fair value of the
Company’s securities, all of which are classified as available-for-sale, and the
related average effective interest rates at March 31, 2008 and December 31,
2007.
March
31, 2008
|
December
31, 2007
|
|||||||||||||||
Value
|
Effective
Interest Rate
|
Value
|
Effective
Interest Rate
|
|||||||||||||
Securities,
available-for-sale at amortized cost:
|
||||||||||||||||
Agency
mortgage-backed securities
|
$ | 34,545 | 4.69 | % | $ | 7,410 | 9.03 | % | ||||||||
Non-agency
mortgage-backed securities
|
7,374 | 10.56 | % | 7,684 | 9.41 | % | ||||||||||
Equity
securities
|
12,423 | 7,704 | ||||||||||||||
Corporate
debt securities
|
4,722 | 4,722 | ||||||||||||||
59,064 | 27,520 | |||||||||||||||
Gross
unrealized gains
|
865 | 2,406 | ||||||||||||||
Gross
unrealized losses
|
(1,649 | ) | (695 | ) | ||||||||||||
Securities,
available-for-sale at fair value
|
$ | 58,280 | $ | 29,231 |
8
In March
2008, the Company purchased two Fannie Mae certificates for $27,742 and financed
the purchase with $24,944 of repurchase agreements. The Company also
sold approximately $5,247 of equity securities during the quarter ended March
31, 2008 on which it recognized a gain of approximately $2,088 and purchased
approximately $9,988 of equity securities of certain publicly traded mortgage
real estate investment trusts.
NOTE
6 — INVESTMENT IN JOINT VENTURE
The
Company, through a wholly-owned subsidiary, holds a 49.875% interest in a joint
venture, Copperhead Ventures, LLC, primarily between the Company and DBAH
Capital, LLC, an affiliate of Deutsche Bank, A. G.
The
Company accounts for its investment in the joint venture using the equity
method, under which it recognizes its proportionate share of the joint venture’s
earnings and comprehensive income. The Company’s interest in the
earnings (loss) and other comprehensive income (loss) of the joint venture for
the three months ended March 31, 2008 were $(2,251) and $(3,636),
respectively.
The joint
venture had total assets at March 31, 2008 of $25,417, which were comprised
primarily of $6,262 of cash and cash equivalents, $7,708 of available-for-sale
subordinate commercial mortgage-backed-securities, a financial instrument backed
by commercial mortgage loans accounted for under SFAS 159 with a fair value of
$11,244 and other assets of $203.
NOTE
7 — OTHER LOANS AND INVESTMENTS
The
following table summarizes the Company’s other loans and investments at March
31, 2008 and December 31, 2007:
March
31, 2008
|
December
31, 2007
|
|||||||
Single-family
mortgage loans
|
$ | 2,323 | $ | 2,486 | ||||
Multifamily
and commercial mortgage loan participations
|
917 | 927 | ||||||
Unamortized
discounts on mortgage loans
|
(275 | ) | (289 | ) | ||||
Mortgage
loans, net
|
2,965 | 3,124 | ||||||
Delinquent
property tax receivable securities
|
482 | 2,127 | ||||||
Notes
receivable and other investments
|
102 | 1,523 | ||||||
Other
loans and investments
|
$ | 3,549 | $ | 6,774 |
On
February 5, 2008, the Company’s subsidiary, GLS Capital, Inc., received $1,625
for the sale of substantially all of the delinquent property tax receivables it
owned in Allegheny County, Pennsylvania.
NOTE
8 –FAIR VALUE MEASURMENTS
On
January 1, 2008, the Company adopted the provisions of SFAS No. 157 for all
assets that are measured at fair value and its obligation to joint venture under
payment agreement liability. Fair value is defined as the price at
which an asset could be exchanged in a current transaction between
knowledgeable, willing parties. A liability’s fair value is defined as the
amount that would be paid to transfer the liability to a new obligor, not the
amount that would be paid to settle the liability with the creditor. Where
available, fair value is based on observable market prices or parameters or
derived from such prices or parameters. Where observable prices or inputs are
not available, valuation models are applied. These valuation techniques involve
some level of management estimation and judgment, the degree of which is
dependent on the price transparency for the instruments or market and the
instruments’ complexity.
9
Assets
and liabilities recorded at fair value in the Condensed Consolidated Balance
Sheets are categorized based upon the level of judgment associated with the
inputs used to measure their fair value. Hierarchical levels, defined by SFAS
157 and directly related to the amount of subjectivity associated with the
inputs to fair valuation of these assets and liabilities, are as
follows:
Level 1 —
Inputs are unadjusted, quoted prices in active markets for identical assets or
liabilities at the measurement date. The types of assets and
liabilities carried at Level 1 fair value generally are equity securities listed
in active markets.
Level 2 —
Inputs (other than quoted prices included in Level 1) are either directly or
indirectly observable for the asset or liability through correlation with market
data at the measurement date and for the duration of the instrument’s
anticipated life. Fair valued assets and liabilities that are
generally included in this category are certain agency securities and certain
derivatives.
Level 3 —
Inputs reflect management’s best estimate of what market participants would use
in pricing the asset or liability at the measurement date. Consideration is
given to the risk inherent in the valuation technique and the risk inherent in
the inputs to the model. Generally, assets and liabilities carried at
fair value and included in this category are certain mortgage and asset-backed
securities, certain corporate debt securities, certain delinquent property tax
receivables and the obligation under payment agreement liability.
The
following table presents the Company’s assets and liabilities, which are
accounted for at fair value, segregated by the hierarchy level of the fair value
estimate.
Fair
Value Measurements at March 31, 2008
|
||||||||||||||||
March
31, 2008
|
Level
1
|
Level
2
|
Level
3
|
|||||||||||||
Assets
|
||||||||||||||||
Agency mortgage-backed
securities
|
$ | 34,670 | $ | – | $ | 34,670 | $ | – | ||||||||
Non-agency mortgage-backed
securities
|
7,402 | – | – | 7,402 | ||||||||||||
Equity securities
|
12,186 | 12,186 | – | – | ||||||||||||
Corporate debt
securities
|
4,022 | – | – | 4,022 | ||||||||||||
Delinquent property tax
receivables
|
482 | – | – | 482 | ||||||||||||
Derivative
instrument
|
103 | – | 103 | – | ||||||||||||
Total assets carried at fair
value
|
$ | 58,865 | $ | 12,186 | $ | 34,773 | $ | 11,906 | ||||||||
Liabilities
|
||||||||||||||||
Obligation under payment
agreement
|
$ | 11,244 | $ | – | $ | – | $ | 11,244 | ||||||||
Total liabilities carried at fair
value
|
$ | 11,244 | $ | – | $ | – | $ | 11,244 |
10
The
following is a reconciliation of the beginning and ending balances of the Level
3 fair value estimates.
Level
3 Fair Values
|
||||||||||||||||||||
Non-agency
mortgage-backed securities
|
Corporate
debt securities
|
Delinquent
property tax receivables
|
Total
assets
|
Obligation
under payment agreement
|
||||||||||||||||
Balance
at January 1, 2008
|
$ | 7,726 | $ | 4,347 | $ | 2,127 | $ | 14,200 | $ | 15,473 | ||||||||||
Total
realized and unrealized gains (losses)
|
||||||||||||||||||||
Included in
earnings
|
– | – | 5 | 5 | 4,229 | |||||||||||||||
Included in other comprehensive
income
|
(16 | ) | (325 | ) | 123 | (218 | ) | – | ||||||||||||
Purchases,
sales, issuances and other settlements, net
|
(308 | ) | – | (1,773 | ) | (2,081 | ) | – | ||||||||||||
Transfers
in and/or out of Level 3
|
– | – | – | – | – | |||||||||||||||
Balance
at March 31, 2008
|
$ | 7,402 | $ | 4,022 | $ | 482 | $ | 11,906 | $ | 11,244 |
There
were no assets or liabilities which were measured at fair value on a
non-recurring basis during the three months ended March 31, 2008.
NOTE
9 – ADOPTION OF SFAS 159
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
(the fair value option). The election to use the fair value option
for a financial asset or financial liability is made when the instrument is
first recorded, with subsequent changes in fair value recorded in the income
statement.
The
Company adopted SFAS 159 on January 1, 2008 for its obligation to joint venture
under payment agreement. The obligation to joint venture under
payment agreement is a liability to remit certain cash flows to an
unconsolidated joint venture in which the Company owns 49.875%
interest. The right to receive those cash flows is recorded as an
asset on the joint ventures balance sheet, which is marked to market as an
available-for-sale security. Prior to the adoption of SFAS 159, the
instrument was accounted for differently on the Company’s books and the joint
ventures books. Electing the fair value option by the Company for the
obligation under payment agreement will increase the consistency with which the
instrument is accounted for and is expected to decrease the volatility in the
Company’s reported earnings and book value over time.
As a
result of the one-time election to account for the obligation to joint venture
under payment agreement under the fair value option, the Company reclassified
the difference between the recorded basis and the fair value of the obligation
under payment agreement as an adjustment to increase beginning accumulated
deficit in the amount of $1,323.
NOTE
10 – SECURITIZATION FINANCING
The
Company, 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 and
having varying repayment terms. The Company, on occasion, may retain
bonds at issuance, or redeem bonds and hold such bonds outstanding for possible
future issuance. Payments received on securitized mortgage loans and
any reinvestment income earned thereon are used to make payments on the
bonds.
11
The
obligations under the securitization financings are payable solely from the
securitized mortgage loans and are otherwise non-recourse to the
Company. 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 the
Company’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.
The
components of non-recourse securitization financing along with certain other
information at March 31, 2008 and December 31, 2007 are summarized as
follows.
March
31, 2008
|
December
31, 2007
|
|||||||||||||||
Bonds
Outstanding
|
Range
of Interest Rates
|
Bonds
Outstanding
|
Range
of Interest Rates
|
|||||||||||||
Fixed-rate
classes
|
$ | 165,381 | 6.6% - 8.8 | % | $ | 167,398 | 6.6% - 8.8 | % | ||||||||
Variable
rate class
|
32,703 | 3.4 | % | 34,500 | 5.1 | % | ||||||||||
Accrued
interest payable
|
1,160 | 1,186 | ||||||||||||||
Deferred
costs
|
(1,680 | ) | (1,851 | ) | ||||||||||||
Unamortized
net bond premium
|
2,749 | 3,152 | ||||||||||||||
$ | 200,313 | $ | 204,385 | |||||||||||||
Range
of stated maturities
|
2024-2027 | 2024-2027 | ||||||||||||||
Estimated
weighted average life
|
3.2 years
|
3.3
years
|
||||||||||||||
Number
of series
|
3 | 3 |
At
March 31, 2008, the weighted-average effective rate of the coupon on the
bonds outstanding was 6.3%. The average effective rate on the bonds
was 7.1% and 7.2% for the three months ended March 31, 2008 and the year ended
December 31, 2007, respectively.
NOTE
11 – 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 $29,556 and $4,612, which were collateralized by securities with a
fair value of $65,522 and $42,975 at March 31, 2008 and December 31, 2007,
respectively.
The
repurchase agreements reprice monthly with interest rates based on a spread to
one-month LIBOR. As of March 31, 2008, the repurchase agreements had
a weighted average interest rate of 2.91%.
NOTE
12 – PREFERRED AND COMMON STOCK
The
Company 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 dividend per share
is equal to the greater of (i) the per quarter base rate of $0.2375 for
Series D, or (ii) the quarterly dividend declared on the Company’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 the Company 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 Company’s assets, prior to any such distribution
to the common shareholders, the issue price per share in cash, plus any accrued
and unpaid dividends. If the Company fails to pay dividends for two
consecutive quarters or if the
12
Company
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. The
Company paid dividends of $0.95 per share of Series D Preferred Stock for each
of the years ended December 31, 2007, 2006 and 2005.
The
following table presents the changes in the number of preferred and common
shares outstanding:
Shares
|
||||||||
Preferred
|
||||||||
Series
D
|
Common
|
|||||||
December
31, 2007
|
4,221,539 | 12,136,262 | ||||||
Restricted
shares granted
|
- | 33,500 | ||||||
March
31, 2008
|
4,221,539 | 12,169,762 |
On
February 5, 2008, the Company’s Board of Directors declared a dividend of $0.10
per common share to shareholders of record on February 15, 2008, which was paid
on February 29, 2008 in the amount of $1,217. On March 19, 2008, the
Company’s Board of Directors declared a dividend of $0.2375 per share of Series
D Preferred Stock to shareholders of record on March 31, 2008, which was paid in
the amount of $1,003 on April 30, 2008.
NOTE
13 — COMMITMENTS AND CONTINGENCIES
The
Company and its subsidiaries may be involved in certain litigation matters
arising in the ordinary course of business from time to
time. Although the ultimate outcome of these matters cannot be
ascertained at this time, and the results of legal proceedings cannot be
predicted with certainty, the Company 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 which were purchased from Allegheny
County. In 2007, the Court of Common Pleas stayed 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 their damages in this matter, and the Company believes that the
ultimate outcome of this litigation will not have a material impact on its
financial condition, but may have a material impact on its reported results for
the particular period presented.
Dynex
Capital, Inc. and Dynex Commercial, Inc. (DCI), a former affiliate of the
Company 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 Court of Appeals
heard oral arguments in this matter in April 2006. The appeal sought
to overturn the trial court’s judgment in the Company’s and DCI’s favor which
denied recovery to Plaintiffs. Plaintiffs sought a reversal of the
trial court’s judgment, and sought rendition of judgment against the Company for
alleged breach of loan agreements for tenant improvements in the
amount of $253. They also sought reversal of the trial court’s judgment
and rendition of judgment against DCI in favor of BCM under two mutually
exclusive damage models, for $2,200 and $25,600, respectively, related to the
alleged breach by DCI of a $160,000 “master” loan commitment.
Plaintiffs also sought reversal and rendition of a judgment in their favor for
attorneys’ fees in the amount of $2,100. Alternatively, Plaintiffs sought
a new trial. On February 22, 2008, the Court of Appeals ruled
in
13
favor of
the Company and DCI, upholding the trial court’s judgment. On May 7,
2008, Plaintiffs filed an appeal with the Supreme Court of
Texas. Even if Plaintiffs were to be successful on appeal, DCI is a
former affiliate of the Company, and the Company believes that it would have no
obligation for amounts, if any, awarded to the Plaintiffs as a result of the
actions of DCI.
The
Company 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 7, 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 the
Company’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 its current Chief
Operating Officer, but did not dismiss the claims against the Company or
MERIT. The Company and MERIT petitioned for an interlocutory appeal
with the United States Court of Appeals for the Second Circuit (Second
Circuit). The Second Circuit granted the Company’s petition on
September 15, 2006 and heard oral argument on the appeal on January 30,
2008. The Company has evaluated the allegations made in the
complaint, 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 its consolidated balance sheet but could materially affect
its consolidated results of operations in a given year or period.
NOTE
14 — STOCK BASED COMPENSATION
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
Stock Incentive Plan. Dynex may also grant dividend equivalent rights
(“DERs”) in connection with the grant of options or SARs.
On
February 4, 2008, Dynex granted 33,500 shares of restricted common stock to
certain of its employees and officers under the Stock Incentive
Plan. Of the restricted stock granted, 3,500 shares vest equally each
quarter of 2008. The remaining 30,000 shares of restricted stock vest
25% per year (on the grant date) over the next four years The weighted-average
grant-date fair value of the restricted stock grants was $8.80 per share for a
total compensation cost of $294, which will be recognized in expense evenly over
the vesting period.
The
following table presents a summary of the SAR activity for the Stock Incentive
Plan:
Three
Months Ended
|
||||||||
March
31, 2008
|
||||||||
Number
of Shares
|
Weighted-Average
Exercise Price
|
|||||||
SARs
outstanding at beginning of period
|
278,146 | $ | 7.27 | |||||
SARs
granted
|
– | – | ||||||
SARs
forfeited or redeemed
|
– | – | ||||||
SARs
exercised
|
– | – | ||||||
SARs
outstanding at end of period
|
278,146 | $ | 7.27 | |||||
SARs
vested and exercisable
|
149,073 | $ | 7.41 |
14
The
following table presents a summary of the option activity for the Stock
Incentive Plan:
Three
Months Ended
|
||||||||
March
31, 2008
|
||||||||
Number
of Shares
|
Weighted-Average
Exercise Price
|
|||||||
Options
outstanding at beginning of period
|
95,000 | $ | 8.28 | |||||
Options
granted
|
– | – | ||||||
Options
forfeited or redeemed
|
– | – | ||||||
Options
exercised
|
– | – | ||||||
Options
outstanding at end of period
|
95,000 | $ | 8.28 | |||||
Options
vested and exercisable
|
95,000 | $ | 8.28 |
As
required by SFAS No. 123(R), “Share Based Payments,” stock options, which are
settleable only in shares of common stock, have been treated as equity awards,
with their fair value measured at the grant date, and SARs, which are settleable
in cash, have been treated as liability awards, with their fair value measured
at the grant date and remeasured at the end of each reporting
period. The fair value of SARs was estimated at March 31, 2008 using
the Black-Scholes option valuation model based upon the assumptions in the table
below.
Dynex
recognized a stock based compensation benefit of $67 and expense of $72 for the
three months ended March 31, 2008 and 2007, respectively, related to the
restricted stock and SARs. The total compensation cost related to
non-vested awards was $519 and $407 at March 31, 2008 and December 31, 2007,
respectively, and will be recognized as the awards vest.
The
following table describes the weighted average of assumptions used for
calculating the fair value of SARs outstanding at March 31, 2008.
SARs
Fair Value
|
|
March
31, 2008
|
|
Expected
volatility
|
16.91%-20.01%
|
Weighted-average
volatility
|
17.48%
|
Expected
dividends
|
4.26%
|
Expected
term (in months)
|
48
|
Risk-free
rate
|
3.21%
|
The
following discussion and analysis of the financial condition and results of
operations of the Company for the three months ended March 31, 2008 should be
read in conjunction with the Company's Unaudited Condensed Consolidated
Financial Statements and the accompanying Notes to Unaudited Condensed
Consolidated Financial Statements included in this report.
The
Company 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. The Company
finances these loans and securities through a combination of non-recourse
securitization financing, repurchase agreements, and equity. Dynex
employs financing in order to increase the overall yield on its invested
capital.
In
February 2008, the Company’s Board of Directors authorized the investment of a
significant portion of its capital in residential mortgage backed securities
(“RMBS”) issued or guaranteed by a federally chartered corporation,
such
15
as
Fannie Mae or Freddie Mac, or an agency of the U.S. government, such as Ginnie
Mae (commonly referred to as Agency RMBS). While the Company has
occasionally invested in Agency RMBS in the past, the Company believes that
risk-adjusted returns for investing in Agency RMBS are currently compelling
given current yields available and the favorable terms and costs to finance the
Agency RMBS. The Company expects to use repurchase agreement leverage
in order to enhance the overall returns on its invested capital. The
leverage ratio on these and other investments may vary depending on market and
economic conditions. The Company also expects to employ derivatives
in order to manage its interest rate risk.
The
Company purchased approximately $27.7 million of Agency RMBS during the quarter
and $41.2 million more in April 2008. The Company’s Agency RMBS are
currently financed with repurchase agreement financing and
equity. The Company expects to significantly increase its holdings of
Agency RMBS using its existing capital and may attempt to raise additional
equity capital to deploy in this strategy.
As a
REIT, the Company is required to distribute to shareholders as dividends at
least 90% of its taxable income, which is the Company’s income as calculated for
tax, after consideration of any tax net operating loss (NOL)
carryforwards. However, unlike other mortgage REITs, the Company may
be able to limit its REIT income distributions by utilizing its NOL
carryforwards, which were approximately $150 million at December 31, 2007,
although the Company has not finalized its 2007 federal income tax
return. As a result, the Company has the option of being able to
invest its capital and compound the returns on an essentially tax-free basis
instead of distributing its earnings to its shareholders. The Company
will balance the desire to retain its capital and compound its returns with
dividend distributions to shareholders.
The Board
of Directors of the Company declared a dividend of $0.10 per common share for
the first quarter of 2008, and a dividend of $0.15 per common share for the
second quarter of 2008. The Company also expects to pay a dividend in
the third and fourth quarters of 2008.
During
the first quarter of 2008, the Company sold approximately $5.2 million of equity
securities for a gain of approximately $2.1 million and purchased approximately
$10.0 million of equity securities later in the same quarter.
CRITICAL
ACCOUNTING POLICIES
The
discussion and analysis of the Company’s financial condition and results of
operations are based in large part upon its 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 the Company’s financial statements. The
following are the Company’s critical accounting policies.
Consolidation of
Subsidiaries. The consolidated financial statements represent the
Company’s accounts after the elimination of inter-company
transactions. The Company consolidates entities in which it owns more
than 50% of the voting equity and control of the entity does not rest with
others and variable interest entities in which it is determeinced to be the
primary beneficiary in accordance with Financial Interpretation (“FIN”)
46(R). The Company 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 the Company 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.
16
Securitization. The
Company 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,
the Company 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 Company’s consolidated financial
statements. A transfer of financial assets in which the Company
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 the Company’s assets, and the associated bonds issued
are treated as its debt as securitization financing. The Company may
retain certain of the bonds issued by the trust and will generally transfer
collateral in excess of the bonds issued. This excess is typically
referred to as over-collateralization. Each securitization trust
generally provides the Company with the right to redeem, at its option, the
remaining outstanding bonds prior to their maturity date.
Impairments. The
Company 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 the Company 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, an impairment charge is recorded 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.
The
Company considers impairments of other investments 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. The Company has credit risk on loans pledged in
securitization financing transactions and classified as securitized finance
receivables in its 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 the attributes of the respective loan, or
the attributes of the underlying real estate which secures the loan, commercial
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 the Company’s exposure on these
loans. The level of allowance for loan losses required for these
loans is reduced by the amount of applicable loan guarantees. The
Company’s actual credit losses may differ from the estimates used to establish
the allowance.
17
FINANCIAL
CONDITION
Below is
a discussion of the Company’s financial condition.
(amounts
in thousands except per share data)
|
March
31, 2008
|
December
31, 2007
|
||||||
Investments:
|
||||||||
Securitized mortgage loans,
net
|
$ | 271,537 | $ | 278,463 | ||||
Securities
|
58,280 | 29,231 | ||||||
Investment in joint
venture
|
13,380 | 19,267 | ||||||
Other loans and
investments
|
3,549 | 6,774 | ||||||
Securitization
financing
|
200,313 | 204,385 | ||||||
Repurchase
agreements
|
29,556 | 4,612 | ||||||
Obligation
under payment agreement
|
11,244 | 16,796 | ||||||
Shareholders’
equity
|
140,366 | 141,936 | ||||||
Common
book value per share
|
$ | 8.07 | $ | 8.22 |
Securitized Mortgage Loans,
Net
Securitized
mortgage loans are comprised of loans secured by first deeds of trust on
single-family residential and commercial properties. The following
table presents the Company’s net basis in these loans at amortized cost, which
includes accrued interest receivable, discounts, premiums, deferred costs and
reserves for loan losses, by the type of property collateralizing the
loan.
(amounts
in thousands)
|
March
31, 2008
|
December
31, 2007
|
||||||
Securitized
mortgage loans, net:
|
||||||||
Commercial
|
$ | 188,638 | $ | 190,570 | ||||
Single-family
|
82,899 | 87,893 | ||||||
271,537 | 278,463 |
Securitized
commercial mortgage loans includes the loans pledged to two securitization
trusts, which were issued in 1993 and 1997, and which have outstanding principal
balances of $34.0 million and $150.0 million, respectively, at March 31,
2008. The decrease in these loans was primarily related to scheduled
principal payments of $2.0 million received during the quarter.
Securitized
single-family mortgage loans includes loans pledged to one securitization trust,
which was issued in 2002 using loans that were principally originated between
1992 and 1997. The decrease in the single-family mortgage loans is
primarily related to principal payments on the loans of $4.8 million, $4.0
million of which was unscheduled.
Securities
Our
securities, which are classified as available-for-sale and carried at their fair
value, are comprised of the following.
(amounts
in thousands)
|
March
31, 2008
|
December
31, 2007
|
||||||
Securities:
|
||||||||
Non-agency RMBS
|
$ | 7,402 | $ | 7,726 | ||||
Agency RMBS
|
34,670 | 7,456 | ||||||
Equity securities
|
12,186 | 9,701 | ||||||
Corporate debt
securities
|
4,022 | 4,347 | ||||||
$ | 58,280 | $ | 29,230 |
18
Non-agency
RMBS declined approximately $0.3 million to $7.4 million at March 31,
2008. The decrease was primarily related to the principal payments
received on these securities during the year.
Agency
RMBS increased by $27.2 million to $34.7 million at March 31,
2008. This increase was primarily the result of the purchase of $27.7
million of Agency RMBS during the first quarter of 2008, which was partially
offset by the receipt of $0.6 million of principal on the Agency RMBS during the
quarter.
Equity
securities increased approximately $2.5 million to $12.2 million and include
preferred stock and common stock issued by publicly-traded mortgage
REITs. The Company purchased approximately $10.0 million of equity
securities during the first quarter and sold approximately $5.2 million of
equity securities on which the Company recognized a net gain of $2.1
million.
Investment in Joint
Venture
Investment
in joint venture declined as a result of the Company’s interest in the net loss
and other comprehensive loss of the joint venture due primarily to adjustments
to fair value of the CMBS securities owned by the joint venture as previously
discussed. The Company wrote-down the carrying value of the
investment in joint venture by an additional $3.6 million reflecting temporary
declines in fair value of securities owned by the joint venture due to widening
credit spreads in CMBS since the end of the December. During the first quarter
of 2008, the Company also recorded an adjustment of $4.2 million which is
included in other income for the obligation under payment agreement due to the
joint venture, reflecting the fair value change during the quarter of this
obligation.
Other Loans and
Investments
Other
loans and investments declined approximately $3.2 million to $3.5 million at
March 31, 2008. The balance at March 31, 2008 is comprised primarily
of $3.0 million of seasoned residential and commercial mortgage loans and $0.5
million related to the Company’s remaining investment in delinquent property tax
receivables. The decline is primarily related to the sale of the
majority of the Company’s tax lien receivables to Allegheny County, Pennsylvania
for $1.6 million during the quarter and the collection of a $1.4 million note
receivable that was outstanding at December 31, 2007.
Securitization
Financing
Securitization
financing are bonds issued by a securitization trust, which the Company
sponsored and is consolidated in its financial statements. These
bonds are secured only by the securitized mortgage loans pledged to the trust
and are otherwise non-recourse to the Company. Principal and interest
on the bonds are paid from the cash flows generated by the loans collateralizing
the bonds. The following table presents the Company’s net
basis, which includes accrued interest, discounts, premiums and deferred costs
in securitization financing.
(amounts
in thousands)
|
March
31, 2008
|
December
31, 2007
|
||||||
Securitization
financing bonds:
|
||||||||
Fixed, secured by commercial
mortgage loans
|
$ | 168,308 | $ | 170,623 | ||||
Variable, secured by single-family
mortgage loans
|
32,005 | 33,762 | ||||||
$ | 200,313 | $ | 204,385 |
The fixed
rate bonds finance the Company’s securitized commercial mortgage loans, which
are also fixed rate. The $2.3 million decrease is primarily related
to principal payments on the bonds during the three months ended March 31, 2008
of $2.0 million. There was also $0.3 million of net amortization of
bond premiums and deferred costs. Approximately $29.2 million of
these bonds are callable by the Compoany in June of 2008. Those bonds
have premiums and deferred costs associated with them, representing a net credit
of approximately $1.3 million, which are being amortized over the life of the
bonds. If the Company chooses to call those bonds in 2008, any
unamortized premium and deferred costs would be written-off and recognized as a
gain at that time.
19
The
Company’s single-family securitized mortgage loans are financed by variable rate
securitization financing bonds. The $1.8 million decline in the
balance to $32.0 million at March 31, 2008 is primarily related to principal
payments on the bonds of $1.8 million, which was partially offset by $0.1
million of bond discount amortization. The Company redeemed all of
the bonds issued by this securitization trust in 2005, financed the redemption
with repurchase agreements and its own capital, and held the bonds for potential
reissue The Company still holds a senior bond issued by this trust,
which had a par value of $41.3 million at March 31, 2008 and is partially
financed with repurchase agreements. As the securitization trust
which issued this bond is consolidated in the Company’s financial statements,
this bond is eliminated in its consolidated financial statements.
Repurchase
Agreements
Repurchase
agreements increased $24.9 million to $29.6 million at March 31,
2008. This increase related to the purchase of Agency RMBS, discussed
above, which the Company financed with $24.9 million of repurchase agreements
and had a fair value of $27.7 million at March 31, 2008.
Obligation Under Payment
Agreement
On
January 1, 2008, the Company adopted the provisions of SFAS No. 159, “The Fair
Value Option for Financial Assets and Financial Liabilities” (“SFAS
159”). SFAS 159 permits entities to choose to measure financial
instruments at fair value. The effect of the adoption of SFAS 159 was
to decrease beginning accumulated deficit by $1.3 million. During the
first quarter of 2008, the Company recorded an additional adjustment of $4.2
million, which is included in fair value adjustments, reflecting the change in
fair value during the quarter of the obligation to the joint venture under
payment agreement.
Shareholders’
Equity
Shareholders’
equity decreased by $1.6 million to $140.4 million. This decrease was
primarily related to a $6.0 million decline in accumulated other comprehensive
income, related to an increase in the unrealized losses on certain of the
Company’s available for sale investments, securities and investment in joint
venture. The Company also paid $1.0 million of preferred dividends
and $1.2 million of common dividends during the quarter. These
decreases were partially offset by net income during the quarter of $5.3 million
and a $1.3 million increase in accumulated deficit for the cumulative effect of
initially adopting SFAS 159 on January 1, 2008 related to the Company’s
obligation to joint venture under payment agreement.
Supplemental
Discussion of Investments
The
Company evaluates and manages its investment portfolio in large part based on
its 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
mortgage loans, because the securitization financing is recourse only to the
mortgage loans pledged and is, therefore, not a general obligation of the
Company, the risk on the Company’s investment in securitized mortgage loans from
an economic point of view is limited to its net retained investment in the
securitization trust.
Below is
the net basis of the Company’s investments as of March 31,
2008. Included in the table is an estimate of the fair value of each
net investment. The fair value of the net investment in securitized
mortgage loans 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 is
calculated by discounting estimated future cash flows at market
rates. For securities and other investments, the Company may employ
leverage to enhance its overall returns on the net capital invested in these
particular assets.
20
March
31, 2008
|
||||||||||||||||
(amounts
in thousands)
|
Amortized
cost basis
|
Financing(4)
|
Net
investment
|
Fair
value of net investment
|
||||||||||||
Securitized
mortgage loans: (1)
|
||||||||||||||||
Single-family
mortgage loans
|
$ | 83,054 | $ | 36,618 | $ | 46,436 | $ | 40,487 | ||||||||
Commercial
mortgage loans
|
191,228 | 168,308 | 22,920 | 15,338 | ||||||||||||
Allowance
for loan losses
|
(2,745 | ) | – | (2,745 | ) | – | ||||||||||
271,537 | 204,926 | 66,611 | 55,825 | |||||||||||||
Securities:
(2)
|
||||||||||||||||
Investment
grade single-family
|
41,645 | 24,944 | 16,701 | 16,739 | ||||||||||||
Non-investment
grade single-family
|
274 | – | 274 | 340 | ||||||||||||
Equity
and other
|
17,145 | – | 17,145 | 16,257 | ||||||||||||
Net
unrealized loss
|
(784 | ) | – | (784 | ) | – | ||||||||||
58,280 | 24,944 | 33,336 | 33,336 | |||||||||||||
Investment
in joint venture(3)
|
13,380 | – | 13,380 | 13,049 | ||||||||||||
Obligation
to joint venture under payment agreement(1)
|
– | 11,244 | (11,244 | ) | (11,244 | ) | ||||||||||
Other
loans and investments(2)
|
3,549 | – | 3,549 | 4,251 | ||||||||||||
Total
|
$ | 346,746 | $ | 241,114 | $ | 105,632 | $ | 95,217 | ||||||||
|
(1)
|
Fair
values for securitized mortgage loans and the obligation to joint venture
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 are based on dealer quotes, if available, and closing prices from a
national exchange where applicable. Approximately $22 million
of fair value of securities were based on available dealer quotes or
closing prices from a national exchange. Where dealer
quotes are not available, fair values are calculated as the net present
value of expected future cash flows, discounted at a weighted average
discount rate of 7.5% for investment grade securities and 35.3% for
non-investment grade securities.
|
|
(3)
|
Fair
value for investment in joint venture represents the Company’s share of
the fair value of the joint venture’s assets valued using methodologies
and assumptions consistent with Note 1
above.
|
|
(4)
|
Financing
includes securitization financing issued to third parties and repurchase
agreements.
|
The
following table summarizes the assumptions used in estimating fair value for the
Company’s net investment in securitized finance receivables and the cash flow
related to those net investments during 2008.
Fair
Value Assumptions
|
|||||
Loan
type
|
Weighted-average
prepayment speeds
|
Losses
|
Weighted-average
discount
rate(6)
|
Projected
cash flow termination date
|
(amounts
in thousands)
YTD
2008 Cash Flows (1)
|
Single-family
mortgage loans
|
20%
CPR
|
0.2%
annually
|
20%
|
Anticipated
final maturity 2024
|
$ 848
|
Commercial
mortgage loans(2)
|
(3)
|
0.8%
annually
|
(4)
|
(5)
|
$ 517
|
(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.
|
21
(3)
|
Assumed
constant prepayment rate (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 to be liquidated in six months at a loss amount that
is calculated for each loan based on its specific
facts.
|
(4)
|
Weighed-average
discount rates for the two securitization trusts were 16.0% and 22.1%,
respectively.
|
(5)
|
Cash
flow termination dates are modeled based on the repayment dates of the
loans or optional redemption dates of the underlying securitization
financing bonds.
|
(6)
|
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 first
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 mortgage loan collateral pledged over the
outstanding bonds issued by the securitization trust.
(amounts
in thousands)
|
March
31, 2008
|
|||
Cash
and cash equivalents
|
$ | 37,935 | ||
Investments:
|
||||
AAA
rated and agency MBS fixed income securities
|
52,783 | |||
AA
and A rated fixed income securities
|
451 | |||
Unrated
and non-investment grade
|
20,327 | |||
Securitization
over-collateralization
|
18,691 | |||
Investment
in joint venture
|
13,380 | |||
$ | 105,632 |
Supplemental
Discussion of Common Equity Book Value
Management
believes that the Company’s shareholders, as well as shareholders of other
companies in the mortgage REIT industry, consider book value per common share an
important measure. The Company’s reported book value per common share
is based on the carrying value of its assets and liabilities as recorded in the
consolidated financial statements in accordance with generally accepted
accounting principles. A substantial portion of the Company’s assets
are carried on a historical, or amortized, cost basis and not at estimated fair
value. The first table included in the “Supplemental Discussion of
Investments” section above compares the amortized cost basis
of investments to their estimated fair value based on assumptions set
forth in the second table.
Management
believes 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 the Company’s
shareholders, representing effectively the Company’s 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 Book Value column include all of the Company’s assets and
liabilities at their estimated fair values, and exclude any value attributable
to the Company’s tax net operating loss carryforwards and other matters that
might impact the Company’s value.
22
March
31, 2008
|
||||||||
(amounts
in thousands, except per share information)
|
Book
Value
|
Adjusted
Book Value
|
||||||
Total
investment assets (per table above)
|
$ | 105,632 | $ | 95,217 | ||||
Cash
and cash equivalents
|
37,935 | 37,935 | ||||||
Other
assets and liabilities, net
|
(3,201 | ) | (3,201 | ) | ||||
140,366 | 129,951 | |||||||
Less: Preferred
stock redemption value
|
(42,215 | ) | (42,215 | ) | ||||
Common
equity book value and adjusted book value
|
$ | 98,151 | $ | 87,736 | ||||
Common
equity book value per share and adjusted book value per
share
|
$ | 8.07 | $ | 7.21 |
Discussion
of Credit Risk
A major
risk in the Company’s investment portfolio today is credit risk (i.e., the risk
that the Company will not receive all amounts contractually due it 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, the Company retained the “first-loss”
credit risk on pools of loans and securities that it securitized. In
addition to the retained interests in certain securitizations, the Company also
has credit risk on approximately $3.5 million of unrated or non-investment grade
mortgage securities and loans.
The
following table summarizes the Company’s credit exposure in securitized mortgage
loans and subordinate mortgage securities. The Company’s net credit
exposure increased from 2007 to 2008 primarily due to amortization of premiums
and the reduction in the balance of the Company’s allowance for loan losses of
$0.8 million as a result of improved performance of the Company’s securitized
commercial mortgage loan portfolio.
Credit Reserves and Actual
Credit Losses
(amounts
in millions)
|
Credit
Exposure (1)
|
Credit
Exposure, Net of Allowance (2)
|
Actual
Credit
Losses
|
Credit
Exposure, Net of Allowance to Outstanding Loan Balance (3)
|
||||||||||||
2007, Quarter
1
|
$ | 25.8 | $ | 22.2 | $ | 0.4 | 6.45 | % | ||||||||
2007, Quarter
2
|
26.5 | 23.0 | 0.0 | 6.95 | ||||||||||||
2007, Quarter
3
|
26.9 | 24.3 | 0.1 | 7.91 | ||||||||||||
2007, Quarter
4
|
27.5 | 24.8 | 0.0 | 8.58 | ||||||||||||
2008, Quarter
1
|
27.9 | 25.2 | 0.0 | 8.91 |
(1)
|
Represents
the overcollateralization pledged to a securitization trust and
subordinate securities the Company owns, net of any premiums
and discounts.
|
(2)
|
Represents
credit exposure, net of allowance for loan
losses.
|
(3)
|
Represents
credit exposure net of allowance divided by current unpaid principal
balance of loans in the securitization
trust
|
The
Company monitors and evaluates its exposure to credit losses and has established
reserves based upon anticipated losses, general economic conditions and trends
in the investment portfolio. Delinquencies as a percentage of all
outstanding securitized mortgage loans decreased to 2.6% at March 31, 2008 from
3.1% at March 31, 2007. At March 31, 2008, management believes the
level of credit reserves is appropriate for currently existing
23
losses. The
following tables summarize single-family mortgage loan and commercial mortgage
loan delinquencies as a percentage of the outstanding commercial securitized
mortgage loans or single-family balance for those securitizations in which the
Company has retained a portion of the direct credit risk.
Loans
secured by low-income housing tax credit (LIHTC) properties account for 88% of
the Company’s securitized commercial loan portfolio. Section 42 of
the Code provides tax credits to investors in projects to construct or
substantially rehabilitate properties that provide housing for qualifying low
income families. Failure to comply with certain income and rental
restrictions required by Section 42 or default on a loan financing a Section 42
property during the compliance period can result in the recapture of previously
received tax credits. The potential cost of tax credit recapture
provides an incentive to the property owner to support the property during the
compliance period. The following table shows the weighted average
remaining compliance period of the Company’s portfolio of LIHTC commercial loans
at March 31, 2008 as a percent of the total LIHTC commercial loan
portfolio.
Months
remaining to end of compliance period
|
As
a Percent of Unpaid Principal Balance
|
|||
Compliance
period already exceeded
|
28.5 | % | ||
Zero
through twelve months remaining
|
4.5 | |||
Thirteen
through thirty six months remaining
|
53.6 | |||
Thirty
seven through sixty months remaining
|
13.4 | |||
100.0 | % |
There
were no delinquent commercial mortgage loans at March 31, 2008 or December 31,
2007.
Single-family
mortgage loan delinquencies decreased by $0.5 million to $7.4 million at March
31, 2008 from $7.9 million at December 31, 2007. Serious
delinquencies, defined as 60+ day delinquencies, increased from $2.9 million to
$3.3 million for the same period. The Company’s single-family loan
portfolio, which had an aggregate unpaid principal balance of $89.7 million at
March 31, 2008, was originated primarily between 1992 and 1997 and continues to
perform and pay-down as expected and with minimal
losses. Approximately $1.2 million of the 60+ day delinquent loans
are credit enhanced with mortgage pool insurance, and the Company does not
expect any realized losses on these loans. For loans without mortgage
pool insurance, the Company expects losses to be minimal given the seasoning of
the underlying loans. During 2007 and 2006, the Company incurred less
than $0.1 million of actual losses in each of those years.
Single-Family Loan
Delinquency Statistics
(amounts
in thousands)
|
30
to 59 days delinquent
|
60
to 89 days
delinquent
|
90
days and over delinquent (1)
|
Total
|
||||||||||||
2007, Quarter
1
|
$ | 5,389 | $ | 937 | $ | 4,273 | $ | 10,599 | ||||||||
2007, Quarter
2
|
4,180 | 874 | 3,157 | 8,211 | ||||||||||||
2007, Quarter
3
|
2,381 | 551 | 3,058 | 5,990 | ||||||||||||
2007, Quarter
4
|
5,003 | 562 | 2,342 | 7,907 | ||||||||||||
2008, Quarter
1
|
4,092 | 761 | 2,543 | 7,396 |
(1)
|
Includes
foreclosures and real estate owned.
|
24
RESULTS
OF OPERATIONS
Three
Months Ended
|
||||||||
March
31,
|
||||||||
(amounts
in thousands except per share information)
|
2008
|
2007
|
||||||
Net
interest income
|
$ | 2,421 | $ | 2,460 | ||||
(Provision
for) recapture of provision for loan losses
|
(26 | ) | 523 | |||||
Net
interest income after recapture of loan losses
|
2,395 | 2,983 | ||||||
Gain
(loss) on sales of investments
|
2,093 | (6 | ) | |||||
Equity
in (loss) earnings of joint venture
|
(2,251 | ) | 630 | |||||
Fair
value adjustments, net
|
4,231 | – | ||||||
Other
income (expense)
|
67 | (539 | ) | |||||
General
and administrative expenses
|
(1,216 | ) | (1,126 | ) | ||||
Net
income
|
5,319 | 1,942 | ||||||
Preferred
stock charge
|
(1,003 | ) | (1,003 | ) | ||||
Net
income to common shareholders
|
4,316 | 939 | ||||||
Net
income per common share:
|
||||||||
Basic
|
$ | 0.36 | $ | 0.08 | ||||
Diluted
|
$ | 0.32 | $ | 0.08 |
Three Months Ended March 31,
2008 Compared to Three Months Ended March 31, 2007
Interest
Income
Interest
income includes interest earned on the investment portfolio and also reflects
the amortization of any related discounts, premiums and deferred
costs. The following tables present the significant components of the
Company’s interest income.
Three
Months Ended March 31,
|
||||||||
(amounts
in thousands)
|
2008
|
2007
|
||||||
Interest
income:
|
||||||||
Securitized mortgage
loans
|
$ | 5,602 | $ | 7,025 | ||||
Securities
|
428 | 324 | ||||||
Cash and cash
equivalents
|
324 | 739 | ||||||
Other loans and
investments
|
129 | 127 | ||||||
$ | 6,483 | $ | 8,215 |
The
change in interest income on securitized mortgage loans and securities is
examined in the discussion and tables that follow.
Interest
income on cash and cash equivalents decreased $0.4 million in 2008 compared to
2007. This decrease is primarily the result of an $13.9 million
decrease in the average balance of cash and cash equivalents outstanding during
2008 compared to 2007 and a decrease in short-term interest
rates. The yield on cash decreased from 5.2% for the three months
ended March 31, 2007 to 3.0% for the same period in 2008.
25
Interest Income –
Securitized Mortgage Loans
The
following table summarizes the detail of the interest income earned on
securitized mortgage loans.
Three
Months Ended March 31,
|
||||||||||||||||||||||||
2008
|
2007
|
|||||||||||||||||||||||
(amounts
in thousands)
|
Interest
Income
|
Net
Amortization
|
Total
Interest Income
|
Interest
Income
|
Net
Amortization
|
Total
Interest Income
|
||||||||||||||||||
Securitized
mortgage loans:
|
||||||||||||||||||||||||
Commercial
|
$ | 3,985 | $ | 100 | $ | 4,085 | $ | 4,868 | $ | 87 | $ | 4,955 | ||||||||||||
Single-family
|
1,604 | (87 | ) | 1,517 | 2,205 | (135 | ) | 2,070 | ||||||||||||||||
Total
mortgage loans
|
$ | 5,589 | $ | 13 | $ | 5,602 | $ | 7,073 | $ | (48 | ) | $ | 7,025 |
The
majority of the decrease of $0.9 million in interest income on commercial
mortgage loans is primarily related to the decline in the average balance of the
commercial mortgage loans outstanding during the first quarter of 2008, which
decreased approximately $38.4 million (54%) from the balance for the same period
in 2007.
Interest
income on securitized single-family mortgage loans declined $0.6 million to $1.5
million for the three months ended March 31, 2008. The decline in
interest income on single-family loans was primarily related to the decrease in
the average balance of the loans outstanding from the first quarter of 2007,
which declined approximately $27.4 million, or approximately 24%, to $85.7
million for the first quarter of 2008. The decline in interest income
on single-family mortgage loans was also negatively impacted by a decrease in
the average yield on the Company’s single-family loan portfolio, approximately
87% of which were variable rate at March 31, 2008.
Interest Income –
Securities
The
following table presents the components of interest income on
securities.
Three
Months Ended March 31,
|
||||||||
(amounts
in thousands)
|
2008
|
2007
|
||||||
Non-agency
RMBS
|
$ | 176 | $ | 262 | ||||
Agency
RMBS
|
104 | 62 | ||||||
Corporate
debt securities and other interest-bearing securities
|
148 | – | ||||||
$ | 428 | $ | 324 |
Although
the balance of securities increased significantly from March 31, 2007 to March
31, 2008, interest income only increased by approximately $0.1 million for the
three months ended March 31, 2008 compared to the corresponding period in
2007. This small increase income was due to the increase in the
balance of securities occurring late in March 2008.
26
Interest
Expense
Interest
expense includes the interest paid and accrued on the Company’s financings as
well as the amortization of any related discounts, premiums and deferred
costs. The following tables present the significant components of
interest expense.
Three
Months Ended March 31,
|
||||||||
(amounts
in thousands)
|
2008
|
2007
|
||||||
Interest
expense:
|
||||||||
Securitization
financing
|
$ | 3,599 | $ | 4,096 | ||||
Repurchase
agreements
|
54 | 1,258 | ||||||
Obligation under payment
agreement
|
401 | 367 | ||||||
Other
|
8 | 34 | ||||||
$ | 4,062 | $ | 5,755 |
Interest Expense –
Securitization Financing
The
following table summarizes the detail of the interest expense recorded on
securitization financing bonds.
Three
Months Ended March 31,
|
||||||||||||||||||||||||
2008
|
2007
|
|||||||||||||||||||||||
(amounts
in thousands)
|
Interest
Expense
|
Net
Amortization
|
Total
Interest Expense
|
Interest
Expense
|
Net
Amortization
|
Total
Interest Expense
|
||||||||||||||||||
Securitization
financing:
|
||||||||||||||||||||||||
Commercial
|
$ | 3,441 | $ | (325 | ) | $ | 3,116 | $ | 4,273 | $ | (286 | ) | $ | 3,987 | ||||||||||
Single-family
|
338 | 52 | 390 | – | – | – | ||||||||||||||||||
Other bond related
costs
|
93 | – | 93 | 109 | – | 109 | ||||||||||||||||||
Total
mortgage loans
|
$ | 3,872 | $ | (273 | ) | $ | 3,599 | $ | 4,382 | $ | (286 | ) | $ | 4,096 |
Interest
expense on commercial securitization financing decreased from $4.0 million for
2007 to $3.1 million for 2008. The majority of this $0.9 million
decrease is related to the $40.1 million (19%) decrease in the weighted average
balance of securitization financing, from $208.4 million in 2007 to $168.3
million in 2008.
The
interest expense on single-family securitization financing is related to a
securitization bond that the Company redeemed in 2005 and reissued in the fourth
quarter of 2007. The net amortization of other bond related costs is
attributable mainly to the $0.8 million discount at which the bond was
reissued.
Interest Expense –
Repurchase Agreements
The
decline in interest expense related to repurchase agreements is due primarily to
the drop in the average balance of repurchase agreement financing outstanding
from $92.7 million for the three months ended March 31, 2007 to $5.7 million for
the same period in 2008. The average rate on the outstanding
repurchase agreements also declined from 5.43% for 2007 to 3.72% for
2008.
Gain (loss) on Sales of
Investments
During
the three months ended March 31, 2008, the Company sold $5.2 million of equity
securities of other real estate investment trusts and realized a net gain of
$2.1 million.
27
(Provision for) Recapture of
Provision for Loan Losses
During
the three months ended March 31, 2007, the Company recaptured approximately $0.5
million of reserves the Company had previously provided for estimated losses on
its securitized mortgage loan portfolio. During the three months
ended March 31, 2008, the Company provided less than $0.1 million for estimated
losses on its portfolio of single family loans.
Equity in (Loss) Earnings of
Joint Venture
The
Company’s interest in the operations of its joint venture changed from income of
$0.6 million to a loss of $2.3 million for the three months ended March 31, 2007
and 2008, respectively. In 2008, the joint venture experienced a
decline in the values of certain of its investments of $4.7 million, due
primarily to the widening of spreads on subordinate CMBS during the first
quarter of 2008.
Fair Value Adjustments,
Net
The $4.2
million fair value adjustment is primarily related to a decline in the fair
value of the Company’s obligation under payment agreement, for which the Company
adopted SFAS 159 on January 1, 2008, as described above.
General and Administrative
Expenses
General
and administrative expenses increased by less than $0.1 million from $1.1
million to $1.2 million for the three months ended March 31, 2007 and 2008,
respectively. General and administrative expenses increased during
2008 primarily due to legal fees and consulting fees. The consulting
fees primarily relate to the Company’s implementation of its strategy of buying
Agency RMBS.
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.
28
Average
Balances and Effective Interest Rates
Three
Months Ended March 31,
|
||||||||||||||||
2008
|
2007
|
|||||||||||||||
(amounts in thousands) |
Average
Balance
|
Effective
Rate
|
Average
Balance
|
Effective
Rate
|
||||||||||||
Interest-earning
assets:(1)
|
||||||||||||||||
Securitized
mortgage loans(2)(3)(5)
|
$ | 276,399 | 8.08 | % | $ | 342,238 | 8.17 | % | ||||||||
Securities
|
21,131 | 8.10 | % | 13,295 | 9.76 | % | ||||||||||
Other
loans and investments
|
3,603 | 16.22 | % | 3,739 | 14.68 | % | ||||||||||
Total
interest-earning assets
|
$ | 301,133 | 8.18 | % | $ | 359,272 | 8.30 | % | ||||||||
Interest-bearing
liabilities:
|
||||||||||||||||
Securitization
financing(3)(4)(5)
|
$ | 201,443 | 7.09 | % | $ | 208,434 | 7.59 | % | ||||||||
Repurchase
agreements
|
5,708 | 3.72 | % | 92,705 | 5.43 | % | ||||||||||
Total
interest-bearing liabilities
|
$ | 207,151 | 7.00 | % | $ | 301,139 | 6.92 | % | ||||||||
Net
interest spread (4)
|
1.18 | % | 1.37 | % | ||||||||||||
Net
yield on average interest-earning assets(3)(4)(5)
|
3.36 | % | 2.49 | % | ||||||||||||
Cash
and cash equivalents
|
$ | 42,652 | 3.03 | % | $ | 56,595 | 5.22 | % | ||||||||
Net
yield on average interest-earning assets, including cash and cash
equivalents
|
3.32 | % | 2.87 | % |
(1)
|
Average
balances exclude unrealized gains and losses on available for sale
securities
|
(2)
|
Average
balances exclude funds held by trustees except defeased funds held by
trustees.
|
(3)
|
Certain
income and expense items of a one-time nature are not annualized for the
calculation of effective rates. Examples of such one-time items
include retrospective adjustments of discount and premium amortization
arising from adjustments of effective interest
rates. Also certain prepayment penalties and income
support payments received on the Company’s commercial mortgage loan
portfolio are not annualized.
|
(4)
|
Effective
rates are calculated excluding non-interest related securitization
financing expenses.
|
(5)
|
Net
yield on average interest-earning assets reflects the annualized net
interest income excluding non-interest related securitization financing
expense divided by average interest-earning assets for the
period.
|
2008
Compared to 2007
The net
interest spread for the three months ended March 31, 2008 decreased 19 basis
points to 1.18% from 1.37% for the three months ended March 31,
2007. The decrease in the net interest spread is primarily related to
decrease in the average rate on the Company’s securitized single-family mortgage
loans, which are predominately variable rate, and a decrease in the average
balance of lower yielding repurchase agreements which caused an increase in the
average yield on interest-bearing liabilities.
The
overall yield on interest-earning assets, which exclude cash and cash
equivalents, decreased to 8.18% for the three months ended March 31, 2008 from
8.30% for the same period in 2007 primarily as a result of the receipt in 2007
of delinquent interest on a commercial mortgage loan which had previously been
on non-accrual status and the overall decrease of yields for new securities
purchased due to the declining rate environment. Yields on
securitized mortgage loans decreased from the resets of variable-rate
securitized single-family mortgage loans. These resets resulted in
the decrease in yield of 25 basis points to 7.06% for the three months ended
March 31, 2008 versus the same period in 2007.
29
The
following table summarizes the amount of change in interest income and interest
expense due to changes in interest rates versus changes in volume:
Three
Months Ended March 31, 2008 versus 2007
|
||||||||||||
(amounts
in thousands)
|
Rate
|
Volume
|
Total
|
|||||||||
Securitized
mortgage loans
|
$ | (87 | ) | $ | (1,334 | ) | $ | (1,421 | ) | |||
Securities
|
(63 | ) | 167 | 104 | ||||||||
Other
loans and investments
|
5 | (3 | ) | 2 | ||||||||
Total
interest income
|
(145 | ) | (1,170 | ) | (1,315 | ) | ||||||
Securitization
financing
|
(351 | ) | (131 | ) | (482 | ) | ||||||
Repurchase
agreements
|
(157 | ) | (1,047 | ) | (1,204 | ) | ||||||
Total
interest expense
|
(508 | ) | (1,178 | ) | (1,686 | ) | ||||||
Net
interest income
|
$ | 363 | $ | 8 | $ | 371 |
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 dividends on
equity securities, securitization financing costs, other interest expense
and provision for credit losses.
|
From
March 31, 2007 to March 31, 2008, average interest-earning assets declined $58.1
million, or approximately 16%. The decline in interest earning-assets
resulted primarily from scheduled and unscheduled payments on the Company’s
securitized mortgage loans, principally adjustable-rate single-family mortgage
loans.
RECENT
ACCOUNTING PRONOUNCEMENTS
In
December 2007, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards (SFAS) No. 160, “Noncontrolling Interests in
Consolidated Financial Statements, an amendment of ARB No. 51.” SFAS
160 addresses reporting requirements in the financial statements of
non-controlling interests to their equity share of subsidiary
investments. SFAS 160 applies to reporting periods beginning
after December 15, 2008. The Company is currently evaluating the
potential impact on adoption of SFAS 160.
In
December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS
141(R)”) which revised SFAS No. 141, “Business Combinations.” This
pronouncement is effective as of January 1, 2009. Under SFAS No. 141,
organizations utilized the announcement date as the measurement date for the
purchase price of the acquired entity. SFAS 141(R) requires
measurement at the date the acquirer obtains control of the acquiree, generally
referred to as the acquisition date. SFAS 141(R) will have a
significant impact on the accounting for transaction costs, restructuring costs,
as well as the initial recognition of contingent assets and liabilities assumed
during a business combination. Under SFAS 141(R), adjustments to the
acquired entity’s deferred tax assets and uncertain tax position balances
occurring outside the measurement period are recorded as a component of the
income tax expense, rather than goodwill. As the provisions of SFAS
141(R) are applied prospectively, the impact cannot be determined until the
transactions occur. The Company is currently evaluating the impact,
if any, that SFAS 141(R) may have on the Company’s financial
statements.
On March
20, 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative
Instruments and Hedging Activities, an amendment of FASB Statement No. 133”
(“SFAS 161”). SFAS 161 provides for enhanced disclosures about how
and why an entity uses derivatives and how and where those derivatives and
related hedged items are reported in the entity’s financial
statements. SFAS 161 also requires certain tabular formats for
disclosing such
30
information. SFAS
161 is effective for fiscal years and interim periods beginning after November
15, 2008 with early application encouraged. SFAS 161 applies to all
entities and all derivative instruments and related hedged items accounted for
under SFAS 133. Among other things, SFAS 161 requires disclosures of
an entity’s objectives and strategies for using derivatives by primary
underlying risk and certain disclosures about the potential future collateral or
cash requirementsas a result of contingent credit-related
features. The Company is currently evaluating the impact, if any,
that the adoption of SFAS 161 will have on the Company’s financial
statements.
LIQUIDITY
AND CAPITAL RESOURCES
The
Company has historically financed its investments and operations from a variety
of sources, including a mix of collateral-based short-term financing sources
such as repurchase agreements, collateral-based long-term financing sources such
as securitization financing, equity capital, and net earnings. The
Company’s primary source of funding for its operations today is the cash flow
generated from the Company’s existing investment portfolio assets, which
includes net interest income and principal payments and prepayments on these
investments. The Company believes that it has sufficient
liquidity and capital resources to continue to service all of its outstanding
recourse obligations, pay operating costs and fund dividends on its capital
stock.
Management
believes that the Company’s investment portfolio cash flows should be adequate
over the next twelve months to fund the Company’s operating needs and to pay its
Series D Preferred Stock dividends.
Assuming
that short-term interest rates decline over the remainder of 2008, the Company
anticipates that the cash flow from its investment portfolio will continue to
decline through the end of the year as its investment in cash and cash
equivalents earns lower returns, absent meaningful reinvestment of capital. The
Company anticipates, however, that it will have sufficient cash flow from the
investment portfolio to meet all of its current obligations on both a short-term
and long-term basis.
At March
31, 2008, the Company had cash and cash equivalents of $37.9
million. Management believes the Company has ample liquidity and
capital resources to fund its business.
The
Company believes that investment opportunities for its capital may be more
readily available in the foreseeable future as disruptions in the fixed income
markets, particularly in the residential mortgage market, have caused a decline
in prices on most residential mortgage securities. These disruptions
have caused volatility in asset prices, causing such asset prices to decline,
correspondingly increasing yields. Equity prices on companies which
originate or invest in these securities have also declined. As a
result, the Company has evaluated several potential investment opportunities for
residential mortgage securities, but to date, has not made meaningful
investments on its capital. The timing of any reinvestment will depend on the
investment opportunity available and whether, in the opinion of management and
the Board of Directors, such investment represents an acceptable risk-adjusted
return opportunity for the Company’s capital.
The
Company currently utilizes a combination of equity, securitization financing and
repurchase agreement financing to finance its investment
portfolio. Securitization financing is recourse only to the assets
pledged as collateral to support the financing and is not otherwise recourse to
the Company. At March 31, 2008, the Company had $200.3 million of
non-recourse securitization financing outstanding, $168.3 million of which
carries a fixed rate of interest. 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.
Repurchase
agreement financing is recourse to the assets pledged and to the Company and
requires the Company to post margin (i.e., collateral deposits in excess of the
repurchase agreement financing). The repurchase agreement
counterparty at any time can request that the Company post additional margin or
repay all financing balances. Repurchase agreement financing is not
committed financing to the Company, and it generally renews or rolls every
30-days. The amounts advanced to the Company by the repurchase agreement
counterparty are determined largely based on the fair value of the asset pledged
to the counterparty, subject to their willingness to provide
financing.
31
Off-Balance Sheet
Arrangements. As of March 31, 2008,
there have been no material changes to the off-balance sheet arrangements
disclosed in “Management’s Discussion and Analysis” in the Company’s Annual
Report on Form 10-K for the year ended December 31, 2007.
Contractual Obligations.
As of March
31, 2008, there have been no material changes outside the ordinary course of
business to the contractual obligations disclosed in “Management’s Discussion
and Analysis” in the Company’s Annual Report on Form 10-K for the year ended
December 31, 2007.
FORWARD-LOOKING
STATEMENTS
Certain
written statements in this Form 10-Q 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 (the “Exchange Act”). All statements contained
in this Item as well as those discussed elsewhere in this report addressing the
results of operations, operating performance, events, or developments that
management expects or anticipates 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 the actual results of the Company to differ materially from
historical results or from any results expressed or implied by such
forward-looking statements. The Company 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. In
recent years, the Company has generally been unable to find investments which
have acceptable risk adjusted yields. As a result, the Company’s 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 its
investment portfolio size and its earnings, the Company needs to reinvest a
portion of the cash flows it receives into new interesting earning
assets. If the Company is unable to find suitable reinvestment
opportunities, the net interest income on its investment portfolio and
investment cash flows could be negatively impacted.
Economic
Conditions. The Company is 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 its investments and the over-collateralization associated with its
securitization transactions.
Investment Portfolio Cash
Flow. Cash flows from the investment portfolio fund the
Company’s operations, the dividends, 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 securitized investments. Based on the
performance of the underlying assets within the securitization structure, cash
flows which may have otherwise been paid to the Company as a result of its
ownership interest may be retained within the securitization
structure. Cash flows from the investment portfolio are likely to
sequentially decline until the Company meaningfully begins to reinvest its
capital. There can be no assurances that the Company will be able to
find suitable investment alternatives for its capital, nor can there be
assurances that it will meet its reinvestment and return hurdles.
32
Defaults. Defaults
by borrowers on loans the Company securitized may have an adverse impact on its
financial performance, if actual credit losses differ materially from its
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 the estimate as a result of
economic conditions. In addition, commercial mortgage loans are generally large
dollar balance loans, and a significant loan default may have an adverse impact
on the Company’s financial results. Such impact may include higher
provisions for loan losses and reduced interest income if the loan is placed on
non-accrual.
Interest Rate
Fluctuations. The Company’s income and cash flow depends on
its ability to earn greater interest on its investments than the interest cost
to finance these investments. Interest rates in the markets served by
the Company generally rise or fall with interest rates as a
whole. Approximately $209 million of the Company’s investments,
including loans and securities currently pledged as securitized mortgage loans
and securities, carry a fixed-rate of interest either for the life of the loan
or security or for a period of longer than 12 months in the case of an
instrument such as an agency RMBS that has an initial fixed period of interest
before its interest rate adjusts. We currently finance these fixed
and variable-rate assets through $168 million of fixed rate securitization
financing, $32 million of variable rate securitization financing and $30 million
of variable rate repurchase agreements. For the portion of the fixed
rate loans and securities, which are financed with variable rate instruments,
the net interest spread for these investments could decrease during a period of
rapidly rising short-term interest rates. In addition, certain
variable rate instruments may have interest rates which reset on a delayed basis
and have periodic interest rate caps whereas the related borrowing has no
delayed resets or such interest rate caps. In a period of rising
interest rates, the net interest spread on these investments may
decrease.
Third-party
Servicers. The Company’s loans and loans underlying securities
are serviced by third-party service providers. As with any external
service provider, the Company is 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 the Company’s delinquency rate that results from improper servicing
or loan performance in general could harm the Company’s ability to securitize
its real estate loans in the future and may have an adverse effect on its
earnings.
Prepayments. Prepayments
by borrowers on loans the Company securitized or securities, which it purchases,
may have an adverse impact on the Company’s financial
performance. Prepayments are expected to increase during a declining
interest rate or flat yield curve environment. The Company’s 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 the Company
competes with a number of institutions with greater financial
resources. In purchasing portfolio investments, obtaining financing
for its investments, and in issuing debt or equity capital, the Company competes
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 the Company does. Increased competition
in the market and the Company’s competitors greater financial resources have
adversely affected the Company in the past and may do so again in the
future. Competition may also continue to keep pressure on spreads
resulting in the Company being unable to reinvest its capital at acceptable
risk-adjusted returns.
Regulatory
Changes. The Company’s businesses as of March 31, 2008 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 the Company and the performance of its securitized loan
pools or the Company’s ability to collect on its delinquent property tax
receivables. The Company is a REIT and is required to meet certain
tests in order to maintain its REIT status. If it should fail to
maintainitsREIT status, the Company would not be able to hold certain
investments and would be subject to income taxes.
33
Section 404 of the Sarbanes-Oxley
Act of 2002. The Company is required to comply with the
provisions of Section 404 of the Sarbanes-Oxley Act of 2002 and the rules and
regulations promulgated by the SEC and the New York Stock
Exchange. Failure to comply may result in doubt in the capital
markets about the quality and adequacy of the Company’s internal controls and
corporate governance. This could result in it having difficulty in,
or being unable to, raise additional capital in these markets in order to
finance its operations and future investments.
Other. The
following risks, which are discussed in more detail in the Company’s Annual
Report on Form 10-K for the year ended December 31, 2007, could also affect the
Company’s results of operations, financial condition and cash
flows:
·
|
The
Company may be unable to invest in new assets with attractive yields, and
yields on new assets in which it does invest may not generate attractive
yields, resulting in a decline in the Company’s earnings per share over
time.
|
·
|
New
investments may entail risks that the Company does not currently have in
its investment portfolio or may substantially add risks to the investment
portfolio which the Company may or may not have managed in the past as
part of its investment strategy. In addition, while the Company
has owned Agency RMBS in the past, it has never had a significant amount
of its capital invested in these
assets.
|
·
|
Competition
may prevent the Company from acquiring new investments at favorable yields
potentially negatively impacting its
profitability.
|
·
|
The
Company’s ownership of certain subordinate interests in securitization
trusts subjects it to credit risk on the underlying loans, and it provides
for loss reserves on these loans as required under generally accepted
accounting principles.
|
·
|
The
Company’s efforts to manage credit risk may not be successful in limiting
delinquencies and defaults in underlying loans or losses on its
investments.
|
·
|
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 the Company’s cash flows and reported
results.
|
·
|
The
Company may be subject to the risks associated with inadequate or untimely
services from third-party service providers, which may harm its results of
operations.
|
·
|
Prepayments
of principal on the Company’s investments, and the timing of prepayments,
may impact its reported earnings and cash
flows.
|
·
|
The
Company finances a portion of its investment portfolio with short-term
recourse repurchase agreements which subjects the Company to margin calls
if the assets pledged subsequently decline in value or if the repurchase
agreement financier chooses to reduce its position in financing afforded
the Company.
|
·
|
Interest
rate fluctuations can have various negative effects on the Company, and
could lead to reduced earnings and/or increased earnings
volatility.
|
·
|
Hedging
against interest rate exposure may adversely affect the Company’s
earnings.
|
·
|
The
Company’s reported income depends on accounting conventions and
assumptions about the future that may
change.
|
34
·
|
Failure
to qualify as a REIT would adversely affect the Company’s dividend
distributions and could adversely affect the value of its
securities.
|
·
|
Maintaining
REIT status may reduce the Company’s flexibility to manage its
operations.
|
·
|
The
Company may fail to properly conduct its operations so as to avoid falling
under the definition of an investment company pursuant to the Investment
Company Act of 1940.
|
·
|
The
Company is dependent on certain key
personnel.
|
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 the Company’s 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 Dynex’s earnings and cash
flows. The Company is subject to risk resulting from interest rate
fluctuations to the extent that there is a gap between the amount of the
Company’s interest-earning assets and the amount of interest-bearing liabilities
that are prepaid, mature or re-price within specified periods.
The
Company monitors the aggregate cash flow, projected net interest income and
estimated market value of its 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.
The
Company specifically focuses on the sensitivity of its investment portfolio cash
flow, primarily the cash flow generated from the net interest income of its
investment portfolio, and measures 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. Because cash and cash equivalents are such a large
portion of the Company’s overall assets, the Company also calculated the
sensitivity of its cash flows including cash and cash equivalents as if they are
part of its investment portfolio. For both analyses, the Company
estimates its 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 March 31, 2008, which is
referred to as the Base Case. Once the Base Case has been estimated,
net interest income 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. To the
extent the Company has any cash flow changes from interest rate swaps, caps,
floors or any other derivative instrument, they are included in this
analysis.
The
following table summarizes the Company’s net interest income cash flow
sensitivity analyses as of March 31, 2008 under the assumptions set forth above.
These analyses represent management’s estimate of the percentage change in net
interest income cash flow (expressed in dollar terms and as a percentage of the
base case) for the investment portfolio only and the investment portfolio
inclusive of cash and cash equivalents, given a parallel shift in interest rates
as discussed above.
As noted
above, the Base Case represents the interest rate environment as it existed as
of March 31, 2008. At March 31, 2008, one-month LIBOR was 2.70% and
six-month LIBOR was 2.61%. The analysis below is heavily dependent
upon the assumptions used in the model. The effect of changes in
future interest rates beyond the forward LIBOR curve, the shape of the yield
curve or the mix of the Company’s assets and liabilities may cause actual
results
35
to differ
significantly from the modeled results. In addition, certain
investments which the Company owns provide a degree of “optionality.” The most
significant option affecting the 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 the Company’s portfolio, and no change to its liability
structure. Historically, there have been significant changes in the
Company’s investment portfolio and the liabilities incurred by the
Company. As a result of anticipated prepayments on assets in the
investment portfolio, there are likely to be such changes in the
future.
(amounts
in thousands)
|
Investment
Portfolio
|
Investment
Portfolio, including Cash and Cash Equivalents
|
||||||
Basis
Point Change in
Interest
Rates
|
Cash
Flow
|
Percent
|
Cash
Flow
|
Percent
|
||||
+200
|
$(300.2)
|
(1.8)%
|
$1,346.3
|
7.1%
|
||||
+100
|
(245.2)
|
(1.5)%
|
578.1
|
3.1%
|
||||
Base
|
|
–
|
|
–
|
||||
-100
|
336.3
|
2.0%
|
(486.9)
|
(2.6)%
|
||||
-200
|
704.5
|
4.2%
|
(942.1)
|
(5.0)%
|
Approximately
$209 million of Dynex’s investment portfolio is comprised of loans or securities
that have coupon rates that are fixed. Approximately $98 million of
its investment portfolio as of March 31, 2008 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 50% and 28% of the adjustable-rate
loans underlying the Company’s securitized finance receivables are indexed to
and reset based upon the level of six-month LIBOR and one-year LIBOR,
respectively.
Generally,
during a period of rising short-term interest rates, the Company’s net interest
income earned and the corresponding cash flow on its investment portfolio will
increase due to the match funding of its securitized mortgage loans and
significant investment in cash and cash equivalents. To the extent of
the Company’s investment in variable rate securitized finance mortgage loans
with variable rate securitization financing, 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 mortgage loans 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), the Company has substantially limited its interest
rate risk by match funding fixed rate assets and variable rate assets. As to
item (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 Dynex has entered into such
agreements.
36
Item
4. Controls and Procedures
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 the Company’s 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 the
Company’s reports filed or submitted under the Exchange Act is accumulated and
communicated to management, including the Company’s Principal Executive Officer
and Principal Financial Officer, as appropriate, to allow timely decisions
regarding required disclosures.
As of the
end of the period covered by this report, the Company carried out an evaluation
of the effectiveness of the design and operation of the Company’s 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 the Company’s management, including the Company’s Principal
Executive Officer and Principal Financial Officer. Based upon that
evaluation, the Company’s Principal Executive Officer and Principal Financial
Officer concluded that the Company’s disclosure controls and procedures were
effective.
Changes in internal
controls.
The
Company’s management is also responsible for establishing and maintaining
adequate internal control over financial reporting to provide reasonable
assurance regarding the reliability of financial reporting and the preparation
of financial statements for external purposes in accordance with generally
accepted accounting principles. There were no changes in the
Company’s internal controls during the Company’s last fiscal quarter that could
materially affect, or are reasonably likely to materially affect the Company’s
internal control over financial reporting.
PART
II. OTHER INFORMATION
As
discussed in Note 13 of the accompanying Notes to Unaudited Condensed Financial
Statements and the Company’s Annual Report on Form 10-K for the year ended
December 31, 2007, the Company and certain of its subsidiaries are defendants in
litigation. The following discussion is the current status of the
litigation. 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 which were purchased from Allegheny
County. In 2007, the Court of Common Pleas stayed 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 their damages in this
matter, and the Company believes that the ultimate outcome of this litigation
will not have a material impact on its financial condition, but may have a
material impact on its reported results for the particular period
presented.
Dynex
Capital, Inc. and Dynex Commercial, Inc. (DCI), a former affiliate of the
Company 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 Court of
Appeals heard oral arguments in this matter in April 2006. The appeal
sought to overturn the trial court’s judgment in the Company’s and DCI’s favor
which denied recovery to Plaintiffs. Plaintiffs sought a reversal of
the trial court’s judgment, and sought rendition of judgment against the Company
for alleged breach of loan agreements for tenant improvements in the
amount of $0.3 million. They also sought reversal of the trial
court’s judgment and rendition of judgment against DCI in favor of BCM under two
mutually exclusive damage
37
models,
for $2.2 million and $25.6 million, respectively, related to the alleged
breach by DCI of a $160.0 million “master” loan
commitment. Plaintiffs also sought reversal and rendition of a
judgment in their favor for attorneys’ fees in the amount of $2.1
million. Alternatively, Plaintiffs sought a new trial. On
February 22, 2008, the Court of Appeals ruled in favor of the Company and DCI,
upholding the trial court’s judgment. On May 7, 2008, Plaintiffs filed an appeal
with the Supreme Court of Texas. Even if Plaintiffs were to be
successful on appeal, DCI is a former affiliate of the Company, and the Company
believes that it would have no obligation for amounts, if any, awarded to the
Plaintiffs as a result of the actions of DCI.
The
Company 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 7, 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 the
Company’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 its current Chief
Operating Officer, but did not dismiss the claims against the Company or
MERIT. The Company and MERIT petitioned for an interlocutory appeal
with the United States Court of Appeals for the Second Circuit (Second
Circuit). The Second Circuit granted the Company’s petition on
September 15, 2006 and heard oral argument on the appeal on January 30,
2008. The Company has evaluated the allegations made in the
complaint, 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 its consolidated balance sheet but could materially affect
its consolidated results of operations in a given period or year.
There
have been no material changes to the risk factors disclosed in “Item 1A – Risk
Factors” of the Company’s Annual Report on Form 10-K for the year ended December
31, 2007. The materialization of any risks and uncertainties identified in the
Company’s Forward Looking Statements contained herein together with those
previously disclosed in the Form 10-K or those that are presently unforeseen
could result in significant adverse effects on the Company’s financial
condition, results of operations and cash flows. See Item 2. “Management’s
Discussion and Analysis of Financial Condition and Results of Operations –
Forward Looking Statements” in this Quarterly Report on Form 10-Q.
None.
None
Not
applicable
38
None
Exhibit
No.
|
Description
|
3.1
|
Articles
of Incorporation, as amended, effective as of February 4, 1988
(incorporated herein by reference to Exhibit 4.9 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, effective March 26, 2008 (incorporated herein by
reference to Exhibit 3.2 to Dynex’s Current Report on Form 8-K filed April
1, 2008).
|
3.3
|
Amendment
to Articles of Incorporation, effective December 29, 1989 (incorporated
herein by reference to Exhibit 4.10 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 19, 1992 (incorporated
herein by reference to Exhibit 4.2 to Dynex’s Amendment No. 1 to the
Registration Statement on Form S-3 (No. 333-10783) filed March 21,
1997).
|
3.5
|
Amendment
to Articles of Incorporation, effective April 25, 1997 (incorporated
herein by reference to Exhibit 3.10 to Dynex’s Quarterly Report on Form
10-Q for the quarter ended March 31, 1997).
|
3.6
|
Amendment
to Articles of Incorporation, effective June 17, 1998 (incorporated herein
by reference to Exhibit 3.7 to Dynex’s Annual Report on Form 10-K for the
year ended December 31, 2004).
|
3.7
|
Amendment
to Articles of Incorporation, effective August 2, 1999 (incorporated
herein by reference to Exhibit 3.8 to Dynex’s Annual Report on Form 10-K
for the year ended December 31, 2004).
|
3.8
|
Amendment
to Articles of Incorporation, effective May 18,
2004 (incorporated herein by reference to Exhibit 3.3 to
Dynex’s Quarterly Report on Form 10-Q for the quarter ended June 30,
2004).
|
10.6
|
Employment
Agreement, dated as of March 31, 2008, between Dynex and Thomas B. Akin
(incorporated herein by reference to Exhibit 10.6 to Dynex’s Current
Report on Form 8-K filed April 4, 2008).
|
10.7
|
Dynex
Capital, Inc. 401(k) Overflow Plan, effective July 1, 1997 (filed
herewith).
|
31.1
|
Certification
of Principal Executive Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002 (filed herewith).
|
31.2
|
Certification
of Principal Financial Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002 (filed herewith).
|
32.1
|
Certification
of Principal Executive Officer and Principal Financial Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002 (filed
herewith).
|
39
Pursuant
to the requirements 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.
|
|
Date: May
12, 2008
|
/s/
Thomas B. Akin
|
Thomas
B. Akin
|
|
Chief Executive
Officer
|
|
(Principal
Executive Officer)
|
|
/s/
Stephen J. Benedetti
|
Stephen
J. Benedetti
|
|
Executive
Vice President and Chief Operating Officer
|
|
(Principal
Financial Officer)
|
40
EXHIBIT
INDEX
Exhibit
No.
|
|
10.7
|
Dynex
Capital, Inc. 401(k) Overflow Plan, effective July 1, 1997 (filed
herewith).
|
31.1
|
Certification
of Principal Executive Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002 (filed herewith).
|
31.2
|
Certification
of Principal Financial Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002 (filed herewith).
|
32.1
|
Certification
of Principal Executive Officer and Principal Financial Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002 (filed
herewith).
|