10-Q 1 a2q17form10-q.htm 10-Q Document
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC  20549
FORM 10-Q
  x
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2017
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.)
 
 
4991 Lake Brook Drive, Suite 100, Glen Allen, Virginia
23060-9245
(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           x           No           o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes           x           No           o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer
o
Accelerated filer
x
Non-accelerated filer
o (Do not check if a smaller reporting company)
Smaller reporting company
o
 
 
Emerging growth company
o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. 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           x

On August 2, 2017, the registrant had 49,234,232 shares outstanding of common stock, $0.01 par value, which is the registrant’s only class of common stock.



DYNEX CAPITAL, INC.
FORM 10-Q
INDEX
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated Balance Sheets as of June 30, 2017 (unaudited) and December 31, 2016
 
 
 
 
 
 
Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2017 (unaudited) and June 30, 2016 (unaudited)
 
 
 
 
 
 
Consolidated Statement of Shareholders' Equity for the six months ended June 30, 2017 (unaudited)
 
 
 
 
 
 
Consolidated Statements of Cash Flows for the six months ended June 30, 2017 (unaudited) and June 30, 2016 (unaudited)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 











i


PART I.        FINANCIAL INFORMATION

ITEM 1.    FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.
CONSOLIDATED BALANCE SHEETS
(amounts in thousands except share data)
 
June 30, 2017
 
December 31, 2016
ASSETS
(unaudited)
 

Mortgage-backed securities (including pledged of $2,743,850 and $3,150,610, respectively)
$
2,864,026

 
$
3,212,084

Mortgage loans held for investment, net
17,345

 
19,036

Cash and cash equivalents
100,863

 
74,120

Restricted cash
45,377

 
24,769

Derivative assets
267

 
28,534

Principal receivable on investments
5,812

 
11,978

Accrued interest receivable
19,295

 
20,396

Other assets, net
7,235

 
6,814

Total assets
$
3,060,220

 
$
3,397,731

 
 
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY


 
 

Liabilities:
 

 
 

Repurchase agreements
$
2,540,759

 
$
2,898,952

Non-recourse collateralized financing
5,892

 
6,440

Derivative liabilities
1,686

 
6,922

Accrued interest payable
1,524

 
3,156

Accrued dividends payable
11,121

 
12,268

Other liabilities
1,963

 
2,809

 Total liabilities
2,562,945

 
2,930,547

 


 
 
Shareholders’ equity:
 

 
 

Preferred stock, par value $.01 per share; 50,000,000 shares authorized; 5,348,658 and 4,571,937 shares issued and outstanding, respectively ($133,716 and $114,298 aggregate liquidation preference, respectively)
$
128,165

 
$
110,005

Common stock, par value $.01 per share, 200,000,000 shares authorized;
49,234,493 and 49,153,463 shares issued and outstanding, respectively
492

 
492

Additional paid-in capital
728,124

 
727,369

Accumulated other comprehensive loss
(257
)
 
(32,609
)
Accumulated deficit
(359,249
)
 
(338,073
)
 Total shareholders' equity
497,275

 
467,184

 Total liabilities and shareholders’ equity
$
3,060,220

 
$
3,397,731

See notes to the unaudited consolidated financial statements.

1


DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(UNAUDITED)
 (amounts in thousands except per share data)
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2017
 
2016
 
2017
 
2016
Interest income
$
24,856

 
$
22,816

 
$
47,275

 
47,905

Interest expense
8,714

 
6,100

 
16,233

 
12,410

  Net interest income
16,142

 
16,716

 
31,042

 
35,495

 
 
 
 
 
 
 
 
Loss on derivative instruments, net
(15,802
)
 
(16,297
)
 
(15,627
)
 
(64,561
)
Loss on sale of investments, net
(3,709
)
 
(297
)
 
(5,417
)
 
(4,238
)
Fair value adjustments, net
30

 
28

 
40

 
51

Other income (loss), net
4

 
290

 
(42
)
 
353

General and administrative expenses:
 
 
 
 


 
 
Compensation and benefits
(2,041
)
 
(1,875
)
 
(4,286
)
 
(4,093
)
Other general and administrative
(2,056
)
 
(1,796
)
 
(4,091
)
 
(3,669
)
Net (loss) income
(7,432
)
 
(3,231
)
 
1,619

 
(40,662
)
Preferred stock dividends
(2,641
)
 
(2,294
)
 
(5,077
)
 
(4,588
)
Net loss to common shareholders
$
(10,073
)
 
$
(5,525
)
 
$
(3,458
)
 
$
(45,250
)
 
 
 
 
 
 
 
 
Other comprehensive income:
 
 
 
 


 
 
Unrealized gain on available-for-sale investments, net
$
8,739

 
$
22,730

 
$
27,107

 
$
60,491

Reclassification adjustment for loss on sale of investments, net
3,709

 
297

 
5,417

 
4,238

Reclassification adjustment for de-designated cash flow hedges
(73
)
 
(80
)
 
(172
)
 
(53
)
Total other comprehensive income
12,375

 
22,947

 
32,352

 
64,676

Comprehensive income to common shareholders
$
2,302

 
$
17,422

 
$
28,894

 
$
19,426

 
 
 
 
 
 
 
 
Net loss per common share-basic and diluted
$
(0.20
)
 
$
(0.11
)
 
$
(0.07
)
 
$
(0.92
)
Weighted average common shares-basic and diluted
49,218

 
49,119

 
49,197

 
49,080

See notes to the unaudited consolidated financial statements.

2


DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
(UNAUDITED)
($ in thousands)
 
Preferred Stock
 
Common Stock
 
Additional
Paid-in
Capital
 
Accumulated
Other
Comprehensive
Loss
 
Accumulated
Deficit
 
Total Shareholders' Equity
 
Shares
Amount
Shares
Amount
Balance as of December 31, 2016
4,571,937

$
110,005

 
49,153,463

$
492

 
$
727,369

 
$
(32,609
)
 
$
(338,073
)
 
$
467,184

Stock issuance
776,721

18,212

 
20,431


 
139

 

 

 
18,351

Restricted stock granted, net of amortization


 
138,166

1

 
1,177

 

 

 
1,178

Adjustments for tax withholding on share-based compensation


 
(77,567
)
(1
)
 
(520
)
 

 

 
(521
)
Stock issuance costs

(52
)
 


 
(41
)
 

 

 
(93
)
Net income


 


 

 

 
1,619

 
1,619

Dividends on preferred stock


 


 

 

 
(5,077
)
 
(5,077
)
Dividends on common stock


 


 

 

 
(17,718
)
 
(17,718
)
Other comprehensive income


 


 

 
32,352

 

 
32,352

Balance as of June 30, 2017
5,348,658

$
128,165

 
49,234,493

$
492

 
$
728,124

 
$
(257
)
 
$
(359,249
)
 
$
497,275

See notes to the unaudited consolidated financial statements.

3


DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
($ in thousands)
 
Six Months Ended
 
June 30,
 
2017
 
2016
Operating activities:
 
 
 
Net income (loss)
$
1,619

 
$
(40,662
)
Adjustments to reconcile net income (loss) to cash provided by operating activities:
 

 
 

Decrease in accrued interest receivable
1,101

 
3,145

Decrease in accrued interest payable
(1,633
)
 
(29
)
Loss on derivative instruments, net
15,627

 
64,561

Loss on sale of investments, net
5,417

 
4,238

Fair value adjustments, net
(40
)
 
(51
)
Amortization of investment premiums, net
81,188

 
73,597

Other amortization and depreciation, net
682

 
850

Stock-based compensation expense
1,179

 
1,443

Decrease in other assets and liabilities, net
(2,120
)
 
(881
)
Net cash and cash equivalents provided by operating activities
103,020

 
106,211

Investing activities:
 

 
 

Purchase of investments
(282,943
)
 
(4,970
)
Principal payments received on investments
183,636

 
187,437

Proceeds from sales of investments
399,483

 
94,033

Principal payments received on mortgage loans held for investment, net
1,876

 
2,319

Distributions received from limited partnership

 
10,835

Net receipts (payments) on derivatives, including terminations
7,405

 
(26,092
)
Other investing activities
(212
)
 
(55
)
Net cash and cash equivalents provided by investing activities
309,245

 
263,507

Financing activities:
 

 
 

Borrowings under repurchase agreements
39,007,126

 
11,394,652

Repayments of repurchase agreement borrowings and FHLB advances
(39,365,319
)
 
(11,640,592
)
Principal payments on non-recourse collateralized financing
(557
)
 
(939
)
Increase in restricted cash
(20,608
)
 
(32,489
)
Proceeds from issuance of preferred stock
18,212

 

Proceeds from issuance of common stock
139

 
77

Cash paid for stock issuance costs
(52
)
 

Cash paid for repurchases of common stock

 
(310
)
Payments related to tax withholding for stock-based compensation
(521
)
 
(485
)
Dividends paid
(23,942
)
 
(26,670
)
Net cash and cash equivalents used in financing activities
(385,522
)
 
(306,756
)
 
 
 
 
Net increase in cash and cash equivalents
26,743

 
62,962

Cash and cash equivalents at beginning of period
74,120

 
33,935

Cash and cash equivalents at end of period
$
100,863

 
$
96,897

Supplemental Disclosure of Cash Activity:
 

 
 

Cash paid for interest
$
18,029

 
$
12,476

See notes to the unaudited consolidated financial statements.

4


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)


NOTE 1 –ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization

Dynex Capital, Inc., ("Company") was incorporated in the Commonwealth of Virginia on December 18, 1987 and commenced operations in February 1988. The Company primarily earns income from investing on a leveraged basis in Agency and non-Agency mortgage-backed securities (“MBS”) consisting of residential MBS (“RMBS”), commercial MBS (“CMBS”) and CMBS interest-only ("IO") securities that are issued or guaranteed by the U.S. Government or U.S. Government sponsored agencies ("Agency MBS") and MBS issued by others ("non-Agency MBS"). We may also invest in other types of mortgage-related securities, such as to-be-announced (“TBA”) forward contracts for the purchase or sale of generic Agency MBS.

Basis of Presentation

The accompanying unaudited consolidated financial statements of Dynex Capital, Inc. and its subsidiaries (together, “Dynex” or, as appropriate, the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to the Quarterly Report on Form 10-Q and Article 10, Rule 10-01 of Regulation S-X promulgated by the Securities and Exchange Commission (the “SEC”). Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all significant adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation of the consolidated financial statements have been included. Operating results for the three months ended June 30, 2017 are not necessarily indicative of the results that may be expected for any other interim periods or for the entire year ending December 31, 2017. The unaudited consolidated financial statements included herein should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016 filed with the SEC.

Reclassifications

Certain items in the prior periods' consolidated financial statements have been reclassified to conform to the current period's presentation. The Company has reclassified amortization of stock issuance costs which was previously recorded in "proceeds from issuance of common stock, net of issuance costs" in the financing activities section of the Company's consolidated statements of cash flows for six months ended June 30, 2016. Amortization of stock issuance costs is now presented within "other operating activities" in the operating activities section of the Company's consolidated statements of cash flows. This presentation change had no effect on reported financial condition or results of operations and did not have a material impact on cash flows from operating or financing activities.

Consolidation
 
The consolidated financial statements include the accounts of the Company and the accounts of its majority owned subsidiaries and variable interest entities ("VIE") for which it is the primary beneficiary. As a primary beneficiary, the Company has both the power to direct the activities that most significantly impact the economic performance of the VIE and a right to receive benefits or absorb losses of the entity that could be potentially significant to the VIE. The Company is required to reconsider its evaluation of whether to consolidate a VIE each reporting period, based upon changes in the facts and circumstances pertaining to the VIE. The Company consolidates certain trusts through which it has securitized mortgage loans as a result of not meeting the sale criteria under GAAP at the time the financial assets were transferred to the trust. All intercompany accounts and transactions have been eliminated in consolidation.

Use of Estimates
 
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenue and expenses during the reported period. Actual results could differ from those estimates. The most significant estimates used by management include, but are not limited to, amortization of premiums and discounts, fair value measurements of its investments, and other-than-temporary impairments. These items are discussed further below within this note to the consolidated financial statements.

5


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)



Income Taxes

The Company has elected to be taxed as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986 and the corresponding provisions of state law. To qualify as a REIT, the Company must meet certain tests including investing in primarily real estate-related assets and the required distribution of at least 90% of its annual REIT taxable income to stockholders after consideration of its net operating loss ("NOL") carryforward and not including taxable income retained in its taxable subsidiaries. As a REIT, the Company generally will not be subject to federal income tax on the amount of its income or capital gains that is distributed as dividends to shareholders.

The Company assesses its tax positions for all open tax years and determines whether the Company has any material unrecognized liabilities in accordance with Accounting Standards Codification ("ASC") Topic 740. The Company records these liabilities, if any, to the extent they are deemed more likely than not to have been incurred.

Net Income (Loss) Per Common Share

The Company calculates basic net income (loss) per common share by dividing net income (loss) to common shareholders for the period by weighted-average shares of common stock outstanding for that period. The Company did not have any potentially dilutive securities outstanding during the three or six months ended June 30, 2017 or June 30, 2016.

Holders of unvested shares of the Company's issued and outstanding restricted common stock are eligible to receive non-forfeitable dividends. As such, these unvested shares are considered participating securities as per ASC Topic 260-10 and therefore are included in the computation of basic net income (loss) per common share using the two-class method. Upon vesting, restrictions on transfer expire on each share of restricted stock, and each such share of restricted stock represents one unrestricted share of common stock.

Because the Company's 8.50% Series A Cumulative Redeemable Preferred Stock (the “Series A Preferred Stock”) and 7.625% Series B Cumulative Redeemable Preferred Stock (the “Series B Preferred Stock”) are redeemable at the Company's option for cash only and may convert into shares of common stock only upon a change of control of the Company, the effect of those shares and their related dividends is excluded from the calculation of diluted net income (loss) per common share.

Cash and Cash Equivalents

Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less.

Restricted Cash

Restricted cash consists of cash the Company has pledged to cover initial and variation margin with its financing and derivative counterparties.

Mortgage-Backed Securities
 
The Company's investments in Agency and non-Agency RMBS, CMBS, and CMBS IO securities are designated as available-for-sale ("AFS") and are recorded at fair value on the Company's consolidated balance sheet. Changes in unrealized gain (loss) on the Company's MBS are reported in other comprehensive income ("OCI") until each security is collected, disposed of, or determined to be other than temporarily impaired. Although the Company generally intends to hold its AFS securities until maturity, it may sell any of these securities as part of the overall management of its business. Upon the sale of an AFS security, any unrealized gain or loss is reclassified out of accumulated other comprehensive income ("AOCI") into net income as a realized "gain (loss) on sale of investments, net" using the specific identification method.

The Company’s MBS pledged as collateral against repurchase agreements and derivative instruments are included in MBS on the consolidated balance sheets with the fair value of the MBS pledged as collateral disclosed parenthetically.


6


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)


Interest Income, Premium Amortization, and Discount Accretion. Interest income on MBS is accrued based on the outstanding principal balance (or notional balance in the case of interest-only, or "IO", securities) and their contractual terms.  Premiums and discounts on Agency MBS as well as any non-Agency MBS rated 'AA' and higher at the time of purchase are amortized or accreted into interest income over the expected life of such securities using the effective yield method and adjustments to premium amortization and discount accretion are made for actual cash payments as well as changes in projected future cash payments. The Company's projections of future cash payments are based on input and analysis received from external sources and internal models, and include assumptions about the amount and timing of loan prepayment rates, fluctuations in interest rates, credit losses, and other factors. On at least a quarterly basis, the Company reviews and makes any necessary adjustments to its cash flow projections and updates the yield recognized on these assets.

The Company holds certain non-Agency MBS that had credit ratings of less than 'AA' at the time of purchase or were not rated by any of the nationally recognized credit rating agencies. A portion of these non-Agency MBS were purchased at discounts to their par value, which management does not believe to be substantial. The discount is accreted into income over the security's expected life based on management's estimate of the security's projected cash flows. Future changes in the timing of projected cash flows or differences arising between projected cash flows and actual cash flows received may result in a prospective change in the effective yield on those securities.

Determination of MBS Fair Value. The Company estimates the fair value of the majority of its MBS based upon prices obtained from third-party pricing services and broker quotes. The remainder of the Company's MBS are valued by discounting the estimated future cash flows derived from cash flow models that utilize information such as the security's coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected losses, and credit enhancements as well as certain other relevant information. Refer to Note 5 for further discussion of MBS fair value measurements.

Other-than-Temporary Impairment. An MBS is considered impaired when its fair value is less than its amortized cost. The Company evaluates all of its impaired MBS for other-than-temporary impairments ("OTTI") on at least a quarterly basis. An impairment is considered other-than-temporary if: (1) the Company intends to sell the MBS; (2) it is more likely than not that the Company will be required to sell the MBS before its fair value recovers; or (3) the Company does not expect to recover the full amortized cost basis of the MBS. If either of the first two conditions is met, the entire amount of the impairment is recognized in earnings. If the impairment is solely due to the inability to fully recover the amortized cost basis, the security is further analyzed to quantify any credit loss, which is the difference between the present value of cash flows expected to be collected on the MBS and its amortized cost. The credit loss, if any, is then recognized in earnings, while the balance of impairment related to other factors is recognized in other comprehensive income.

Following the recognition of an OTTI through earnings, a new cost basis is established for the security. Any subsequent recoveries in fair value may be accreted back into the amortized cost basis of the MBS on a prospective basis through interest income. Please see Note 2 for additional information related to the Company's evaluation for OTTI.

Repurchase Agreements
 
The Company's repurchase agreements, which are used to finance its purchases of MBS, are accounted for as secured borrowings under which the Company pledges its securities as collateral to secure a loan, which is equal in value to a specified percentage of the estimated fair value of the pledged collateral. The Company retains beneficial ownership of the pledged collateral. At the maturity of a repurchase agreement, the Company is required to repay the loan and concurrently receives back its pledged collateral from the lender or, with the consent of the lender, the Company may renew the agreement at the then prevailing financing rate. A repurchase agreement lender may require the Company to pledge additional collateral in the event of a decline in the fair value of the collateral pledged. Repurchase agreement financing is recourse to the Company and the assets pledged. Most of the Company’s repurchase agreements are based on the September 1996 version of the Bond Market Association Master Repurchase Agreement, which generally provides that the lender, as buyer, is responsible for obtaining collateral valuations from a generally recognized source agreed to by both the Company and the lender, or, in an instance when such source is not available, the value determination is made by the lender.


7


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)


Derivative Instruments

The Company's derivative instruments include interest rate swaps and forward contracts for the purchase or sale of generic Agency RMBS, commonly referred to as "TBA securities" or "TBA contracts". Derivative instruments are accounted for at the fair value of their unit of account. Derivative instruments in a gain position are reported as derivative assets and derivative instruments in a loss position are reported as derivative liabilities on the Company's consolidated balance sheet. All periodic interest costs and changes in fair value of derivative instruments, including gains and losses realized upon termination, maturity, or settlement are recorded in "gain (loss) on derivative instruments, net" on the Company's consolidated statement of comprehensive income. Cash receipts and payments related to derivative instruments are classified in the investing activities section of our consolidated statements of cash flows in accordance with the underlying nature or purpose of the derivative transactions.

Our interest rate swap agreements are privately negotiated in the over-the-counter ("OTC") market and the majority of these agreements are centrally cleared through the Chicago Mercantile Exchange ("CME") with the rest being subject to bilateral agreements between the Company and the swap counterparty. The Company's CME cleared swaps require that the Company post initial margin as determined by the CME, and in addition, variation margin is exchanged, typically in cash, for changes in the fair value of the CME cleared swaps. Beginning in January 2017, as a result of a change in the CME's rulebook, the exchange of variation margin for CME cleared swaps is legally considered to be the settlement of the derivative itself as opposed to a pledge of collateral. Accordingly, beginning in 2017, the Company accounts for the daily exchange of variation margin associated with its CME cleared interest rate swaps as a direct increase or decrease to the carrying value of the related derivative asset or liability. The carrying value of CME cleared interest rate swaps on the Company's consolidated balance sheets is the unsettled fair value of those instruments.

A TBA security is a forward contract for the purchase or sale of a generic Agency MBS at a predetermined price with certain principal and interest terms and certain types of collateral, but the particular Agency securities to be delivered are not identified until shortly before the TBA settlement date. The Company executes TBA dollar roll transactions which effectively delay the settlement of a forward purchase of a TBA Agency RMBS by entering into an offsetting short position (referred to as a "pair off"), net settling the paired-off positions in cash, and simultaneously entering a similar TBA contract for a later settlement date. TBA securities purchased for a forward settlement month are generally priced at a discount relative to TBA securities sold for settlement in the current month. This discount, often referred to as “drop income” is the economic equivalent of net interest interest income on the underlying Agency securities over the roll period (interest income less implied financing cost).

The Company accounts for TBA securities as derivative instruments because the Company cannot assert that it is probable at inception and throughout the term of an individual TBA contract that its settlement will result in physical delivery of the underlying Agency RMBS, or the individual TBA contract will not settle in the shortest time period possible.

Please refer to Note 4 for additional information regarding the Company's derivative instruments as well as Note 5 for information on how the fair value of these instruments are calculated.

Share-Based Compensation

Pursuant to the Company’s 2009 Stock and Incentive Plan, the Company may grant share-based compensation to eligible employees, directors or consultants or advisers to the Company, including stock awards, stock options, stock appreciation rights, dividend equivalent rights, performance shares, and restricted stock units. The Company's restricted stock currently issued and outstanding under this plan may be settled only in shares of its common stock, and therefore are treated as equity awards with their fair value measured at the grant date and recognized as compensation cost over the requisite service period with a corresponding credit to shareholders' equity. The requisite service period is the period during which an employee is required to provide service in exchange for an award, which is equivalent to the vesting period specified in the terms of the time-based restricted stock award. None of the Company's restricted stock awards have performance based conditions. The Company does not currently have any share-based compensation issued or outstanding other than restricted stock issued to its employees, officers, and directors.


8


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)


Contingencies

In the normal course of business, there may be various lawsuits, claims, and other contingencies pending against the Company. On a quarterly basis, the Company evaluates whether to establish provisions for estimated losses from those matters. The Company recognizes a liability for a contingent loss when: (a) the underlying causal event has occurred prior to the balance sheet date; (b) it is probable that a loss has been incurred; and (c) there is a reasonable basis for estimating that loss. A liability is not recognized for a contingent loss when it is only possible or remotely possible that a loss has been incurred, however, possible contingent losses shall be disclosed. If the contingent loss (or an additional loss in excess of any accrual) is at least a reasonable possibility and material, then the Company discloses a reasonable estimate of the possible loss or range of loss, if such reasonable estimate can be made. If the Company cannot make a reasonable estimate of the possible material loss, or range of loss, then that fact is disclosed.

Recent Accounting Pronouncements

The Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2017-08, Receivables-Nonrefundable Fees and Other Costs, which shortens the amortization period for certain callable debt securities held at a premium, requiring the premium to be amortized to the earliest call date. The amendments in this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018 and early adoption is permitted. The amendments in this Update should be applied using the modified-retrospective transition approach and will require disclosures for the change in accounting principle. The Company is currently evaluating the impact of this ASU on its consolidated financial statements.

NOTE 2 – MORTGAGE-BACKED SECURITIES
 
The majority of the Company's MBS are pledged as collateral for the Company's secured borrowings. The following tables present the Company’s MBS by investment type as of the dates indicated:
 
June 30, 2017
 
Par
 
Net Premium (Discount)
 
Amortized Cost
 
Gross Unrealized Gain
 
Gross Unrealized Loss
 
Fair Value
 
WAC (1)
CMBS:
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
$
1,315,974

 
$
14,110

 
1,330,084

 
$
6,026

 
$
(15,492
)
 
1,320,618

 
3.04
%
Non-Agency
41,142

 
(4,855
)
 
36,287

 
3,280

 

 
39,567

 
5.53
%
 
1,357,116

 
9,255

 
1,366,371

 
9,306

 
(15,492
)
 
1,360,185

 
 
CMBS IO (2):
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency

 
413,368

 
413,368

 
6,719

 
(322
)
 
419,765

 
0.63
%
Non-Agency

 
339,493

 
339,493

 
5,401

 
(578
)
 
344,316

 
0.62
%
 

 
752,861

 
752,861

 
12,120

 
(900
)
 
764,081

 
 
RMBS:
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
715,015

 
29,074

 
744,089

 
1,959

 
(7,464
)
 
738,584

 
2.98
%
Non-Agency
1,156

 

 
1,156

 
46

 
(26
)
 
1,176

 
6.75
%
 
716,171

 
29,074

 
745,245

 
2,005

 
(7,490
)
 
739,760

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


Total AFS securities:
$
2,073,287

 
$
791,190

 
$
2,864,477

 
$
23,431

 
$
(23,882
)
 
$
2,864,026

 
 
(1)
The weighted average coupon ("WAC") is the gross interest rate of the pool of mortgages underlying the security weighted by the outstanding principal balance (or by notional balance in the case of an IO security).
(2)
The notional balance for Agency CMBS IO and non-Agency CMBS IO was $14,248,128 and $11,126,737, respectively, as of June 30, 2017.

9


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)


 
December 31, 2016
 
Par
 
Net Premium (Discount)
 
Amortized Cost
 
Gross Unrealized Gain
 
Gross Unrealized Loss
 
Fair Value
 
WAC (1)
CMBS:
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
$
1,152,586

 
$
13,868

 
$
1,166,454

 
$
6,209

 
$
(28,108
)
 
$
1,144,555

 
3.12
%
Non-Agency
79,467

 
(6,718
)
 
72,749

 
5,467

 

 
78,216

 
4.72
%
 
1,232,053

 
7,150

 
1,239,203

 
11,676

 
(28,108
)
 
1,222,771

 
 
CMBS IO (2):
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency

 
411,737

 
411,737

 
3,523

 
(3,362
)
 
411,898

 
0.67
%
Non-Agency

 
346,155

 
346,155

 
1,548

 
(5,055
)
 
342,648

 
0.61
%
 

 
757,892

 
757,892

 
5,071

 
(8,417
)
 
754,546

 
 
RMBS:
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
$
1,157,258

 
$
57,066

 
$
1,214,324

 
$
2,832

 
$
(15,951
)
 
$
1,201,205

 
3.05
%
Non-Agency
33,572

 
(24
)
 
33,548

 
64

 
(50
)
 
33,562

 
3.58
%
 
1,190,830

 
57,042

 
1,247,872

 
2,896

 
(16,001
)
 
1,234,767

 
 



 
 
 


 


 
 
 


 
 
Total AFS securities:
$
2,422,883

 
$
822,084

 
$
3,244,967

 
$
19,643

 
$
(52,526
)
 
$
3,212,084

 


(1)
The WAC is the gross interest rate of the pool of mortgages underlying the security weighted by the outstanding principal balance (or by notional balance in the case of an IO security).
(2)
The notional balance for the Agency CMBS IO and non-Agency CMBS IO was $13,106,912 and $10,884,964, respectively, as of December 31, 2016.

Actual maturities of MBS are affected by the contractual lives of the underlying mortgage collateral, periodic payments of principal, prepayments of principal, and the payment priority structure of the security; therefore, actual maturities are generally shorter than the securities' stated contractual maturities.

The following table presents information regarding the sales included in "loss on sale of investments, net" on the Company's consolidated statements of comprehensive income for the periods indicated:

10


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)


 
Three Months Ended
 
June 30,
 
2017
 
2016
 
Proceeds Received
 
Realized Gain (Loss)
 
Proceeds Received
 
Realized Gain (Loss)
Agency RMBS
$
265,893

 
$
(5,524
)
 
$
10,287

 
$
(297
)
Agency CMBS
24,305

 
574

 

 

Non-Agency CMBS
35,705

 
1,199

 

 

Non-Agency RMBS
16,407

 
42

 

 

 
$
342,310

 
$
(3,709
)
 
$
10,287

 
$
(297
)
 
 
 
 
 
 
 
 
 
Six Months Ended
 
June 30,
 
2017
 
2016
 
Proceeds Received
 
Realized Gain (Loss)
 
Proceeds Received
 
Realized Gain (Loss)
Agency RMBS
$
323,057

 
$
(7,232
)
 
$
54,178

 
$
(3,010
)
Agency CMBS
24,305

 
574

 

 

Non-Agency CMBS
35,705

 
1,199

 
33,640

 
(1,228
)
Non-Agency RMBS
16,407

 
42

 

 

 
$
399,474

 
$
(5,417
)
 
$
87,818

 
$
(4,238
)

The following table presents certain information for those MBS in an unrealized loss position as of the dates indicated:
 
June 30, 2017
 
December 31, 2016
 
Fair Value
 
Gross Unrealized Losses
 
# of Securities
 
Fair Value
 
Gross Unrealized Losses
 
# of Securities
Continuous unrealized loss position for less than 12 months:
 
 
 
 
 
 
 
 
 
 
 
Agency MBS
$
1,254,502

 
$
(20,694
)
 
101
 
$
1,738,094

 
$
(38,469
)
 
133
Non-Agency MBS
19,542

 
(154
)
 
3
 
205,484

 
(2,773
)
 
48
 
 
 
 
 
 
 
 
 
 
 
 
Continuous unrealized loss position for 12 months or longer:
 
 
 
 
 
 
 
 
 
 
 
Agency MBS
$
186,382

 
$
(2,584
)
 
28
 
$
427,405

 
$
(8,952
)
 
72
Non-Agency MBS
40,122

 
(450
)
 
16
 
81,660

 
(2,332
)
 
26

Because the principal related to Agency MBS is guaranteed by the government-sponsored entities Fannie Mae and Freddie Mac which have the implicit guarantee of the U.S. government, the Company does not consider any of the unrealized losses on its Agency MBS to be credit related. Although the unrealized losses are not credit related, the Company assesses its ability and intent to hold any Agency MBS with an unrealized loss until the recovery in its value in accordance with GAAP. This assessment is based on the amount of the unrealized loss and significance of the related investment as well as the Company’s leverage and liquidity position. Based on this analysis, the Company has determined that the unrealized losses on its Agency MBS as of June 30, 2017 and December 31, 2016 were temporary.

The Company reviews any non-Agency MBS in an unrealized loss position to evaluate whether any decline in fair value represents an OTTI. The evaluation includes a review of the credit ratings of the non-Agency MBS, the credit characteristics

11


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)


of the mortgage loans collateralizing these securities, and the estimated future cash flows including projected collateral losses. The Company performed this evaluation for its non-Agency MBS in an unrealized loss position and has determined that there have not been any adverse changes in the timing or amount of estimated future cash flows that necessitate a recognition of OTTI amounts as of June 30, 2017 or December 31, 2016.

NOTE 3 – REPURCHASE AGREEMENTS
    
The Company’s repurchase agreements outstanding as of June 30, 2017 and December 31, 2016 are summarized in the following tables:
 
 
June 30, 2017
 
December 31, 2016
Collateral Type
 
Balance
 
Weighted
Average Rate
 
Fair Value of
Collateral Pledged
 
Balance
 
Weighted
Average Rate
 
Fair Value of
Collateral Pledged
Agency CMBS
 
$
1,192,447

 
1.21
%
 
$
1,252,560

 
$
1,005,726

 
0.82
%
 
$
1,095,002

Non-Agency CMBS
 
31,407

 
2.23
%
 
38,934

 
66,881

 
1.63
%
 
77,840

Agency CMBS IO
 
353,922

 
2.04
%
 
415,988

 
346,892

 
1.57
%
 
407,481

Non-Agency CMBS IO
 
293,725

 
2.13
%
 
343,600

 
291,199

 
1.67
%
 
341,139

Agency RMBS
 
665,346

 
1.29
%
 
692,126

 
1,157,302

 
0.82
%
 
1,191,147

Non-Agency RMBS
 

 
%
 

 
26,149

 
1.98
%
 
31,952

Securitization financing bond
 
3,912

 
2.45
%
 
4,249

 
4,803

 
2.00
%
 
5,278

Total repurchase agreements
 
$
2,540,759

 
1.47
%
 
$
2,747,457

 
$
2,898,952

 
1.03
%
 
$
3,149,839


As of June 30, 2017, the weighted average remaining term to maturity of our repurchase agreements was 19 days compared to 20 days as of December 31, 2016. The following table provides a summary of the original term to maturity of our secured borrowings as of June 30, 2017 and December 31, 2016:
Original Term to Maturity
 
June 30,
2017
 
December 31,
2016
Less than 30 days
 
$
1,215,553

 
$
910,937

30 to 90 days
 
1,268,716

 
533,112

91 to 180 days
 
56,490

 
1,454,903

 
 
$
2,540,759

 
$
2,898,952


The following table lists the counterparties with whom the Company had over 10% of its shareholders' equity at risk (defined as the excess of collateral pledged over the borrowings outstanding):
 
 
June 30, 2017
Counterparty Name
 
Balance
 
Weighted Average Rate
 
Equity at Risk
Wells Fargo Bank, N. A. and affiliates
 
$
371,660

 
2.09
%
 
$
65,366

    
Of the amount outstanding with Wells Fargo Bank, N.A. and affiliates, $359,263 is under a committed repurchase facility which has an aggregate maximum borrowing capacity of $400,000 and is scheduled to mature on May 12, 2019, subject to early termination provisions contained in the master repurchase agreement. The facility is collateralized primarily by CMBS IO, and its weighted average borrowing rate as of June 30, 2017 was 2.09%.

As of June 30, 2017, the Company had repurchase agreement amounts outstanding with 18 of its 34 available repurchase agreement counterparties. The Company's counterparties, as set forth in the master repurchase agreement with the counterparty, require the Company to comply with various customary operating and financial covenants, including, but not limited to, minimum

12


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)


net worth, maximum declines in net worth in a given period, and maximum leverage requirements as well as maintaining the Company's REIT status. In addition, some of the agreements contain cross default features, whereby default under an agreement with one lender simultaneously causes default under agreements with other lenders. To the extent that the Company fails to comply with the covenants contained in these financing agreements or is otherwise found to be in default under the terms of such agreements, the counterparty has the right to accelerate amounts due under the master repurchase agreement. The Company was in full compliance with all covenants as of June 30, 2017.

The Company's repurchase agreements are subject to underlying agreements with master netting or similar arrangements, which provide for the right of offset in the event of default or in the event of bankruptcy of either party to the transactions. The Company reports its repurchase agreements to these arrangements on a gross basis. The following tables present information regarding the Company's repurchase agreements as if the Company had presented them on a net basis as of June 30, 2017 and December 31, 2016:
 
Gross Amount of Recognized Liabilities
 
Gross Amount Offset in the Balance Sheet
 
Net Amount of Liabilities Presented in the Balance Sheet
 
Gross Amount Not Offset in the Balance Sheet (1)
 
Net Amount
Financial Instruments Posted as Collateral
 
Cash Posted as Collateral
June 30, 2017
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
2,540,759

 
$

 
$
2,540,759

 
$
(2,540,759
)
 
$

 
$

 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2016:
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
2,898,952

 
$

 
$
2,898,952

 
$
(2,898,952
)
 
$

 
$

(1)
Amounts disclosed for collateral received by or posted to the same counterparty include cash and the fair value of MBS up to and not exceeding the net amount of the asset or liability presented in the balance sheet. The fair value of the actual collateral received by or posted to the same counterparty may exceed the amounts presented.

Please see Note 4 for information related to the Company's derivatives which are also subject to underlying agreements with master netting or similar arrangements.

NOTE 4 – DERIVATIVES

     As of June 30, 2017, the Company's derivative instruments include interest rate swaps and TBA securities. The Company utilizes interest rate swaps to economically hedge a portion of its exposure to interest rate risk. The objective of the Company's risk management strategy is to mitigate declines in book value resulting from fluctuations in the fair value of the Company's assets from changing interest rates and to protect some portion of the Company's earnings from rising interest rates.

During the second quarter of 2017, the Company began investing in TBA securities for the purchase or sale of Agency RMBS on a non-specified pool basis. TBA securities are forward contracts which are accounted for as derivative instruments, however, management views TBA securities as the economic equivalent of investing in and financing generic Agency fixed-rate RMBS through the repurchase agreement markets. Please refer to Note 1 for information related to the Company's accounting policy for its derivative instruments.
    
The table below summarizes information about the fair value by type of derivative instrument on the Company's consolidated balance sheets as of the dates indicated:  

13


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)


 
 
 
 
June 30, 2017
 
December 31, 2016
Type of Derivative Instruments
 
Balance Sheet Location
 
Fair Value
 
Fair Value (1)
Interest rate swaps
 
Derivative assets
 
$
267

 
$
28,534

TBA securities
 
Derivative assets
 

 

 
 
 
 
$
267

 
$
28,534

 
 
 
 
 
 
 
Interest rate swaps
 
Derivative liabilities
 
$
(18
)
 
$
(6,922
)
TBA securities
 
Derivative liabilities
 
(1,668
)
 

 
 
 
 
$
(1,686
)
 
$
(6,922
)
(1)
Refer to Note 1 regarding information on a change in the CME rulebook. Amounts reported on the consolidated balance sheet as of June 30, 2017 for its interest rate swaps reflect the netting of the derivative asset or liability with the related collateral received or posted, respectively. The net amounts comparable to June 30, 2017 for the derivative asset and derivative liabilities as of December 31, 2016 were $104 and $(576), respectively.

The following tables present information about the Company's interest rate swaps as of the dates indicated:
 
 
June 30, 2017
 
 
 
 
Weighted-Average:
 
 
Years to Maturity:
 
Net Notional Amount (1)
 
Pay Rate (2)
 
Life Remaining (in Years)
 
Fair Value
< 3 years
 
$
3,060,000

 
1.39
%
 
1.1
 
$
249

>3 and < 6 years
 
1,050,000

 
1.63
%
 
4.3
 

>6 and < 10 years
 
1,175,000

 
2.45
%
 
8.3
 

Total
 
$
5,285,000

 
1.67
%
 
3.4
 
$
249

 
 
 
 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
Weighted-Average:
 
 
Years to Maturity:
 
Net Notional Amount (1)
 
Pay Rate (2)
 
Life Remaining (in Years)
 
Fair Value
< 3 years
 
$
595,000

 
0.73
%
 
2.3
 
$
4,348

>3 and < 6 years
 
1,185,000

 
1.47
%
 
4.3
 
8,631

>6 and < 10 years
 
1,250,000

 
2.42
%
 
8.9
 
8,633

Total
 
$
3,030,000

 
1.58
%
 
5.3
 
$
21,612

(1)
The net notional amounts included in the tables above represent pay-fixed interest rate swaps, net of receive-fixed interest rate swaps and include $2,425,000 and $2,725,000 of pay-fixed forward starting interest rate swaps as of June 30, 2017 and December 31, 2016, respectively.
(2) Excluding forward starting pay-fixed interest rate swaps, the weighted average pay rate was 1.31% and 0.73% as of June 30, 2017 and December 31, 2016, respectively.

The following table summarizes information about the Company's TBA securities as of June 30, 2017:

14


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)


 
 
June 30, 2017
By Coupon:
 
Notional Amount (1)
 
Cost Basis (2)
 
Market Value (3)
 
Net Carrying Value (4)
30-year TBA securities:
 
 
 
 
 
 
 
 
3.0%
 
$
100,000

 
$
100,656

 
$
99,867

 
$
(789
)
4.0%
 
300,000

 
315,656

 
314,777

 
(879
)
Total 30-year TBA securities
 
$
400,000

 
$
416,312

 
$
414,644

 
$
(1,668
)
(1)
Notional amount represents the par value (or principal balance) of the underlying Agency MBS.
(2)
Cost basis represents the forward price to be paid for the underlying Agency MBS as if settled.
(3)
Market value is the current fair value of the TBA contract and represents the estimated fair value of the underlying Agency security as of the end of the period.
(4)
Net carrying value represents the difference between the market value and the cost basis of the TBA contract as of the end of the period and is included on the consolidated balance sheets within "derivative assets (liabilities)".

The tables below summarize changes in our derivative instruments for the periods indicated:
Type of Derivative Instrument
 
Notional Amount as of December 31, 2016
 
Additions
 
Settlements,
Terminations,
or Pair-Offs
 
Notional Amount as of June 30, 2017
Receive-fixed interest rate swaps
 
$
425,000

 
$

 
$
(325,000
)
 
$
100,000

Pay-fixed interest rate swaps
 
3,455,000

 
2,750,000

 
(820,000
)
 
5,385,000

TBA securities
 

 
1,300,000

 
(900,000
)
 
400,000


The table below provides detail of the Company's "loss on derivative instruments, net" by type of derivative for the periods indicated:
 
 
Three Months Ended
 
Six Months Ended
 
 
June 30,
 
June 30,
Type of Derivative Instrument
 
2017
 
2016
 
2017
 
2016
Receive-fixed interest rate swaps
 
$
979

 
$
3,743

 
$
845

 
$
14,277

Pay-fixed interest rate swaps
 
(18,498
)
 
(15,854
)
 
(18,189
)
 
(62,466
)
TBA securities
 
1,717

 

 
1,717

 

Eurodollar futures
 

 
(4,186
)
 

 
(16,372
)
Loss on derivative instruments, net
 
$
(15,802
)
 
$
(16,297
)
 
$
(15,627
)
 
$
(64,561
)

There is a net unrealized gain of $499 remaining in AOCI on the Company's consolidated balance sheet as of June 30, 2017 which represents the activity related to interest rate swap agreements while they were previously designated as cash flow hedges, and this amount will be recognized in the Company's net income as an adjustment to "interest expense" over the remaining contractual life of the agreements. The Company estimates a credit of $193 will be reclassified to net income as a reduction of "interest expense" within the next 12 months.

A portion of the Company's interest rate swaps were entered into under bilateral agreements which contain cross-default provisions with other agreements between the parties. In addition, these bilateral agreements contain financial and operational covenants similar to those contained in our repurchase agreements as described in Note 3. The Company was in compliance with all covenants with respect to bilateral agreements under which interest rate swaps were entered into as of June 30, 2017.

The Company's derivatives are subject to underlying agreements with master netting or similar arrangements, which provide for the right of offset in the event of default or in the event of bankruptcy of either party to the transactions. The Company

15


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)


reports its derivative assets and liabilities subject to these arrangements on a gross basis. The following tables present information regarding those derivative assets and liabilities subject to such arrangements as if the Company had presented them on a net basis as of June 30, 2017 and December 31, 2016:
 
Offsetting of Assets
 
Gross Amount of Recognized Assets
 
Gross Amount Offset in the Balance Sheet
 
Net Amount of Assets Presented in the Balance Sheet
 
Gross Amount Not Offset in the Balance Sheet (1)
 
Net Amount
Financial Instruments Received as Collateral
 
Cash Received as Collateral
June 30, 2017
 
 
 
 
 
 
 
 
 
 
 
Interest rate swaps
$
267

 
$

 
$
267

 
$
(4
)
 
$

 
$
263

TBA securities

 

 

 

 

 

Derivative assets
$
267

 
$

 
$
267

 
$
(4
)
 
$

 
$
263

December 31, 2016:
 
 
 
 
 
 
 
 
 
 
 
Interest rate swaps
$
28,534

 
$

 
$
28,534

 
$
(6,449
)
 
$
(22,085
)
 
$

TBA securities

 

 

 

 

 

Derivative assets
$
28,534

 
$

 
$
28,534

 
$
(6,449
)
 
$
(22,085
)
 
$


 
Offsetting of Liabilities
 
Gross Amount of Recognized Liabilities
 
Gross Amount Offset in the Balance Sheet
 
Net Amount of Liabilities Presented in the Balance Sheet
 
Gross Amount Not Offset in the Balance Sheet (1)
 
Net Amount
Financial Instruments Posted as Collateral
 
Cash Posted as Collateral
June 30, 2017
 
 
 
 
 
 
 
 
 
 
 
Interest rate swaps
$
18

 
$

 
$
18

 
$
(18
)
 
$

 
$

TBA securities
1,668

 

 
1,668

 

 
(961
)
 
707

Derivative liabilities
$
1,686

 
$

 
$
1,686

 
$
(18
)
 
$
(961
)
 
$
707

 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2016:
 
 
 
 
 
 
 
 
 
 
 
Interest rate swaps
$
6,922

 
$

 
$
6,922

 
$
(6,913
)
 
$

 
$
9

TBA securities

 

 

 

 

 

Derivative liabilities
$
6,922

 
$

 
$
6,922

 
$
(6,913
)
 
$

 
$
9

(1)
Amounts disclosed for collateral received by or posted to the same counterparty include cash and the fair value of MBS up to and not exceeding the net amount of the asset or liability presented in the balance sheet. The fair value of the actual collateral received by or posted to the same counterparty may exceed the amounts presented.
Please see Note 3 for information related to the Company's repurchase agreements which are also subject to underlying agreements with master netting or similar arrangements.

NOTE 5 – FAIR VALUE OF FINANCIAL INSTRUMENTS
 
ASC Topic 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC Topic 820 clarifies that fair value should be based on the assumptions market participants would use when pricing an asset or liability and also requires an entity to consider all aspects of nonperformance risk, including the entity's own credit standing, when measuring fair value of a liability. ASC Topic 820 established a valuation hierarchy of three levels as follows:

16


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)


 
Level 1 – Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities as of the measurement date.
Level 2 – Inputs include quoted prices in active markets for similar assets or liabilities; quoted prices in inactive markets for identical or similar assets or liabilities; or inputs either directly observable or indirectly observable through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.  
Level 3 – Unobservable inputs are supported by little or no market activity. The unobservable inputs represent management’s best estimate of how market participants would price 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.  
    
The Company reviews the classification of its financial instruments within the fair value hierarchy on a quarterly basis, and management may conclude that its financial instruments should be reclassified to a different level in the future if a change in type of inputs occurs. 

The following table presents the fair value of the Company’s financial instruments segregated by the hierarchy level of the fair value estimate that are measured at fair value on a recurring basis as of the dates indicated:
 
June 30, 2017
 
Fair Value
 
Level 1 - Unadjusted Quoted Prices in Active Markets
 
Level 2 - Observable Inputs
 
Level 3 - Unobservable Inputs
Assets:
 
 
 
 
 
 
 
Mortgage-backed securities
$
2,864,026

 
$

 
$
2,856,229

 
$
7,797

Interest rate swaps
267

 

 
267

 

Total assets carried at fair value
$
2,864,293

 
$

 
$
2,856,496

 
$
7,797

Liabilities:
 

 
 

 
 

 
 

Interest rate swaps
$
18

 
$

 
$
18

 
$

TBA securities
1,668

 

 
1,668

 

Total liabilities carried at fair value
$
1,686

 
$

 
$
1,686

 
$

 
 
 
 
 
 
 
 
 
December 31, 2016
 
Fair Value
 
Level 1 - Unadjusted Quoted Prices in Active Markets
 
Level 2 - Observable Inputs
 
Level 3 - Unobservable Inputs
Assets:
 
 
 
 
 
 
 
Mortgage-backed securities
$
3,212,084

 
$

 
$
3,201,157

 
$
10,927

Interest rate swaps
28,534

 

 
28,534

 

Total assets carried at fair value
$
3,240,618

 
$

 
$
3,229,691

 
$
10,927

Liabilities:
 
 
 
 
 
 
 
Interest rate swaps
$
6,922

 
$

 
$
6,922

 
$

Total liabilities carried at fair value
$
6,922

 
$


$
6,922

 
$


The fair value measurements for a majority of the Company's MBS are considered Level 2. These Level 2 securities are substantially similar to securities that either are actively traded or have been recently traded in their respective markets. The Company determines the fair value of its Level 2 securities based on prices received from the Company's primary pricing service

17


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)


as well as other pricing services and brokers. The Company evaluates the third party prices it receives to assess their reasonableness. Although the Company does not adjust third party prices, they may be excluded from use in the determination of a security's fair value if they are significantly different from other observable market data. In valuing a security, the primary pricing service uses either a market approach, which uses observable prices and other relevant information that is generated by market transactions of identical or similar securities, or an income approach, which uses valuation techniques to convert future amounts to a single, discounted present value amount. The Company also reviews the assumptions and inputs utilized in the valuation techniques of its primary pricing service. Examples of these observable inputs and assumptions include market interest rates, credit spreads, and projected prepayment speeds, among other things.

The fair value of interest rate swaps are measured using the income approach with the primary input being the forward interest rate swap curve, which is considered an observable input, and thus their fair values are considered Level 2 measurements as of June 30, 2017 and December 31, 2016. The fair value of TBA securities are estimated using methods similar those used to fair value the Company's Level 2 MBS.

The Company owns certain non-Agency MBS for which there are not sufficiently recent trades of substantially similar securities, and their fair value measurements are thus considered Level 3. The Company determines the fair value of its Level 3 securities by discounting the estimated future cash flows derived from cash flow models using significant inputs which are determined by the Company when market observable inputs are not available. Information utilized in those pricing models include the security’s credit rating, coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected credit losses, and credit enhancement as well as certain other relevant information. Significant changes in any of these inputs in isolation may result in a significantly different fair value measurement. Level 3 assets are generally most sensitive to the default rate and severity assumptions.

The activity of the instruments measured at fair value on a recurring basis using Level 3 inputs is presented in the following table for the period indicated:
 
Level 3 Fair Value
 
Non-Agency CMBS
 
Non-Agency RMBS
 
Total
Balance as of December 31, 2016
$
9,669

 
$
1,258

 
$
10,927

Unrealized loss included in OCI (1)
(1,250
)
 
8

 
(1,242
)
Principal payments
(3,535
)
 
(90
)
 
(3,625
)
Accretion
1,737

 

 
1,737

Balance as of June 30, 2017
$
6,621

 
$
1,176

 
$
7,797

(1)
Amount included in "unrealized gain on available-for-sale investments, net" on consolidated statements of comprehensive income (loss).


18


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)


The following table presents a summary of the carrying value and estimated fair values of the Company’s financial instruments as of the dates indicated:
 
June 30, 2017
 
December 31, 2016
 
Carrying Value
 
Fair Value
 
Carrying Value
 
Fair Value
Assets:
 
 
 
 
 
 
 
Mortgage-backed securities
$
2,864,026

 
$
2,864,026

 
$
3,212,084

 
$
3,212,084

Mortgage loans held for investment, net (1)
17,345

 
14,329

 
19,036

 
15,971

Derivative assets
267

 
267

 
28,534

 
28,534

Liabilities:
 

 
 

 
 

 
 

Repurchase agreements (2)
$
2,540,759

 
$
2,540,759

 
$
2,898,952

 
$
2,898,952

Non-recourse collateralized financing (1)
5,892

 
5,873

 
6,440

 
6,357

Derivative liabilities
1,686

 
1,686

 
6,922

 
6,922

(1)
The Company determines the fair value of its mortgage loans held for investment, net and its non-recourse collateralized financing using internally developed cash flow models with inputs similar to those used to estimate the fair value of the Company's Level 3 non-Agency MBS.
(2)
The carrying value of repurchase agreements generally approximates fair value due to their short term maturities.

NOTE 6 – SHAREHOLDERS' EQUITY AND SHARE-BASED COMPENSATION

Preferred Stock

The Company's articles of incorporation authorize the issuance of up to 50,000,000 shares of preferred stock, par value $0.01 per share, of which the Company's Board of Directors has designated 8,000,000 shares of 8.50% Series A Preferred Stock and 7,000,000 shares of 7.625% Series B Preferred Stock, (the Series A Preferred Stock and the Series B Preferred Stock collectively, the "Preferred Stock"). The Company had 2,300,000 shares of its Series A Preferred Stock and 3,048,658 shares of its Series B Preferred Stock issued and outstanding as of June 30, 2017 compared to 2,300,000 shares of Series A Preferred Stock and 2,271,937 shares of Series B Preferred Stock as of December 31, 2016.

The Preferred Stock has no maturity and will remain outstanding indefinitely unless redeemed or otherwise repurchased or converted into common stock pursuant to the terms of the Preferred Stock. Except under certain limited circumstances, the Company may not redeem the Series A Preferred Stock prior to July 31, 2017 or the Series B Preferred Stock prior to April 30, 2018. On or after these dates, at any time and from time to time, the Preferred Stock may be redeemed in whole, or in part, at the Company's option at a cash redemption price of $25.00 per share plus any accumulated and unpaid dividends. Because the Preferred Stock is redeemable only at the option of the issuer, it is classified as equity on the Company's consolidated balance sheet. The Series A Preferred Stock pays a cumulative cash dividend equivalent to 8.50% of the $25.00 liquidation preference per share each year and the Series B Preferred Stock pays a cumulative cash dividend equivalent to 7.625% of the $25.00 liquidation preference per share each year. The Company paid its regular quarterly dividends on its Preferred Stock for the second quarter on July 17, 2017 to shareholders of record as of July 1, 2017.
    
Common Stock
    
The Company declared a second quarter common stock dividend of $0.18 per share that was paid on July 28, 2017 to shareholders of record as of July 6, 2017.
    
2009 Stock and Incentive Plan. Of the 2,500,000 shares of common stock authorized for issuance under its 2009 Stock and Incentive Plan, the Company had 785,962 available for issuance as of June 30, 2017. Total stock-based compensation expense recognized by the Company for the three and six months ended June 30, 2017 was $642 and $1,179, respectively, compared to $614 and $1,443 for the three and six months ended June 30, 2016, respectively.
  
The following table presents a rollforward of the restricted stock activity for the periods indicated:

19


NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
(amounts in thousands except share data)


 
Three Months Ended
 
June 30,
 
2017
 
2016
 
Shares
 
Weighted Average Grant Date Fair Value Per Share
 
Shares
 
Weighted Average Grant Date Fair Value Per Share
Restricted stock outstanding as of beginning of period
386,151

 
$
7.05

 
547,486

 
$
7.63

Restricted stock granted
29,720

 
6.73

 
46,158

 
6.50

Restricted stock vested
(62,768
)
 
7.14

 
(32,555
)
 
7.68

Restricted stock outstanding as of end of period
353,103

 
$
7.01

 
561,089

 
$
7.54

 
 
 
 
 
 
 
 
 
Six Months Ended
 
June 30,
 
2017
 
2016
 
Shares
 
Weighted Average Grant Date Fair Value Per Share
 
Shares
 
Weighted Average Grant Date Fair Value Per Share
Restricted stock outstanding as of beginning of period
553,396

 
$
7.55

 
696,597

 
$
8.54

Restricted stock granted
138,166

 
6.76

 
214,878

 
6.28

Restricted stock vested
(338,459
)
 
7.80

 
(350,386
)
 
8.76

Restricted stock outstanding as of end of period
353,103

 
$
7.01

 
561,089

 
$
7.54


As of June 30, 2017, the grant date fair value of the Company’s remaining nonvested restricted stock is $1,892 which will be amortized into compensation expense over a weighted average period of 1.6 years.

NOTE 7 – SUBSEQUENT EVENTS

Management has evaluated events and circumstances occurring as of and through the date this Quarterly Report on Form 10-Q was filed with the SEC and has determined that there have been no significant events or circumstances that qualify as a "recognized" or "nonrecognized" subsequent event as defined by ASC Topic 855.


20


ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with our unaudited financial statements and the accompanying notes included in Part 1, Item 1. “Financial Statements” in this Quarterly Report on Form 10-Q and our audited financial statements and the accompanying notes included in Part II, Item 8 in our Annual Report on Form 10-K for the year ended December 31, 2016. References herein to “Dynex,” the “Company,” “we,” “us,” and “our” include Dynex Capital, Inc. and its consolidated subsidiaries, unless the context otherwise requires. In addition to current and historical information, the following discussion and analysis contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to our future business, financial condition or results of operations. For a description of certain factors that may have a significant impact on our future business, financial condition or results of operations, see “Forward-Looking Statements” at the end of this discussion and analysis.

For more information about our business including our operating policies, investment philosophy and strategy, financing and hedging strategies, and other important information, please refer to Part I, Item 1 of our Annual Report on Form 10-K for the year ended December 31, 2016.

EXECUTIVE OVERVIEW

Company Overview

We are an internally managed mortgage real estate investment trust, or mortgage REIT, which invests in residential and commercial mortgage-backed securities on a leveraged basis. Our common stock is traded on the New York Stock Exchange ("NYSE") under the symbol "DX". Our objective is to provide attractive risk-adjusted returns to our shareholders over the long term that are reflective of a leveraged, high quality fixed income portfolio with a focus on capital preservation. We seek to provide returns to our shareholders primarily through regular quarterly dividends, and also through capital appreciation.

We also have two series of preferred stock outstanding, our 8.50% Series A Cumulative Redeemable Preferred Stock (the "Series A Preferred Stock") which is traded on the NYSE under the symbol "DXPRA", and our 7.625% Series B Cumulative Redeemable Preferred Stock (the "Series B Preferred Stock") which is traded on the NYSE under the symbol "DXPRB".
 
We invest in Agency and non-Agency mortgage-backed securities (“MBS”) consisting of residential MBS (“RMBS”), commercial MBS (“CMBS”) and CMBS interest-only ("IO") securities. Agency MBS have a guaranty of principal payment by an agency of the U.S. government or a U.S. government-sponsored entity ("GSE") such as Fannie Mae and Freddie Mac. Non-Agency MBS have no such guaranty of payment. Our investments in non-Agency MBS are generally higher quality senior or mezzanine classes (typically rated 'A' or better by one or more of the nationally recognized statistical rating organizations) because they are typically more liquid (i.e., they are more easily converted into cash either through sales or pledges as collateral for repurchase agreement borrowings) and have less exposure to credit losses than lower-rated non-Agency MBS.

We invest and manage our capital pursuant to Operating Policies approved by our Board of Directors. We use leverage to enhance the returns on our invested capital by pledging our investments as collateral for borrowings such as repurchase agreements as discussed further below. We also use derivative instruments to attempt to mitigate our exposure to adverse changes in interest rates as discussed further below.

RMBS. Our Agency RMBS investments include MBS collateralized by adjustable-rate mortgage loans ("ARMs"), which have interest rates that generally will adjust at least annually to an increment over a specified interest rate index, and hybrid adjustable-rate mortgage loans ("hybrid ARMs"), which are loans that have a fixed rate of interest for a specified period (typically three to ten years) and then adjust their interest rate at least annually to an increment over a specified interest rate index. Agency ARMs also include hybrid Agency ARMs that are past their fixed-rate periods or within twelve months of their initial reset period. Substantially all of our ARMs reset based on the one-year LIBOR index. We sold the majority of our non-Agency RMBS during the second quarter of 2017 because these investments were within a year of their maturity.


21


In the second quarter of 2017, we began entering into forward contracts for the purchase of TBA securities as a means of investing in and financing non-specified Agency RMBS. A TBA security is a forward contract for the purchase or sale of a fixed-rate Agency MBS at a predetermined price with certain principal and interest terms and certain types of collateral, but the particular Agency securities to be delivered are not identified until shortly before the TBA settlement date. The Company executes TBA dollar roll transactions which effectively delay the settlement of a forward purchase of an Agency MBS by entering into an offsetting short position, net settling the paired-off positions in cash, and simultaneously entering a similar TBA contract for a later settlement date. TBA securities purchased for a forward settlement month are generally priced at a discount relative to TBA securities sold for settlement in the current month. This discount, often referred to as “drop income,” is the economic equivalent of net interest income on the underlying Agency securities over the roll period (interest income less implied financing cost). Consequently, TBA dollar roll transactions represent a form of off-balance sheet financing. We account for TBA securities as derivative instruments because we cannot assert that it is probable at inception and throughout the term of an individual TBA contract that its settlement will result in physical delivery of the underlying Agency RMBS, or the individual TBA contract will not settle in the shortest time period possible.

CMBS. The majority of our CMBS investments are primarily fixed-rate Agency-issued securities backed by multifamily housing loans. The remainder of our CMBS portfolio contains both Agency and non-Agency issued securities backed by other commercial real estate property types such as office building, retail, hospitality, and health care. Loans underlying CMBS generally are geographically diverse, are fixed-rate, mature in eight to eighteen years and have amortization terms of up to 30 years. Typically these loans have some form of prepayment protection provisions (such as prepayment lock-out) or prepayment compensation provisions (such as yield maintenance or prepayment penalty). Yield maintenance and prepayment penalty requirements are intended to create an economic disincentive for the loans to prepay.

CMBS IO. CMBS IO are interest-only securities issued as part of a CMBS securitization and represent the right to receive a portion of the monthly interest payments (but not principal cash flows) on the unpaid principal balance of the underlying pool of commercial mortgage loans. We invest in both Agency-issued and non-Agency issued CMBS IO. The loans collateralizing CMBS IO pools are very similar in composition to the pools of loans that generally collateralize CMBS as discussed above. Since CMBS IO securities have no principal associated with them, the interest payments received are based on the unpaid principal balance of the underlying pool of mortgage loans, which is often referred to as the notional amount. Most loans in these securities have some form of prepayment protection from early repayment including absolute loan prepayment lock-outs, loan prepayment penalties, or yield maintenance requirements similar to CMBS described above. There are no prepayment protections, however, if the loan defaults and is partially or wholly repaid earlier as a result of loss mitigation actions taken by the underlying loan servicer, and therefore yields on CMBS IO investments are dependent upon the underlying loan performance. Because Agency-issued MBS generally contain higher credit quality loans, Agency CMBS IO are expected to have a lower risk of default than non-Agency CMBS IO. Our CMBS IO investments are investment grade-rated with the majority rated 'AAA' by at least one of the nationally recognized statistical rating organizations.

Financing. We finance our investments primarily through the use of uncommitted repurchase agreements which are provided principally by major financial institutions and broker-dealers. We pledge our MBS as collateral to secure the amounts borrowed from our counterparties. These repurchase agreements generally have original terms to maturity of overnight to six months, though in some instances we may enter into longer-dated maturities depending on market conditions. We pay interest on our repurchase agreement borrowings at a rate usually based on a spread to LIBOR and fixed for the term of the borrowing. Borrowings under these repurchase agreements are renewable at the discretion of our lenders and do not contain guaranteed roll-over terms. One of our repurchase agreement lenders provides a committed repurchase agreement financing facility to us with an aggregate borrowing capacity of $400.0 million that expires in May 2019.

As noted above, the Company enters into TBA forward contracts and dollar roll transactions as a form of off-balance sheet financing for generic 30-year fixed-rate Agency RMBS. TBA transactions require the us to post initial margin (though typically the amount is less than margin amount for repurchase agreements) and variation margin for fluctuations in fair value of the TBA securities. These dollar roll transactions have an implied financing rate which changes with market conditions, expected prepayment speeds and the underlying demand for Agency RMBS in a given delivery period.

Hedging. We currently use interest rate swaps to hedge our exposure to changes in interest rates. Such exposure results from our ownership of hybrid and fixed-rate investments that are financed with repurchase agreements which have significantly shorter maturities than the weighted average life of these investments. Changes in interest rates can impact the market value of

22


our investments and our net interest income, thereby ultimately impacting book value per common share. We frequently adjust our hedging portfolio based on our expectation of future interest rates, including the absolute level of rates and the slope of the yield curve versus market expectations.

Factors that Affect Our Results of Operations and Financial Condition

Our financial performance is driven by the performance of our investment portfolio and related financing and hedging activity. Management focuses on net interest income, net income, comprehensive income, book value per common share, and core net operating income to common shareholders (a non-GAAP measure) as measurements of our financial performance. Our financial performance may be impacted by multiple factors, many of which are related to macroeconomic conditions, geopolitical conditions, central bank and government policy, and other factors beyond our control. These factors include, but are not limited to, the absolute level of interest rates, the relative slope of interest rate curves, changes in market expectations of future interest rates, actual and estimated future prepayment rates on our investments, competition for investments, economic conditions and their impact on the credit performance of our investments, and market required yields as reflected by market spreads. All of these factors are influenced by market forces and generally are exacerbated during periods of market volatility.

The performance of our investment portfolio, the cost and availability of financing and the availability of investments at acceptable risk-adjusted returns could also be influenced by regulatory actions and regulatory policy measures of the U.S. government including, but not limited to, the Federal Housing Finance Administration ("FHFA"), the U. S. Department of the Treasury (the "Treasury"), and the Board of Governors of the Federal Reserve System (the "Federal Reserve") and could also be influenced by reactions in U.S. markets from activities of central banks around the world.

Our business model may also be impacted by other factors such as the availability and cost of financing and the state of the overall credit markets. Reductions in or limitations of financing for our investments could force us to sell assets, potentially at losses. While repurchase agreement lending availability has generally recovered from the 2008 financial crisis, such lending by larger U.S. domiciled banks has declined due to increased regulation. Their repurchase market participation has been replaced by smaller independent broker dealers that are generally less regulated and by U.S. domiciled broker dealer subsidiaries of foreign financial institutions. It is uncertain how these new participants will react during periods of market stress. Other factors that could also impact our business include changes in regulatory requirements, including requirements to qualify for registration under the 1940 Act, and REIT requirements.

We believe that regulatory impacts on financial institutions, many of which are our trading and financing counterparties, continue to pose a threat to the overall liquidity in the capital markets. There remains uncertainty as to the outcome of certain regulations under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") and restrictions on market-making activities of large U.S. financial institutions could result in reduced liquidity in times of market stress. The Federal Reserve has also announced that it will soon begin curtailing its reinvestment of principal payments received on its Agency RMBS portfolio, which could result in volatile asset prices. Finally, the market liquidity of our investments and the financing markets could be negatively impacted if the Federal Reserve's Federal Open Market Committee (or "FOMC") suddenly changes market expectations of the target Federal Funds Rate or takes other actions which have the effect of tightening monetary policy.

To complement the performance of our investment portfolio, we regularly review our existing operations to determine whether our investment strategy or business model should change, including through a change in our investment portfolio, our targeted investments, and our risk position. We may also consider reallocating our capital resources to other assets or portfolios that better align with our long-term strategy, expanding our capital base, or merger, acquisition or divestiture opportunities. We analyze and evaluate potential business opportunities that we identify or are presented to us, including possible merger, acquisition, or divestiture transactions, that might be a strategic fit for our investment strategy or asset allocation or otherwise maximize value for our shareholders.