10-Q 1 a3q18form10-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 September 30, 2018
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 every Interactive Data File required to be submitted 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 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 
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 October 31, 2018, the registrant had 59,688,862 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 September 30, 2018 (unaudited) and December 31, 2017
 
 
 
 
 
 
Consolidated Statements of Comprehensive Income (Loss) for the three and nine months ended September 30, 2018 (unaudited) and September 30, 2017 (unaudited)
 
 
 
 
 
 
Consolidated Statement of Shareholders' Equity for the nine months ended September 30, 2018 (unaudited)
 
 
 
 
 
 
Consolidated Statements of Cash Flows for the nine months ended September 30, 2018 (unaudited) and September 30, 2017 (unaudited)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 



i


PART I.        FINANCIAL INFORMATION
ITEM 1.    FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.
CONSOLIDATED BALANCE SHEETS
(amounts in thousands except share data)
 
September 30, 2018
 
December 31, 2017
ASSETS
(unaudited)
 

Investments in securities, at fair value:
 
 
 
Mortgage-backed securities (including pledged of $2,877,985 and $2,640,884 respectively)
$
3,294,510

 
$
3,026,989

U.S. Treasuries (including pledged of $0 and $124,215, respectively)

 
146,530

 
 
 
 
Mortgage loans held for investment, net
12,342

 
15,738

Cash and cash equivalents
55,251

 
40,867

Restricted cash
58,334

 
46,333

Derivative assets
2,612

 
2,940

Accrued interest receivable
19,575

 
19,819

Other assets, net
5,555

 
6,562

Total assets
$
3,448,179

 
$
3,305,778

 
 
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY


 
 

Liabilities:
 

 
 

Repurchase agreements
$
2,690,858

 
$
2,565,902

Payable for unsettled securities
182,922

 
156,899

Non-recourse collateralized financing
3,709

 
5,520

Derivative liabilities
2,039

 
269

Accrued interest payable
5,676

 
3,734

Accrued dividends payable
13,121

 
12,526

Other liabilities
3,101

 
3,870

 Total liabilities
2,901,426

 
2,748,720

 


 
 
Shareholders’ equity:
 

 
 

Preferred stock, par value $.01 per share; 50,000,000 shares authorized; 5,941,659 and 5,888,680 shares issued and outstanding, respectively ($148,541 and $147,217 aggregate liquidation preference, respectively)
$
142,574

 
$
141,294

Common stock, par value $.01 per share, 200,000,000 shares authorized;
59,016,554 and 55,831,549 shares issued and outstanding, respectively
590

 
558

Additional paid-in capital
795,630

 
775,873

Accumulated other comprehensive loss
(85,833
)
 
(8,697
)
Accumulated deficit
(306,208
)
 
(351,970
)
 Total shareholders’ equity
546,753

 
557,058

 Total liabilities and shareholders’ equity
$
3,448,179

 
$
3,305,778

See notes to the unaudited consolidated financial statements.

1


DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)
 (amounts in thousands except per share data)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2018
 
2017
 
2018
 
2017
Interest income
$
26,925

 
$
23,103

 
$
78,037

 
$
70,378

Interest expense
14,751

 
9,889

 
40,521

 
26,122

  Net interest income
12,174

 
13,214

 
37,516

 
44,256

 
 
 
 
 
 
 
 
Gain (loss) on derivative instruments, net
19,499

 
5,993

 
78,520

 
(9,634
)
Loss on sale of investments, net
(1,726
)
 
(5,211
)
 
(17,945
)
 
(10,628
)
Fair value adjustments, net
12

 
23

 
68

 
63

Other operating expense, net
(409
)
 
(109
)
 
(1,001
)
 
(150
)
General and administrative expenses:
 
 
 
 
 
 
 
Compensation and benefits
(1,712
)
 
(2,070
)
 
(5,425
)
 
(6,356
)
Other general and administrative
(2,252
)
 
(1,529
)
 
(6,188
)
 
(5,620
)
Net income
25,586

 
10,311

 
85,545

 
11,931

Preferred stock dividends
(2,956
)
 
(2,808
)
 
(8,838
)
 
(7,885
)
Net income to common shareholders
$
22,630

 
$
7,503

 
$
76,707

 
$
4,046

 
 
 
 
 
 
 
 
Other comprehensive income:


 
 
 
 
 
 
Unrealized (loss) gain on available-for-sale investments, net
$
(23,574
)
 
$
981

 
$
(94,919
)
 
$
28,087

Reclassification adjustment for loss on sale of investments, net
1,726

 
5,211

 
17,945

 
10,628

Reclassification adjustment for de-designated cash flow hedges
(66
)
 
(48
)
 
(162
)
 
(220
)
Total other comprehensive (loss) income
(21,914
)
 
6,144

 
(77,136
)
 
38,495

Comprehensive income (loss) to common shareholders
$
716

 
$
13,647

 
$
(429
)
 
$
42,541

 
 
 
 
 
 
 
 
Net income per common share-basic and diluted
$
0.39

 
$
0.15

 
$
1.35

 
$
0.08

Weighted average common shares-basic and diluted
57,727

 
49,832

 
56,638

 
49,411

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, 2017
5,888,680

$
141,294

 
55,831,549

$
558

 
$
775,873

 
$
(8,697
)
 
$
(351,970
)
 
$
557,058

Stock issuance
52,979

1,290

 
3,028,983

31

 
19,250

 

 

 
20,571

Restricted stock granted, net of amortization


 
213,157

2

 
928

 

 

 
930

Adjustments for tax withholding on share-based compensation


 
(57,135
)
(1
)
 
(363
)
 

 

 
(364
)
Stock issuance costs

(10
)
 


 
(58
)
 

 

 
(68
)
Net income


 


 

 

 
85,545

 
85,545

Dividends on preferred stock


 


 

 

 
(8,838
)
 
(8,838
)
Dividends on common stock


 


 

 

 
(30,945
)
 
(30,945
)
Other comprehensive loss


 


 

 
(77,136
)
 

 
(77,136
)
Balance as of
September 30, 2018
5,941,659

$
142,574

 
59,016,554

$
590

 
$
795,630

 
$
(85,833
)
 
$
(306,208
)
 
$
546,753

See notes to the unaudited consolidated financial statements.

3


DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
($ in thousands)
 
Nine Months Ended
 
September 30,
 
2018
 
2017
Operating activities:
 
 
 
Net income
$
85,545

 
$
11,931

Adjustments to reconcile net income to cash provided by operating activities:
 

 
 

Decrease in accrued interest receivable
244

 
1,129

Increase (decrease) in accrued interest payable
1,942

 
(436
)
(Gain) loss on derivative instruments, net
(78,520
)
 
9,634

Loss on sale of investments, net
17,945

 
10,628

Fair value adjustments, net
(68
)
 
(63
)
Amortization of investment premiums, net
110,501

 
122,621

Other amortization and depreciation, net
937

 
983

Stock-based compensation expense
930

 
1,567

Change in other assets and liabilities, net
(896
)
 
(1,905
)
Net cash and cash equivalents provided by operating activities
138,560

 
156,089

Investing activities:
 

 
 

Purchase of investments
(1,080,485
)
 
(772,590
)
Principal payments received on investments
137,362

 
248,298

Proceeds from sales of investments
642,900

 
792,984

Principal payments received on mortgage loans held for investment, net
3,375

 
2,641

Net receipts on derivatives, including terminations
80,618

 
11,743

Other investing activities
(72
)
 
(214
)
Net cash and cash equivalents (used in) provided by investing activities
(216,302
)
 
282,862

Financing activities:
 

 
 

Borrowings under repurchase agreements
76,890,349

 
60,229,426

Repayments of repurchase agreement borrowings
(76,765,393
)
 
(60,609,148
)
Principal payments on non-recourse collateralized financing
(1,838
)
 
(747
)
Proceeds from issuance of preferred stock
1,290

 
25,884

Proceeds from issuance of common stock
19,281

 
14,495

Cash paid for stock issuance costs
(10
)
 
(61
)
Payments related to tax withholding for stock-based compensation
(364
)
 
(521
)
Dividends paid
(39,188
)
 
(35,479
)
Net cash and cash equivalents provided by (used in) financing activities
104,127

 
(376,151
)
 
 
 
 
Net increase in cash, cash equivalents, and restricted cash
26,385

 
62,800

Cash, cash equivalents, and restricted cash at beginning of period
87,200

 
98,889

Cash, cash equivalents, and restricted cash at end of period
$
113,585

 
$
161,689

Supplemental Disclosure of Cash Activity:
 

 
 

Cash paid for interest
$
38,713

 
$
26,766

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 debt securities, the majority of which are specified pools of 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”). The Company also invests in other types of mortgage-related securities, such as to-be-announced securities (“TBAs” or “TBA securities”), and in other debt securities, such as U.S. Treasury securities, which are not collateralized but are backed by the full faith and credit of the U.S. government.

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 and nine months ended September 30, 2018 are not necessarily indicative of the results that may be expected for any other interim periods or for the entire year ending December 31, 2018. 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, 2017 filed with the SEC.

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 Per Common Share

The Company calculates basic net income per common share by dividing net income 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 nine months ended September 30, 2018 or September 30, 2017.

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 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 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.

The Company has adopted Accounting Standards Update ("ASU") No. 2016-18, Statement of Cash Flows (Topic 230) - Restricted Cash, which requires amounts generally described as restricted cash or restricted cash equivalents to be included with cash and cash equivalents when reconciling the beginning of period and end of period total amounts shown on the statement of cash flows. Because this ASU is to be applied retrospectively to each period presented, “net cash and cash equivalents used in financing activities” on the Company’s consolidated statement of cash flows for the nine months ended September 30, 2017 now omits the change in restricted cash as previously reported for that period, and that change is now included within “net increase in cash, cash equivalents, and restricted cash” in order to conform to the current period’s presentation.

The following table provides a reconciliation of cash, cash equivalents, and restricted cash reported on the Company's consolidated balance sheet as of September 30, 2018 that sum to the total of the same such amounts shown on the Company’s consolidated statement of cash flows for the nine months ended September 30, 2018:

6


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


 
 
September 30, 2018
Cash and cash equivalents
 
$
55,251

Restricted cash
 
58,334

Total cash, cash equivalents, and restricted cash shown on consolidated statement of cash flows
 
$
113,585


Investments in Debt Securities
 
The Company’s investments in debt 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 debt securities are reported in other comprehensive income (“OCI”) until the investment is sold, matures, or is 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 fair value of the Company’s debt securities pledged as collateral against repurchase agreements and derivative instruments is disclosed parenthetically on the Company’s consolidated balance sheets.

Interest Income, Premium Amortization, and Discount Accretion. Interest income on debt securities 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 or discounts associated with the purchase of Agency MBS as well as any non-Agency MBS rated ‘AA’ and higher 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. The Company may also adjust premium amortization and discount accretion for 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 does not estimate future prepayments on its fixed-rate Agency RMBS.

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.

7


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



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 debt securities, 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.

Derivative Instruments

The Company’s derivative instruments generally include interest rate swaps, Eurodollar futures, options on U.S. Treasury futures, and forward contracts for the purchase or sale of non-specified 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 the consolidated statements of cash flows in accordance with the underlying nature or purpose of the derivative transactions.

The Company’s 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 derivative instruments on the Company’s consolidated balance sheets is the unsettled fair value of the instruments subject to bilateral agreements and not centrally cleared through the CME.

A TBA security is a forward contract (“TBA contract”) for the purchase (“long position”) or sale (“short position”) of a non-specified 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 settlement date. The Company accounts for long and short positions in TBAs as derivative instruments because the Company cannot assert that it is probable at inception and throughout the term of an individual TBA transaction that its settlement will result in physical delivery of the underlying Agency RMBS, or the individual TBA transaction 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.


8


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


Share-Based Compensation

Pursuant to the Company’s 2018 Stock and Incentive Plan (“2018 Plan”), the Company may grant share-based compensation to eligible employees, non-employee directors or consultants or advisors to the Company, including restricted stock awards, stock options, stock appreciation rights, performance units, restricted stock units, and performance cash awards. The Company’s restricted stock currently issued and outstanding 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 a participant 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.

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.

NOTE 2 – INVESTMENTS IN DEBT SECURITIES
 
The majority of the Company’s debt securities are pledged as collateral for the Company’s repurchase agreements. The following tables present the Company’s debt securities by investment type as of the dates indicated:
 
September 30, 2018
 
Par
 
Net Premium (Discount)
 
Amortized Cost
 
Gross Unrealized Gain
 
Gross Unrealized Loss
 
Fair Value
 
WAC (1)
RMBS:
 
 
 
 


 
 
 
 
 
 
 
 
Agency
$
1,761,274

 
$
55,092

 
$
1,816,366

 
$
1,214

 
$
(42,428
)
 
$
1,775,152

 
3.92
%
Non-Agency
909

 

 
909

 
24

 
(20
)
 
913

 
6.75
%
 
1,762,183

 
55,092

 
1,817,275

 
1,238

 
(42,448
)
 
1,776,065

 
 
CMBS:
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
987,266

 
9,792

 
997,058

 
363

 
(49,125
)
 
948,296

 
3.08
%
Non-Agency
7,027

 
(3,103
)
 
3,924

 
1,399

 

 
5,323

 
8.90
%
 
994,293

 
6,689

 
1,000,982

 
1,762

 
(49,125
)
 
953,619

 
 
CMBS IO (2):
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency

 
308,174

 
308,174

 
2,197

 
(1,141
)
 
309,230

 
0.59
%
Non-Agency

 
254,153

 
254,153

 
2,403

 
(960
)
 
255,596

 
0.59
%
 

 
562,327

 
562,327

 
4,600

 
(2,101
)
 
564,826

 
 
 
 
 
 
 
 
 
 
 
 
 


 


U.S. Treasuries:

 

 

 

 

 

 
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total AFS securities:
$
2,756,476

 
$
624,108

 
$
3,380,584

 
$
7,600

 
$
(93,674
)
 
$
3,294,510

 
 

9


(1)
The weighted average coupon (“WAC”) is the gross interest rate of 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 $13,238,960 and $10,391,240 respectively, as of September 30, 2018.
 
December 31, 2017
 
Par
 
Net Premium (Discount)
 
Amortized Cost
 
Gross Unrealized Gain
 
Gross Unrealized Loss
 
Fair Value
 
WAC (1)
RMBS:
 
 
 
 


 
 
 


 
 
 
 
Agency (2)
$
1,146,553

 
$
46,021

 
$
1,192,574

 
$
1,626

 
$
(9,939
)
 
$
1,184,261

 
3.56
%
Non-Agency
1,070

 

 
1,070

 
41

 
(20
)
 
1,091

 
6.75
%
 
1,147,623

 
46,021

 
1,193,644

 
1,667

 
(9,959
)
 
1,185,352

 
 
CMBS:
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
1,123,967

 
10,442

 
1,134,409

 
3,514

 
(13,572
)
 
1,124,351

 
3.03
%
Non-Agency
26,501

 
(4,035
)
 
22,466

 
2,298

 

 
24,764

 
5.47
%
 
1,150,468

 
6,407

 
1,156,875

 
5,812

 
(13,572
)
 
1,149,115

 
 
CMBS IO (3):
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency

 
375,361

 
375,361

 
5,238

 
(293
)
 
380,306

 
0.62
%
Non-Agency

 
308,472

 
308,472

 
4,468

 
(724
)
 
312,216

 
0.61
%
 

 
683,833

 
683,833

 
9,706

 
(1,017
)
 
692,522

 
 
 
 
 
 
 
 
 
 
 
 
 


 
 
U.S. Treasuries:
148,400

 
(133
)
 
148,267

 

 
(1,737
)
 
146,530

 
2.13
%



 
 
 


 


 
 
 


 
 
Total AFS securities:
$
2,446,491

 
$
736,128

 
$
3,182,619

 
$
17,185

 
$
(26,285
)
 
$
3,173,519

 


(1)
The WAC is the gross interest rate of the security weighted by the outstanding principal balance (or by notional balance in the case of an IO security).
(2)
Includes purchased securities pending settlement.
(3)
The notional balance for the Agency CMBS IO and non-Agency CMBS IO was $14,196,122 and $11,006,463, respectively, as of December 31, 2017.

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 categorizes the Company’s debt securities according to their stated maturity as of the dates indicated:
 
 
September 30, 2018
 
December 31, 2017
 
 
Amortized Cost
 
Fair Value
 
Amortized Cost
 
Fair Value
Less than 1 year
 
$
47,271

 
$
47,217

 
$
4,480

 
$
4,542

>1 and <5 years
 
158,325

 
159,007

 
208,046

 
210,727

>5 and <10 years
 
935,687

 
893,930

 
1,334,795

 
1,326,178

> 10 years
 
2,239,301

 
2,194,356

 
1,635,298

 
1,632,072

 
 
$
3,380,584

 
$
3,294,510

 
$
3,182,619

 
$
3,173,519


The following table presents information regarding the sales that generated the “loss on sale of investments, net” on the Company’s consolidated statements of comprehensive income for the periods indicated:



10


 
Three Months Ended
 
September 30,
 
2018
 
2017
 
Proceeds Received
 
Realized Gain (Loss)
 
Proceeds Received
 
Realized Gain (Loss)
Agency RMBS
$

 
$

 
$
393,502

 
$
(5,160
)
Agency CMBS
48,237

 
(1,720
)
 
13,433

 
(51
)
Agency CMBS IO
10,571

 
127

 

 

U.S. Treasuries
57,843

 
(133
)
 

 

 
$
116,651

 
$
(1,726
)
 
$
406,935

 
$
(5,211
)
 

 
 
 
 
 
 
 
Nine Months Ended
 
September 30,
 
2018
 
2017
 
Proceeds Received
 
Realized Gain (Loss)
 
Proceeds Received
 
Realized Gain (Loss)
Agency RMBS
$
217,837

 
$
(7,785
)
 
$
716,560

 
$
(12,392
)
Agency CMBS
156,995

 
(3,771
)
 
206,993

 
523

Agency CMBS IO
10,571

 
127

 

 

Non-Agency CMBS

 

 
35,705

 
1,199

Non-Agency RMBS

 

 
16,407

 
42

Non-Agency CMBS IO
8,695

 
51

 

 

U.S. Treasuries
248,802

 
(6,567
)
 

 


$
642,900

 
$
(17,945
)
 
$
975,665

 
$
(10,628
)

The following table presents certain information for the AFS securities in an unrealized loss position as of the dates indicated:
 
September 30, 2018
 
December 31, 2017
 
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
$
1,540,220

 
$
(29,765
)
 
91
 
$
1,293,798

 
$
(9,769
)
 
71
Non-Agency MBS
79,326

 
(447
)
 
23
 
51,406

 
(421
)
 
11
U.S. Treasuries

 

 
0
 
146,530

 
(1,737
)
 
1
 
 
 
 
 
 
 
 
 
 
 
 
Continuous unrealized loss position for 12 months or longer:
 
 
 
 
 
 
 
 
 
 
 
Agency MBS
$
1,064,620

 
$
(62,929
)
 
58
 
$
423,698

 
$
(14,035
)
 
30
Non-Agency MBS
31,282

 
(533
)
 
13
 
20,414

 
(323
)
 
12

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.

11


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 September 30, 2018 and December 31, 2017 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 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 September 30, 2018 or December 31, 2017.

NOTE 3 – REPURCHASE AGREEMENTS
    
The Company’s repurchase agreements outstanding as of September 30, 2018 and December 31, 2017 are summarized in the following tables:
 
 
September 30, 2018
 
December 31, 2017
Collateral Type
 
Balance
 
Weighted
Average Rate
 
Fair Value of
Collateral Pledged
 
Balance
 
Weighted
Average Rate
 
Fair Value of
Collateral Pledged
Agency RMBS
 
$
1,362,687

 
2.26
%
 
$
1,423,415

 
$
836,281

 
1.47
%
 
$
867,120

Agency CMBS
 
840,346

 
2.22
%
 
897,077

 
1,003,146

 
1.44
%
 
1,071,904

Agency CMBS IO
 
271,305

 
2.72
%
 
302,403

 
324,163

 
2.17
%
 
372,077

Non-Agency CMBS IO
 
216,520

 
3.11
%
 
255,090

 
263,694

 
2.43
%
 
311,571

Non-Agency CMBS
 

 
%
 

 
15,508

 
2.47
%
 
18,212

U.S. Treasuries
 

 
%
 

 
123,110

 
1.85
%
 
124,215

Total repurchase agreements
 
$
2,690,858

 
2.36
%
 
$
2,877,985

 
$
2,565,902

 
1.67
%
 
$
2,765,099


The Company also had $182,922 and $156,899 payable to counterparties as of September 30, 2018 and December 31, 2017, respectively, which consisted of securities pending settlement as of those respective dates.

The following table provides information on the remaining term to maturity and original term to maturity for the Company’s repurchase agreements as of the dates indicated:
 
 
September 30, 2018
 
December 31, 2017
Remaining Term to Maturity
 
Balance
 
WAVG Original Term to Maturity
 
Balance
 
WAVG Original Term to Maturity
Less than 30 days
 
$
2,081,391

 
45

 
$
2,240,791

 
49

30 to 90 days
 
609,467

 
91

 
274,231

 
90

91 to 180 days
 

 

 
50,880

 
121

Total
 
$
2,690,858

 
55

 
$
2,565,902

 
54


The following table lists the counterparties with whom the Company had approximately 10% or more of its shareholders’ equity at risk (defined as the excess of collateral pledged over the borrowings outstanding):

12


 
 
September 30, 2018
Counterparty Name
 
Balance
 
Weighted Average Rate
 
Equity at Risk
Wells Fargo Bank, N. A. and affiliates
 
$
303,564

 
2.93
%
 
$
47,192

    
Of the amount outstanding with Wells Fargo Bank, N.A. and affiliates, $228,992 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 by CMBS IO, and its weighted average borrowing rate as of September 30, 2018 was 3.10%.

As of September 30, 2018, the Company had repurchase agreement amounts outstanding with 17 of its 35 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 net worth and earnings, 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 September 30, 2018.

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 September 30, 2018 and December 31, 2017:
 
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
September 30, 2018
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
2,690,858

 
$

 
$
2,690,858

 
$
(2,690,858
)
 
$

 
$

 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
2,565,902

 
$

 
$
2,565,902

 
$
(2,565,902
)
 
$

 
$

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

     The Company is a party to certain types of financial instruments that are accounted for as derivative instruments. Please refer to Note 1 for information related to the Company’s accounting policy for its derivative instruments.

Types and Uses of Derivatives Instruments
Interest Rate Derivatives. Changing interest rates impact the fair value of the Company’s investments as well as the interest rates on the Company’s repurchase agreement borrowings used to finance its investments. The Company primarily uses

13


interest rate swaps and Eurodollar futures as economic hedges to mitigate declines in book value and to protect some portion of the Company's earnings from rising interest rates.
TBA Transactions. The Company also holds long positions in TBA securities by executing a series of transactions which effectively delay the settlement of a forward purchase of a non-specified Agency RMBS by entering into an offsetting TBA short position, net settling the paired-off positions in cash, and simultaneously entering into an identical TBA long position with a later settlement date. These long positions in TBA securities (“dollar roll positions”) are viewed by management as economically equivalent to investing in and financing non-specified fixed-rate Agency RMBS. 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” represents the economic equivalent of net interest income (interest income less implied financing cost) on the underlying Agency security from trade date to settlement date.
Periodically, the Company may also hold short positions in TBA securities for the purpose of economically hedging a portion of the impact of changing interest rates on the fair value of the Company’s fixed-rate Agency RMBS. The Company did not hold any short positions in TBA securities as of September 30, 2018.
Other Derivatives. The Company periodically utilizes options on Treasury futures in order to manage the duration of the Company’s investment portfolio while minimizing the impact on the Company’s exposure to the spread risk inherent in owning MBS. The options on Treasury futures outstanding as of September 30, 2018 will expire during the fourth quarter of 2018.
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:  
Type of Derivative Instrument
 
Balance Sheet Location
 
Purpose
 
September 30, 2018
 
December 31, 2017
Interest rate swaps
 
Derivative assets
 
Economic hedging
 
$
694

 
$
791

Eurodollar futures
 
Derivative assets
 
Economic hedging
 

 
666

TBA securities
 
Derivative assets
 
Trading
 
871

 
1,483

Call Options on U.S. Treasury futures
 
Derivative assets
 
Trading
 
328

 

Put Options on U.S. Treasury futures
 
Derivative assets
 
Trading
 
719

 

 
 
 
 
 
 
$
2,612

 
$
2,940

 
 
 
 
 
 
 
 
 
TBA securities
 
Derivative liabilities
 
Trading
 
$
(2,039
)
 
$

TBA securities
 
Derivative liabilities
 
Economic hedging
 

 
(269
)
 
 
 
 
 
 
$
(2,039
)
 
$
(269
)


14


The following tables present information about the Company’s interest rate swaps as of the dates indicated:
 
 
September 30, 2018
 
 
 
 
Weighted-Average:
 
 
Years to Maturity:
 
Net Notional Amount (1)
 
Pay Rate (2)
 
Life Remaining (in Years)
 
Fair Value (3)
< 3 years
 
$
1,520,000

 
2.01
%
 
1.4
 
$
694

>3 and < 6 years
 
1,290,000

 
2.10
%
 
4.1
 

>6 and < 10 years
 
1,150,000

 
2.61
%
 
7.9
 

   >10 years
 
220,000

 
2.81
%
 
22.2
 

Total
 
$
4,180,000

 
2.24
%
 
5.1
 
$
694

 
 
 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
Weighted-Average:
 
 
Years to Maturity:
 
Net Notional Amount (1)
 
Pay Rate (2)
 
Life Remaining (in Years)
 
Fair Value (3)
< 3 years
 
$
3,320,000

 
1.35
%
 
0.7
 
$
791

>3 and < 6 years
 
1,210,000

 
2.00
%
 
4.6
 

>6 and < 10 years
 
1,025,000

 
2.49
%
 
8.0
 

   >10 years
 
120,000

 
2.75
%
 
17.3
 

Total
 
$
5,675,000

 
1.71
%
 
3.1
 
$
791

(1)
The net notional amounts included in the tables above represent pay-fixed interest rate swaps, net of any receive-fixed interest rate swaps, and include $1,525,000 and $2,655,000 of pay-fixed forward starting interest rate swaps as of September 30, 2018 and December 31, 2017, respectively.
(2)
Excluding forward starting pay-fixed interest rate swaps, the weighted average pay rate was 1.66% and 1.36% as of September 30, 2018 and December 31, 2017, respectively.
(3)
The majority of the Company’s interest rate swap agreements are centrally cleared through the CME. Please refer to Note 1 for information regarding the exchange of variation margin being legally considered as settlement of the derivative as opposed to a pledge of collateral.

The following table summarizes information about the Company's TBA securities as of the dates indicated:
 
 
September 30, 2018
TBA Securities:
 
Notional Amount (1)
 
Implied Cost Basis (2)
 
Implied Market Value (3)
 
Net Carrying Value (4)
Dollar roll positions
 
$
761,000

 
$
780,865

 
$
779,697

 
$
(1,168
)
Economic hedges
 
$

 
$

 
$

 
$

 
 
December 31, 2017
 
 
Notional Amount (1)
 
Implied Cost Basis (2)
 
Implied Market Value (3)
 
Net Carrying Value (4)
Dollar roll positions
 
$
795,000

 
$
829,425

 
$
830,908

 
$
1,483

Economic hedges
 
$
150,000

 
$
(153,797
)
 
$
(154,066
)
 
$
(269
)
(1)
Notional amount represents the par value (or principal balance) of the underlying Agency MBS as if settled as of the end of the period.
(2)
Implied cost basis represents the forward price to be paid for the underlying Agency MBS as if settled as of end of the period.
(3)
Implied market value represents the estimated fair value of the underlying Agency MBS as if settled as of the end of the period.

15


(4)
Net carrying value is the amount included on the consolidated balance sheets within “derivative assets (liabilities)” and represents the difference between the implied market value and the implied cost basis of the TBA security as of the end of the period.

The tables below summarize changes in the Company’s derivative instruments for the periods indicated:
Type of Derivative Instrument
 
Notional Amount as of December 31, 2017
 
Additions
 
Settlements,
Terminations,
or Pair-Offs
 
Notional Amount as of September 30, 2018
Receive-fixed interest rate swaps
 
$
100,000

 
$

 
$
(100,000
)
 
$

Pay-fixed interest rate swaps
 
5,775,000

 
955,000

 
(2,550,000
)
 
4,180,000

Eurodollar futures (1)
 
1,950,000

 

 
(1,950,000
)
 

TBA dollar roll positions
 
795,000

 
7,857,000

 
(7,891,000
)
 
761,000

TBA economic hedges
 
150,000

 

 
(150,000
)
 

Call Options on U.S. Treasury futures
 

 
100,000

 

 
100,000

Put Options on U.S. Treasury futures
 

 
400,000

 
(300,000
)
 
100,000

(1)
The Eurodollar futures notional amounts represent the total notional of the 3-month contracts all of which expire in 2018. The maximum notional outstanding for any future 3-month period did not exceed $650,000 during the period indicated.

The table below provides detail of the Company’s “gain (loss) on derivative instruments, net” by type of derivative for the periods indicated:
 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
Type of Derivative Instrument
 
2018
 
2017
 
2018
 
2017
Receive-fixed interest rate swaps
 
$
(153
)
 
$
(99
)
 
$
(1,658
)
 
$
746

Pay-fixed interest rate swaps
 
25,172

 
(611
)
 
95,491

 
(18,799
)
Eurodollar futures
 
(189
)
 

 
1,886

 

TBA dollar roll positions
 
(5,204
)
 
6,703

 
(18,256
)
 
8,419

TBA economic hedges
 

 

 
293

 

Call Options on U.S. Treasury futures
 
148

 

 
148

 

Put Options on U.S. Treasury futures
 
(275
)
 

 
616

 

Gain (loss) on derivative instruments, net
 
$
19,499

 
$
5,993

 
$
78,520

 
$
(9,634
)

There is a net unrealized gain of $240 remaining in AOCI on the Company’s consolidated balance sheet as of September 30, 2018 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 $177 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 the 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 September 30, 2018.

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 reports its derivative assets and liabilities subject to these arrangements on a gross basis. The following tables present information

16


regarding those derivative assets and liabilities subject to such arrangements as if the Company had presented them on a net basis as of September 30, 2018 and December 31, 2017:
 
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
September 30, 2018
 
 
 
 
 
 
 
 
 
 
 
Interest rate swaps
$
694

 
$

 
$
694

 
$

 
$

 
$
694

Eurodollar Futures

 

 

 

 

 

TBA securities
871

 

 
871

 
(346
)
 
(123
)
 
402

Options on U.S. Treasury futures
1,047

 

 
1,047

 
(1,047
)
 

 

Derivative assets
$
2,612

 
$

 
$
2,612

 
$
(1,393
)
 
$
(123
)
 
$
1,096

December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
Interest rate swaps
$
791

 
$

 
$
791

 
$

 
$

 
$
791

Eurodollar Futures
666

 

 
666

 

 
(666
)
 

TBA securities
1,483

 

 
1,483

 
(180
)
 

 
1,303

Options on U.S. Treasury futures

 

 

 

 

 

Derivative assets
$
2,940

 
$

 
$
2,940

 
$
(180
)
 
$
(666
)
 
$
2,094


 
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
September 30, 2018
 
 
 
 
 
 
 
 
 
 
 
Interest rate swaps
$

 
$

 
$

 
$

 
$

 
$

TBA securities
2,039

 

 
2,039

 
(346
)
 
(873
)
 
820

Derivative liabilities
$
2,039

 
$

 
$
2,039

 
$
(346
)
 
$
(873
)
 
$
820

 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
Interest rate swaps
$

 
$

 
$

 
$

 
$

 
$

TBA securities
269

 

 
269

 
(180
)
 

 
89

Derivative liabilities
$
269

 
$

 
$
269

 
$
(180
)
 
$

 
$
89

(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 total 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.


17


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:
 
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 Company’s financial instruments that are measured at fair value on a recurring basis by their valuation hierarchy levels as of the dates indicated:

18


 
September 30, 2018
 
Fair Value
 
Level 1 - Unadjusted Quoted Prices in Active Markets
 
Level 2 - Observable Inputs
 
Level 3 - Unobservable Inputs
Assets carried at fair value:
 
 
 
 
 
 
 
Investments in securities:
 
 
 
 
 
 
 
Mortgage-backed securities
$
3,294,510

 
$

 
$
3,288,274

 
$
6,236

U.S. Treasuries

 

 

 

Derivative assets:
 
 
 
 
 
 
 
Interest rate swaps
694

 

 
694

 

Eurodollar futures

 

 

 

TBA securities
871

 

 
871

 

Options on U.S. Treasury futures
1,047

 
1,047

 

 

Total assets carried at fair value
$
3,297,122

 
$
1,047

 
$
3,289,839

 
$
6,236

 
 
 
 
 
 
 
 
Liabilities carried at fair value:
 
 
 
 
 
 
 
TBA securities
2,039

 

 
2,039

 

Total liabilities carried at fair value
$
2,039

 
$

 
$
2,039

 
$

 
 
 
 
 
 
 
 
 
December 31, 2017
 
Fair Value
 
Level 1 - Unadjusted Quoted Prices in Active Markets
 
Level 2 - Observable Inputs
 
Level 3 - Unobservable Inputs
Assets carried at fair value:
 
 
 
 
 
 
 
Investments in securities:
 
 
 
 
 
 
 
Mortgage-backed securities
$
3,026,989

 
$

 
$
3,019,746

 
$
7,243

U.S. Treasuries
146,530

 
146,530

 

 

Derivative assets:
 
 
 
 
 
 
 
Interest rate swaps
791

 

 
791

 

Eurodollar futures
666

 
666