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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-K
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
DYNEX CAPITAL, INC.
(Exact name of registrant as specified in its charter)
1-9819
(Commission file number)
Virginia 52-1549373
(State or other jurisdiction of incorporation or organization) (IRS Employer I.D. No.)
4551 Cox Road, Suite 300, Glen Allen, Virginia 23060-6740
(Address of principal executive offices) (Zip Code)
(804) 217-5800
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
- ------------------- -----------------------------------------
Common Stock, $.01 par value New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
Title of each class Name of each exchange on which registered
- ------------------- -----------------------------------------
Series A 9.75% Cumulative Convertible Preferred Stock, $.01 par value NASDAQ National Market
Series B 9.55% Cumulative Convertible Preferred Stock, $.01 par value NASDAQ National Market
Series C 9.73% Cumulative Convertible Preferred Stock, $.01 par value NASDAQ National Market
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 |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2).
Yes |_| No |X|
As of June 30, 2003, the aggregate market value of the voting stock held by
non-affiliates of the registrant was approximately $64,808,462 at a closing
price on The New York Stock Exchange of $5.96. Common stock outstanding as of
February 29, 2004 was 10,873,903 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Definitive Proxy Statement to be filed pursuant to Regulation
14A within 120 days from December 31, 2003, are incorporated by reference into
Part III.
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(xi)
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DYNEX CAPITAL, INC.
2003 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
Page
Number
PART I.
Item 1. Business.....................................................................................1
Item 2. Properties..................................................................................11
Item 3. Legal Proceedings...........................................................................11
Item 4. Submission of Matters to a Vote of Security Holders.........................................12
PART II.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.......................12
Item 6. Selected Financial Data.....................................................................13
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations.......................................................................13
Item 7A. Quantitative and Qualitative Disclosures about Market Risk..................................28
Item 8. Financial Statements and Supplementary Data.................................................29
Item 9. Changes In and Disagreements with Accountants on Accounting and
Financial Disclosure........................................................................29
Item 9A. Controls and Procedures.....................................................................30
PART III.
Item 10. Directors and Executive Officers of the Registrant..........................................30
Item 11. Executive Compensation......................................................................30
Item 12. Security Ownership of Certain Beneficial Owners and Management..............................31
Item 13. Certain Relationships and Related Transactions..............................................31
Item 14. Principal Accountant Fees and Services......................................................31
PART IV.
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K.............................31
SIGNATURES ............................................................................................34
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PART I
Item 1. Business
GENERAL
Dynex Capital, Inc. was incorporated in the Commonwealth of Virginia in
1987. References to "Dynex", or "the Company" contained herein refer to Dynex
Capital, Inc. together with its qualified real estate investment trust (REIT)
subsidiaries and taxable REIT subsidiary. Dynex is a financial services company,
which invests in loans and securities consisting of, or secured by, principally
single family mortgage loans, commercial mortgage loans, manufactured housing
installment loans and delinquent property tax receivables. The loans and
securities in which the Company invests have generally been pooled and pledged
(i.e. securitized) as collateral for non-recourse securitization financing,
which provides long-term financing for such loans while limiting credit,
interest rate and liquidity risk. This securitization financing consists of
bonds issued pursuant to an indenture. The Company has elected to be treated as
a REIT for federal income tax purposes under the Internal Revenue Code of 1986,
as amended, and, as such, must distribute substantially all of its taxable
income to shareholders. Provided that the Company meets all of the prescribed
Internal Revenue Code requirements for a REIT, the Company will generally not be
subject to federal income tax.
As a result of financial difficulties encountered by the Company since
2000, the Company's business operations have been essentially limited to the
management of its investment portfolio and the active collection of its
portfolio of delinquent property tax receivables. The Company's focus has been
on conserving capital and maximizing cash flow from its investment portfolio.
Cash flow from the investment portfolio generally results from the excess
interest income received on these investments less interest expense on
securitization financing and other borrowings financing the investments. Given
the absolute level of interest rates, which, since mid-2001, have been at or
near historic lows, and given the favorable spread between medium and long-term
interest rates versus short-term interest rates (on which the Company's
financing costs are generally based), cash flows from the investment portfolio
for 2002 and 2003 have been robust. The cash flows from the investment portfolio
have enabled the Company to repay its recourse obligations, and to provide
liquidity to its preferred shareholders in the form of multiple tender offers.
Despite the prospects for increasing short-term interest rates, the
Company's investment portfolio is expected to continue to generate reasonable
levels of cash flow into 2004, and the Company has been evaluating alternative
uses for this cash flow in an effort to improve shareholder value, including
alternatives with respect to the Company's preferred stock outstanding. To that
end, in January 2004, the Company announced its intention to initiate a
recapitalization of the Company through an offer to its preferred shareholders
to exchange outstanding shares of Series A preferred stock, Series B preferred
stock, and Series C preferred stock for Senior Notes due March 2007, and to
convert the remaining shares of Series A preferred stock, Series B preferred
stock, and Series C preferred stock into a new Series D preferred stock. The
recapitalization plan will require the approval of two-thirds of the outstanding
shares of each Series of preferred stock, by Series, and the approval of a
majority of the common shareholders. The board of directors has determined that
the recapitalization, including the Note Offer, is fair to Dynex Capital's
unaffiliated Preferred Stockholders of each series and unaffiliated Common
Stockholders from both a substantive and procedural point of view, and is
advisable and in the best interests of the Company and all of its stockholders.
The Company has filed a preliminary Schedule TO in connection with the exchange
offer and preliminary proxy statements for the solicitation of votes from the
holders of the preferred stock and the holders of the common stock. The
anticipated closing date for the recapitalization is April 2004 assuming the
shareholders approve the transaction.
The recapitalization plan should utilize very little of the Company's
free cash flow, enabling the Company, once the recapitalization plan is approved
and implemented, the flexibility to engage in an evaluation of possible
strategic investment alternatives for the Company. The Company also believes
that successful completion of the recapitalization plan will be instrumental in
its ability to attract additional debt capital in the near-term and equity
capital in the future. While failure to complete the recapitalization plan as
scheduled would not cause undue harm to the Company, the pursuance of any
strategic investment alternatives would likely be delayed pending the settlement
of dividend arrearages on the Company's preferred stock. The Company has in
excess of $124 million of net operating loss carryforwards and is seeking ways
to utilize such carryforwards or otherwise extract value from them. Given the
availability of tax net operating loss carryforwards, the Company could forego
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its REIT status in connection with the introduction of a new business plan, if
such business plan included activities not traditionally associated with REITs,
or that are prohibited or otherwise restricted for REITs.
Business Focus and Strategy
The Company's primary business focus is managing its investment
portfolio to maximize its earnings and cash flow. The Company acts in certain
instances as both a primary and master servicer on assets included in its
investment portfolio. The Company's principal source of earnings and cash flow
has historically been its net interest income from its investment portfolio. The
Company has generally financed investments in its portfolio through the issuance
of non-recourse securitization financing, which in turn are secured by a pledge
of loans and securities (such pledged loans and securities hereinafter referred
to as securitized finance receivables). Commensurate with this desire to
conserve capital, the Company's investment portfolio has been declining in
recent years as the result of sales and pay-downs. In December 2003, the Company
called approximately $28 million of seasoned single-family mortgage-backed
securities, and financed the call of such securities with a combination of
available cash and repurchase agreement financing. The repurchase agreement
financing was the first collateralized, recourse financing for the Company since
2000.
The Company funds its investment portfolio primarily through
non-recourse securitization financing, repurchase agreement borrowings and funds
raised from the issuance of equity. For the portion of the investment portfolio
funded with securitization financing or other borrowings, the Company generates
net interest income to the extent that there is a positive spread between the
yield on the interest-earning assets and the cost of the borrowed funds. The
cost of the Company's borrowings may be increased or decreased by interest rate
swap, cap or floor agreements. For the other portion of the investment portfolio
funded with equity, interest income is primarily a function of the yield
generated from the interest-earning asset.
The Company owns the right to redeem, generally by class, the
securitization financing on its balance sheet once the outstanding balance of
such securitization financing reaches 35% or less of the original amount issued,
or a specified date. Generally interest rates on the bonds issued in the
securitization financing increase by 0.30%-2.00% if the bonds are not redeemed
by the Company. The Company will evaluate the benefit of calling such bonds at
the time they are redeemable. An estimated $200 million of securitization
financing will be redeemable in March 2004 and an estimated $230 million will be
redeemable in August 2004. These non-recourse securitization financings are
collateralized by manufactured housing loans, and certain of the bonds may have
interest rates which exceed current market rates. The Company has the right to
call such bonds by class and is contemplating calling these bonds and reissuing
them at the lower current market rates. In March 2004, the Company agreed to
redeem the highest rated bonds in the series redeemable in March 2004, and
reissue the bonds at an estimated $7.3 million premium to the Company.
During 2003, the Company called seven adjustable-rate and fixed-rate
mortgage pass-through securities previously issued and sold by the Company, with
an aggregate balance of approximately $86.7 million, five of which were sold at
a gain of $2.2 million. The remaining securities aggregating approximately $32.1
million were added to the Company's investment portfolio.
Primary Servicing. The Company services as primary servicer of its
portfolio of delinquent property tax receivables and a small amount of remaining
commercial mortgage loans which have not been securitized. The Company also
retains an interest in the servicing of approximately $53 million of securitized
single-family mortgage loans, which are being sub-serviced by a former
subsidiary of the Company. As a result of retaining this interest in the
servicing, the Company is obligated to advance scheduled principal and interest
on delinquent loans in accordance with the underlying loan servicing agreements.
The Company's delinquent property tax receivable servicing operation
resides in Pittsburgh, Pennsylvania, with a satellite office in Cleveland, Ohio.
The Company's responsibilities as servicer include collecting voluntary payments
from property owners, and if collection efforts fail, foreclosing, stabilizing
and selling the underlying properties. As of December 31, 2003, the Company was
servicing delinquent property tax receivables with an aggregate redemptive value
of approximately $104 million of delinquent property tax receivables in six
states, but with the majority in Pennsylvania and Ohio. In 2003, the Company
entered into an agreement to service more than $7.5 million of liens on real
estate for a regional utility in Pennsylvania. The Company will be compensated
based on the results of its collection efforts. Given the existing
infrastructure now in place to service the Company's investment in property tax
receivables, the incremental cost to service these liens is marginal. The
Company will seek to gain other third-party servicing contracts in the future.
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Master Servicing. The Company performs the function of master servicer
for certain of the series of securitization financing bond securities which it
has issued, and certain loans which have not been securitized. The master
servicer's function typically includes monitoring and reconciling the loan
payments remitted by the servicers of the loans, determining the payments due on
the securities and determining that the funds are correctly sent to a trustee or
investors for each series of securities. Master servicing responsibilities also
include monitoring the servicers' compliance with servicing guidelines. As
master servicer, at December 31, 2003, the Company monitored the performance of
four third-party servicers of single family loans; the servicer one of the
series of the Company's securitized commercial mortgage loans, and the servicer
of the Company's manufactured housing loans. In its capacity as master servicer,
the Company is obligated to advance scheduled principal and interest on
delinquent loans in accordance with the underlying servicing agreements should
the primary servicer fail to make such advance.
As master servicer, the Company is paid a monthly fee based on the
outstanding principal balance of each such loan master serviced or serviced by
the Company as of the last day of each month. As of December 31, 2003, the
Company master serviced $788 million in securities.
Securitization. The Company's predominate securitization structure is
non-recourse securitization financing, whereby loans and securities are pledged
to a trust and the trust issues bonds pursuant to an indenture. Generally, for
accounting and tax purposes, the loans and securities financed through the
issuance of bonds in the securitization financing are treated as assets
(securitized finance receivables) of the Company, and the non-recourse
securitization financing is treated as debt of the Company. The Company earns
the net interest spread between the interest income on the securitized finance
receivables and the interest and other expenses associated with the
securitization financing. The net interest spread is directly impacted by the
credit performance of the underlying loans and securities, by the level of
prepayments of the underlying loans and securities and, to the extent bond
classes are variable-rate, may be affected by changes in short-term rates. The
Company's investment in the securitization financing structure is typically
referred to as the over-collateralization. The Company analyzes and values its
investment in securitization financing on a "net investment basis" (i.e., the
excess of the securitized finance receivable collateral pledged over the
outstanding securitization financing, and the resulting net cash flow to the
Company), as further discussed below.
Investment Portfolio
Composition. The following table presents the balance sheet composition
of the investment portfolio by investment type and the percentage of the total
investments as of December 31, 2003 and 2002. Securitized finance receivables
include loans which are carried at amortized cost, and debt securities, which
are considered available-for-sale pursuant to the provisions of SFAS No. 115 and
are carried at fair value. Other investments include a security backed by
delinquent tax receivables, which is classified as held-to-maturity pursuant to
the provisions of SFAS No. 115, and is carried at amortized cost. Other
investments also include unsecuritized delinquent tax receivables which are
carried at amortized cost. Securities consist of mortgage-related debt
securities are considered available-for-sale and are carried at fair value.
Securities also include a security backed by consumer installment loans, which
is also classified as held-to-maturity pursuant to the provisions of SFAS No.
115, and is carried at amortized cost. Loans are carried at amortized cost.
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As of December 31,
2003 2002
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(amounts in thousands) Balance % of Total Balance % of Total
- ------------------------------------ ----------------- ------------------ ----------------- -----------------
Investments:
Securitized finance receivables:
Loans (at amortized cost, net) $1,518,613 82.1% $1,787,254 81.8%
Debt securities (at fair value) 255,580 13.8% 328,674 15.0%
Other investments 37,903 2.1 54,322 2.5
Securities 30,275 1.6 6,208 0.3
Other loans 8,304 0.4 9,288 0.4
- ------------------------------------ ----------------- ------------------ ----------------- -----------------
Total investments $1,850,675 100.0% $2,185,746 100.0%
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Securitized finance receivables. Securitized finance receivables
include loans and securities, consisting of, or secured by, adjustable-rate and
fixed-rate mortgage loans secured by first liens on single family housing,
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fixed-rate loans secured by first liens on multifamily and commercial
properties, and manufactured housing installment loans secured by either a UCC
filing or a motor vehicle title. Securitized finance receivables have been
pledged to support the repayment of associated non-recourse securitization
financing outstanding. Non-recourse securitization financing is non-recourse to
the Company in that the financing is repaid solely from the cash flow from the
securitized finance receivables. Should the cash flow from the securitized
finance receivables be insufficient to repay the non-recourse securitization
financing, the Company is not obligated to fund the shortfall. The Company's
exposure to credit risk on securitized finance receivables is limited to the
difference between the securitized finance receivables and the non-recourse
securitization financing, as more fully described below. The Company's return on
its net investment in securitized finance receivables is affected primarily by
changes in interest rates, prepayment rates and credit losses on the underlying
loans. By virtue of its net investment, the Company generally retains the net
interest margin cashflow generated by the non-recourse securitization financing
structure.
Other investments. Other investments include a security backed by
delinquent tax receivables, which is classified as held-to-maturity pursuant to
the provisions of SFAS No. 115, and is carried at amortized cost. Other
investments also include unsecuritized delinquent tax receivables, which are
carried at amortized cost, and real estate owned resulting from the foreclosure
of delinquent property tax receivables. During 2003, the Company collected an
aggregate $12.3 million on its delinquent property tax receivables, with
collections of $6.6 million relating to delinquent property tax receivables
located in Allegheny County, Pennsylvania, $5.3 million relating to delinquent
property tax receivables located in Cuyahoga County, Ohio, and $0.4 million
relating to various other jurisdictions. All cash payments are applied to reduce
principal, and the Company continually evaluates the carrying value of the
security for other-than-temporary impairment. The Company recorded
other-than-temporary impairments on the security backed by delinquent property
tax receivables of $7.3 million during 2003 due to lower projected cash flows on
the security and $3.0 million on related real estate owned due to reduced sales
expectations.
Securities. Securities at December 31, 2003 include fixed-rate
securities, which includes fixed-rate mortgage securities consisting of
mortgage-related debt securities that have a fixed-rate of interest over their
remaining life and asset-backed securities collateralized by consumer
installment loans, and other mortgage-related securities. Other mortgage-related
securities consist primarily of interest-only securities ("I/Os"). An I/O is a
class of non-recourse securitization financing or a mortgage pass-through
security that pays to the holder substantially all interest. The yields on the
above referenced securities are affected primarily by changes in prepayment
rates and by changes in short-term interest rates.
Other loans. As of December 31, 2003, other loans consist principally
of single-family mortgage loans, both current and delinquent, mezzanine loans
secured by healthcare properties, and participations in first mortgage loans
secured by multifamily and commercial mortgage properties.
Investment Portfolio Risks
The Company is exposed to several types of risks inherent in its
investment portfolio. These risks include credit risk (inherent in the loan
and/or security structure), prepayment/interest rate risk (inherent in the
underlying loan) and margin call risk (inherent in the security if it is used as
collateral for recourse borrowings).
Credit Risk. The predominant risk to the Company is credit risk. Credit
risk is the risk of loss to the Company from the failure by a borrower (or the
proceeds from the liquidation of the underlying collateral) to fully repay the
principal balance and interest due on a loan or a security. A borrower's ability
to repay, or the value of the underlying collateral, could be negatively
influenced by economic and market conditions. These conditions could be global,
national, regional or local in nature. Upon securitization of the pool of loans
or securities backed by loans, the credit risk retained by the Company is
generally limited to the excess of the principal balance of the securitized
finance receivables pledged over the corresponding securitization financing
sold. The Company refers to this excess as the "principal balance of net
investment" or "over-collateralization" and/or subordinated securities that it
may retain from a securitization. For securitized pools of loans, the Company
provides for reserves for expected losses based on the current performance of
the respective pool or on an individual loan basis. If losses are experienced
more rapidly due to market conditions than the Company has provided for in its
reserves, the Company may be required to provide for additional reserves for
these losses. For debt securities pledged as securitized finance receivables,
the Company recognizes losses when incurred or when such security is deemed to
be impaired on an other-than-temporary basis.
The Company evaluates and monitors its exposure to credit losses and
has established reserves and discounts for probable credit losses based upon
anticipated future losses on the loans and securities, general economic
conditions and historical trends in the portfolio. For loans and securities
pledged as securitized finance receivables, the Company considers its credit
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exposure to include over-collateralization as defined above. The Company has
also retained subordinated securities from other securitizations. As of December
31, 2003, the Company's credit risk as to over-collateralization, and
subordinated securities retained was $144.8 million. The Company has reserves
and discounts of $80.1 million relative to this credit exposure. The Company
also has credit risk on the entire amount of investments that are not
securitized, or are securitized and the Company retained the entire security
issued. Such investments include loans and delinquent property tax receivables
(both securitized and unsecuritized) of $8.3 million and $37.9 million,
respectively, at December 31, 2003. Delinquent property tax receivables are
carried at amortized cost, and all amounts collected on these receivables are
applied against the carrying value of these receivables.
The Company also has various other forms of credit enhancement which,
based upon the performance of the underlying loans and securities, may provide
additional protection against losses. These other forms of credit enhancement
pertain principally to securitization financing structures. Specifically, as of
December 31, 2003, two separate pools totaling $163.0 million and $135.2 million
of commercial mortgage loans, respectively, are subject to guarantees of $14.3
million and $14.4 million on those deals, whereby losses on such loans would
need to exceed the respective guarantee amount before the Company would incur
credit losses; $168 million of the single family mortgage loans in various pools
are subject to various mortgage pool insurance policies whereby losses would
need to exceed the remaining stop loss of at least 75% on such policies before
the Company would incur losses; and $52.4 million of the single family mortgage
loans are subject to various loss reimbursement agreements totaling $27.5
million with a remaining aggregate deductible of approximately $0.9 million.
Prepayment/Interest Rate Risk. The interest rate environment may also
impact the Company. For example, in a rising rate environment, the Company's net
interest margin may be reduced, as the interest cost for its funding sources
could increase more rapidly than the interest earned on the associated asset
financed. The Company's floating-rate funding sources are substantially based on
the one-month London InterBank Offered Rate ("LIBOR") and re-price at least
monthly, while the associated assets are principally six-month LIBOR or one-year
Constant Maturity Treasury ("CMT") based and generally re-price every six to
twelve months. Additionally, the Company has approximately $209 million of
fixed-rate assets financed with floating-rate non-recourse securitization
liabilities. In a declining rate environment, net interest margin may be
enhanced for the opposite reason. In a period of declining interest rates,
however, loans and securities in the investment portfolio will generally prepay
more rapidly (to the extent that such loans are not prohibited from prepayment),
which may result in additional amortization of asset premium. In a flat yield
curve environment (i.e., when the spread between the yield on the one-year
Treasury security and the yield on the ten-year Treasury security is less than
1.0%), single-family adjustable rate mortgage ("ARM") loans and securities tend
to rapidly prepay, causing additional amortization of asset premium. In
addition, the spread between the Company's funding costs and asset yields would
most likely compress, causing a further reduction in the Company's net interest
margin. Lastly, the Company's investment portfolio may shrink, or proceeds
returned from prepaid assets may be invested in lower yielding assets. The
severity of the impact of a flat yield curve to the Company would depend on the
length of time the yield curve remained flat. The Company uses derivative
financial instruments to manage its interest rate risk arising from the changes
in variable versus fixed interest rates.
Non-GAAP Information on Securitized Finance Receivables and Non-Recourse
Securitization Financing
As previously discussed, the Company finances its securitized finance
receivables through the issuance of non-recourse securitization financing. The
Company presents in its consolidated financial statements the securitized
finance receivables as assets, and the associated securitization financing as a
liability. Because the securitization financing is recourse only to the finance
receivables pledged, and is therefore not a general obligation of the Company,
the risk to the Company on its investment in securitized finance receivables is
limited to its net investment (i.e., the excess of the finance receivables
pledged over the non-recourse securitization financing). This excess is often
referred to as overcollateralization. The purpose of the information presented
in this section is to present the securitized finance receivables on a net
investment basis, and to provide estimated fair value information using various
assumptions on such net investment. In the tables below, the "principal balance
of net investment" in securitized finance receivables represents the excess of
the principal balance of the collateral pledged over the outstanding balance of
the associated non-recourse securitization financing owned by third parties. The
"amortized cost basis of net investment" is principal balance of net investment
plus or minus premiums and discounts and related costs. The Company generally
has sold the investment grade classes of the securitization financing to third
parties, and has retained the portion of the securitization financing that is
below investment grade. The Company estimates the fair value of its net
investment in securitized finance receivables as the present value of the
projected cash flow from the collateral, adjusted for the impact of and assumed
level of future prepayments and credit losses, less the projected principal and
interest due on the bonds owned by third parties. The Company master services
four of the securitization financings. Structured Asset Securitization
Corporation (SASCO) Series 2002-9 and CCA One Series 2 and Series 3 are
5
master-serviced by other parties. Monthly payment reports for those securities
master-serviced by the Company may be found on the Company's website at
www.dynexcapital.com.
Below is a summary as of December 31, 2003, by each series of the
Company's net investment in securitized finance receivables where the fair value
exceeds $0.5 million. The following tables show the Company's net investment in
each of the securities presented below on both a principal balance and amortized
cost basis, as those terms are defined above. The accompanying consolidated
financial statements of the Company present the securitized finance receivables
as an asset, and presents the associated securitization financing bond
obligation as a non-recourse liability. In addition, the Company carries only
its investment in MERIT Series 11 at fair value. As a result, the table below is
not meant to present the Company's investment in securitized finance receivables
or the non-recourse securitization financing in accordance with generally
accepted accounting principles applicable to the Company's transactions. See
below for a reconciliation of the amounts included in the table to the Company's
consolidated financial statements.
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(amounts in thousands)
Principal Principal Principal Amortized
Balance Balance of Balance Cost Basis
Of Bonds Of Of
Securitization Financing Collateral Outstanding to Net Net
Series (1) Collateral Type Pledged Third Parties Investment Investment
- -----------------------------------------------------------------------------------------------------------------------------
MERIT Series 11 Securities backed by $ 261,942 $ 227,760 $ 34,182 $ 25,025
single-family mortgage and
manufactured housing loans
MERIT Series 12 Manufactured housing loans 223,799 204,491 19,308 15,574
MERIT Series 13 Manufactured housing loans 267,431 242,443 24,988 18,766
SASCO 2002-9 Single family mortgage loans 317,631 308,621 9,010 15,327
MCA Series 1 Commercial mortgage loans 79,815 75,096 4,719 139
CCA One Series 2 Commercial mortgage loans 288,930 266,827 22,103 9,559
CCA One Series 3 Commercial mortgage loans 389,399 348,453 40,946 53,060
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$ 1,828,947 $ 1,673,691 $ 155,256 $ 137,450
- -----------------------------------------------------------------------------------------------------------------------------
(1) MERIT stands for MERIT Securities Corporation; MCA stands for Multifamily
Capital Access One, Inc. (now known as Commercial Capital Access One,
Inc.); and CCA stands for Commercial Capital Access One, Inc. Each such
entity is a wholly owned limited purpose subsidiary of the Company. SASCO
stands for Structured Asset Securitization Corporation.
The following table reconciles the balances presented in the table
above with the amounts included for securitized finance receivables and
securitization financing in the accompanying consolidated financial statements.
- ----------------------------------------------------------------------------------------------------------------------------
(amounts in thousands) Securitized
Non-recourse
Securitization Net
Finance Receivables Financing Investment
- ----------------------------------------------------------------------------------------------------------------------------
Principal balances per the above table $ 1,828,947 $ 1,673,691 $ 155,256
Principal balance of security excluded from above table 3,829 3,876 (47)
Recorded impairments on debt securities (12,456) - (12,456)
Premiums and discounts (14,631) (5,150) (9,481)
Unrealized gain 118 - 118
Accrued interest and other 11,750 7,413 4,337
Allowance for loan losses (43,364) - (43,364)
- ----------------------------------------------------------------------------------------------------------------------------
Balance per consolidated financial statements $ 1,774,193 $ 1,679,830 $ 94,363
- ----------------------------------------------------------------------------------------------------------------------------
6
The following table summarizes the fair value of the Company's net
investment in securitized finance receivables, the various assumptions made in
estimating value, and the cash flow received from such net investment during
2003. As the Company does not present its investment in securitized finance
receivables on a net investment basis and carries only its investment in MERIT
Series 11 at fair value, the table below is not meant to present the Company's
investment in securitized finance receivables or securitization financing in
accordance with generally accepted accounting principles applicable to the
Company's transactions.
- ----------------------------------------------------------------------------------------------------------------------------
Fair Value Assumptions ($ in thousands)
-----------------------------------------------------------------------------------------------------
Securitization Weighted-average Projected cash Fair value of net Cash flows
Financing Series prepayment speeds Losses flow termination investment (1) received in 2003,
date net (2)
- ----------------------------------------------------------------------------------------------------------------------------
MERIT Series 11 35%-40% CPR on 3.0% annually on MH Anticipated final $ 25,030 $ 15,419
Single-Family loans maturity in 2025
securities; 10%
CPR on
Manufactured
Housing securities
MERIT Series 12 9% CPR 3.1% annually on MH Anticipated final 8,543 1,152
loans maturity in 2027
MERIT Series 13 9% CPR 3.5% annually Anticipated final 1,168 1,285
maturity in 2026
SASCO 2002-9 30% CPR 0.2% annually Anticipated call 20,130 15,327
date in 2005
MCA One Series 1 (3) 0.80% annually Anticipated final 2,748 596
beginning in 2004 maturity in 2018
CCA One Series 2 (4) 0.80% annually Anticipated call 10,725 1,721
beginning in 2004 date in 2012
CCA One Series 3 (4) 1.20% annually Anticipated call 17,813 1,825
beginning in 2004 date in 2009
- ----------------------------------------------------------------------------------------------------------------------------
$ 86,157 $ 37,325
- ----------------------------------------------------------------------------------------------------------------------------
(1) Calculated as the net present value of expected future cash flows,
discounted at 16%. Expected cash flows were based on the forward LIBOR
curve as of December 31, 2003, and incorporates the resetting of the
interest rates on the adjustable rate assets to a level consistent with
projected prevailing rates. Increases or decreases in interest rates and
index levels from those used would impact the calculation of fair value, as
would differences in actual prepayment speeds and credit losses versus the
assumptions set forth above.
(2) Cash flows received by the Company during the year, equal to the excess of
the cash flows received on the collateral pledged, over the cash flow
requirements of the securitization financing bond security
(3) Computed at 0% CPR through June 2008 due to prepayment lockouts and yield
maintenance provisions (4) Computed at 0% CPR until the respective call
date due to prepayment lockouts and yield maintenance provisions
The above tables illustrate the Company's estimated fair value of its net
investment in securitized finance receivables. In its consolidated financial
statements, the Company carries its investments at amortized cost, except for
its investment in MERIT Series 11, which it carries at estimated fair value. The
fair value of net investment for Merit Series 12 in the above table includes
$7.3 million in proceeds which the Company will receive in April 2004 from the
redemption of the two most senior classes of bonds and the resale of such bonds
to a third-party. Beginning in March 2004, the Company has the option to redeem
the outstanding bonds of Merit Series 12, in whole or in part, by class, at
their current principal balance outstanding. Merit Series 13, which is secured
by similar collateral, is redeemable beginning in August 2004. However, as the
Company has not determined whether it will redeem any classes from Series 13,
and has not obtained an independent valuation of the optional redemption
provision for Series 13, no value for such provision is included in the above
table. Inclusive of recorded allowance for losses aggregating $43.4 million, the
Company's net investment in securitized finance receivables as reported in its
consolidated financial statements is approximately $94.4 million. This amount
compares to an estimated fair value, utilizing a discount rate of 16%, of
approximately $86.2 million, as set forth in the table above. The difference
7
between the $94.4 million in net investment as included in the consolidated
financial statements and the $86.2 million of estimated fair value, is due to
the differences between the estimated fair value of such net investment and
amortized cost.
The following table compares the fair value of these investments at
various discount rates, but otherwise using the same assumptions as set forth
for the two immediately preceding tables:
- --------------------------------------------------------------------------------
Fair Value of Net Investment
- --------------------------------------------------------------------------------
Securitization 12% 16% 20% 25%
Financing Bond
Series
- ------------------- -------------- ---------------- --------------- ------------
MERIT Series 11A $ 27,950 $ 25,030 $ 22,787 $ 20,609
MERIT Series 12-1 8,573 8,543 8,470 8,342
MERIT Series 13 1,039 1,168 1,241 1,285
SASCO 2002-9 20,791 20,130 19,495 18,738
MCA One Series 1 3,424 2,748 2,243 1,781
CCA One Series 2 13,255 10,725 8,830 7,096
CCA One Series 3 21,060 17,813 15,134 12,427
- ------------------- -------------- ---------------- --------------- ------------
$ 96,092 $ 86,157 $ 78,200 $ 70,278
- ------------------- -------------- ---------------- --------------- ------------
FEDERAL INCOME TAX CONSIDERATIONS
General
The Company believes it has complied with the requirements for
qualification as a REIT under the Internal Revenue Code (the "Code"). As such,
the Company believes that it qualifies as a REIT for federal income tax
purposes, and it generally will not be subject to federal income tax on the
amount of its income or gain that is distributed as dividends to shareholders.
The Company uses the calendar year for both tax and financial reporting
purposes. There may be differences between taxable income and income computed in
accordance with accounting principles generally accepted in the United States of
America ("GAAP"). These differences primarily arise from timing differences in
the recognition of revenue and expense for tax and GAAP purposes. The Company's
estimated taxable income for 2003, excluding net operating losses carried
forward from prior years, was $10.8 million, comprised entirely of ordinary
income. Such amounts were fully offset by tax loss carry-forwards of a similar
amount. The Company currently has tax operating loss carry-forwards of
approximately $124 million. Included in the $10.8 million in ordinary income is
excess inclusion income of $1.0 million which is required to be distributed by
the Company by the time the Company files its consolidated income tax return in
order to maintain its REIT status. The Company intends to make such distribution
in accordance with the prescribed requirements. Substantially all of the $124
million in net operating loss carry-forwards expire in 2014 and 2015, and $27
million of capital loss carry-forwards expire in 2004.
The REIT rules generally require that a REIT invest primarily in real
estate-related assets, that its activities be passive rather than active and
that it distribute annually to its shareholders substantially all of its taxable
income. The Company could be subject to income tax if it failed to satisfy those
requirements or if it acquired certain types of income-producing real property.
Although no complete assurances can be given, the Company does not expect that
it will be subject to material amounts of such taxes.
Failure to satisfy certain Code requirements could cause the Company to
lose its status as a REIT. If the Company failed to qualify as a REIT for any
taxable year, it would be subject to federal income tax (including any
applicable alternative minimum tax) at regular corporate rates and would not
receive deductions for dividends paid to shareholders. The Company could utilize
loss carry-forwards to offset any taxable income. In addition, given the size of
its tax loss carry-forwards, the Company could pursue a business plan in the
future whereby the Company would voluntarily forego its REIT status. If the
Company lost its status as REIT, the Company could not elect REIT status again
for five years.
In December 1999, with an effective date of January 1, 2001, Congress
signed into law several changes to the provisions of the Code relating to REITs.
The most significant of these changes relates to the reduction of the
distribution requirement from 95% to 90% of taxable income and to the ability of
REITs to own a 100% interest in taxable REIT subsidiaries. The Company had one
taxable REIT subsidiary at December 31, 2003.
8
Qualification of the Company as a REIT
Qualification as a REIT requires that the Company satisfy a variety of
tests relating to its income, assets, distributions and ownership. The
significant tests are summarized below.
Sources of Income. To continue qualifying as a REIT, the Company must
satisfy two distinct tests with respect to the sources of its income: the "75%
income test" and the "95% income test". The 75% income test requires that the
Company derive at least 75% of its gross income (excluding gross income from
prohibited transactions) from certain real estate-related sources. In order to
satisfy the 95% income test, 95% of the Company's gross income for the taxable
year must consist either of income that qualifies under the 75% income test or
certain other types of passive income.
If the Company fails to meet either the 75% income test or the 95%
income test, or both, in a taxable year, it might nonetheless continue to
qualify as a REIT, if its failure was due to reasonable cause and not willful
neglect and the nature and amounts of its items of gross income were properly
disclosed to the Internal Revenue Service. However, in such a case the Company
would be required to pay a tax equal to 100% of any excess non-qualifying
income.
Nature and Diversification of Assets. At the end of each calendar
quarter, three asset tests must be met by the Company. Under the 75% asset test,
at least 75% of the value of the Company's total assets must represent cash or
cash items (including receivables), government securities or real estate assets.
Under the "10% asset test", the Company may not own more than 10% of the
outstanding voting securities of any single non-governmental issuer, provided
such securities do not qualify under the 75% asset test or relate to taxable
REIT subsidiaries. Under the "5% asset test," ownership of any stocks or
securities that do not qualify under the 75% asset test must be limited, in
respect of any single non-governmental issuer, to an amount not greater than 5%
of the value of the total assets of the Company.
If the Company inadvertently fails to satisfy one or more of the asset
tests at the end of a calendar quarter, such failure would not cause it to lose
its REIT status, provided that (i) it satisfied all of the asset tests at the
close of a preceding calendar quarter and (ii) the discrepancy between the
values of the Company's assets and the standards imposed by the asset tests
either did not exist immediately after the acquisition of any particular asset
or was not wholly or partially caused by such an acquisition. If the condition
described in clause (ii) of the preceding sentence was not satisfied, the
Company still could avoid disqualification by eliminating any discrepancy within
30 days after the close of the calendar quarter in which it arose.
Distributions. With respect to each taxable year, in order to maintain
its REIT status, the Company generally must distribute to its shareholders an
amount at least equal to 90% of the sum of its "REIT taxable income" (determined
without regard to the deduction for dividends paid and by excluding any net
capital gain) and any after-tax net income from certain types of foreclosure
property minus any "excess non-cash income" (the "90% distribution
requirement"). The Code provides that in certain circumstances distributions
relating to a particular year may be made in the following year for purposes of
the 90% distribution requirement. The Company will balance the benefit to the
shareholders of making these distributions and maintaining REIT status against
their impact on the liquidity of the Company. In certain situations, it may
benefit the shareholders if the Company retained cash to preserve liquidity and
thereby lose REIT status.
Ownership. In order to maintain its REIT status, the Company must not
be deemed to be closely held and must have more than 100 shareholders. The
closely held prohibition requires that not more than 50% of the value of the
Company's outstanding shares be owned by five or fewer persons at anytime during
the last half of the Company's taxable year. The more than 100 shareholders rule
requires that the Company have at least 100 shareholders for 335 days of a
twelve-month taxable year. In the event that the Company failed to satisfy the
ownership requirements the Company would be subject to fines and required taking
curative action to meet the ownership requirements in order to maintain its REIT
status.
For federal income tax purposes, the Company is required to recognize
income on an accrual basis and to make distributions to its shareholders when
income is recognized. Accordingly, it is possible that income could be
recognized and distributions required to be made in advance of the actual
receipt of such funds by the Company. The nature of the Company's investments,
coupled with its tax loss carry-forwards, is such that the Company expects to
have sufficient assets to meet federal income tax distribution requirements.
9
Taxation of Distributions by the Company
By the Company maintaining its status as a REIT, any distributions that
are properly designated as "capital gain dividends" will generally be taxed to
shareholders as long-term capital gains, regardless of how long a shareholder
has owned his shares. Any other distributions out of the Company's current or
accumulated earnings and profits will be dividends taxable as ordinary income.
Distributions in excess of the Company's current or accumulated earnings and
profits will be treated as tax-free returns of capital, to the extent of the
shareholder's basis in his shares and, as gain from the disposition of shares,
to the extent they exceed such basis. Shareholders may not include on their own
tax returns any of the Company's ordinary or capital losses. Distributions to
shareholders attributable to "excess inclusion income"' of the Company will be
characterized as excess inclusion income in the hands of the shareholders.
Excess inclusion income can arise from the Company's holdings of residual
interests in real estate mortgage investment conduits and in certain other types
of mortgage-backed security structures created after 1991. Excess inclusion
income constitutes unrelated business taxable income ("UBTI") for tax-exempt
entities (including employee benefit plans and individual retirement accounts)
and it may not be offset by current deductions or net operating loss carryovers.
In the event that the Company's excess inclusion income is greater than its
taxable income, the Company's distribution requirement would be based on the
Company's excess inclusion income. Dividends paid by the Company to
organizations that generally are exempt from federal income tax under Section
501(a) of the Code should not be taxable to them as UBTI except to the extent
that (i) purchase of shares of the Company was financed by "acquisition
indebtedness" or (ii) such dividends constitute excess inclusion income. In
2003, the Company paid a dividend on its preferred stocks equal to approximately
$1.8 million, representing the Company's excess inclusion income in 2002. The
Company estimates that excess inclusion income for 2003 was $1.0 million.
Taxable Income
The Company uses the calendar year for both tax and financial reporting
purposes. However, there may be differences between taxable income and income
computed in accordance with accounting principles generally accepted in the
United States of America, ("GAAP"). These differences primarily arise from
timing differences in the recognition of revenue and expense for tax and GAAP
purposes. The principal difference relates to reserves for loan losses and
other-than-temporary impairment charges provided for GAAP purposes, which are
not deductible for tax purposes, versus actual charge-offs on loans, which are
deductible for tax purposes as ordinary losses
REGULATION
The Company's existing consumer-related servicing activities consist of
collections on the delinquent property tax receivables. The Company believes
that such servicing operations are managed in compliance with the Fair Debt
Collections Practices Act.
The Company believes that it is in material compliance with all
material rules and regulations to which it is subject.
COMPETITION
The Company may compete with a number of institutions with greater
financial resources. In purchasing portfolio investments and in issuing
securities, the Company competes with investment banking firms, savings and loan
associations, commercial banks, mortgage bankers, insurance companies. federal
agencies and other entities purchasing investments and issuing securities, many
of which have greater financial resources and a lower cost of capital than the
Company.
EMPLOYEES
As of December 31, 2003, the Company had 67 employees. The Company's
relationship with its employees is good. No employees of the Company are covered
by any collective bargaining agreements, and the Company is not aware of any
union organizing activity relating to its employees.
10
Item 2. Properties
The Company's executive and administrative offices and operations
offices are both located in Glen Allen, Virginia, on properties leased by the
Company which consist of 11,194 square feet. The address is 4551 Cox Road, Suite
300, Glen Allen, Virginia 23060. The lease expires in 2005. The Company also
occupies space located in Cleveland, Ohio, and the Pittsburgh, Pennsylvania
metropolitan area. These locations consist of approximately 16,384 square feet,
and the leases associated with these properties expire in 2005 and 2007. The
Company believes that its properties are maintained in good operating condition
and are suitable and adequate for its purposes.
Item 3. Legal Proceedings
The Company and its subsidiaries are involved in certain litigation
arising in the ordinary course of their businesses. Although the ultimate
outcome of these matters cannot be ascertained at this time, and the results of
legal proceedings cannot be predicted with certainty, the Company believes,
based on current knowledge, that the resolution of these matters will not have a
material adverse effect on the Company's financial position or results of
operations. Information on litigation arising out of the ordinary course of
business is described below.
GLS Capital, Inc. ("GLS"), a subsidiary of the Company, together with
the County of Allegheny, Pennsylvania ("Allegheny County"), were defendants in a
lawsuit in the Commonwealth Court of Pennsylvania (the "Commonwealth Court"),
the appellate court of the state of Pennsylvania. Plaintiffs were two local
businesses seeking status to represent as a class, delinquent taxpayers in
Allegheny County whose delinquent tax liens had been assigned to GLS. Plaintiffs
challenged the right of Allegheny County and GLS to collect certain interest,
costs and expenses related to delinquent property tax receivables in Allegheny
County, and whether the County had the right to assign the delinquent property
tax receivables to GLS and therefore employ procedures for collection enjoyed by
Allegheny County under state statute. This lawsuit was related to the purchase
by GLS of delinquent property tax receivables from Allegheny County in 1997,
1998, and 1999. In July 2001, the Commonwealth Court issued a ruling that
addressed, among other things, (i) the right of GLS to charge to the delinquent
taxpayer a rate of interest of 12% per annum versus 10% per annum on the
collection of its delinquent property tax receivables, (ii) the charging of a
full month's interest on a partial month's delinquency; (iii) the charging of
attorney's fees to the delinquent taxpayer for the collection of such tax
receivables, and (iv) the charging to the delinquent taxpayer of certain other
fees and costs. The Commonwealth Court in its opinion remanded for further
consideration to the lower trial court items (i), (ii) and (iv) above, and ruled
that neither Allegheny County nor GLS had the right to charge attorney's fees to
the delinquent taxpayer related to the collection of such tax receivables. The
Commonwealth Court further ruled that Allegheny County could assign its rights
in the delinquent property tax receivables to GLS, and that plaintiffs could
maintain equitable class in the action. In October 2001, GLS, along with
Allegheny County, filed an Application for Extraordinary Jurisdiction with the
Supreme Court of Pennsylvania, Western District appealing certain aspects of the
Commonwealth Court's ruling. In March 2003, the Supreme Court issued its opinion
as follows: (i) the Supreme Court determined that GLS can charge delinquent
taxpayers a rate of 12% per annum; (ii) the Supreme Court remanded back to the
lower trial court the charging of a full month's interest on a partial month's
delinquency; (iii) the Supreme Court revised the Commonwealth Court's ruling
regarding recouping attorney fees for collection of the receivables indicating
that the recoupment of fees requires a judicial review of collection procedures
used in each case; and (iv) the Supreme Court upheld the Commonwealth Court's
ruling that GLS can charge certain fees and costs, while remanding back to the
lower trial court for consideration the facts of each individual case. Finally,
the Supreme Court remanded to the lower trial court to determine if the
remaining claims can be resolved as a class action. In August 2003, the
Pennsylvania legislature signed a bill amending and clarifying certain
provisions of the Pennsylvania statute governing GLS' right to the collection of
certain interest, costs and expenses. The law is retroactive to 1996, and amends
and clarifies that as to items (ii)-(iv) noted above by the Supreme Court, that
GLS can charge a full month's interest on a partial month's delinquency, that
GLS can charge the taxpayer for legal fees, and that GLS can charge certain fees
and costs to the taxpayer at redemption. The issues remanded back to the Trial
Court are currently on hold as the Court addresses the challenge made to the
retroactive components of the legislation.
The Company and Dynex Commercial, Inc. ("DCI"), formerly an affiliate
of the Company and now known as DCI Commercial, Inc., were defendants in state
court in Dallas County, Texas in the matter of Basic Capital Management et al
(collectively, "BCM" or "the Plaintiffs") versus Dynex Commercial, Inc. et al.
The suit was filed in April 1999 originally against DCI, and in March 2000, BCM
amended the complaint and added the Company as a defendant. The complaint, which
was further amended during pretrial proceedings, alleged that, among other
things, DCI and the Company failed to fund tenant improvement or other advances
allegedly required on various loans made by DCI to BCM, which loans were
11
subsequently acquired by the Company; that DCI breached an alleged $160 million
"master" loan commitment entered into in February 1998; and that DCI breached
another alleged loan commitment of approximately $9 million. The trial commenced
in January 2004 and in February 2004, the jury in the case rendered a verdict in
favor of one of the plaintiffs and against the Company on the alleged breach of
the loan agreements for tenant improvements and awarded that plaintiff damages
in the amount of $0.25 million. The jury also awarded the Plaintiffs' attorneys
fees in the amount of $2.1 million. The jury entered a separate verdict against
DCI in favor of BCM under two mutually exclusive damage models, for $2.2 million
and $25.6 million, respectively. The verdict, any judgement, and the
apportionment of the award of attorneys fees between the Company and DCI, if
appropriate, remains subject to the outcome of post-judgment motions pending or
to be filed with the trial court. The Company does not believe that it has any
legal responsibility for the verdict against DCI. Plaintiffs are seeking to
set-off any damages that may be awarded against obligations to or loans held by
DCI or the Company, as applicable. The Plaintiffs may attempt to include loans
which have been pledged by the Company as securitized finance receivables in
non-recourse securitization financings. The jury found in favor of DCI on the
alleged $9 million loan commitment, but did not find in favor of DCI for
counterclaims made against BCM. The Company (and DCI) are vigorously contesting
Plaintiffs' claims including whether any Plaintiff is entitled to any judgement.
Although no assurance can be given with respect to the ultimate outcome
of the above litigation, the Company believes the resolution of these lawsuits
will not have a material effect on the Company's consolidated balance sheet, but
could materially affect consolidated results of operations in a given year.
Item 4. Submission Of Matters To A Vote Of Security Holders
None.
PART II
Item 5. Market For Registrant's Common Equity And Related Stockholder Matters
Dynex Capital, Inc.'s common stock is traded on the New York Stock
Exchange under the trading symbol DX. The common stock was held by approximately
2,363 holders of record and beneficial holders who hold common stock in street
name as of February 27, 2004. During the last two years, the high and low
closing stock prices and cash dividends declared on common stock, adjusted for
the two-for-one stock split effective May 5, 1997 and the one-for-four reverse
stock split effective August 2, 1999 were as follows:
- ---------------------- ------------- ---------------- ------------------------
Cash Dividends Declared
High Low
- ---------------------- ------------- ---------------- ------------------------
2003:
First quarter $ 5.33 $ 4.26 $ -
Second quarter 5.96 4.46 -
Third quarter 6.02 5.30 -
Fourth quarter 6.15 5.11 -
2002:
First quarter $ 3.92 $ 2.02 $ -
Second quarter 5.40 3.30 -
Third quarter 5.20 3.91 -
Fourth quarter 4.84 4.06 -
- ---------------------- ------------- ---------------- ------------------------
Dividends declared by the Board of Directors over the last three years
have been for the purpose of maintaining the Company's REIT status.
Dividends-in-arrears for the preferred stock must be fully paid before dividends
can be paid on common stock. Dividends-in-arrears on preferred stock were $18.5
million at December 31, 2003. No common dividends have been paid since 1998. See
Federal Income Tax Considerations.
12
Item 6. Selected Financial Data
- ----------------------------------------------------------------------------------------------------------------------
Years ended December 31, 2003 2002 2001 2000 1999
- ----------------------------------------------------------------------------------------------------------------------
(amounts in thousands except share and per share data)
Net interest margin (1) $ 1,889 $ 20,670 $ 28,410 $ 2,377 $ 54,609
Impairment charges (2) (16,355) (18,477) (43,439) (84,039) (107,470)
Equity in net loss of Dynex Holding, Inc. (3) - - - (1,061) (19,927)
Other income (expense) 436 1,397 7,876 (428) 156
General and administrative expenses (8,632) (9,493) (10,526) (8,712) (7,740)
Net loss $ (21,107) $ (9,360) $ (21,209) $ (91,863) $ (75,135)
- ----------------------------------------------------------------------------------------------------------------------
Net loss to common shareholders $ (14,260) $ (18,946) $ (13,492) $(104,774) $ (88,045)
Net (loss) income per common share:
Basic & diluted (4) $ (1.31) $ (1.74) $ (1.18) $ (9.15) $ (7.67)
Dividends declared per share:
Common (4) $ - $ - $ - $ - $ -
Series A Preferred 0.8775 0.2925 0.2925 - 1.17
Series B Preferred 0.8775 0.2925 0.2925 - 1.17
Series C Preferred 1.0950 0.3651 0.3649 - 1.46
- ----------------------------------------------------------------------------------------------------------------------
December 31, 2003 2002 2001 2000 1999
- ----------------------------------------------------------------------------------------------------------------------
Investments (6) $1,850,675 $2,185,746 $2,511,229 $3,148,667 $4,136,563
Total assets (6) 1,865,235 2,205,735 2,531,509 3,195,354 4,217,722
Non-recourse debt (6) 1,679,830 1,980,702 2,225,863 2,812,161 3,282,378
Recourse debt 33,933 - 58,134 134,168 537,098
Total liabilities (6) 1,715,389 1,982,314 2,289,399 2,957,898 3,867,445
Shareholders' equity 149,846 223,421 242,110 237,456 350,277
Number of common shares outstanding 10,873,903 10,873,903 10,873,853 11,446,206 11,444,099
Average number of common shares (4) 10,873,903 10,873,871 11,430,471 11,445,236 11,483,977
Book value per common share (5) $ 7.55 $ 8.57 $ 11.06 $ 7.39 $ 18.38
- ----------------------------------------------------------------------------------------------------------------------
(1) Net interest margin has decreased due to increased provisions for losses on
manufactured housing loans and commercial mortgage loans and overall
shrinking earning asset base.
(2) Net loss on sale, write-downs, impairment charges and litigation for the
year ended December 31, 2000 and 1999 include several adjustments related
largely to non-recurring items.
(3) Dynex Holding, Inc. was liquidated at the end of 2000.
(4) Adjusted for two-for-one common stock split effective May 5, 1997 and the
one-for-four reverse common stock split effective August 2, 1999.
(5) Inclusive of the liquidation preference on the Company's preferred stock.
(6) Certain deferred hedging gains and losses for 2002 and prior years were
reclassified from securitized finance receivables to non-recourse
securitized financing.
Item 7. Management's Discussion And Analysis Of Financial Condition And Results
Of Operations
The Company is a financial services company, which invests in loans and
securities consisting of or secured by, principally single family mortgage
loans, commercial mortgage loans, manufactured housing installment loans and
delinquent property tax receivables. The loans and securities in which the
Company invests have generally been pooled and pledged (i.e. securitized) as
collateral for non-recourse bonds ("non-recourse securitization financing"),
which provides long-term financing for such loans while limiting credit,
interest rate and liquidity risk. The Company earns the net interest spread
between the interest income on the loans and securities in its investment
portfolio and the interest and other expenses associated with the non-recourse
securitization financing. The Company also collects payments from property
13
owners on its investment in delinquent property tax receivables. The Company
manages the cash flow on these investments to maximize shareholders' value.
CRITICAL ACCOUNTING POLICIES
The discussion and analysis of the Company's financial condition and
results of operations are based in large part upon its consolidated financial
statements, which have been prepared in conformity with accounting principles
generally accepted in the United States of America. The preparation of the
financial statements requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenue and expenses during the reported period. Actual
results could differ from those estimates.
Critical accounting policies are defined as those that are reflective
of significant judgments or uncertainties, and which may result in materially
different results under different assumptions and conditions, or the application
of which may have a material impact on the Company's financial statements. The
following are the Company's critical accounting policies.
Consolidation of Subsidiaries. The consolidated financial statements
represent the Company's accounts after the elimination of inter-company
transactions. The Company follows the equity method of accounting for
investments with greater than 20% and less than a 50% interest in partnerships
and corporate joint ventures when it is able to influence the financial and
operating policies of the investee. For all other investments, the cost method
is applied.
Impairments. The Company evaluates all securities in its investment
portfolio for other-than-temporary impairments. A security is generally defined
to be other-than-temporarily impaired if, for a maximum period of three
consecutive quarters, the carrying value of such security exceeds its estimated
fair value and the Company estimates, based on projected future cash flows or
other fair value determinants, that the carrying value is not likely to exceed
fair value in the foreseeable future. If an other-than-temporary impairment is
deemed to exist, the Company records an impairment charge to adjust the carrying
value of the security down to its estimated fair value. In certain instances, as
a result of the other-than-temporary impairment analysis, the recognition or
accrual of interest will be discontinued and the security will be placed on
non-accrual status.
The Company considers an investment to be impaired if the fair value of
the investment is less than its recorded cost basis. Impairments of other
investments are considered other-than-temporary when the Company determines that
the collection trends indicate the investment is not recoverable. The impairment
recognized on other investments is the difference between the book value of the
investment and the expected collections less collection costs.
Allowance for Loan Losses. The Company has credit risk on loans pledged
in securitization financing transactions and classified as securitized finance
receivables in its investment portfolio. An allowance for loan losses has been
estimated and established for currently existing probable losses to the extent
losses are borne by the Company under the terms of the securitization
transaction. Factors considered in establishing an allowance include current
loan delinquencies, historical cure rates of delinquent loans, and historical
and anticipated loss severity of the loans as they are liquidated. The allowance
for loan losses is evaluated and adjusted periodically by management based on
the actual and estimated timing and amount of probable credit losses, using the
above factors, as well as industry loss experience. Where loans are considered
homogeneous, the allowance for losses are established and evaluated on a pool
basis. Otherwise, the allowance for losses is established and evaluated on a
loan-specific basis. Provisions made to increase the allowance are a current
period expense to operations. Generally, the Company considers manufactured
housing loans to be impaired when they are 30-days past due. The Company also
provides an allowance for currently existing credit losses within outstanding
manufactured housing loans that are current as to payment but which the Company
has determined to be impaired based on default trends, current market conditions
and empirical observable performance data on the loans. Single-family loans are
considered impaired when they are 60-days past due. Commercial mortgage loans
are evaluated on a loan by loans basis for impairment. Generally, commercial
mortgage loans with a debt service coverage ratio less than 1:1 are considered
impaired. Based on the specific details of a loan, loans with a debt service
coverage ratio greater than 1:1 may be considered impaired; conversely, loans
with a debt service coverage ratio less than 1:1 may not be considered impaired.
A range of loss severity assumptions are applied to these impaired loans to
determine the level of reserves necessary. Certain of the commercial mortgage
loans are covered by loan guarantees that limits the Company's exposure on these
loans. The level of allowance for loan losses required for these loans is
14
reduced by the amount of applicable loan guarantees. The Company's actual credit
losses may differ from those estimates used to establish the allowance.
FINANCIAL CONDITION
Below is a discussion of the Company's financial condition.
- --------------------------------------------- ----------------------------------
December 31,
----------------------------------
(amounts in thousands except per share data) 2003 2002
- --------------------------------------------- ----------------- ----------------
Investments:
Securitized finance receivables:
Loans, net $1,518,613 $1,787,254
Debt securities, available for sale 255,580 328,674
Other investments 37,903 54,322
Securities 30,275 6,208
Other loans 8,304 9,288
Non-recourse securitization financing 1,679,830 1,980,702
Repurchase agreements 23,884 -
Senior notes 10,049 -
Shareholders' equity 149,846 223,421
Book value per common share (inclusive
of preferred stock liquidation preference) $7.55 $8.57
- --------------------------------------------- ----------------- ----------------
Securitized Finance Receivables
Securitized finance receivables includes loans and securities
consisting of, or secured by adjustable-rate and fixed-rate mortgage loans
secured by first liens on single family properties, fixed-rate loans secured by
first liens on multifamily and commercial properties, and manufactured housing
installment loans secured by either a UCC filing or a motor vehicle title. As of
December 31, 2003, the Company had 20 series of non-recourse securitization
financing outstanding. The securitized finance receivables decreased to $1.77
billion at December 31, 2003 compared to $2.12 billion at December 31, 2002.
This decrease of $341.7 million is primarily the result of $297.6 million in
principal pay-downs, $37.1 million of increased allowance for loan losses, net,
$8.6 million of impairment charges recorded on debt securities and market value
adjustments of $0.2 million. These decreases were partially offset by increases
resulting from $1.8 million of amortization of loan discounts. Principal
pay-downs resulted from normal principal amortization of the underlying loan or
security, and higher than anticipated prepayments on these assets due to the low
interest-rate environment. Allowance for loan losses have increased as a result
of provisions for losses on current manufactured housing loans and additional
reserves for commercial loan losses. It is expected that the Company will incur
future losses such that additional reserves will be required until the Company's
net exposure to credit losses in the manufactured housing loans is fully
reserved. Impairment charges result from other-than-temporary decreases in
market value on debt securities backed by manufactured housing loan collateral.
Other Investments
Other investments at December 31, 2003 and 2002 consist primarily of
delinquent property tax receivables, a security collateralized by delinquent
property tax receivables, and associated real estate owned. Other investments
decreased to $37.9 million at December 31, 2003 compared to $54.3 million at
December 31, 2002. This decrease of $16.4 million resulted from payments of
$10.6 million collected on delinquent property tax receivables and applied
against the carrying value of the investment, $2.1 million in sales of related
real estate owned and $10.4 million of valuation adjustments on the security as
a result of an other-than-temporary impairment charge arising from lower
projected cash flows from the delinquent tax receivable portfolio. These
decreases were partially offset by $3.5 million of additional capitalized costs
incurred and $3.5 million of interest accrued in the collection of the
delinquent property tax receivables. As a result of further impairment of these
assets, the accrual of interest was discontinued in October 2003.
15
Securities
Securities increased to $30.3 million at December 31, 2003 compared to
$6.2 million at December 31, 2002, primarily as a result of the call and
retention of a fixed rate security with a principal balance of $28.9 million,
amortization of $1.1 million of the discount on first loss securities and a $0.2
million net increase in market value of the securities. These increases were
partially offset by principal payments of $4.5 million during the year, the sale
of a security with a principal balance of $0.4 million and the write-off of six
interest-only strips with a principal balance of $1.2 million related to the
call and sale or retention of securities during 2003. Unrealized losses of $0.8
million are less than twelve months old.
Other loans
Other loans decreased to $8.3 million at December 31, 2003 from $9.3
million at December 31, 2002 due primarily to paydowns on the loans of $4.3
million. This decrease was partially offset by the redemption and subsequent
termination of a mortgage-backed security collateralized by $3.2 million of
fixed-rate single-family mortgage loans.
Non-recourse Securitization Financing
Securitization financing issued by the Company are recourse only to the
assets pledged as collateral, and are otherwise non-recourse to the Company.
Non-recourse securitization financing decreased to $1.68 billion at December 31,
2003 from $1.98 billion at December 31, 2002. This decrease was primarily a
result of principal payments received of $295.2 million on the associated
collateral pledged which were used to pay down the securitization financing in
accordance with the respective indentures. Additionally, for certain
securitizations, surplus cash in the amount of $3.3 million was retained within
the security structure and used to repay securitization financing outstanding,
instead of being released to the Company. For certain other securitizations,
surplus cash in the amount of $4.9 million was retained to cover losses, as
certain performance triggers were not met in such securitizations. Net premium
amortization of $1.2 million partially offset these decreases.
Repurchase Agreements
In December 2003, the Company entered into a $23.9 million repurchase
agreement to finance the call and purchase of $28.9 million of fixed-rate
securities where the Company owned the call rights on such securities.
Senior Notes
Senior Notes increased $10.0 million as a result of the issuance of
$32.1 million of February 2005 Senior Notes in exchange for Preferred Stock in
February 2003. Since their issuance, the Company has repaid $12.1 million of the
Senior Notes in accordance with their contractual terms on May 31, August 31,
and November 31 and redeemed early $10.0 million of the notes in August 2003.
Shareholders' Equity
Shareholders' equity decreased from $223.4 million at December 31, 2002
to $149.8 million at December 31, 2003. This decrease of $73.6 million resulted
from the net loss for the year of $21.1 million, the redemption in February 2003
of $47.6 million of preferred stock, a decrease in additional paid-in capital of
$4.1 million resulting from the premium paid for the retired preferred shares, a
$1.0 million decrease in accumulated other comprehensive loss, and a payment of
$1.8 million of preferred stock dividends. The decrease in accumulated other
comprehensive loss resulted principally from the decrease in the fair value of
debt securities of $0.2 million, and mark-to-market gains of $0.8 million on
interest-rate swap and synthetic interest-rate swap contracts resulting from the
realization in income of losses on settled contracts and deferred gains on the
remaining hedge contracts. Of $3.9 million of accumulated other comprehensive
loss, $3.6 million is related to derivative financial instruments accounted for
as cash flow hedges, of which $2.8 million is expected to be recognized in
income during the next twelve months. Of the remaining net $0.3 million, $0.8
million represents unrealized losses, all of which are less than twelve months
old and unrealized gains of $0.5.
16
RESULTS OF OPERATIONS
- ----------------------------------------------------------------- ------------------------------------------------------
For the Year Ended December 31,
------------------------------------------------------
(amounts in thousands except per share information) 2003 2002 2001
- ----------------------------------------------------------------- ----------------- ------------------ -----------------
Net interest margin before provision for losses $ 38,971 $ 49,153 $ 48,082
Provision for losses (37,082) (28,483) (19,672)
Net interest margin 1,889 20,670 28,410
Impairment charges (16,355) (18,477) (43,439)
Gain (loss) on sales of investments 1,555 (150) (439)
Trading losses - (3,307) (3,091)
Other income 436 1,397 7,876
General and administrative expenses (8,632) (9,493) (10,526)
Net loss (21,107) (9,360) (21,209)
Preferred stock benefit (charge) 6,847 (9,586) 7,717
Net loss to common shareholders $ (14,260) $ (18,946) $ (13,492)
Basic & diluted net loss per common share $ (1.31) $ (1.74) $ (1.18)
Dividends declared per share:
Common - - -
Series A and B Preferred $ 0.8775 $ 0.2925 $ 0.2925
Series C Preferred 1.0950 0.3651 0.3649
- ----------------------------------------------------------------- ----------------- ------------------ -----------------
2003 Compared to 2002
Net loss increased to $21.1 million in 2003 from $9.4 million in 2002
as a result of the decline in net interest margin, offset by a decline in
impairment charges, an increase in gain on sale of investments, a decrease in
trading losses, and a decrease in general and administrative expenses. Net loss
per common share decreased during 2003 as compared to 2002 as a result of the
preferred stock benefit for 2003 from the tender offer on the preferred stock
completed in February 2003.
Net interest margin before provision for losses for the year ended
December 31, 2003 decreased to $39.0 million, from $49.2 million for the same
period in 2002. The decrease in net interest margin before provision for losses
of $10.2 million, or 20.7%, was the result of a decline in average
interest-earning assets, a decrease in the net interest spread on
interest-earning assets, and a reduction in interest income in 2003 versus 2002
for a security collateralized by delinquent property tax receivables which, due
to further impairment of the asset, was placed on non-accrual status in 2003.
The Company provides for losses on its loans where it has retained
credit risk. Provision for losses for loans increased to $37.1 million in 2003,
from $28.5 million in 2002. Provision for losses increased by $8.6 million from
2002 as a result of additions to allowance for loan losses on commercial
mortgage loans of $6.1 million and reserves on losses on current manufactured
housing loans in the Company's investment portfolio of $31.0 million for 2003
compared to $28.6 million for 2002. For commercial mortgage loans, underlying
commercial properties concentrated in the health care and hospitality industries
are generally under-performing relative to expectations and are suffering from
high vacancy rates and lower fees and rents. Included in 2003 is $13.8 million
in provision for loan losses recorded specifically for currently existing credit
losses within outstanding manufactured housing loans that are current as to
payment but which the Company has determined to be impaired. Previously, the
Company had not considered current loans to be impaired under generally accepted
accounting principles and therefore had not previously provided an allowance for
losses for these loans. Continued worsening trends in both the industry as a
whole and the Company's pools of manufactured housing loans prompted the Company
to prepare an extensive analysis on these pools of loans. Loss severity on the
manufactured housing loans continued to remain high during 2003 as a result of
the saturation in the market place with both new and used (repossessed)
manufactured housing units. Defaults in 2003 on manufactured housing loans
averaged 4.0% on an annualized basis, versus 4.5% in 2002, and loss severity on
such loans approximated 77% during the year. While defaults on manufactured
housing loans declined relative to 2002, defaults are expected to remain at 2003
levels. Defaults are influenced by general economic conditions in the various
local markets.
17
Impairment charges decreased from $18.5 million in 2002 to an aggregate
$16.4 million in 2003. Such impairment charges included other-than-temporary
impairment of debt securities pledged as securitized finance receivables of $5.5
million for 2003. In addition, the Company incurred impairment charges in 2003
of $10.4 million related to a security where the underlying property tax
receivable collateral has been foreclosed and represents real estate owned, and
$0.6 million of losses on investments in a limited liability partnership. The
impairment charges on the debt securities result from revised expectations on
related collateral. All cash received will be applied to reduce the carrying
value of the security.
Gain on sale of investments for 2003 includes the gain from the sale of
loans acquired through the redemption of adjustable-rate and fixed-rate mortgage
pass-through securities previously issued and sold by the Company. Upon
redemption, the Company collapsed the security structure and sold the underlying
loans.
In 2002, the Company entered into a $100 million notional short
position on 5-Year Treasury Notes futures to, in effect, mitigate its exposure
to rising interest rates on a like amount of floating-rate liabilities. These
instruments failed to meet the hedge criteria of SFAS No. 133, and were
accounted for on a trading basis. The Company terminated these contracts at a
loss of $3.3 million in 2002. No such trading activity was engaged in by the
Company in 2003.
The Company purchased and retired $51.6 million of its Series A, Series
B and Series C preferred shares in 2003 resulting in a preferred stock benefit
of $6.8 million which was comprised of the elimination of $16.1 million of
dividends in arrears which was partially offset by a $4.1 million premium to
book value paid to obtain the preferred shares tendered and $5.2 million of
period accrual of dividends on the shares remaining after the completion of the
tender offer.
2002 Compared to 2001
The decrease in net loss during 2002 as compared to 2001 is primarily
the result of decreases in impairment charges and an increase in net margin
before provision for losses, partially offset by increases in provision for
losses, and decreases in other income and gains from extinguishment of debt. Net
loss per common share increased as a result of preferred stock charges in 2002
versus preferred stock benefits in the prior year, partially offset by the
decrease in net loss during 2002.
Net interest margin before provision for losses for the year ended
December 31, 2002 increased to $49.2 million, from $48.1 million for the same
period in 2001. The increase in net interest margin before provision for losses
of $1.1 million, or 2.2%, was the result of an increase in the net interest
spread on interest-earning assets and interest income recognized on a security
collateralized by delinquent property tax receivables, partially offset by the
decline in interest earning assets.
The Company provides for losses on its loans where it has retained
credit risk. Provision for losses for loans increased to $28.5 million in 2002,
from $19.7 million in 2001. Provision for losses increased by $8.8 million as a
result of additions for manufactured housing loans. The continuing
under-performance of these loans prompted the Company to revise its estimate of
losses to include a percentage of all loans with delinquencies greater than 30
days. This revision, which was instituted during the fourth quarter of 2002,
resulted in an increase in provision for losses of $7.4 million during the
quarter. Loss severity on the manufactured housing loans continued to remain
high during 2002 as a result of the saturation in the market place with both new
and used (repossessed) manufactured housing units. Defaults in 2002 on
manufactured housing loans averaged 4.5%, versus 4.2% in 2001, and loss severity
continued at 77% during the year.
Impairment charges decreased to $18.5 million in 2002 from $43.4
million in 2001. Impairment charges included other-than-temporary impairment of
debt securities pledged as securitized finance receivables of $15.6 million for
2002. In addition, the Company incurred impairment charges in 2002 related to a
$1.9 million adjustment to the lower of cost or market for certain delinquent
single-family mortgage loans. Such loans were included in securities called by
the Company, the balances of which were included in the SASCO Series 2002-9
securitization completed in April 2002. During 2001, the Company incurred
other-than-temporary impairments of debt securities pledged as securitized
finance receivables of $15.8 million, and recorded additional
other-than-temporary impairment charges of $24.9 million related to a reduction
in the carrying value of the delinquent property tax receivable security, $2.7
million for property tax receivables that have been foreclosed and represent
real estate owned.
Other income for 2001 includes a net benefit from a litigation
settlement of $6.1 million. No such litigation benefit was received in 2002.
18
Average Balances and Effective Interest Rates
The following table summarizes the average balances of interest-earning
assets and their average effective yields, along with the average
interest-bearing liabilities and the related average effective interest rates,
for each of the periods presented. Assets that are on non-accrual status are
excluded from the table below for each period presented.
- ---------------------------------------------------------------------------------------------------------------------------
Year ended December 31,
- ---------------------------------------------------------------------------------------------------------------------------
2003 2002 2001
- ---------------------------------------------------- ----------------------- ----------------------- -----------------------
(amounts in thousands) Average Effective Average Effective Average Effective
Balance Rate Balance Rate Balance Rate
- ---------------------------------------------------- ----------- ----------- ----------- ----------- ----------- -----------
Interest-earning assets (1):
Securitized finance receivables (2) (3) $1,949,201 7.50% $2,272,387 7.69% $2,783,270 7.95%
Other investments 45,936 7.41% 53,456 10.08% 37,185 14.69%
Securities 5,631 13.74% 4,816 21.31% 8,830 9.60%
Other loans 9,048 6.72% 9,706 4.54% 4,068 12.56%
Cash Investments 14,109 0.94% 19,207 1.48% 17,560 5.52%
----------- ----------- ----------- ----------- ----------- -----------
Total interest-earning assets $2,023,925 7.47% $2,359,572 7.71% $2,850,913 8.03%
=========== =========== =========== =========== =========== ===========
Interest-bearing liabilities:
Non-recourse securitization financing $1,822,877 6.23% $2,113,330 6.12% $2,508,454 6.77%
Repurchase agreements secured by
securitization financing bonds retained - - - - 17,016 6.28%
----------- ----------- ----------- ----------- ----------- -----------
1,822,877 6.23% 2,113,330 6.12% 2,525,470 6.76%
Senior notes 19,330 9.53% 26,112 8.14% 71,174 8.26%
Repurchase agreements 398 1.79% - - - -
----------- ----------- ----------- ----------- ----------- -----------
Total interest-bearing liabilities $1,842,605 6.26% $2,139,442 6.15% $2,596,644 6.80%
=========== =========== =========== =========== =========== ===========
Net interest spread (3) 1.21% 1.56% 1.23%
Net yield on average interest-earning assets (3) 1.77% 2.14% 1.83%
- ---------------------------------------------------- ----------- ----------- ----------- ----------- ----------- -----------
(1) Average balances exclude adjustments made in accordance with Statement of
Financial Accounting Standards No. 115, "Accounting for Certain Investments
in Debt and Equity Securities," to record available for sale securities at
fair value.
(2) Average balances exclude funds held by trustees of $374, $2,590,and $507
for the years ended December 31, 2003, 2002, and 2001, respectively.
(3) Effective rates are calculated excluding non-interest related non-recourse
securitization financing expenses and provision for credit losses.
2003 compared to 2002
The net interest spread for the year ended December 31, 2003 decreased
to 1.21% from 1.56% for the year ended December 31, 2002. This decrease can be
generally attributed to the resetting of interest rates on adjustable rate
mortgage loans in the Company's investment portfolio and the prepayment of
higher rate loans in that portfolio which together caused a decline in interest
earning asset yield of 24 basis points in 2003. The overall yield on
interest-earnings assets, decreased to 7.47% for the year ended December 31,
2003 from 7.71% for the same period in 2002, following the falling-rate
environment, yet lagging relative to the Company's liabilities. A substantial
portion of the Company's interest-bearing liabilities re-price monthly, and are
indexed to one-month LIBOR, which on average decreased to 1.21% for 2003, versus
1.76% for 2002. While on average one-month LIBOR declined during the period, the
Company's overall cost of its interest-bearing liabilities increased for the
year from 6.15% for 2002 to 6.26% for 2003, as lower rate non-recourse
securitization financing was repaid during the year. One-month LIBOR fell from
1.38% at December 31, 2002 to its lowest point in June 2003 of 1.02% where it
climbed to its December 31, 2003 point of 1.12%. The Company's net interest
spread in 2003 also effected by the issuance in February of 9.5% senior notes
due February 2005.
2002 compared to 2001
The net interest spread for the year ended December 31, 2002 increased
to 1.56% from 1.23% for the year ended December 31, 2001. This increase was
primarily due to the reduction of short-term interest rates during 2001, which
benefited the Company's borrowing costs in 2002. A substantial portion of the
Company's interest-bearing liabilities re-price monthly, and are indexed to
one-month LIBOR, which on average decreased to 1.76% for 2002, versus 3.88% for
2001. The overall yield on interest-earnings assets, decreased to 7.71% for the
year ended December 31, 2002 from 8.03% for the same period in 2001, following
19
the falling-rate environment, yet lagging relative to the Company's liabilities.
The Company's net interest spread in 2002 also benefited from the repayment of
all remaining recourse debt outstanding.
The following tables summarize the amount of change in interest income
and interest expense due to changes in interest rates versus changes in volume:
- ----------------------------------------------------------------------------------------------------------------------------
2003 to 2002 2002 to 2001
- ----------------------------------------------------------------------------------------------------------------------------
Rate Volume Total Rate Volume Total
- ----------------------------------------------------------------------------------------------------------------------------
Securitized finance receivables $ (4,199) $ (24,338) $ (28,537) $ (6,924) $ (39,491) $ (46,415)
Other investments (1,252) (885) (2,137) (4,756) 3,999 (757)
Securities (406) 154 (252) 691 (513) 178
Other loans 199 (32) 167 (469) 399 (70)
- ----------------------------------------------------------------------------------------------------------------------------
Total interest income (5,658) (25,101) (30,759) (11,458) (35,606) (47,064)
- ----------------------------------------------------------------------------------------------------------------------------
Non-recourse debt 2,202 (18,049) (15,847) (15,746) (25,683) (41,429)
Senior notes 325 (609) (284) (105) (3,571) (3,676)
Repurchase agreements - 7 7 (40) (40) (80)
- ----------------------------------------------------------------------------------------------------------------------------
Total interest expense 2,527 (18,651) (16,124) (15,891) (29,294) (45,185)
- ----------------------------------------------------------------------------------------------------------------------------
Net interest margin $ (8,185) $ (6,450) $ (14,635) $ 4,433 $ (6,312) $ (1,879)
- ----------------------------------------------------------------------------------------------------------------------------
Note: The change in interest income and interest expense due to changes in both
volume and rate, which cannot be segregated, has been allocated
proportionately to the change due to volume and the change due to rate.
This table excludes non-interest related non-recourse securitization
financing expense, other interest expense and provision for credit
losses.
Interest Income and Interest-Earning Assets
Approximately $1.5 billion of the investment portfolio as of December
31, 2003, or 81%, is comprised of loans or securities that pay a fixed-rate of
interest. Also at December 31, 2003, approximately $352 million, or 19%, is
comprised of loans or securities that have coupon rates which adjust over time
(subject to certain periodic and lifetime limitations) in conjunction with
changes in short-term interest rates. Approximately 72% of the adjustable-rate
mortgage (ARM) loans underlying the securitized finance receivables are indexed
to and reset based upon the level of six-month LIBOR, and approximately 14% are
indexed to and reset based upon the level of the one-year Constant Maturity
Treasury (CMT) index. The following table presents a breakdown, by principal
balance, of the Company's securitized finance receivables and securities, by
type of underlying loan as of December 31, 2003, 2002 and 2001. The percentage
of fixed-rate loans to all loans increased from 76% at December 31, 2002, to 81%
at December 31, 2003, as most of the prepayments in the Company's investment
portfolio have occurred in the single-family ARM portion. The table below
excludes various investments in the Company's portfolio, including securities
such as derivative and residual securities, other securities, and securities
backed by delinquent property tax receivables, and non-securitized investments
including other investments and loans. Most of these excluded investments would
be considered fixed-rate, and amounted to approximately $52.9 million at
December 31, 2003.
Investment Portfolio Composition (1)
($ in millions)
- ------------------------------- ----------------- -------------------- --------------------- --------------- ---------------
Other Indices Based
LIBOR Based ARM CMT Based ARM Loans ARM Loans Fixed-Rate
December 31, Loans Loans Total
- ------------------------------- ----------------- -------------------- --------------------- --------------- ---------------
2001 $ 472.4 $ 144.6 $ 73.6 $ 1,765.8 $ 2,456.4
2002 $ 384.6 $ 73.2 $ 57.0 $ 1,647.0 $ 2,161.8
2003 $ 258.2 $ 48.8 $ 45.4 $ 1,512.2 $ 1,864.6
- ------------------------------- ----------------- -------------------- --------------------- --------------- ---------------
(1) Only principal amounts are included.
20
Credit Exposures
The Company invests in non-recourse securitization financing or
pass-through securitization structures. Generally these securitization
structures use over-collateralization, subordination, third-party guarantees,
reserve funds, bond insurance, mortgage pool insurance or any combination of the
foregoing as a form of credit enhancement. The Company generally has retained a
limited portion of the direct credit risk in these structures. In most
instances, the Company retained the "first-loss" credit risk on pools of loans
and securities that it has securitized.
The following table summarizes the aggregate principal amount of
securitized finance receivables and mortgage pass-through securities
outstanding; the direct credit exposure retained by the Company (represented by
the amount of over-collateralization pledged and subordinated securities owned
by the Company), net of the credit reserves and discounts maintained by the
Company for such exposure; and the actual credit losses incurred for each year.
For 2003 and 2002, the table includes any subordinated security retained by the
Company. The Company's credit exposure, net of credit reserves, has declined
from 2002 by $27.2 million due to charge-offs on the collateral and bonds of
$23.4 million and the addition of reserves, net of losses, of $3.8 million. The
table excludes other forms of credit enhancement from which the Company
benefits, and based upon the performance of the underlying loans, may provide
additional protection against losses as discussed above in Investment Portfolio
Risks. This table also excludes any risks related to