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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, 2004
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
1-9819
(Commission file number)
DYNEX CAPITAL, INC.
(Exact name of registrant as specified in its charter)
Virginia 52-1549373
(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.)
4551 Cox Road, Suite 300, Glen Allen, Virginia 23060-6740
(Address of principal executive offices) (Zip Code)
(804) 217-5800 (Registrant's
telephone number, including area code)
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
Series D 9.50% Cumulative Convertible New York Stock Exchange
Preferred Stock, $.01 par value
Securities registered pursuant to Section 12(g) of the Act:
None
(Title of class)
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, 2004, 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 28, 2005 was 12,162,391 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Definitive Proxy Statement to be filed pursuant to Regulation
14A within 120 days from December 31, 2004, are incorporated by reference into
Part III.
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DYNEX CAPITAL, INC.
2004 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, Related Stockholder Matters and
Issuer Purchases of Equity Securities...................................................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
Item 9B. Other Information.......................................................................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 and Related
Stockholder Matters.....................................................................31
Item 13. Certain Relationships and Related Transactions..........................................31
Item 14. Principal Accounting Fees and Services..................................................31
PART IV.
Item 15. Exhibits, Financial Statement Schedules.................................................31
SIGNATURES ........................................................................................34
PART I
Item 1. Business
AVAILABLE INFORMATION
---------------------
This annual report on Form 10-K, our quarterly reports on Form 10-Q and
our current reports on Form 8-K, and amendments to those reports filed or
furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of
1934 are made available as soon as reasonably practicable after such material is
electronically filed with or furnished to the Securities and Exchange
Commission, free of charge, through our website. Our website address is
www.dynexcapital.com.
We have adopted a code of conduct that applies to all of our employees,
officers and directors. Our code of conduct is also available, free of charge,
on our website, along with our Audit Committee Charter, our Nominating and
Corporate Governance Committee Charter, and our Compensation Committee Charter.
We will post on our website any amendments to the code or waivers from our code
of conduct, if any, which are applicable to any of our directors or executive
officers.
GENERAL
We were incorporated in the Commonwealth of Virginia in 1987. We are a
financial services company, which has investments 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 we invest have
generally been pooled and pledged to securitization trusts, which issue bonds
collateralized by the assets pledged to the trust. These bonds are non-recourse
to us and are utilized as a means of providing long-term financing for our
investments. The process of pooling investments, creating a securitization trust
and issuing bonds is referred to as securitization. From an economic point of
view, the securitization of collateral limits the credit, interest rate and
liquidity risk resulting from the ownership of the collateral. Assets that have
been pledged as collateral in a securitization transaction are presented in our
financial statements as securitized finance receivables, and the associated
financing is presented as non-recourse securitization financing. Together, the
securitized finance receivables and associated financing are hereinafter
referred to as securitization trusts.
We have elected to be treated as a real estate investment trust (REIT)
for federal income tax purposes under the Internal Revenue Code of 1986, as
amended, and, as such, must distribute substantially all of our taxable income
to shareholders. Provided that we meet all of the prescribed Internal Revenue
Code requirements for a REIT, we will generally not be subject to federal income
tax.
In recent years, we have elected to shrink our investment portfolio,
converting what we deem to be non-core assets into cash, while improving our
overall financial position and flexibility. Our non-core assets currently
include manufactured housing loans and delinquent property tax receivables.
During 2004, we engaged in a number of strategic sales of assets, including the
sale of our delinquent property tax receivables portfolio located in Cuyahoga
County, Ohio for $19.2 million, and the sale of our interest in a manufactured
housing loan securitization trust for $11.9 million. These two sales resulted in
the derecognition of approximately $241.5 million of investments and $226.7
million in securitization financing, at a net gain of $14.3 million. Our
investments at the end of 2004 included approximately $347.7 million of
manufactured housing loans and debt securities, as well as approximately $7.6
million of delinquent property tax receivable securities. We will continue to
attempt to convert these assets to cash, but only at amounts we deem reasonable.
See Business Focus and Strategy below for a discussion of our current and
potential long-term investment strategies.
In May 2004, we completed a recapitalization of our equity capital
structure through the exchange of our outstanding shares of Series A, Series B
and Series C preferred stock into shares of new Series D preferred stock and
common stock. The recapitalization resulted in the elimination or
payment-in-kind of $18.5 million of dividends in arrears and the issuance of
1,288,488 shares of common stock. The shares of Series D preferred stock
automatically convert to 9.50% senior notes if the Company fails to pay two
consecutive quarterly preferred dividends or if the Company fails to maintain
consolidated shareholders' equity of at least 200% of the aggregate issue price
of the Series D preferred stock.
We are currently precluded from paying a dividend on our common stock
under the terms of the Series D Preferred Stock until such time that total
shareholders' equity equals or exceeds 300% of the Series D Preferred Stock
outstanding. We do not anticipate meeting this covenant for the foreseeable
future. Assuming that we properly execute our investment strategy, as indicated
above and as discussed further below, we should be able to compound the returns
on our investable capital as a result of not paying a common dividend. Once the
Series D Preferred Stock covenant is met, we will continually review the payment
of a common dividend to our shareholders, balancing the benefit of retaining and
reinvesting capital with providing the common shareholders a cash distribution
on their investment.
We had net operating loss carryforwards (NOLs) of approximately $149
million at December 31, 2004, which expire beginning in 2018. Unlike other
mortgage REITs, our required REIT income distributions are likely to be limited
well into the future due to the reduction of our future taxable income by these
NOL carryforwards. As a result, we anticipate that we will invest our capital
and compound the returns on such invested capital on an essentially tax-free
basis for the foreseeable future. Over the long-term this will allow us to
increase our book value per common share while potentially utilizing a lower
risk investment strategy than some of our competitors would have to utilize in
order to achieve similar results.
Business Focus and Strategy
- ---------------------------
Our current business strategy is to manage our investment portfolio to
maximize our overall cash flow and earnings in order to improve our financial
flexibility and to position us to be an opportunistic investor in equity and
fixed-income instruments in the future. Our principal source of cash flow and
earnings has historically been the net interest income from our investment
portfolio.
Over the last year, we have elected to sell certain non-core assets,
improving our financial flexibility by converting investments into cash, and we
completed a restructuring of our equity capital while simultaneously eliminating
preferred dividends in arrears. Our focus for 2005 will be similar as we
continue to attempt to sell non-core assets and improve the transparency of our
balance sheet. As we sell non-core assets, we expect that our investment
portfolio will evolve principally into investments in single-family mortgage
loans and securities and commercial mortgage loans. We believe that competitive
pressures overall in the fixed-income markets, the current rising interest-rate
environment, and the fundamental changes in the mortgage market, which have led
to less predictable prepayment patterns and credit loss expectations on
single-family mortgage loans and securities, have diminished current
opportunities to earn acceptable longer-term risk-adjusted returns on newly
invested capital. As a result, we have been investing our capital in short-term,
fixed income instruments of high-credit quality and using modest amounts of
repurchase agreement leverage to increase the returns on our invested capital.
On a longer-term basis, we will continue to evaluate a number of
different investment alternatives. Our Board has formed a committee to review
long-term strategic alternatives for us, and the Board believes that it is in
the best interests of the shareholders to remain an independent company for the
foreseeable future. Because of our NOL carryforwards and our related ability to
compound our capital on a tax-free basis, our return requirements can be less
than our competitors' until our NOL carryforwards are fully utilized. Other
mortgage REITs do not pay taxes but instead must distribute at least 90% of
their taxable income to their shareholders in order to maintain their REIT
status. Upon receiving those distributions, shareholders in other mortgage REITs
must then pay taxes on the distributions, which are generally taxed as
non-qualifying ordinary income. The current maximum Federal rate on ordinary
income is 35%; therefore, for every $1.00 distributed as a dividend of ordinary
income by a mortgage REIT, the investor retains as little as $0.65, after taxes.
In addition, REIT income distribution requirements limit the ability of other
mortgage REITs to retain capital created from organic growth of their investment
portfolios (either through earnings or sales of appreciated investments), which
requires the REITs, therefore, to continually raise capital in the market place
in order to grow its book value and earnings. On the other hand, given our NOL
carryforwards, we can retain the $1.00 earned instead of distributing it,
thereby increasing our book value until the NOL carryforwards are fully
utilized.
In our securitization trusts, we have retained the right to redeem
outstanding securitization financing bonds based on percentages of the original
financing that remains outstanding, or at a certain date. Approximately $217
million in securitization financing outstanding collateralized by approximately
$225 million in single-family loans will be redeemable in March 2005. We intend
to redeem these bonds and either reissue them under new terms or retire them and
securitize the remaining $225 million in loans in a new securitization trust.
INVESTMENT PORTFOLIO
--------------------
The Company primarily invests in loans and securities on single family,
manufactured housing and commercial mortgages. The following section provides
detail on the Company's investments, financing for such investments and the
related risks.
Composition
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The following table presents the composition of the investment
portfolio by investment type and the percentage of total investments each type
represents as of December 31, 2004 and 2003. 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 Statement of
Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain
Investments in Debt and Equity Securities," and are carried at fair value. Other
investments include a security backed by delinquent property tax receivables,
which is classified as available-for-sale and is carried at fair value.
Securities consist of mortgage-related debt securities and an asset-backed
security collateralized by consumer installment loans. Securities are considered
available-for-sale and are carried at fair value. Other loans are carried at
amortized cost.
- --------------------------------------------------- ------------------------------------------------------------------------
As of December 31,
2004 2003
------------------------------------ -----------------------------------
(amounts in thousands) Amount % of Total Amount % of Total
- --------------------------------------------------- ----------------- ------------------ ----------------- -----------------
Investments:
Securitized finance receivables:
Loans $1,036,123 77.1% $1,518,613 81.9%
Debt securities 206,434 15.4 255,580 13.8
Securities 87,706 6.5 33,275 1.8
Other investments 7,596 0.6 37,903 2.0
Other loans 5,589 0.4 8,304 0.5
- --------------------------------------------------- ----------------- ------------------ ----------------- -----------------
Total investments $1,343,448 100.0% $1,853,675 100.0%
- --------------------------------------------------- ----------------- ------------------ ----------------- -----------------
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,
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 a securitization trust to support the repayment of associated
non-recourse securitization financing outstanding. Non-recourse securitization
financing is non-recourse to us 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, we are not obligated to fund the shortfall. Our return
on our 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 our investment in the securitization trust, we generally
retain the net interest income cash flow generated by the securitization trust.
Securities. Securities at December 31, 2004 include fixed-rate mortgage
securities consisting of mortgage-related debt securities with a recorded
balance of $79.1 million that have a fixed-rate of interest over their remaining
life, an asset-backed security with a recorded balance of $0.4 million
collateralized by consumer installment loans and equity securities with a
recorded balance of $7.4 million. Except for the equity securities, the yields
on the above referenced securities are affected primarily by changes in
prepayment rates on the underlying mortgage and consumer loans. The equity
security represents an investment in another mortgage REIT.
Other Investments. Other investments include our remaining investment
in delinquent property tax securities and receivables (collectively, the
delinquent property tax receivable portfolio). During the third quarter of 2004,
we sold all of our rights, title and interest in our delinquent property tax
receivable portfolio and servicing operation located in Cuyahoga County, Ohio to
a third party for $19.2 million. Of this amount, $0.7 million is being held in
escrow for up to one year for customary representations and warranties.
Other Loans. As of December 31, 2004, 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.
Financing For Our Investment Portfolio
- --------------------------------------
Securitization Trusts. Our 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 our assets
(securitized finance receivables), and the non-recourse securitization financing
is treated as our debt. We earn the net interest income between the interest
income on the securitized finance receivables and the interest and other
expenses associated with the securitization financing bonds. The net interest
income 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, by changes in
short-term interest rates. We typically retain the overcollateralization tranche
of the securitization trust. Overcollateralization is essentially the equity
investment in the trust and represents the excess of the collateral pledged over
the securitization financing bonds outstanding. We analyze our investment in
securitization financing based on our overcollateralization investment (which is
commonly referred to as our "net investment", as further discussed below). The
ownership of the overcollateralization tranche subjects us to credit risk. See
Investment Portfolio Risks - Credit Risk, below.
Master Servicing. As well as being the issuer of the securitization
financing bonds, we also master service most of the associated securitization
trusts. Our function as master servicer typically includes monitoring and
reconciling the loan payments remitted by the primary 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 primary servicers'
compliance with servicing guidelines. At December 31, 2004, as master servicer,
we monitored the performance of four third-party servicers of single family
loans, the servicer of one of the series of our securitized commercial mortgage
loan pools, and the servicer of our manufactured housing loans. In our capacity
as master servicer, we are obligated to advance scheduled principal and interest
payments on delinquent loans in accordance with the underlying servicing
agreements should the primary servicer fail to make such advance. As master
servicer, we are paid a monthly fee based on the outstanding principal balance
of each loan for which we act as master servicer. During 2004, we received
approximately $0.1 million of master servicing fees. As of December 31, 2004, we
master serviced $688.7 million in securities.
Investment Portfolio Risks
- --------------------------
We are exposed to several types of risks inherent in our 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. As the result of our ownership of the
overcollateralization portion of the securitization trust, the predominant risk
to us in our investment portfolio is credit risk. Credit risk is the risk of
loss to us from the failure by a borrower (or the proceeds from the liquidation
of the underlying collateral) to fully repay the principal balance and interest
due on a loan. A borrower's ability to repay and the value of the underlying
collateral could be negatively influenced by economic and market conditions.
These conditions could be global, national, regional or local in nature. Upon
securitization of the pool of loans or securities backed by loans, the credit
risk retained by us from an economic point of view is generally limited to the
overcollateralization tranche of the securitization trust. We provide for
estimated losses on the gross amount of loans pledged to securitization trusts
included in our financial statements as required by accounting principles
generally accepted in the United States of America ("GAAP"). As a result, we
establish reserves for loan losses in excess of our retained credit risk as
discussed further in "Non-GAAP Information on Securitized Finance Receivables
and Non-Recourse Securitization Financing" below. In some instances, we may also
retain subordinated bonds from the securitization trust, which increases our
credit risk above the overcollateralization tranche from an economic
perspective. In some instances, cash flow from the trust which otherwise would
be distributed to us as the holder of the overcollateralization tranche may be
retained within the trust if certain performance triggers are not met.
In our securitization trusts, losses of principal and interest from the
liquidation of the underlying loans pledged to the trust are applied first
against the principal balance of the overcollateralization tranche, and in
certain instances, to the cash flow which would otherwise be distributed to the
overcollateralization tranche. If cumulative losses on loans are incurred by the
trust in excess of the principal balance of the overcollateralization tranche,
such losses will then generally be applied against subordinate bonds issued by
the trust. We provide reserves for existing losses based on the current
performance of the respective pool or on an individual loan basis. If losses are
experienced more rapidly due to market conditions than we have provided for in
our reserves, we may be required to provide for additional reserves for these
losses. For debt securities pledged as securitized finance receivables, we
recognize losses when incurred or when such security is deemed to be impaired on
an other-than-temporary basis in accordance with generally accepted accounting
principles.
We also have credit risk on investments that are not securitized or
that are securitized and with respect to which we retain the entire security
issued. Such investments include loans, which are carried at amortized cost less
reserves for estimated losses, and securitized delinquent property tax
receivables, which are carried at fair value.
We also have 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 trust structures. Specifically, as of
December 31, 2004, two separate commercial mortgage loan pools totaling $97.1
million and $103.9 million are subject to loss reimbursement guarantees of $8.0
million and $11.5 million, respectively. The losses on the loans covered by
these loss reimbursement guarantees would have to exceed the respective
guarantee amount before we would incur credit losses. Single family mortgage
loans of $114.3 million pledged to securitization trusts benefit from various
mortgage pool insurance policies, which limit our credit risk until the losses
on the covered loans exceed the remaining stop loss of at least 68% on the
policies. An additional $33.3 million of single family mortgage loans
principally pledged to securitization trusts are subject to various loss
reimbursement agreements totaling $29.5 million with a remaining aggregate
deductible of approximately $0.4 million.
Prepayment/Interest Rate Risk. Our investment in single-family and
commercial mortgage loans and securities and manufactured housing installment
contracts subject us to the risk of early prepayment of principal on these
assets and to interest-rate risk. In a rising rate environment, our net interest
income may be reduced, as the interest cost for our funding sources could
increase more rapidly than the interest earned on the associated asset financed.
To the extent that assets and liabilities are both fixed-rate or adjustable rate
with corresponding payment dates, interest-rate risk may be mitigated. In a
declining interest-rate environment, net interest income may be enhanced as the
interest cost for our funding sources decreases more rapidly than the interest
earned on the associated assets. 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%), adjustable rate mortgage loans and securities tend to rapidly prepay,
causing additional amortization of asset premium. In addition, the spread
between our funding costs and asset yields may compress, causing a further
reduction in our net interest income.
Along with match-funding assets and liabilities, we may, on occasion,
utilize various derivative financial instruments to manage our sensitivity to
changes in interest rates, principally when the Company has financed investments
carrying a fixed rate of interest with floating rate liabilities. As of December
31, 2004, approximately $227.1 million in fixed-rate investments were financed
with floating-rate securitization financing and repurchase agreement financing.
We had entered into an interest-rate swap with a notional balance of $100
million and a maturity date of June 30, 2005 to hedge a portion of this risk.
Margin Call Risk. The Company finances some of its investments,
primarily high credit-quality, liquid securities, with recourse borrowings,
primarily repurchase agreements. These arrangements require the Company to
maintain a certain level of collateral for the related borrowings. If the
collateral should fall below the required level, the repurchase agreement lender
could initiate a margin call. This would require that the Company either pledge
additional collateral acceptable to the lender or repay a portion of the debt in
order to meet the margin requirement. Should the Company be unable to meet a
margin call, it might have to liquidate the collateral or other assets quickly.
Because a margin call and quick sale could result in a lower than otherwise
expected and attainable sale price, the Company could be unable to achieve its
anticipated results in the event of a margin call.
Non-GAAP Information on Securitized Finance Receivables and
Non-Recourse Securitization Financing
- -----------------------------------------------------------
As previously discussed, we finance our securitized finance receivables
through the issuance of non-recourse securitization financing bonds. In our
consolidated financial statements we present 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 our general obligation, the risk on our investment in
securitized finance receivables from an economic point of view is limited to our
net retained investment in the securitization trust, as previously discussed.
However, GAAP requires, and our financial statements reflect, reserves for loan
losses on all of the loans pledged as collateral on securitization financings,
which resulted in our providing for loan losses of a cumulative $1.1 million as
of December 31, 2004 in which we do not retain the credit risk. 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 our net investment. We believe this
information is useful to investors in understanding the risks to which our
business and cash flows are subject. We generally have sold the investment grade
classes of the securitization financing to third parties and have retained the
portion of the securitization financing that is below investment grade,
generally consisting of the overcollateralization tranche. We estimate the fair
value of our net investment in securitized finance receivables as the present
value of the projected cash flow from the collateral, adjusted for the impact
and assumed level of future prepayments and credit losses, less the projected
principal and interest due on the bonds owned by third parties. We master
service four of the securitization trusts. Structured Asset Securitization
Corporation (SASCO) Series 2002-9 and CCA One Series 2 and Series 3 are
master-serviced by other parties. Monthly payment reports for those securities
master-serviced by us may be found on our website at www.dynexcapital.com.
Below is a summary, as of December 31, 2004, of our net investment in
securitized finance receivables by series where the fair value exceeds $0.5
million. The following tables show our 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 table below is not intended to present our
investment in securitized finance receivables or the non-recourse securitization
financing in accordance with generally accepted accounting principles. A
reconciliation of the amounts included in the table to our consolidated
financial statements is provided below the following table.
- -----------------------------------------------------------------------------------------------------------------------------
(amounts in thousands)
Principal Principal Principal Amortized
Balance Balance of Balance Cost Basis
Of Bonds Of Of
Securitization Collateral Outstanding to Net Net
Trust (1) Collateral Type Pledged Third Parties Investment(2) Investment(3)
- -----------------------------------------------------------------------------------------------------------------------------
MERIT Series 11 Securities backed by $ 215,169 $ 188,094 $ 27,075 $ 13,160
single-family mortgage and
manufactured housing loans
MERIT Series 12 Manufactured housing loans 198,246 185,764 12,482 2,508
SASCO 2002-9 Single family mortgage loans 225,055 217,142 7,913 11,735
MCA Series 1 Commercial mortgage loans 69,923 65,205 4,718 794
CCA One Series 2 Commercial mortgage loans 218,953 196,850 22,103 12,565
CCA One Series 3 Commercial mortgage loans 351,214 310,267 40,947 48,899
- -----------------------------------------------------------------------------------------------------------------------------
$ 1,278,560 $1,163,322 $ 115,238 $ 89,661
- -----------------------------------------------------------------------------------------------------------------------------
(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 us. SASCO stands for
Structured Asset Securitization Corporation.
(2) Calculated as the amount by which the principal balance of the collateral
pledged exceeds the principal of the related bonds outstanding to third
parties.
(3) Represents the net investment plus or minus the related premiums, discounts
and related costs.
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.
- ----------------------------------------------------------------------------------------------------------------------------
Securitized Non-recourse
Finance Securitization
(amounts in thousands) Receivables Financing
- ----------------------------------------------------------------------------------------------------------------------------
Principal balances per the above table $ 1,278,560 $ 1,163,322
Principal balance of security excluded from above table 2,600 2,586
Recorded impairments on debt securities (15,596) -
Discounts and premiums, net (2,980) 6,135
Unrealized gain 1,064 -
Accrued interest and other 6,923 5,237
Allowance for loan losses (28,014) -
- ----------------------------------------------------------------------------------------------------------------------------
Balance per consolidated financial statements $ 1,242,557 $ 1,177,280
- ----------------------------------------------------------------------------------------------------------------------------
The following table summarizes the fair value of our net investment in
securitized finance receivables, the various assumptions made in estimating
value and the cash flow related to those net investments during 2004. As we do
not present our investment in securitized finance receivables on a net
investment basis in our consolidated financial statements, the table below is
not meant to present our investment in the securitization trust in accordance
with GAAP.
- ----------------------------------------------------------------------------------------------------------------------------
Fair Value Assumptions ($ in thousands)
------------------------------------------------------------------------------------------------------
Cash flows
Securitization Weighted-average Projected cash flow Fair value of net received in
Trust prepayment speeds Losses termination date investment (1) 2004, net (2)
- ----------------------------------------------------------------------------------------------------------------------------
MERIT Series 11 30% CPR on 4.0% annually Anticipated final $ 10,149 $ 11,581
Single-Family on MH loans maturity in 2025
securities; 7% CPR
on Manufactured
Housing securities
MERIT Series 12 8% CPR 3.5% annually Anticipated final 706 1,061
on MH loans maturity in 2027
SASCO 2002-9 30% CPR 0.1% annually Anticipated call 12,254 9,531
date in 2005
MCA One Series 1 (3) 1.0% annually Anticipated final 2,729 1,301
maturity in 2018
CCA One Series 2 (4) 0.8% annually Anticipated call 12,512 1,726
date in 2011
CCA One Series 3 (4) 1.2% annually Anticipated call 21,611 1,578
date in 2009
- ----------------------------------------------------------------------------------------------------------------------------
$ 59,961 $ 26,778
- ----------------------------------------------------------------------------------------------------------------------------
(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, 2004, and incorporate the resetting of the
interest rates on the adjustable rate assets to a level consistent with
projected prevailing rates. Increases or decreases in interest rates and
index levels from those used would impact the calculation of fair value, as
would differences in actual prepayment speeds and credit losses versus the
assumptions set forth above.
(2) Represents 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 estimated fair value of our net
investment in the securitization trust. In our consolidated financial
statements, we carry our investments at amortized cost, except for our
investment in MERIT Series 11, which is carried at its estimated fair value.
Including recorded allowance for losses of $28.0 million, our net investment in
securitized finance receivables as reported in our consolidated financial
statements is approximately $61.6 million. This amount compares to an estimated
fair value, utilizing a discount rate of 16%, of approximately $60.0 million, as
set forth in the table above.
The following table compares the fair value of our investments in
securitized finance receivables at various discount rates but otherwise uses the
same assumptions as set forth in the above table:
- ----------------------------------------------------------------------------------------------------------------------------
Fair Value of Net Investment
----------------------------
(amounts in thousands)
Securitization Trust 12% 16% 20% 25%
- ----------------------------------------------------------------------------------------------------------------------------
MERIT Series 11A $ 11,993 $ 10,149 $ 8,794 $ 7,538
MERIT Series 12-1 626 706 750 777
SASCO 2002-9 13,956 12,254 10,948 9,695
MCA One Series 1 3,305 2,729 2,281 1,856
CCA One Series 2 14,965 12,512 10,548 8,624
CCA One Series 3 24,857 21,611 18,842 15,940
- ----------------------------------------------------------------------------------------------------------------------------
$ 69,702 $ 59,961 $ 52,163 $ 44,430
- ----------------------------------------------------------------------------------------------------------------------------
FEDERAL INCOME TAX CONSIDERATIONS
---------------------------------
General
- -------
We believe that we have complied with the requirements for
qualification as a REIT under the Internal Revenue Code (the "Code"). As such,
we believe that we qualify as a REIT for federal income tax purposes, and we
generally will not be subject to federal income tax on the amount of our income
or gain that is distributed as dividends to shareholders. We use the calendar
year for both tax and financial reporting purposes. There may be differences
between taxable income and income computed in accordance with GAAP. These
differences primarily arise from timing differences in the recognition of
revenue and expense for tax and GAAP purposes. Our estimated net taxable loss
for 2004, excluding net operating losses carried forward from prior years, was
$6.3 million, comprised of ordinary loss of $13.3 million and capital gain of
$7.0 million. We currently have tax operating loss carryforwards of
approximately $149 million. The $149 million in net operating loss carryforwards
expire between 2018 and 2024. We do not have any meaningful remaining amounts of
capital loss carryforward at the end of 2004. We also had excess inclusion
income of $1.4 million. REIT rules require that we distribute all of our excess
inclusion income as discussed below.
The REIT rules generally require that a REIT invest primarily in real
estate-related assets, that our activities be passive rather than active and
that we distribute annually to our shareholders substantially all of our taxable
income. We could be subject to income tax if we failed to satisfy those
requirements or if we acquired certain types of income-producing real property.
Although no complete assurances can be given, we do not expect that we will be
subject to material amounts of such taxes.
Failure to satisfy certain Code requirements could cause us to lose our
status as a REIT. If we failed to qualify as a REIT for any taxable year, we may
be subject to federal income tax (including any applicable alternative minimum
tax) at regular corporate rates and would not receive deductions for dividends
paid to shareholders. We could utilize loss carryforwards to offset any taxable
income. In addition, given the size of our tax loss carryforwards, we could
pursue a business plan in the future in which we would voluntarily forego our
REIT status. If we lost our status as REIT, we could not elect REIT status again
for five years.
Qualification of Us As A REIT
- -----------------------------
Qualification as a REIT requires that we satisfy a variety of tests
relating to our income, assets, distributions and ownership. The significant
tests are summarized below.
Sources of Income. To continue qualifying as a REIT, we must satisfy
two distinct tests with respect to the sources of our income: the "75% income
test" and the "95% income test." The 75% income test requires that we derive at
least 75% of our gross income (excluding gross income from prohibited
transactions) from certain real estate-related sources. In order to satisfy the
95% income test, 95% of our gross income for the taxable year must consist
either of income that qualifies under the 75% income test or certain other types
of passive income.
If we fail to meet either the 75% income test or the 95% income test,
or both, in a taxable year, we might nonetheless continue to qualify as a REIT,
if our failure was due to reasonable cause and not willful neglect and the
nature and amounts of our items of gross income were properly disclosed to the
Internal Revenue Service. However, in such a case we would be required to pay a
tax equal to 100% of any excess non-qualifying income.
Nature and Diversification of Assets. At the end of each calendar
quarter, three asset tests must be met by us. Under the 75% asset test, at least
75% of the value of our total assets must represent cash or cash items
(including receivables), government securities or real estate assets. Under the
"10% asset test," we may not own more than 10% of the outstanding voting
securities of any single non-governmental issuer, provided such securities do
not qualify under the 75% asset test or relate to taxable REIT subsidiaries.
Under the "5% asset test," ownership of any stocks or securities that do not
qualify under the 75% asset test must be limited, in respect of any single
non-governmental issuer, to an amount not greater than 5% of the value of the
total assets of us.
If we inadvertently fail to satisfy one or more of the asset tests at
the end of a calendar quarter, such failure would not cause us to lose our REIT
status, provided that (i) we satisfied all of the asset tests at the close of a
preceding calendar quarter and (ii) the discrepancy between the values of our
assets and the standards imposed by the asset tests either did not exist
immediately after the acquisition of any particular asset or was not wholly or
partially caused by such an acquisition. If the condition described in clause
(ii) of the preceding sentence was not satisfied, we still could avoid
disqualification by eliminating any discrepancy within 30 days after the close
of the calendar quarter in which it arose.
Distributions. With respect to each taxable year, in order to maintain
our REIT status, we generally must distribute to our shareholders an amount at
least equal to 90% of the sum of our "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. REIT taxable income may be offset by our tax net
operating loss carryforwards. At a minimum, we must distribute 100% of our
excess inclusion income (defined below), if any.
Ownership. In order to maintain our REIT status, we must not be deemed
to be closely held and must have more than 100 shareholders. The closely held
prohibition requires that not more than 50% of the value of our outstanding
shares be owned by five or fewer persons at anytime during the last half of our
taxable year. The more than 100 shareholders rule requires that we have at least
100 shareholders for 335 days of a twelve-month taxable year. In the event that
we failed to satisfy the ownership requirements we would be subject to fines and
be required to take curative action to meet the ownership requirements in order
to maintain our REIT status.
For federal income tax purposes, we are required to recognize income on
an accrual basis and to make distributions to our 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 us. The nature of our investments, coupled with our tax loss carryforwards,
is such that we expect to have sufficient assets to meet federal income tax
distribution requirements.
Taxation of Distributions
- -------------------------
By maintaining our 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 our current or accumulated
earnings and profits will be dividends taxable as ordinary income. Distributions
in excess of our 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 or
her 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
our ordinary or capital losses. Distributions to shareholders attributable to
"excess inclusion income" will be characterized as excess inclusion income in
the hands of the shareholders. Excess inclusion income can arise from our
holdings of residual interests in real estate mortgage investment conduits and
in certain other types of mortgage-backed security structures. 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
carryforwards. In the event that our excess inclusion income is greater than our
taxable income, our distribution requirement would be based on our excess
inclusion income. Dividends paid by us 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 was
financed by "acquisition indebtedness" or (ii) such dividends constitute excess
inclusion income. In 2004, we declared and paid dividends on our Series D
preferred stock equal to approximately $2.6 million, of which $1.4 million
represented excess inclusion income and $1.2 million return of capital. We
declared a dividend on our Series D preferred stock in December 2004, which was
paid in January 2005 and which will be used by us for our 2005 REIT distribution
requirements.
Taxable Income
- --------------
We use the calendar year for both tax and financial reporting purposes.
However, there may be differences between taxable income and income computed in
accordance with 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
----------
Our existing consumer-related servicing activities consist of
collections on the delinquent property tax receivables. We believe that such
servicing operations are managed in compliance with the Fair Debt Collections
Practices Act.
We believe that we are in material compliance with all material rules
and regulations to which we are subject.
COMPETITION
-----------
The financial services industry is a highly competitive market in which
we compete with a number of institutions with greater financial resources. In
purchasing portfolio investments and in issuing securities, we compete with
other mortgage REITs, investment banking firms, savings and loan associations,
commercial banks, mortgage bankers, insurance companies, federal agencies,
foreign investors, and other entities, many of which have greater financial
resources and a lower cost of capital than we do. Increased competition in the
market and our competitors' greater financial resources have adversely affected
the Company's ability to invest its capital on an acceptable risk-adjusted
basis, and may continue to do so. Competition may also continue to keep pressure
on spreads resulting in the Company being unable to reinvest its capital at an
acceptable risk-adjusted basis.
EMPLOYEES
---------
As of December 31, 2004, we had 34 employees. Our relationship with our
employees is good. None of our employees are covered by any collective
bargaining agreements, and we are not aware of any union organizing activity
relating to our employees.
Item 2. Properties
Our executive and administrative offices and operations offices are
both located in Glen Allen, Virginia, on properties leased by us. The address is
4551 Cox Road, Suite 300, Glen Allen, Virginia 23060. As of December 31, 2004,
we leased 11,194 square feet. The lease, which originally expired in May 2005,
was amended subsequent to December 31, 2004 to reduce the square footage
occupied from 11,194 square feet to 8,244 square feet, and reduce the lease rate
per square foot. The term of the lease was extended to May 2008.
We also own and lease space located in the Pittsburgh, Pennsylvania
metropolitan area. These locations consist of approximately 14,039 square feet,
4,039 square feet of which we lease, and the leases associated with these
properties expire in 2005. Subsequent to December 31, 2004, the lease on
approximately 3,200 square feet was terminated early for a payment equal to four
months rent.
We believe that our properties are maintained in good operating
condition and are suitable and adequate for our purposes.
Item 3. Legal Proceedings
We and our 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, we believe, based on current knowledge, that
the resolution of these matters will not have a material adverse effect on our
financial position or results of operations. Information on litigation arising
out of the ordinary course of business is described below.
GLS Capital, Inc. ("GLS"), one of our subsidiaries, 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 enacted a law 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. Subsequent to the enactment of the law,
challenges to the retroactivity provisions of the law were filed in separate
cases, which did not include GLS as a defendant. In September 2004, the trial
court in that litigation upheld the retroactive provisions enacted in 2003.
Plaintiffs in the case are seeking class action status and have not currently
set forth a damage claim. A hearing on the class-action status is currently set
for late April 2005. We believe that the ultimate outcome of this litigation
will not have a material impact on our financial condition, but may have a
material impact on reported results for the particular period presented.
We and Dynex Commercial, Inc. ("DCI"), formerly an affiliate of ours
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 us as a defendant. The complaint, which was further amended
during pretrial proceedings, alleged that, among other things, DCI and we failed
to fund tenant improvement or other advances allegedly required on various loans
made by DCI to BCM, which loans were subsequently acquired by us; that DCI
breached an alleged $160 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 us on the alleged breach of the loan agreements for tenant
improvements and awarded that Plaintiff damages in the amount of $0.25 million.
The jury entered a separate verdict against DCI in favor of BCM under two
mutually exclusive damage models, for $2.2 million and $25.6 million,
respectively. The jury found in favor of DCI on the alleged $9 million loan
commitment, but did not find in favor of DCI for counterclaims made against BCM.
The jury also awarded the Plaintiffs attorneys' fees in the amount of $2.1
million. After considering post-trial motions, the presiding judge entered
judgment in favor of us and DCI, effectively overturning the verdicts of the
jury and dismissing damages awarded by the jury. Plaintiffs have filed an
appeal. DCI is a former affiliate, and we believe that we will have no
obligation for amounts, if any, awarded to the Plaintiffs as a result of the
actions of DCI.
On February 11, 2005, we became a defendant in a lawsuit filed in
United States District Court for the Southern District of New York by the
Teamsters Local 445 Freight Division Pension Fund. The allegations include
securities laws violations in connection with the issuance in August 1999 by our
subsidiary and co-defendant, MERIT Securities Corporation, of our MERIT Series
13 securitization financing bonds, which are collateralized by manufactured
housing loans. The suit also alleges fraud and negligent misrepresentations in
connection with the MERIT Series 13 issuance. We are currently evaluating the
allegations made in the lawsuit and intend to vigorously defend ourselves
against them.
Although no assurance can be given with respect to the ultimate outcome
of the above litigation, we believe the resolution of these lawsuits will not
have a material effect on our consolidated balance sheet, but could materially
affect our consolidated results of operations in a given year.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of our shareholders during the
fourth quarter of 2004.
PART II
-------
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and
Issuer Purchases of Equity Securities
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 1,810 holders of record and beneficial holders who hold common
stock in street name as of December 31, 2004. During the last two years, the
high and low closing stock prices and cash dividends declared on common stock
were as follows:
- ----------------------------------------------------------------------------------------------------------------------------
High Low Cash Dividends Declared
- ----------------------------------------------------------------------------------------------------------------------------
2004:
First quarter $ 7.65 $ 6.15 $ -
Second quarter 7.71 6.35 -
Third quarter 7.24 6.48 -
Fourth quarter 7.83 6.70 -
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 -
- ----------------------------------------------------------------------------------------------------------------------------
Dividends declared by the Board of Directors have generally been for
the purpose of maintaining the Company's REIT status, and in compliance with
requirements set forth at the time of the issuance of the Series D Preferred
Shares. The quarterly dividend on Series D Preferred Shares is $0.2375 per
share. In accordance with the terms of the Series D Preferred Shares, if the
Company fails to pay two consecutive quarterly preferred dividends or if the
Company fails to maintain consolidated shareholders' equity of at least 200% of
the aggregate issue price of the Series D preferred stock, then these shares
automatically convert into a new series of 9.50% senior notes. Dividends for the
preferred stock must be fully paid before dividends can be paid on common stock.
No common dividends have been paid since 1998. See Federal Income Tax
Considerations in Item 1 above.
The Company did not repurchase any of its equity securities during the
fourth quarter of 2004.
Item 6. Selected Financial Data
- ------------------------------------------------------------------------------------------------------------------------------
Years ended December 31, 2004 2003 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------
(amounts in thousands except share and per share data)
Net interest income(1) $ 23,281 $ 38,971 $ 49,153 $ 48,082 $ 31,487
Net interest income after provision for loan losses(1) 4,818 1,889 20,670 28,410 2,377
Impairment charges(2) (14,756) (16,355) (18,477) (43,439) (84,039)
Other (expense) income and trading losses(3) (179) 436 1,397 7,876 (1,489)
General and administrative expenses (7,748) (8,632) (9,493) (10,526) (8,712)
Net loss $ (3,375) $ (21,107) $ (9,360) $ (21,209) $ (91,863)
Net loss to common shareholders $ (5,194) $ (14,260) $ (18,946) $ (13,492) $(104,774)
Net loss per common share:
Basic & diluted $ (0.46) $ (1.31) $ (1.74) $ (1.18) $ (9.15)
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 -
Series D Preferred 0.6993 - - - -
- ------------------------------------------------------------------------------------------------------------------------------
December 31, 2004 2003 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------
Investments(4) $1,343,448 $1,853,675 $2,185,746 $2,511,229 $3,148,667
Total assets(4) 1,400,934 1,865,235 2,205,735 2,531,509 3,195,354
Non-recourse securitization financing(4) 1,177,280 1,679,830 1,980,702 2,225,863 2,812,161
Recourse debt 70,468 33,933 - 58,134 134,168
Total liabilities(4) 1,252,168 1,715,389 1,982,314 2,289,399 2,957,898
Shareholders' equity 148,766 149,846 223,421 242,110 237,456
Number of common shares outstanding 12,162,391 10,873,903 10,873,903 10,873,853 11,446,206
Average number of common shares 11,272,259 10,873,903 10,873,871 11,430,471 11,445,236
Book value per common share(5) $ 7.60 $ 7.55 $ 8.57 $ 11.06 $ 7.39
- ------------------------------------------------------------------------------------------------------------------------------
(1) Net interest income after provision for loan losses increased due to a
reduction in the manufactured housing loan loss provision associated with
the derecognition of the MERIT Series 13 securitization.
(2) Impairment charges for the year ended December 31, 2000 included several
adjustments related largely to non-recurring items.
(3) Other (expense) income for 2000 included our equity in the net loss of
Dynex Holding, Inc. which was liquidated at the end of 2000.
(4) Certain deferred hedging gains and losses for 2002 and prior years were
reclassified from securitized finance receivables to non-recourse
securitization financing.
(5) Inclusive of the effects of the liquidation preference on the Company's
preferred stock.
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 principally consisting of, or secured by, 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
owners on its investment in delinquent property tax receivables. The Company
manages the cash flow on these investments to maximize shareholders' value.
In May 2004, the Company completed a recapitalization of its equity
capital structure through the restructuring of its outstanding shares of Series
A, Series B and Series C preferred stock, resulting in the exchange of 5,628,727
shares of Series D preferred stock and 1,288,488 shares of common stock for the
shares of Series A, Series B and Series C preferred stock. The Series D
preferred stock has an issue price of $10 per share, is convertible into one
share of common stock and has the right to receive a quarterly dividend of
$0.2375 per share.
During 2003, the Company completed a tender offer for its Series A,
Series B and Series C preferred stock resulting in a preferred stock benefit of
$6.8 million. The Company purchased and retired $51.6 million shares of Series
A, Series B and Series C preferred stock in 2003. The resulting 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.
The following discussion provides information about the major
components of the results of operations and financial condition, liquidity, and
capital resources of the Company. This discussion and analysis should be read in
conjunction with the Company's Consolidated Financial Statements and Notes to
Consolidated Financial Statements. It should also be read in conjunction with
the "Caution About Forward Looking Statements" section at the end of this
discussion.
CRITICAL ACCOUNTING POLICIES
----------------------------
The discussion and analysis of the Company's financial condition and
results of operations are based in large part upon its consolidated financial
statements, which have been prepared in conformity with accounting principles
generally accepted in the United States of America. The preparation of the
financial statements requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenue and expenses during the reported period. Actual
results could differ from those estimates.
Critical accounting policies are defined as those that are reflective
of significant judgments or uncertainties, and which may result in materially
different results under different assumptions and conditions, or the application
of which may have a material impact on the Company's financial statements. The
following are the Company's critical accounting policies.
Consolidation of Subsidiaries. The consolidated financial statements
represent the Company's accounts after the elimination of inter-company
transactions. The Company consolidates entities in which it owns more than 50%
of the voting equity and control of the entity does not rest with others. The
Company follows the equity method of accounting for investments with greater
than 20% and less than a 50% interest in partnerships and corporate joint
ventures or when it is able to influence the financial and operating policies of
the investee but owns less than 50% of the voting equity. For all other
investments, the cost method is applied.
Impairments. The Company evaluates all securities in its investment
portfolio for other-than-temporary impairments. A security is generally defined
to be other-than-temporarily impaired if, for a maximum period of three
consecutive quarters, the carrying value of such security exceeds its estimated
fair value and the Company estimates, based on projected future cash flows or
other fair value determinants, that the fair value will remain below the
carrying value for the foreseeable future. If an other-than-temporary impairment
is deemed to exist, 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 generally considered to be other-than-temporary when the fair
value remains below the carrying value for three consecutive quarters. If the
impairment is determined to be other-than-temporary, an impairment charge is
recorded in order to adjust the carrying value of the investment to its
estimated value.
Allowance for Loan Losses. The Company has credit risk on loans pledged
in securitization financing transactions and classified as securitized finance
receivables in its investment portfolio. An allowance for loan losses has been
estimated and established for currently existing probable losses. Factors
considered in establishing an allowance include current loan delinquencies,
historical cure rates of delinquent loans, and historical and anticipated loss
severity of the loans as they are liquidated. The allowance for loan losses is
evaluated and adjusted periodically by management based on the actual and
estimated timing and amount of probable credit losses, using the above factors,
as well as industry loss experience. Where loans are considered homogeneous, the
allowance for losses is established and evaluated on a pool basis. Otherwise,
the allowance for losses is established and evaluated on a loan-specific basis.
Provisions made to increase the allowance are a current period expense to
operations. 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 an individual basis for impairment. Generally, a commercial loan with a debt
service coverage ratio of less than one is considered impaired. However, based
on a commercial loan's details, commercial loans with a debt service ratio less
than one may not be considered impaired; conversely, commercial loans with a
debt service coverage ratio greater than one may be considered impaired. Certain
of the commercial mortgage loans are covered by loan guarantees that limit the
Company's exposure on these loans. The level of allowance for loan losses
required for these loans is reduced by the amount of applicable loan guarantees.
The Company's actual credit losses may differ from the estimates used to
establish the allowance.
FINANCIAL CONDITION
-------------------
Below is a discussion of the Company's financial condition.
- ---------------------------------------------------------------------------------------
December 31,
---------------------------------
(amounts in thousands except per share data) 2004 2003
- ---------------------------------------------------------------------------------------
Investments:
Securitized finance receivables:
Loans, net $1,036,123 $1,518,613
Debt securities 206,434 255,580
Securities 87,706 33,275
Other investments 7,596 37,903
Other loans 5,589 8,304
Non-recourse securitization financing 1,177,280 1,679,830
Repurchase agreements 70,468 23,884
Senior notes - 10,049
Shareholders' equity 148,766 149,846
Book value per common share (inclusive of preferred
stock liquidation preference) $7.60 $7.55
- ---------------------------------------------------------------------------------------
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 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. The securitized
finance receivables decreased to $1.24 billion at December 31, 2004 from $1.77
billion at December 31, 2003. This decrease of $531.6 million is primarily the
result of $286.2 million in principal pay-downs, the derecognition of $219.2
million of manufactured housing loans associated with the sale of the call
rights on the related securitization trust, $18.5 million of decreased allowance
for loan losses, net, $9.1 million of impairment charges recorded on debt
securities and decreases in accrued interest payable of $4.7 million. These
decreases were partially offset by an increase in the unrealized gains and
premiums of $3.5 million and $0.8 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. The allowance for loan losses
decreased primarily as a result of the sale of the manufactured housing loans
and charge-offs during the year on the manufactured housing and commercial loans
exceeding the provisions on such loans. Impairment charges resulted from
other-than-temporary decreases in market value on debt securities backed by
manufactured housing loan collateral.
Securities
- ----------
Securities increased to $87.7 million at December 31, 2004 compared to
$33.3 million at December 31, 2003, primarily as a result of the purchases of a
$62.1 million debt security and a $4.9 million equity security and a $1.1
million net increase in market value of available-for-sale securities. These
increases were partially offset by principal payments of $13.2 million during
the year and the sale of equity securities with a balance of $0.5 million.
Other Investments
- -----------------
Other investments at December 31, 2004 and 2003 consist primarily of
delinquent property tax receivables, a security collateralized by delinquent
property tax receivables, and the associated real estate owned. Other
investments decreased to $7.6 million at December 31, 2004 compared to $37.9
million at December 31, 2003. This decrease of $30.3 million resulted from the
sale of a portfolio of tax lien receivables located in Ohio portfolio with a
basis of $22.3 million, payments of $5.7 million collected in 2004 and applied
against the carrying value of the investment, $1.0 million in sales of related
real estate owned, and a $4.9 million other-than-temporary impairment charge.
These decreases were partially offset by increases related to foreclosure
advances made of $1.5 million and the purchase of new receivables of
approximately $2.7 million, which were substantially sold in the Ohio tax lien
portfolio sale described above.
Other Loans
- -----------
Other loans decreased to $5.6 million at December 31, 2004 from $8.3
million at December 31, 2003 due primarily to payments received on the loans of
$2.9 million.
Non-recourse Securitization Financing
- -------------------------------------
Non-recourse securitization financing decreased to $1.18 billion at
December 31, 2004 from $1.68 billion at December 31, 2003. This decrease was
primarily a result of principal payments received of $286.2 million on the
associated collateral pledged which were used to pay down the securitization
financing in accordance with the respective indentures, the derecognition of
$226.7 million of non-recourse securitization financing as a result of the sale
of the call rights on the related securitization trust as described above, and a
$2.2 million decrease of accrued interest payable. Offsetting these decreases
was the receipt of $7.4 million from the redemption and reissuance of
approximately $226.7 million in bonds outstanding, and net amortization of
approximately $3.9 million of bond discounts and issuance and hedging costs.
Repurchase Agreements
- ---------------------
In December 2004, the Company entered into a $56.6 million repurchase
agreement to finance the purchase of approximately $62.0 million of fixed-rate
securities. This increase was partially offset by net repayments of $10.0
million on repurchase agreement borrowings during 2004.
Senior Notes
- ------------
The $10.0 million of February 2005 Senior Notes outstanding as of
December 31, 2003 were paid in March 2004.
Shareholders' Equity
- --------------------
Shareholders' equity decreased from $149.8 million at December 31, 2003
to $148.8 million at December 31, 2004. This decrease of $1.0 million resulted
from a net loss of $3.4 million, a net decrease of $1.5 million resulting from
the shares tendered for senior notes in connection with the recapitalization
transaction completed in May 2004 and dividends declared on shares of Series D
Preferred Stock of $3.9 million. These decreases were partially offset by an
increase in accumulated other comprehensive income of $7.7 million which
resulted principally from the increase in fair value of debt and equity
securities of $4.7 million, and an increase of $3.0 million on interest-rate
swap and synthetic interest-rate swap contracts from the realization of losses
on settled contracts and deferred gains on the remaining hedge contracts.
RESULTS OF OPERATIONS
---------------------
- ------------------------------------------------------------------------------------------------------------------------
For the Year Ended December 31,
------------------------------------------------------
(amounts in thousands except per share information) 2004 2003 2002
- ----------------------------------------------------------------------------------- ------------------ -----------------
Net interest income $ 23,281 $ 38,971 $ 49,153
Provision for loan losses (18,463) (37,082) (28,483)
Net interest income after provision for loan losses 4,818 1,889 20,670
Impairment charges (14,756) (16,355) (18,477)
Gain (loss) on sales of investments 14,490 1,555 (150)
General and administrative expenses (7,748) (8,632) (9,493)
Net loss (3,375) (21,107) (9,360)
Preferred stock (charge) benefit (1,819) 6,847 (9,586)
Net loss to common shareholders $ (5,194) $ (14,260) $ (18,946)
Basic & diluted net loss per common share $ (0.46) $ (1.31) $ (1.74)
Dividends declared per share:
Common $ - $ - $ -
Series A and B Preferred - 0.8775 0.2925
Series C Preferred - 1.0950 0.3651
Series D Preferred 0.6993 - -
- ------------------------------------------------------------------------------------------------------------------------
2004 Compared to 2003
- ---------------------
Net loss decreased in 2004 by $17.7 million, to $3.4 million in 2004
from a loss of $21.1 million in 2003, as a result of an increase in net interest
income after provision for loan losses of $2.9 million and an increase in gain
on sales of investments of $12.9 million. Net loss to common shareholders
decreased by $9.1 million in 2004, from $14.3 million in 2003 to $5.2 million in
2004. The improvement in net loss to common shareholders was due to reduced net
loss of $17.7 million, offset by the reduction in preferred stock benefit of
$8.7 million. The preferred stock benefit in 2003 resulted from the effects of a
tender offer on the outstanding preferred stock completed in 2003 as compared to
the net effect of the recapitalization of the preferred stock in 2004 and 2004
preferred stock dividends.
Net interest income for the year ended December 31, 2004 decreased to
$23.3 million, from $39.0 million for the same period in 2003. Net interest
income decreased $15.7 million, or 40.3%, as a result of a decline in average
interest-earning assets and a decrease in the net interest spread on
interest-earning assets. Net interest spread decreased in 2003 as a result of
prepayments of higher coupon assets, the proceeds of which have been reinvested
in lower-yielding cash equivalents, and also decreased due in part to increasing
borrowing costs from both increasing LIBOR rates and repayment of lower-cost
securitization financing bonds pursuant to the terms of the securitization
trust. See further discussion below as to changes in the net interest spread on
the Company's investment portfolio during 2004.
Net interest income after provision for loan losses increased as a
result of the decline of the provision for loan losses in 2004 compared to 2003
of $18.6 million. Provision for loan losses decreased to $18.5 million in 2004,
from $37.1 million in 2003. The decrease of $18.6 million from 2003 was
primarily due to $14.4 million of provision for loan losses recorded during the
second quarter of 2003 specifically for currently existing credit losses within
outstanding manufactured housing loans that were current as to payment but which
the Company had determined to be impaired. The remaining $4.2 million of the
decrease was primarily due to a decrease in the estimated losses on commercial
and manufactured housing loans.
Impairment charges decreased from $16.4 million in 2003 to $14.8
million in 2004. Impairment charges in 2004 included $9.1 million on a debt
security collateralized by manufactured housing loans and $4.9 million on a debt
security collateralized by delinquent property tax receivables.
Other-than-temporary impairment charges were recorded as a result of the
carrying value of the debt securities referenced above exceeded their estimated
fair value and the Company determined that the carrying value would likely
exceed the fair value for the foreseeable future. Impairment charges for 2003
included $5.5 million on manufactured housing loan securities and $10.4 million
on delinquent property tax receivable securities.
Gain on sale of investments for 2004 included a $17.6 million gain from
the sale of securitized finance receivables with a carrying value of $219.2
million, net of allowance for loan losses of $16.2 million, and the
de-recognition of the associated securitization financing bonds with a carrying
amount of $226.7 million. The Company received a net $11.9 million in proceeds
from the sale of these receivables. This gain was partially offset by a $3.2
million loss on the sale of the Company's Ohio delinquent property tax
receivable investment.
The Company reported a preferred stock charge of $1.8 million for the
year ended December 31, 2004, which represents a decline of $8.6 million from
the preferred stock benefit of $6.8 million reported for the year ended December
31, 2003. This decrease in the preferred stock (charge) benefit was due to the
recapitalization completed in 2004 and the tender offer completed in 2003
described in more detail above.
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
other (expense) income relating to decreased 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 income before provision for loan 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 income before provision for loan
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 compared to
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.
Provision for loan losses 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 generally
under-performed relative to expectations and suffered 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 were 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, compared to 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.
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 was applied to reduce the carrying value
of the security.
Gain on sale of investments for 2003 included 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 SFASards No. 133, "Accounting
for Derivative Instruments and Hedging Activities," 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.
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,
- ---------------------------------------------------------------------------------------------------------------------------
2004 2003 2002
- ---------------------------------------------------- ----------------------- ----------------------- -----------------------
Average Effective Average Effective Average Effective
(amounts in thousands) Balance Rate Balance Rate Balance Rate
- ---------------------------------------------------- ----------- ----------- ----------- ----------- ----------- -----------
Interest-earning assets(1):
Securitized finance receivables(2)(3) $1,601,553 7.41% $1,948,204 7.56% $2,272,387 7.69%
Securities 25,476 7.74% 5,631 13.74% 4,816 21.31%
Other loans 6,825 10.34% 9,048 6.72% 9,706 4.54%
Cash and other investments 24,532 1.37% 58,128 6.09% 72,663 7.81%
----------- ----------- ----------- ----------- ----------- -----------
Total interest-earning assets $1,658,386 7.34% $2,021,011 7.53% $2,359,572 7.71%
=========== =========== =========== =========== =========== ===========
Interest-bearing liabilities:
Securitization financing(3) $1,499,772 6.40% $1,826,827 5.85% $2,113,330 6.12%
Senior notes 2,020 9.90% 19,330 9.53% 26,112 8.14%
Repurchase agreements 21,040 1.75% 398 1.79% - -
----------- ----------- ----------- ----------- ----------- -----------
Total interest-bearing liabilities $1,522,832 6.34% $1,846,555 5.88% $2,139,442 6.15%
=========== =========== =========== =========== =========== ===========
Net interest spread(3) 1.00% 1.65% 1.56%
Net yield on average interest-earning assets(3) 1.51% 2.15% 2.14%
- ---------------------------------------------------- ----------- ----------- ----------- ----------- ----------- -----------
(1) Average balances exclude adjustments made in accordance with SFAS No. 115,
"Accounting for Certain Investments in Debt and Equity Securities," to
record available for sale securities at fair value.
(2) Average balances exclude funds held by trustees of $342, $374,and $2,590
for the years ended December 31, 2004, 2003, and 2002, respectively.
(3) Effective rates are calculated excluding non-interest related non-recourse
securitization financing expenses and provision for credit losses.
2004 compared to 2003
The net interest spread for the year ended December 31, 2004 decreased
to 1.00% from 1.65% for the year ended December 31, 2003. This decrease can be
generally attributed to the prepayment of higher coupon investments, principally
securitized finance receivables, and the resulting reinvestment of net proceeds
available as a result of these prepayments into lower yielding cash and cash
equivalents. In addition, net interest spread declined approximately 0.17% from
the non-accrual status of a delinquent property tax receivable in 2004 compared
to 2003, and declined approximately 0.07% as a result of net asset premium and
bond discount amortization expense from the unexpected prepayment of
approximately $98.0 million in commercial mortgage loans during 2004. The
overall yield on interest-earnings assets, decreased to 7.34% for the year ended
December 31, 2004 from 7.53% for the same period in 2003. The overall yield
declined by 0.17% as a result of the non-accrual status in 2004 of a delinquent
property tax receivable security, with the balance of the decline due to the
prepayment of higher coupon investments. In addition to declining asset yields,
interest-bearing liability costs increased from 5.88% to 6.34% as a result of
the overall increase in market interest rates, including LIBOR rates, and the
repayment of lower-cost securitization financing bonds pursuant to the terms of
the securitization trust. Approximately 38% of the Company's interest-bearing
liabilities re-price monthly and are indexed to one-month LIBOR, which averaged
1.50% for 2004, compared to 1.21% for 2003. In addition, interest bearing
liability costs increased by approximately a net 0.04% for bond discount
amortization resulting from the prepayment of approximately $98.0 million of
securitization financing related to commercial loans which prepaid during the
year.
2003 compared to 2002
The net interest spread for the year ended December 31, 2003 increased
to 1.65% from 1.56% for the year ended December 31, 2002. While overall asset
yields decreased, principally as a result of the prepayment of higher coupon
investments, 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, the overall weighted-average liability costs decreased as well
as a result of the overall decline in short-term market interest rates. The
change in one-month LIBOR is a proxy for the change in the Company's yield on
the adjustable-rate investments in its portfolio (which have reset periods
ranging from six months to one year) and a proxy for change in the cost of
borrowing for the Company's floating rate liabilities (which reset, on average,
every month). During 2003, the one-month LIBOR averaged 1.21% for 2003, compared
to 1.76% for 2002. The overall yield on interest-earnings assets, decreased to
7.53% for the year ended December 31, 2003 from 7.71% for the same period in
2002, following the falling-rate environment and reflecting payments on higher
coupon investments in the portfolio. Average interest-bearing liability costs
decreased from 6.15% to 5.88% in 2003, principally as a result of the above
referenced decline in short-term market rates, which was partially offset by the
prepayment of lower cost securitization finance bonds outstanding pursuant to
the terms of the securitization trust. A portion of the Company's
interest-bearing liabilities re-price monthly, and are indexed to one-month
LIBOR. As indicated above, one-month LIBOR on average was 0.55% less in 2003
than 2002.
The following table summarizes the amount of change in interest income
and interest expense due to changes in interest rates versus changes in volume:
- ----------------------------------------------------------------------------------------------------------------------------
2004 to 2003 2003 to 2002
- ----------------------------------------------------------------------------------------------------------------------------
(amounts in thousands) Rate Volume Total Rate Volume Total
- ----------------------------------------------------------------------------------------------------------------------------
Securitized finance receivables $ (2,915) $ (25,735) $ (28,650) $ (2,932) $ (24,556) $ (27,488)
Other investments (1,835) (1,367) (3,202) (1,121) (1,016) (2,137)
Securities (470) 1,667 1,197 (406) 154 (252)
Other loans 273 (175) 98 199 (32) 167
- ----------------------------------------------------------------------------------------------------------------------------
Total interest income (4,947) (25,610) (30,557) (4,260) (25,450) (29,710)
- ----------------------------------------------------------------------------------------------------------------------------
Securitization financing 9,527 (20,321) (10,794) (5,548) (16,948) (22,496)
Senior notes 69 (1,711) (1,642) 325 (609) (284)
Repurchase agreements (3) 361 358 - 7 7
- ----------------------------------------------------------------------------------------------------------------------------
Total interest expense 9,593 (21,671) (12,078) (5,223) (17,550) (22,773)
- ----------------------------------------------------------------------------------------------------------------------------
Net interest income $ (14,540) $ (3,939) $ (18,479) $ 963 $ (7,900) $ (6,937)
- ----------------------------------------------------------------------------------------------------------------------------
Note: The change in interest income and interest expense due to changes in both
volume and rate, which cannot be segregated, has been allocated
proportionately to the change due to volume and the change due to rate.
This table excludes non-interest related securitization financing
expense, other interest expense and provision for credit losses.
Interest Income and Interest-Earning Assets
- -------------------------------------------
Approximately $1.3 billion of the investment portfolio as of December 31,
2004, or 84%, was comprised of loans or securities that pay a fixed-rate of
interest. Also at December 31, 2004, approximately $251 million, or 16%, was
comprised of loans or securities that have coupon rates which adjust over time
(subject to certain periodic and lifetime limitations) in conjunction with
changes in short-term interest rates. 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, 2004, 2003 and 2002.
LIBOR Based ARM Loans are adjustable rate mortgage loans, which carry a rate of
interest based on a spread to six-month LIBOR. CMT Based ARM Loans are
adjustable rate mortgage loans, which carry a rate of interest based on a spread
to the one-year Constant Maturity Treasury index. Other Indices Based ARM Loans
carry a rate of interest based on a spread to an index other than six-month
LIBOR, such as the Prime Rate. The percentage of fixed-rate loans to all loans
increased from 81% at December 31, 2003, to 84% at December 31, 2004. Fixed-rate
loans at December 31, 2004 consisted principally of manufactured housing loans
which have historically had low rates of prepayment, and commercial mortgage
loans which are prohibited from prepayment for a period of up to ten years from
their date of funding. A substantial portion of the prepayments in the Company's
investment portfolio have occurred in the single-family ARM loans which carry no
prepayment penalties. Given the low absolute interest-rate environment,
single-family ARM loans and fixed-rate loans have experienced higher than
historical average prepayment experience over the years presented. The table
below excludes various investments in the Company's portfolio, including
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 $21.3
million at December 31, 2004.
Investment Portfolio Composition(1)
-----------------------------------
($ in millions)