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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 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, 1997
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission file number 1-9819
DYNEX CAPITAL, INC.
(Exact name of registrant as specified in its charter)
Virginia 52-1549373
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer I.D. No.)
10900 Nuckols Road, 3rd Floor, Glen Allen, Virginia 23060
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (804) 217-5800
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
Common Stock, $.01 par value New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
Title of each class Name of each exchange on which registered
Series A 9.75% Cumulative Convertible Preferred Stock, Nasdaq National Market
$.01 par value
Series B 9.55% Cumulative Convertible Preferred Stock, $.01 Nasdaq National Market
par value
Series C 9.73% Cumulative Convertible Preferred Stock, $.01 Nasdaq National Market
par value
Indicate by check mark whether the registrant(1) has filed all reports
required to be filed by Section 13 or 15(d) of theSecurities 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 XX 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. |X|
As of February 28, 1998, the aggregate market value of the voting stock
held by non-affiliates of the registrant was approximately $542,631,239
(43,848,989) shares at a closing price on The New York Stock Exchange of
$12.375). Common stock outstanding as of February 28, 1998 was 45,543,182
shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Definitive Proxy Statement to be filed pursuant to
Regulation 14A within 120 days from December 31, 1997, are incorporated by
reference into Part III.
DYNEX CAPITAL, INC.
1997 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PART I PAGE
Item 1. BUSINESS.................................................. 3
Item 2. PROPERTIES................................................ 15
Item 3. LEGAL PROCEEDINGS......................................... 15
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS....... 15
PART II
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY
AND RELATED STOCKHOLDER MATTERS........................... 16
Item 6. SELECTED FINANCIAL DATA................................... 17
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS............. 18
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA............... 35
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE..................... 35
PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT......... 35
Item 11. EXECUTIVE COMPENSATION..................................... 35
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
OWNERS AND MANAGEMENT...................................... 35
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS............. 35
PART IV
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
AND REPORTS ON FORM 8-K..................................... 35
SIGNATURES ........................................................... 38
Item 1. BUSINESS
GENERAL
Dynex Capital, Inc. (the "Company") was incorporated in the
Commonwealth of Virginia in 1987. References to the "Company" mean the parent
company, its wholly-owned subsidiaries and certain other affiliated
entities consolidated for financial reporting purposes. The Company has
elected to be treated as a real estate investment trust ("REIT") for federal
income tax purposes and, as such, must distribute substantially all of
its taxable income to shareholders and will generally not be subject to
federal income tax.
The Company is a mortgage and consumer finance company which uses its loan
production operations to create investments for its portfolio. The Company's
primary loan production operations include the origination of mortgage loans
secured by multifamily and commercial real estate properties (hereinafter
referred to as "commercial loans") and the origination of loans secured by
manufactured homes. The Company will generally securitize the loans
funded as collateral for collateralized bonds, limiting its credit risk and
providing long-term financing for its portfolio.
The Company's principal source of earnings is net interest income
on its investment portfolio. The Company's investment portfolio consists
principally of collateral for collateralized bonds, adjustable-rate
mortgage ("ARM") securities and loans held for securitization. The Company
funds its portfolio investments with both borrowings and cash raised from
the issuance of equity. For the portion of the portfolio investments
funded with borrowings, the Company generates net interest income to the
extent that there is a positive spread between the yield on the interest-
earning assets and the cost of borrowed funds. The cost of the Company's
borrowings may be increased or decreased by interest rate swap, cap or floor
agreements. For the portion of the balance sheet that is funded with equity,
net interest income is primarily a function of the yield generated from the
interest-earning asset.
Business Focus and Strategy
The Company'strives to create a diversified portfolio of investments that
in the aggregate generates stable income for the Company in a variety of
interest rate environments and preserves the capital base of the Company.
The Company'seeks to generate growth in earnings and dividends per share in a
variety of ways, including (i) adding investments to its portfolio when
opportunities in the market are favorable; (ii) developing production
capabilities to originate and acquire financial assets in order to create
attractively priced investments for its portfolio, as well as control the
underwriting and servicing of such financial assets and (iii) increasing the
efficiency with which the Company utilizes its equity capital over time.
To increase potential returns to shareholders, the Company also employs
leverage through the use of secured borrowings and repurchase agreements to
fund a portion of its portfolio investments. The Company's specific
strategies for its lending operations and investment portfolio are discussed
below.
Lending Strategies
The Company strives to be a vertically integrated lender by
performing the sourcing, underwriting, funding and servicing of loans to
maximize efficiency and provide superior customer service. The Company
adheres to the following business strategies in its lending operations:
develop loan production capabilities to originate and acquire financial
assets in order to create attractively priced investments for its
portfolio, generally at a lower cost than if investments with
comparable risk profiles were purchased in the secondary market;
focus on loan products that maximize the advantages of the REIT tax
election;
emphasize direct relationships with the borrower and minimize, to the
extent practical, the use of origination intermediaries;
use internally generated guidelines to underwrite loans for all
product types and maintain centralized loan pricing; and
perform the servicing function for loans on which the Company has credit
exposure; emphasizing the use of early intervention, aggressive
collection and loss mitigation techniques in the servicing process to
manage and seek to reduce delinquencies and to minimize losses in its
securitized loan pools.
Investment Portfolio Strategies
The Company adheres to the following business strategies in managing its
investment portfolio:
use its loan origination capabilities to provide assets for it
investment portfolio, generally at a lower effective cost than if
investments of comparable risk profiles were purchased in the secondary
market;
securitize its loan production to provide long-term financing for its
investment portfolio and to reduce the Company's liquidity, interest rate
and credit risk;
utilize leverage to finance purchases of loans and investments in line
with prudent capital allocation guidelines which are designed to balance
the risk in certain assets, thereby increasing potential returns to
shareholders while seeking to protect the Company's equity base;
structure borrowings to have interest rate adjustment indices and
interest rate adjustment periods that, on an aggregate basis,
generally correspond (within a range of one to six months) to the
interest rate adjustment indices and interest rate adjustment periods
of the related asset; and
utilize interest rate caps, swaps and similar instruments and
securitization vehicles with such instruments embodied in the
structure to mitigate the risk of the cost of its variable rate
liabilities increasing at a faster rate than the earnings on its assets
during a period of rising interest rates.
Lending Operations
The Company's primary lending activities include commercial mortgage
lending and manufactured housing lending. The Company will provide mortgage
financing for apartment properties, assisted living and retirement housing,
limited and full service hotels, urban and suburban office buildings, retail
shopping strips and centers, light industrial buildings and manufactured
housing parks. The Company's manufactured housing production includes
installment loans, land/home loans and inventory financing to manufactured
housing dealers. In addition to these primary sources of loan production, the
Company leases and provides financing to builders of single family homes that
serve as model homes for those builders and purchases and manages real estate
property tax portfolios. Additionally, the Company has purchased and may
continue to purchase single family mortgage loans on a "bulk" basis from time
to time.
The main purposes of the Company's production operations are to enhance
the return on shareholders' equity ("ROE") by earning a favorable net interest
spread while loans are being accumulated for securitization and to create
investments for the Company's portfolio at a lower cost than if such
investments were purchased from third parties. The creation of such
investments generally involves the issuance of collateralized bonds or pass-
through securities collateralized by the loans generated from the Company's
production activities, and the retention of one or more classes of the
collateralized bonds or securities relating to such issuance. The
securitization of loans as collateralized bonds and pass-through securities
generally limits the Company's credit and interest rate risk in contrast to
retaining loans in the portfolio in whole-loan form.
The following table summarizes the production activity for the three years
ended December 31, 1997, 1996 and 1995.
Loan Production Activity
($ in thousands)
- --------------------------------------------------- -- --------------------------------------------------
For the Years Ended December 31,
--------------------------------------------------
1997 1996 1995
-------------- -------------- --------------
Commercial $ 290,988 (1) $ 201,496 $ 18,432
Manufactured housing 265,906 41,031 -
Single family - 499,288 875,521
Specialty finance 168,965 35,505 184
-- ----------- -- ----------- -- -----------
Total fundings through direct production 725,859 777,320 894,137
Securities acquired through bond calls 493,152 - -
Single family fundings through bulk purchases 1,271,479 731,460 22,433
== =========== == =========== == ===========
Total fundings $ 2,490,490 $ 1,508,780 $ 916,570
== =========== == =========== == ===========
Principal amount of loans and securities
securitized or sold $ 2,278,633 $ 1,357,564 $ 1,172,101
== =========== == =========== == ===========
(1) Included in commercial fundings were $49 million of loans funded in
connection with the issuance of tax-exempt bonds. These loans are not
included in the balance of the loans held for securitization, as funding for
these loans was provided by the sale of tax-exempt bonds.
During 1997, the Company funded $291 million of commercial mortgage
loans consisting of $118 million of multifamily loans, $49 million in
construction/permanent loans and $124 million in other types of commercial
loans. The majority of the multifamily loans funded in 1997 consist of
permanent mortgage loans on properties that have been allocated low
income housing tax credits. The Company initiated a construction/permanent
lending program on multifamily properties in the fourth quarter of 1997.
The majority of such construction/permanent loans related to mortgage loans
securing tax-exempt bonds. Other types of commercial loans consist primarily
of loans on hotels, office buildings, light industrial space and
distribution centers. As of December 31, 1997, commitments to fund
commercial loans were approximately $642 million. Additionally, the
Company securitized $314 million of its commercial loan production through a
collateralized bond issuance in October 1997.
During 1997, the Company funded $266 million of manufactured housing
loans and as of December 31, 1997, had commitments outstanding to fund
$56 million of such loans. The Company securitized a total of $235 million of
its manufactured housing production through the issuance of two
collateralized bonds during 1997.
The Company's specialty finance businesses funded $169 million during
1997. Such fundings principally included the purchase and leaseback or
financing of $110 million of model homes and the acquisition of $39 million of
property tax liens.
The Company owns the right to call $1.0 billion of securities previously
issued by the Company once the outstanding value of such securities reaches
35% or less of the original amount issued. During 1997, the Company
exercised its call rights on $493 million of such securities. These securities
were included in new securitizations during 1997.
Additionally, during 1997, the Company purchased $1.3 billion of
single family ARM loans through various bulk purchases. The Company will
continue to purchase single family loans on a bulk basis to the
extent, that upon securitization, such purchases would generate a
favorable return to the Company on a proforma basis. All of the single
family ARM loans purchased were securitized through the issuance of the
collateralized bonds in 1997.
Commercial Lending Operations
The Company originates commercial mortgage loans which are secured
primarily by multifamily properties, as well as limited service hotels,
office buildings, light industrial and warehouse spaces, retirement homes,
distribution centers and retail space. The Company originally entered the
commercial market in 1992 as a multifamily lender focused on multifamily
mortgage loans secured by apartment properties that qualified for low-income
housing tax credits ("LIHTCs") under Section 42 of the Internal Revenue Code.
Since 1992, the Company has funded or provided loan commitments for
approximately $1 billion of LIHTC communities nationwide. The Company
believes that it is one of the country's leading LIHTC lenders, with an
estimated market share of 15%. In 1997, the Company broadened its commercial
mortgage lending beyond LIHTC apartment properties to include apartment
properties that have not received LIHTCs, assisted living and retirement
housing, limited service hotels, office buildings, retail shopping strips and
centers and light industrial buildings.
LIHTC Lending
Approximately one-third of all multifamily housing starts during 1997
were LIHTC properties. For property owners to comply with the LIHTC
regulations, owners must "set aside" at least 20% of the units for rental to
families with income of 50% or less of the median income for the locality as
determined by the Department of Housing and Urban Development (HUD), or at
least 40% of the units to families with income of 60% or less of the HUD
median income. Most owners elect the "40-60 set-aside" and designate 100%
of the units in the project as LIHTC units. Additionally, rents cannot
exceed 30% of the annual HUD median income adjusted for the unit's designated
"family size."
Generally, the LIHTCs are sold by the developers to investors prior to
construction in order to provide additional equity for the project. The sale
of the LIHTCs typically provides funds equal to approximately 50% of the
construction costs of the project. The multifamily loans made by the Company
normally fund the difference between the project cost (including a fee to
the developer) and the funds generated from the sale of the LIHTCs. The
average principal balance of LIHTC loans originated in 1997 was $3.5
million, ranging in size from $1.0 million to $10.0 million. The multifamily
mortgage loans originated by the Company are currently sourced through
direct relationships with the developers and syndicators of LIHTCs.
There are no correspondent or broker relationships.
Multifamily Construction/Permanent Lending
As a part of its product expansion efforts during 1997, the Company began
offering a multifamily construction/permanent loan program for LIHTC
properties. The construction loans range in size from $1 million to
$10 million with a loan-to-value of 80% or less of the appraised property
value. The Company underwrites each property to its required debt service
coverage and loan-to-value levels, and serves as the construction loan
administrator on each property.
Tax-exempt Bonds
The Company facilitates the issuance of tax-exempt multifamily housing
bonds, the proceeds of which are used to fund mortgage loans on multifamily
properties. The Company enters into standby commitment agreements whereby
the Company is required to pay principal and interest to the bondholders
in the event there is a payment shortfall on the underlying mortgage loans.
In addition, the Company is required to purchase the bonds if such bonds
are not able to be remarketed by the remarketing agent. The bonds are
remarketed in the tax-exempt market generally every seven days. The Company
has provided letters of credit to support its obligations in amounts equal
$25.9 million at December 31, 1997. There were nooutstanding letters of credit
at December 31, 1996.
Other Commercial Lending
The Company's expansion into non-multifamily commercial lending during
1997 was due to several factors: (i) to increase volume to expedite
securitizations, (ii) to capitalize on the underwriting, closing and servicing
infrastructure that the Company already had in place, and (iii) to benefit in
the securitization rating levels from a more diversified pool of loans.
The commercial loans are combined with the multifamily loans and securitized
through the issuance of collateralized bonds.
The Company sources these commercial loans through direct relationships
with developers, property owners and on a selected basis from commercial
mortgage bankers. The Company's underwriting guidelines for other commercial
mortgage loans are generally consistent with rating agency and investor
requirements.
The other commercial mortgages primarily have fixed interest rates with
loan sizes that generally vary from $1 million to $20 million. The product
types include mainly limited service hotels, industrial warehouse,
distribution centers, retirement homes, retail and office property.
Risk Management
Because the Company funds and commits to fund commercial loans at
fixed-interest rates, the Company is exposed to interest rate risk to the
extent that interest rates increase prior to the time such loans are
securitized. The Company'strives to mitigate such risk by the use of futures
contracts and forward contracts of US treasury securities with duration
characteristics similar to such loans and loan commitments.
Manufactured Housing Lending Operations
The Company has been funding manufactured housing loans since 1996.
The Company believes the manufactured housing lending market is growing
as a result of strong customer demand. The market for loans on new
manufactured homes is approximately $14 billion annually, and is expected to
grow as shipments of multi-section homes relative to single-section homes
increases and average loan size increases. The manufactured home is
gaining greater market acceptance as the product's quality improves and its
affordability remains attractive versus site built housing.
A manufactured home is distinguished from a traditional single family home
in that the housing unit is constructed in a plant, transported to the site
and secured to a pier or a foundation, whereas a single family home is built
on the site. The majority of the manufactured housing loans are in the form of
a consumer installment loan (i.e., a personal property loan) in which the
borrower rents or owns the land underlying the manufactured home. However,
an increasing percentage of these loans are in the form of a "land/home"
loan, a first lien mortgage loan. The Company offers both fixed and
adjustable rate loans with terms ranging from 7 to 30 years. The Company
underwrites all loans which it originates. As of December 31, 1997, the
Company had $56 million in principal balance of manufactured housing
loans in inventory and had commitments outstanding of approximately $56
million. As of December 31, 1997, the average funded amount per loan is
approximately $40,000. To date, approximately 96% of the Company's loan
fundings have been fixed interest rate loans.
The Company has two primary distribution channels -- its dealer network
and direct lending. Substantially all new manufactured homes are sold through
manufactured housing dealers. Approximately 90% of these homes are financed.
There are over 7,000 manufactured housing dealers operating in the United
States, many with multiple sales locations. The Company plans to expand
its distribution channels to nearly all sources for manufactured housing
loans by establishing relationships with park owners, developers of
manufactured housing communities, manufacturers of manufactured homes,
brokers and correspondents. As of December 31, 1997, the Company had 1,113
approved dealers with 1,867 sales locations.
The Company services its dealer network through its home office in
Virginia and its five regional offices located in North Carolina, Georgia,
Texas, Ohio and Washington. The Company also has three district sales offices.
Each regional office supports three to four district sales managers who
establish and maintain relationships with manufactured housing dealers. By
using the home/regional/district office structure, the Company has created a
decentralized customer service and loan origination organization with
centralized controls and support functions. The Company believes that this
approach also provides the Company with a greater ability to maintain customer
service, to respond to market conditions, to enter and exit local markets
and to test new products.
Inventory Financing.
The Company offers inventory financing, or "lines of credit," to
retail dealers for the purpose of purchasing manufactured housing
inventory to display and sell to customers. Under such arrangements, the
Company will lend against the dealer's line of credit when an invoice
representing the purchase of a manufactured home by a dealer is presented to
the Company by the manufacturer of the manufactured home. Prior to
approval of the line of credit for the dealer, the Company will perform a
financial review of the manufacturer as well as the dealer. The Company
performs monthly inspections of the dealer's inventory financed by the
Company and annual reviews of both the dealer and the manufacturer. The
Company believes that offering this product will increase market presence
and will enable the Company to improve its positioning with the dealers and
manufacturers.
Manufactured housing loans originated by the Company are primarily
fixed-rate loans. To reduce interest rate risk associated with these
fixed-rate loans, the Company utilizes interest rate forwards, futures and
swaps until the pool ofloans is securitized. To date, the loans have been
securitized through the issuance of variable rate bonds, with the interest
on a portion of such bonds swapped to a fixed rate through an interest rate
swap agreement.
Specialty Finance
Model Home Sales/Leaseback and Lending.
The Company provides financing to single family home builders through a
sale/leaseback program in which the Company purchases single family homes
from builders and the builders simultaneously lease back the homes for use
as models. The Company also provides loans to builders secured by the single
family homes used as models. The Company has an appraisal performed on each
home and limits the amount of the loan or purchase price for the homes to a
predetermined percentage of each home's appraised value. Upon expiration
of the lease period, the Company'sells the home to a third-party buyer. The
lease terms are generally 12-24 months and can be extended at the option of
the builder upon approval of the Company. During 1997, the Company
purchased and subsequently leased back or provided financing to builders
for $116 million of models homes. At December 31, 1997, the Company had
$131 million of model homes on lease or had provided financing to 21 builders
throughout the United States and Mexico.
Property Tax Receivables. Since 1993, the Company has been involved in
the purchase and management of property tax receivables from various state
and local jurisdictions. A property tax receivable is a delinquent tax on
real property that has a lien status superior to any mortgage (and most other
liens) on the property. As a result, the property tax receivables generally
have a very low "lien-to-value". Various jurisdictions sell these property
tax receivables to investors, as the private sector is more efficient and
better equipped to collect the taxes and to get the properties back on the
tax rolls. The Company offers payment plans to taxpayers in order to assist
them in bringing their property taxes current. In the event the taxpayer
does not pay the property tax receivable, the Company has the right to
foreclose on the property to recover the amount of the tax and associated costs.
The Company had $42 million of property tax receivables at December 31,
1997 in five states. Over 80% of the property tax receivables are on single
family residential properties. The Company has established local offices
responsible for collecting the property tax receivables, and if necessary,
foreclosing on the properties in the event that the collection efforts fail.
Due to the short duration of the property tax receivables, the Company holds
such assets in the portfolio with no current plans to securitize them.
Single Family Lending
Pursuant to the terms of the sale of the Company's single family
mortgage operations to a subsidiary of Dominion Resources, Inc. during the
second quarter of 1996, the Company is precluded from originating or purchasing
certain types of single family loans through a wholesale or correspondent
network through April, 2001. However, the Company may purchase any type of
single family loans on a bulk basis, i.e., in blocks of $25 million or more,
and may originate loans on a retail basis. Currently, the Company purchases
"A" quality adjustable-rate, single family loans on a bulk basis to the extent
that the Company can generate a favorable return on investment upon
securitization. Due to the sale of its single family mortgage operations,
the Company does not currently have the internal capability to directly
underwrite single family mortgage loans. In the future, the Company may
re-establish an internal capability for single family mortgage loans. In the
interim, the Company may utilize independent contractors to assist in the
underwriting and servicing of such loans. During 1997, the Company purchased
$1.3 billion of single family, "A" quality loans through such bulk loan
purchases and securitized the entire amount.
Loan Servicing
During 1996, the Company established the capability to service both
commercial and manufactured housing loans funded through its production
operations. The purpose of servicing the loans funded through the production
operations is to manage the Company's credit exposure more effectively while
the loans are held for securitization, as well as to limit the credit exposure
that is usually retained when the Company securitizes the pool of loans. The
commercial servicing function is located in Glen Allen, Virginia and
includes collection and remittance of principal and interest payments,
administration of tax and insurance accounts, management of the replacement
reserve funds, collection of certain insurance claims and, in the event of
default, the workout of such situations through either a modification
of the loan or the foreclosure and sale of the property.
The manufactured housing servicing function is operated in Fort Worth,
Texas. As the servicer of manufactured housing loans, the Company is
responsible for the collection of monthly payments, and if the loan defaults,
the resolution of the defaulted loan through either a modification of the
loan or the repossession and sale of the related property. With manufactured
housing loans, minimizing the time between the date the loan goes in
default and the time that the manufactured home is repossessed and sold is
critical to mitigating losses on these loans.
Loan Securitization Strategy
The Company primarily uses funds provided by its senior notes, bank
borrowings and equity to finance loan production when loans are initially
funded. When a sufficient volume of loans is accumulated, the loans are
securitized through the issuance of collateralized bonds. As a result of
the reduction in the availability of mortgage pool insurance, and the
Company's desire to reduce both its recourse borrowings as a percentage of its
overall borrowings and the variability of its earnings, the Company has
utilized the collateralized bond structure for securitizing substantially
all of its loan production since the beginning of 1995. Prior to 1995,
the Company issued pass-through securities, in a senior-subordinated
structure or with pool insurance.
The Company believes that securitization is an efficient and cost
effective way to (i) reduce capital otherwise required to own the loans in
whole loan form; (ii) limit the Company's credit exposure on the loans;
(iii)lower the overall cost of financing the loans and (iv) limit the Company's
exposure to interest rate and/or valuation risk, depending on the
securitization structure. The length of time between when the Company funds
the loan and when it securitizes such loan varies depending on certain
factors including the loan volume, fluctuations in the prices of securities
and variations in the securitization process.
The securities are structured by the Company'so that a substantial
portion of the securities are rated in one of the two highest rating categories
(i.e., AAA or AA) by at least one of the nationally recognized rating agencies.
In contrast to mortgage-backed securities in which the principal and interest
payments are guaranteed by the U. S. government or an agency thereof,
securities created by the Company do not benefit from any such guarantee.
The ratings for the Company's collateralized bonds are based on the perceived
credit risk by the applicable rating agency of the underlying mortgage loans,
the structure of the securities and the associated level of credit enhancement.
Credit enhancement is designed to provide protection to one or more
classes of security holders in the event of a borrower default and to protect
against other losses, including those associated with fraud or reductions in
the principal balances or interest rates on mortgage loans as required by
law or a bankruptcy court. Credit enhancement for these securities may
take the form of over-collateralization, subordination, reserve funds,
mortgage pool insurance, bond insurance, third-party limited guaranties
or any combination of the foregoing. The Company'strives to use the most cost
effective security structure and form of credit enhancement available at
the time of securitization. Each series of securities is expected to be
fully payable from the collateral pledged to secure the series.
Master Servicing
The Company performs the function of master servicer for certain of the
securities it has issued, including all of the securities it has issued since
1995. The master servicer's function typically includes monitoring and
reconciling the loan payments remitted by the servicers of the loans,
determining the payments due on the securities and determining that the
funds are correctly sent to a trustee or investors for each series of
securities. Master servicing responsibilities also include monitoring
the servicers' compliance with its servicing guidelines. As master
servicer, the Company is paid a monthly fee based on the outstanding
principal balance of each such loan master serviced or serviced by the
Company as of the last day of each month. As of December 31, 1997, the
Company master serviced $4.0 billion in securities.
Investment Portfolio
The core of the Company's earnings is derived from its investment
portfolio. The Company's strategy for its investment portfolio is to create a
diversified portfolio of high quality assets that in the aggregate generates
stable income in a variety of interest rate and prepayment environments and
preserves the Company's capital base. In many instances, the investment
strategy involves not only the creation of the asset, but also structuring
the related securitization or borrowing to create a stable yield profile and
reduce interest rate and credit risk.
The Company continuously monitors the aggregate cash flow, projected
net yield and market value of its investment portfolio under various interest
rate and prepayment environments. While certain investments may perform
poorly in an increasing or decreasing interest rate environment, certain
investments may perform well, and others may not be impacted at all. Generally,
the Company adds investments to its portfolio which are designed to increase
the diversification and reduce the variability of the yield produced by the
portfolio in different interest rate environments.
Credit Quality. The investment portfolio is of very high credit quality.
Excluding certain securities where the risk is primarily the rate of prepayments
and not credit, 98% of the Company's investments relate to securities rated
AA or AAA by at least one rating agency. These ratings are based on AAA
rated bond insurance, mortgage pool insurance or subordination. On
securities where the Company has retained a portion of the credit risk below
the investment grade level (BBB), the Company's maximum exposure to credit
losses (net of discounts, reserves and third party guarantees) was $87
million as of December 31, 1997.
Composition. The following table presents the balance sheet composition of
the investment portfolio by investment type and the percentage of the total
investments as of December 31, 1997 and 1996.
- ----------------------------------------------------------------------------------------------------
As of December 31,
------------------------------------------------------------
1997 1996
- ----------------------------------------------------------------------------------------------------
(amounts in thousands) Balance % of Balance % of
Total Total
bonds
Mortgage securities:
Adjustable-rate mortgage 386,159 7 758,746 19
securities
Fixed-rate mortgage 23,065 1 32,535 1
securities
Derivative and residual 104,526 2 98,931 3
securities
Other investments 214,120 4 98,943 3
Loans held for securitization 235,023 4 265,537 6
---------------- ------------ ------------- ------------
Total investments $ 5,338,454 100% $ 3,953,034 100 %
================ ============ ============= ============
- ----------------------------------------------------------------------------------------------------
Collateral for collateralized bonds. Collateral for collateralized
bonds represents the single largest investment in the Company's portfolio.
Interest margin on the net investment in collateralized bonds (defined as the
principal balance of collateral for collateralized bonds less the principal
balance of the collateralized bonds outstanding) is derived primarily from
the difference between (i) the cash flow generated from the collateral pledged
to secure the collateralized bonds and (ii) the amounts required for
payment on the collateralized bonds and related insurance and
administrative expenses. Collateralized bonds are generally non-recourse
to the Company. The Company's yield on its net investment in collateralized
bonds is affected primarily by changes in interest rates and prepayment
rates and, to a lesser extent, credit losses on the underlying loans. The
Company may retain for its investment portfolio certain classes of the
collateralized bonds issued and pledge such classes as collateral for repurchase
agreements. Collateral for collateralized bonds is composed primarily of ARM
securities with indices based on six-month LIBOR and one-year CMT. The
Company's current lending production is predominantly fixed-rate loans, and
accordingly the mix of adjustable-rate versus fixed-rate loans may change in
future periods.
ARM securities. Another segment of the Company's portfolio is the
investments in ARM securities. The interest rates on the majority of the
Company's ARM securities reset every six months and the rates are subject
to both periodic and lifetime limitations. Generally, the Company finances
a portion of its ARM securities with repurchase agreements, which have a fixed
rate of interest over a term that ranges from 30 to 90 days and, therefore,
are not subject to repricing limitations. As a result, the net interest
margin on the ARM securities could decline if the spread between the yield on
the ARM security versus the interest rate on the repurchase agreement was to be
reduced.
Fixed-rate mortgage securities. Fixed-rate mortgage securities consist
of securities that have a fixed-rate of interest for specified periods of
time. Certain fixed-rate mortgage securities have a fixed interest rate for
the first 3, 5 or 7 years and an interest rate that adjusts at six- or
twelve-month intervals thereafter, subject to periodic and lifetime
interest rate caps. The Company's yields on these securities are primarily
affected by changes in prepayment rates. Such yields will decline with an
increase in prepayment rates and will increase with a decrease in prepayment
rates. The Company generally borrows against its fixed-rate mortgage securities
through the use of repurchase agreements.
Derivative and residual securities. Derivative and residual securities
consist primarily of interest-only securities ("I/Os"), principal-only
securities ("P/Os") and residual interests which were either purchased or were
created through the Company's production operations. An I/O is a class of a
collateralized bond or a mortgage pass-through security that pays
to the holder substantially all interest. A P/O is a class of a collateralized
bond or a mortgage pass-through security that pays to the holder substantially
all principal. Residual interests represent the excess cash flows on a
pool of mortgage collateral after payment of principal, interest and expenses
of the related mortgage-backed security or repurchase arrangement. Residual
interests may have little or no principal amount and may not receive
scheduled interest payments. Included in the residual interests at December
31, 1997 was $81 million of equity ownership in residual trusts which own
collateral financed with repurchase agreements. The collateral consists
primarily of agency ARM securities. The Company's borrowings against its
derivative and residual securities is limited by certain loan covenants to
3% of shareholders' equity. The yields on these securities are affected
primarily by changes in prepayment rates and by changes in short-term
interest rates.
Other investments. Other investments consists primarily of single
family homes purchased and simultaneously leased back to home builders.
At the end of each lease, generally after a twelve to eighteen month lease
term, the Company will sell the home. Also included in other investments are
property tax receivables and an installment note received as part of
the consideration for the sale of the single family mortgage operations in 1996.
Loans held for securitization. Loans held for securitization consist
primarily of loans originated or purchased through the Company's production
operations that have not been securitized. During the accumulation period, the
Company is exposed to risks of interest rate fluctuations and may enter into
hedging transactions to reduce the change in value of such loans caused by
changes in interest rates. The Company is also at risk for credit losses
on these loans during accumulation. This risk is managed through the
application of loan underwriting and risk management standards and
procedures and the establishment of reserves.
Hedging and other portfolio transactions. As part of its asset/liability
management process, the Company enters into interest rate agreements such as
interest rate caps and swaps and financial futures contracts ("hedges").
These agreements are used to reduce interest rate risk which arises from
the lifetime interest rate caps on the ARM securities, the mismatched
repricing of portfolio investments versus borrowed funds and assets repricing
on indices such as the prime rate which are different than the related
borrowing indices. The agreements are designed to protect the portfolio's
cash flow and to stabilize the portfolio's yield profile in a variety of
interest rate environments.
Approximately $4.1 billion of the Company's investment portfolio as
of December 31, 1997 is comprised of loans or securities that have coupon
rates which adjust over time (subject to certain periodic and lifetime
limitations) in conjunction with changes in short-term interest rates.
Generally, during a period of rising short-term interest rates, the Company's
net interest spread earned on its investment portfolio will decrease. The
decrease of the net interest spread results from (i) the lag in resets of the
ARM loans underlying the ARM securities and collateral for collateralized bonds
relative to the rate resets on the associated borrowings and (ii) rate resets
on the ARM loans which are generally limited to 1% every six months and
subject to lifetime caps, while the associated borrowings have no such
limitation. As short-term interest rates stabilize and the ARM loans reset,
the net interest margin may be restored to its former level as the yields on
the ARM loans adjust to market conditions. Conversely, net interest margin
may increase following a fall in short-term interest rates. This increase
may be temporary as the yields on the ARM loans adjust to the new market
conditions after a lag period. In each case, however, the Company expects
that the increase or decrease in the net interest spread due to changes in
the short-term interest rates to be temporary. The net interest spread
may also be increased or decreased by the cost or proceeds of interest rate
swap, cap or floor agreements.
Because of the 1% periodic cap nature of the ARM loans underlying the ARM
securities, these securities may decline in market value in a rising interest
rate environment. In a rapidly increasing rate environment, as was experienced
in 1994, a decline in value may be significant enough to impact the amount of
funds available under repurchase agreements to borrow against these
securities. In order to maintain liquidity, the Company may be required to
sell certain securities. To mitigate this potential liquidity risk, the
Company strives to maintain excess liquidity to cover any additional margin
required in a rapidly increasing interest rate environment, defined as a 3%
increase in short-term interest rates over a twelve-month time period. The
Company has also entered into an interest rate swap transaction aggregating
$1.02 billion notional amount, which is designed to protect the Company's
cash flow and earnings on the ARM securities and certain collateral on
collateralized bonds in a rapidly rising interest rate environment. Under
the terms of this interest rate swap agreement, the Company receives payment
if one-month LIBOR increases by 1% or more in any six-month period. Finally,
the Company has purchased $1.5 billion notional amount of interest rate cap
agreements to reduce the risk of the lifetime interest rate limitation on the
ARM securities and on certain collateralized bonds owned by the Company.
Liquidity risk also exists with all other investments pledged as collateral
for repurchase agreements, but to a lesser extent.
The remaining portion of the Company's investments portfolio as of
December 31, 1997, approximately $1.2 billion, is comprised of loans or
securities that have coupon rates that are either fixed or do not reset
within the next 15 months. The Company has limited its interest rate risk on
such investments through (i) the issuance of fixed-rate collateralized bonds
and notes payable, (ii) interest rate swap agreements (Company receives
floating, pays fixed) and (iii) equity, which in the aggregate totals
approximately $1.2 billion as of the same date. Overall, the Company's
interest rate risk is primarily related to the rate of change in short term
interest rates, not the level of short term interest rates.
Risks
The Company is exposed to three types of risks inherent in its investment
portfolio. These risks include credit risk (inherent in the loans before
securitization and the security structure after securitization), prepayment/
interest rate risk (inherent in the underlying loan) and margin call risk
(inherent in the security if it is used as collateral for borrowings).
In general, the Company has developed analytical tools and risk management
strategies to monitor and address these risks, including (i) weekly
mark-to-market of a representative basket of securities within the
portfolio, (ii) monthly analysis using advanced option-adjusted spread
("OAS") methodology to calculate the expected change in the market
value of various assets within the portfolio under various extreme
scenarios; (iii) a monthly static cash flow and yield projection under 49
different scenarios, and (iv) a monthly "Portfolio Committee" meeting to
review the status of the portfolio, changes in the portfolio and any issues
and recommendations. Additionally, the portfolio status is reviewed
with the Board of Directors on a quarterly basis. Such tools allow the
Company to continually monitor and evaluate its exposure to these risks
and to manage the risk profile of the investment portfolio in response to
changes in the risk profile. While the Company may use such tools, there
can be no assurance the Company will accomplish the goal of adequately
managing the risk profile of the investment portfolio.
Credit Risk. When a loan is funded and becomes part of the Company's
investment portfolio, the Company has all of the credit risk on the loan
should it default. Upon securitization of the pool of loans, the credit
risk retained by the Company is generally limited to the net investment in
collateralized bonds and subordinated securities. The Company began to retain
a portion of the credit risk on securitized mortgage loans in 1994 as
mortgage pool insurance became less available in the market and as the
Company diversified into other products. To the extent the Company has
credit exposure on a pool of loans after securitization, the Company will
generally utilize its servicing capabilities in an effort to better manage
its credit exposure. The Company evaluates and monitors its exposure to
credit losses and has established reserves and discounts for anticipated
credit losses based upon estimated future losses on the loans, general
economic conditions and trends in the portfolio. As of December 31, 1997,
the Company's maximum credit exposure (net of discounts, reserves and
guarantees from a third party) on its investment portfolio (excluding loans
held for securitization) is $87 million or less than 16% of total equity.
The reserve relating to loans held for securitization was $2 million or 0.76%
of total loans held for securitization at December 31, 1997.
Prepayment/Interest Rate Risk. The Company strives to structure its
portfolio of investments to provide stable spread income in a variety of
prepayment and interest rate scenarios. To manage prepayment risk (i.e. from a
decline in long-term rates on fixed rate assets, or a flattening or inverse
yield curve as to ARM assets), the Company minimizes the amount of
"interest-only" investments or premium on assets. Thus, in a period of low
interest rates or a flat yield curve, the Company should not have a material
earnings exposure to rapid amortization or write-down of assets due to faster
prepayments. The Company has, in aggregate, less than $69 million of asset
premium and "interest-only" investments. In addition, future earnings may be
lowered as a result of the reduction in the interest earning assets from the
increased prepayment speeds.
The Company also views its hedging activities as a tool to manage interest
rate risk. To manage interest rate spread risk as a result of a rapid increase
in short term rates, the Company has entered into a $1.02 million interest rate
swap agreement which essentially removes the 1% periodic cap on certain
six-month ARM assets. Additionally, if short term rates were to rise
significantly, the Company has over $1 billion in interest rate cap agreements
(with strike prices between 9% and 11%) which would limit the Company's
borrowing cost on its $1.0 billion of short term debt.
Margin Call Risk. The Company uses repurchase agreements to finance a
portion of its investment portfolio. This financing structure exposes the
Company to "margin calls" if the market value of the assets pledged as
collateral for the repurchase agreements declines. The Company has established a
target equity requirement for each type of investment to take into account the
price volatility and liquidity of each such investment. The Company models and
plans for the margin call risk related to its repurchase borrowings through the
use of its OAS model to calculate the projected change in market value of its
investments that are pledged as collateral for repurchase borrowings under
various adverse scenarios. The Company generally maintains enough immediate or
available liquidity to meet margin call requirements if short-term interest
rates increased up to 300 basis points over a one-year period. As of December
31, 1997, the Company had total repurchase agreements outstanding of $889
million, secured by collateralized bonds retained, ARM securities, fixed-rate
mortgage securities and derivative and residual securities at their market
values of $524 million, $389 million, $21 million and $9 million, respectively.
The Company also has liquidity risk inherent to its investment in certain
residual trusts. These trusts are subject to margin calls and the Company, at
its option, may provide additional equity to the trust to meet the margin call.
Should the Company not provide the additional equity, the assets of the trust
could be sold to meet the trusts' obligations, resulting in a potential loss to
the Company.
Since 1996, the Company has structured all of its ARM loan securitizations
as collateralized bonds, with the financing, in effect, incorporated into the
bond structure. This structure eliminates the need for repurchase agreements on
such collateral, and consequently eliminates the margin call risk and to a
lesser degree the interest rate risk. During 1997 and 1996, the Company issued
approximately $2.4 billion and $1.8 billion, respectively in collateralized
bonds. The Company plans to continue to use collateralized bonds as its primary
securitization vehicle.
FEDERAL INCOME TAX CONSIDERATIONS
General
The Company and its qualified REIT subsidiaries (collectively "Dynex REIT")
believes it has complied and, intends to comply in the future, with the
requirements for qualification as a REIT under the Internal Revenue Code (the
Code). To the extent that Dynex REIT qualifies as a REIT for federal income tax
purposes, it generally will not be subject to federal income tax on the amount
of its income or gain that is distributed to shareholders. However, various
affiliated companies, which conduct the production operations and are included
in the Company's consolidated financial statements prepared in accordance with
generally accepted accounting principles ("GAAP"), are not qualified REIT
subsidiaries. Consequently, all of the nonqualified REIT subsidiaries' taxable
income is subject to federal and state income taxes.
The REIT rules generally require that a REIT invest primarily in real
estate-related assets, that its activities be passive rather than active and
that it distribute annually to its shareholders substantially all of its taxable
income. The Company could be subject to income tax if it failed to satisfy those
requirements or if it acquired certain types of income-producing real property.
Although no complete assurances can be given, Dynex REIT does not expect that it
will be subject to material amounts of such taxes.
Dynex REIT's failure to satisfy certain Code requirements could cause the
Company to lose its status as a REIT. If Dynex REIT failed to qualify as a REIT
for any taxable year, it would be subject to federal income tax (including any
applicable minimum tax) at regular corporate rates and would not receive
deductions for dividends paid to shareholders. As a result, the amount of
after-tax earnings available for distribution to shareholders would decrease
substantially. While the Board of Directors intends to cause Dynex REIT to
operate in a manner that will enable it to qualify as a REIT in future taxable
years, there can be no certainty that such intention will be realized.
Qualification of the Company as a REIT
Qualification as a REIT requires that Dynex REIT satisfy a variety of tests
relating to its income, assets, distributions and ownership. The significant
tests are summarized below.
Sources of Income. To continue qualifying as a REIT in any taxable year
beginning 1998, Dynex REIT must satisfy two distinct tests with respect to the
sources of its income: the "75% income test" and the "95% income test". The 75%
income test requires that Dynex REIT derive at least 75% of its gross income
(excluding gross income from prohibited transactions) from certain real
estate-related sources.
In order to satisfy the 95% income test, 95% Dynex REIT's gross income for
the taxable year must consist either of income that qualifies under the 75%
income test or certain other types of passive income.
If Dynex REIT fails to meet either the 75% income test or the 95% income
test, or both, in a taxable year, it might nonetheless continue to qualify as a
REIT, if its failure was due to reasonable cause and not willful neglect and the
nature and amounts of its items of gross income were properly disclosed to the
Internal Revenue Service. However, in such a case Dynex REIT 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 Dynex REIT. Under the 75% asset test, at least
75% of the value of Dynex REIT's total assets must represent cash or cash items
(including receivables), government securities or real estate assets. Under the
"10% asset test", Dynex REIT may not own more than 10% of the outstanding voting
securities of any single non-governmental issuer, if such securities do not
qualify under the 75% asset test. 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 Dynex REIT.
If Dynex REIT inadvertently fails to satisfy one or more of the asset tests
at the end of a calendar quarter, such failure would not cause it to lose its
REIT status, provided that (i) it satisfied all of the asset tests at the close
of a preceding calendar quarter and (ii) the discrepancy between the values of
Dynex REIT's assets and the standards imposed by the asset tests either did not
exist immediately after the acquisition of any particular asset or was not
wholly or partially caused by such an acquisition. If the condition described in
clause (ii) of the preceding sentence was not satisfied, Dynex REIT still could
avoid disqualification by eliminating any discrepancy within 30 days after the
close of the calendar quarter in which it arose.
Distributions. With respect to each taxable year, in order to maintain its
REIT status, Dynex REIT generally must distribute to its shareholders an amount
at least equal to 95% of the sum of its "REIT taxable income" (determined
without regard to the deduction for dividends paid and by excluding any net
capital gain) and any after-tax net income from certain types of foreclosure
property minus any "excess noncash income." The Code provides that distributions
relating to a particular year may be made in the following year, in certain
circumstances. The Company will balance the benefit to the shareholders of
making these distributions and maintaining REIT status against their impact on
the liquidity of the Company. In an unlikely situation, it may benefit the
shareholders if the Company retained cash to preserve liquidity and thereby lose
REIT status.
For federal income tax purposes, Dynex REIT is required to recognize income
on an accrual basis and to make distributions to its shareholders when income is
recognized. Accordingly, it is possible that income could be recognized and
distributions required to be made in advance of the actual receipt of such funds
by Dynex REIT. The nature of Dynex REIT's investments is such that it expects to
have sufficient cash to meet any federal income tax distribution requirements.
Taxation of Distributions by the Company
Assuming that Dynex REIT maintains its status as a REIT, any distributions
that are properly designated as "capital gain dividends" will generally be taxed
to shareholders as long-term or mid-term capital gains, regardless of how long a
shareholder has owned his shares. Any other distributions out of Dynex REIT's
current or accumulated earnings and profits will be dividends taxable as
ordinary income. Distributions in excess of Dynex REIT's current or accumulated
earnings and profits will be treated as tax-free returns of capital, to the
extent of the shareholder's basis in his shares and, as gain from the
disposition of shares, to the extent they exceed such basis. Shareholders may
not include on their own tax returns any of Dynex REIT ordinary or capital
losses. Distributions to shareholders attributable to "excess inclusion income"'
of Dynex REIT will be characterized as excess inclusion income in the hands of
the shareholders. Excess inclusion income can arise from Dynex REIT's holdings
of residual interests in real estate mortgage investment conduits and in certain
other types of mortgage-backed security structures created after 1991. Excess
inclusion income constitutes unrelated business taxable income ("UBTI") for
tax-exempt entities (including employee benefit plans and individual retirement
accounts) and it may not be offset by current deductions or net operating loss
carryovers. In the unlikely event that the Company's excess inclusion income is
greater than its taxable income, the Company's distribution would be based on
the Company's excess inclusion income.
Dividends paid by Dynex REIT to organizations that generally are exempt
from federal income tax under Section 501(a) of the Code should not be taxable
to them as UBTI except to the extent that (i) purchase of shares of Dynex REIT
was financed by "acquisition indebtedness" or (ii) such dividends constitute
excess inclusion income. In 1997, Dynex REIT's excess inclusion income was de
minimus.
Taxable Income
Dynex REIT uses the calendar year for both tax and financial reporting
purposes. However, there may be differences between taxable income and income
computed in accordance with GAAP. These differences primarily arise from timing
differences in the recognition of revenue and expense for tax and GAAP purposes.
Additionally, Dynex REIT's taxable income does not include the taxable income of
its taxable affiliate, although the affiliates are included in the Company's
GAAP consolidated financial statements. For the year ended December 31, 1997,
Dynex REIT's estimated taxable income was approximately $71.3 million.
REGULATION
As an approved mortgage and consumer loan originator, the Company is
subject to various federal and state regulations. A violation of such
regulations may result in the Company losing its ability to originate mortgage
and consumer loans in the respective jurisdiction.
The rules and regulations applicable to the production operations, among
other things, prohibit discrimination and establish underwriting guidelines that
include provisions for inspections and appraisals, require credit reports on
prospective borrowers and fix maximum loan amounts. Certain of the Company's
funding activities are subject to, among other laws, the Equal Credit
Opportunity Act, Federal Truth-in-Lending Act and the Real Estate Settlement
Procedures Act and the regulations promulgated thereunder that prohibit
discrimination and require the disclosure of certain basic information to
mortgagors concerning credit terms and settlement costs.
Additionally, there are various state and local laws and regulations
affecting the production operations. The production operations are licensed in
those states requiring such a license. Production operations may also be subject
to applicable state usury statutes. The Company believes that it is in material
compliance with all material rules and regulations to which it is subject.
COMPETITION The Company competes with a number of institutions with greater
financial resources in originating and purchasing loans through their production
operations. In addition, in purchasing portfolio investments and in issuing
securities, the Company competes with investment banking firms, savings and loan
associations, commercial banks, mortgage bankers, insurance companies and
federal agencies and other entities purchasing mortgage assets, many of which
have greater financial resources than the Company. Additionally, securities
issued relative to its production operations will face competition from other
investment opportunities available to prospective purchasers.
EMPLOYEES
As of December 31, 1997, the Company had 231 employees.
Item 2. PROPERTIES
The Company's executive and administrative offices and operations offices
are both located in Glen Allen, Virginia, on properties leased by the Company.
The address is 10900 Nuckols Road, 3rd Floor, Glen Allen, Virginia 23060.
Item 3. LEGAL PROCEEDINGS
On March 20, 1997, American Model Homes ("Plaintiff") filed a complaint
against the Company in Federal District Court in the Central District of
California alleging that the Company, among other things, misappropriated
Plaintiff's trade secrets and confidential information in connection with the
Company's establishment of its model home lending business. The US District
Court for the Eastern District of Virginia dismissed this complaint with
prejudice on February 20, 1998. The plaintiffs have appealed the Court's
decision to the Fourth Circuit Court of Appeals. The Company is subject to
various lawsuits as result of its lending activities. The Company does not
anticipate that the resolution of such lawsuits will have a material impact on
the Company's financial condition. Item 4. SUBMISSION OF MATTERS TO A VOTE OF
SECURITY HOLDERS No matters were submitted to a vote of the Company's
stockholders during the fourth quarter of 1997.
PART II Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS The Company's common stock is traded on the New York Stock
Exchange under the trading symbol DX. The Company's common stock was held by
approximately 4,422 holders of record as of February 28, 1998. During the last
two years, the high and low closing stock prices and cash dividends declared on
common stock, adjusted for the two-for-one stock split effective May 5, 1997,
were as follows:cash dividends declared on common stock, adjusted for the
two-for-one stock split effective May 5, 1997, were as follows:
Cash Dividends
High Low Declared
1997
First quarter $ 15 11/16 $ 12 3/4 $ 0.325
Second quarter 15 1/2 12 13/16 0.335
Third quarter 15 5/16 13 1/8 0.345
Fourth quarter 14 13/16 13 1/16 0.350
1996
First quarter $ 11 $ 9 3/8 $ 0.255
Second quarter 12 9/16 9 3/4 0.275
Third quarter 12 3/4 10 5/8 0.293
Fourth quarter 14 13/16 11 15/16 0.310
Item 6. SELECTED FINANCIAL DATA
(amounts in thousands except share data)
Years ended December 31, 1997 1996 1995 1994 1993
- -------------------------------------------------------------------------------------------------------------------------
Net interest margin $ 84,737 $ 75,141 $ 43,791 $ 44,978 45,019
Gain on sale of single family mortgage - 17,285 - - -
operations
Gain on sale of assets, net 10,254 503 9,651 27,723 23,585
Other income 3,604 882 1,591 840 734
General and administrative expenses 24,597 20,763 18,123 21,284 15,211
------ ------ ------ ------ ------
Net income $ 73,998 $ 73,048 $ 36,910 $ 52,257 54,127
============== ============= ============= ============= =============
Total revenue $ 350,762 $ 330,971 $ 266,496 $ 256,483 196,575
============== ============= ============= ============= =============
Total expenses $ 276,764 $ 257,923 $ 229,586 $ 204,226 142,448
============== ============= ============= ============= =============
Net income per common share
Basic(1) $ 1.38 $ 1.54 $ 0.85 $ 1.32 1.56
Diluted (1) 1.37 1.49 0.85 1.32 1.56
Dividends declared per share:
Common (1) $ 1.355 $ 1.133 $ 0.84 $ 1.38 1.53
Series A Preferred 2.710 2.375 1.17 - -
Series B Preferred 2.710 2.375 0.42 - -
Series C Preferred 2.920 0.600 - $ -
-
Return on average common shareholders' equity 17.9% 21.6% 12.5% 19.2% 25.8%
(2)
Total fundings $ 2,490,490 $ 1,508,780 $ 916,570 $ 2,861,443 4,093,714
As of December 31, 1997 1996 1995 1994 1993
- -------------------------------------------------------------------------------------------------------------------------
Investments (3) $ 5,338,454 $ 3,953,034 $ 3,426,413 $ 3,539,778 $ 3,513,416
Total assets 5,378,172 3,983,122 3,486,288 3,590,383 3,724,554
Non-recourse debt 3,632,079 2,147,384 843,856 351,406 430,470
Recourse debt 1,145,695 1,299,876 2,238,931 3,010,372 2,990,289
Total liabilities 4,817,263 3,479,505 3,131,465 3,400,350 3,471,522
Shareholders' equity 560,909 503,617 354,823 190,033 253,032
Number of common shares outstanding 45,146,242 20,653,593 20,198,654 20,078,013 19,331,932
Average number of common shares 43,031,381 20,444,790 20,122,722 19,829,609 17,364,309
Book value per common share (1) $ 9.53 $ 8.81 $ 6.63 $ 4.73 $ 6.54
- --------------------------------------------------------------------------------
(2) Excludes unrealized gain/loss on investments available-for-sale.
(3) Investments classified as available-for-sale are shown at fair value
as of December 31, 1997, 1996, 1995, and 1994 and at amortized cost as
of December 31, 1993
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
FINANCIAL CONDITION
- -------------------------------------------------- -----------------------------
December 31,
---------------------------
(amounts in thousands
except per share data) 1997 1996
- -------------------------------------------------- ---------------------
Investments:
Collateral for collateralized bonds $4,375,561 $2,698,342
Mortgage securities 513,750 890,212
Other investments 214,120 98,943
Loans held for securitization 235,023 265,537
Non-recourse debt - collateralized bonds 3,632,079 2,147,384
Recourse debt 1,145,695 1,299,876
Shareholders' equity 560,909 503,617
Book value per common share 9.53 8.81
- -------------------------------------------------- -- ------------------ --- --
Dynex Capital, Inc. (the "Company") is a mortgage and consumer finance
company which uses its loan production operations to create investments for its
portfolio. Currently, the Company's primary loan production operations include
the origination of mortgage loans secured by multifamily and commercial
properties and the origination of loans secured by manufactured homes. The
Company will generally securitize the loans funded as collateral for
collateralized bonds, limiting its credit risk and providing long-term financing
for its portfolio.
Collateral for collateralized bonds As of December 31, 1997, the Company
had 33 series of collateralized bonds outstanding. The collateral for
collateralized bonds increased to $4.4 billion at December 31, 1997 compared to
$2.7 billion at December 31, 1996. This increase of $1.7 billion is primarily
the result of the addition of $2.7 billion of collateral related to the issuance
of three series of collateralized bonds in 1997, net of $0.9 billion in paydowns
on collateral.
Mortgage securities
Mortgage securities decreased to $513.8 million at December 31, 1997
compared to $890.2 million at December 31, 1996. The decrease was primarily the
result of the Company pledging $311.1 million of mortgage securities as part of
the collateral for two series of collateralized bonds issued during 1997.
Additionally, the Company purchased $848.7 million of primarily fixed-rate
mortgage securities and sold $847.3 million of primarily fixed-rate mortgage
securities during 1997.
Other investments
Other investments increased from $98.9 million at December 31, 1996 to
$214.1 million at December 31, 1997. The increase is primarily the result of
additional purchases or financing of $116.0 million of model homes and the
purchase of $38.7 million of property tax receivables in 1997. These increases
were partially offset by the sale of $15.3 million in model homes and the
receipt of the $9.5 million annual principal payment on the note receivable from
the 1996 sale of the single family mortgage operations.
Loans held for securitization
Loans held for securitization decreased from $265.5 million at December 31,
1996 to $235.0 million at December 31, 1997. The decrease resulted from the
securitization of $1.8 billion of loans as collateral for collateralized bonds
during 1997. This decrease was principally offset with new loan fundings from
the Company's production operations, totaling $565.1 million and bulk purchases
of single family loans, totaling $1.3 billion.
Non-recourse debt
Collateralized bonds increased to $3.6 billion at December 31, 1997 from
$2.1 billion at December 31, 1996 as a result of the issuance of $2.6 billion of
collateralized bonds during 1997. Two series of collateralized bonds, totaling
$2.3 billion, were collateralized by securities secured by single family
mortgage loans and manufactured housing loans. One series, totaling $313.5
million was collateralized by securities secured by commercial and multifamily
mortgage loans.
Recourse debt
Recourse debt decreased to $1.1 billion at December 31, 1997 from $1.3
billion at December 31, 1996. This decrease was primarily due to securitizing
$311.1 of mortgage securities as collateral for collateralized bonds, offset by
the addition of $144.9 million of repurchase agreements secured by
collateralized bonds retained by the Company as a result of securitizations
during 1997 and the issuance of $100 million of senior unsecured notes during
1997.
Shareholders' Equity
Shareholders' equity increased to $560.9 million at December 31, 1997 from
$503.6 million at December 31, 1996. This increase was primarily the result of
$42 million of common stock proceeds received, principally through the dividend
reinvestment program. In addition, the net unrealized gain on investments
available-for-sale increased $15.0 million from $64.4 million at December 31,
1996 to $79.4 million at December 31, 1997 primarily due to the issuance of the
three series of collateralized bonds during 1997.
RESULTS OF OPERATIONS
- --------------------------------------------------------------------------------
For the Year Ended December 31,
----------------------------------------------------------
(amounts in thousands except per share information) 1997 1996 1995
- ------------------------------------------------------------------------------------------------------------------------
Net interest margin $ 84,737 $ 75,141 $ 43,791
Gain on sale of single family mortgage operations - 17,285 -
Gain on sale of assets, net 10,254 503 9,651
General and administrative expenses 24,597 20,763 18,123
Net income 73,998 73,048 36,910
Basic net income per common share(1) 1.38 1.54 0.85
Diluted net income per common share(1) 1.37 1.49 0.85
Total fundings 2,490,490 1,508,780 916,570
Dividends declared per share:
Common(1) $ 1.355 $ 1.1325 0.840
Series A Preferred 2.710 2.3750 1.170
Series B Preferred 2.710 2.3750 0.423
Series C Preferred 2.920 0.6000 -
- --------------------------------------------------------------------------------
(1) 1996 and 1995 have been adjusted for two-for-one common stock split
effective May 5, 1997.
1997 Compared to 1996. The increase in the Company's net income during 1997
as compared to 1996 is primarily the result of an increase in both net interest
margin and gain on sale of assets. These increases were offset partially by an
increase in general and administrative expenses and no comparable gain to the
gain on sale of the single family mortgage operations in 1996. The decrease in
the Company's net income per common share during 1997 as compared to 1996 is
primarily the result of an increase in the average number of common shares
outstanding due to the issuance of new common stock and the partial conversion
of outstanding preferred stock.
Net interest margin for the year ended December 31, 1997 increased to $84.7
million, or 12.8%, over net interest margin of $75.1 million for the same period
in 1996. This increase in net interest margin was a result of an overall growth
in average interest-earning assets which increased to $4.5 billion during 1997
as compared to $4.1 billion for 1996. Additionally, the increase in net interest
margin was due to the additional common stock issued during 1997, the proceeds
from which was initially used to pay short-term borrowings.
The gain on the sale of the single family mortgage operations in 1996 was a
one-time gain related to the sale of the Company's single family correspondent,
wholesale and servicing business on May 13, 1996. The gain on sale of assets,
net for 1997 increased to $10.3 million, as compared to a $0.5 million gain for
1996. The gain on sale of assets during 1997 is primarily the result of premiums
received of $9.9 million on covered call options and put options written during
1997 and gains generated of $0.6 million on the sale of certain investments.
During 1996, the Company sold certain investments in its portfolio which
resulted in a $2.0 million net gain. The Company also wrote down, by $1.5
million, the carrying value of certain mortgage derivative securities as
anticipated future prepayment rates were expected to result in the Company
receiving less cash than its remaining basis in those investments.
General and administrative expenses increased $3.8 million, or 18.5%, to
$24.6 million in 1997. This increase is primarily a result of the growth in the
Company's current production operations offset partially by the expense
reductions resulting from the sale of the single family mortgage operations in
May 1996. In 1997, the Company opened one regional office and three district
offices to support its manufactured housing lending operations. General and
administrative expenses should continue increasing during 1998 as the Company
continues to build its production infrastructure, including a retail
manufactured housing loan origination effort.
1996 Compared to 1995. The increase in the Company's net income and net
income per common share during 1996 as compared to 1995 was primarily the result
of the increase in net interest margin and the gain on the sale of the single
family mortgage operations. These increases were offset partially by a decline
in the gain on sale of assets and an increase in general and administrative
expenses.
Net interest margin for 1996 increased to $75.1 million, or 71.5%, over net
interest margin of $43.8 million for 1995. This increase was a result of an
overall increase in the net interest spread on all interest-earning assets,
which increased to 1.52% for 1996 versus 1.04% for 1995, as well as the
increased contribution from the net investment in collateralized bonds. The
increase in the net interest spread was attributable to the ARM securities being
fully-indexed during 1996, and to the more favorable interest rate environment
on both collateralized bonds and recourse borrowings related to the ARM
securities. During 1995, as a result of rising short-term rates during both 1994
and early 1995, the Company's ARM securities were generally not fully-indexed
throughout the year.
Prior to the sale of the Company's single family mortgage operations on May
13, 1996, the single family mortgage operations had contributed to the Company's
earnings through the securitization and sale of loans funded through its
production activities, recorded as gain on sale of assets. During 1995, the
Company recorded a $4.7 million net gain on sale of assets related to the
securitization and sale of loans. No gain on securitization or sale of loans was
recorded during 1996. During 1996, the Company'sold certain investments in its
portfolio which resulted in a $2.0 million gain. The Company also wrote down by
$1.5 million the carrying value of certain mortgage derivative securities as
anticipated future prepayment rates were expected to result in the Company
receiving less cash than its remaining basis in those investments. In
comparison, during 1995, the Company'sold investments for a net gain of $3.8
million and recorded no write-downs. The Company also sold previously purchased
mortgage servicing rights in 1995 for a gain of $1.2 million.
General and administrative expenses increased $2.6 million, or 14.6%, to
$20.8 million in 1996, as the Company continued to build its infrastructure for
its manufactured housing lending operations. General and administrative expenses
also increased from 1995 as a result of the Company's continued expansion of its
wholesale origination capabilities for its single family mortgage operations
prior to their sale. The Company continued to expand its manufactured housing
lending operations, and in August 1996, acquired Multi-Family Capital Markets,
Inc. to expand its multifamily and commercial real estate lending businesses.
The following table summarizes the average balances of the Company's
interest-earning assets and their average effective yields, along with the
Company's average interest-bearing liabilities and the related average effective
interest rates, for each of the periods presented.
Average Balances and Effective Interest Rates
- ------------------------------------------------------------------------------------------------------------------------
(amounts in thousands) Year Ended December 31,
- ------------------------------------------------------------------------------------------------------------------------
1997 1996 1995
------------------------- --------------------------- ------------------------
Average Effective Average Effective Average Effective
Balance Rate Balance Rate Balance Rate
-------------- -------- -------------- ----------- ------------ ----------
Interest-earning assets: (1)
Collateral for collateralized $ 2,775,494 7.53 % 1,832,141 8.11 % $ 711,316 8.58 %
bonds(2) (3)
Mortgage securities 1,110,646 8.36 1,831,621 7.01 2,277,906 7.05
Other investments 136,932 10.00 62,484 9.18 35,413 14.97
Loans held for securitization 502,677 7.98 355,326 8.29 331,995 8.54
------- ---- ------- ---- ------- ----
Total interest-earning assets $ 4,525,749 7.86 % 4,081,572 7.65 % $ 3,356,630 7.60 %
============== ====== ============== ======== ============ ========
Interest-bearing liabilities:
Non-recourse debt - collateralized $ 2,226,894 6.67 % 1,493,397 6.63 % 530,616 7.52 %
bonds (3)
Recourse debt - collateralized 419,621 5.74 248,657 5.60 148,935 6.01
bonds retained
-------------- ------ -------------- -------- ------------ --------
2,646,515 6.53 1,742,054 6.50 679,551 7.21
Recourse debt secured by
investments:
Mortgage securities 931,334 5.74 1,691,629 5.55 2,071,750 6.07
Other investments 31,372 7.74 1,241 9.59 11,329 8.64
Loans held for securitization 354,116 5.83 229,494 5.90 274,686 7.05
Recourse debt - unsecured 88,059 9.01 46,375 10.01 49,375 9.97
------ ---- ------ ----- ------ ----
Total interest-bearing $ 4,051,396 6.38 % 3,710,793 6.13 % $ 3,086,691 6.56 %
liabilities
============== ====== ============== ======== ============ ========
Net interest spread on all investments 1.48 % 1.52 % 1.04 %
(3)
====== ======== ========
Net yield on average interest-earning 2.15 % 2.08 % 1.57 %
assets
====== ======== ========
- --------------------------------------------------------------------------------------------------------------------------
___________________________
(1) Average balances exclude adjustments made in accordance with Statement of
Financial Accounting Standards No. 115, "Accounting for Certain Investments
in Debt and Equity Securities", to record available for sale securities at
fair
value.
(2) Average balances exclude funds held by trustees of $2,481, $2,839 and
$3,815 for the years ended December 31, 1997, 1996 and 1995,
respectively.
(3) Effective rates are calculated excluding non-interest related
collateralized bond expenses and provision for credit losses.
1997 compared to 1996 The net interest spread decreased to 1.48% for the
year ended December 31, 1997 from 1.52% for the same period in 1996. This
decrease was primarily the result of the decline in the spread on the
collateralized bonds, which for 1997 constituted the largest portion of the
Company's investment portfolio on a weighted-average basis. In addition,
short-term interest rates increased 0.25% during March 1997, which raised the
Company's weighted-average borrowing costs to 6.38% for the year ended December
31, 1997, from 6.13% for the year ended December 31, 1996. The overall yield on
interest-earning assets increased to 7.86% for year ended December 31, 1997,
from 7.65% for the same period in 1996. This increase is primarily due to the
ARM assets in the Company's portfolio resetting upwards during 1997 and the
purchase of higher yielding ARM residual trusts during the latter part of 1996
and during the first three quarters of 1997.
Individually, the net interest spread on collateralized bonds decreased 61
basis points, from 161 basis points for the year ended December 31, 1996 to 100
basis points for the same period in 1997. This decline was primarily due to the
securitization of lower coupon collateral, principally A+ quality single family
ARM loans during 1997 coupled with the prepayments of seasoned, higher coupon
single family collateral during 1997. In addition, the spread on the net
investment in collateralized bonds decreased due to higher premium amortization
caused by increased prepayments during the latter part of 1997. The net interest
spread on mortgage securities increased 116 basis points, from 146 basis points
for the year ended December 31, 1996 to 262 basis points for the year ended
December 31, 1997. This increase is primarily attributed to the ARM securities
in the Company's portfolio during 1997 having a higher margin than those ARM
securities in the Company's portfolio in 1996. In addition, the Company
purchased higher yielding ARM residual trusts during the latter part of 1996 and
during the first three quarters of 1997. The net interest spread on other
investments increased 267 basis points, from a negative 41 basis points for the
year ended December 31, 1996, to 226 basis points for the year ended December
31, 1997, due primarily to lower borrowing costs associated with the Company's
single family model home purchase and leaseback business during 1997. The net
interest spread on loans held for securitization decreased 24 basis points, from
239 basis points from the year ended December 31, 1996, to 215 basis points for
the same period in 1997. This decrease is primarily attributable to the purchase
of lower coupon loans, principally A+ quality single family ARM loans during
1997.
1996 compared to 1995. The increase in net interest spread for 1996
relative to 1995 is primarily the result of the increase in the spread on ARM
securities and an increase in the average balance and spread on the net
investment in collateralized bonds, which for 1996, constituted the largest
portion of the Company's investment portfolio on a weighted-average basis. The
net interest spread benefited as a result of the declining short-term interest
rate environment during the first part of 1996, which had the impact of reducing
the Company's borrowing costs faster than reducing the yields on the Company's
interest-earning assets. The Company's overall weighted-average borrowing costs
decreased to 6.13% for 1996 from 6.56% for 1995. The overall yield on
interest-earning assets increased to 7.65% from 7.60% as the Company's portfolio
became more heavily weighted in collateral for collateralized bonds which have
higher effective rates than ARM securities. Collateral for collateralized bonds
increased to an average $1.8 billion for the year ended December 31, 1996, or
158%, from an average $711.3 million for the year ended December 31, 1995.
Individually, the net interest spread on the net investment in
collateralized bonds increased 24 basis points, from 137 basis points for the
year ended December 31, 1995, to 161 basis points for the same period in 1996.
This increase is partially attributable to the declining short-term interest
rate environment, which had the impact of reducing the collateralized bonds
borrowing costs faster than reducing the yield on the collateral for
collateralized bonds. The net interest spread on mortgage securities increased
48 basis points, from 98 basis points for the year ended December 31, 1995 to
146 basis points for the year ended December 31, 1996. During 1995, the ARM
securities were "teased" during the first nine months of 1995. Subsequently, the
ARM securities became fully-indexed as short-term rates stabilized and then
declined during the latter half of 1995 and through the first quarter of 1996.
In addition, the Company purchased higher yielding fixed-rate securities during
1996. The net interest spread on other investments decreased 674 basis points,
from 633 basis points from the year ended December 31, 1995, to negative 41
basis points for the year ended December 31, 1996, due primarily to higher
borrowing costs associated with the Company's single family model home purchase
and leaseback business during 1996. The net interest spread on loans held for
securitization increased 90 basis points, from 149 basis points for the year
ended December 31, 1995, to 239 basis points for the same period in 1996. This
increase is primarily attributed to the reduced borrowing costs associated with
the decline in short-term interest rates during the first part of 1996.
The following tables summarize the amount of change in interest income
and interest expense due to changes in interest rates versus changes in volume:
- ---------------------------------------------------------------------------------------------------------------
1997 to 1996 1996 to 1995
------------------------------------- ------------------------------------
(amounts in thousands) Rate Volume Total Rate Volume Total
------------ ----------- ------------ ------------ ----------- -----------
Collateral for collateralized bonds $ (11,428) $ 71,699 $ 60,271 $ (3,456 ) $ 91,124 $ 87,668
Mortgage securities 21,435 (57,076) (35,641) (844 ) (31,302 ) (32,146)
Other investments 556 7,405 7,961 (2,577 ) 3,012 435
Loans held for securitization (1,122) 11,795 10,673 (861 ) 1,951 1,090
------------ ------------------------ ------------ ----------- -----------
Total interest income 9,441 33,823 43,264 (7,738 ) 64,785 57,047
------------ ------------------------ ------------ ----------- -----------
Non-recourse debt - collateralized 472 48,887 49,359 (5,200 ) 64,385 59,185
bonds
Recourse debt - collateralized bonds 329 9,939 10,268 (668 ) 5,712 5,044
retained
------------ ------------------------ ------------ ----------- -----------
Total collateralized bonds 801 58,826 59,627 (5,868 ) 70,097 64,229
Recourse debt secured by investments:
Mortgage securities 2,845 (44,158) (41,313) (10,296 ) (22,099 ) (32,395)
Other investments (28) 2,369 2,341 99 (973 ) (874)
Loans held for securitization (169) 7,370 7,201 (2,940 ) (2,967 ) (5,907)
Recourse debt - unsecured (529) 3,852 3,323 20 (305 ) (285)
------------ ------------------------ ------------ ----------- -----------
Total interest expense 2,920 28,259 31,179 (18,985 ) 43,753 24,768
------------ ------------ ---------- ----------- --------- ---------
Net interest on mortgage assets $ 6,521 $ 5,564 $ 12,085 $ 11,247 $ 21,032 $ 32,279
============ ======================== ============ =========== ===========
- -----------------------------------------------------------------------------------------------------------------
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 other interest expense and provision for credit losses.
Interest Income and Interest-Earning Assets
The Company's average interest-earning assets grew to $4.5 billion during
1997, an increase of 11% from $4.1 billion of average interest-earning assets
during 1996. This increase in average interest-earnings assets was primarily the
result of the addition of $2.7 billion of collateral for collateralized bonds
during 1997. Of this amount, $0.3 billion resulted from the pledge of ARM
securities already owned by the Company as collateral for collateralized bonds.
This was offset by $1.1 billion of principal paydowns on securities and loans
during 1997. Average interest-earning assets increased to $4.1 billion during
1996, from $3.4 billion during 1995. This increase in interest-earnings assets
from 1995 to 1996 was primarily a result of the addition of $2.1 billion of
collateral for collateralized bonds during 1996, net of $0.8 billion of
principal paydowns on securities and loans during 1996. Total interest income
rose 14% during 1997, from $312.3 million for the year ended December 31, 1996,
to $355.6 million for the same period of 1997. This increase in total interest
income was due to the growth in average interest-earning assets during 1997.
Total interest income also rose 22% during 1996 from $255.3 million for the year
ended December 31, 1995 to $312.3 million for the same period in 1996. Overall,
the yield on average interest-earning assets rose to 7.86% for the year ended
December 31, 1997, from 7.65% and 7.60% for the years ended December 31, 1996
and 1995, respectively. These increases resulted from increased yields on ARM
loans included in the Company's investment portfolio for collateral for
collateralized bonds, ARM securities and ARM residual trusts. As indicated in
the table below, the average yields were 2.02%, 2.06% and 1.50% higher than the
average daily six-month LIBOR interest rate during 1997, 1996 and 1995,
respectively. While a majority of the ARM loans underlying the Company's ARM
securities and collateral for collateralized bonds are indexed to and reset
based upon the level of the London InterBank Offered Rate (LIBOR) for six-month
deposits (six-month LIBOR), approximately one-third are indexed to and reset
based upon the level of the Constant Maturity Treasury Index (CMT).
Earning Asset Yield
($ in millions)
- -------------- --------------- -- ------------- --- -------------- ---- ------------------ ---------------
Average Asset
Interest-Earning Daily Average Yield versus
Assets Interest Average Six Month LIBOR Six Month
Income(1) Asset Yield LIBOR
- -------------- --------------- -- ------------- --- -------------- ---- ------------------ ---------------
1995 $ 3,356.6 $ 255.3 7.60% 6.10% 1.50%
1996 4,081.6 312.3 7.65% 5.59% 2.06%
1997 4,525.7 355.6 7.86% 5.84% 2.02%
- -------------- -- ------------ --- ------------ --- -------------- ---- ------------------ ---------------
(1) Interest income includes amounts related to the gross interest
income on securities which are accounted for on a net basis.
The average asset yield is reduced for the amortization of premiums, net of
discounts on the Company's investment portfolio. By creating its investments
through its production operations, the Company believes that premium amounts are
less than if the investments were acquired in the market. As indicated in the
table below, premiums on the Company's collateral for collateralized bonds, ARM
securities and fixed-rate securities at December 31, 1997 were $56.9 million, or
approximately 1.23% of the aggregate investment portfolio balance. The principal
repayment rate for the Company (indicated in the table below as "CPR Annualized
Rate") was 37% for the year ended December 31, 1997. CPR or "constant prepayment
rate" and is a measure of the annual prepayment rate on a pool of loans.
Premium Basis and Amortization
($ in millions)
- ---------------------------------------------------------------------------------------------------------------------
Amortization
CPR Expense as a %
Net Amortization Annualized Principal of Principal
Premium Expense Rate Paydowns Paydowns
- ---------------------------------------------------------------------------------------------------------------------
1995 $ 46.6 $ 7.9 (1) $ 462.3 1.71%
1996 54.1 13.8 24% 752.5 1.84%
1997 56.9 18.4 37% 993.2 1.85%
- ---------------------------------------------------------------------------------------------------------------------
(1) CPR rate was not available for the period.
Interest Expense and Cost of Funds
The Company's largest expense is the interest cost on borrowed funds. Funds
to finance the investment portfolio are borrowed primarily in the form of
collateralized bonds and repurchase agreements, both of which are primarily
indexed to LIBOR, principally one-month LIBOR. The Company may use interest rate
swaps, caps and financial futures to manage its interest rate risk. The net cost
of these instruments is included in the cost of funds table below as a component
of interest expense for the period to which it relates. The Company's average
borrowed funds increased from $3.7 billion during 1996 to $4.1 billion during
1997. The increase resulted primarily from the issuance of $2.6 billion of
collateralized bonds during 1997. This increase was partially offset by a
reduction of repurchase agreements primarily as a result of the Company
securitizing $311.1 million of ARM securities previously financed with
repurchase agreements as collateral for collateralized bonds. For the year ended
December 31, 1997, interest expense also increased to $258.5 million from $227.3
million for the year ended 1996, while the average cost of funds increased to
6.38% for 1997 compared to 6.13% for 1996. The increase in the cost of funds was
a result of an increase in the one-month LIBOR rates during the first quarter of
1997. The cost of funds for the year ended December 31, 1996, compared to
December 31, 1995, decreased to 6.13% from 6.56 %, respectively as a result of
the decline of the one-month LIBOR rate during 1996.
Cost of Funds
($ in millions)
- -----------------------------------------------------------------------------------------------------------
Average Cost of Funds
Average Borrowed Interest Cost One-month versus
Funds Expense (1)(2) of Funds LIBOR One-month LIBOR
- -----------------------------------------------------------------------------------------------------------
1995 $ 3,086.7 $ 202.5 6.56% 5.97% 0.59%
1996 3,710.8 227.3 6.13% 5.45% 0.68%
1997 4,051.4 258.5 6.38% 5.64% 0.74%
- -----------------------------------------------------------------------------------------------------------
(1) Excludes non-interest related expenses.
(2) Includes the net amortization expense of bond discounts and bond premiums
of $2.4 million, ($0.2) million and ($0.3) million for the years ended
December 31, 1997, 1996 and 1995, respectively.
Interest Rate Agreements
As part of the Company's asset/liability management process for its
investment portfolio, the Company enters into interest rate agreements such as
interest rate caps, swaps and financial futures contracts. These agreements are
used to reduce interest rate risk which arises from the lifetime yield caps on
the ARM securities, the mismatched repricing of portfolio investments versus
borrowed funds, and finally, assets repricing on indices such as the prime rate
which differ from the related borrowing indices. The agreements are designed to
protect the portfolio's cash flow and to provide income and capital appreciation
to the Company in the event that short-term interest rates rise quickly.
The following table includes all interest rate agreements in effect as of
each year end for asset/liability management of the investment portfolio.
Interest rate agreements used by the Company for asset/liability management
include interest rate swap, cap, futures and forward agreements and options on
interest rate futures. This table excludes all interest rate agreements in
effect for the Company's loan production operations. Generally, interest rate
swaps and caps are used to manage the interest rate risk associated with assets
that have periodic and annual interest rate reset limitations financed with
borrowings that have no such limitations. Financial futures contracts and
options on futures may be used to lengthen the terms of repurchase agreement
financing, generally from one month to three and six months. Amounts presented
are aggregate notional amounts. To the extent any of these agreements are
terminated, gains and losses are generally amortized over the remaining period
of the original agreement. Interest rate caps included $425 million of forward
start caps beginning in 2001.
Instruments Used for Interest Rate Risk Management Purposes(1)
(Notional amounts in millions)
- --------------------------------------------------------------------------------
Interest Rate Interest Rate Financial Options on
December 31, Caps Swaps Futures Futures
- --------------------------------------------------------------------------------
1995 $ 1,575 $ 1,227 $ 1,000 $ 2,130
1996 1,499 1,453 - -
1997 1,499 1,354 - -
- --------------------------------------------------------------------------------
(1) Excludes all hedge agreements in effect for the Company's production
operations.
Net Interest Rate Agreement Expense
The net interest rate agreement expense, or hedging expense, equals the
expenses, net of any benefits received, from these agreements. For the year
ended December 31, 1997, net hedging expense amounted to $6.61 million versus
$6.62 million and $3.70 million for the years ended December 31, 1996 and 1995,
respectively. Such amounts exclude the hedging costs and benefits associated
with the Company's production activities as these amounts are deferred as
additional premium or discount on the loan funded and amortized over the life of
the loan as an adjustment to its yield. The net interest rate agreement expense
declined slightly for the year ended December 31, 1997 compared to the same
period in 1996. This slight decrease was the result of the amortization of
existing interest rate agreements and no new interest rate agreements being
entered into during 1997. The increase in the net interest rate agreement
expense for 1996 compared to 1995 is primarily the result of the addition of an
interest rate swap agreements to reduce the Company's exposure to basis risk for
certain collateral for collateralized bonds and to cap the borrowing costs
during any six-month period for a portion of the short-term borrowings.
Net Interest Rate Agreement Expense
($ in millions)
- --------------------------------------------------------------------------------
Net Expense Net Expense as
Net Interest as Percentage Percentage of Average
Rate Agreement of Average Borrowings
Expense Assets (annualized) (annualized)
- --------------------------------------------------------------------------------
1995 $ 3.70 0.11% 0.12%
1996 6.62