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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-K
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
1-9819
(Commission file number)
DYNEX CAPITAL, INC.
(Exact name of registrant as specified in its charter)
Virginia 52-1549373
(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.)
4551 Cox Road, Suite 300, Glen Allen, Virginia 23060-6740
(Address of principal executive offices) (Zip Code)
(804) 217-5800 (Registrant's
telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
- ------------------- -----------------------------------------
Common Stock, $.01 par value New York Stock Exchange
Series D 9.50% Cumulative Convertible New York Stock Exchange
Preferred Stock, $.01 par value
Securities registered pursuant to Section 12(g) of the Act:
None
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2).
Yes |_| No |X|
As of June 30, 2004, the aggregate market value of the voting stock held by
non-affiliates of the registrant was approximately $64,808,462 at a closing
price on The New York Stock Exchange of $5.96. Common stock outstanding as of
February 28, 2005 was 12,162,391 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Definitive Proxy Statement to be filed pursuant to Regulation
14A within 120 days from December 31, 2004, are incorporated by reference into
Part III.
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DYNEX CAPITAL, INC.
2004 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
Page
Number
PART I.
Item 1. Business.................................................................................1
Item 2. Properties..............................................................................11
Item 3. Legal Proceedings.......................................................................11
Item 4. Submission of Matters to a Vote of Security Holders.....................................12
PART II.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and
Issuer Purchases of Equity Securities...................................................12
Item 6. Selected Financial Data.................................................................13
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations...................................................................13
Item 7A. Quantitative and Qualitative Disclosures about Market Risk..............................28
Item 8. Financial Statements and Supplementary Data.............................................29
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure....................................................................29
Item 9A. Controls and Procedures.................................................................30
Item 9B. Other Information.......................................................................30
PART III.
Item 10. Directors and Executive Officers of the Registrant......................................30
Item 11. Executive Compensation..................................................................30
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters.....................................................................31
Item 13. Certain Relationships and Related Transactions..........................................31
Item 14. Principal Accounting Fees and Services..................................................31
PART IV.
Item 15. Exhibits, Financial Statement Schedules.................................................31
SIGNATURES ........................................................................................34
PART I
Item 1. Business
AVAILABLE INFORMATION
---------------------
This annual report on Form 10-K, our quarterly reports on Form 10-Q and
our current reports on Form 8-K, and amendments to those reports filed or
furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of
1934 are made available as soon as reasonably practicable after such material is
electronically filed with or furnished to the Securities and Exchange
Commission, free of charge, through our website. Our website address is
www.dynexcapital.com.
We have adopted a code of conduct that applies to all of our employees,
officers and directors. Our code of conduct is also available, free of charge,
on our website, along with our Audit Committee Charter, our Nominating and
Corporate Governance Committee Charter, and our Compensation Committee Charter.
We will post on our website any amendments to the code or waivers from our code
of conduct, if any, which are applicable to any of our directors or executive
officers.
GENERAL
We were incorporated in the Commonwealth of Virginia in 1987. We are a
financial services company, which has investments in loans and securities
consisting of, or secured by, principally single family mortgage loans,
commercial mortgage loans, manufactured housing installment loans and delinquent
property tax receivables. The loans and securities in which we invest have
generally been pooled and pledged to securitization trusts, which issue bonds
collateralized by the assets pledged to the trust. These bonds are non-recourse
to us and are utilized as a means of providing long-term financing for our
investments. The process of pooling investments, creating a securitization trust
and issuing bonds is referred to as securitization. From an economic point of
view, the securitization of collateral limits the credit, interest rate and
liquidity risk resulting from the ownership of the collateral. Assets that have
been pledged as collateral in a securitization transaction are presented in our
financial statements as securitized finance receivables, and the associated
financing is presented as non-recourse securitization financing. Together, the
securitized finance receivables and associated financing are hereinafter
referred to as securitization trusts.
We have elected to be treated as a real estate investment trust (REIT)
for federal income tax purposes under the Internal Revenue Code of 1986, as
amended, and, as such, must distribute substantially all of our taxable income
to shareholders. Provided that we meet all of the prescribed Internal Revenue
Code requirements for a REIT, we will generally not be subject to federal income
tax.
In recent years, we have elected to shrink our investment portfolio,
converting what we deem to be non-core assets into cash, while improving our
overall financial position and flexibility. Our non-core assets currently
include manufactured housing loans and delinquent property tax receivables.
During 2004, we engaged in a number of strategic sales of assets, including the
sale of our delinquent property tax receivables portfolio located in Cuyahoga
County, Ohio for $19.2 million, and the sale of our interest in a manufactured
housing loan securitization trust for $11.9 million. These two sales resulted in
the derecognition of approximately $241.5 million of investments and $226.7
million in securitization financing, at a net gain of $14.3 million. Our
investments at the end of 2004 included approximately $347.7 million of
manufactured housing loans and debt securities, as well as approximately $7.6
million of delinquent property tax receivable securities. We will continue to
attempt to convert these assets to cash, but only at amounts we deem reasonable.
See Business Focus and Strategy below for a discussion of our current and
potential long-term investment strategies.
In May 2004, we completed a recapitalization of our equity capital
structure through the exchange of our outstanding shares of Series A, Series B
and Series C preferred stock into shares of new Series D preferred stock and
common stock. The recapitalization resulted in the elimination or
payment-in-kind of $18.5 million of dividends in arrears and the issuance of
1,288,488 shares of common stock. The shares of Series D preferred stock
automatically convert to 9.50% senior notes if the Company fails to pay two
consecutive quarterly preferred dividends or if the Company fails to maintain
consolidated shareholders' equity of at least 200% of the aggregate issue price
of the Series D preferred stock.
We are currently precluded from paying a dividend on our common stock
under the terms of the Series D Preferred Stock until such time that total
shareholders' equity equals or exceeds 300% of the Series D Preferred Stock
outstanding. We do not anticipate meeting this covenant for the foreseeable
future. Assuming that we properly execute our investment strategy, as indicated
above and as discussed further below, we should be able to compound the returns
on our investable capital as a result of not paying a common dividend. Once the
Series D Preferred Stock covenant is met, we will continually review the payment
of a common dividend to our shareholders, balancing the benefit of retaining and
reinvesting capital with providing the common shareholders a cash distribution
on their investment.
We had net operating loss carryforwards (NOLs) of approximately $149
million at December 31, 2004, which expire beginning in 2018. Unlike other
mortgage REITs, our required REIT income distributions are likely to be limited
well into the future due to the reduction of our future taxable income by these
NOL carryforwards. As a result, we anticipate that we will invest our capital
and compound the returns on such invested capital on an essentially tax-free
basis for the foreseeable future. Over the long-term this will allow us to
increase our book value per common share while potentially utilizing a lower
risk investment strategy than some of our competitors would have to utilize in
order to achieve similar results.
Business Focus and Strategy
- ---------------------------
Our current business strategy is to manage our investment portfolio to
maximize our overall cash flow and earnings in order to improve our financial
flexibility and to position us to be an opportunistic investor in equity and
fixed-income instruments in the future. Our principal source of cash flow and
earnings has historically been the net interest income from our investment
portfolio.
Over the last year, we have elected to sell certain non-core assets,
improving our financial flexibility by converting investments into cash, and we
completed a restructuring of our equity capital while simultaneously eliminating
preferred dividends in arrears. Our focus for 2005 will be similar as we
continue to attempt to sell non-core assets and improve the transparency of our
balance sheet. As we sell non-core assets, we expect that our investment
portfolio will evolve principally into investments in single-family mortgage
loans and securities and commercial mortgage loans. We believe that competitive
pressures overall in the fixed-income markets, the current rising interest-rate
environment, and the fundamental changes in the mortgage market, which have led
to less predictable prepayment patterns and credit loss expectations on
single-family mortgage loans and securities, have diminished current
opportunities to earn acceptable longer-term risk-adjusted returns on newly
invested capital. As a result, we have been investing our capital in short-term,
fixed income instruments of high-credit quality and using modest amounts of
repurchase agreement leverage to increase the returns on our invested capital.
On a longer-term basis, we will continue to evaluate a number of
different investment alternatives. Our Board has formed a committee to review
long-term strategic alternatives for us, and the Board believes that it is in
the best interests of the shareholders to remain an independent company for the
foreseeable future. Because of our NOL carryforwards and our related ability to
compound our capital on a tax-free basis, our return requirements can be less
than our competitors' until our NOL carryforwards are fully utilized. Other
mortgage REITs do not pay taxes but instead must distribute at least 90% of
their taxable income to their shareholders in order to maintain their REIT
status. Upon receiving those distributions, shareholders in other mortgage REITs
must then pay taxes on the distributions, which are generally taxed as
non-qualifying ordinary income. The current maximum Federal rate on ordinary
income is 35%; therefore, for every $1.00 distributed as a dividend of ordinary
income by a mortgage REIT, the investor retains as little as $0.65, after taxes.
In addition, REIT income distribution requirements limit the ability of other
mortgage REITs to retain capital created from organic growth of their investment
portfolios (either through earnings or sales of appreciated investments), which
requires the REITs, therefore, to continually raise capital in the market place
in order to grow its book value and earnings. On the other hand, given our NOL
carryforwards, we can retain the $1.00 earned instead of distributing it,
thereby increasing our book value until the NOL carryforwards are fully
utilized.
In our securitization trusts, we have retained the right to redeem
outstanding securitization financing bonds based on percentages of the original
financing that remains outstanding, or at a certain date. Approximately $217
million in securitization financing outstanding collateralized by approximately
$225 million in single-family loans will be redeemable in March 2005. We intend
to redeem these bonds and either reissue them under new terms or retire them and
securitize the remaining $225 million in loans in a new securitization trust.
INVESTMENT PORTFOLIO
--------------------
The Company primarily invests in loans and securities on single family,
manufactured housing and commercial mortgages. The following section provides
detail on the Company's investments, financing for such investments and the
related risks.
Composition
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The following table presents the composition of the investment
portfolio by investment type and the percentage of total investments each type
represents as of December 31, 2004 and 2003. Securitized finance receivables
include loans, which are carried at amortized cost, and debt securities, which
are considered available-for-sale pursuant to the provisions of Statement of
Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain
Investments in Debt and Equity Securities," and are carried at fair value. Other
investments include a security backed by delinquent property tax receivables,
which is classified as available-for-sale and is carried at fair value.
Securities consist of mortgage-related debt securities and an asset-backed
security collateralized by consumer installment loans. Securities are considered
available-for-sale and are carried at fair value. Other loans are carried at
amortized cost.
- --------------------------------------------------- ------------------------------------------------------------------------
As of December 31,
2004 2003
------------------------------------ -----------------------------------
(amounts in thousands) Amount % of Total Amount % of Total
- --------------------------------------------------- ----------------- ------------------ ----------------- -----------------
Investments:
Securitized finance receivables:
Loans $1,036,123 77.1% $1,518,613 81.9%
Debt securities 206,434 15.4 255,580 13.8
Securities 87,706 6.5 33,275 1.8
Other investments 7,596 0.6 37,903 2.0
Other loans 5,589 0.4 8,304 0.5
- --------------------------------------------------- ----------------- ------------------ ----------------- -----------------
Total investments $1,343,448 100.0% $1,853,675 100.0%
- --------------------------------------------------- ----------------- ------------------ ----------------- -----------------
Securitized Finance Receivables. Securitized finance receivables
include loans and securities, consisting of, or secured by, adjustable-rate and
fixed-rate mortgage loans secured by first liens on single family housing,
fixed-rate loans secured by first liens on multifamily and commercial
properties, and manufactured housing installment loans secured by either a UCC
filing or a motor vehicle title. Securitized finance receivables have been
pledged to a securitization trust to support the repayment of associated
non-recourse securitization financing outstanding. Non-recourse securitization
financing is non-recourse to us in that the financing is repaid solely from the
cash flow from the securitized finance receivables. Should the cash flow from
the securitized finance receivables be insufficient to repay the non-recourse
securitization financing, we are not obligated to fund the shortfall. Our return
on our investment in securitized finance receivables is affected primarily by
changes in interest rates, prepayment rates and credit losses on the underlying
loans. By virtue of our investment in the securitization trust, we generally
retain the net interest income cash flow generated by the securitization trust.
Securities. Securities at December 31, 2004 include fixed-rate mortgage
securities consisting of mortgage-related debt securities with a recorded
balance of $79.1 million that have a fixed-rate of interest over their remaining
life, an asset-backed security with a recorded balance of $0.4 million
collateralized by consumer installment loans and equity securities with a
recorded balance of $7.4 million. Except for the equity securities, the yields
on the above referenced securities are affected primarily by changes in
prepayment rates on the underlying mortgage and consumer loans. The equity
security represents an investment in another mortgage REIT.
Other Investments. Other investments include our remaining investment
in delinquent property tax securities and receivables (collectively, the
delinquent property tax receivable portfolio). During the third quarter of 2004,
we sold all of our rights, title and interest in our delinquent property tax
receivable portfolio and servicing operation located in Cuyahoga County, Ohio to
a third party for $19.2 million. Of this amount, $0.7 million is being held in
escrow for up to one year for customary representations and warranties.
Other Loans. As of December 31, 2004, other loans consist principally
of single-family mortgage loans, both current and delinquent, mezzanine loans
secured by healthcare properties, and participations in first mortgage loans
secured by multifamily and commercial mortgage properties.
Financing For Our Investment Portfolio
- --------------------------------------
Securitization Trusts. Our predominate securitization structure is
non-recourse securitization financing, whereby loans and securities are pledged
to a trust, and the trust issues bonds pursuant to an indenture. Generally, for
accounting and tax purposes, the loans and securities financed through the
issuance of bonds in the securitization financing are treated as our assets
(securitized finance receivables), and the non-recourse securitization financing
is treated as our debt. We earn the net interest income between the interest
income on the securitized finance receivables and the interest and other
expenses associated with the securitization financing bonds. The net interest
income is directly impacted by the credit performance of the underlying loans
and securities, by the level of prepayments of the underlying loans and
securities, and, to the extent bond classes are variable-rate, by changes in
short-term interest rates. We typically retain the overcollateralization tranche
of the securitization trust. Overcollateralization is essentially the equity
investment in the trust and represents the excess of the collateral pledged over
the securitization financing bonds outstanding. We analyze our investment in
securitization financing based on our overcollateralization investment (which is
commonly referred to as our "net investment", as further discussed below). The
ownership of the overcollateralization tranche subjects us to credit risk. See
Investment Portfolio Risks - Credit Risk, below.
Master Servicing. As well as being the issuer of the securitization
financing bonds, we also master service most of the associated securitization
trusts. Our function as master servicer typically includes monitoring and
reconciling the loan payments remitted by the primary servicers of the loans,
determining the payments due on the securities and determining that the funds
are correctly sent to a trustee or investors for each series of securities.
Master servicing responsibilities also include monitoring the primary servicers'
compliance with servicing guidelines. At December 31, 2004, as master servicer,
we monitored the performance of four third-party servicers of single family
loans, the servicer of one of the series of our securitized commercial mortgage
loan pools, and the servicer of our manufactured housing loans. In our capacity
as master servicer, we are obligated to advance scheduled principal and interest
payments on delinquent loans in accordance with the underlying servicing
agreements should the primary servicer fail to make such advance. As master
servicer, we are paid a monthly fee based on the outstanding principal balance
of each loan for which we act as master servicer. During 2004, we received
approximately $0.1 million of master servicing fees. As of December 31, 2004, we
master serviced $688.7 million in securities.
Investment Portfolio Risks
- --------------------------
We are exposed to several types of risks inherent in our investment
portfolio. These risks include credit risk (inherent in the loan and/or security
structure), prepayment/interest rate risk (inherent in the underlying loan) and
margin call risk (inherent in the security if it is used as collateral for
recourse borrowings).
Credit Risk. As the result of our ownership of the
overcollateralization portion of the securitization trust, the predominant risk
to us in our investment portfolio is credit risk. Credit risk is the risk of
loss to us from the failure by a borrower (or the proceeds from the liquidation
of the underlying collateral) to fully repay the principal balance and interest
due on a loan. A borrower's ability to repay and the value of the underlying
collateral could be negatively influenced by economic and market conditions.
These conditions could be global, national, regional or local in nature. Upon
securitization of the pool of loans or securities backed by loans, the credit
risk retained by us from an economic point of view is generally limited to the
overcollateralization tranche of the securitization trust. We provide for
estimated losses on the gross amount of loans pledged to securitization trusts
included in our financial statements as required by accounting principles
generally accepted in the United States of America ("GAAP"). As a result, we
establish reserves for loan losses in excess of our retained credit risk as
discussed further in "Non-GAAP Information on Securitized Finance Receivables
and Non-Recourse Securitization Financing" below. In some instances, we may also
retain subordinated bonds from the securitization trust, which increases our
credit risk above the overcollateralization tranche from an economic
perspective. In some instances, cash flow from the trust which otherwise would
be distributed to us as the holder of the overcollateralization tranche may be
retained within the trust if certain performance triggers are not met.
In our securitization trusts, losses of principal and interest from the
liquidation of the underlying loans pledged to the trust are applied first
against the principal balance of the overcollateralization tranche, and in
certain instances, to the cash flow which would otherwise be distributed to the
overcollateralization tranche. If cumulative losses on loans are incurred by the
trust in excess of the principal balance of the overcollateralization tranche,
such losses will then generally be applied against subordinate bonds issued by
the trust. We provide reserves for existing losses based on the current
performance of the respective pool or on an individual loan basis. If losses are
experienced more rapidly due to market conditions than we have provided for in
our reserves, we may be required to provide for additional reserves for these
losses. For debt securities pledged as securitized finance receivables, we
recognize losses when incurred or when such security is deemed to be impaired on
an other-than-temporary basis in accordance with generally accepted accounting
principles.
We also have credit risk on investments that are not securitized or
that are securitized and with respect to which we retain the entire security
issued. Such investments include loans, which are carried at amortized cost less
reserves for estimated losses, and securitized delinquent property tax
receivables, which are carried at fair value.
We also have various other forms of credit enhancement which, based
upon the performance of the underlying loans and securities, may provide
additional protection against losses. These other forms of credit enhancement
pertain principally to securitization trust structures. Specifically, as of
December 31, 2004, two separate commercial mortgage loan pools totaling $97.1
million and $103.9 million are subject to loss reimbursement guarantees of $8.0
million and $11.5 million, respectively. The losses on the loans covered by
these loss reimbursement guarantees would have to exceed the respective
guarantee amount before we would incur credit losses. Single family mortgage
loans of $114.3 million pledged to securitization trusts benefit from various
mortgage pool insurance policies, which limit our credit risk until the losses
on the covered loans exceed the remaining stop loss of at least 68% on the
policies. An additional $33.3 million of single family mortgage loans
principally pledged to securitization trusts are subject to various loss
reimbursement agreements totaling $29.5 million with a remaining aggregate
deductible of approximately $0.4 million.
Prepayment/Interest Rate Risk. Our investment in single-family and
commercial mortgage loans and securities and manufactured housing installment
contracts subject us to the risk of early prepayment of principal on these
assets and to interest-rate risk. In a rising rate environment, our net interest
income may be reduced, as the interest cost for our funding sources could
increase more rapidly than the interest earned on the associated asset financed.
To the extent that assets and liabilities are both fixed-rate or adjustable rate
with corresponding payment dates, interest-rate risk may be mitigated. In a
declining interest-rate environment, net interest income may be enhanced as the
interest cost for our funding sources decreases more rapidly than the interest
earned on the associated assets. In a period of declining interest rates,
however, loans and securities in the investment portfolio will generally prepay
more rapidly (to the extent that such loans are not prohibited from prepayment),
which may result in additional amortization of asset premium. In a flat yield
curve environment (i.e., when the spread between the yield on the one-year
Treasury security and the yield on the ten-year Treasury security is less than
1.0%), adjustable rate mortgage loans and securities tend to rapidly prepay,
causing additional amortization of asset premium. In addition, the spread
between our funding costs and asset yields may compress, causing a further
reduction in our net interest income.
Along with match-funding assets and liabilities, we may, on occasion,
utilize various derivative financial instruments to manage our sensitivity to
changes in interest rates, principally when the Company has financed investments
carrying a fixed rate of interest with floating rate liabilities. As of December
31, 2004, approximately $227.1 million in fixed-rate investments were financed
with floating-rate securitization financing and repurchase agreement financing.
We had entered into an interest-rate swap with a notional balance of $100
million and a maturity date of June 30, 2005 to hedge a portion of this risk.
Margin Call Risk. The Company finances some of its investments,
primarily high credit-quality, liquid securities, with recourse borrowings,
primarily repurchase agreements. These arrangements require the Company to
maintain a certain level of collateral for the related borrowings. If the
collateral should fall below the required level, the repurchase agreement lender
could initiate a margin call. This would require that the Company either pledge
additional collateral acceptable to the lender or repay a portion of the debt in
order to meet the margin requirement. Should the Company be unable to meet a
margin call, it might have to liquidate the collateral or other assets quickly.
Because a margin call and quick sale could result in a lower than otherwise
expected and attainable sale price, the Company could be unable to achieve its
anticipated results in the event of a margin call.
Non-GAAP Information on Securitized Finance Receivables and
Non-Recourse Securitization Financing
- -----------------------------------------------------------
As previously discussed, we finance our securitized finance receivables
through the issuance of non-recourse securitization financing bonds. In our
consolidated financial statements we present the securitized finance receivables
as assets, and the associated securitization financing as a liability. Because
the securitization financing is recourse only to the finance receivables pledged
and is, therefore, not our general obligation, the risk on our investment in
securitized finance receivables from an economic point of view is limited to our
net retained investment in the securitization trust, as previously discussed.
However, GAAP requires, and our financial statements reflect, reserves for loan
losses on all of the loans pledged as collateral on securitization financings,
which resulted in our providing for loan losses of a cumulative $1.1 million as
of December 31, 2004 in which we do not retain the credit risk. The purpose of
the information presented in this section is to present the securitized finance
receivables on a net investment basis and to provide estimated fair value
information using various assumptions on our net investment. We believe this
information is useful to investors in understanding the risks to which our
business and cash flows are subject. We generally have sold the investment grade
classes of the securitization financing to third parties and have retained the
portion of the securitization financing that is below investment grade,
generally consisting of the overcollateralization tranche. We estimate the fair
value of our net investment in securitized finance receivables as the present
value of the projected cash flow from the collateral, adjusted for the impact
and assumed level of future prepayments and credit losses, less the projected
principal and interest due on the bonds owned by third parties. We master
service four of the securitization trusts. Structured Asset Securitization
Corporation (SASCO) Series 2002-9 and CCA One Series 2 and Series 3 are
master-serviced by other parties. Monthly payment reports for those securities
master-serviced by us may be found on our website at www.dynexcapital.com.
Below is a summary, as of December 31, 2004, of our net investment in
securitized finance receivables by series where the fair value exceeds $0.5
million. The following tables show our net investment in each of the securities
presented below on both a principal balance and amortized cost basis, as those
terms are defined above. The table below is not intended to present our
investment in securitized finance receivables or the non-recourse securitization
financing in accordance with generally accepted accounting principles. A
reconciliation of the amounts included in the table to our consolidated
financial statements is provided below the following table.
- -----------------------------------------------------------------------------------------------------------------------------
(amounts in thousands)
Principal Principal Principal Amortized
Balance Balance of Balance Cost Basis
Of Bonds Of Of
Securitization Collateral Outstanding to Net Net
Trust (1) Collateral Type Pledged Third Parties Investment(2) Investment(3)
- -----------------------------------------------------------------------------------------------------------------------------
MERIT Series 11 Securities backed by $ 215,169 $ 188,094 $ 27,075 $ 13,160
single-family mortgage and
manufactured housing loans
MERIT Series 12 Manufactured housing loans 198,246 185,764 12,482 2,508
SASCO 2002-9 Single family mortgage loans 225,055 217,142 7,913 11,735
MCA Series 1 Commercial mortgage loans 69,923 65,205 4,718 794
CCA One Series 2 Commercial mortgage loans 218,953 196,850 22,103 12,565
CCA One Series 3 Commercial mortgage loans 351,214 310,267 40,947 48,899
- -----------------------------------------------------------------------------------------------------------------------------
$ 1,278,560 $1,163,322 $ 115,238 $ 89,661
- -----------------------------------------------------------------------------------------------------------------------------
(1) MERIT stands for MERIT Securities Corporation; MCA stands for Multifamily
Capital Access One, Inc. (now known as Commercial Capital Access One,
Inc.); and CCA stands for Commercial Capital Access One, Inc. Each such
entity is a wholly owned limited purpose subsidiary of us. SASCO stands for
Structured Asset Securitization Corporation.
(2) Calculated as the amount by which the principal balance of the collateral
pledged exceeds the principal of the related bonds outstanding to third
parties.
(3) Represents the net investment plus or minus the related premiums, discounts
and related costs.
The following table reconciles the balances presented in the table
above with the amounts included for securitized finance receivables and
securitization financing in the accompanying consolidated financial statements.
- ----------------------------------------------------------------------------------------------------------------------------
Securitized Non-recourse
Finance Securitization
(amounts in thousands) Receivables Financing
- ----------------------------------------------------------------------------------------------------------------------------
Principal balances per the above table $ 1,278,560 $ 1,163,322
Principal balance of security excluded from above table 2,600 2,586
Recorded impairments on debt securities (15,596) -
Discounts and premiums, net (2,980) 6,135
Unrealized gain 1,064 -
Accrued interest and other 6,923 5,237
Allowance for loan losses (28,014) -
- ----------------------------------------------------------------------------------------------------------------------------
Balance per consolidated financial statements $ 1,242,557 $ 1,177,280
- ----------------------------------------------------------------------------------------------------------------------------
The following table summarizes the fair value of our net investment in
securitized finance receivables, the various assumptions made in estimating
value and the cash flow related to those net investments during 2004. As we do
not present our investment in securitized finance receivables on a net
investment basis in our consolidated financial statements, the table below is
not meant to present our investment in the securitization trust in accordance
with GAAP.
- ----------------------------------------------------------------------------------------------------------------------------
Fair Value Assumptions ($ in thousands)
------------------------------------------------------------------------------------------------------
Cash flows
Securitization Weighted-average Projected cash flow Fair value of net received in
Trust prepayment speeds Losses termination date investment (1) 2004, net (2)
- ----------------------------------------------------------------------------------------------------------------------------
MERIT Series 11 30% CPR on 4.0% annually Anticipated final $ 10,149 $ 11,581
Single-Family on MH loans maturity in 2025
securities; 7% CPR
on Manufactured
Housing securities
MERIT Series 12 8% CPR 3.5% annually Anticipated final 706 1,061
on MH loans maturity in 2027
SASCO 2002-9 30% CPR 0.1% annually Anticipated call 12,254 9,531
date in 2005
MCA One Series 1 (3) 1.0% annually Anticipated final 2,729 1,301
maturity in 2018
CCA One Series 2 (4) 0.8% annually Anticipated call 12,512 1,726
date in 2011
CCA One Series 3 (4) 1.2% annually Anticipated call 21,611 1,578
date in 2009
- ----------------------------------------------------------------------------------------------------------------------------
$ 59,961 $ 26,778
- ----------------------------------------------------------------------------------------------------------------------------
(1) Calculated as the net present value of expected future cash flows,
discounted at 16%. Expected cash flows were based on the forward LIBOR
curve as of December 31, 2004, and incorporate the resetting of the
interest rates on the adjustable rate assets to a level consistent with
projected prevailing rates. Increases or decreases in interest rates and
index levels from those used would impact the calculation of fair value, as
would differences in actual prepayment speeds and credit losses versus the
assumptions set forth above.
(2) Represents the excess of the cash flows received on the collateral pledged
over the cash flow requirements of the securitization financing bond
security.
(3) Computed at 0% CPR through June 2008 due to prepayment lockouts and yield
maintenance provisions.
(4) Computed at 0% CPR until the respective call date due to prepayment
lockouts and yield maintenance provisions.
The above tables illustrate the estimated fair value of our net
investment in the securitization trust. In our consolidated financial
statements, we carry our investments at amortized cost, except for our
investment in MERIT Series 11, which is carried at its estimated fair value.
Including recorded allowance for losses of $28.0 million, our net investment in
securitized finance receivables as reported in our consolidated financial
statements is approximately $61.6 million. This amount compares to an estimated
fair value, utilizing a discount rate of 16%, of approximately $60.0 million, as
set forth in the table above.
The following table compares the fair value of our investments in
securitized finance receivables at various discount rates but otherwise uses the
same assumptions as set forth in the above table:
- ----------------------------------------------------------------------------------------------------------------------------
Fair Value of Net Investment
----------------------------
(amounts in thousands)
Securitization Trust 12% 16% 20% 25%
- ----------------------------------------------------------------------------------------------------------------------------
MERIT Series 11A $ 11,993 $ 10,149 $ 8,794 $ 7,538
MERIT Series 12-1 626 706 750 777
SASCO 2002-9 13,956 12,254 10,948 9,695
MCA One Series 1 3,305 2,729 2,281 1,856
CCA One Series 2 14,965 12,512 10,548 8,624
CCA One Series 3 24,857 21,611 18,842 15,940
- ----------------------------------------------------------------------------------------------------------------------------
$ 69,702 $ 59,961 $ 52,163 $ 44,430
- ----------------------------------------------------------------------------------------------------------------------------
FEDERAL INCOME TAX CONSIDERATIONS
---------------------------------
General
- -------
We believe that we have complied with the requirements for
qualification as a REIT under the Internal Revenue Code (the "Code"). As such,
we believe that we qualify as a REIT for federal income tax purposes, and we
generally will not be subject to federal income tax on the amount of our income
or gain that is distributed as dividends to shareholders. We use the calendar
year for both tax and financial reporting purposes. There may be differences
between taxable income and income computed in accordance with GAAP. These
differences primarily arise from timing differences in the recognition of
revenue and expense for tax and GAAP purposes. Our estimated net taxable loss
for 2004, excluding net operating losses carried forward from prior years, was
$6.3 million, comprised of ordinary loss of $13.3 million and capital gain of
$7.0 million. We currently have tax operating loss carryforwards of
approximately $149 million. The $149 million in net operating loss carryforwards
expire between 2018 and 2024. We do not have any meaningful remaining amounts of
capital loss carryforward at the end of 2004. We also had excess inclusion
income of $1.4 million. REIT rules require that we distribute all of our excess
inclusion income as discussed below.
The REIT rules generally require that a REIT invest primarily in real
estate-related assets, that our activities be passive rather than active and
that we distribute annually to our shareholders substantially all of our taxable
income. We could be subject to income tax if we failed to satisfy those
requirements or if we acquired certain types of income-producing real property.
Although no complete assurances can be given, we do not expect that we will be
subject to material amounts of such taxes.
Failure to satisfy certain Code requirements could cause us to lose our
status as a REIT. If we failed to qualify as a REIT for any taxable year, we may
be subject to federal income tax (including any applicable alternative minimum
tax) at regular corporate rates and would not receive deductions for dividends
paid to shareholders. We could utilize loss carryforwards to offset any taxable
income. In addition, given the size of our tax loss carryforwards, we could
pursue a business plan in the future in which we would voluntarily forego our
REIT status. If we lost our status as REIT, we could not elect REIT status again
for five years.
Qualification of Us As A REIT
- -----------------------------
Qualification as a REIT requires that we satisfy a variety of tests
relating to our income, assets, distributions and ownership. The significant
tests are summarized below.
Sources of Income. To continue qualifying as a REIT, we must satisfy
two distinct tests with respect to the sources of our income: the "75% income
test" and the "95% income test." The 75% income test requires that we derive at
least 75% of our gross income (excluding gross income from prohibited
transactions) from certain real estate-related sources. In order to satisfy the
95% income test, 95% of our gross income for the taxable year must consist
either of income that qualifies under the 75% income test or certain other types
of passive income.
If we fail to meet either the 75% income test or the 95% income test,
or both, in a taxable year, we might nonetheless continue to qualify as a REIT,
if our failure was due to reasonable cause and not willful neglect and the
nature and amounts of our items of gross income were properly disclosed to the
Internal Revenue Service. However, in such a case we would be required to pay a
tax equal to 100% of any excess non-qualifying income.
Nature and Diversification of Assets. At the end of each calendar
quarter, three asset tests must be met by us. Under the 75% asset test, at least
75% of the value of our total assets must represent cash or cash items
(including receivables), government securities or real estate assets. Under the
"10% asset test," we may not own more than 10% of the outstanding voting
securities of any single non-governmental issuer, provided such securities do
not qualify under the 75% asset test or relate to taxable REIT subsidiaries.
Under the "5% asset test," ownership of any stocks or securities that do not
qualify under the 75% asset test must be limited, in respect of any single
non-governmental issuer, to an amount not greater than 5% of the value of the
total assets of us.
If we inadvertently fail to satisfy one or more of the asset tests at
the end of a calendar quarter, such failure would not cause us to lose our REIT
status, provided that (i) we satisfied all of the asset tests at the close of a
preceding calendar quarter and (ii) the discrepancy between the values of our
assets and the standards imposed by the asset tests either did not exist
immediately after the acquisition of any particular asset or was not wholly or
partially caused by such an acquisition. If the condition described in clause
(ii) of the preceding sentence was not satisfied, we still could avoid
disqualification by eliminating any discrepancy within 30 days after the close
of the calendar quarter in which it arose.
Distributions. With respect to each taxable year, in order to maintain
our REIT status, we generally must distribute to our shareholders an amount at
least equal to 90% of the sum of our "REIT taxable income" (determined without
regard to the deduction for dividends paid and by excluding any net capital
gain) and any after-tax net income from certain types of foreclosure property
minus any "excess non-cash income" (the "90% distribution requirement"). The
Code provides that in certain circumstances distributions relating to a
particular year may be made in the following year for purposes of the 90%
distribution requirement. REIT taxable income may be offset by our tax net
operating loss carryforwards. At a minimum, we must distribute 100% of our
excess inclusion income (defined below), if any.
Ownership. In order to maintain our REIT status, we must not be deemed
to be closely held and must have more than 100 shareholders. The closely held
prohibition requires that not more than 50% of the value of our outstanding
shares be owned by five or fewer persons at anytime during the last half of our
taxable year. The more than 100 shareholders rule requires that we have at least
100 shareholders for 335 days of a twelve-month taxable year. In the event that
we failed to satisfy the ownership requirements we would be subject to fines and
be required to take curative action to meet the ownership requirements in order
to maintain our REIT status.
For federal income tax purposes, we are required to recognize income on
an accrual basis and to make distributions to our shareholders when income is
recognized. Accordingly, it is possible that income could be recognized and
distributions required to be made in advance of the actual receipt of such funds
by us. The nature of our investments, coupled with our tax loss carryforwards,
is such that we expect to have sufficient assets to meet federal income tax
distribution requirements.
Taxation of Distributions
- -------------------------
By maintaining our status as a REIT, any distributions that are
properly designated as "capital gain dividends" will generally be taxed to
shareholders as long-term capital gains, regardless of how long a shareholder
has owned his shares. Any other distributions out of our current or accumulated
earnings and profits will be dividends taxable as ordinary income. Distributions
in excess of our current or accumulated earnings and profits will be treated as
tax-free returns of capital, to the extent of the shareholder's basis in his or
her shares and, as gain from the disposition of shares, to the extent they
exceed such basis. Shareholders may not include on their own tax returns any of
our ordinary or capital losses. Distributions to shareholders attributable to
"excess inclusion income" will be characterized as excess inclusion income in
the hands of the shareholders. Excess inclusion income can arise from our
holdings of residual interests in real estate mortgage investment conduits and
in certain other types of mortgage-backed security structures. Excess inclusion
income constitutes unrelated business taxable income ("UBTI") for tax-exempt
entities (including employee benefit plans and individual retirement accounts),
and it may not be offset by current deductions or net operating loss
carryforwards. In the event that our excess inclusion income is greater than our
taxable income, our distribution requirement would be based on our excess
inclusion income. Dividends paid by us to organizations that generally are
exempt from federal income tax under Section 501(a) of the Code should not be
taxable to them as UBTI except to the extent that (i) purchase of shares was
financed by "acquisition indebtedness" or (ii) such dividends constitute excess
inclusion income. In 2004, we declared and paid dividends on our Series D
preferred stock equal to approximately $2.6 million, of which $1.4 million
represented excess inclusion income and $1.2 million return of capital. We
declared a dividend on our Series D preferred stock in December 2004, which was
paid in January 2005 and which will be used by us for our 2005 REIT distribution
requirements.
Taxable Income
- --------------
We use the calendar year for both tax and financial reporting purposes.
However, there may be differences between taxable income and income computed in
accordance with GAAP. These differences primarily arise from timing differences
in the recognition of revenue and expense for tax and GAAP purposes. The
principal difference relates to reserves for loan losses and
other-than-temporary impairment charges provided for GAAP purposes, which are
not deductible for tax purposes, versus actual charge-offs on loans, which are
deductible for tax purposes as ordinary losses.
REGULATION
----------
Our existing consumer-related servicing activities consist of
collections on the delinquent property tax receivables. We believe that such
servicing operations are managed in compliance with the Fair Debt Collections
Practices Act.
We believe that we are in material compliance with all material rules
and regulations to which we are subject.
COMPETITION
-----------
The financial services industry is a highly competitive market in which
we compete with a number of institutions with greater financial resources. In
purchasing portfolio investments and in issuing securities, we compete with
other mortgage REITs, investment banking firms, savings and loan associations,
commercial banks, mortgage bankers, insurance companies, federal agencies,
foreign investors, and other entities, many of which have greater financial
resources and a lower cost of capital than we do. Increased competition in the
market and our competitors' greater financial resources have adversely affected
the Company's ability to invest its capital on an acceptable risk-adjusted
basis, and may continue to do so. Competition may also continue to keep pressure
on spreads resulting in the Company being unable to reinvest its capital at an
acceptable risk-adjusted basis.
EMPLOYEES
---------
As of December 31, 2004, we had 34 employees. Our relationship with our
employees is good. None of our employees are covered by any collective
bargaining agreements, and we are not aware of any union organizing activity
relating to our employees.
Item 2. Properties
Our executive and administrative offices and operations offices are
both located in Glen Allen, Virginia, on properties leased by us. The address is
4551 Cox Road, Suite 300, Glen Allen, Virginia 23060. As of December 31, 2004,
we leased 11,194 square feet. The lease, which originally expired in May 2005,
was amended subsequent to December 31, 2004 to reduce the square footage
occupied from 11,194 square feet to 8,244 square feet, and reduce the lease rate
per square foot. The term of the lease was extended to May 2008.
We also own and lease space located in the Pittsburgh, Pennsylvania
metropolitan area. These locations consist of approximately 14,039 square feet,
4,039 square feet of which we lease, and the leases associated with these
properties expire in 2005. Subsequent to December 31, 2004, the lease on
approximately 3,200 square feet was terminated early for a payment equal to four
months rent.
We believe that our properties are maintained in good operating
condition and are suitable and adequate for our purposes.
Item 3. Legal Proceedings
We and our subsidiaries are involved in certain litigation arising in
the ordinary course of their businesses. Although the ultimate outcome of these
matters cannot be ascertained at this time, and the results of legal proceedings
cannot be predicted with certainty, we believe, based on current knowledge, that
the resolution of these matters will not have a material adverse effect on our
financial position or results of operations. Information on litigation arising
out of the ordinary course of business is described below.
GLS Capital, Inc. ("GLS"), one of our subsidiaries, together with the
County of Allegheny, Pennsylvania ("Allegheny County"), were defendants in a
lawsuit in the Commonwealth Court of Pennsylvania (the "Commonwealth Court"),
the appellate court of the state of Pennsylvania. Plaintiffs were two local
businesses seeking status to represent as a class, delinquent taxpayers in
Allegheny County whose delinquent tax liens had been assigned to GLS. Plaintiffs
challenged the right of Allegheny County and GLS to collect certain interest,
costs and expenses related to delinquent property tax receivables in Allegheny
County, and whether the County had the right to assign the delinquent property
tax receivables to GLS and therefore employ procedures for collection enjoyed by
Allegheny County under state statute. This lawsuit was related to the purchase
by GLS of delinquent property tax receivables from Allegheny County in 1997,
1998, and 1999. In July 2001, the Commonwealth Court issued a ruling that
addressed, among other things, (i) the right of GLS to charge to the delinquent
taxpayer a rate of interest of 12% per annum versus 10% per annum on the
collection of its delinquent property tax receivables, (ii) the charging of a
full month's interest on a partial month's delinquency; (iii) the charging of
attorney's fees to the delinquent taxpayer for the collection of such tax
receivables, and (iv) the charging to the delinquent taxpayer of certain other
fees and costs. The Commonwealth Court in its opinion remanded for further
consideration to the lower trial court items (i), (ii) and (iv) above, and ruled
that neither Allegheny County nor GLS had the right to charge attorney's fees to
the delinquent taxpayer related to the collection of such tax receivables. The
Commonwealth Court further ruled that Allegheny County could assign its rights
in the delinquent property tax receivables to GLS, and that plaintiffs could
maintain equitable class in the action. In October 2001, GLS, along with
Allegheny County, filed an Application for Extraordinary Jurisdiction with the
Supreme Court of Pennsylvania, Western District appealing certain aspects of the
Commonwealth Court's ruling. In March 2003, the Supreme Court issued its opinion
as follows: (i) the Supreme Court determined that GLS can charge delinquent
taxpayers a rate of 12% per annum; (ii) the Supreme Court remanded back to the
lower trial court the charging of a full month's interest on a partial month's
delinquency; (iii) the Supreme Court revised the Commonwealth Court's ruling
regarding recouping attorney fees for collection of the receivables indicating
that the recoupment of fees requires a judicial review of collection procedures
used in each case; and (iv) the Supreme Court upheld the Commonwealth Court's
ruling that GLS can charge certain fees and costs, while remanding back to the
lower trial court for consideration the facts of each individual case. Finally,
the Supreme Court remanded to the lower trial court to determine if the
remaining claims can be resolved as a class action. In August 2003, the
Pennsylvania legislature enacted a law amending and clarifying certain
provisions of the Pennsylvania statute governing GLS' right to the collection of
certain interest, costs and expenses. The law is retroactive to 1996, and amends
and clarifies that as to items (ii)-(iv) noted above by the Supreme Court, that
GLS can charge a full month's interest on a partial month's delinquency, that
GLS can charge the taxpayer for legal fees, and that GLS can charge certain fees
and costs to the taxpayer at redemption. Subsequent to the enactment of the law,
challenges to the retroactivity provisions of the law were filed in separate
cases, which did not include GLS as a defendant. In September 2004, the trial
court in that litigation upheld the retroactive provisions enacted in 2003.
Plaintiffs in the case are seeking class action status and have not currently
set forth a damage claim. A hearing on the class-action status is currently set
for late April 2005. We believe that the ultimate outcome of this litigation
will not have a material impact on our financial condition, but may have a
material impact on reported results for the particular period presented.
We and Dynex Commercial, Inc. ("DCI"), formerly an affiliate of ours
and now known as DCI Commercial, Inc., were defendants in state court in Dallas
County, Texas in the matter of Basic Capital Management et al (collectively,
"BCM" or "the Plaintiffs") versus Dynex Commercial, Inc. et al. The suit was
filed in April 1999 originally against DCI, and in March 2000, BCM amended the
complaint and added us as a defendant. The complaint, which was further amended
during pretrial proceedings, alleged that, among other things, DCI and we failed
to fund tenant improvement or other advances allegedly required on various loans
made by DCI to BCM, which loans were subsequently acquired by us; that DCI
breached an alleged $160 million "master" loan commitment entered into in
February 1998; and that DCI breached another alleged loan commitment of
approximately $9 million. The trial commenced in January 2004, and, in February
2004, the jury in the case rendered a verdict in favor of one of the Plaintiffs
and against us on the alleged breach of the loan agreements for tenant
improvements and awarded that Plaintiff damages in the amount of $0.25 million.
The jury entered a separate verdict against DCI in favor of BCM under two
mutually exclusive damage models, for $2.2 million and $25.6 million,
respectively. The jury found in favor of DCI on the alleged $9 million loan
commitment, but did not find in favor of DCI for counterclaims made against BCM.
The jury also awarded the Plaintiffs attorneys' fees in the amount of $2.1
million. After considering post-trial motions, the presiding judge entered
judgment in favor of us and DCI, effectively overturning the verdicts of the
jury and dismissing damages awarded by the jury. Plaintiffs have filed an
appeal. DCI is a former affiliate, and we believe that we will have no
obligation for amounts, if any, awarded to the Plaintiffs as a result of the
actions of DCI.
On February 11, 2005, we became a defendant in a lawsuit filed in
United States District Court for the Southern District of New York by the
Teamsters Local 445 Freight Division Pension Fund. The allegations include
securities laws violations in connection with the issuance in August 1999 by our
subsidiary and co-defendant, MERIT Securities Corporation, of our MERIT Series
13 securitization financing bonds, which are collateralized by manufactured
housing loans. The suit also alleges fraud and negligent misrepresentations in
connection with the MERIT Series 13 issuance. We are currently evaluating the
allegations made in the lawsuit and intend to vigorously defend ourselves
against them.
Although no assurance can be given with respect to the ultimate outcome
of the above litigation, we believe the resolution of these lawsuits will not
have a material effect on our consolidated balance sheet, but could materially
affect our consolidated results of operations in a given year.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of our shareholders during the
fourth quarter of 2004.
PART II
-------
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and
Issuer Purchases of Equity Securities
Dynex Capital, Inc.'s common stock is traded on the New York Stock
Exchange under the trading symbol "DX". The common stock was held by
approximately 1,810 holders of record and beneficial holders who hold common
stock in street name as of December 31, 2004. During the last two years, the
high and low closing stock prices and cash dividends declared on common stock
were as follows:
- ----------------------------------------------------------------------------------------------------------------------------
High Low Cash Dividends Declared
- ----------------------------------------------------------------------------------------------------------------------------
2004:
First quarter $ 7.65 $ 6.15 $ -
Second quarter 7.71 6.35 -
Third quarter 7.24 6.48 -
Fourth quarter 7.83 6.70 -
2003:
First quarter $ 5.33 $ 4.26 $ -
Second quarter 5.96 4.46 -
Third quarter 6.02 5.30 -
Fourth quarter 6.15 5.11 -
- ----------------------------------------------------------------------------------------------------------------------------
Dividends declared by the Board of Directors have generally been for
the purpose of maintaining the Company's REIT status, and in compliance with
requirements set forth at the time of the issuance of the Series D Preferred
Shares. The quarterly dividend on Series D Preferred Shares is $0.2375 per
share. In accordance with the terms of the Series D Preferred Shares, if the
Company fails to pay two consecutive quarterly preferred dividends or if the
Company fails to maintain consolidated shareholders' equity of at least 200% of
the aggregate issue price of the Series D preferred stock, then these shares
automatically convert into a new series of 9.50% senior notes. Dividends for the
preferred stock must be fully paid before dividends can be paid on common stock.
No common dividends have been paid since 1998. See Federal Income Tax
Considerations in Item 1 above.
The Company did not repurchase any of its equity securities during the
fourth quarter of 2004.
Item 6. Selected Financial Data
- ------------------------------------------------------------------------------------------------------------------------------
Years ended December 31, 2004 2003 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------
(amounts in thousands except share and per share data)
Net interest income(1) $ 23,281 $ 38,971 $ 49,153 $ 48,082 $ 31,487
Net interest income after provision for loan losses(1) 4,818 1,889 20,670 28,410 2,377
Impairment charges(2) (14,756) (16,355) (18,477) (43,439) (84,039)
Other (expense) income and trading losses(3) (179) 436 1,397 7,876 (1,489)
General and administrative expenses (7,748) (8,632) (9,493) (10,526) (8,712)
Net loss $ (3,375) $ (21,107) $ (9,360) $ (21,209) $ (91,863)
Net loss to common shareholders $ (5,194) $ (14,260) $ (18,946) $ (13,492) $(104,774)
Net loss per common share:
Basic & diluted $ (0.46) $ (1.31) $ (1.74) $ (1.18) $ (9.15)
Dividends declared per share:
Common $ - $ - $ - $ - $ -
Series A and B Preferred - 0.8775 0.2925 0.2925 -
Series C Preferred - 1.0950 0.3651 0.3649 -
Series D Preferred 0.6993 - - - -
- ------------------------------------------------------------------------------------------------------------------------------
December 31, 2004 2003 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------
Investments(4) $1,343,448 $1,853,675 $2,185,746 $2,511,229 $3,148,667
Total assets(4) 1,400,934 1,865,235 2,205,735 2,531,509 3,195,354
Non-recourse securitization financing(4) 1,177,280 1,679,830 1,980,702 2,225,863 2,812,161
Recourse debt 70,468 33,933 - 58,134 134,168
Total liabilities(4) 1,252,168 1,715,389 1,982,314 2,289,399 2,957,898
Shareholders' equity 148,766 149,846 223,421 242,110 237,456
Number of common shares outstanding 12,162,391 10,873,903 10,873,903 10,873,853 11,446,206
Average number of common shares 11,272,259 10,873,903 10,873,871 11,430,471 11,445,236
Book value per common share(5) $ 7.60 $ 7.55 $ 8.57 $ 11.06 $ 7.39
- ------------------------------------------------------------------------------------------------------------------------------
(1) Net interest income after provision for loan losses increased due to a
reduction in the manufactured housing loan loss provision associated with
the derecognition of the MERIT Series 13 securitization.
(2) Impairment charges for the year ended December 31, 2000 included several
adjustments related largely to non-recurring items.
(3) Other (expense) income for 2000 included our equity in the net loss of
Dynex Holding, Inc. which was liquidated at the end of 2000.
(4) Certain deferred hedging gains and losses for 2002 and prior years were
reclassified from securitized finance receivables to non-recourse
securitization financing.
(5) Inclusive of the effects of the liquidation preference on the Company's
preferred stock.
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations
The Company is a financial services company, which invests in loans and
securities principally consisting of, or secured by, single family mortgage
loans, commercial mortgage loans, manufactured housing installment loans and
delinquent property tax receivables. The loans and securities in which the
Company invests have generally been pooled and pledged (i.e. securitized) as
collateral for non-recourse bonds ("non-recourse securitization financing"),
which provides long-term financing for such loans while limiting credit,
interest rate and liquidity risk. The Company earns the net interest spread
between the interest income on the loans and securities in its investment
portfolio and the interest and other expenses associated with the non-recourse
securitization financing. The Company also collects payments from property
owners on its investment in delinquent property tax receivables. The Company
manages the cash flow on these investments to maximize shareholders' value.
In May 2004, the Company completed a recapitalization of its equity
capital structure through the restructuring of its outstanding shares of Series
A, Series B and Series C preferred stock, resulting in the exchange of 5,628,727
shares of Series D preferred stock and 1,288,488 shares of common stock for the
shares of Series A, Series B and Series C preferred stock. The Series D
preferred stock has an issue price of $10 per share, is convertible into one
share of common stock and has the right to receive a quarterly dividend of
$0.2375 per share.
During 2003, the Company completed a tender offer for its Series A,
Series B and Series C preferred stock resulting in a preferred stock benefit of
$6.8 million. The Company purchased and retired $51.6 million shares of Series
A, Series B and Series C preferred stock in 2003. The resulting preferred stock
benefit of $6.8 million which was comprised of the elimination of $16.1 million
of dividends in arrears which was partially offset by a $4.1 million premium to
book value paid to obtain the preferred shares tendered and $5.2 million of
period accrual of dividends on the shares remaining after the completion of the
tender offer.
The following discussion provides information about the major
components of the results of operations and financial condition, liquidity, and
capital resources of the Company. This discussion and analysis should be read in
conjunction with the Company's Consolidated Financial Statements and Notes to
Consolidated Financial Statements. It should also be read in conjunction with
the "Caution About Forward Looking Statements" section at the end of this
discussion.
CRITICAL ACCOUNTING POLICIES
----------------------------
The discussion and analysis of the Company's financial condition and
results of operations are based in large part upon its consolidated financial
statements, which have been prepared in conformity with accounting principles
generally accepted in the United States of America. The preparation of the
financial statements requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenue and expenses during the reported period. Actual
results could differ from those estimates.
Critical accounting policies are defined as those that are reflective
of significant judgments or uncertainties, and which may result in materially
different results under different assumptions and conditions, or the application
of which may have a material impact on the Company's financial statements. The
following are the Company's critical accounting policies.
Consolidation of Subsidiaries. The consolidated financial statements
represent the Company's accounts after the elimination of inter-company
transactions. The Company consolidates entities in which it owns more than 50%
of the voting equity and control of the entity does not rest with others. The
Company follows the equity method of accounting for investments with greater
than 20% and less than a 50% interest in partnerships and corporate joint
ventures or when it is able to influence the financial and operating policies of
the investee but owns less than 50% of the voting equity. For all other
investments, the cost method is applied.
Impairments. The Company evaluates all securities in its investment
portfolio for other-than-temporary impairments. A security is generally defined
to be other-than-temporarily impaired if, for a maximum period of three
consecutive quarters, the carrying value of such security exceeds its estimated
fair value and the Company estimates, based on projected future cash flows or
other fair value determinants, that the fair value will remain below the
carrying value for the foreseeable future. If an other-than-temporary impairment
is deemed to exist, the Company records an impairment charge to adjust the
carrying value of the security down to its estimated fair value. In certain
instances, as a result of the other-than-temporary impairment analysis, the
recognition or accrual of interest will be discontinued and the security will be
placed on non-accrual status.
The Company considers an investment to be impaired if the fair value of
the investment is less than its recorded cost basis. Impairments of other
investments are generally considered to be other-than-temporary when the fair
value remains below the carrying value for three consecutive quarters. If the
impairment is determined to be other-than-temporary, an impairment charge is
recorded in order to adjust the carrying value of the investment to its
estimated value.
Allowance for Loan Losses. The Company has credit risk on loans pledged
in securitization financing transactions and classified as securitized finance
receivables in its investment portfolio. An allowance for loan losses has been
estimated and established for currently existing probable losses. Factors
considered in establishing an allowance include current loan delinquencies,
historical cure rates of delinquent loans, and historical and anticipated loss
severity of the loans as they are liquidated. The allowance for loan losses is
evaluated and adjusted periodically by management based on the actual and
estimated timing and amount of probable credit losses, using the above factors,
as well as industry loss experience. Where loans are considered homogeneous, the
allowance for losses is established and evaluated on a pool basis. Otherwise,
the allowance for losses is established and evaluated on a loan-specific basis.
Provisions made to increase the allowance are a current period expense to
operations. Generally, the Company considers manufactured housing loans to be
impaired when they are 30-days past due. The Company also provides an allowance
for currently existing credit losses within outstanding manufactured housing
loans that are current as to payment but which the Company has determined to be
impaired based on default trends, current market conditions and empirical
observable performance data on the loans. Single-family loans are considered
impaired when they are 60-days past due. Commercial mortgage loans are evaluated
on an individual basis for impairment. Generally, a commercial loan with a debt
service coverage ratio of less than one is considered impaired. However, based
on a commercial loan's details, commercial loans with a debt service ratio less
than one may not be considered impaired; conversely, commercial loans with a
debt service coverage ratio greater than one may be considered impaired. Certain
of the commercial mortgage loans are covered by loan guarantees that limit the
Company's exposure on these loans. The level of allowance for loan losses
required for these loans is reduced by the amount of applicable loan guarantees.
The Company's actual credit losses may differ from the estimates used to
establish the allowance.
FINANCIAL CONDITION
-------------------
Below is a discussion of the Company's financial condition.
- ---------------------------------------------------------------------------------------
December 31,
---------------------------------
(amounts in thousands except per share data) 2004 2003
- ---------------------------------------------------------------------------------------
Investments:
Securitized finance receivables:
Loans, net $1,036,123 $1,518,613
Debt securities 206,434 255,580
Securities 87,706 33,275
Other investments 7,596 37,903
Other loans 5,589 8,304
Non-recourse securitization financing 1,177,280 1,679,830
Repurchase agreements 70,468 23,884
Senior notes - 10,049
Shareholders' equity 148,766 149,846
Book value per common share (inclusive of preferred
stock liquidation preference) $7.60 $7.55
- ---------------------------------------------------------------------------------------
Securitized Finance Receivables
- -------------------------------
Securitized finance receivables include loans and securities consisting
of or secured by adjustable-rate and fixed-rate mortgage loans secured by first
liens on single family properties, fixed-rate loans secured by first liens on
multifamily and commercial properties, and manufactured housing installment
loans secured by either a UCC filing or a motor vehicle title. The securitized
finance receivables decreased to $1.24 billion at December 31, 2004 from $1.77
billion at December 31, 2003. This decrease of $531.6 million is primarily the
result of $286.2 million in principal pay-downs, the derecognition of $219.2
million of manufactured housing loans associated with the sale of the call
rights on the related securitization trust, $18.5 million of decreased allowance
for loan losses, net, $9.1 million of impairment charges recorded on debt
securities and decreases in accrued interest payable of $4.7 million. These
decreases were partially offset by an increase in the unrealized gains and
premiums of $3.5 million and $0.8 million of amortization of loan discounts.
Principal pay-downs resulted from normal principal amortization of the
underlying loan or security, and higher than anticipated prepayments on these
assets due to the low interest-rate environment. The allowance for loan losses
decreased primarily as a result of the sale of the manufactured housing loans
and charge-offs during the year on the manufactured housing and commercial loans
exceeding the provisions on such loans. Impairment charges resulted from
other-than-temporary decreases in market value on debt securities backed by
manufactured housing loan collateral.
Securities
- ----------
Securities increased to $87.7 million at December 31, 2004 compared to
$33.3 million at December 31, 2003, primarily as a result of the purchases of a
$62.1 million debt security and a $4.9 million equity security and a $1.1
million net increase in market value of available-for-sale securities. These
increases were partially offset by principal payments of $13.2 million during
the year and the sale of equity securities with a balance of $0.5 million.
Other Investments
- -----------------
Other investments at December 31, 2004 and 2003 consist primarily of
delinquent property tax receivables, a security collateralized by delinquent
property tax receivables, and the associated real estate owned. Other
investments decreased to $7.6 million at December 31, 2004 compared to $37.9
million at December 31, 2003. This decrease of $30.3 million resulted from the
sale of a portfolio of tax lien receivables located in Ohio portfolio with a
basis of $22.3 million, payments of $5.7 million collected in 2004 and applied
against the carrying value of the investment, $1.0 million in sales of related
real estate owned, and a $4.9 million other-than-temporary impairment charge.
These decreases were partially offset by increases related to foreclosure
advances made of $1.5 million and the purchase of new receivables of
approximately $2.7 million, which were substantially sold in the Ohio tax lien
portfolio sale described above.
Other Loans
- -----------
Other loans decreased to $5.6 million at December 31, 2004 from $8.3
million at December 31, 2003 due primarily to payments received on the loans of
$2.9 million.
Non-recourse Securitization Financing
- -------------------------------------
Non-recourse securitization financing decreased to $1.18 billion at
December 31, 2004 from $1.68 billion at December 31, 2003. This decrease was
primarily a result of principal payments received of $286.2 million on the
associated collateral pledged which were used to pay down the securitization
financing in accordance with the respective indentures, the derecognition of
$226.7 million of non-recourse securitization financing as a result of the sale
of the call rights on the related securitization trust as described above, and a
$2.2 million decrease of accrued interest payable. Offsetting these decreases
was the receipt of $7.4 million from the redemption and reissuance of
approximately $226.7 million in bonds outstanding, and net amortization of
approximately $3.9 million of bond discounts and issuance and hedging costs.
Repurchase Agreements
- ---------------------
In December 2004, the Company entered into a $56.6 million repurchase
agreement to finance the purchase of approximately $62.0 million of fixed-rate
securities. This increase was partially offset by net repayments of $10.0
million on repurchase agreement borrowings during 2004.
Senior Notes
- ------------
The $10.0 million of February 2005 Senior Notes outstanding as of
December 31, 2003 were paid in March 2004.
Shareholders' Equity
- --------------------
Shareholders' equity decreased from $149.8 million at December 31, 2003
to $148.8 million at December 31, 2004. This decrease of $1.0 million resulted
from a net loss of $3.4 million, a net decrease of $1.5 million resulting from
the shares tendered for senior notes in connection with the recapitalization
transaction completed in May 2004 and dividends declared on shares of Series D
Preferred Stock of $3.9 million. These decreases were partially offset by an
increase in accumulated other comprehensive income of $7.7 million which
resulted principally from the increase in fair value of debt and equity
securities of $4.7 million, and an increase of $3.0 million on interest-rate
swap and synthetic interest-rate swap contracts from the realization of losses
on settled contracts and deferred gains on the remaining hedge contracts.
RESULTS OF OPERATIONS
---------------------
- ------------------------------------------------------------------------------------------------------------------------
For the Year Ended December 31,
------------------------------------------------------
(amounts in thousands except per share information) 2004 2003 2002
- ----------------------------------------------------------------------------------- ------------------ -----------------
Net interest income $ 23,281 $ 38,971 $ 49,153
Provision for loan losses (18,463) (37,082) (28,483)
Net interest income after provision for loan losses 4,818 1,889 20,670
Impairment charges (14,756) (16,355) (18,477)
Gain (loss) on sales of investments 14,490 1,555 (150)
General and administrative expenses (7,748) (8,632) (9,493)
Net loss (3,375) (21,107) (9,360)
Preferred stock (charge) benefit (1,819) 6,847 (9,586)
Net loss to common shareholders $ (5,194) $ (14,260) $ (18,946)
Basic & diluted net loss per common share $ (0.46) $ (1.31) $ (1.74)
Dividends declared per share:
Common $ - $ - $ -
Series A and B Preferred - 0.8775 0.2925
Series C Preferred - 1.0950 0.3651
Series D Preferred 0.6993 - -
- ------------------------------------------------------------------------------------------------------------------------
2004 Compared to 2003
- ---------------------
Net loss decreased in 2004 by $17.7 million, to $3.4 million in 2004
from a loss of $21.1 million in 2003, as a result of an increase in net interest
income after provision for loan losses of $2.9 million and an increase in gain
on sales of investments of $12.9 million. Net loss to common shareholders
decreased by $9.1 million in 2004, from $14.3 million in 2003 to $5.2 million in
2004. The improvement in net loss to common shareholders was due to reduced net
loss of $17.7 million, offset by the reduction in preferred stock benefit of
$8.7 million. The preferred stock benefit in 2003 resulted from the effects of a
tender offer on the outstanding preferred stock completed in 2003 as compared to
the net effect of the recapitalization of the preferred stock in 2004 and 2004
preferred stock dividends.
Net interest income for the year ended December 31, 2004 decreased to
$23.3 million, from $39.0 million for the same period in 2003. Net interest
income decreased $15.7 million, or 40.3%, as a result of a decline in average
interest-earning assets and a decrease in the net interest spread on
interest-earning assets. Net interest spread decreased in 2003 as a result of
prepayments of higher coupon assets, the proceeds of which have been reinvested
in lower-yielding cash equivalents, and also decreased due in part to increasing
borrowing costs from both increasing LIBOR rates and repayment of lower-cost
securitization financing bonds pursuant to the terms of the securitization
trust. See further discussion below as to changes in the net interest spread on
the Company's investment portfolio during 2004.
Net interest income after provision for loan losses increased as a
result of the decline of the provision for loan losses in 2004 compared to 2003
of $18.6 million. Provision for loan losses decreased to $18.5 million in 2004,
from $37.1 million in 2003. The decrease of $18.6 million from 2003 was
primarily due to $14.4 million of provision for loan losses recorded during the
second quarter of 2003 specifically for currently existing credit losses within
outstanding manufactured housing loans that were current as to payment but which
the Company had determined to be impaired. The remaining $4.2 million of the
decrease was primarily due to a decrease in the estimated losses on commercial
and manufactured housing loans.
Impairment charges decreased from $16.4 million in 2003 to $14.8
million in 2004. Impairment charges in 2004 included $9.1 million on a debt
security collateralized by manufactured housing loans and $4.9 million on a debt
security collateralized by delinquent property tax receivables.
Other-than-temporary impairment charges were recorded as a result of the
carrying value of the debt securities referenced above exceeded their estimated
fair value and the Company determined that the carrying value would likely
exceed the fair value for the foreseeable future. Impairment charges for 2003
included $5.5 million on manufactured housing loan securities and $10.4 million
on delinquent property tax receivable securities.
Gain on sale of investments for 2004 included a $17.6 million gain from
the sale of securitized finance receivables with a carrying value of $219.2
million, net of allowance for loan losses of $16.2 million, and the
de-recognition of the associated securitization financing bonds with a carrying
amount of $226.7 million. The Company received a net $11.9 million in proceeds
from the sale of these receivables. This gain was partially offset by a $3.2
million loss on the sale of the Company's Ohio delinquent property tax
receivable investment.
The Company reported a preferred stock charge of $1.8 million for the
year ended December 31, 2004, which represents a decline of $8.6 million from
the preferred stock benefit of $6.8 million reported for the year ended December
31, 2003. This decrease in the preferred stock (charge) benefit was due to the
recapitalization completed in 2004 and the tender offer completed in 2003
described in more detail above.
2003 Compared to 2002
- ---------------------
Net loss increased to $21.1 million in 2003 from $9.4 million in 2002
as a result of the decline in net interest margin, offset by a decline in
impairment charges, an increase in gain on sale of investments, a decrease in
other (expense) income relating to decreased trading losses, and a decrease in
general and administrative expenses. Net loss per common share decreased during
2003 as compared to 2002 as a result of the preferred stock benefit for 2003
from the tender offer on the preferred stock completed in February 2003.
Net interest income before provision for loan losses for the year ended
December 31, 2003 decreased to $39.0 million, from $49.2 million for the same
period in 2002. The decrease in net interest income before provision for loan
losses of $10.2 million, or 20.7%, was the result of a decline in average
interest-earning assets, a decrease in the net interest spread on
interest-earning assets, and a reduction in interest income in 2003 compared to
2002 for a security collateralized by delinquent property tax receivables which,
due to further impairment of the asset, was placed on non-accrual status in
2003.
Provision for loan losses increased to $37.1 million in 2003, from
$28.5 million in 2002. Provision for losses increased by $8.6 million from 2002
as a result of additions to allowance for loan losses on commercial mortgage
loans of $6.1 million and reserves on losses on current manufactured housing
loans in the Company's investment portfolio of $31.0 million for 2003 compared
to $28.6 million for 2002. For commercial mortgage loans, underlying commercial
properties concentrated in the health care and hospitality industries generally
under-performed relative to expectations and suffered from high vacancy rates
and lower fees and rents. Included in 2003 is $13.8 million in provision for
loan losses recorded specifically for currently existing credit losses within
outstanding manufactured housing loans that were current as to payment but which
the Company has determined to be impaired. Previously, the Company had not
considered current loans to be impaired under generally accepted accounting
principles and therefore had not previously provided an allowance for losses for
these loans. Continued worsening trends in both the industry as a whole and the
Company's pools of manufactured housing loans prompted the Company to prepare an
extensive analysis on these pools of loans. Loss severity on the manufactured
housing loans continued to remain high during 2003 as a result of the saturation
in the market place with both new and used (repossessed) manufactured housing
units. Defaults in 2003 on manufactured housing loans averaged 4.0% on an
annualized basis, compared to 4.5% in 2002, and loss severity on such loans
approximated 77% during the year. While defaults on manufactured housing loans
declined relative to 2002, defaults are expected to remain at 2003 levels.
Defaults are influenced by general economic conditions in the various local
markets.
Impairment charges decreased from $18.5 million in 2002 to an aggregate
$16.4 million in 2003. Such impairment charges included other-than-temporary
impairment of debt securities pledged as securitized finance receivables of $5.5
million for 2003. In addition, the Company incurred impairment charges in 2003
of $10.4 million related to a security where the underlying property tax
receivable collateral has been foreclosed and represents real estate owned, and
$0.6 million of losses on investments in a limited liability partnership. The
impairment charges on the debt securities result from revised expectations on
related collateral. All cash received was applied to reduce the carrying value
of the security.
Gain on sale of investments for 2003 included the gain from the sale of
loans acquired through the redemption of adjustable-rate and fixed-rate mortgage
pass-through securities previously issued and sold by the Company. Upon
redemption, the Company collapsed the security structure and sold the underlying
loans.
In 2002, the Company entered into a $100 million notional short
position on 5-Year Treasury Notes futures to, in effect, mitigate its exposure
to rising interest rates on a like amount of floating-rate liabilities. These
instruments failed to meet the hedge criteria of SFASards No. 133, "Accounting
for Derivative Instruments and Hedging Activities," and were accounted for on a
trading basis. The Company terminated these contracts at a loss of $3.3 million
in 2002. No such trading activity was engaged in by the Company in 2003.
The Company purchased and retired $51.6 million of its Series A, Series
B and Series C preferred shares in 2003 resulting in a preferred stock benefit
of $6.8 million which was comprised of the elimination of $16.1 million of
dividends in arrears which was partially offset by a $4.1 million premium to
book value paid to obtain the preferred shares tendered and $5.2 million of
period accrual of dividends on the shares remaining after the completion of the
tender offer.
Average Balances and Effective Interest Rates
---------------------------------------------
The following table summarizes the average balances of interest-earning
assets and their average effective yields, along with the average
interest-bearing liabilities and the related average effective interest rates,
for each of the periods presented. Assets that are on non-accrual status are
excluded from the table below for each period presented.
- ---------------------------------------------------------------------------------------------------------------------------
Year ended December 31,
- ---------------------------------------------------------------------------------------------------------------------------
2004 2003 2002
- ---------------------------------------------------- ----------------------- ----------------------- -----------------------
Average Effective Average Effective Average Effective
(amounts in thousands) Balance Rate Balance Rate Balance Rate
- ---------------------------------------------------- ----------- ----------- ----------- ----------- ----------- -----------
Interest-earning assets(1):
Securitized finance receivables(2)(3) $1,601,553 7.41% $1,948,204 7.56% $2,272,387 7.69%
Securities 25,476 7.74% 5,631 13.74% 4,816 21.31%
Other loans 6,825 10.34% 9,048 6.72% 9,706 4.54%
Cash and other investments 24,532 1.37% 58,128 6.09% 72,663 7.81%
----------- ----------- ----------- ----------- ----------- -----------
Total interest-earning assets $1,658,386 7.34% $2,021,011 7.53% $2,359,572 7.71%
=========== =========== =========== =========== =========== ===========
Interest-bearing liabilities:
Securitization financing(3) $1,499,772 6.40% $1,826,827 5.85% $2,113,330 6.12%
Senior notes 2,020 9.90% 19,330 9.53% 26,112 8.14%
Repurchase agreements 21,040 1.75% 398 1.79% - -
----------- ----------- ----------- ----------- ----------- -----------
Total interest-bearing liabilities $1,522,832 6.34% $1,846,555 5.88% $2,139,442 6.15%
=========== =========== =========== =========== =========== ===========
Net interest spread(3) 1.00% 1.65% 1.56%
Net yield on average interest-earning assets(3) 1.51% 2.15% 2.14%
- ---------------------------------------------------- ----------- ----------- ----------- ----------- ----------- -----------
(1) Average balances exclude adjustments made in accordance with SFAS No. 115,
"Accounting for Certain Investments in Debt and Equity Securities," to
record available for sale securities at fair value.
(2) Average balances exclude funds held by trustees of $342, $374,and $2,590
for the years ended December 31, 2004, 2003, and 2002, respectively.
(3) Effective rates are calculated excluding non-interest related non-recourse
securitization financing expenses and provision for credit losses.
2004 compared to 2003
The net interest spread for the year ended December 31, 2004 decreased
to 1.00% from 1.65% for the year ended December 31, 2003. This decrease can be
generally attributed to the prepayment of higher coupon investments, principally
securitized finance receivables, and the resulting reinvestment of net proceeds
available as a result of these prepayments into lower yielding cash and cash
equivalents. In addition, net interest spread declined approximately 0.17% from
the non-accrual status of a delinquent property tax receivable in 2004 compared
to 2003, and declined approximately 0.07% as a result of net asset premium and
bond discount amortization expense from the unexpected prepayment of
approximately $98.0 million in commercial mortgage loans during 2004. The
overall yield on interest-earnings assets, decreased to 7.34% for the year ended
December 31, 2004 from 7.53% for the same period in 2003. The overall yield
declined by 0.17% as a result of the non-accrual status in 2004 of a delinquent
property tax receivable security, with the balance of the decline due to the
prepayment of higher coupon investments. In addition to declining asset yields,
interest-bearing liability costs increased from 5.88% to 6.34% as a result of
the overall increase in market interest rates, including LIBOR rates, and the
repayment of lower-cost securitization financing bonds pursuant to the terms of
the securitization trust. Approximately 38% of the Company's interest-bearing
liabilities re-price monthly and are indexed to one-month LIBOR, which averaged
1.50% for 2004, compared to 1.21% for 2003. In addition, interest bearing
liability costs increased by approximately a net 0.04% for bond discount
amortization resulting from the prepayment of approximately $98.0 million of
securitization financing related to commercial loans which prepaid during the
year.
2003 compared to 2002
The net interest spread for the year ended December 31, 2003 increased
to 1.65% from 1.56% for the year ended December 31, 2002. While overall asset
yields decreased, principally as a result of the prepayment of higher coupon
investments, the resetting of interest rates on adjustable rate mortgage loans
in the Company's investment portfolio and the prepayment of higher rate loans in
that portfolio, the overall weighted-average liability costs decreased as well
as a result of the overall decline in short-term market interest rates. The
change in one-month LIBOR is a proxy for the change in the Company's yield on
the adjustable-rate investments in its portfolio (which have reset periods
ranging from six months to one year) and a proxy for change in the cost of
borrowing for the Company's floating rate liabilities (which reset, on average,
every month). During 2003, the one-month LIBOR averaged 1.21% for 2003, compared
to 1.76% for 2002. The overall yield on interest-earnings assets, decreased to
7.53% for the year ended December 31, 2003 from 7.71% for the same period in
2002, following the falling-rate environment and reflecting payments on higher
coupon investments in the portfolio. Average interest-bearing liability costs
decreased from 6.15% to 5.88% in 2003, principally as a result of the above
referenced decline in short-term market rates, which was partially offset by the
prepayment of lower cost securitization finance bonds outstanding pursuant to
the terms of the securitization trust. A portion of the Company's
interest-bearing liabilities re-price monthly, and are indexed to one-month
LIBOR. As indicated above, one-month LIBOR on average was 0.55% less in 2003
than 2002.
The following table summarizes the amount of change in interest income
and interest expense due to changes in interest rates versus changes in volume:
- ----------------------------------------------------------------------------------------------------------------------------
2004 to 2003 2003 to 2002
- ----------------------------------------------------------------------------------------------------------------------------
(amounts in thousands) Rate Volume Total Rate Volume Total
- ----------------------------------------------------------------------------------------------------------------------------
Securitized finance receivables $ (2,915) $ (25,735) $ (28,650) $ (2,932) $ (24,556) $ (27,488)
Other investments (1,835) (1,367) (3,202) (1,121) (1,016) (2,137)
Securities (470) 1,667 1,197 (406) 154 (252)
Other loans 273 (175) 98 199 (32) 167
- ----------------------------------------------------------------------------------------------------------------------------
Total interest income (4,947) (25,610) (30,557) (4,260) (25,450) (29,710)
- ----------------------------------------------------------------------------------------------------------------------------
Securitization financing 9,527 (20,321) (10,794) (5,548) (16,948) (22,496)
Senior notes 69 (1,711) (1,642) 325 (609) (284)
Repurchase agreements (3) 361 358 - 7 7
- ----------------------------------------------------------------------------------------------------------------------------
Total interest expense 9,593 (21,671) (12,078) (5,223) (17,550) (22,773)
- ----------------------------------------------------------------------------------------------------------------------------
Net interest income $ (14,540) $ (3,939) $ (18,479) $ 963 $ (7,900) $ (6,937)
- ----------------------------------------------------------------------------------------------------------------------------
Note: The change in interest income and interest expense due to changes in both
volume and rate, which cannot be segregated, has been allocated
proportionately to the change due to volume and the change due to rate.
This table excludes non-interest related securitization financing
expense, other interest expense and provision for credit losses.
Interest Income and Interest-Earning Assets
- -------------------------------------------
Approximately $1.3 billion of the investment portfolio as of December 31,
2004, or 84%, was comprised of loans or securities that pay a fixed-rate of
interest. Also at December 31, 2004, approximately $251 million, or 16%, was
comprised of loans or securities that have coupon rates which adjust over time
(subject to certain periodic and lifetime limitations) in conjunction with
changes in short-term interest rates. The following table presents a breakdown,
by principal balance, of the Company's securitized finance receivables and
securities, by type of underlying loan as of December 31, 2004, 2003 and 2002.
LIBOR Based ARM Loans are adjustable rate mortgage loans, which carry a rate of
interest based on a spread to six-month LIBOR. CMT Based ARM Loans are
adjustable rate mortgage loans, which carry a rate of interest based on a spread
to the one-year Constant Maturity Treasury index. Other Indices Based ARM Loans
carry a rate of interest based on a spread to an index other than six-month
LIBOR, such as the Prime Rate. The percentage of fixed-rate loans to all loans
increased from 81% at December 31, 2003, to 84% at December 31, 2004. Fixed-rate
loans at December 31, 2004 consisted principally of manufactured housing loans
which have historically had low rates of prepayment, and commercial mortgage
loans which are prohibited from prepayment for a period of up to ten years from
their date of funding. A substantial portion of the prepayments in the Company's
investment portfolio have occurred in the single-family ARM loans which carry no
prepayment penalties. Given the low absolute interest-rate environment,
single-family ARM loans and fixed-rate loans have experienced higher than
historical average prepayment experience over the years presented. The table
below excludes various investments in the Company's portfolio, including
securities backed by delinquent property tax receivables, and non-securitized
investments including other investments and loans. Most of these excluded
investments would be considered fixed-rate, and amounted to approximately $21.3
million at December 31, 2004.
Investment Portfolio Composition(1)
-----------------------------------
($ in millions)
- ----------------------------------------------------------------------------------------------------------------------------
Other Indices
LIBOR Based CMT Based Based ARM Fixed-Rate
December 31, ARM Loans ARM Loans Loans Loans Total
- ----------------------------------------------------------------------------------------------------------------------------
2002 $ 384.6 $ 73.2 $ 57.0 $ 1,647.0 $ 2,161.8
2003 $ 258.2 $ 48.8 $ 45.4 $ 1,512.2 $ 1,864.6
2004 $ 178.4 $ 34.5 $ 37.6 $ 1,347.4 $ 1,597.9
- ----------------------------------------------------------------------------------------------------------------------------
(1) Only principal amounts are included.
Credit Exposures
- ----------------
As discussed in Investment Portfolio - Financing for Our Investment
Portfolio - Securitization Trusts in Item 1 above, the Company's predominate
securitization structure is non-recourse securitization financing, whereby loans
and securities are pledged to a trust, and the trust issues bonds pursuant to an
indenture. Generally these securitization structures use over-collateralization,
subordination, third-party guarantees, reserve funds, bond insurance, mortgage
pool insurance or any combination of the foregoing as a form of credit
enhancement. From an economic point of view, the Company generally has retained
a limited portion of the direct credit risk in these structures. In many
instances, the Company retained the "first-loss" credit risk on pools of loans
and securities that it has securitized.
The following table summarizes the aggregate principal amount of
certain investments of the Company; the direct credit exposure retained by the
Company (represented by the amount of over-collateralization pledged and
subordinated securities owned by the Company), net of the credit reserves and
discounts maintained by the Company for such exposure; and the actual credit
losses incurred for each year. Credit Exposure, Net of Credit Reserves is based
on the credit risk retained by the Company for the loans and securities pledged
to the securitization trust, from an economic point of view. For 2004 and 2003,
the table includes any subordinated security retained by the Company. The
Company's credit exposure, net of credit reserves, has decreased from 2003 by
$26.2 million due to the sale of $219.2 million of securitized finance
receivables, resulting in a net decrease of $6.5 million, reduction of principal
on loans of $19.4 million, and an increase in reserves, net of losses of $0.3
million. The table excludes other forms of credit enhancement from which the
Company benefits, and based upon the performance of the underlying loans, may
provide additional protection against losses as discussed in Investment
Portfolio- Investment Portfolio Risks in Item 1 above. This table also excludes
any risks related to representations and warranties made on single-family loans
funded by the Company and securitized in mortgage pass-through securities
generally funded prior to 1995. This table also excludes any credit exposure on
loans and other investments.
Credit Reserves and Actual Credit Losses
----------------------------------------
($ in millions)
- ----------------------------------------------------------------------------------------------------------------------------
Credit Exposure, Actual Credit Exposure, Net of
Outstanding Loan Net of Credit Credit Credit Reserves to
Principal Balance Reserves Losses Outstanding Loan Balance
- ----------------------------------------------------------------------------------------------------------------------------
2002 (1) $2,246.9 $ 91.8 $30.3 4.09%
2003 (1) $1,859.1 $ 66.1 $25.5 3.56%
2004 $1,296.5 $ 39.9 $25.1 3.08%
- ----------------------------------------------------------------------------------------------------------------------------
(1) In 2004, the Company began including certain subordinated securities in
the table above. The previously reported information for 2003 and 2002
has been adjusted to be consistent with the 2004 presentation
The following table summarizes single family mortgage loan,
manufactured housing loan and commercial mortgage loan delinquencies as a
percentage of the outstanding collateral balance for those structures in which
the Company has retained a portion of the direct credit risk included in the
table above. The delinquencies as a percentage of the outstanding collateral was
6.97% at December 31, 2004, an increase from 4.81% and 4.49% at December 31,
2003 and 2002, respectively, primarily from increasing delinquencies in the
Company's commercial mortgage loan and manufactured housing loan portfolios and
a declining overall outstanding collateral balance as a result of prepayments.
The trend of delinquencies in the manufactured housing portfolio arises from
general economic conditions, the maturity of the portfolio and depressed values
of manufactured housing properties. The increase in delinquencies in the
commercial mortgage loan portfolio was largely due to one loan with a balance of
approximately $23.6 million in the accompanying financial statements. A
forbearance agreement with the borrower has been reached in principal on this
loan, but it is subject to receipt of payment for certain costs associated with
the loan before the agreement takes effect. Overall, less than 90-day
delinquencies on loans have improved as a result of improving performance in the
single-family and commercial mortgage loan portfolios. The Company monitors and
evaluates its exposure to credit losses and has established reserves based upon
anticipated losses, general economic conditions and trends in the investment
portfolio. Management believes the level of credit reserves was proper for the
inherent probable losses in the portfolio as of December 31, 2004. The trend of
delinquencies within the portfolio is presented in the table below.
Delinquency Statistics
----------------------
- ----------------------------------------------------------------------------------------------------------------------------
30 to 59 days 60 to 89 days 90 days and over
December 31, delinquent delinquent delinquent (1) Total
- ----------------------------------------------------------------------------------------------------------------------------
2002 (2) 1.78% 0.64% 2.07% 4.49%
2003 (2) 1.67% 0.44% 2.70% 4.81%
2004 1.27% 0.32% 5.38% 6.97%
- ----------------------------------------------------------------------------------------------------------------------------
(1) Includes foreclosures, repossessions and real estate owned.
(2) In 2004, the Company began including certain subordinated securities in
the calculations used to produce the information in the table above.
The previously reported information for 2003 and 2002 has been adjusted
to be consistent with the 2004 presentation.
General and Administrative Expense
----------------------------------
The following table presents a breakdown of general and administrative
expense by business unit.
- ----------------------------------------------------------------------------------------------------------------------------
Corporate/Investment
(amounts in thousands) Servicing Portfolio Management Total
- ----------------------------------------------------------------------------------------------------------------------------
2002 $ 4,274.0 $ 5,218.7 $ 9,492.7
2003 4,848.9 3,783.4 8,632.3
2004 3,483.4 4,264.4 7,747.8
- ----------------------------------------------------------------------------------------------------------------------------
General and administrative expense decreased $0.9 million from $8.6
million in 2003 to $7.7 million in 2004. General and administrative expenses for
servicing decreased during 2004 with the sale in October of the Ohio delinquent
property tax receivable servicing operation. Corporate/Investment Portfolio
Management expenses have increased primarily as a result of litigation and legal
expenses. The Company's legal and litigation expenses incurred in 2004 were $1.2
million compared to $0.9 million in 2003. The Company anticipates reductions in
2005 general and administrative expenses due to reduced litigation costs and
reductions in its delinquent property tax lien servicing operations.
LIQUIDITY AND CAPITAL RESOURCES
-------------------------------
The Company has historically financed its operations from a variety of
sources. The Company's primary source of funding its operations today is
principally the cash flow generated from the investment portfolio, which
includes net interest income and principal payments and prepayments on these
investments. The Company also sold investments and other of its interests during
the year generating approximately $32.1 million in net cash flow, which included
the proceeds from the sale of its rights to redeem (and subsequently resell)
securitization financing bonds for a net $19.2 million. The Company's investment
portfolio continues to provide positive cash flow, which can be utilized by the
Company for reinvestment or other purposes. The Company has utilized its cash
flow to repay recourse debt outstanding and to purchase loans and securities for
its investment portfolio. In 2004, the Company completed a recapitalization of
its capital structure resulting in the issuance of a new Series D preferred
stock and common stock in exchange for all outstanding shares of Series A, B and
C preferred stock.
The Company's cash flow from its investment portfolio for the year and
quarter ended December 31, 2004 was approximately $40.5 million and $6.8
million, respectively, excluding proceeds from the sales of investments. Such
cash flow is after payment of principal and interest on the associated
non-recourse securitization financing (i.e., non-recourse debt) outstanding.
From the cash flow on its investment portfolio, the Company funds its operating
overhead costs, including the servicing of its delinquent property tax
receivables, and repays any remaining recourse debt. Excluding any cash flow
derived from the sale or re-securitization of assets, and assuming that
short-term interest rates remain stable, the Company anticipates that the cash
flow from its investment portfolio will decline in 2005 compared to 2004 as the
investment portfolio continues to pay down. The Company anticipates, however,
that it will have sufficient cash flow from its investment portfolio to meet all
of its obligations on both a short-term and long-term basis.
In the second quarter of 2004, the Company completed a recapitalization
plan whereby the Company converted its Series A, Series B, and Series C
preferred stock into a new Series D preferred stock and common stock. The
aggregate required quarterly dividend on the shares of Series D preferred stock
outstanding as of December 31, 2004 was approximately $1.3 million. The Series D
preferred stock automatically converts to 9.50% subordinate notes if the Company
fails to pay two consecutive quarterly dividends or if the Company fails to
maintain consolidated stockholders equity of at least 200% of the aggregate
issue price of the Series D preferred stock.
In September 2004, the Company sold its delinquent property tax
receivable portfolio located in Cuyahoga County, Ohio and its associated
servicing operation, for $19.2 million. In addition, the Company may receive
contingent consideration of up to approximately $0.8 million that also would be
held in escrow for customary representations and warranties until the first
anniversary of the sale.
We will continue to look to sell non-core assets including our
remaining investments in manufactured housing loans and delinquent property tax
receivables. At the same time, we are reducing our overhead and rationalizing
our infrastructure costs. As discussed in General - Business Focus and Strategy
in Item 1 above, our goal is to be invested in short-duration assets and cash
while we evaluate opportunities that provide acceptable risk-adjusted rates of
return.
Securitization Financing
- ------------------------
We have historically used securitization financing to fund our
investment portfolio. The obligations under the securitization trust structure
are payable solely from the securitized finance receivables pledged and are
otherwise non-recourse to us. Securitized trust structures are not subject to
margin calls. The maturity of each class of non-recourse securitization
financing is directly affected by the rate of principal prepayments on the
related collateral. Each series is also subject to redemption in whole or in
part at our option according to specific terms of the respective indentures. At
December 31, 2004, we had $1.2 billion of securitization financings outstanding.
One securitization trust is redeemable at our option beginning in April 2005.
The respective indenture for the trust provides for increases in interest rates
ranging from 0.30 - 0.575% on the underlying non-recourse securitization
financing classes if such classes are not called by the issuer. We anticipate
redeeming these bonds and initially financing the redemption using repurchase
agreement financing. After the redemption, we will evaluate our alternatives
with respect to this trust and may reissue the bonds. For purposes of the
"Contractual Obligations" table below, these obligations are not redeemed.
Repurchase Agreements
- ---------------------
We have repurchase agreement relationships with a counterparty for
temporary financing of eligible investments. We may continue to utilize
repurchase agreement financing in the future, but we will manage the amount of
this type of financing that we use as it is largely collateral dependent and
puts our capital at risk if the collateral securing the repurchase agreement
financing declines in value. If we redeem the securitization financing trust
redeemable in April 2005, we anticipate financing the redemption of the
outstanding bonds using repurchase agreement financing on a temporary basis, as
discussed above.
Contractual Obligations and Commitments
- ---------------------------------------
The following table shows expected cash payments on contractual
obligations of the Company as of December 31, 2004 for the following time
periods:
- -----------------------------------------------------------------------------------------------------------------------------
Payments due by period
----------------------------------------------------------------------------
Contractual Obligations (1) Total < 1 year 1-3 years 3-5 years > 5 years
- -----------------------------------------------------------------------------------------------------------------------------
Long-Term Debt Obligations: (2)
Non-recourse securitization financing (3) $1,570,611 $ 213,760 $ 540,201 $ 368,939 $ 447,711
Repurchase agreements 70,615 70,615 - - -
Operating lease obligations 232 205 27 - -
- -----------------------------------------------------------------------------------------------------------------------------
Total $1,641,458 $ 284,580 $ 540,228 $ 368,939 $ 447,711
- -----------------------------------------------------------------------------------------------------------------------------
(1) As the master servicer for certain of the series of non-recourse
securitization financing securities which it has issued, and certain loans
which have been securitized but which the Company is not the master
servicer of the security, the Company has an obligation to advance
scheduled principal and interest on delinquent loans in accordance with the
underlying servicing agreements should the primary servicer fail to make
such advance. Such advance amounts are generally repaid in the same month
as they are made, or shortly thereafter, and the contractual obligation
with respect to these advances is excluded from the above table.
(2) Amounts presented for Long-Term Debt Obligations include estimated
principal and interest on the related obligations.
(3) Securitization financing is non-recourse to the Company as the bonds are
payable solely from loans and securities pledged as securitized finance
receivables. Payments due by period were estimated based on the principal
repayments forecast for the underlying loans and securities, substantially
all of which is used to repay the associated securitization financing
outstanding.
Off-Balance Sheet Arrangements
- ------------------------------
The Company does not believe that any off-balance sheet arrangements
exist that are reasonably likely to have a material current or future effect on
the Company's financial condition, changes in financial condition, revenues or
expenses, results of operations, liquidity, capital expenditures or capital
resources.
Selected Quarterly Results
- --------------------------
The following table presents the Company's unaudited selected quarterly
results for 2004.
Summary of Selected Quarterly Results (unaudited)
(amounts in thousands except share and per share data)
- -----------------------------------------------------------------------------------------------------------------------------
Year ended December 31, 2004 First Quarter Second Quarter Third Quarter Fourth Quarter
- -----------------------------------------------------------------------------------------------------------------------------
Operating results:
Total interest income $ 33,631 $ 33,217 $ 30,026 $ 25,349
Net interest income after provision for loan losses (765) (3,428) 5,103 3,908
Net (loss) income (2) (5,387) (12,953) (56) 15,021
Basic net (loss) income per common share (0.60) (0.95) (0.12) 1.13
Diluted net (loss) income per common share (0.60) (0.95) (0.12) 0.77
Cash dividends declared per common share - - - -
- ------------------------------------------------------------ --------------- --------------- --------------- ----------------
Average interest-earning assets 1,813,282 1,753,743 1,635,146 1,431,374
Average borrowed funds 1,710,843 1,622,815 1,503,468 1,282,657
- ------------------------------------------------------------ --------------- --------------- --------------- ----------------
Net interest spread on interest-earning assets 1.21% 0.92% 1.21% 0.71%
Average asset yield 7.42% 7.56% 7.32% 6.98%
Net yield on average interest-earning assets (1) 1.56% 1.41% 1.69% 1.35%
Cost of funds 6.21% 6.64% 6.11% 6.27%
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
First Second Third Fourth
Year Ended December 31, 2003 Quarter Quarter Quarter Quarter
- -----------------------------------------------------------------------------------------------------------------------------
Operating results:
Total interest income $ 39,493 $ 37,142 $ 35,849 $ 39,731
Net interest income after provision for loan losses 5,599 (9,214) 3,001 2,503
Net income (loss) 2,044 (10,986) (501) (11,664)
Basic net income (loss) per common share 1.15 (1.12) (0.16) (1.18)
Diluted net income (loss) per common share 1.13 (1.12) (0.16) (1.18)
- ------------------------------------------------------------ --------------- --------------- --------------- ---------------
Cash dividends declared per common share - - - -
- ------------------------------------------------------------ --------------- --------------- --------------- ---------------
Average interest-earning assets 2,146,752 2,060,132 1,983,146 1,894,014
Average borrowed funds 1,952,341 1,894,099 1,810,782 1,728,998
- ------------------------------------------------------------ --------------- --------------- --------------- ---------------
Net interest spread on interest-earning assets 1.68% 1.40% 1.39% 2.16%
Average asset yield 7.61% 7.48% 7.50% 7.53%
Net yield on average interest-earning assets (1) 2.22% 1.88% 1.91% 2.62%
Cost of funds 5.93% 6.08% 6.12% 5.38%
- ----------------------------------------------------------------------------------------------------------------------------
(1) Computed as net interest margin excluding non-interest non-recourse
securitization financing expenses divided by average interest earning
assets.
(2) During the three months ended December 31, 2004, the Company recognized a
gain of $17.6 million associated with the de-recognition of the assets and
liabilities of a securitization trust resulting from the sale of
redemption rights and other retained interests of the trust. The Company
recognized impairment charges of $5.2 million, made up primarily of $4.9
million on its investment in a security backed by delinquent property tax
receivables and related real estate owned.
FORWARD-LOOKING STATEMENTS
--------------------------
Certain written statements in this Form 10-K made by the Company that
are not historical fact constitute "forward-looking statements" within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended. All statements contained
in this Item as well as those discussed elsewhere in this Report addressing the
results of operations, our operating performance, events, or developments that
we expect or anticipate will occur in the future, including statements relating
to investment strategies, net interest income growth, earnings or earnings per
share growth, and market share, as well as statements expressing optimism or
pessimism about future operating results, are forward-looking statements. The
forward-looking statements are based upon management's views and assumptions as
of the date of this Report, regarding future events and operating performance
and are applicable only as of the dates of such statements. Such forward-looking
statements may involve factors that could cause the actual results of the
Company to differ materially from historical results or from any results
expressed or implied by such forward-looking statements. The Company cautions
the public not to place undue reliance on forward-looking statements, which may
be based on assumptions and anticipated events that do not materialize.
Factors that may cause actual results to differ from historical results
or from any results expressed or implied by forward-looking statements include
the following:
Economic Conditions. The Company is affected by general economic
conditions.. An increase in the risk of defaults and credit risk resulting from
an economic slowdown or recession could result in a decrease in the value of the
Company's investments and the over-collateralization associated with its
securitization transactions. As a result of the Company being heavily invested
in short-term high quality investments, a worsening economy could also benefit
the Company by creating opportunities for the Company to invest in assets that
become distressed as a result of the worsening conditions. These changes could
have an effect on the Company's financial performance and the performance on the
Company's securitized loan pools.
Investment Portfolio Cash Flow. Cash flows from the investment
portfolio fund the Company's operations and repayments of outstanding debt, and
are subject to fluctuation due to changes in interest rates, repayment rates and
default rates and related losses. Cash flows from the investment portfolio are
likely to sequentially decline until the Company meaningfully begins to reinvest
its capital. There can be no assurances that the Company will be able to find
suitable investment alternatives for its capital, nor can there be assurances
that the Company will meet its reinvestment and return hurdles.
Defaults. Defaults by borrowers on loans securitized by the Company may
have an adverse impact on the Company's financial performance, if actual credit
losses differ materially from estimates made by the Company or exceed reserves
for losses recorded in the financial statements. The allowance for loan losses
is calculated on the basis of historical experience and management's best
estimates. Actual default rates or loss severity may differ from the Company's
estimate as a result of economic conditions. Actual defaults on adjustable-rate
mortgage loans may increase during a rising interest rate environment. In
addition, commercial mortgage loans are generally large dollar balance loans,
and a significant loan default may have an adverse impact on the Company's
financial results.
Interest Rate Fluctuations. The Company's income and cash flow depends
on its ability to earn greater interest on its investments than the interest
cost to finance these investments. Interest rates in the markets served by the
Company generally rise or fall with interest rates as a whole. A majority of the
Company's investments, including loans and securities currently pledged as
securitized finance receivables and securities, are fixed-rate. The Company
currently finances these fixed-rate assets through non-recourse securitization
financing and repurchase agreements, approximately $227 million of which is
variable rate and resets monthly. Financing fixed-rate assets with variable-rate
bonds exposes the Company to reductions in income and cash flow in a period of
rising interest rates. Through the use of interest rate swaps and synthetic
swaps, the Company has reduced this exposure by approximately $120 million as of
December 31, 2004. In addition, a portion of the investments held by the Company
are adjustable-rate securitized finance receivables. These investments are
financed through non-recourse long-term securitization financing, which reset
monthly. The net interest spread for these investments could decrease during a
period of rapidly rising short-term interest rates, since the investments
generally have interest rates which reset on a delayed basis and have periodic
interest rate caps; the related borrowing has no delayed resets or such interest
rate caps.
Third-party Servicers. Third-party servicers service the majority of
the Company's investment portfolio. To the extent that these servicers are
financially impaired, the performance of the Company's investment portfolio may
deteriorate, and defaults and credit losses may be greater than estimated. In
addition, third-party servicers are generally obligated to advance scheduled
principal and interest on a loan if such loan is securitized, and to the extent
the third-party servicer fails to make this advance, the Company may be required
to make the advance. The actual credit losses experienced by the Company are in
large part influenced by the quality of servicing by these third-party
servicers.
Prepayments. Prepayments by borrowers on loans securitized by the
Company may have an adverse impact on the Company's financial performance.
Prepayments are expected to increase during a declining interest rate or flat
yield curve environment. The Company's exposure to rapid prepayments is
primarily (i) the faster amortization of premium on the investments and, to the
extent applicable, amortization of bond discount, and (ii) the replacement of
investments in its portfolio with lower yielding investments.
Competition. The financial services industry is a highly competitive
market in which we compete with a number of institutions with greater financial
resources. In purchasing portfolio investments and in issuing securities, we
compete with other mortgage REITs, investment banking firms, savings and loan
associations, commercial banks, mortgage bankers, insurance companies, federal
agencies and other entities, many of which have greater financial resources and
a lower cost of capital than we do. Increased competition in the market and our
competitors greater financial resources have adversely affected the Company, and
may continue to do so. Competition may also continue to keep pressure on spreads
resulting in the Company being unable to reinvest its capital at a satisfactory
risk-adjusted basis.
Regulatory Changes. The Company's businesses as of and for the year
ended December 31, 2004 were not subject to any material federal or state
regulation or licensing requirements. However, changes in existing laws and
regulations or in the interpretation thereof, or the introduction of new laws
and regulations, could adversely affect the Company and the performance of the
Company's securitized loan pools or its ability to collect on its delinquent
property tax receivables. The Company is a REIT and is required to meet certain
tests in order to maintain its REIT status as described in the earlier
discussion of "Federal Income Tax Considerations." If the Company should fail to
maintain its REIT status, it would not be able to hold certain investments and
would be subject to income taxes
Section 404 of the Sarbanes-Oxley Act of 2002. Based on the Company's
expected market capitalization at June 30, 2005, the Company anticipates that it
will be required to be compliant with the provisions of Section 404 of the
Sarbanes-Oxley Act of 2002 by December 31, 2005. Failure to be compliant may
result in doubt in the capital markets about the quality and adequacy of the
Company's internal disclosure controls. This could result in the Company having
difficulty in or being unable to raise additional capital in these markets in
order to finance its operations and future investments.
RECENT ACCOUNTING PRONOUNCEMENTS
In December 2003, the Accounting Standards Executive Committee (AcSEC)
of the American Institute of Certified Professional Accountants (AICPA) issued
Statement of Position (SOP) No. 03-3, "Accounting for Certain Loans or Debt
Securities Acquired in a Transfer." SOP No. 03-3 is effective for loans acquired
in fiscal years beginning after December 15, 2004, with early adoption
encouraged. A certain transition provision applies for certain aspects of loans
currently within the scope of Practice Bulletin 6, Amortization of Discounts on
Certain Acquired Loans. SOP No. 03-3 addresses accounting for differences
between contractual cash flows and cash flows expected to be collected from an
investor's initial investment in loans or debt securities (loans) acquired in a
transfer if those differences are attributable, at least in part, to credit
quality. It includes loans acquired in business combinations and applies to all
non-governmental entities, including not-for-profit organizations. SOP No. 03-3
does not apply to loans originated by the entity. The Company has reviewed the
implications of SOP No. 03-3 but does not believe that its adoption will have a
significant impact on its financial position, results of operations or cash
flows.
In December 2004, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 123 (Revised 2004), Share-Based Payment. This statement
supersedes APB Opinion No. 25 and its related implementation guidance. The
statement establishes standards for the accounting for transactions in which an
entity exchanges its equity instruments for goods and services. This statement
focuses primarily on accounting for transactions in which an entity obtains
employee services in share-based payment transactions. The most significant
change resulting from this statement is the requirement for public companies to
expense employee share-based payments under fair value as originally introduced
in SFAS No. 123. This statement is effective for public companies as of the
beginning of the first interim or annual reporting period that begins after June
15, 2005. The Company will adopt this statement effective July 1, 2005 and is
currently evaluating the impact it will have on net income had the Company
adopted the provisions of SFAS No. 123, for each year presented.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Market risk generally represents the risk of loss that may result from
the potential change in the value of a financial instrument due to fluctuations
in interest and foreign exchange rates and in equity and commodity prices.
Market risk is inherent to both derivative and non-derivative financial
instruments, and accordingly, the scope of the Company's market risk management
extends beyond derivatives to include all market risk sensitive financial
instruments. As a financial services company, net interest income comprises the
primary component of the Company's earnings and cash flows. The Company is
subject to risk resulting from interest rate fluctuations to the extent that
there is a gap between the amount of the Company's interest-earning assets and
the amount of interest-bearing liabilities that are prepaid, mature or re-price
within specified periods.
The Company monitors the aggregate cash flow, projected net yield and
estimated market value of its investment portfolio under various interest rate
and prepayment assumptions. While certain investments may perform poorly in an
increasing or decreasing interest rate environment, other investments may
perform well, and others may not be impacted at all.
The Company focuses on the sensitivity of its investment portfolio cash
flow, and measures such sensitivity to changes in interest rates. Changes in
interest rates are defined as instantaneous, parallel, and sustained interest
rate movements in 100 basis point increments. The Company estimates its net
interest income cash flow for the next twenty-four months assuming interest
rates over such time period follow the forward LIBOR curve (based on 90-day
Eurodollar futures contracts) as of December 31, 2004. Once the base case has
been estimated, cash flows are projected for each of the defined interest rate
scenarios. Those scenario results are then compared against the base case to
determine the estimated change to cash flow. Cash flow changes from interest
rate swaps, caps, floors or any other derivative instrument are included in this
analysis.
The following table summarizes the Company's net interest income cash
flow and market value sensitivity analyses as of December 31, 2004. These
analyses represent management's estimate of the percentage change in net
interest margin cash flow and value expressed as a percentage change of
shareholders' equity, given a parallel shift in interest rates, as discussed
above. Other investments are excluded from this analysis because they are not
considered interest rate sensitive. The "Base" case represents the interest rate
environment as it existed as of December 31, 2004. At December 31, 2004,
one-month LIBOR was 2.40% and six-month LIBOR was 2.78%. The analysis is heavily
dependent upon the assumptions used in the model. The effect of changes in
future interest rates, the shape of the yield curve or the mix of assets and
liabilities may cause actual results to differ significantly from the modeled
results. In addition, certain financial instruments provide a degree of
"optionality." The most significant option affecting the Company's portfolio is
the borrowers' option to prepay the loans. The model applies prepayment rate
assumptions representing management's estimate of prepayment activity on a
projected basis for each collateral pool in the investment portfolio. The model
applies the same prepayment rate assumptions for all five cases indicated below.
The extent to which borrowers utilize the ability to exercise their option may
cause actual results to significantly differ from the analysis. Furthermore, the
projected results assume no additions or subtractions to the Company's
portfolio, and no change to the Company's liability structure. Historically,
there have been significant changes in the Company's investment portfolio and
the liabilities incurred by the Company. As a result of anticipated prepayments
on assets in the investment portfolio, there are likely to be such changes in
the future.
Projected Change in Net Projected Change in
Basis Point Interest Margin Value, Expressed as a
Increase (Decrease) Cash Flow From Percentage of
in Interest Rates Base Case Shareholders' Equity
- --------------------------------------------------------------------------------
+200 (12.6)% (4.5)%
+100 (6.0)% (2.0)%
Base
-100 9.8% 2.3%
-200 23.4% 5.5%
The Company's interest rate risk is related both to the rate of change
in short term interest rates and to the level of short-term interest rates.
Approximately $1.3 billion of the Company's investment portfolio is comprised of
loans or securities that have coupon rates that are fixed. Approximately $251
million of the Company's investment portfolio as of December 31, 2004 was
comprised of loans or securities that have coupon rates which adjust over time
(subject to certain periodic and lifetime limitations) in conjunction with
changes in short-term interest rates. Approximately 70% and 14% of the
adjustable-rate loans underlying the Company's securitized finance receivables
are indexed to and reset based upon the level of six-month LIBOR and one-year
CMT, respectively.
Generally, during a period of rising short-term interest rates, the
Company's net interest income earned and the corresponding cash flow on its
investment portfolio will decrease. The decrease of the net interest spread
results from (i) fixed-rate loans and investments financed with variable-rate
debt, (ii) the lag in resets of the adjustable-rate loans underlying the
securitized finance receivables relative to the rate resets on the associated
borrowings, and (iii) rate resets on the adjustable-rate loans which are
generally limited to 1% every six months or 2% every twelve months and subject
to lifetime caps, while the associated borrowings have no such limitation. As to
item (i), the Company has substantially limited its interest rate risk on such
investments through (x) the issuance of fixed-rate non-recourse securitization
financing which approximated $800 million as of December 31, 2004, and (y)
equity, which was $148.8 million. In addition, the Company has entered into
interest rate swaps and synthetic swaps to mitigate its interest rate risk
exposure on fixed-rate investments financed with variable rate bonds as further
discussed below. As to items (ii) and (iii), as short-term interest rates
stabilize and the adjustable-rate loans reset, the net interest margin may be
partially restored as the yields on the adjustable-rate loans adjust to market
conditions.
In addition, the Company has entered into an interest rate swap to
mitigate its interest rate risk exposure on $100 million in notional value of
its variable rate bonds. The swap agreement has been constructed such that the
Company will pay interest at a fixed rate of 3.73% on the notional amount and
will receive interest based on one month LIBOR on the same notional amount
through June 2005. The impact on cash flows from the interest rate swap has been
included in the table above for each of the respective interest-rate scenarios.
An additional approximate $20 million of floating-rate liabilities are being
converted to a fixed rate through an amortizing synthetic swap created by the
short sale of a string of Eurodollar futures contract in October 2002. The
synthetic swap has remaining an estimated duration of 0.72 years. As of December
31, 2004, the weighted-average fixed rate cost of the synthetic swap to the
Company was 2.70%.
Net interest income may increase following a fall in short-term
interest rates. This increase may be temporary as the yields on the
adjustable-rate loans adjust to the new market conditions after a lag period.
The net interest spread may also be increased or decreased by the proceeds or
costs of interest rate swap, cap or floor agreements, to the extent that the
Company has entered into such agreements.
Item 8. Financial Statements and Supplementary Data
The consolidated financial statements of the Company and the related
notes, together with the Report of the Independent Registered Public Accounting
Firm thereon, are set forth on pages F-1 through F-25 of this Form 10-K.
Item 9. Changes in and Disagreements With Accountants on Accounting and
Financial Disclosure
None.
Item 9A. Controls and Procedures
(a) Evaluation of disclosure controls and procedures.
Disclosure controls and procedures are controls and other procedures
that are designed to ensure that information required to be disclosed in the
Company's reports filed or submitted under the Exchange Act is recorded,
processed, summarized and reported within the time periods specified in the
SEC's rules and forms. Disclosure controls and procedures include, without
limitation, controls and procedures designed to ensure that information required
to be disclosed in the Company's reports filed under the Exchange Act is
accumulated and communicated to management, including the Company's management,
as appropriate, to allow timely decisions regarding required disclosures.
As of the end of the period covered by this annual report, the Company
carried out an evaluation of the effectiveness of the design and operation of
the Company's disclosure controls and procedures pursuant to Rule 13a-15 under
the Exchange Act. This evaluation was carried out under the supervision and with
the participation of the Company's management, including the Company's Principal
Executive Officer and Chief Financial Officer. Based upon that evaluation, the
Company's management concluded that the Company's disclosure controls and
procedures are effective.
In conducting its review of disclosure controls, management concluded
that sufficient disclosure controls and procedures did exist to ensure that
information required to be disclosed in the Company's reports filed or submitted
under the Exchange Act is recorded, processed, summarized and reported within
the time periods specified in the SEC's rules and forms.
(b) Changes in internal controls.
The Company's management is also responsible for establishing and
maintaining adequate internal control over financial reporting. There were no
changes in the Company's internal controls or in other factors during the fourth
quarter of 2004 that materially affected, or are reasonably likely to materially
affect, the Company's internal control over financial reporting. There were also
no significant deficiencies or material weaknesses in such internal controls
requiring corrective actions.
Item 9B. Other Information
None.
PART III
--------
Item 10. Directors and Executive Officers of the Registrant
The information required by Item 10 is included in the Company's proxy
statement for its 2005 Annual Meeting of Stockholders (the 2005 Proxy Statement)
in the Election of Directors, Corporate Governance and the Board of Directors,
Ownership of Stock and Management and Executive Compensation of the Company
sections and is incorporated herein by reference.
Item 11. Executive Compensation
The information required by Item 11 is included in the 2005 Proxy
Statement in the Management of the Company and Executive Compensation section
and is incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters
The information required by Item 12 is included in the 2005 Proxy
Statement in the Ownership of Stock and Management of the Company and Executive
Compensation sections and is incorporated herein by reference.
Item 13. Certain Relationships and Related Transactions
The information required by Item 13 is included in the 2005 Proxy
Statement in Management of the Company and Executive Compensation section and is
incorporated herein by reference.
Item 14. Principal Accounting Fees and Services
The information required by Item 14 is included in the 2005 Proxy
Statement in the Audit Information section and is incorporated herein by
reference.
PART IV
-------
Item 15. Exhibits, Financial Statement Schedules
(a) Documents filed as part of this report:
1. and 2. Financial Statements and Schedules
The information required by this section of Item
15 is set forth in the Consolidated Financial
Statements and Report of Independent Registered
Public Accounting Firm beginning at page F-1 of
this Form 10-K. The index to the Financial
Statements is set forth at page F-2 of this Form
10-K.
3. Exhibits
Number Exhibit
3.1 Articles of Incorporation of the Registrant,
as amended, effective as of February 4,
1988. (Incorporated herein by reference to
the Company's Amendment No. 1 to the
Registration Statement on Form S-3 (No. 333-
10783) filed March 21, 1997.)
3.2 Amended Bylaws of the Registrant.
(Incorporated by reference to the Company's
Annual Report on Form 10-K for the year
ended December 31, 1992, as amended.)
3.3 Amendment to Articles of Incorporation,
effective December 29, 1989. (Incorporated
herein by reference to the Company's Amend-
ment No. 1 to the Registration Statement on
Form S-3 (No. 333-10783) filed March 21, 1997.)
3.4 Amendment to Articles of Incorporation,
effective October 9, 1996. (Incorporated
herein by reference to the Registrant's
Current Report on Form 8-K, filed October
15, 1996.)
3.5 Amendment to Articles of Incorporation,
effective October 19, 1992. (Incorporated
herein by reference to the Company's
Amendment No. 1 to the Registration
Statement on Form S-3 (No. 333-10783) filed
March 21, 1997.)
3.6 Amendment to Articles of Incorporation,
effective April 25, 1997. (Incorporated
herein by reference to the Company's
Quarterly Report on Form 10-Q for the
quarter ended March 31, 1997.)
3.7 Amendment to Articles of Incorporation,
effective June 17, 1998 (filed herewith).
3.8 Amendment to Articles of Incorporation,
effective August 2, 1999 (filed herewith).
3.9 Amendment to Articles of Incorporation,
effective May 19, 2004. (Incorporated
herein by reference to the Company's
Quarterly Report on Form 10-Q for the
quarter ended June 30, 2004.)
3.10 Amendments to the Bylaws of the Company.
(Incorporated herein by reference to the
Company's Annual Report on Form 10-K for
the year ended December 31, 2002, as
amended.)
10.1 Dynex Capital, Inc. 2004 Stock Incentive Plan
(filed herewith)
21.1 List of consolidated entities of the Company
(filed herewith)
23.1 Consent of Deloitte & Touche LLP
(filed herewith)
31.1 Certification of Principal Executive
Officer and Principal Financial Officer
pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002 (filed
herewith).
32.1 Certification of Principal Executive
Officer and Chief Financial Officer
pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 (filed
herewith).
(b) Exhibits: See Item 15(a)(3) above.
(c) Financial Statement Schedules:
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
DYNEX CAPITAL, INC.
(Registrant)
April 14, 2005 -------------------------------------------
Stephen J. Benedetti,
Executive Vice President
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Signature Capacity Date
- --------- -------- ----
/s/ Stephen J. Benedetti Principal Executive Officer April 14, 2005
- ------------------------------------------------- Principal Financial Officer
Stephen J. Benedetti Principal Accounting Officer
/s/ Thomas B. Akin Director April 14, 2005
- -------------------------------------------------
Thomas B. Akin
/s/ J. Sidney Davenport, IV Director April 14, 2005
- -------------------------------------------------
J. Sidney Davenport, IV
/s/ Leon A. Felman Director April 14, 2005
- -------------------------------------------------
Leon A. Felman
/s/ Barry Igdaloff Director April 14, 2005
- -------------------------------------------------
Barry Igdaloff
/s/ Donald B. Vaden Director April 14, 2005
- -------------------------------------------------
Donald B. Vaden
/s/ Eric P. Von der Porten Director April 14, 2005
- -------------------------------------------------
Eric P. Von der Porten
DYNEX CAPITAL, INC.
CONSOLIDATED FINANCIAL STATEMENTS AND
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
For Inclusion in Form 10-K
Annual Report Filed with
Securities and Exchange Commission
December 31, 2004
DYNEX CAPITAL, INC.
INDEX TO FINANCIAL STATEMENTS
Financial Statements:
Page
Report of Independent Registered Public Accounting Firm...........F-3
Consolidated Balance Sheets
December 31, 2004 and 2003......................................F-4
Consolidated Statements of Operations -- Years ended
December 31, 2004, 2003 and 2002................................F-5
Consolidated Statements of Shareholders' Equity -- Years ended
December 31, 2004, 2003 and 2002................................F-6
Consolidated Statements of Cash Flows -- Years ended
December 31, 2004, 2003 and 2002................................F-7
Notes to Consolidated Financial Statements
December 31, 2004, 2003, and 2002...............................F-8
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Dynex Capital, Inc.
Glen Allen, Virginia
We have audited the accompanying consolidated balance sheets of Dynex Capital,
Inc. and subsidiaries (the "Company") as of December 31, 2004 and 2003, and the
related consolidated statements of operations, shareholders' equity, and cash
flows for each of the three years in the period ended December 31, 2004. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on the financial statements based on our
audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The Company is not required to
have, nor were we engaged to perform, an audit of its internal control over
financial reporting. Our audit included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly, we express no such opinion. An audit includes examining,
on a test basis, evidence supporting the amounts and disclosures in the
financial statements, assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of the Company as of December 31, 2004
and 2003, and the results of their operations and their cash flows for each of
the three years in the period ended December 31, 2004, in conformity with
accounting principles generally accepted in the United States of America.
Princeton, New Jersey
April 7, 2005
CONSOLIDATED BALANCE SHEETS
DYNEX CAPITAL, INC.
December 31, 2004 and 2003
(amounts in thousands except share data)
2004 2003
--------------- ---------------
ASSETS
Cash and cash equivalents $ 52,522 $ 7,386
Other assets 4,964 4,174
--------------- ---------------
57,486 11,560
Investments:
Securitized finance receivables:
Loans, net 1,036,123 1,518,613
Debt securities 206,434 255,580
Securities 87,706 33,275
Other investments 7,596 37,903
Other loans 5,589 8,304
--------------- ---------------
1,343,448 1,853,675
--------------- ---------------
$ 1,400,934 $ 1,865,235
=============== ===============
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Non-recourse securitization financing $ 1,177,280 $ 1,679,830
Repurchase agreements 70,468 23,884
Senior notes - 10,049
-------------- --------------
1,247,748 1,713,763
Accrued expenses and other liabilities 4,420 1,626
--------------- ---------------
1,252,168 1,715,389
--------------- ---------------
Commitments and Contingencies (Note 16) - -
SHAREHOLDERS' EQUITY
Preferred stock, par value $.01 per share, 50,000,000 shares authorized:
9.75% Cumulative Convertible Series A,
None and 493,595 shares issued and outstanding, respectively - 11,274
(None and $16,322 aggregate liquidation preference, respectively)
9.55% Cumulative Convertible Series B,
None and 688,189 shares issued and outstanding, respectively - 16,109
(None and $23,100 aggregate liquidation preference, respectively)
9.73% Cumulative Convertible Series C,
None and 684,893 shares issued and outstanding, respectively - 19,631
(None and $28,295 aggregate liquidation preference, respectively)
9.75% Cumulative Convertible Series D,
5,628,737 and no shares issued and outstanding, respectively 55,666 -
($58,040 and None aggregate liquidation preference, respectively)
Common stock, par value $.01 per share, 100,000,000 shares authorized,
12,162,391 and 10,873,903 shares issued and outstanding, respectively 122 109
Additional paid-in capital 366,896 360,684
Accumulated other comprehensive income (loss) 3,817 (3,882)
Accumulated deficit (277,735) (254,079)
--------------- ---------------
148,766 149,846
-------------- ---------------
$ 1,400,934 $ 1,865,235
=============== ===============
See notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
DYNEX CAPITAL, INC.
Years ended December 31, 2004, 2003 and 2002
(amounts in thousands except share data)
2004 2003 2002
-------------------- --------------------- --------------------
Interest income:
Securitized finance receivables $ 118,647 $ 147,297 $ 174,999
Securities 2,535 773 1,026
Other investments 335 3,537 5,673
Other loans 706 608 441
-------------------- --------------------- --------------------
122,223 152,215 182,139
-------------------- --------------------- --------------------
Interest and related expense:
Non-recourse securitization financing 98,271 111,056 130,768
Senior notes and repurchase agreements 567 1,849 2,132
Other 104 339 86
-------------------- --------------------- --------------------
98,942 113,244 132,986
-------------------- --------------------- --------------------
Net interest income 23,281 38,971 49,153
Provision for loan losses (18,463) (37,082) (28,483)
-------------------- --------------------- --------------------
Net interest income after provision for loan losses 4,818 1,889 20,670
Impairment charges (14,756) (16,355) (18,477)
Gain (loss) on sale of investments, net 14,490 1,555 (150)
Trading losses - - (3,307)
General and administrative expenses (7,748) (8,632) (9,493)
Other (expense) income (179) 436 1,397
-------------------- --------------------- --------------------
Net loss (3,375) (21,107) (9,360)
Preferred stock (charge) benefit (1,819) 6,847 (9,586)
-------------------- --------------------- --------------------
Net loss to common shareholders $ (5,194) $ (14,260) $ (18,946)
==================== ===================== ====================
Net loss per common share :
Basic and diluted $ (0.46) $ (1.31) $ (1.74)
==================== ===================== ====================
See notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
DYNEX CAPITAL, INC.
Years ended December 31, 2004, 2003, and 2002
(amounts in thousands except share data)
Accumulated
Other
Additional Comprehensive
Preferred Common Paid-in (Loss) Accumulated
Stock Stock Capital Income Deficit Total
---------------------------------------------------------------------------------
Balance at January 1, 2002 $ 94,588 $ 109 $ 364,740 $ 3,298 $(220,625) $242,110
Comprehensive loss:
Net loss - 2002 - - - - (9,360) (9,360)
Change in net unrealized
gain/(loss) on:
Investments classified as
available for sale - - - (3,669) - (3,669)
Hedge instruments - - - (4,461) - (4,461)
-------------
Total comprehensive loss (17,490)
Conversion of preferred to (2) - 3 - - 1
common stock
Dividends on preferred stock - - - - (1,200) (1,200)
---------------------------------------------------------------------------------
Balance at December 31, 2002 94,586 109 364,743 (4,832) (231,185) 223,421
Comprehensive loss:
Net loss - 2003 - - - - (21,107) (21,107)
Change in net unrealized
gain/(loss) on:
Investments classified as
available for sale - - - 115 - 115
Hedge instruments - - - 835 - 835
-------------
Total comprehensive loss (20,157)
Repurchase of preferred stock (47,572) - (4,059) - - (51,631)
Dividends on preferred stock - - - - (1,787) (1,787)
---------------------------------------------------------------------------------
Balance at December 31, 2003 47,014 109 360,684 (3,882) (254,079) 149,846
Comprehensive loss:
Net loss - 2004 - - - - (3,375) (3,375)
Change in net unrealized
gain/(loss) on:
Investments classified as
available for sale - - - 4,681 - 4,681
Hedge instruments - - - 3,018 - 3,018
-------------
Total comprehensive income - - - 4,324
Recapitalization 8,652 13 6,212 - (16,345) (1,468)
Dividends on preferred stock - - - - (3,936) (3,936)
---------------------------------------------------------------------------------
Balance at December 31, 2004 $ 55,666 $ 122 $ 366,896 $ 3,817 $(277,735) $ 148,766
=====================================================================================================================
See notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
DYNEX CAPITAL, INC.
Years ended December 31, 2004, 2003 and 2002
(amounts in thousands except share data)
2004 2003 2002
---------------- ---------------- ----------------
Operating activities:
Net loss $ (3,375) $ (21,107) $ (9,360)
Adjustments to reconcile net loss to cash provided by operating
activities:
Provision for loan losses 18,463 37,082 28,483
Impairment charges 14,756 16,355 18,477
(Gain) loss on sale of investments (14,490) (1,555) 150
Amortization and depreciation 3,726 3,072 6,446
Net change in other assets and other liabilities 3,953 (4,031) (4,266)
---------------- ---------------- ----------------
Net cash and cash equivalents provided by operating activities 23,033 29,816 39,930
---------------- ---------------- ----------------
Investing activities:
Principal payments received on collateral 286,212 294,785 416,370
Purchase of securities and other investments (71,468) (32,196) (152,928)
Payments received on securities, other investments and loans 21,601 17,781 17,150
Proceeds from sales of securities and other investments 32,066 2,937 2,191
Other 180 245 (444)
---------------- ---------------- ----------------
Net cash and cash equivalents provided by investing activities 268,591 283,552 282,339
---------------- ---------------- ----------------
Financing activities:
Proceeds from issuance of bonds 7,377 - 172,898
Principal payments on bonds (286,330) (301,573) (428,027)
Repayment of senior notes (10,872) (22,030) (57,994)
Proceeds from recourse debt borrowings 46,584 23,884 -
Retirement of preferred stock (648) (19,552) -
Dividends paid (2,599) (1,787) (1,199)
---------------- ---------------- ----------------
Net cash and cash equivalents used for financing activities (246,488) (321,058) (314,322)
---------------- ---------------- ----------------
Net increase (decrease) in cash and cash equivalents 45,136 (7,690) 7,947
Cash and cash equivalents at beginning of period 7,386 15,076 7,129
---------------- ---------------- ----------------
Cash and cash equivalents at end of period $ 52,522 $ 7,386 $ 15,076
================ ================ ================
See notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DYNEX CAPITAL, INC.
December 31, 2004, 2003, and 2002
(amounts in thousands except share and per share data)
NOTE 1 - BASIS OF PRESENTATION
Basis of Presentation
The accompanying consolidated financial statements have been prepared
in accordance with the instructions to Form 10-K and include all of the
information and notes required by accounting principles generally accepted in
the United States of America, hereinafter referred to as "generally accepted
accounting principles," for complete financial statements. The consolidated
financial statements include the accounts of Dynex Capital, Inc. and its
qualified real estate investment trust ("REIT") subsidiaries and taxable REIT
subsidiary ("Dynex" or the "Company"). All inter-company balances and
transactions have been eliminated in consolidation of Dynex.
The Company believes it has complied with the requirements for
qualification as a REIT under the Internal Revenue Code (the "Code"). As such,
the Company believes that it qualifies as a REIT, and it generally will not be
subject to federal income tax on the amount of its income or gain that is
distributed as dividends to shareholders.
In the opinion of management, all significant adjustments, consisting
of normal recurring accruals, considered necessary for a fair presentation of
the condensed consolidated financial statements have been included.
The Company uses estimates in establishing fair value for its
securities as discussed in Note 2.
The Company also has credit risk on certain investments in its
portfolio as discussed in Note 4. An allowance for loan losses has been
estimated and established for currently existing losses based on management's
judgment. The allowance for loan losses is evaluated and adjusted periodically
by management based on the actual and estimated timing and amount of currently
existing credit losses. Provisions made to increase the allowance related to
credit risk are presented as provision for loan losses in the accompanying
condensed consolidated statements of operations. The Company's actual credit
losses may differ from those estimates used to establish the allowance.
Certain amounts for 2002 and 2003 have been reclassified to conform to
the presentation adopted in 2004.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Consolidation of Subsidiaries
The consolidated financial statements represent the Company's accounts
after the elimination of inter-company transactions. The Company consolidates
entities in which it owns more than 50% of the voting equity and control does
not rest with others. The Company follows the equity method of accounting for
investments with greater than 20% and less than a 50% interest in partnerships
and corporate joint ventures or when it is able to influence the financial and
operating policies of the investee but owns less than 50% of the voting equity.
For all other investments, the cost method is applied.
Federal Income Taxes
The Company believes it has complied with the requirements for
qualification as a REIT under the Internal Revenue Code (the "Code"). As such,
the Company believes that it qualifies as a REIT for federal income tax
purposes, and it generally will not be subject to federal income tax on the
amount of its income or gain that is distributed as dividends to shareholders.
The Company uses the calendar year for both tax and financial reporting
purposes. There may be differences between taxable income and income computed in
accordance with accounting principles generally accepted in the United States of
America ("GAAP"). The Company's estimated taxable loss for 2004, excluding net
operating losses carried forward from prior years, was $13,276. At December 31,
2004, the Company's cumulative tax operating loss carry-forwards is an estimated
$148,917. The Company paid dividends on the Series D Preferred Stock during 2004
of $2,599 or $0.4618 per share, which consisted of $1,358 or $0.2412 per share
of ordinary income and $1,241 or $0.2206 per share return of capital. The $1,358
dividends of ordinary income are due to the Company's ownership of residual
interests in certain REMIC securitizations.
Investments
Pursuant to the requirements of Statement of Financial Accounting
Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and
Equity Securities," the Company is required to classify certain investments
considered debt securities as either trading, available-for-sale or
held-to-maturity.
Securitized Finance Receivables. Securitized finance receivables
consist of collateral pledged to support the repayment of non-recourse
securitization financing issued by the Company. Securitized finance receivables
include loans and debt securities consisting of, or secured by adjustable-rate
and fixed-rate mortgage loans secured by first liens on single family
properties, fixed-rate loans secured by first liens on multifamily and
commercial properties, and manufactured housing installment loans secured by
either a UCC filing or a motor vehicle title. Loans included in securitized
finance receivables are reported at amortized cost. An allowance has been
established for currently existing losses on such loans. Debt securities
included in securitized finance receivables are considered available-for-sale
and are reported at fair value, with unrealized gains and losses excluded from
earnings and reported as accumulated other comprehensive income. The basis for
any gain/loss on any debt securities sold is computed using the specific
identification method. Securitized finance receivables can only be sold subject
to the lien of the respective securitization financing indenture, unless the
related bonds have been redeemed.
Other Investments. Other investments include unsecuritized delinquent
property tax receivables, securities backed by delinquent property tax
receivables, and real estate owned. The unsecuritized delinquent property tax
receivables are carried at amortized cost. Securities backed by delinquent
property tax receivables were transferred from held-to-maturity to
available-for-sale during 2004 and are carried at fair value as of December 31,
2004. As of December 31, 2003, these securities were classified as
held-to-maturity and recorded at amortized cost. Other investments include real
estate owned acquired through, or in lieu of foreclosure in connection with the
servicing of the delinquent tax lien receivables portfolio. Such investments are
considered held for sale and are initially recorded at fair value less cost to
sell ("net realizable value") at the date of foreclosure, establishing a new
cost basis. Subsequent to foreclosure, management periodically performs
valuations if such amount is less than the current amortized cost basis of the
real estate owned. Revenue and expenses from operations and changes in the
valuation of the real estate owned are included in other income (expense).
Securities. Securities include debt and equity securities, which are
considered available-for-sale under SFAS No. 115 and are reported at fair value,
with unrealized gains and losses excluded from earnings and reported as
accumulated other comprehensive income. The basis used to determine the
gain/loss on any debt and equity securities sold is the specific identification
method and average cost method, respectively.
Other loans. Other loans are carried at amortized cost.
Interest Income. Interest income is recognized when earned according to
the terms of the underlying investment and when, in the opinion of management,
it is collectible. For loans, the accrual of interest is discontinued when, in
the opinion of management, the interest is not collectible in the normal course
of business, when the loan is past due and when the primary servicer of the loan
fails to advance the interest and/or principal due on the loan. For securities
and other investments, the accrual of interest is discontinued when, in the
opinion of management, it is probable that all amounts contractually due will
not be collected. Loans are considered past due when the borrower fails to make
a timely payment in accordance with the underlying loan agreement, inclusive of
all applicable cure periods. All interest accrued but not collected for
investments that are placed on a non-accrual status or are charged-off is
reversed against interest income. Interest on these investments is accounted for
on the cash-basis or cost-recovery method, until qualifying for return to
accrual status. Investments are returned to accrual status when all the
principal and interest amounts contractually due are brought current and future
payments are reasonably assured.
Premiums, Discounts and Hedging Basis Adjustments
Premiums and discounts on investments and obligations are amortized
into interest income or expense, respectively, over the life of the related
investment or obligation using the effective yield method. Hedging basis
adjustments on associated debt obligations are amortized over the expected
remaining life of the debt instrument. If the indenture for a particular debt
obligation provides for a step-up of interest rates on the optional redemption
date and the Company has the ability and intent to exercise its call option,
then premiums, discounts, and deferred hedging losses are amortized to that
optional redemption date. Otherwise, these amounts are amortized over the
estimated remaining life of the obligation.
Debt Issuance Costs
Costs incurred in connection with the issuance of non-recourse debt and
recourse debt are deferred and amortized over the estimated lives of their
respective debt obligations using the effective yield method.
Derivative Financial Instruments
On occasion, the Company may enter into interest rate swap agreements,
interest rate cap agreements, interest rate floor agreements, financial
forwards, financial futures and options on financial futures ("Interest Rate
Agreement") to manage its sensitivity to changes in interest rates. These
interest rate agreements are intended to provide income and cash flow to offset
potential reduced net interest income and cash flow under certain interest rate
environments. At the inception of the Interest Rate Agreement, these instruments
are designated as either hedge positions or trading positions using criteria
established in SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities" (as amended). If, at the inception of the Interest Rate Agreement,
formal documentation is prepared that describes the risk being hedged,
identifies the hedging instrument and the means to be used for assessing the
effectiveness of the hedge and if it can be demonstrated that the hedging
instrument will be highly effective at hedging the risk exposure, the derivative
instrument will be designated as a cash flow hedge position. Otherwise, the
Interest Rate Agreement will be classified as a trading position.
For Interest Rate Agreements designated as cash flow hedges, the
Company evaluates the effectiveness of these hedges against the financial
instrument being hedged. The effective portion of the hedge relationship on an
interest rate agreement designated as a cash flow hedge is reported in
accumulated other comprehensive income, and the ineffective portion of such
hedge is reported in income. Amounts in accumulated other comprehensive income
are reclassified into earnings in the same period during which the hedged
transaction affects earnings. Derivative instruments are carried at fair value
in the financial statements of the Company.
As a part of the Company's interest rate risk management process, the
Company may be required periodically to terminate hedge instruments. Any basis
adjustments or changes in the fair value of hedges recorded in other
comprehensive income are recognized into income or expense in conjunction with
the original hedge or hedged exposure.
If the underlying asset, liability or commitment is sold or matures,
the hedge is deemed partially or wholly ineffective, or the criteria that was
executed at the time the hedge instrument was entered into no longer exists, the
interest rate agreement no longer qualifies as a designated hedge. Under these
circumstances, such changes in the market value of the interest rate agreement
are recognized in current income.
For interest rate agreements entered into for trading purposes,
realized and unrealized changes in fair value of these instruments are
recognized in the consolidated statements of operations as trading income or
loss in the period in which the changes occur or when such trade instruments are
settled. Amounts receivable from counter-parties, if any, are included on the
consolidated balance sheets in other assets.
Cash Equivalents
The Company considers investments with original maturities of three
months or less to be cash equivalents.
Net Income Per Common Share
Net income per common share is presented on both a basic net income per
common share and diluted net income per common share basis. Diluted net income
per common share assumes the conversion of the convertible preferred stock into
common stock, using the if-converted method, and stock appreciation rights,
using the treasury stock method, but only if these items are dilutive. The
preferred stock is convertible into one share of common stock for two shares of
preferred stock.
Use of Estimates
The preparation of financial statements, in conformity with accounting
principles generally accepted in the United States of America, requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenue and
expenses during the reported period. Actual results could differ from those
estimates. The primary estimates inherent in the accompanying consolidated
financial statements are discussed below.
Fair Value. Securities classified as available-for-sale are carried in
the accompanying financial statements at estimated fair value. Estimates of fair
value for securities may be based on market prices provided by certain dealers.
Estimates of fair value for certain other securities are determined by
calculating the present value of the projected cash flows of the instruments
using estimates of market-based discount rates, prepayment rates and credit loss
assumptions. The estimate of fair value for securities pledged as securitized
finance receivables is determined by calculating the present value of the
projected cash flows of the instruments, using discount rates, prepayment rate
assumptions and credit loss assumptions based on historical experience and
estimated future activity, and using discount rates commensurate with those the
Company believes would be used by third parties in a market purchase. The
discount rate used in the determination of fair value of securities pledged as
securitized finance receivables was 16% at December 31, 2004 and 2003.
Prepayment rate assumptions at December 31, 2004 and 2003 were generally at a
"constant prepayment rate," or CPR, were 30% for 2004, and were 30%-50% for
2003, for securitized finance receivables consisting of securities backed by
single-family mortgage loans, and a CPR equivalent of 7% for 2004 and 9%-10% for
2003, for securitized finance receivables consisting of securities backed by
manufactured housing loans. CPR assumptions for each year are based in part on
the actual prepayment rates experienced for the prior six-month period and in
part on management's estimate of future prepayment activity. The loss
assumptions utilized vary for each series of securitized finance receivables,
depending on the collateral pledged.
Estimates of fair value for financial instruments are based primarily
on management's judgment. Since the fair value of the Company's financial
instruments is based on estimates, actual fair values recognized may differ from
those estimates recorded in the consolidated financial statements. The fair
value of all financial instruments is presented in Note 10.
Allowance for Loan Losses. An allowance for loan losses has been
estimated and established for currently existing probable losses for loans in
the Company's investment portfolio. Factors considered in establishing an
allowance include current loan delinquencies, historical cure rates of
delinquent loans, and historical and anticipated loss severity of the loans as
they are liquidated. The allowance for losses is evaluated and adjusted
periodically by management based on the actual and estimated timing and amount
of probable credit losses, using the above factors, as well as industry loss
experience. Where loans are considered homogeneous, the allowance for losses are
established and evaluated on a pool basis. Otherwise, the allowance for losses
is established and evaluated on a loan-specific basis. Provisions made to
increase the allowance are charged as a current period expense. Generally, the
Company considers manufactured housing loans to be impaired when they are
30-days past due. The Company also provides an allowance for currently existing
credit losses within outstanding manufactured housing loans that are current as
to payment but which the Company has determined to be impaired based on default
trends, current market conditions and empirical observable performance data on
the loans. Single-family loans are considered impaired when they are 60-days
past due. Commercial mortgage loans are evaluated on an individual basis for
impairment. Generally, a commercial loan with a debt service coverage ratio of
less than one is considered impaired. However, based on a commercial loan's
details, commercial loans with a debt service ratio less than one may not be
considered impaired; conversely, commercial loans with a debt service coverage
ratio greater than one may be considered impaired. Certain of the commercial
mortgage loans are covered by loan guarantees that limit the Company's exposure
on these loans. The level of allowance for loan losses required for these loans
is reduced by the amount of applicable loan guarantees. The Company's actual
credit losses may differ from the estimates used to establish the allowance.
Impairments. The Company evaluates all securities in its investment
portfolio for other-than-temporary impairments. A security is generally defined
to be other-than-temporarily impaired if, for a maximum period of three
consecutive quarters, the carrying value of such security exceeds its estimated
fair value and the Company estimates, based on projected future cash flows or
other fair value determinants, that the fair value will remain below the
carrying value for the foreseeable future. If an other-than-temporary impairment
is deemed to exist, the Company records an impairment charge to adjust the
carrying value of the security down to its estimated fair value. In certain
instances, as a result of the other-than-temporary impairment analysis, the
recognition or accrual of interest will be discontinued and the security will be
placed on non-accrual status.
The Company considers an investment to be impaired if the fair value of
the investment is less than its recorded cost basis. Impairments of other
investments are generally considered to be other-than-temporary when the fair
value remains below the carrying value for three consecutive quarters. If the
impairment is determined to be other-than-temporary, an impairment charge is
recorded in order to adjust the carrying value of the investment to its
estimated value.
Mortgage-Related Securities. Income on certain mortgage-related
securities is accrued using the effective yield method based upon estimates of
future cash flows to be received over the estimated remaining lives of the
related securities. Reductions in carrying value are made when the total
discounted projected cash flow is less than the Company's basis, based on either
the dealers' prepayment assumptions or, if it would accelerate such adjustments,
management's expectations of interest rates and future prepayment rates. In some
cases, mortgage-related securities may also be placed on non-accrual status.
Mortgage Servicing Liability. The Company retains the primary servicing
rights for certain of its loans, and subcontracts the performance of the primary
servicing to unrelated third parties. The Company recognizes a liability for the
amount by which the estimated value of the payments to the third-party servicer
exceeds the estimated value of the Company's expected servicing cash inflows on
the related loans. The value of the mortgage servicing liability is estimated
using a discounted cash flow model. The mortgage servicing liability is
amortized in proportion to and over the period of the estimated net servicing
loss.
Securitization Transactions
The Company securitizes loans and securities in a securitization
financing transaction by transferring financial assets to a wholly owned trust,
and the trust issues non-recourse bonds pursuant to an indenture. Generally, the
Company retains some form of control over the transferred assets, and/or the
trust is not deemed to be a qualified special purpose entity. In instances where
the trust is deemed not to be a qualified special purpose entity, the trust is
included in the consolidated financial statements of the Company. A transfer of
financial assets in which the Company surrenders control over those assets is
accounted for as a sale to the extent that consideration other than beneficial
interests in the transferred assets is received in exchange. For accounting and
tax purposes, the loans and securities financed through the issuance of bonds in
a securitization financing transaction are treated as assets of the Company, and
the associated bonds issued are treated as debt of the Company as securitization
financing. The Company may retain certain of the bonds issued by the trust, and
the Company generally will transfer collateral in excess of the bonds issued.
This excess is typically referred to as over-collateralization. Each
securitization trust generally provides the Company the right to redeem, at its
option, the remaining outstanding bonds prior to their maturity date. If the
Company does not exercise its option, the interest rates on the bonds issued
will increase on rates ranging from 0.30% to 2.0%.
Recent Accounting Pronouncements
In December 2003, the Accounting Standards Executive Committee (AcSEC)
of the American Institute of Certified Professional Accountants (AICPA) issued
Statement of Position (SOP) No. 03-3, "Accounting for Certain Loans or Debt
Securities Acquired in a Transfer." SOP No. 03-3 is effective for loans acquired
in fiscal years beginning after December 15, 2004, with early adoption
encouraged. A certain transition provision applies for certain aspects of loans
currently within the scope of Practice Bulletin 6, Amortization of Discounts on
Certain Acquired Loans. SOP No. 03-3 addresses accounting for differences
between contractual cash flows and cash flows expected to be collected from an
investor's initial investment in loans or debt securities (loans) acquired in a
transfer if those differences are attributable, at least in part, to credit
quality. It includes loans acquired in business combinations and applies to all
non-governmental entities, including not-for-profit organizations. SOP No. 03-3
does not apply to loans originated by the entity. The Company has reviewed the
implications of SOP No. 03-3 but does not believe that its adoption will have a
significant impact on its financial position, results of operations or cash
flows.
In December 2004, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 123 (Revised 2004), "Share-Based Payment." This statement
supersedes APB Opinion No. 25 and its related implementation guidance. The
statement establishes standards for the accounting for transactions in which an
entity exchanges its equity instruments for goods and services. This statement
focuses primarily on accounting for transactions in which an entity obtains
employee services in share-based payment transactions. The most significant
change resulting from this statement is the requirement for public companies to
expense employee share-based payments under fair value as originally introduced
in SFAS No. 123. This statement is effective for public companies as of the
beginning of the first interim or annual reporting period that begins after June
15, 2005. The Company will adopt this statement effective July 1, 2005 and is
currently evaluating the impact it will have on net income had the Company
adopted the provisions of SFAS No. 123, for each year presented.
NOTE 3 - SECURITIZED FINANCE RECEIVABLES
The following table summarizes the components of securitized finance
receivables as of December 31, 2004 and 2003.
- ------------------------------------------------------------------------------------------------------------------------------
2004 2003
- ------------------------------------------------------------------------------------------------------------------------------
Loans, at amortized cost $ 1,064,137 $ 1,561,977
Allowance for loan losses (28,014) (43,364)
- ------------------------------------------------------------------------------------------------------------------------------
Loans, net 1,036,123 1,518,613
Debt securities, at fair value 206,434 255,580
- ------------------------------------------------------------------------------------------------------------------------------
$ 1,242,557 $ 1,774,193
- ------------------------------------------------------------------------------------------------------------------------------
The following table summarizes the amortized cost basis, gross
unrealized gains and losses and estimated fair value of debt securities pledged
as securitized finance receivables as of December 31, 2004 and 2003.
-----------------------------------------------------------------------------------------------------------------------------
2004 2003
-----------------------------------------------------------------------------------------------------------------------------
Debt securities, available-for-sale, at amortized cost $ 205,370 $ 255,462
Gross unrealized gains 1,064 118
-----------------------------------------------------------------------------------------------------------------------------
Estimated fair value $ 206,434 $ 255,580
-----------------------------------------------------------------------------------------------------------------------------
The components of securitized finance receivables at December 31, 2004
and 2003 are as follows:
- ----------------------------------------------------------------------------------------------------------------------------
2004 2003
- ----------------------------------------------------------------------------------------------------------------------------
Loans, net Debt Total Loans, net Debt Total
Securities Securities
- ------------------------------- --------------- -------------- --------------- -------------- --------------- --------------
Collateral:
Commercial $ 640,090 $ - $ 640,090 $ 758,144 $ - $ 758,144
Manufactured housing 198,246 149,420 347,666 491,230 172,847 664,077
Single-family 225,055 52,753 277,808 317,631 80,468 398,099
--------------- -------------- --------------- -------------- --------------- --------------
1,063,391 202,173 1,265,564 1,567,005 253,315 1,820,320
Allowance for loan losses (28,014) - (28,014) (43,364) - (43,364)
Funds held by trustees 130 43 173 131 147 278
Accrued interest receivable 6,548 202 6,750 9,878 1,594 11,472
Unamortized premiums and
(discounts), net (5,932) 2,952 (2,980) (15,037) 406 (14,631)
Unrealized gain, net - 1,064 1,064 - 118 118
- ------------------------------- --------------- -------------- --------------- -------------- --------------- --------------
$ 1,036,123 $206,434 $ 1,242,557 $1,518,613 $255,580 $1,774,193
- ----------------------------------------------------------------------------------------------------------------------------
All of the securitized finance receivables are encumbered by non-recourse
securitization financing (see Note 8).
During the three-months ended December 31, 2004, the Company sold its
rights and interests in a securitization trust for $11,888, which resulted in
the derecognition of the securitization trust from the Company's financial
statements. As part of the de-recognition, the Company was considered to have
sold all of the assets and liabilities associated with the trust, which were
$219,178 and $226,674, respectively, and resulted in a gain of $17,578. The gain
also reflects a mortgage servicing liability of $1,806, which the Company
recorded to reflect its obligation to continue to provide the primary servicing
on the assets in the trust.
The fair value of the mortgage servicing liability of $1,806 recorded
in connection with the derecognition of the securitization trust discussed above
was estimated using a discount rate of 5% and the cash flows were modeled using
a CPR and default rate of approximately 7% and 4%, respectively. The mortgage
servicing fees are calculated on the outstanding principal balance of the
underlying loans, which is projected based on the scheduled principal payments
and expected prepayment speeds.
NOTE 4 - ALLOWANCE FOR LOAN LOSSES
The Company reserves for credit risk where it has exposure to losses on
loans in its securitized finance receivables portfolio. The allowance for loan
losses is included in securitized finance receivables in the accompanying
consolidated balance sheets. The following table summarizes the aggregate
activity for the allowance for loan losses for the years ended December 31,
2004, 2003 and 2002:
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Allowance at beginning of year $ 43,364 $ 25,472 $ 21,508
Provision for loan losses 18,463 37,082 28,483
Credit losses, net of recoveries (17,651) (19,190) (24,519)
Transfers (16,162) - -
- --------------------------------------------------------------------------------
Allowance at end of year $ 28,014 $ 43,364 $ 25,472
- --------------------------------------------------------------------------------
For the year 2004, the Company added $18,463 in provisions for loan
losses, $3,218 of which relates to the commercial mortgage loan portfolio and
$15,245 of reserves on its manufactured housing loan portfolio. The transfer of
$16,162 represents the elimination of the reserves associated with the
securitization trust derecognized as described above in Note 3. The Company
enhanced its model used to estimate probable losses on its manufactured housing
loans for the year ended December 31, 2004 to account for the impact loan
modifications have on anticipated losses. If the Company had applied its
previous methodology to calculate the allowance for loan losses on manufactured
housing, the net loss for the year would have decreased by $2,093 to $11,450 or
$0.19 per share.
The following table presents certain information on commercial mortgage
loans that the Company has determined to be impaired.
- ----------------------------------------------------------------------------------------------------------
Total Recorded Amount for Which There Amount for Which There
Investment in is a Related Allowance for is no Related Allowance
December 31, Impaired Loans Credit Losses for Credit Losses
- ----------------------------------------------------------------------------------------------------------
2002 $ 160,563 $ 4,748 $ 155,815
2003 191,484 10,861 180,623
2004 72,431 17,379 55,052
- ----------------------------------------------------------------------------------------------------------
Certain of the commercial mortgage loans considered impaired in 2003
and 2002 as a result of inadequate debt service coverage on the loan, are not
considered impaired in 2004. These loans, which are included in the above table
and which had a recorded investment at 2003 and 2002 of $90,088 and $91,690,
respectively, had loss reimbursement guarantees from a `AAA'-rated third party
insurance company of up to a maximum of $28,739 at December 31, 2003 and 2002.
During 2004, approximately $76,382 of these loans repaid in full, and based on
the repayment history of the loans and the remaining balance of the guarantee
with the third party insurer of approximately $19,536 at December 31, 2004,
these loans were deemed not to be impaired for 2004.
NOTE 5 - OTHER INVESTMENTS
The following table summarizes the Company's other investments for the
years ended December 31, 2004 and 2003:
- ------------------------------------------------------------------------------
2004 2003
- ------------------------------------------------------------------------------
Delinquent property tax receivables and security $ 6,000 $ 34,939
Real estate owned 1,595 2,960
Other 1 4
- ------------------------------------------------------------------------------
$ 7,596 $ 37,903
- ------------------------------------------------------------------------------
As of December 31, 2004, delinquent property tax receivables and
security include principally a pool of receivables located in Pennsylvania.
During the fourth quarter of 2004, the Company began actively pursuing the sale
of its Pennsylvania tax lien portfolio and related servicing operations.
Consequently, the Company transferred the tax lien receivable security from
held-to-maturity to available-for-sale. The tax lien receivable security was
transferred at its fair value of $6,000 and the unrecognized loss of $4,891 was
recorded as an impairment, because the Company believes the decrease in value
represents an other than temporary change. Because of such transfer, the Company
was no longer able to assert its intent to hold any of its securities to
maturity and, therefore, transferred its other held-to-maturity securities to
available for sale. Such securities were transferred at their fair value of
$204,154 and the related unrealized gain of $1,064 was recorded in other
comprehensive income.
During 2004, the Company sold its delinquent property tax receivable
portfolio and servicing operation located in Cuyahoga County, Ohio, in which it
had a basis of approximately $22,260, to a third party for $19,219 resulting in
a loss of approximately $3,241, which includes approximately $200 of transaction
expenses. Of the $19,219 in consideration received, $700 is being held in escrow
for up to one year for customary representations and warranties and is included
within Other Assets.
At December 31, 2004 and 2003, the Company has real estate owned with a
current carrying value of $1,595 and $2,960, respectively, resulting from
foreclosures on delinquent property tax receivables. Cash collections on all
delinquent property tax receivables, including proceeds from sales of real
estate owned, amounted to $7,165 and $12,317 during 2004 and 2003, respectively.
NOTE 6 - SECURITIES
The following table summarizes the Company's amortized cost basis and
fair value of securities, all of which are classified as available-for-sale, as
of December 31, 2004 and 2003, and the related average effective interest rates:
- --------------------------------------------------------------------------------------------------------------
2004 2003
- --------------------------------------------------------------------------------------------------------------
Fair Effective Fair Effective
Value Interest Rate Value Interest Rate
- --------------------------------------------------------- ----------------- ---------------- -----------------
Securities, available-for-sale:
Fixed-rate mortgage securities $ 79,081 4.54% $ 29,713 14.0%
Mortgage-related securities 28 0.33% 54 12.7%
Asset-backed security 381 -
Equity securities 7,438 3,000
- --------------------------------------------------------- ----------------- ---------------- -----------------
86,928 32,767
Gross unrealized gains 852 517
Gross unrealized losses (74) (810)
- --------------------------------------------------------- ----------------- ---------------- -----------------
Securities, available-for-sale 87,706 32,474
Asset-backed security, held-to-maturity - 801
- --------------------------------------------------------- ----------------- ---------------- -----------------
$ 87,706 $ 33,275
- --------------------------------------------------------------------------------------------------------------
In 2003, securities with little or no remaining recorded investment
were receiving interest payments, which caused an unusually large effective
interest rate for the aggregate securities balance.
Purchase of investments. During 2004, the Company purchased a debt
security with a principal balance of $62,000 at a premium of $136. In addition,
the Company purchased 340,000 shares of common stock in a REIT at a price of
$14.50 per share. During the year, 33,500 shares were sold for a gain of $38.
Sale of investments. Proceeds from sales of securities totaled $530,
$482, and none in 2004, 2003 and 2002, respectively. Gross gains of $38, $715,
and none and gross losses of none, $26, and none were realized on those sales in
2004, 2003 and 2002, respectively.
Unrealized gain/loss on securities. At December 31, 2004, unrealized
gains on securities were $852 and unrealized losses were $74 on securities with
a balance of $61,817, none of which were more than twelve months old as of
December 31, 2004.
NOTE 7 - OTHER LOANS
The following table summarizes the Company's carrying basis for other
loans at December 31, 2004 and 2003, respectively.
- --------------------------------------------------------------------------------
2004 2003
- --------------------------------------------------------------------------------
Single-family mortgage loans $ 3,693 $ 5,560
Multifamily and commercial mortgage loans 2,878 2,912
- --------------------------------------------------------------------------------
6,571 8,472
Unamortized discounts (982) (168)
- --------------------------------------------------------------------------------
$ 5,589 $ 8,304
- --------------------------------------------------------------------------------
NOTE 8 -- NON RECOURSE SECURITIZATION FINANCING
The Company, through limited-purpose finance subsidiaries, has issued
bonds pursuant to indentures in the form of non-recourse securitization
financing. Each series of securitization financing may consist of various
classes of bonds, either at fixed or variable rates of interest. Payments
received on securitized finance receivables and any reinvestment income thereon
are used to make payments on the securitization financing (see Note 3). The
obligations under the securitization financings are payable solely from the
securitized finance receivables and are otherwise non-recourse to the Company.
The stated maturity date for each class of bonds is generally calculated based
on the final scheduled payment date of the underlying collateral pledged. The
actual maturity of each class will be directly affected by the rate of principal
prepayments on the related collateral. Each series is also subject to redemption
at the Company's option according to specific terms of the respective
indentures. As a result, the actual maturity of any class of a series of
securitization financing is likely to occur earlier than its stated maturity. If
the Company does not exercise its option to redeem a class or classes of bonds
when it first has the right to do so, the interest rates on the bonds not
redeemed will automatically increase from 0.30% to 2.00%. One series of bonds,
with a principal balance at December 31, 2004 of $217,142 will reach its
optional redemption date in the first quarter 2005. The Company recorded a
premium of $7,377 as a result of its redemption and reissuance of certain
classes of bonds in a securitization trust during 2004.
The Company may retain certain bond classes of securitization financing
issued, including investment grade classes, financing these retained bonds with
equity. Total investment grade bonds at December 31, 2004 and 2003 were $20,000
and carried a rating of `BBB' as rated by a nationally recognized ratings
agency. As these limited-purpose finance subsidiaries are included in the
consolidated financial statements of the Company, such retained bonds are
eliminated in the consolidated financial statements, while the associated
repurchase agreements outstanding, if any, are included as recourse debt.
The components of non-recourse securitization financing along with
certain other information at December 31, 2004 and 2003 are summarized as
follows:
- ------------------------------------------------------------------------------------------------------------------
2004 2003
- ------------------------------------------------------------------------------------------------------------------
Bonds Outstanding Range of Interest Bonds Outstanding Range of Interest
Rates Rates
- --------------------------------------------------- -------------------- -------------------- --------------------
Variable-rate classes $ 405,236 2.6% - 3.7% $ 536,381 1.4% - 2.8%
Fixed-rate classes 760,672 6.3% - 11.5% 1,141,186 6.3% - 11.5%
Accrued interest payable 5,237 7,413
Deferred bond issuance costs (2,889) (4,428)
Deferred hedge losses (22,769) (29,945)
Unamortized net bond premium 31,793 29,223
- --------------------------------------------------- -------------------- -------------------- --------------------
$ 1,177,280 $ 1,679,830
- ------------------------------------------------------------------------------------------------------------------
Range of stated maturities 2009-2033 2009-2033
Estimated weighted average life 4.7 years 5.0 years
Number of series 17 20
- ------------------------------------------------------------------------------------------------------------------
The variable rate classes are based on one-month London InterBank
Offered Rate (LIBOR). At December 31, 2004, the weighted-average effective rate
of the variable-rate classes was 2.9%, and the weighted-average effective rate
of fixed rate classes was 7.6%. The average effective rate of interest for
non-recourse securitization financing was 6.3%, 6.2%, and 6.1%, for the years
ended December 31, 2004, 2003, and 2002, respectively.
NOTE 9 - REPURCHASE AGREEMENTS AND SENIOR NOTES
The Company utilizes repurchase agreements and senior notes to finance certain
of its investments. The following table summarizes the amounts outstanding and
the weighted-average annual rates at December 31, 2004:
- ---------------------------------------------------------------------------------------------------------------------------
2004 2003
- ---------------------------------------------------------------------------------------------------------------------------
Weighted- Weighted-
Amount Average Annual Amount Average Annual
Outstanding Rate Outstanding Rate
- --------------------------------------- -------------------- -------------------- -------------------- --------------------
Repurchase agreements - securities $ 70,468 2.48% $ 23,884 1.79%
February 2005 Senior Notes - - 10,049 9.53%
- --------------------------------------- -------------------- -------------------- -------------------- --------------------
$ 70,468 2.48% $ 23,884 4.07%
- ---------------------------------------------------------------------------------------------------------------------------
The repurchase agreements mature monthly and bear interest at a spread
of 0.13% and 0.24% on a weighted-average basis to one-month LIBOR as of December
31, 2004 and 2003, respectively. The repurchase agreements are secured by
fixed-rate mortgage backed securities with a market value as of December 31,
2004 and 2003 of $78,491 and $26,517, respectively.
The "February 2005 Senior Notes" were issued in connection with a
tender offer on the Company's Preferred Stock in February 2003. Principal
payments in the amount of $4,010, along with interest payments at a rate of
9.50% per annum, are due quarterly beginning May 2003, with final payment due on
February 28, 2005. The Company at its option can prepay the February 2005 Senior
Notes in whole or part, without penalty, at any time. The Company redeemed
$10,000 of the February 2005 Senior Notes in August 2003 and redeemed the
remaining notes outstanding in 2004 as part of the recapitalization described in
Note 13.
NOTE 10 - FAIR VALUE AND ADDITIONAL INFORMATION ABOUT FINANCIAL INSTRUMENTS
SFAS No. 107, "Disclosures about Fair Value of Financial Instruments"
requires the disclosure of the estimated fair value of financial instruments.
The following table presents the recorded basis and estimated fair values of the
Company's financial instruments as of December 31, 2004 and 2003:
- ------------------------------------------------------------------------------------------------------------------------------
2004 2003
------------------------------------------ ------------------------------------------
Recorded Fair Recorded Fair
Basis Value Basis Value
- ---------------------------------------- -------------------- --------------------- -------------------- ---------------------
Assets:
Securitized finance receivables
Loans, net $ 1,036,123 $ 1,096,971 $ 1,518,613 $ 1,572,038
Debt securities 206,434 206,434 255,580 255,580
-------------------- --------------------- -------------------- ---------------------
Securitized finance receivables 1,242,557 1,303,405 1,774,075 1,827,618
Other investments 7,596 7,596 34,943 23,714
Securities 87,706 87,706 33,275 33,275
Other loans 5,589 7,872 8,304 10,258
Liabilities:
Non-recourse securitization financing 1,177,280 1,236,899 1,679,830 1,741,385
Repurchase agreements 70,468 70,468 23,884 23,884
Senior Notes - - 10,049 10,049
- ------------------------------------------------------------------------------------------------------------------------------
Estimates of fair value for securitized finance receivables are
determined by calculating the present value of the projected cash flows of the
instruments, using discount rates, prepayment rate assumptions and credit loss
assumptions based on historical experience and estimated future activity, and
using discount rates commensurate with those the Company believes would be used
by third parties. The discount rate used in the determination of fair value of
securities pledged as securitized finance receivables was 16% at December 31,
2004 and 2003. Prepayment rate assumptions for each year are based in part on
the actual prepayment rates experienced for the prior six-month period and in
part on management's estimate of future prepayment activity. The loss
assumptions utilized vary for each series of securitized finance receivables,
depending on the collateral pledged. Estimates of fair value for other
investments are determined by calculating the present value of the projected net
cash flows, inclusive of the estimated cost to service these investments.
Estimates of fair value for securities are based principally on market prices
provided by certain dealers. Non-recourse securitization financing are both
floating and fixed-rate, and fair value is determined for fixed-rate financing
based on estimated current market rates for similar instruments.
NOTE 11 - DERIVATIVE FINANCIAL INSTRUMENTS
In June 2002, the Company entered into an interest rate swap which
matures on June 28, 2005, to mitigate its interest rate risk exposure on
$100,000 in notional value of its variable rate non-recourse securitization
financing, which finance a like amount of fixed rate assets. Under the
agreement, the Company pays interest at a fixed rate of 3.73% on the notional
amount and will receive interest based on one month LIBOR on the same amount.
This contract has been treated as a cash flow hedge with gains and losses
associated with the change in the value of the hedge being reported as a
component of accumulated other comprehensive income. Amounts in accumulated
other comprehensive income are reclassified into earnings in the same period
during which the hedged transaction affects earnings. During the year ended
December 31, 2004, the Company recognized $2,455 in other comprehensive income
on this hedge instrument. At December 31, 2004 and 2003, the aggregate
accumulated other comprehensive loss on this hedge instrument was $493 and
$2,938, respectively. As the repricing dates, interest rate indices and formulae
for computing net settlements of the interest rate swap agreement match the
corresponding terms of the underlying non-recourse securitization financing
being hedged, no ineffectiveness is assumed on this agreement and, accordingly,
any prospective gains or losses are included in other comprehensive income until
such time as the interest rate swap payments are settled. Over the next six
months, the Company expects to reclassify $493 of this other comprehensive loss
to interest expense.
In October 2002, the Company entered into a synthetic three-year
amortizing interest-rate swap (using Eurodollar Futures contracts) with an
initial notional balance of approximately $81,000 to mitigate its exposure to
rising interest rates on a portion of its variable rate non-recourse
securitization financing, which finance a like amount of fixed rate assets. This
contract is accounted for as a cash flow hedge with gains and losses associated
with the change in the value of the hedge being reported as a component of
accumulated other comprehensive income. Amounts in accumulated other
comprehensive income are reclassified into earnings in the same period during
which the hedged transaction affects earnings. At December 31, 2004, the current
notional balance of the amortizing synthetic swap was $20,000, and the remaining
weighted-average fixed-rate payable by the Company under the terms of the
synthetic swap was 2.70%. During 2004, the Company recognized $572 in other
comprehensive income for the synthetic interest-rate swap. At December 31, 2004
and 2003, the aggregate accumulated other comprehensive loss on this hedge
instrument was $116 and $688, respectively. During 2004, the Company determined
that this hedge instrument ceased to be effective due to a significant
deterioration in the correlation between the synthetic interest rate swap cash
flow hedge and the financing being hedged, as measured by the correlation
between the three-month Eurodollar futures and one-month LIBOR. Accordingly, the
Company has discontinued hedge accounting and reflected the changes in market
value of the hedge instrument in its statement of operations as other income
(expense). The remaining unrealized loss included in other comprehensive income
at the time the Company discontinued hedge accounting is being amortized over
the remaining term of the hedge exposure. The following tables summarize the
Company's derivative positions at December 31, 2004:
- ----------------------------------------------------------------------------
Notional Fair Weighted Average
Amount Value Maturity in Years
- ----------------------------------------------------------------------------
Interest Rate Swap $ 100,000 $ (493) 0.50
Eurodollar Futures 20,000 (72) 0.72
- ----------------------------------------------------------------------------
$ 120,000 $ (565) 0.54
- ----------------------------------------------------------------------------
NOTE 12 - LOSS PER SHARE
The following table reconciles the numerator and denominator for both
the basic and diluted EPS for the years ended December 31, 2004, 2003, and 2002.
- ------------------------------------------------------------------------------------------------------------------------------
2004 2003 2002
- ------------------------------- --------------- --------------- --------------- -------------- --------------- ---------------
Weighted-Average Weighted-Average Weighted-Average
Income Number of Income Number of Income Number of
(loss) Shares (loss) Shares (loss) Shares
- ------------------------------- --------------- --------------- --------------- -------------- --------------- ---------------
Net loss $ (3,375) $ (21,107) $ (9,360)
Preferred stock (charge) (1,819) 6,847 (9,586)
benefit
--------------- --------------- --------------- -------------- --------------- ---------------
Net loss available to common
shareholders $ (5,194) 11,272,259 $ (14,260) 10,873,903 $ (18,946) 10,873,871
=============== =============== =============== ============== =============== ===============
Net loss per share:
Basic and diluted EPS $ (0.46) $ (1.31) $ (1.74)
=============== ============== ===============
Dividends and potentially
anti-dilutive common
shares assuming conversion
of preferred stock: Shares Shares Shares
--------------- --------------- ---------------
Series A $ 337 94,403 $ 1,252 287,083 $ 2,321 496,019
Series B 537 131,621 1,745 399,903 3,226 689,354
Series C 666 130,990 2,170 398,912 4,039 691,766
Series D 3,936 3,491,047 - - - -
Expense and incremental - 21,045 - 20,164 - 15,346
shares of stock
appreciation rights
- ------------------------------------------------------------------------------------------------------------------------------
$ 5,476 3,869,106 $ 5,167 1,106,062 $ 9,586 1,892,485
- ------------------------------------------------------------------------------------------------------------------------------
The Company issued 1,288,488 shares of common stock as part of the
recapitalization plan completed in May 2004. In 2003 and 2002, the Company did
not issue any shares of common stock.
NOTE 13 - PREFERRED AND COMMON STOCK
The following table presents a summary of the Company's issued and
outstanding preferred stock:
- -----------------------------------------------------------------------------------------------------------------------------
Dividends Paid Per Share
Issue Price ------------------------------------------
Per share 2004 2003 2002
- -----------------------------------------------------------------------------------------------------------------------------
Series A 9.75% Cumulative Convertible Preferred Stock ("Series A") $ 24.00 $ - $ 0.8775 $ 0.2925
Series B 9.55% Cumulative Convertible Preferred Stock ("Series B") $ 24.50 $ - $ 0.8775 $ 0.2925
Series C 9.73% Cumulative Convertible Preferred Stock ("Series C") $ 30.00 $ - $ 1.0950 $ 0.3651
Series D 9.75% Cumulative Convertible Preferred Stock ("Series D") $ 10.00 $ 0.6993 $ - $ -
- ----------------------------------------------------------------------------------------------------------------------------
On May 19, 2004, the Company completed a recapitalization plan whereby
the Company converted the Series A, Series B, and Series C preferred stock into
a new Series D preferred stock and common stock. As part of the recapitalization
plan, the Company also exchanged 9.50% Senior Notes due 2007 for Series A,
Series B and Series C preferred stock. The remaining shares of Series A, Series
B and Series C preferred stock were converted into 5,628,737 shares of Series D
preferred stock and 1,288,488 shares of common stock. The Series D preferred
stock had an issue price of $10 per share and pays $0.95 per year in dividends.
All prior dividends-in-arrears on the Series A, Series B and Series C preferred
stock were extinguished.
The Company is authorized to issue up to 50,000,000 shares of preferred
stock. For all series issued, dividends are cumulative from the date of issue
and are payable quarterly in arrears. The dividends are equal, per share, to the
greater of (i) the per quarter base rate of $0.2375 for Series D, or (ii) the
quarterly dividend declared on the Company's common stock. One share of Series D
preferred stock is convertible at any time at the option of the holder into one
share of common stock. The series is redeemable by the Company at any time, in
whole or in part, (i) at a rate of one share of preferred stock for one share of
common stock, plus accrued and unpaid dividends, provided that for 20 trading
days within any period of 30 consecutive trading days, the closing price of the
common stock equals or exceeds the issue price, or (ii) for cash at the issue
price, plus any accrued and unpaid dividends.
In the event of liquidation, the holders of this series of preferred
stock will be entitled to receive out of the assets of the Company, prior to any
such distribution to the common shareholders, the issue price per share in cash,
plus any accrued and unpaid dividends. For purposes of determining net income
(loss) to common shareholders used in the calculation of earnings (loss) per
share, preferred stock charge includes the current period dividend accrual
amount for the Preferred Stock outstanding for the years ended December 31,
2004, 2003 and 2002 of $3,936, $5,167, and $9,586, respectively. As of December
31, 2004, 2003, and 2002, the total amount of dividends-in-arrears was none,
$18,466, and $31,157, respectively. If the Company fails to pay dividends for
two quarterly dividend periods or if the Company fails to maintain consolidated
shareholders' equity of at least 200% of the aggregate issue price of the Series
D preferred stock, then these shares automatically convert into a new series of
9.50% senior notes.
The following table presents the changes in the number of preferred and
common shares outstanding:
- ------------------------------------------------------------------------------------------------------------------------------
Preferred Shares Common
Series A Series B Series C Series D Total Shares
- ------------------------------- --------------- --------------- --------------- -------------- --------------- ---------------
January 1, 2002 992,038 1,378,807 1,383,532 - 3,754,377 10,873,853
Preferred share conversion - (100) - - (100) 50
--------------- --------------- --------------- -------------- --------------- ---------------
December 31, 2002 992,038 1,378,707 1,383,532 - 3,754,277 10,873,903
Tender offer (498,443) (690,518) (698,639) - (1,887,600) -
--------------- --------------- --------------- -------------- --------------- ---------------
December 31, 2003 493,595 688,189 684,893 - 1,866,677 10,873,903
Recapitalization (493,595) (688,189) (684,893) 5,628,737 3,762,060 1,288,488
--------------- --------------- --------------- -------------- --------------- ---------------
December 31, 2004 - - - 5,628,737 5,628,737 12,162,391
- ------------------------------------------------------------------------------------------------------------------------------
NOTE 14 - IMPAIRMENT CHARGES
Impairment charges for 2004, 2003, and 2002 are summarized below.
Impairment charges include other-than-temporary impairment of debt securities
arising from deteriorating market values of securities backed by manufactured
housing loans. Impairment charges for 2002 also included $1,883 for the
adjustment to the lower of cost or market for certain delinquent single-family
mortgage loans acquired in 2002 which at that time were considered as
held-for-sale. During 2004, 2003 and 2002, the Company incurred
other-than-temporary impairment charges on its investment in delinquent property
tax receivables and valuation adjustments for related real estate owned. These
impairments arose from revised projections of collections on the delinquent
property tax receivable portfolio, as discussed in Note 5, and lower expected
recoveries on real estate owned.
- ------------------------------------------------------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------- ---------------------- ---------------------- ----------------------
Debt securities, manufactured housing $ 9,072 $ 5,494 $ 15,563
Debt securities, delinquent property tax receivables 4,891 10,364 1,064
Single-family loans - - 1,850
Other 793 497 -
- --------------------------------------------------------- ---------------------- ---------------------- ----------------------
Total impairments $ 14,756 $ 16,355 $ 18,477
- ------------------------------------------------------------------------------------------------------------------------------
NOTE 15 - EMPLOYEE BENEFITS
Stock Incentive Plan
Pursuant to the Company's 2004 Stock Incentive Plan, as approved by the
shareholders at the Company's 2004 annual shareholders' meeting (the "Employee
Incentive Plan"), the Company may grant to eligible officers, directors and
employees stock options, stock appreciation rights ("SARs") and restricted stock
awards. An aggregate of 1,500,000 shares of common stock is available for
distribution pursuant to the Employee Incentive Plan. The Company may also grant
dividend equivalent rights ("DERs") in connection with the grant of options or
SARs.
The Company issued 30,000 SARs to an executive during 2001 at an exercise
price of $2.00 and which were exercised in 2004. The Company incurred expense of
$13, $38 and $85 for SARs and DERs related to the Employee Incentive Plan during
2004, 2003 and 2002, respectively.
The following table presents a summary of the SARs activity for both
the Employee Incentive Plan and the Board Incentive Plan.
- ----------------------------------------------------------------------------------------------------------------------------
Year ended December 31,
2004 2003 2002
- ---------------------------------------- --------------------------- --------------------------- ---------------------------
Weighted- Weighted- Weighted-
Number Average Number Average Number Average
Of Exercise Of Exercise Of Exercise
Shares Price Shares Price Shares Price
- ---------------------------------------- ------------- ------------- ------------- ------------- ------------- -------------
SARs outstanding at beginning of year 30,000 $ 2.00 30,000 $ 2.00 30,000 $ 2.00
SARs granted - - - - - -
SARs forfeited or redeemed - - - - - -
SARs exercised 30,000 2.00 - - - -
SARs outstanding at end of year - - 30,000 2.00 30,000 2.00
- ---------------------------------------- ------------- ------------- ------------- ------------- ------------- -------------
SARs vested and exercisable - $ - 30,000 $ 2.00 30,000 $ 2.00
- ----------------------------------------------------------------------------------------------------------------------------
Employee Savings Plan
The Company provides an Employee Savings Plan under Section 401(k) of
the Internal Revenue Code. The Employee Savings Plan allows eligible employees
to defer up to 25% of their income on a pretax basis. The Company matches the
employees' contribution, up to 6% of the employees' eligible compensation. The
Company may also make discretionary contributions based on the profitability of
the Company. The total expense related to the Company's matching and
discretionary contributions in 2004, 2003, and 2002 was $122, $136 and $127,
respectively. The Company does not provide post employment or post retirement
benefits to its employees.
401(k) Overflow Plan
During 1997, the Company adopted a non-qualifying overflow plan which
covers employees who have contributed to the Employee Savings Plan the maximum
amount allowed under the Internal Revenue Code. The excess contributions are
made to the overflow plan on an after-tax basis. However, the Company partially
reimburses employees for the effect of the contributions being made on an
after-tax basis. The Company matches the employee's contribution up to 6% of the
employee's eligible compensation. There was no reimbursement expense in 2004 or
2003. The total expense related to the Company's reimbursements in 2002 was $11.
NOTE 16 - COMMITMENTS AND CONTINGENCIES
The Company makes various representations and warranties relating to
the sale or securitization of loans. To the extent the Company were to breach
any of these representations or warranties, and such breach could not be cured
within the allowable time period, the Company would be required to repurchase
such loans, and could incur losses. In the opinion of management, no material
losses are expected to result from any such representations and warranties and,
therefore, have not been accrued for as a liability.
As of December 31, 2004, the Company is obligated under non-cancelable
operating leases with expiration dates through 2007. Rent and lease expense
under those leases was $473, $489, and $442, respectively in 2004, 2003, and
2002. The future minimum lease payments under these non-cancelable leases are as
follows:
--------------------------------------------- -------------------
Years Ending December 31,
--------------------------------------------- -------------------
2005 $ 205
2006 12
2007 11
2008 4
2009 and thereafter -
--------------------------------------------- -------------------
Total $ 232
--------------------------------------------- -------------------
NOTE 17 - LITIGATION
GLS Capital, Inc. ("GLS"), a subsidiary of the Company, together with
the County of Allegheny, Pennsylvania ("Allegheny County"), were defendants in a
lawsuit in the Commonwealth Court of Pennsylvania (the "Commonwealth Court"),
the appellate court of the state of Pennsylvania. Plaintiffs were two local
businesses seeking status to represent as a class, delinquent taxpayers in
Allegheny County whose delinquent tax liens had been assigned to GLS. Plaintiffs
challenged the right of Allegheny County and GLS to collect certain interest,
costs and expenses related to delinquent property tax receivables in Allegheny
County, and whether the County had the right to assign the delinquent property
tax receivables to GLS and therefore employ procedures for collection enjoyed by
Allegheny County under state statute. This lawsuit was related to the purchase
by GLS of delinquent property tax receivables from Allegheny County in 1997,
1998, and 1999. In July 2001, the Commonwealth Court issued a ruling that
addressed, among other things, (i) the right of GLS to charge to the delinquent
taxpayer a rate of interest of 12% per annum versus 10% per annum on the
collection of its delinquent property tax receivables, (ii) the charging of a
full month's interest on a partial month's delinquency; (iii) the charging of
attorney's fees to the delinquent taxpayer for the collection of such tax
receivables, and (iv) the charging to the delinquent taxpayer of certain other
fees and costs. The Commonwealth Court in its opinion remanded for further
consideration to the lower trial court items (i), (ii) and (iv) above, and ruled
that neither Allegheny County nor GLS had the right to charge attorney's fees to
the delinquent taxpayer related to the collection of such tax receivables. The
Commonwealth Court further ruled that Allegheny County could assign its rights
in the delinquent property tax receivables to GLS, and that plaintiffs could
maintain equitable class in the action. In October 2001, GLS, along with
Allegheny County, filed an Application for Extraordinary Jurisdiction with the
Supreme Court of Pennsylvania, Western District appealing certain aspects of the
Commonwealth Court's ruling. In March 2003, the Supreme Court issued its opinion
as follows: (i) the Supreme Court determined that GLS can charge delinquent
taxpayers a rate of 12% per annum; (ii) the Supreme Court remanded back to the
lower trial court the charging of a full month's interest on a partial month's
delinquency; (iii) the Supreme Court revised the Commonwealth Court's ruling
regarding recouping attorney fees for collection of the receivables indicating
that the recoupment of fees requires a judicial review of collection procedures
used in each case; and (iv) the Supreme Court upheld the Commonwealth Court's
ruling that GLS can charge certain fees and costs, while remanding back to the
lower trial court for consideration the facts of each individual case. Finally,
the Supreme Court remanded to the lower trial court to determine if the
remaining claims can be resolved as a class action. In August 2003, the
Pennsylvania legislature enacted a law amending and clarifying certain
provisions of the Pennsylvania statute governing GLS' right to the collection of
certain interest, costs and expenses. The law is retroactive to 1996, and amends
and clarifies that as to items (ii)-(iv) noted above by the Supreme Court, that
GLS can charge a full month's interest on a partial month's delinquency, that
GLS can charge the taxpayer for legal fees, and that GLS can charge certain fees
and costs to the taxpayer at redemption. Subsequent to the enactment of the law,
challenges to the retroactivity provisions of the law were filed in separate
cases, which did not include GLS as a defendant. In September 2004, the Trial
Court in that litigation upheld the retroactive provisions enacted in 2003.
Plaintiffs in the case are seeking class action status and have not currently
set forth a damage claim. A hearing on the class-action status is currently set
for late April 2005. We believe that the ultimate outcome of this litigation
will not have a material impact on our financial condition, but may have a
material impact on reported results for the particular period presented.
The Company and Dynex Commercial, Inc. ("DCI"), formerly an affiliate
of the Company and now known as DCI Commercial, Inc., were defendants in state
court in Dallas County, Texas in the matter of Basic Capital Management et al
(collectively, "BCM" or "the Plaintiffs") versus Dynex Commercial, Inc. et al.
The suit was filed in April 1999 originally against DCI, and in March 2000, BCM
amended the complaint and added the Company as a defendant. The complaint, which
was further amended during pretrial proceedings, alleged that, among other
things, DCI and the Company failed to fund tenant improvement or other advances
allegedly required on various loans made by DCI to BCM, which loans were
subsequently acquired by the Company; that DCI breached an alleged $160,000
"master" loan commitment entered into in February 1998; and that DCI breached
another alleged loan commitment of approximately $9,000. The trial commenced in
January 2004 and in February 2004, the jury in the case rendered a verdict in
favor of one of the plaintiffs and against the Company on the alleged breach of
the loan agreements for tenant improvements and awarded that plaintiff damages
in the amount of $253. The jury also awarded the Plaintiffs' attorneys fees in
the amount of $2,100. The jury entered a separate verdict against DCI in favor
of BCM under two mutually exclusive damage models, for $2,200 and $25,600,
respectively. The jury found in favor of DCI on the alleged $9,000 loan
commitment, but did not find in favor of DCI for counterclaims made against BCM.
After considering post-trial motions, the presiding judge entered judgment in
favor of the Company and DCI, effectively overturning the verdicts of the jury
and dismissing damages awarded by the jury. Plaintiffs have filed an appeal. DCI
is a former affiliate of the Company, and the Company believes that it will have
no obligation for amounts, if any, awarded to the plaintiffs as a result of the
actions of DCI.
On February 11, 2005, a putative class action lawsuit was filed against
the Company, our subsidiary MERIT Securities Corporation, Stephen J. Benedetti
and Thomas H. Potts in United States District Court for the Southern District of
New York by the Teamsters Local 445 Freight Division Pension Fund. The lawsuit
purports to be a class action on behalf of purchasers of MERIT Series 13
securitization financing bonds, which are collateralized by manufactured housing
loans. The allegations include federal securities laws violations in connection
with the issuance in August 1999 by MERIT Securities Corporation of our MERIT
Series 13 bonds.. The suit also alleges fraud and negligent misrepresentations
in connection with MERIT Series 13. We are currently evaluating the allegations
made in the lawsuit and intend to vigorously defend ourselves against them.
Although no assurance can be given with respect to the ultimate outcome
of the above litigation, we believe the resolution of these lawsuits will not
have a material effect on our consolidated balance sheet, but could materially
affect our consolidated results of operations in a given year.
NOTE 18 - SUPPLEMENTAL CONSOLIDATED STATEMENTS OF CASH FLOWS INFORMATION
- --------------------------------------------------------------------------------------------------------------------------
Years ended December 31,
2004 2003 2002
- --------------------------------------------------------------------------------------------------------------------------
Cash paid for interest $ 96,473 $ 107,737 $ 130,654
Supplemental disclosure of non-cash activities:
9.75% senior unsecured notes due April 2007 issued in connection
with recapitalization plan 823 - -
9.50% senior unsecured notes due February 2005 issued in connection
with Preferred Stock tender offer - 32,079 -
Securitized finance receivables owned subsequently securitized - - 453,400
Securities owned subsequently securitized - - 2,020
- --------------------------------------------------------------------------------------------------------------------------
NOTE 19 - RELATED PARTY TRANSACTIONS
The Company and Dynex Commercial, Inc., now known as DCI Commercial,
Inc ("DCI") have been jointly named in litigation regarding the activities of
DCI while it was an operating subsidiary of an affiliate of the Company. The
Company and DCI entered into a Litigation Cost Sharing Agreement whereby the
parties set forth how the costs of defending against litigation would be shared,
and whereby the Company agreed to fund all costs of such litigation, including
DCI's portion. DCI's cumulative portion of costs associated with litigation and
funded by the Company is $3,134 and is secured by the proceeds of any
counterclaims that DCI may receive in the litigation. DCI costs funded by the
Company are considered loans, and bear simple interest at the rate of Prime plus
8.0% per annum. At December 31, 2004, the total amount due the Company under the
Litigation Cost Sharing Agreement, including interest, was $4,034, which has
been fully reserved by the Company. DCI is currently wholly owned by ICD
Holding, Inc. An executive of the Company is the sole shareholder of ICD
Holding.
NOTE 20 - NON-CONSOLIDATED AFFILIATES
The following tables summarize the financial condition and result of
operations of all entities for which the Company accounts for by use of the
equity method.
- --------------------------------------------------------------------------------
Condensed Statement of Operations
- ------------------------------------------------------------------------------
2004 2003 2002
- ------------------------------------------------------------------------------
Total revenues $ 2,537 $ 2,537 $ 2,538
Total expenses 1,832 1,948 2,048
Net income 706 589 490
- ------------------------------------------------------------------------------
- ------------------------------------------------------------------------------
Condensed Balanced Sheet
- -----------------------------------------------------------------------------
December 31,
- -----------------------------------------------------------------------------
2004 2003
- -----------------------------------------------------------------------------
Total assets $ 16,587 $ 17,070
Total liabilities 13,533 14,721
Total equity 3,054 2,349
- -----------------------------------------------------------------------------
The Company has a 99% limited partnership interest in a partnership
that owns a commercial office building located in St. Paul, Minnesota. The
building is leased pursuant to a triple-net master lease to a single-tenant and
the second mortgage lender has a bargain purchase option to purchase the
building in 2007. Rental income derived from the master lease for the term of
the lease exactly covers the operating cash requirements on the building,
including the payment of debt service. The Company accounts for the partnership
using the cost method. The partnership had net income of $706, $589 and $490 for
the years ended December 31, 2004, 2003 and 2002, respectively. Due to the
bargain purchase option, any increase in basis of the investment due to the
accrual of its share of earnings of the partnership is immediately reduced by a
charge of a like amount to the same account, given the probability of exercise
of the option by the second mortgage lender. The Company's investment in this
partnership amounted to $11 at December 31, 2004, 2003 and 2002.
The Company owns a 1% limited partnership interest in a partnership
that owns a low income housing tax credit multifamily housing property located
in Texas. In May 2001, the Company sold a 98% limited partnership interest in a
partnership to a former director for a purchase price of $198, which was equal
to its estimated fair value. By reason of the director's investment in the
partnership, the Company has guaranteed to the director the use of the
low-income housing tax credits associated with the property, proportionate to
his investment, that are reported annually to the Internal Revenue Service.
During 2004, 2003 and 2002, the Company loaned the partnership none, none and
$17, respectively. These advances bear interest at a rate of 7.50% and are due
on demand. The Company, through its subsidiary Commercial Capital Access One,
Inc., has made a first mortgage loan to the partnership secured by the Property,
with a current unpaid principal balance of $1,787. As the Company does not have
control or exercise significant influence over the operations of this
partnership, its investment and advances of $249 at December 31, 2004 are
accounted for using the cost method.
NOTE 21 - SUMMARY OF FOURTH QUARTER RESULTS
The following table summarizes selected information for the quarter ended
December 31, 2004:
- -----------------------------------------------------------------------------
Fourth Quarter, 2004
- -----------------------------------------------------------------------------
Operating results:
Net interest income $ 4,933
Provisions for losses (1,025)
Net interest income after provision for losses 3,908
Impairment charges (5,187)
Gain of sale of investments 17,633
Net income 15,021
Net income to common shareholders 13,729
- -----------------------------------------------------------------------------
Basic earnings per common share $ 1.13
Diluted earnings per common share 0.77
- -----------------------------------------------------------------------------
During the three-months ended December 31, 2004, the Company recognized
a gain of $17,578 associated with the de-recognition of a securitization trust,
as discussed in Note 3. The Company recognized impairment charges of $5,187,
made up primarily of $4,891 on its investment in delinquent property tax
receivables and related real estate owned.