UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC  20549
FORM 10-Q
  x
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended March 31, 2018
or
  o
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
Commission File Number: 1-9819
DYNEX CAPITAL, INC.
(Exact name of registrant as specified in its charter)
Virginia
52-1549373
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification No.)
 
 
4991 Lake Brook Drive, Suite 100, Glen Allen, Virginia
23060-9245
(Address of principal executive offices)
(Zip Code)
 
 
(804) 217-5800
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes            x            No            o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes            x            No            o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer
o
Accelerated filer
x
Non-accelerated filer
o  (Do not check if a smaller reporting company)
Smaller reporting company
o
 
 
Emerging growth company
o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes            o            No            x

On April 30, 2018, the registrant had 55,996,048 shares outstanding of common stock, $0.01 par value, which is the registrant’s only class of common stock.



DYNEX CAPITAL, INC.
FORM 10-Q
INDEX
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated Balance Sheets as of March 31, 2018 (unaudited) and December 31, 2017
 
 
 
 
 
 
Consolidated Statements of Comprehensive Income for the three months ended March 31, 2018 (unaudited) and March 31, 2017 (unaudited)
 
 
 
 
 
 
Consolidated Statement of Shareholders' Equity for the three months ended March 31, 2018 (unaudited)
 
 
 
 
 
 
Consolidated Statements of Cash Flows for the three months ended March 31, 2018 (unaudited) and March 31, 2017 (unaudited)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 



i


PART I.        FINANCIAL INFORMATION
ITEM 1.    FINANCIAL STATEMENTS

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

Investments in securities, at fair value:
 
 
 
Mortgage-backed securities (including pledged of $2,730,427 and $2,640,884 respectively)
$
2,864,822

 
$
3,026,989

U.S. Treasuries (including pledged of $73,343 and $124,215, respectively)
204,535

 
146,530

 
 
 
 
Mortgage loans held for investment, net
15,099

 
15,738

Cash and cash equivalents
28,072

 
40,867

Restricted cash
58,312

 
46,333

Derivative assets
4,754

 
2,940

Receivable for securities sold
643

 

Principal receivable on investments
66

 
165

Accrued interest receivable
22,913

 
19,819

Other assets, net
6,456

 
6,397

Total assets
$
3,205,672

 
$
3,305,778

 
 
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY


 
 

Liabilities:
 

 
 

Repurchase agreements
$
2,613,892

 
$
2,565,902

Payable for unsettled securities
23,468

 
156,899

Non-recourse collateralized financing
5,290

 
5,520

Derivative liabilities

 
269

Accrued interest payable
5,123

 
3,734

Accrued dividends payable
12,563

 
12,526

Other liabilities
1,712

 
3,870

 Total liabilities
2,662,048

 
2,748,720

 


 
 
Shareholders’ equity:
 

 
 

Preferred stock, par value $.01 per share; 50,000,000 shares authorized; 5,908,999 and 5,888,680 shares issued and outstanding, respectively ($147,725 and $147,217 aggregate liquidation preference, respectively)
$
141,788

 
$
141,294

Common stock, par value $.01 per share, 200,000,000 shares authorized;
55,996,048 and 55,831,549 shares issued and outstanding, respectively
560

 
558

Additional paid-in capital
776,117

 
775,873

Accumulated other comprehensive loss
(54,159
)
 
(8,697
)
Accumulated deficit
(320,682
)
 
(351,970
)
 Total shareholders’ equity
543,624

 
557,058

 Total liabilities and shareholders’ equity
$
3,205,672

 
$
3,305,778

See notes to the unaudited consolidated financial statements.

1


DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)
  (amounts in thousands except per share data)
 
Three Months Ended
 
March 31,
 
2018
 
2017
Interest income
$
25,190

 
$
22,419

Interest expense
11,595

 
7,519

  Net interest income
13,595

 
14,900

 
 
 
 
Gain on derivative instruments, net
38,354

 
175

Loss on sale of investments, net
(3,775
)
 
(1,708
)
Fair value adjustments, net
29

 
10

Other expense, net
(253
)
 
(46
)
General and administrative expenses:
 
 
 
Compensation and benefits
(1,962
)
 
(2,245
)
Other general and administrative
(1,681
)
 
(2,035
)
Net income
44,307

 
9,051

Preferred stock dividends
(2,940
)
 
(2,435
)
Net income to common shareholders
$
41,367

 
$
6,616

 
 
 
 
Other comprehensive income:


 
 
Unrealized (loss) gain on available-for-sale investments, net
$
(49,189
)
 
$
18,368

Reclassification adjustment for loss on sale of investments, net
3,775

 
1,708

Reclassification adjustment for de-designated cash flow hedges
(48
)
 
(99
)
Total other comprehensive (loss) income
(45,462
)
 
19,977

Comprehensive (loss) income to common shareholders
$
(4,095
)
 
$
26,593

 
 
 
 
Net income per common share-basic and diluted
$
0.74

 
$
0.13

Weighted average common shares-basic and diluted
55,871

 
49,176

See notes to the unaudited consolidated financial statements.

2


DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
(UNAUDITED)
($ in thousands)
 
Preferred Stock
 
Common Stock
 
Additional
Paid-in
Capital
 
Accumulated
Other
Comprehensive
Loss
 
Accumulated
Deficit
 
Total Shareholders’ Equity
 
Shares
Amount
Shares
Amount
Balance as of
December 31, 2017
5,888,680

$
141,294

 
55,831,549

$
558

 
$
775,873

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

Stock issuance
20,319

494

 
45,401

1

 
293

 

 

 
788

Restricted stock granted, net of amortization


 
176,233

2

 
333

 

 

 
335

Adjustments for tax withholding on share-based compensation


 
(57,135
)
(1
)
 
(363
)
 

 

 
(364
)
Stock issuance costs


 


 
(19
)
 

 

 
(19
)
Net income


 


 

 

 
44,307

 
44,307

Dividends on preferred stock


 


 

 

 
(2,940
)
 
(2,940
)
Dividends on common stock


 


 

 

 
(10,079
)
 
(10,079
)
Other comprehensive loss


 


 

 
(45,462
)
 

 
(45,462
)
Balance as of
March 31, 2018
5,908,999

$
141,788

 
55,996,048

$
560

 
$
776,117

 
$
(54,159
)
 
$
(320,682
)
 
$
543,624

See notes to the unaudited consolidated financial statements.

3


DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
($ in thousands)
 
Three Months Ended
 
March 31,
 
2018
 
2017
Operating activities:
 
 
 
Net income
$
44,307

 
$
9,051

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

 
 

Increase in accrued interest receivable
(3,094
)
 
(2,453
)
Increase (decrease) in accrued interest payable
1,389

 
(528
)
Gain on derivative instruments, net
(38,354
)
 
(175
)
Loss on sale of investments, net
3,775

 
1,708

Fair value adjustments, net
(29
)
 
(10
)
Amortization of investment premiums, net
35,769

 
39,862

Other amortization and depreciation, net
312

 
325

Stock-based compensation expense
335

 
538

Change in other assets and liabilities, net
(2,514
)
 
(1,210
)
Net cash and cash equivalents provided by operating activities
41,896

 
47,108

Investing activities:
 

 
 

Purchase of investments
(321,348
)
 
(141,436
)
Principal payments received on investments
51,972

 
95,546

Proceeds from sales of investments
154,613

 
57,173

Principal payments received on mortgage loans held for investment, net
649

 
987

Net receipts on derivatives, including terminations
36,271

 
21,573

Other investing activities
(67
)
 
(146
)
Net cash and cash equivalents (used in) provided by investing activities
(77,910
)
 
33,697

Financing activities:
 

 
 

Borrowings under repurchase agreements
27,508,732

 
21,748,733

Repayments of repurchase agreement borrowings
(27,460,742
)
 
(21,821,740
)
Principal payments on non-recourse collateralized financing
(234
)
 
(370
)
Proceeds from issuance of preferred stock
494

 
7,504

Proceeds from issuance of common stock
294

 
127

Cash paid for stock issuance costs

 
(36
)
Payments related to tax withholding for stock-based compensation
(364
)
 
(521
)
Dividends paid
(12,982
)
 
(12,626
)
Net cash and cash equivalents provided by (used in) financing activities
35,198

 
(78,929
)
 
 
 
 
Net (decrease) increase in cash, cash equivalents, and restricted cash
(816
)
 
1,876

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

 
98,889

Cash, cash equivalents, and restricted cash at end of period
$
86,384

 
$
100,765

Supplemental Disclosure of Cash Activity:
 

 
 

Cash paid for interest
$
10,251

 
$
8,141

See notes to the unaudited consolidated financial statements.

4


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


NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization

Dynex Capital, Inc., (“Company”) was incorporated in the Commonwealth of Virginia on December 18, 1987 and commenced operations in February 1988. The Company primarily earns income from investing on a leveraged basis in debt securities, the majority of which are specified pools of Agency and non-Agency mortgage-backed securities (“MBS”) consisting of residential MBS (“RMBS”), commercial MBS (“CMBS”) and CMBS interest-only (“IO”) securities that are issued or guaranteed by the U.S. Government or U.S. Government sponsored agencies (“Agency MBS”) and MBS issued by others (“non-Agency MBS”). The Company also invests in other types of mortgage-related securities, such as to-be-announced securities (“TBAs” or “TBA securities”), and in other debt securities, such as U.S. Treasury securities, which are not collateralized but are backed by the full faith and credit of the U.S. government.

Basis of Presentation

The accompanying unaudited consolidated financial statements of Dynex Capital, Inc. and its subsidiaries (together, “Dynex” or, as appropriate, the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to the Quarterly Report on Form 10-Q and Article 10, Rule 10-01 of Regulation S-X promulgated by the Securities and Exchange Commission (the “SEC”). Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all significant adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation of the consolidated financial statements have been included. Operating results for the three months ended March 31, 2018 are not necessarily indicative of the results that may be expected for any other interim periods or for the entire year ending December 31, 2018. The unaudited consolidated financial statements included herein should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 filed with the SEC.

Consolidation
 
The consolidated financial statements include the accounts of the Company and the accounts of its majority owned subsidiaries and variable interest entities (“VIE”) for which it is the primary beneficiary. As a primary beneficiary, the Company has both the power to direct the activities that most significantly impact the economic performance of the VIE and a right to receive benefits or absorb losses of the entity that could be potentially significant to the VIE. The Company is required to reconsider its evaluation of whether to consolidate a VIE each reporting period, based upon changes in the facts and circumstances pertaining to the VIE. The Company consolidates certain trusts through which it has securitized mortgage loans as a result of not meeting the sale criteria under GAAP at the time the financial assets were transferred to the trust. All intercompany accounts and transactions have been eliminated in consolidation.

Use of Estimates
 
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenue and expenses during the reported period. Actual results could differ from those estimates. The most significant estimates used by management include, but are not limited to, amortization of premiums and discounts, fair value measurements of its investments, and other-than-temporary impairments. These items are discussed further below within this note to the consolidated financial statements.


5


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


Income Taxes

The Company has elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986 and the corresponding provisions of state law. To qualify as a REIT, the Company must meet certain tests including investing in primarily real estate-related assets and the required distribution of at least 90% of its annual REIT taxable income to stockholders after consideration of its net operating loss (“NOL”) carryforward and not including taxable income retained in its taxable subsidiaries. As a REIT, the Company generally will not be subject to federal income tax on the amount of its income or capital gains that is distributed as dividends to shareholders.

The Company assesses its tax positions for all open tax years and determines whether the Company has any material unrecognized liabilities in accordance with Accounting Standards Codification (“ASC”) Topic 740. The Company records these liabilities, if any, to the extent they are deemed more likely than not to have been incurred.

Net Income Per Common Share

The Company calculates basic net income per common share by dividing net income to common shareholders for the period by weighted-average shares of common stock outstanding for that period. The Company did not have any potentially dilutive securities outstanding during the three months ended March 31, 2018 or March 31, 2017 .

Holders of unvested shares of the Company’s issued and outstanding restricted common stock are eligible to receive non-forfeitable dividends. As such, these unvested shares are considered participating securities as per ASC Topic 260-10 and therefore are included in the computation of basic net income per common share using the two-class method. Upon vesting, restrictions on transfer expire on each share of restricted stock, and each such share of restricted stock represents one unrestricted share of common stock.

Because the Company’s 8.50% Series A Cumulative Redeemable Preferred Stock (the “Series A Preferred Stock”) and 7.625% Series B Cumulative Redeemable Preferred Stock (the “Series B Preferred Stock”) are redeemable at the Company’s option for cash only and may convert into shares of common stock only upon a change of control of the Company, the effect of those shares and their related dividends is excluded from the calculation of diluted net income per common share.

Cash and Cash Equivalents

Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less.

Restricted Cash

Restricted cash consists of cash the Company has pledged to cover initial and variation margin with its financing and derivative counterparties.

The Company has adopted Accounting Standards Update ("ASU") No. 2016-18, Statement of Cash Flows (Topic 230) - Restricted Cash , which requires amounts generally described as restricted cash or restricted cash equivalents to be included with cash and cash equivalents when reconciling the beginning of period and end of period total amounts shown on the statement of cash flows. Because this ASU is to be applied retrospectively to each period presented, “net cash and cash equivalents used in financing activities” on the Company’s consolidated statement of cash flows for the three months ended March 31, 2017 now omits the change in restricted cash as previously reported for that period, and that change is now included within “net increase in cash, cash equivalents, and restricted cash” in order to conform to the current period’s presentation.

The following table provides a reconciliation of cash, cash equivalents, and restricted cash reported on the Company's consolidated balance sheet as of March 31, 2018 that sum to the total of the same such amounts shown on the Company’s consolidated statement of cash flows for the three months ended March 31, 2018 :

6


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


 
 
March 31, 2018
Cash and cash equivalents
 
$
28,072

Restricted cash
 
58,312

Total cash, cash equivalents, and restricted cash shown on consolidated statement of cash flows
 
$
86,384


Investments in Debt Securities
 
The Company’s investments in debt securities are designated as available-for-sale (“AFS”) and are recorded at fair value on the Company’s consolidated balance sheet. Changes in unrealized gain (loss) on the Company’s debt securities are reported in other comprehensive income (“OCI”) until the investment is sold, matures, or is determined to be other than temporarily impaired. Although the Company generally intends to hold its AFS securities until maturity, it may sell any of these securities as part of the overall management of its business. Upon the sale of an AFS security, any unrealized gain or loss is reclassified out of accumulated other comprehensive income (“AOCI”) into net income as a realized “gain (loss) on sale of investments, net” using the specific identification method.

The fair value of the Company’s debt securities pledged as collateral against repurchase agreements and derivative instruments is disclosed parenthetically on the Company’s consolidated balance sheets.

Interest Income, Premium Amortization, and Discount Accretion. Interest income on debt securities is accrued based on the outstanding principal balance (or notional balance in the case of interest-only, or “IO”, securities) and their contractual terms. Premiums or discounts associated with the purchase of Agency MBS as well as any non-Agency MBS rated ‘AA’ and higher are amortized or accreted into interest income over the expected life of such securities using the effective yield method, and adjustments to premium amortization and discount accretion are made for actual cash payments. The Company may also adjust premium amortization and discount accretion for changes in projected future cash payments. The Company’s projections of future cash payments are based on input and analysis received from external sources and internal models, and include assumptions about the amount and timing of loan prepayment rates, fluctuations in interest rates, credit losses, and other factors. On at least a quarterly basis, the Company reviews and makes any necessary adjustments to its cash flow projections and updates the yield recognized on these assets. The Company does not estimate future prepayments on its fixed-rate Agency RMBS.

The Company holds certain non-Agency MBS that had credit ratings of less than ‘AA’ at the time of purchase or were not rated by any of the nationally recognized credit rating agencies. A portion of these non-Agency MBS were purchased at discounts to their par value, which management does not believe to be substantial. The discount is accreted into income over the security’s expected life based on management’s estimate of the security’s projected cash flows. Future changes in the timing of projected cash flows or differences arising between projected cash flows and actual cash flows received may result in a prospective change in the effective yield on those securities.

Determination of MBS Fair Value. The Company estimates the fair value of the majority of its MBS based upon prices obtained from third-party pricing services and broker quotes. The remainder of the Company’s MBS are valued by discounting the estimated future cash flows derived from cash flow models that utilize information such as the security’s coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected losses, and credit enhancements as well as certain other relevant information. Refer to Note 5 for further discussion of MBS fair value measurements.

Other-than-Temporary Impairment. An MBS is considered impaired when its fair value is less than its amortized cost. The Company evaluates all of its impaired MBS for other-than-temporary impairments (“OTTI”) on at least a quarterly basis. An impairment is considered other-than-temporary if: (1) the Company intends to sell the MBS; (2) it is more likely than not that the Company will be required to sell the MBS before its fair value recovers; or (3) the Company does not expect to recover the full amortized cost basis of the MBS. If either of the first two conditions is met, the entire amount of the impairment is recognized in earnings. If the impairment is solely due to the inability to fully recover the amortized cost basis, the security is further analyzed to quantify any credit loss, which is the difference between the present value of cash flows expected to be collected on the MBS and its amortized cost. The credit loss, if any, is then recognized in earnings, while the balance of impairment related to other factors is recognized in other comprehensive income.

7


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



Following the recognition of an OTTI through earnings, a new cost basis is established for the security. Any subsequent recoveries in fair value may be accreted back into the amortized cost basis of the MBS on a prospective basis through interest income. Please see Note 2 for additional information related to the Company’s evaluation for OTTI.

Repurchase Agreements
 
The Company’s repurchase agreements, which are used to finance its purchases of debt securities, are accounted for as secured borrowings under which the Company pledges its securities as collateral to secure a loan, which is equal in value to a specified percentage of the estimated fair value of the pledged collateral. The Company retains beneficial ownership of the pledged collateral. At the maturity of a repurchase agreement, the Company is required to repay the loan and concurrently receives back its pledged collateral from the lender or, with the consent of the lender, the Company may renew the agreement at the then prevailing financing rate. A repurchase agreement lender may require the Company to pledge additional collateral in the event of a decline in the fair value of the collateral pledged. Repurchase agreement financing is recourse to the Company and the assets pledged. Most of the Company’s repurchase agreements are based on the September 1996 version of the Bond Market Association Master Repurchase Agreement, which generally provides that the lender, as buyer, is responsible for obtaining collateral valuations from a generally recognized source agreed to by both the Company and the lender, or, in an instance when such source is not available, the value determination is made by the lender.

Derivative Instruments

The Company’s derivative instruments include interest rate swaps, Eurodollar futures, and forward contracts for the purchase or sale of non-specified Agency RMBS, commonly referred to as “TBA securities” or “TBA contracts”. Derivative instruments are accounted for at the fair value of their unit of account. Derivative instruments in a gain position are reported as derivative assets and derivative instruments in a loss position are reported as derivative liabilities on the Company’s consolidated balance sheet. All periodic interest costs and changes in fair value of derivative instruments, including gains and losses realized upon termination, maturity, or settlement are recorded in “gain (loss) on derivative instruments, net” on the Company’s consolidated statement of comprehensive income. Cash receipts and payments related to derivative instruments are classified in the investing activities section of the consolidated statements of cash flows in accordance with the underlying nature or purpose of the derivative transactions.

The Company’s interest rate swap agreements are privately negotiated in the over-the-counter (“OTC”) market and the majority of these agreements are centrally cleared through the Chicago Mercantile Exchange (“CME”) with the rest being subject to bilateral agreements between the Company and the swap counterparty. The Company’s CME cleared swaps require that the Company post initial margin as determined by the CME, and in addition, variation margin is exchanged, typically in cash, for changes in the fair value of the CME cleared swaps. Beginning in January 2017, as a result of a change in the CME’s rulebook, the exchange of variation margin for CME cleared swaps is legally considered to be the settlement of the derivative itself as opposed to a pledge of collateral. Accordingly, beginning in 2017, the Company accounts for the daily exchange of variation margin associated with its CME cleared interest rate swaps as a direct increase or decrease to the carrying value of the related derivative asset or liability. The carrying value of on the Company’s consolidated balance sheets is the unsettled fair value of the instruments subject to bilateral agreements and not centrally cleared through the CME.

A TBA security is a forward contract (“TBA contract”) for the purchase (“long position”) or sale (“short position”) of a non-specified Agency MBS at a predetermined price with certain principal and interest terms and certain types of collateral, but the particular Agency securities to be delivered are not identified until shortly before the settlement date. The Company accounts for long and short positions in TBAs as derivative instruments because the Company cannot assert that it is probable at inception and throughout the term of an individual TBA transaction that its settlement will result in physical delivery of the underlying Agency RMBS, or the individual TBA transaction will not settle in the shortest time period possible.

Please refer to Note 4 for additional information regarding the Company’s derivative instruments as well as Note 5 for information on how the fair value of these instruments are calculated.


8


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


Share-Based Compensation

Pursuant to the Company’s 2009 Stock and Incentive Plan (“2009 Plan”), the Company may grant share-based compensation to eligible employees, directors or consultants or advisers to the Company, including stock awards, stock options, stock appreciation rights, dividend equivalent rights, performance shares, and restricted stock units. The Company’s restricted stock currently issued and outstanding under this plan may be settled only in shares of its common stock, and therefore are treated as equity awards with their fair value measured at the grant date and recognized as compensation cost over the requisite service period with a corresponding credit to shareholders’ equity. The requisite service period is the period during which an employee is required to provide service in exchange for an award, which is equivalent to the vesting period specified in the terms of the time-based restricted stock award. None of the Company’s restricted stock awards have performance based conditions. The Company does not currently have any share-based compensation issued or outstanding other than restricted stock issued to its employees, officers, and directors. Please refer to Note 6 for additional information regarding the Board’s adoption of the 2018 Stock and Incentive Plan which will replace the 2009 Plan upon approval by the Company’s shareholders at its Annual Meeting on May 15, 2018.

Contingencies

In the normal course of business, there may be various lawsuits, claims, and other contingencies pending against the Company. On a quarterly basis, the Company evaluates whether to establish provisions for estimated losses from those matters. The Company recognizes a liability for a contingent loss when: (a) the underlying causal event has occurred prior to the balance sheet date; (b) it is probable that a loss has been incurred; and (c) there is a reasonable basis for estimating that loss. A liability is not recognized for a contingent loss when it is only possible or remotely possible that a loss has been incurred, however, possible contingent losses shall be disclosed. If the contingent loss (or an additional loss in excess of any accrual) is at least a reasonable possibility and material, then the Company discloses a reasonable estimate of the possible loss or range of loss, if such reasonable estimate can be made. If the Company cannot make a reasonable estimate of the possible material loss, or range of loss, then that fact is disclosed.


9


NOTE 2 – INVESTMENTS IN DEBT SECURITIES
 
The majority of the Company’s debt securities are pledged as collateral for the Company’s repurchase agreements. The following tables present the Company’s debt securities by investment type as of the dates indicated:
 
March 31, 2018
 
Par
 
Net Premium (Discount)
 
Amortized Cost
 
Gross Unrealized Gain
 
Gross Unrealized Loss
 
Fair Value
 
WAC (1)
RMBS:
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency (2)
$
1,197,306

 
$
46,341

 
$
1,243,647

 
$
1,224

 
$
(29,431
)
 
$
1,215,440

 
3.52
%
Non-Agency
994

 

 
994

 
32

 
(19
)
 
1,007

 
6.75
%
 
1,198,300

 
46,341

 
1,244,641

 
1,256

 
(29,450
)
 
1,216,447

 
 
CMBS:
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
1,004,572

 
10,914

 
1,015,486

 
1,095

 
(32,516
)
 
984,065

 
3.05
%
Non-Agency
7,777

 
(3,679
)
 
4,098

 
1,943

 

 
6,041

 
7.15
%
 
1,012,349

 
7,235

 
1,019,584

 
3,038

 
(32,516
)
 
990,106

 
 
CMBS IO (3) :
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency

 
358,471

 
358,471

 
4,175

 
(561
)
 
362,085

 
0.75
%
Non-Agency

 
294,092

 
294,092

 
3,040

 
(948
)
 
296,184

 
0.71
%
 

 
652,563

 
652,563

 
7,215

 
(1,509
)
 
658,269

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


U.S. Treasuries:
209,000

 
(1,917
)
 
207,083

 
741

 
(3,289
)
 
204,535

 
2.32
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total AFS securities:
$
2,419,649

 
$
704,222

 
$
3,123,871

 
$
12,250

 
$
(66,764
)
 
$
3,069,357

 
 
(1)
The weighted average coupon (“WAC”) is the gross interest rate of the security weighted by the outstanding principal balance (or by notional balance in the case of an IO security).
(2)
Includes purchased securities pending settlement.
(3)
The notional balance for Agency CMBS IO and non-Agency CMBS IO was $14,208,611 and $10,944,703 respectively, as of March 31, 2018 .

10


 
December 31, 2017
 
Par
 
Net Premium (Discount)
 
Amortized Cost
 
Gross Unrealized Gain
 
Gross Unrealized Loss
 
Fair Value
 
WAC (1)
RMBS:
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency (2)
$
1,146,553

 
$
46,021

 
$
1,192,574

 
$
1,626

 
$
(9,939
)
 
$
1,184,261

 
3.56
%
Non-Agency
1,070

 

 
1,070

 
41

 
(20
)
 
1,091

 
6.75
%
 
1,147,623

 
46,021

 
1,193,644

 
1,667

 
(9,959
)
 
1,185,352

 
 
CMBS:
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
1,123,967

 
10,442

 
1,134,409

 
3,514

 
(13,572
)
 
1,124,351

 
3.03
%
Non-Agency
26,501

 
(4,035
)
 
22,466

 
2,298

 

 
24,764

 
5.47
%
 
1,150,468

 
6,407

 
1,156,875

 
5,812

 
(13,572
)
 
1,149,115

 
 
CMBS IO (3) :
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency

 
375,361

 
375,361

 
5,238

 
(293
)
 
380,306

 
0.62
%
Non-Agency

 
308,472

 
308,472

 
4,468

 
(724
)
 
312,216

 
0.61
%
 

 
683,833

 
683,833

 
9,706

 
(1,017
)
 
692,522

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasuries:
148,400

 
(133
)
 
148,267

 

 
(1,737
)
 
146,530

 
2.13
%



 
 
 


 


 
 
 


 
 
Total AFS securities:
$
2,446,491

 
$
736,128

 
$
3,182,619

 
$
17,185

 
$
(26,285
)
 
$
3,173,519

 


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

Actual maturities of MBS are affected by the contractual lives of the underlying mortgage collateral, periodic payments of principal, prepayments of principal, and the payment priority structure of the security; therefore, actual maturities are generally shorter than the securities' stated contractual maturities. The following table categorizes the Company’s debt securities according to their stated maturity as of the dates indicated:
 
 
March 31, 2018
 
December 31, 2017
 
 
Amortized Cost
 
Fair Value
 
Amortized Cost
 
Fair Value
Less than 1 year
 
$
26,507

 
$
26,699

 
$
4,480

 
$
4,542

> 1 and <5 years
 
198,463

 
200,395

 
208,046

 
210,727

> 5 and <10 years
 
1,243,105

 
1,214,133

 
1,334,795

 
1,326,178

>  10 years
 
1,655,796

 
1,628,130

 
1,635,298

 
1,632,072

 
 
$
3,123,871

 
$
3,069,357

 
$
3,182,619

 
$
3,173,519


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

11


 
Three Months Ended
 
March 31,
 
2018
 
2017
 
Proceeds Received
 
Realized Gain (Loss)
 
Proceeds Received
 
Realized Gain (Loss)
Agency RMBS
$

 
$

 
$
57,164

 
$
(1,708
)
Agency CMBS
108,758

 
(2,052
)
 

 

U.S. Treasuries
46,498

 
(1,723
)
 

 


$
155,256

 
$
(3,775
)
 
$
57,164

 
$
(1,708
)

The following table presents certain information for the AFS securities in an unrealized loss position as of the dates indicated:
 
March 31, 2018
 
December 31, 2017
 
Fair Value
 
Gross Unrealized Losses
 
# of Securities
 
Fair Value
 
Gross Unrealized Losses
 
# of Securities
Continuous unrealized loss position for less than 12 months:
 
 
 
 
 
 
 
 
 
 
 
Agency MBS
$
1,698,318

 
$
(41,169
)
 
109
 
$
1,293,798

 
$
(9,769
)
 
71
Non-Agency MBS
75,424

 
(730
)
 
18
 
51,406

 
(421
)
 
11
U.S. Treasuries
96,758

 
(3,289
)
 
1
 
146,530

 
(1,737
)
 
1
 
 
 
 
 
 
 
 
 
 
 
 
Continuous unrealized loss position for 12 months or longer:
 
 
 
 
 
 
 
 
 
 
 
Agency MBS
$
409,927

 
$
(21,341
)
 
30
 
$
423,698

 
$
(14,035
)
 
30
Non-Agency MBS
17,052

 
(237
)
 
11
 
20,414

 
(323
)
 
12

Because the principal related to Agency MBS is guaranteed by the government-sponsored entities Fannie Mae and Freddie Mac which have the implicit guarantee of the U.S. government, the Company does not consider any of the unrealized losses on its Agency MBS to be credit related. Although the unrealized losses are not credit related, the Company assesses its ability and intent to hold any Agency MBS with an unrealized loss until the recovery in its value in accordance with GAAP. This assessment is based on the amount of the unrealized loss and significance of the related investment as well as the Company’s leverage and liquidity position. Based on this analysis, the Company has determined that the unrealized losses on its Agency MBS as of March 31, 2018 and December 31, 2017 were temporary.

The Company reviews any non-Agency MBS in an unrealized loss position to evaluate whether any decline in fair value represents an OTTI. The evaluation includes a review of the credit ratings of the non-Agency MBS, the credit characteristics of the mortgage loans collateralizing these securities, and the estimated future cash flows including projected collateral losses. The Company performed this evaluation for its non-Agency MBS in an unrealized loss position and has determined that there have not been any adverse changes in the timing or amount of estimated future cash flows that necessitate a recognition of OTTI amounts as of March 31, 2018 or December 31, 2017 .


12


NOTE 3 – REPURCHASE AGREEMENTS
    
The Company’s repurchase agreements outstanding as of March 31, 2018 and December 31, 2017 are summarized in the following tables:
 
 
March 31, 2018
 
December 31, 2017
Collateral Type
 
Balance
 
Weighted
Average Rate
 
Fair Value of
Collateral Pledged
 
Balance
 
Weighted
Average Rate
 
Fair Value of
Collateral Pledged
Agency RMBS
 
$
1,059,749

 
1.77
%
 
$
1,120,858

 
$
836,281

 
1.47
%
 
$
867,120

Agency CMBS
 
912,095

 
1.75
%
 
959,385

 
1,003,146

 
1.44
%
 
1,071,904

Non-Agency CMBS
 

 
%
 

 
15,508

 
2.47
%
 
18,212

Agency CMBS IO
 
320,418

 
2.28
%
 
354,578

 
324,163

 
2.17
%
 
372,077

Non-Agency CMBS IO
 
249,482

 
2.75
%
 
295,606

 
263,694

 
2.43
%
 
311,571

U.S. Treasuries
 
72,148

 
2.00
%
 
73,343

 
123,110

 
1.85
%
 
124,215

Total repurchase agreements
 
$
2,613,892

 
1.92
%
 
$
2,803,770

 
$
2,565,902

 
1.67
%
 
$
2,765,099


The Company also had $23,468 and $156,899 payable to counterparties as of March 31, 2018 and December 31, 2017 , respectively, which consisted primarily of purchases of $22,941 and $156,551 of fixed-rate Agency RMBS which were pending settlement as of those respective dates.

The following table provides information on the remaining term to maturity and original term to maturity for the Company’s repurchase agreements as of the dates indicated:
 
 
March 31, 2018
 
December 31, 2017
Remaining Term to Maturity
 
Balance
 
WAVG Original Term to Maturity
 
Balance
 
WAVG Original Term to Maturity
Less than 30 days
 
$
2,339,638

 
51

 
$
2,240,791

 
49

30 to 90 days
 
274,254

 
8

 
274,231

 
90

91 to 180 days
 

 

 
50,880

 
121

Total
 
$
2,613,892

 
46

 
$
2,565,902

 
54


The following table lists the counterparties with whom the Company had approximately 10% or more of its shareholders’ equity at risk (defined as the excess of collateral pledged over the borrowings outstanding):
 
 
March 31, 2018
Counterparty Name
 
Balance
 
Weighted Average Rate
 
Equity at Risk
Wells Fargo Bank, N. A. and affiliates
 
$
280,383

 
2.74
%
 
$
52,144

    
Of the amount outstanding with Wells Fargo Bank, N.A. and affiliates, $273,218 is under a committed repurchase facility which has an aggregate maximum borrowing capacity of $400,000 and is scheduled to mature on May 12, 2019 , subject to early termination provisions contained in the master repurchase agreement. The facility is collateralized primarily by CMBS IO, and its weighted average borrowing rate as of March 31, 2018 was 2.74% .

As of March 31, 2018 , the Company had repurchase agreement amounts outstanding with 16 of its 34 available repurchase agreement counterparties. The Company’s counterparties, as set forth in the master repurchase agreement with the counterparty, require the Company to comply with various customary operating and financial covenants, including, but not

13


limited to, minimum net worth and earnings, maximum declines in net worth in a given period, and maximum leverage requirements as well as maintaining the Company’s REIT status. In addition, some of the agreements contain cross default features, whereby default under an agreement with one lender simultaneously causes default under agreements with other lenders. To the extent that the Company fails to comply with the covenants contained in these financing agreements or is otherwise found to be in default under the terms of such agreements, the counterparty has the right to accelerate amounts due under the master repurchase agreement. The Company was in full compliance with all covenants as of March 31, 2018 .

The Company's repurchase agreements are subject to underlying agreements with master netting or similar arrangements, which provide for the right of offset in the event of default or in the event of bankruptcy of either party to the transactions. The Company reports its repurchase agreements to these arrangements on a gross basis. The following tables present information regarding the Company's repurchase agreements as if the Company had presented them on a net basis as of March 31, 2018 and December 31, 2017 :
 
Gross Amount of Recognized Liabilities
 
Gross Amount Offset in the Balance Sheet
 
Net Amount of Liabilities Presented in the Balance Sheet
 
Gross Amount Not Offset in the Balance Sheet (1)
 
Net Amount
Financial Instruments Posted as Collateral
 
Cash Posted as Collateral
March 31, 2018
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
2,613,892

 
$

 
$
2,613,892

 
$
(2,613,892
)
 
$

 
$

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

 
$

 
$
2,565,902

 
$
(2,565,902
)
 
$

 
$

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

Please see Note 4 for information related to the Company’s derivatives which are also subject to underlying agreements with master netting or similar arrangements.

NOTE 4 – DERIVATIVES

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

Types and Uses of Derivatives Instruments
Interest Rate Derivatives
Changing interest rates impact the fair value of the Company’s investments as well as the interest rates on the Company’s repurchase agreement borrowings used to finance its investments. The Company primarily uses interest rate swaps and Eurodollar futures as economic hedges to mitigate declines in book value and to protect some portion of the Company's earnings from rising interest rates.
TBA Transactions
The Company also holds long positions in TBA securities by executing a series of transactions which effectively delay the settlement of a forward purchase of a non-specified Agency RMBS by entering into an offsetting TBA short position, net settling the paired-off positions in cash, and simultaneously entering into an identical TBA long position with a later settlement date . These long positions in TBA securities (“dollar roll positions”) are viewed by management as economically equivalent to investing in and financing non-specified fixed-rate Agency RMBS. TBA securities purchased for a forward settlement month are generally priced at a discount relative to TBA securities sold for settlement in the current month. This discount, often referred to as “drop income” represents the economic equivalent of net interest income (interest income less implied financing cost) on the underlying Agency security from trade date to settlement date.

14


Periodically, the Company may also hold short positions in TBA securities for the purpose of economically hedging a portion of the impact of changing interest rates on the fair value of the Company’s fixed-rate Agency RMBS. The Company did not hold any short positions in TBA securities as of March 31, 2018 .
The table below summarizes information about the fair value by type of derivative instrument on the Company’s consolidated balance sheets as of the dates indicated:  
Type of Derivative Instrument
 
Balance Sheet Location
 
Purpose
 
March 31, 2018
 
December 31, 2017
Interest rate swaps
 
Derivative assets
 
Economic hedging
 
$
1,081

 
$
791

Eurodollar futures
 
Derivative assets
 
Economic hedging
 
1,674

 
666

TBA securities
 
Derivative assets
 
Investing
 
1,999

 
1,483

 
 
 
 
 
 
$
4,754

 
$
2,940

 
 
 
 
 
 
 
 
 
TBA securities
 
Derivative liabilities
 
Economic hedging
 
$

 
(269
)

The following tables present information about the Company’s interest rate swaps as of the dates indicated:
 
 
March 31, 2018
 
 
 
 
Weighted-Average:
 
 
Years to Maturity:
 
Net Notional Amount (1)
 
Pay Rate (2)
 
Life Remaining (in Years)
 
Fair Value (3)
<  3 years
 
$
2,020,000

 
1.39
%
 
0.8
 
$
1,081

>3 and <  6 years
 
1,310,000

 
2.01
%
 
4.5
 

>6 and <  10 years
 
1,100,000

 
2.56
%
 
8.2
 

   >10 years
 
220,000

 
2.81
%
 
22.3
 

Total
 
$
4,650,000

 
1.89
%
 
4.5
 
$
1,081

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

 
1.35
%
 
0.7
 
$
791

>3 and <  6 years
 
1,210,000

 
2.00
%
 
4.6
 

>6 and <  10 years
 
1,025,000

 
2.49
%
 
8.0
 

   >10 years
 
120,000

 
2.75
%
 
17.3
 

Total
 
$
5,675,000

 
1.71
%
 
3.1
 
$
791

(1)
The net notional amounts included in the tables above represent pay-fixed interest rate swaps, net of receive-fixed interest rate swaps and include $1,575,000 and $2,525,000 of pay-fixed forward starting interest rate swaps as of March 31, 2018 and December 31, 2017 , respectively.
(2)
Excluding forward starting pay-fixed interest rate swaps, the weighted average pay rate was 1.63% and 1.36% as of March 31, 2018 and December 31, 2017 , respectively.
(3)
The majority of the Company’s interest rate swap agreements are centrally cleared through the CME. Please refer to Note 1 for information regarding the exchange of variation margin being legally considered as settlement of the derivative as opposed to a pledge of collateral.

The following table summarizes information about the Company's TBA securities as of the dates indicated:

15


 
 
March 31, 2018
TBA Securities:
 
Notional Amount (1)
 
Implied Cost Basis (2)
 
Implied Market Value (3)
 
Net Carrying Value (4)
Dollar roll positions
 
$
825,000

 
$
844,941

 
$
846,940

 
$
1,999

Economic hedges
 
$

 
$

 
$

 
$

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

 
$
829,425

 
$
830,908

 
$
1,483

Economic hedges
 
$
150,000

 
$
(153,797
)
 
$
(154,066
)
 
$
(269
)
(1)
Notional amount represents the par value (or principal balance) of the underlying Agency MBS as if settled as of the end of the period.
(2)
Implied cost basis represents the forward price to be paid for the underlying Agency MBS as if settled as of end of the period.
(3)
Implied market value represents the estimated fair value of the underlying Agency MBS as if settled as of the end of the period.
(4)
Net carrying value is the amount included on the consolidated balance sheets within “derivative assets (liabilities)” and represents the difference between the implied market value and the implied cost basis of the TBA security as of the end of the period.

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

 
$

 
$

 
$
100,000

Pay-fixed interest rate swaps
 
5,775,000

 
375,000

 
(1,400,000
)
 
4,750,000

Eurodollar futures (1)
 
1,950,000

 

 
(650,000
)
 
1,300,000

TBA dollar roll positions
 
795,000

 
2,840,000

 
(2,810,000
)
 
825,000

TBA economic hedges
 
(150,000
)
 

 
150,000

 

(1)
The Eurodollar futures notional amounts represent the total notional of the 3-month contracts all of which expire in 2018. The maximum notional outstanding for any future 3-month period did not exceed $650,000 as of March 31, 2018 or December 31, 2017 .

The table below provides detail of the Company’s “gain on derivative instruments, net” by type of derivative for the periods indicated:
 
 
Three Months Ended
 
 
March 31,
Type of Derivative Instrument
 
2018
 
2017
Receive-fixed interest rate swaps
 
$
(1,129
)
 
$
(134
)
Pay-fixed interest rate swaps
 
49,372

 
309

Eurodollar futures
 
1,905

 

TBA dollar roll positions
 
(12,087
)
 

TBA economic hedges
 
293

 

Gain on derivative instruments, net
 
$
38,354

 
$
175


There is a net unrealized gain of $354 remaining in AOCI on the Company’s consolidated balance sheet as of March 31, 2018 which represents the activity related to interest rate swap agreements while they were previously designated as cash flow hedges, and this amount will be recognized in the Company’s net income as an adjustment to “interest expense” over the remaining

16


contractual life of the agreements. The Company estimates a credit of $216 will be reclassified to net income as a reduction of “interest expense” within the next 12 months.

A portion of the Company’s interest rate swaps were entered into under bilateral agreements which contain cross-default provisions with other agreements between the parties. In addition, these bilateral agreements contain financial and operational covenants similar to those contained in the repurchase agreements as described in Note 3 . The Company was in compliance with all covenants with respect to bilateral agreements under which interest rate swaps were entered into as of March 31, 2018 .

The Company's derivatives are subject to underlying agreements with master netting or similar arrangements, which provide for the right of offset in the event of default or in the event of bankruptcy of either party to the transactions. The Company reports its derivative assets and liabilities subject to these arrangements on a gross basis. The following tables present information regarding those derivative assets and liabilities subject to such arrangements as if the Company had presented them on a net basis as of March 31, 2018 and December 31, 2017 :
 
Offsetting of Assets
 
Gross Amount of Recognized Assets
 
Gross Amount Offset in the Balance Sheet
 
Net Amount of Assets Presented in the Balance Sheet
 
Gross Amount Not Offset in the Balance Sheet (1)
 
Net Amount
Financial Instruments Received as Collateral
 
Cash Received as Collateral
March 31, 2018
 
 
 
 
 
 
 
 
 
 
 
Interest rate swaps
$
1,081

 
$

 
$
1,081

 
$

 
$

 
$
1,081

Eurodollar Futures
1,674

 

 
1,674

 

 
(1,674
)
 

TBA securities
1,999

 

 
1,999

 

 

 
1,999

Derivative assets
$
4,754

 
$

 
$
4,754

 
$

 
$
(1,674
)
 
$
3,080

December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
Interest rate swaps
$
791

 
$

 
$
791

 
$

 
$

 
$
791

Eurodollar Futures
666

 

 
666

 

 
(666
)
 

TBA securities
1,483

 

 
1,483

 
(180
)
 

 
1,303

Derivative assets
$
2,940

 
$

 
$
2,940

 
$
(180
)
 
$
(666
)
 
$
2,094


 
Offsetting of Liabilities
 
Gross Amount of Recognized Liabilities
 
Gross Amount Offset in the Balance Sheet
 
Net Amount of Liabilities Presented in the Balance Sheet
 
Gross Amount Not Offset in the Balance Sheet (1)
 
Net Amount
Financial Instruments Posted as Collateral
 
Cash Posted as Collateral
March 31, 2018
 
 
 
 
 
 
 
 
 
 
 
Interest rate swaps
$

 
$

 
$

 
$

 
$

 
$

TBA securities

 

 

 

 

 

Derivative liabilities
$

 
$

 
$

 
$

 
$

 
$

 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
Interest rate swaps
$

 
$

 
$

 
$

 
$

 
$

TBA securities
269

 

 
269

 
(180
)
 

 
89

Derivative liabilities
$
269

 
$

 
$
269

 
$
(180
)
 
$

 
$
89


17


(1)
Amounts disclosed for collateral received by or posted to the same counterparty include cash and the fair value of MBS up to and not exceeding the net amount of the asset or liability presented in the balance sheet. The fair value of the total collateral received by or posted to the same counterparty may exceed the amounts presented.
Please see Note 3 for information related to the Company’s repurchase agreements which are also subject to underlying agreements with master netting or similar arrangements.

NOTE 5 – FAIR VALUE OF FINANCIAL INSTRUMENTS
 
ASC Topic 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC Topic 820 clarifies that fair value should be based on the assumptions market participants would use when pricing an asset or liability and also requires an entity to consider all aspects of nonperformance risk, including the entity’s own credit standing, when measuring fair value of a liability. ASC Topic 820 established a valuation hierarchy of three levels as follows:
 
Level 1 – Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities as of the measurement date.
Level 2 – Inputs include quoted prices in active markets for similar assets or liabilities; quoted prices in inactive markets for identical or similar assets or liabilities; or inputs either directly observable or indirectly observable through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.  
Level 3 – Unobservable inputs are supported by little or no market activity. The unobservable inputs represent management’s best estimate of how market participants would price the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.  
    
The Company reviews the classification of its financial instruments within the fair value hierarchy on a quarterly basis, and management may conclude that its financial instruments should be reclassified to a different level in the future if a change in type of inputs occurs. 

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

18


 
March 31, 2018
 
Fair Value
 
Level 1 - Unadjusted Quoted Prices in Active Markets
 
Level 2 - Observable Inputs
 
Level 3 - Unobservable Inputs
Assets carried at fair value:
 
 
 
 
 
 
 
Investments in securities:
 
 
 
 
 
 
 
Mortgage-backed securities
$
2,864,822

 
$

 
$
2,857,939

 
$
6,883

U.S. Treasuries
204,535

 
204,535

 

 

Derivative assets:
 
 
 
 
 
 
 
Interest rate swaps
1,081

 

 
1,081

 

Eurodollar futures
1,674

 
1,674

 

 

TBA securities
1,999

 

 
1,999

 

Total assets carried at fair value
$
3,074,111

 
$
206,209

 
$
2,861,019

 
$
6,883

 
 
 
 
 
 
 
 
Liabilities carried at fair value:
 

 
 

 
 

 
 

Total liabilities carried at fair value
$

 
$

 
$

 
$

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

 
$

 
$
3,019,746

 
$
7,243

U.S. Treasuries
146,530

 
146,530

 

 

Derivative assets:
 
 
 
 
 
 
 
Interest rate swaps
791

 

 
791

 

Eurodollar futures
666

 
666

 

 

TBA securities
1,483

 

 
1,483

 

Total assets carried at fair value
$
3,176,459

 
$
147,196

 
$
3,022,020

 
$
7,243

 
 
 
 
 
 
 
 
Liabilities carried at fair value:
 
 
 
 
 
 
 
TBA securities
269

 

 
269

 

Total liabilities carried at fair value
$
269

 
$


$
269

 
$


The Company's derivative assets and liabilities include interest rate swaps, Eurodollar futures, and TBA securities. The fair value of interest rate swaps is measured using the income approach with the primary input being the forward interest rate swap curve, which is considered an observable input, and thus their fair values are considered Level 2 measurements. Eurodollar futures are valued based on closing exchange prices on these contracts and are classified accordingly as Level 1 measurements. The fair value of TBA securities is estimated using methods similar those used to fair value the Company’s Level 2 MBS.
    
The fair value measurements for a majority of the Company's MBS are considered Level 2 because these securities are substantially similar to securities that either are actively traded or have been recently traded in their respective markets. The Company determines the fair value of its Level 2 securities based on prices received from the Company's primary pricing service as well as other pricing services and brokers. The Company evaluates the third party prices it receives to assess their

19


reasonableness. Although the Company does not adjust third party prices, they may be excluded from use in the determination of a security's fair value if they are significantly different from other observable market data. In valuing a security, the primary pricing service uses either a market approach, which uses observable prices and other relevant information that is generated by market transactions of identical or similar securities, or an income approach, which uses valuation techniques to convert future amounts to a single, discounted present value amount. The Company also reviews the assumptions and inputs utilized in the valuation techniques of its primary pricing service. Examples of these observable inputs and assumptions include market interest rates, credit spreads, and projected prepayment speeds, among other things.

The Company owns certain non-Agency MBS for which there are not sufficiently recent trades of substantially similar securities, and their fair value measurements are thus considered Level 3. The Company determines the fair value of its Level 3 securities by discounting the estimated future cash flows derived from cash flow models using significant inputs which are determined by the Company when market observable inputs are not available. Information utilized in those pricing models include the security’s credit rating, coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected credit losses, and credit enhancement as well as certain other relevant information. Significant changes in any of these inputs in isolation may result in a significantly different fair value measurement. Level 3 assets are generally most sensitive to the default rate and severity assumptions.

The activity of the Company’s non-Agency MBS measured at fair value on a recurring basis using Level 3 inputs is presented in the following table for the periods indicated:
 
Three Months Ended
 
March 31, 2018
Balance as of beginning of period
$
7,243

Unrealized loss included in OCI
(310
)
Principal payments
(361
)
Accretion
311

Balance as of end of period
$
6,883


The following table presents a summary of the carrying value and estimated fair values of the Company’s financial instruments as of the dates indicated:
 
March 31, 2018
 
December 31, 2017
 
Carrying Value
 
Fair Value
 
Carrying Value
 
Fair Value
Assets:
 
 
 
 
 
 
 
Mortgage-backed securities
$
2,864,822

 
$
2,864,822

 
$
3,026,989

 
$
3,026,989

U.S. Treasuries
204,535

 
204,535

 
146,530

 
146,530

Mortgage loans held for investment, net (1)
15,099

 
11,952

 
15,738

 
12,973

Derivative assets
4,754

 
4,754

 
2,940

 
2,940

Liabilities:
 

 
 

 
 

 
 

Repurchase agreements (2)
$
2,613,892

 
$
2,613,892

 
$
2,565,902

 
$
2,565,902

Non-recourse collateralized financing (1)
5,290

 
5,319

 
5,520

 
5,554

Derivative liabilities

 

 
269

 
269

(1)
The Company determines the fair value of its mortgage loans held for investment, net and its non-recourse collateralized financing using internally developed cash flow models with inputs similar to those used to estimate the fair value of the Company’s Level 3 non-Agency MBS.
(2)
The carrying value of repurchase agreements generally approximates fair value due to their short-term maturities.


20


NOTE 6 – SHAREHOLDERS’ EQUITY AND SHARE-BASED COMPENSATION

Preferred Stock

The Company's articles of incorporation authorize the issuance of up to 50,000,000 shares of preferred stock, par value $0.01 per share, of which the Company’s Board of Directors has designated 8,000,000 shares of 8.50% Series A Preferred Stock and 7,000,000 shares of 7.625% Series B Preferred Stock, (the Series A Preferred Stock and the Series B Preferred Stock collectively, the “Preferred Stock”). The Company had 2,300,000 shares of its Series A Preferred Stock and 3,608,999 shares of its Series B Preferred Stock issued and outstanding as of March 31, 2018 compared to 2,300,000 shares of Series A Preferred Stock and 3,588,680 shares of Series B Preferred Stock as of December 31, 2017 .

The Preferred Stock has no maturity and will remain outstanding indefinitely unless redeemed or otherwise repurchased or converted into common stock pursuant to the terms of the Preferred Stock. The Company's Preferred Stock may be redeemed in whole, or in part, at any time and from time to time at the Company's option at a cash redemption price of $25.00 per share plus any accumulated and unpaid dividends. Because the Preferred Stock is redeemable only at the option of the issuer, it is classified as equity on the Company’s consolidated balance sheet. The Series A Preferred Stock pays a cumulative cash dividend equivalent to 8.50% of the $25.00 liquidation preference per share each year and the Series B Preferred Stock pays a cumulative cash dividend equivalent to 7.625% of the $25.00 liquidation preference per share each year. The Company paid its regular quarterly dividends on its Preferred Stock for the first quarter on April 16, 2018 to shareholders of record as of April 1, 2018 .
    
Common Stock
    
The Company declared a first quarter common stock dividend of $0.18 per share that was paid on April 30, 2018 to shareholders of record as of April 3, 2018 .
    
Stock and Incentive Plans. Upon recommendation by the Company’s Compensation Committee, the Company’s Board adopted the 2018 Stock and Incentive Plan subject to approval by the Company’s shareholders. If approved by the shareholders at the Company’s Annual Meeting of Shareholders to be held on May 15, 2018, the 2018 Plan will replace the Company’s 2009 Stock and Incentive Plan and will reserve for issuance up to 3,000,000 shares of common stock for eligible employees, non-employee directors, consultants, and advisers to the Company to be granted in the form of stock options, restricted stock, restricted stock units, stock appreciation rights, performance units, and performance cash awards. Awards previously granted under the 2009 Plan will remain outstanding in accordance with their terms, but none of the remaining shares of common stock authorized under the 2009 Plan will be transferred to or used under the 2018 Plan. If shareholders do not approve the 2018 Plan at the Annual Meeting, any future equity awards will be granted under the 2009 Plan until its expiration date of May 12, 2019, under which the Company had 635,463 shares of common stock available for issuance as of March 31, 2018 .

Total stock-based compensation expense recognized by the Company for the three months ended March 31, 2018 and March 31, 2017 was $335 and $538 , respectively. The following table presents a rollforward of the restricted stock activity for the periods indicated:
 
Three Months Ended
 
March 31,
 
2018
 
2017
 
Shares
 
Weighted Average Grant Date Fair Value Per Share
 
Shares
 
Weighted Average Grant Date Fair Value Per Share
Restricted stock outstanding as of beginning of period
353,103

 
$
7.01

 
553,396

 
$
7.55

Restricted stock granted
176,233

 
6.28

 
108,446

 
6.77

Restricted stock vested
(194,827
)
 
7.37

 
(275,691
)
 
7.94

Restricted stock outstanding as of end of period
334,509

 
$
6.42

 
386,151

 
$
7.05



21


As of March 31, 2018 , the grant date fair value of the Company’s remaining nonvested restricted stock is $1,889 which will be amortized into compensation expense over a weighted average period of 2.2 years.

NOTE 7 – SUBSEQUENT EVENTS

Management has evaluated events and circumstances occurring as of and through the date this Quarterly Report on Form 10-Q was filed with the SEC and has determined that there have been no significant events or circumstances that qualify as a "recognized" or "nonrecognized" subsequent event as defined by ASC Topic 855.

22


ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with our unaudited financial statements and the accompanying notes included in Part 1, Item 1. “Financial Statements” in this Quarterly Report on Form 10-Q and our audited financial statements and the accompanying notes included in Part II, Item 8 in our Annual Report on Form 10-K for the year ended December 31, 2017. References herein to “Dynex,” the “Company,” “we,” “us,” and “our” include Dynex Capital, Inc. and its consolidated subsidiaries, unless the context otherwise requires. In addition to current and historical information, the following discussion and analysis contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to our future business, financial condition or results of operations. For a description of certain factors that may have a significant impact on our future business, financial condition or results of operations, see “Forward-Looking Statements” at the end of this discussion and analysis.

For more information about our business including our operating policies, investment philosophy and strategy, financing and hedging strategies, and other important information, please refer to Part I, Item 1 of our Annual Report on Form 10-K for the year ended December 31, 2017.

EXECUTIVE OVERVIEW

Company Overview

We are an internally managed mortgage real estate investment trust, or mortgage REIT, which primarily invests in residential and commercial mortgage-backed securities (“MBS”). We finance our investments principally with borrowings under repurchase agreements. Our common stock is traded on the New York Stock Exchange (“NYSE”) under the symbol “DX”. Our objective is to provide attractive risk-adjusted returns to our shareholders over the long term that are reflective of a leveraged, high quality fixed income portfolio with a focus on capital preservation. We seek to provide returns to our shareholders primarily through regular quarterly dividends and also through capital appreciation.

We also have two series of preferred stock outstanding, our 8.50% Series A Cumulative Redeemable Preferred Stock (the "Series A Preferred Stock") which is traded on the NYSE under the symbol "DXPRA", and our 7.625% Series B Cumulative Redeemable Preferred Stock (the "Series B Preferred Stock") which is traded on the NYSE under the symbol "DXPRB".
    
We invest in Agency and non-Agency MBS consisting of residential MBS (“RMBS”), commercial MBS (“CMBS”) and CMBS interest-only ("IO") securities. Agency MBS have a guaranty of principal payment by an agency of the U.S. government or a U.S. government-sponsored entity ("GSE") such as Fannie Mae and Freddie Mac. Non-Agency MBS have no such guaranty of payment. Our investments in non-Agency MBS are generally higher quality senior or mezzanine classes (typically rated 'A' or better by one or more of the nationally recognized statistical rating organizations) because they are typically more liquid (i.e., they are more easily converted into cash either through sales or pledges as collateral for repurchase agreement borrowings) and have less exposure to credit losses than lower-rated non-Agency MBS. We may also invest in debt securities issued by the United States Department of the Treasury (“the Treasury” and such securities, “U.S. Treasuries”).

RMBS. The majority of our RMBS are Agency issued securities collateralized primarily by fixed-rate single family mortgage loans. The remainder of our RMBS portfolio is collateralized by adjustable-rate mortgage loans (“ARMs”), which have interest rates that generally adjust at least annually to an increment over a specified interest rate index, and hybrid ARMs, which are loans that have a fixed rate of interest for a specified period (typically three to ten years) and then adjust their interest rate at least annually to an increment over a specified interest rate index (primarily one-year LIBOR).

We also purchase to-be-announced securities (“TBAs” or “TBA securities”) as a means of investing in and financing non-specified fixed-rate Agency RMBS. A TBA security is a forward contract (“TBA contract”) for the purchase (“long position”) or sale (“short position”) of a fixed-rate Agency MBS at a predetermined price with certain principal and interest terms and certain types of collateral, but the particular Agency securities to be delivered are not identified until shortly before the settlement date. Our purchases of TBAs are financed by executing a series of transactions which effectively delay the settlement of a forward purchase of a non-specified Agency RMBS by entering into an offsetting TBA short position, net settling the paired-off positions

23


in cash, and simultaneously entering into an identical TBA long position with a later settlement date . We refer to these net long positions in TBAs as “dollar roll positions” and view them as economically equivalent to investing in and financing Agency RMBS using short-term repurchase agreements. TBAs purchased for a forward settlement month are generally priced at a discount relative to TBAs sold for settlement in the current month. This discount, often referred to as “drop income”, represents the economic equivalent of net interest income (interest income less implied financing cost) on the underlying Agency security from trade date to settlement date. We may also enter into short positions in TBAs as economic hedges. We account for all TBAs (whether dollar roll positions or economic hedges) as derivative instruments because we cannot assert that it is probable at inception and throughout the term of an individual TBA transaction that its settlement will result in physical delivery of the underlying Agency RMBS, or the individual TBA transaction will not settle in the shortest period possible.

CMBS. The majority of our CMBS investments are fixed-rate Agency-issued securities backed by multifamily housing loans. The remainder of our CMBS portfolio contains non-Agency issued securities backed by multifamily housing as well as other commercial real estate property types such as office building, retail, hospitality, and health care. Loans underlying CMBS are generally fixed-rate, mature in eight to eighteen years, have amortization terms of up to 30 years, and are geographically dispersed. These loans typically have some form of prepayment protection provisions (such as prepayment lock-out) or prepayment compensation provisions (such as yield maintenance or prepayment penalty). Yield maintenance and prepayment penalty requirements are intended to create an economic disincentive for the loans to prepay.

CMBS IO . CMBS IO are interest-only securities issued as part of a CMBS securitization and represent the right to receive a portion of the monthly interest payments (but not principal cash flows) on the unpaid principal balance of the underlying pool of commercial mortgage loans. We invest in both Agency-issued and non-Agency issued CMBS IO. The loans collateralizing CMBS IO pools are very similar in composition to the pools of loans that collateralize CMBS as discussed above. Since CMBS IO securities have no principal associated with them, the interest payments received are based on the unpaid principal balance of the underlying pool of mortgage loans, which is often referred to as the notional amount. Most loans in these securities have some form of prepayment protection from early repayment including absolute loan prepayment lock-outs, loan prepayment penalties, or yield maintenance requirements similar to CMBS described above. There are no prepayment protections, however, if the loan defaults and is partially or wholly repaid earlier because of loss mitigation actions taken by the underlying loan servicer, and therefore yields on CMBS IO investments are dependent upon the underlying loan performance. Because Agency-issued MBS generally contain higher credit quality loans, Agency CMBS IO are expected to have a lower risk of default than non-Agency CMBS IO. Our CMBS IO investments are investment grade-rated with the majority rated ‘AAA’ by at least one of the nationally recognized statistical rating organizations.

Financing. We use leverage to enhance the returns on our invested capital by pledging our investments as collateral for borrowings primarily through the use of uncommitted repurchase agreements with major financial institutions and broker-dealers. These repurchase agreements generally have original terms to maturity of overnight to six months, though in some instances we may enter into longer-dated maturities depending on market conditions. We pay interest on our repurchase agreement borrowings at a rate usually based on a spread to a short-term interest rate such as LIBOR and fixed for the term of the borrowing. Borrowings under these repurchase agreements are renewable at the discretion of our lenders and do not contain guaranteed roll-over terms. One of our repurchase agreement lenders provides a committed repurchase agreement financing facility to us with an aggregate borrowing capacity of $400.0 million that expires in May 2019.

Hedging. We use currently use interest rate swaps and Eurodollar futures to hedge our exposure to changes in interest rates. Such exposure results from our ownership of investments which are primarily fixed-rate and financed with repurchase agreements which have adjustable rates and significantly shorter maturities than the weighted average life of our investments. Changes in interest rates can impact the market value of our investments and our net interest income, thereby ultimately impacting book value per common share. We frequently adjust our hedging portfolio based on our expectation of future interest rates, including the absolute level of rates and the slope of the yield curve versus market expectations.

Factors that Affect Our Financial Condition and Results of Operations

In assessing our financial performance, management primarily focuses on net interest income, net interest spread, net income, comprehensive income, book value per common share, and core net operating income to common shareholders (a non-GAAP measure) as measures of our financial performance. Our financial performance may be impacted by a number of factors, many of which are related to or influenced by macroeconomic conditions, market volatility, geopolitical conditions, U.S. Federal

24


Reserve policy, U.S. fiscal and regulatory policy, and foreign central bank and government policy. Other factors that may impact our financial performance include, but are not limited to, the absolute level of interest rates, the relative slope of interest rate curves, changes in interest rates and market expectations of future interest rates, actual and estimated future prepayment rates on our investments, supply of investments, competition for investments, economic conditions and their impact on the credit performance of our investments, and market required yields as reflected by market spreads. These factors are influenced by market forces beyond our control.

Our business model may also be impacted by the availability and cost of financing and the state of the overall credit markets. Reductions or limitations in the availability of financing for our investments could significantly impact our business or force us to sell assets, potentially at losses. Repurchase agreement lending markets have been stable for the last several years, but lending by larger U.S. domiciled banks has declined in recent years due to increased regulation and changes to regulatory capital requirements. Their repurchase market participation has been replaced by smaller independent broker dealers that are generally less regulated and by U.S. domiciled broker dealer subsidiaries of foreign financial institutions. It is uncertain how these relatively new participants will react during periods of market stress. Other factors that could also impact our business include changes in regulatory requirements, including requirements to qualify for registration under the 1940 Act, and REIT requirements.

We believe that regulatory impacts on financial institutions, many of which are our trading and financing counterparties, continue to pose a threat to the overall liquidity in the capital markets. In 2017, the Federal Reserve began curtailing its reinvestment of principal payments received on its Agency RMBS portfolio. Prices in Agency RMBS generally have not been significantly impacted by the reduction, however prices may be more significantly impacted as the amount of curtailment increases each successive quarter. Market liquidity of our investments and the financing markets could be negatively impacted if the Federal Reserve's Federal Open Market Committee (or "FOMC") suddenly changes market expectations of the target Federal Funds Rate or takes other actions which have the effect of tightening monetary policy that are not anticipated by the market. And finally, there remains uncertainty as to the ultimate impact or outcome of certain regulations under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), and restrictions on market-making activities of large U.S. financial institutions could result in reduced liquidity in times of market stress. 

As discussed above, investing in mortgage-related securities (including on a leveraged basis) subjects us to many risks including interest rate risk, prepayment and reinvestment risk, credit risk, spread risk, and liquidity risk which are discussed in "Liquidity and Capital Resources" within this Item 2 and in Part I, Item 3, “Quantitative and Qualitative Disclosures About Market Risk” of this Quarterly Report on Form 10-Q as well as in Item 1A, "Risk Factors" of Part I of our Annual Report on Form 10-K for the year ended December 31, 2017. Please see these Items for a detailed discussion of these risks and the potential impact on our results of operations and financial condition.

Market Conditions and Recent Activity

Interest rates rose during the first quarter of 2018, ending the quarter near the top of the quarter’s range, as markets adjusted to anticipated tighter monetary policy in 2018. Many market participants believe that recent domestic tax cuts will lead to increased economic activity and higher inflation. In addition, we believe that the increasing supply of U.S. Treasuries is also putting upward pressure on interest rates. As shown in the charts below, short-term rates increased more than long-term rates, resulting in a flattening of the Treasury and swap curves during the first quarter of 2018. Given higher rates and the flatter yield curve relative to our net duration position, our book value per common share declined by 3.7% during the first quarter as the fair value of our investments declined more than the fair value of our hedges increased. Credit spreads had only a modest impact on our book value per common share during the first quarter as tighter spreads in Agency CMBS and CMBS IO mostly offset slightly wider spreads in Agency RMBS.

The chart below shows the highest and lowest rates during the three months ended March 31, 2018 as well as the rates as of March 31, 2018 and December 31, 2017 for the indicated U.S. Treasury securities:

25


     CHART-474ED65B797E5E3581CA05.JPG
    
The chart below shows the highest and lowest swap rates during the three months ended March 31, 2018 as well as the swap rates as of March 31, 2018 and December 31, 2017 :
CHART-9E5256B607E15F96978A05.JPG

    


26


Highlights of the First Quarter of 2018
    
For the first quarter of 2018, we reported a comprehensive loss to common shareholders of $(4.1) million , which was comprised of net income to common shareholders of $41.4 million and other comprehensive loss of $(45.5) million . Net income to common shareholders was comprised mostly of a gain on derivatives instruments, net of $38.4 million , which resulted primarily from an increase in fair value of our derivative instruments due to increasing swap rates. Other comprehensive loss was comprised mostly of declines in the fair value of our AFS investments due to increasing interest rates.

Net interest income of $13.6 million for the first quarter of 2018 was down slightly compared to $14.1 million for the fourth quarter of 2017. Our average interest earning asset balance grew during the first quarter of 2018, which increased our interest income by approximately $1.7 million, but this benefit was more than offset by a decline of $0.6 million in prepayment penalty compensation from CMBS and CMBS IO (as voluntary prepayments on these securities fell quarter to quarter) and an increase of $1.5 million in repurchase agreement financing costs. Drop income from TBA dollar roll positions was $3.7 million for the first quarter, a decline of $0.2 million from the prior quarter, which resulted primarily from having a lower average balance outstanding during the first quarter. Lower net interest income and lower TBA drop income were partially offset by a decline of $0.1 million in net periodic interest costs from interest rate swaps, which was driven primarily by the increase in 3-month LIBOR during the first quarter of 2018. As a result, core net operating income to common shareholders (a non-GAAP measure) declined $0.6 million to $10.2 million , or $0.18 per common share, for the first quarter compared to $10.8 million, or $0.20 per common share, for the fourth quarter of 2017. Please see "Non-GAAP Financial Measures" at the end of this "Executive Overview" for additional important information about non-GAAP measures.
Our overall leverage including TBA dollar roll positions at cost (as if settled) increased slightly to 6.5 times shareholders’ equity as of March 31, 2018 compared to 6.4 times as of December 31, 2017 as we continued to invest our capital principally in 30-year fixed-rate Agency RMBS through the purchase of specified pools and TBA securities. We are focusing on fixed-rate Agency RMBS because their higher liquidity gives us the ability to readjust our risk position more rapidly than other asset classes. Management believes that risk-adjusted returns on fixed-rate Agency RMBS are more favorable than other asset classes, particularly if credit spreads widen in the future.
Management Outlook
    
We anticipate that economic data globally and in the U.S. will be stable for at least the next several quarters. Underlying fundamentals appear to support continued economic growth and are poised to strengthen in the short-term. The employment picture is favorable, as employment rates continue to rise and consequently, the market is focusing on wage growth. Inflation as measured by most indicators is rising, and it is uncertain how sustainable the current trend will be. Given the positive economic environment and higher inflation, interest rates continued to rise after the end of the first quarter and briefly touched 3.0% on the 10-year U.S. Treasury before falling back to 2.95% at the end of April 2018.

As it relates to investment opportunities, the investment environment in recent years has been dominated by monetary and balance sheet stimulus by central banks, which have significantly reduced market volatility and impacted the level of interest rates, the shape of the yield curve, asset credit spreads, and risk taking by the market in general. Central banks are now beginning to reduce monetary stimulus, led by the Federal Reserve with the European Central Bank poised to follow. We believe that the withdrawal of central bank monetary and balance sheet stimulus, coupled with the impact on U.S. Treasury supply from stimulative fiscal policy (such as tax reform), will precipitate a transition of markets to an investment environment more favorable to the Company and other fixed-income investors over the balance of 2018. We believe this environment will be marked by a steeper yield curve (after a short-period with a flat yield curve) and wider credit spreads, particularly as the Federal Reserve’s purchases of Agency RMBS significantly wane in the second half of 2018. Credit spreads could eventually face corrections as less risky assets reprice or if economic growth slows, or another event occurs that causes markets to revalue credit risk. Without central bank purchases, greater private capital involvement in markets could begin to reflect risks more appropriately, and asset prices could be more volatile as participants adjust. The above factors all point to opportunities to invest capital later in 2018 at long-term accretive returns for Dynex shareholders. A key to our success will be managing effectively through the transition period to this more favorable investment environment.
    


27


Non-GAAP Financial Measures

In addition to the Company's operating results presented in accordance with GAAP, the information presented within Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Quarterly Report on Form 10-Q contains the following non-GAAP financial measures: core net operating income to common shareholders (including per common share), adjusted interest expense, adjusted net interest income, and the related metrics adjusted cost of funds and adjusted net interest spread. Because these measures are used in the Company's internal analysis of financial and operating performance, management believes that they provide greater transparency to our investors of management's view of our economic performance. Management also believes the presentation of these measures, when analyzed in conjunction with the Company's GAAP operating results, allows investors to more effectively evaluate and compare the performance of the Company to that of its peers, although the Company's presentation of its non-GAAP measures may not be comparable to other similarly-titled measures of other companies. A reconciliation of core net operating income to common shareholders to GAAP net income to common shareholders is presented below, and reconciliations of adjusted interest expense and adjusted net interest income to GAAP financial measures are provided within "Results of Operations".

Management views core net operating income to common shareholders as an estimate of the Company’s financial performance excluding changes in fair value of its investments and derivatives. In addition to the non-GAAP reconciliation set forth below, which derives core net operating income to common shareholders from GAAP net income to common shareholders as the nearest GAAP equivalent measure, core net operating income to common shareholders can also be determined by adjusting net interest income to include interest rate swap periodic interest costs, drop income on TBA dollar roll positions, general and administrative expenses, and preferred dividends. Management includes drop income, which is included in "gain (loss) on derivatives instruments, net" on the Company's consolidated statements of comprehensive income, in core net operating income and in adjusted net interest income because TBA dollar roll positions are viewed by management as economically equivalent to holding and financing Agency RMBS using short-term repurchase agreements. Management also includes periodic interest costs from its interest rate swaps, which are also included in "gain (loss) on derivatives instruments, net", in adjusted net interest expense, and in adjusted net interest income because interest rate swaps are used by the Company to economically hedge the impact of changing interest rates on its borrowing costs from repurchase agreements, and including periodic interest costs from interest rate swaps is a helpful indicator of the Company’s total cost of financing in addition to GAAP interest expense. However, these non-GAAP measures do not provide a full perspective on our results of operations, and therefore, their usefulness is limited. For example, these non-GAAP measures do not include gains or losses from available-for-sale investments, changes in fair value of and costs of terminating interest rate swaps, as well as realized and unrealized gains or losses from any instrument used by management to economically hedge the impact of changing interest rates on its portfolio and book value per common share, such as Eurodollar futures and TBA short positions, as applicable. As a result, these non-GAAP measures should be considered as a supplement to, and not as a substitute for, the Company's GAAP results as reported on its consolidated statements of comprehensive income.
 
Three Months Ended
($ in thousands, except per share amounts)
March 31, 2018
 
December 31, 2017
GAAP net income to common shareholders
$
41,367

 
$
19,053

Less:
 
 
 
Change in fair value of derivative instruments, net (1)
(34,841
)
 
(9,072
)
Loss on sale of investments, net
3,775

 
902

Accretion of de-designated cash flow hedges (2)
(48
)
 
(48
)
Fair value adjustments, net
(29
)
 
(12
)
Core net operating income to common shareholders
$
10,224

 
$
10,823

 
 
 
 
Weighted average common shares outstanding
55,871

 
53,399

Core net operating income per common share
$
0.18

 
$
0.20

(1)
Amount represents net realized and unrealized gains and losses on derivatives and excludes net periodic interest costs related to these instruments.

28


(2)
Included in GAAP interest expense and relates to the accretion of the balance remaining in accumulated other comprehensive income as a result of our discontinuation of cash flow hedge accounting effective June 30, 2013.


CRITICAL ACCOUNTING POLICIES

The discussion and analysis of our financial condition and results of operations are based in large part upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of our consolidated financial statements requires management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities. We base these estimates and judgments on historical experience and assumptions believed to be reasonable under current facts and circumstances. Actual results, however, may differ from the estimated amounts we have recorded.
Critical accounting policies are defined as those that require management's most difficult, subjective or complex judgments, and which may result in materially different results under different assumptions and conditions. Our critical accounting policies are discussed in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the year ended December 31, 2017 under “Critical Accounting Policies”. There have been no significant changes in our critical accounting policies during the three months ended March 31, 2018 .

FINANCIAL CONDITION

Our investment portfolio is comprised mostly of fixed-rate investments, of which over 46% is 30-year Agency RMBS including TBA dollar roll positions as of March 31, 2018. Approximately 42% of our investments are backed by commercial assets, mainly in the multifamily sector, which help to stabilize our duration profile and reduce prepayment risk.The following charts compare our investment portfolio as of March 31, 2018 to December 31, 2017 :

CHART-10AA52600F445520809A05.JPG CHART-1171D6C138985E729FBA05.JPG
(1)
Includes securities pending settlement as of dates indicated.
(2)
Includes long positions in TBAs used for investment purposes at their implied market value as if settled and excludes short positions in TBAs used for economic hedging purposes. All TBAs are accounted for as “derivative assets (liabilities)” on our consolidated balance sheet.

    

29



The following table provides a summary of the amortized cost and fair value of our AFS portfolio and includes TBA dollar roll positions used for investment purposes as of the dates indicated:
 
 
March 31, 2018
 
December 31, 2017
($ in thousands)
 
Amortized Cost
 
Fair Value
 
Amortized Cost
 
Fair Value
RMBS:
 
 
 

 
 
 
 
Agency RMBS, 30 year fixed-rate (1)
 
$
965,173

 
$
942,805

 
$
903,270

 
$
898,678

TBAs, 30 year fixed-rate (2)
 
844,941

 
846,940

 
829,425

 
830,908

Agency RMBS - adjustable rate
 
278,474

 
272,635

 
289,304

 
285,583

Non-Agency RMBS
 
994

 
1,007

 
1,070

 
1,091


 
2,089,582

 
2,063,387

 
2,023,069

 
2,016,260

CMBS and CMBS IO:
 

 

 
 
 
 
Fixed-rate Agency CMBS
 
$
1,015,486

 
$
984,065

 
$
1,134,409

 
$
1,124,351

Non-Agency CMBS
 
4,098

 
6,041

 
22,466

 
24,764

Agency CMBS IO
 
358,471

 
362,085

 
375,361

 
380,306

Non-Agency CMBS IO
 
294,092

 
296,184

 
308,472

 
312,216

 
 
1,672,147

 
1,648,375

 
1,840,708

 
1,841,637

 
 
 
 
 
 
 
 
 
U.S. Treasuries:
 
$
207,083

 
204,535

 
148,267

 
146,530

 
 
 
 

 
 
 
 
Total AFS portfolio including TBA dollar roll positions
 
$
3,968,812

 
$
3,916,297

 
$
4,012,044

 
$
4,004,427

(1)
Includes securities pending settlement as of dates indicated.
(2)
Consists of long positions in TBAs used for investment purposes at their implied cost basis and implied market value, respectively, as if settled and excludes short positions in TBAs used for economic hedging purposes. All TBAs are accounted for as “derivative assets (liabilities)” on our consolidated balance sheet.

Our investment portfolio as of March 31, 2018 decreased slightly from December 31, 2017 as we slowed our reinvestment of principal payments and sale proceeds. As mentioned in “Executive Overview”, the markets experienced further credit spreads tightening early in the first quarter of 2018. Although the we did redeploy some capital during the quarter, we continue to expect credit spreads to widen in the second half of 2018, which should provide more attractive reinvestment opportunities at better risk-adjusted returns than were available during the first quarter of 2018. The following table details the activity related to our MBS portfolio including TBA dollar roll positions during the three months ended March 31, 2018:
 
Agency RMBS
 
Agency CMBS
 
CMBS IO (3)
 
Non-Agency Other  (4)
 
Total
($ in thousands)
30-Year Fixed
 Rate (1) (2)
 
Adjustable Rate
 
 
 
 
Balance as of December 31, 2017
$
1,729,586

 
$
285,583

 
$
1,124,351

 
$
692,522

 
$
25,855

 
$
3,857,897

Purchases
93,611

 

 

 
2,814

 

 
96,425

Principal payments
(15,237
)
 
(10,343
)
 
(7,494
)
 

 
(18,799
)
 
(51,873
)
Sales

 

 
(110,810
)
 

 

 
(110,810
)
(Amortization) accretion
(955
)
 
(487
)
 
(619
)
 
(34,085
)
 
356

 
(35,790
)
Change in fair value
(17,260
)
 
(2,118
)
 
(21,363
)
 
(2,982
)
 
(364
)
 
(44,087
)
Balance as of March 31, 2018
$
1,789,745

 
$
272,635

 
$
984,065

 
$
658,269

 
$
7,048

 
$
3,711,762

(1)
Includes securities pending settlement as of dates indicated.
(2)
Includes long positions in TBAs used for investment purposes at their implied market value as if settled and excludes short positions in TBAs used for economic hedging purposes. All TBAs are accounted for as “derivative assets (liabilities)” on our consolidated balance sheet.
(3)
Includes Agency and non-Agency issued CMBS IO.
(4)
Includes non-Agency CMBS and RMBS.


30


We sold certain seasoned Agency CMBS during the first quarter of 2018 and replaced a portion of these assets with U.S. Treasuries early in the first quarter to take advantage of tight spreads. As of March 31, 2018, our investment in U.S. Treasuries was $204.5 million compared to $146.5 million as of December 31, 2017. We view U.S. Treasuries as having less exposure to the impact of widening credit spreads, and we expect to redeploy the capital we have invested in U.S. Treasuries into higher yielding assets opportunistically as credit spreads widen.

RMBS

During the first quarter of 2018, we added investments in specified and non-specified pools of 30-year fixed-rate Agency RMBS with coupons of 4.0% or higher as this sector continues to offer the most attractive risk-adjusted returns in the current rising interest rate environment. The following table provides information on our Agency RMBS investments including securities pending settlement and TBA dollar roll positions as of the dates indicated:

31


 
 
March 31, 2018
 
 
 
 
 
 
 
 
Weighted Average Based on Par
Coupon
 
Par
 
Amortized Cost/
Implied Cost
Basis  (1)(3)
 
Fair
Value (2)(3)
 
Average Original Loan
Balance (4)
 
Loan Age
(in months) (4)
 
3 Month
CPR (4)(5)
 
Duration  (6)
 
 
($ in thousands)
 
 
 
 
 
 
30-year fixed-rate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
3.0%
 
$
240,229

 
$
241,958

 
$
234,745

 
$
233,300

 
17

 
4.7
%
 
6.57

4.0%
 
688,534

 
723,215

 
708,060

 
280,434

 
6

 
5.5
%
 
4.50

TBA 4.0%
 
725,000

 
740,691

 
742,413

 
n/a

 
n/a

 
n/a

 
4.16

TBA 4.5%
 
100,000

 
104,250

 
104,527

 
n/a

 
n/a

 
n/a

 
3.42

Total 30-year fixed-rate
 
$
1,753,763

 
$
1,810,114

 
$
1,789,745

 
$
268,243

 
9

 
5.3
%
 
4.58

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Adjustable-rate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
3.1% (7)
 
$
268,543

 
$
278,474

 
$
272,635

 
$
272,737

 
77

 
11.0
%
 
2.21

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total Agency RMBS (including TBA dollar roll positions)
 
$
2,022,306

 
$
2,088,588

 
$
2,062,380

 
$
269,251

 
24

 
6.6
%
 
4.27

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
 
Weighted Average Based on Par
Coupon
 
Par
 
Amortized Cost/Implied Cost Basis  (1)(3)
 
Fair
Value (2)(3)
 
Average Original Loan
Balance (4)
 
Loan Age
(in months)
  (4)
 
3 Month
CPR (4)(5)
 
Duration  (6)
 
 
($ in thousands)
 
 
 
 
 
 
30-year fixed-rate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
3.0%
 
$
244,374

 
$
246,155

 
$
244,818

 
$
233,584

 
13

 
5.0
%
 
6.30

4.0%
 
623,293

 
657,114

 
653,860

 
274,965

 
4

 
4.0
%
 
3.91

TBA 4.0%
 
795,000

 
829,425

 
830,908

 
n/a

 
n/a

 
n/a

 
2.95

Total 30-year fixed-rate
 
$
1,662,667

 
$
1,732,694

 
$
1,729,586

 
$
263,310

 
6

 
4.3
%
 
3.80

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Adjustable-rate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
3.1% (7)
 
$
278,886

 
$
289,305

 
$
285,583

 
$
271,516

 
74

 
16.0
%
 
2.28

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total Agency RMBS (including TBA dollar roll positions)
 
$
1,941,553

 
$
2,021,999

 
$
2,015,169

 
$
265,306

 
23

 
7.1
%
 
3.58

(1)
Implied cost basis of TBA dollar roll positions represents the forward price to be paid for the underlying Agency MBS as if settled.
(2)
Fair value of TBA dollar roll positions is the implied market value of the underlying Agency security as of the end of the period if settled.
(3)
The net carrying value of TBA dollar roll positions, which is the difference between their implied market value and implied cost basis, was $1.5 million as of March 31, 2018 and is included on the consolidated balance sheet within “derivative assets”.
(4)
TBA dollar roll positions are excluded from this calculation as they do not have a defined weighted-average loan balance or age until mortgages have been assigned to the pool.
(5)
Constant prepayment rate (“CPR”) represents the 3-month CPR of Agency RMBS held as of date indicated. Securities with no prepayment history are excluded from this calculation.

32


(6)
Duration measures the sensitivity of a security's price to the change in interest rates and represents the percent change in price of a security for a 100 basis point increase in interest rates. We calculate duration using third-party financial models and empirical data. Different models and methodologies can produce different estimates of duration for the same securities.
(7)
Coupon of adjustable-rate Agency RMBS represents the weighted average coupon based on amortized cost.
    
CMBS

During the first quarter of 2018, we sold $110.8 million of seasoned Agency CMBS, and we are continuing to seek opportunities to divest our more seasoned assets in this sector as we find attractive bids. Currently, tighter credit spreads and rising costs of repurchase agreement financing are limiting the supply of Agency CMBS available in the market that meet our threshold for acceptable risk/return. Though we expect to reinvest in higher credit Agency CMBS when credit spreads widen, we do not anticipate reinvesting in non-Agency CMBS in the near term because we believe the higher cost of leveraging these assets offsets any benefit from wider credit spreads.
 
Because Agency CMBS are guaranteed by the GSEs with respect to return of principal, our credit exposure is limited to any unamortized premium remaining on those securities. Because non-Agency CMBS are not guaranteed, our entire investment is exposed to credit losses from the underlying loans collateralizing the CMBS. The amortized cost of our non-Agency CMBS as of March 31, 2018 declined to $4.1 million compared to $22.5 million as of December 31, 2017 due to significant prepayment activity during the first quarter of 2018. The majority of non-Agency CMBS remaining as of March 31, 2018 is comprised of securities collateralized by loans we originated prior to 2000. The following table presents the par value, amortized cost, and weighted average months to estimated maturity of our CMBS investments as of the dates indicated by year of origination:
 
March 31, 2018
 
December 31, 2017
($ in thousands)
Par Value
 
Amortized Cost
 
Months to Estimated Maturity (1)
 
Par Value
 
Amortized Cost
 
Months to Estimated Maturity (1)
Year of Origination:
 
 
 
 
 
 
 
 
 
 
 
2008 and prior
$
29,987

 
$
27,121

 
42
 
$
34,065

 
$
31,026

 
41
2009 to 2012
86,362

 
88,750

 
29
 
106,619

 
109,234

 
27
2013 to 2014
19,913

 
20,260

 
79
 
20,237

 
20,600

 
82
2015
355,354

 
357,761

 
105
 
468,296

 
469,657

 
103
2016
238,995

 
240,633

 
107
 
239,139

 
240,831

 
110
2017
281,738

 
285,059

 
115
 
282,112

 
285,527

 
118
 
$
1,012,349

 
$
1,019,584

 
99
 
$
1,150,468

 
$
1,156,875

 
99
(1)
Months to estimated maturity is an average weighted by the amortized cost of the investment.



33


CMBS IO

As of March 31, 2018 , our CMBS IO investments comprised approximately 17% of our total portfolio. We do not expect to acquire additional CMBS IO in the near term until more attractive spreads become available. While we remain committed to holding our highest yielding positions in these investments, we expect to cull our lowest yielding positions as we find attractive bids in the market.

Income earned from CMBS IO is based on interest payments received on the underlying commercial mortgage loan pools. Our return on these investments may be negatively impacted by any change in scheduled cash flows such as modifications of the mortgage loans or involuntary prepayments including defaults, foreclosures, and liquidations on or of the underlying mortgage loans prior to its contractual maturity date. In order to manage our exposure to credit performance, we generally invest in senior tranches of these securities and where we have evaluated the credit profile of the underlying loan pool and can monitor credit performance. In addition, to address changes in market fundamentals and the composition of mortgage loans collateralizing an investment, we consider the year of origination of the loans underlying CMBS IO in our selection of investments. The following table presents our CMBS IO investments as of March 31, 2018 by year of origination:
 
March 31, 2018
 
December 31, 2017
($ in thousands)
Amortized Cost
 
Fair Value
 
Remaining WAL  (1)
 
Amortized Cost
 
Fair Value
 
Remaining WAL  (1)
Year of Origination:
 
 
 
 
 
 
 
 
 
 
 
2010
$
5,693

 
$
5,768

 
12

 
$
6,421

 
$
6,554

 
13

2011
23,516

 
24,482

 
17

 
25,652

 
26,720

 
18

2012
65,490

 
66,532

 
21

 
71,615

 
72,913

 
22

2013
97,826

 
97,907

 
26

 
103,730

 
104,568

 
28

2014
162,579

 
163,613

 
33

 
171,285

 
173,043

 
34

2015
164,138

 
165,853

 
39

 
170,663

 
172,974

 
40

2016
80,265

 
80,758

 
45

 
82,698

 
83,444

 
47

2017
50,415

 
50,724

 
52

 
51,769

 
52,306

 
53

2018
2,641

 
2,632

 
76

 

 

 

 
$
652,563

 
$
658,269

 
35

 
$
683,833

 
$
692,522

 
36

(1) Remaining weighted average life (“WAL”) represents an estimate of the number of months of interest earnings remaining for the investments by year of origination.

There have been no material changes to the characteristics or geographic distribution of collateral underlying our CMBS IO securities since December 31, 2017.

Derivative Assets and Liabilities
    
We regularly monitor and adjust our hedging portfolio in response to many factors including, but not limited to, changes in our investment portfolio, shifts in the yield curve, and our expectations with respect to the future path of interest rates and interest rate volatility. Please refer to “Quantitative and Qualitative Disclosures about Market Risk” in Part I, Item 3 of this Quarterly Report on Form 10-Q for more information.

Interest rate swaps and Eurodollar futures. As of March 31, 2018 , we used interest rate swaps and Eurodollar futures to hedge a portion of our earnings and book value exposure to fluctuations in interest rates. The following graphs present the effective notional balance outstanding and weighted average net pay-fixed rate for our interest rate swaps and Eurodollar futures for the periods indicated:


34


CHART-D80651BB941F5551BA9A05.JPG
CHART-08D3723FD18C57568A4A05.JPG

During the three months ended March 31, 2018 , we added interest rate swaps with a combined notional balance of $0.4 billion at a weighted average net pay-fixed rate of 2.84% which replaced interest rate swaps with a notional balance of $1.3 billion and a weighted average rate of 1.27% that matured early in the quarter.During the three months ended March 31, 2018, we also terminated interest rate swaps with a notional balance of $0.1 billion and a weighted average net pay-fixed rate of 2.92%, realizing a loss of $(0.5) million.
As of March 31, 2018 , we held Eurodollar futures with an aggregate notional balance of $1.3 billion at a weighted average rate of 1.82% which mature in June and September 2018. The Eurodollar futures aggregate notional balance represents the total notional balance of 3-month contracts. The maximum notional balance outstanding for any future 3-month period did not exceed $650 million as of March 31, 2018 . We realized a gain of $0.9 million during the first quarter of 2018 for Eurodollar futures with a notional balance of $0.7 billion and a weighted average rate of 1.67% that matured late in the first quarter.

35


TBAs. We hold long positions in TBA securities which are accounted for as derivative instruments because the Company cannot assert that it is probable at inception and throughout the term of an individual TBA transaction that its settlement will result in physical delivery of the underlying Agency RMBS or the individual TBA transaction will not settle in the shortest time period possible. Please refer to “RMBS” above in this section of Part I, Item 2 for additional information about long positions in TBAs, or TBA dollar roll positions, which are used as a means of investing in and financing fixed-rate Agency RMBS. We may also periodically enter into short positions in TBAs to partially hedge the impact of adverse changes in interest rates on the fair value of our fixed-rate Agency RMBS. We did not hold any short positions in TBA securities as of March 31, 2018 . As of December 31, 2017, we held one TBA short position with a coupon of 3.5% and an implied cost basis (if settled) of $(153.8) million, which is included in our derivative liabilities at that date at its net carrying value of $(0.3) million.

Repurchase Agreements
 
The majority of our repurchase agreement borrowings are collateralized with Agency MBS which have historically had lower liquidity risk than non-Agency MBS. The following table presents the amount pledged and leverage against the fair value of our non-Agency MBS investments by credit rating as of March 31, 2018 and December 31, 2017 :
 
March 31, 2018
 
December 31, 2017
($ in thousands)
Fair Value
 
Amount Pledged
 
Related Borrowings
 
Fair Value
 
Amount Pledged
 
Related Borrowings
Non-Agency CMBS:
 
 
 
 
 
 
 
 
 
 
 
A

 

 

 
$
18,212

 
$
18,212

 
$
15,508

Below A/Not Rated
 
 

 

 
6,552

 

 

   
$

 
$

 
$

 
$
24,764

 
$
18,212

 
$
15,508

 
 
 
 
 
 
 
 
 
 
 
 
Non-Agency CMBS IO:
 
 
 
 
 
 
 
 
 
 
 
AAA
$
245,445

 
$
245,439

 
$
206,986

 
$
259,155

 
$
259,151

 
$
218,995

AA
40,511

 
39,938

 
33,743

 
42,486

 

 

A
722

 
722

 
620

 
735

 
735

 
641

Below A/Not Rated
9,506

 
9,506

 
8,133

 
9,840

 
51,685

 
44,058

 
$
296,184


$
295,605

 
$
249,482

 
$
312,216

 
$
311,571

 
$
263,694


Please refer to Note 3 of the Notes to the Unaudited Consolidated Financial Statements contained within this Quarterly Report on Form 10-Q as well as “Results of Operations” and “Liquidity and Capital Resources” contained within this Item 2 for additional information relating to our repurchase agreement borrowings.


36


Accumulated Other Comprehensive Loss

We recorded other comprehensive income of $(45.5) million for the three months ended March 31, 2018 related primarily to declines in fair value of our available-for-sale debt securities as a result of increasing interest rates. The following table includes detail of the accumulated gain (loss) position and change in fair value by type of debt security as of and for the periods indicated:
($ in thousands)
As of
December 31, 2017
 
Three Months Ended
 
As of
March 31, 2018
 
March 31, 2018
 
Fixed-rate Agency RMBS
$
(4,592
)
 
$
(17,776
)
 
$
(22,368
)
Adjustable-rate Agency RMBS
(3,721
)
 
(2,118
)
 
(5,839
)
Non-Agency RMBS
21

 
(8
)
 
13

Agency CMBS
(10,058
)
 
(21,363
)
 
(31,421
)
Non-Agency CMBS
2,298

 
(355
)
 
1,943

Agency CMBS IO
4,945

 
(1,331
)
 
3,614

Non-Agency CMBS IO
3,744

 
(1,652
)
 
2,092

U.S. Treasuries
(1,737
)
 
(811
)
 
(2,548
)
De-designated cash flow hedges
403

 
(48
)
 
355

Total
$
(8,697
)
 
$
(45,462
)
 
$
(54,159
)

RESULTS OF OPERATIONS

The discussions below provide information on items on our consolidated statements of comprehensive income. These discussions include both GAAP and non-GAAP financial measures which management utilizes in its internal analysis of financial and operating performance. Please read the section “Non-GAAP Financial Measures” at the end of “Executive Overview” in Item 2 of this Quarterly Report on Form 10-Q for additional important information about these measures.

Interest Income and Asset Yields
    
The following table summarizes information about our results from our investments during the periods indicated:
 
Three Months Ended
 
March 31,
 
2018
 
2017
($ in thousands)
Income
 
Average Balance
 
Yield
 
Income
 
Average Balance
 
Yield
MBS
$
23,883

 
$
2,956,175

 
3.13
%
 
$
22,157

 
$
3,187,108

 
2.78
%
U.S. Treasuries
967

 
168,508

 
2.33
%
 

 

 
%
Mortgage loans held for investment, net
162

 
15,442

 
4.05
%
 
185

 
18,918

 
3.81
%
Total from investments
25,012

 
3,140,125

 
3.09
%
 
22,342

 
3,206,026

 
2.79
%
Cash and cash equivalents
178

 
 
 
 
 
77

 
 
 
 
Total interest income
$
25,190

 
 
 
 
 
$
22,419

 
 
 
 
    
The following table presents details on average balances, interest income, and effective yields of MBS for the periods indicated:

37


 
Three Months Ended
 
March 31,
 
2018
 
2017
($ in thousands)
Amount
 
Yield
 
Amount
 
Yield
RMBS:
 
 
 
 
 
 
 
Coupon and scheduled amortization
$
8,611

 
2.90
%
 
$
5,729

 
1.93
 %
Prepayment adjustments  (1)
99

 
0.01
%
 
(1,153
)
 
(0.10
)%
 
$
8,710

 
2.91
%
 
$
4,576

 
1.83
 %
Average balance
$
1,186,946

 
 
 
$
1,188,616

 
 
 


 
 
 
 
 
 
CMBS:
 
 
 
 
 
 
 
Coupon and scheduled amortization
$
8,030

 
2.92
%
 
$
9,196

 
2.96
 %
Prepayment adjustments  (1)
202

 
0.02
%
 
64

 
0.01
 %
 
$
8,232

 
2.94
%
 
$
9,260

 
2.97
 %
Average balance
$
1,099,803

 


 
$
1,240,857

 
 
 


 
 
 
 
 
 
CMBS IO:


 
 
 


 
 
Coupon and scheduled amortization
$
6,251

 
3.74
%
 
$
7,224

 
3.81
 %
Prepayment adjustments  (1)
690

 
0.10
%
 
1,097

 
0.14
 %
 
$
6,941

 
3.84
%
 
$
8,321

 
3.96
 %
Average balance
$
669,426

 


 
$
757,635

 
 
 


 


 
 
 
 
Total MBS interest income and effective yield:
$
23,883

 
3.13
%
 
$
22,157

 
2.78
 %
 


 
 
 
 
 
 
Total average balance:
$
2,956,175

 
 
 
$
3,187,108

 
 
(1)
Prepayment adjustments represent effective interest amortization adjustments related to changes in actual and projected prepayment speeds for RMBS and prepayment compensation, net of amortization for CMBS and CMBS IO.


Interest income and effective yields on our total MBS portfolio for the three months ended March 31, 2018 increased compared to the three months ended March 31, 2017 primarily due to the shift in our portfolio to 30-year fixed-rate Agency RMBS which have higher yields and lower premium amortization than the adjustable-rate Agency RMBS held in our portfolio during the first quarter of 2017. The following table presents the estimated impact of changes in average balances, yields, and prepayment adjustments on interest income by type of MBS for the periods indicated:
 
Three Months Ended
 
March 31, 2018 Compared to March 31, 2017
 
Increase (Decrease) in Interest Income
 
Due to Change In
($ in thousands)
 
Average Balance
 
Coupon and Scheduled Amortization
 
Prepayment Adjustments (1)
RMBS
$
4,134

 
$
2,852

 
$
30

 
$
1,252

CMBS
(1,028
)
 
(1,207
)
 
41

 
138

CMBS IO
(1,380
)
 
(862
)
 
(111
)
 
(407
)
Total
$
1,726

 
$
783

 
$
(40
)
 
$
983

(1)
Prepayment adjustments represent effective interest amortization adjustments related to changes in actual and projected prepayment speeds for RMBS and prepayment compensation, net of amortization for CMBS and CMBS IO.

In addition to interest income from MBS for the three months ended March 31, 2018, our investments in U.S. Treasuries earned $1.0 million, yielding 2.33% on an average balance of $168.5 million outstanding during the quarter. These highly liquid securities allow us a low cost method of earning a return on available cash without increasing spread risk while monitoring the

38


availability of higher yielding MBS with attractive risk/return profiles. We did not own any U.S. Treasuries during the first quarter of 2017.

Interest Expense and Cost of Funds

The following table summarizes the components of interest expense as well as average balances and cost of funds for the periods indicated:
 
Three Months Ended
 
March 31,
($ in thousands)
2018
 
2017
Interest expense on repurchase agreement borrowings
$
11,614

 
$
7,596

Accretion of de-designated cash flow hedges (1)
(48
)
 
(99
)
Non-recourse collateralized financing
29

 
22

Total interest expense
$
11,595

 
$
7,519

 


 
 
Average balance of repurchase agreements
$
2,645,714

 
$
2,843,733

Average balance of non-recourse collateralized financing
5,387

 
6,359

Average balance of borrowings
$
2,651,101

 
$
2,850,092

Cost of funds (2)
1.75
%
 
1.06
%
(1)
Amount recorded as a portion of "interest expense" in accordance with GAAP which represents the accretion of the balance remaining in accumulated other comprehensive loss as of June 30, 2013 related to derivatives for which we discontinued cash flow hedge accounting.
(2)
Cost of funds is calculated by dividing annualized interest expense by the total average balance of borrowings outstanding during the period with an assumption of 360 days in a year.

The following table presents the estimated impact of the change in average balances and borrowing rates of repurchase agreements and other differences in interest expense for the comparative periods presented:
 
Three Months Ended
($ in thousands)
March 31, 2018 Compared to March 31, 2017
Change in borrowing rates on repurchase agreements
$
4,547

Change in average balance of repurchase agreements
(529
)
Increase in accretion of de-designated cash flow hedges
51

Decrease in non-recourse collateralized financing
7

Total increase in interest expense
$
4,076


Interest expense increased for the three months ended March 31, 2018 compared to the same period in 2017 due to higher borrowing rates on our repurchase agreements. Our borrowing rates are based primarily on one-month LIBOR which has increased approximately 90 basis points from March 31, 2017 to March 31, 2018 .

Adjusted Interest Expense

Because we use interest rate swaps to economically hedge a portion of the impact of increasing short-term interest rates on our repurchase agreement financing costs, management considers net periodic interest costs from interest rate swaps to be an additional cost of financing investments. As such, management uses the non-GAAP financial measure “adjusted interest expense” which includes the net periodic interest costs of our effective interest rate swaps excluded from GAAP interest expense. Please read the section "Non-GAAP Financial Measures" at the end of "Executive Overview" in Part 1, Item 2 of this Quarterly Report on Form 10-Q for additional important information about this non-GAAP financial measure. The table below presents the reconciliation of GAAP interest expense and cost of funds to adjusted interest expense and adjusted cost of funds for the periods indicated:


39


 
Three Months Ended
 
March 31,
 
2018
 
2017
($ in thousands)
Amount
 
Rate
 
Amount
 
Rate
Interest expense/cost of funds
$
11,595

 
1.75
%
 
$
7,519

 
1.06
%
Less: accretion of de-designated cash flow hedges (1)
48

 
0.01
%
 
99

 
0.01
%
Add: net periodic interest costs of interest rate swaps
220

 
0.03
%
 
615

 
0.09
%
Adjusted interest expense/adjusted cost of funds
$
11,863

 
1.79
%
 
$
8,233

 
1.16
%
(1)
Amount recorded as a portion of "interest expense" in accordance with GAAP which represents the accretion of the balance remaining in accumulated other comprehensive loss as of June 30, 2013 related to derivatives for which we discontinued cash flow hedge accounting.

Adjusted interest expense for the three months ended March 31, 2018 increased to $11.9 million compared to $8.2 million for the three months ended December 31, 2016 primarily because of higher borrowing rates on our repurchase agreements as mentioned previously.

Net Interest Income and Net Interest Spread

The tables below present net interest income and net interest spread for our interest-earning assets and interest-bearing liabilities for the periods indicated:
 
Three Months Ended
 
March 31,
 
2018
 
2017
($ in thousands)
Amount
 
Yield
 
Amount
 
Yield
Interest income
$
25,190

 
3.09
%
 
$
22,419

 
2.79
%
Interest expense
11,595

 
1.75
%
 
7,519

 
1.06
%
Net interest income/spread
13,595

 
1.34
%
 
14,900

 
1.73
%
 
 
 
 
 
 
 
 
Average interest earning assets
$
3,140,125

 
 
 
$
3,206,026

 
 
Average balance of borrowings
$
2,651,101

 
 
 
$
2,850,092

 
 

Net interest income and net interest spread declined due to higher borrowing costs during the three months ended March 31, 2018 compared to the three months ended March 31, 2017 . Higher borrowings costs were partially mitigated by an increase in interest income for the three months ended March 31, 2018 compared to the same period in 2017, which primarily resulted from the shift in our investments from lower yielding adjustable-rate RMBS to higher yielding fixed-rate MBS during the past twelve months. Please refer to “Interest Income and Effective Yields” and “Interest Expense and Cost of Funds” for additional information.

Adjusted Net Interest Income

Drop income from TBA dollar roll positions and net periodic interest costs from interest rate swaps effective during the period are included in "gain on derivatives instruments, net" on the Company's consolidated statements of comprehensive income. Drop income is the difference in price between the near settling TBA contract and the price for the same contract with a later settlement date . Management believes drop income represents the economic equivalent of net interest income (interest income less implied financing cost) on the underlying Agency security from trade date to settlement date. Management also views net periodic interest costs from interest rate swaps used to hedge interest rate risk as an additional cost of using repurchase agreements to finance its investments. As such, management includes drop income from TBA dollar roll positions and net periodic interest costs from interest rate swaps in a non-GAAP financial measure “adjusted net interest income”. Please read the section “Non-GAAP Financial Measures” for additional important information about this non-GAAP financial measure. The following table reconciles adjusted net interest income to GAAP net interest income for the periods indicated:

40


 
Three Months Ended
 
March 31,
($ in thousands)
2018
 
2017
Net interest income
$
13,595

 
$
14,900

Add: TBA drop income
3,733

 

Add: net periodic interest costs of interest rate swaps
(220
)
 
(615
)
Less: accretion of de-designated hedges (1)
(48
)
 
(99
)
Adjusted net interest income
$
17,060

 
$
14,186

(1)
Amount recorded as a portion of "interest expense" in accordance with GAAP which represents the accretion of the balance remaining in accumulated other comprehensive loss as of June 30, 2013 related to derivatives for which we discontinued cash flow hedge accounting.

    Adjusted net interest income for the three months ended March 31, 2018 increased $2.9 million compared to the three months ended March 31, 2017 due primarily to $3.7 million in drop income from TBA dollar roll positions which we did not invest in during the first quarter of 2017. In addition, as discussed below, net periodic interest costs from interest rate swaps for the first quarter of 2018 declined $0.4 million compared to first quarter of 2017.

Gain on Derivative Instruments, Net

Changes in the fair value of derivative instruments and net periodic interest costs are impacted by changing market interest rates and adjustments that we may make to our derivative positions in any given period. Because of the changes made to our derivatives portfolio from one reporting period to the next, results of any given reporting period are generally not comparable to results of another.

The following table provides information on our financial instruments accounted for as derivative instruments for the periods indicated:
 
 
Three Months Ended
 
 
March 31, 2018
($ in thousands)
 
2018
 
2017
Interest rate derivatives:
 
 
 
 
Interest rate swaps:
 
 
 
 
Net periodic interest costs
 
$
(220
)
 
$
(615
)
Change in fair value (1)
 
48,463
 
 
790
 
Total interest rate swap gains, net
 
48,243
 
 
175
 
Eurodollar futures:
 
 
 
 
Change in fair value (1)
 
1,905
 
 
 
TBA short positions (economic hedges):
 
 
 
 
Change in fair value (2)
 
293
 
 
 
Total interest rate derivative gains (losses), net
 
50,441
 
 
175
 
 
 
 
 
 
TBA dollar roll positions:
 
 
 
 
TBA drop income
 
3,733
 
 
 
Change in fair value (2)
 
(15,820
)
 
 
Total TBA dollar roll gains (losses), net
 
(12,087
)
 
 
 
 
 
 
 
Total gain on derivative instruments, net
 
$
38,354
 
 
$
175
 
(1)
Changes in fair value for interest rate swaps and Eurodollar futures include unrealized gains (losses) from current and forward starting derivative instruments and realized gains (losses) from terminated derivative instruments.
(2)
Changes in fair value for TBA positions include unrealized gains (losses) from open TBA contracts and realized gains (losses) on paired off or terminated positions.


41


Gain on derivative instruments, net for the three months ended March 31, 2018 included $(0.5) million of realized losses on terminated interest rate swaps with a notional balance of $100.0 million, $12.6 million of realized losses on TBA dollar roll positions, and $0.9 million of realized gains resulting from $650.0 million of Eurodollar futures with a rate of 1.67% that matured during the first quarter of 2018. The decline in fair value of TBAs of $(15.8) million was driven primarily by the increase in interest rates during the first quarter.

Our net periodic interest costs for effective interest rate swaps was $0.4 million lower during the three months ended March 31, 2018 compared to the same period in 2017 because the difference between the weighted average net pay-fixed and weighted average net receive-variable rates were lower for the first quarter of 2018 compared to first quarter of 2017. The floating rate we receive on the majority of our pay-fixed interest rate swaps is based on 3-month LIBOR which averaged approximately 1.93% for the three months ended March 31, 2018 compared to 1.03% for the same period in 2017. The following table provides details on the effective interest rate swaps outstanding during the periods indicated:
 
Three Months Ended
 
March 31,
($ in thousands)
2018
 
2017
Average pay-fixed notional balance, net of receive-fixed
$
3,290,556

 
$
1,292,167

Weighted average net pay-fixed rate
1.66
%
 
1.16
%
Weighted average net receive-variable rate
1.64
%
 
0.97
%

As mentioned in “Financial Condition” of Part I, Item 2 of this Quarterly Report on Form 10-Q, we hold long positions in TBA securities which management views as economically equivalent to investing in and financing Agency RMBS using short-term repurchase agreements. We execute a series of transactions which effectively delay the settlement of a forward purchase of a non-specified Agency RMBS by entering into an offsetting TBA short position, net settling the paired-off positions in cash, and simultaneously entering into an identical TBA long position with a later settlement date. A portion of the total change in fair value of TBAs is referred to by management as “drop income (loss)” and is calculated as the difference in price between the TBA security purchased for a forward settlement month and the price of a TBA security sold for settlement in the current month times its notional amount.

We may also periodically enter into short positions in TBAs to hedge the impact of adverse changes in interest rates on the fair value of our fixed-rate Agency RMBS. Unlike long positions in TBAs in which we execute dollar roll transactions, we do not simultaneously enter into an identical TBA short position with a later settlement date when we pair off initial short positions. Therefore, short positions in TBAs used as economic hedges do not generate drop income (loss). We did not have any short positions in TBAs used as economic hedges as of March 31, 2018 .

Loss on Sale of Investments, Net

Sales of our investments occur in the ordinary course of business as we manage our risk, capital and liquidity profiles, and as we reallocate capital to various investments. The following tables provide information related to our loss on sale of investments, net for the periods indicated:
 
Three Months Ended
 
March 31,
 
2018
 
2017
($ in thousands)
Amortized cost basis sold
 
Loss on sale of investments, net
 
Amortized cost basis sold
 
Loss on sale of investments, net
Agency RMBS
$

 
$

 
$
58,872

 
$
(1,708
)
Agency CMBS
110,810

 
(2,052
)
 

 

U.S. Treasuries
48,221

 
(1,723
)
 

 

 
$
159,031

 
$
(3,775
)
 
$
58,872

 
$
(1,708
)


42


General and Administrative Expenses

General and administrative expenses decreased to $(3.6) million for the three months ended March 31, 2018 compared to $(4.3) million for the three months ended March 31, 2017 . We incurred higher legal and litigation expenses as well as higher compensation and benefits expenses related to bonus accrual adjustments during the first quarter of 2017 compared to the first quarter of 2018.

LIQUIDITY AND CAPITAL RESOURCES
 
 Our primary sources of liquidity include borrowings under repurchase arrangements and monthly principal and interest payments we receive on our investments. Additional sources may also include proceeds from the sale of investments, equity offerings, and payments received from counterparties from interest rate swap agreements. We use our liquidity to purchase investments and to pay our operating expenses and dividends on our common and preferred stock. We also use our liquidity to post initial and variation margins on our repurchase agreements and derivative transactions, including TBA contracts, when required under the terms of the related agreements. We may also use liquidity to repurchase shares of our stock periodically.
 
Our liquid assets fluctuate based on our investment activities, our financing and capital raising activities, and changes in the fair value of our investments and derivative instruments. We seek to maintain sufficient liquidity to support our operations and to meet our anticipated liquidity demands, including potential margin calls from lenders (as discussed further below). We measure, manage, and forecast our liquidity on a daily basis. Our most liquid assets include unrestricted cash and cash equivalents, U.S. Treasuries and unencumbered Agency RMBS, CMBS, and CMBS IO. As of March 31, 2018 , our most liquid assets were $263.0 million compared to $283.9 million as of December 31, 2017 .

We perform sensitivity analysis on our liquidity based on changes in the fair value of our investments due to changes in interest rates, credit spreads, lender haircuts, and prepayment speeds as well as changes in the fair value of our derivative instruments due to changes in interest rates. In performing this analysis we will also consider the current state of the fixed income markets and the repurchase agreement markets in order to determine if market forces such as supply-demand imbalances or structural changes to these markets could change the liquidity of MBS or the availability of financing. The objective of our analysis is to assess the adequacy of our liquidity to withstand potential adverse events. We may change our leverage targets based on market conditions and our perceptions of the liquidity of our investments.

We closely monitor our debt-to-invested equity ratio (which is the ratio of debt financing to invested equity for any investment) as part of our liquidity management process as well as our overall enterprise level debt-to-equity ratio. We also monitor the ratio of our available liquidity to outstanding repurchase agreement borrowings, which fluctuates due to changes in the fair value of collateral we have pledged to our lenders. Including our TBA dollar roll positions at cost (if settled), which was $844.9 million as of March 31, 2018 , our leverage was 6.5 times shareholders’ equity. It is possible under certain market conditions that it may be uneconomical for us to roll our TBA dollar roll positions into future months, which may result in us having to take physical delivery of the underlying securities. Because under those circumstances we would have to fund our total purchase commitment with cash or other financing sources, which may impact our liquidity position, management includes our TBA dollar roll positions at cost (if settled) in evaluating the Company’s leverage.

The following table presents information regarding the balances of our repurchase agreement borrowings and our TBA dollar roll positions for the periods indicated:
 
Repurchase Agreements
 
TBA Dollar Roll Positions (1)
($ in thousands)
Balance Outstanding As of Quarter End
 
Average Balance Outstanding For the Quarter Ended
 
Maximum Balance Outstanding During the Quarter Ended
 
Balance Outstanding As of Quarter End
 
Average Balance Outstanding For the Quarter Ended
March 31, 2018
$
2,613,892

 
$
2,645,714

 
$
2,716,729

 
$
844,941

 
$
863,615

December 31, 2017
2,565,902

 
2,557,573

 
2,677,894

 
829,425

 
928,329

September 30, 2017
2,519,230

 
2,616,250

 
2,801,418

 
683,813

 
745,270

June 30, 2017
2,540,759

 
2,753,019

 
2,826,005

 
416,312

 
305,720

March 31, 2017
2,825,945

 
2,843,733

 
2,913,617

 

 


43


(1)
Balance outstanding as of quarter end and average balance outstanding for the quarter ended includes TBA dollar roll positions as reported at cost (as if settled). Does not include short TBA positions used to hedge interest rate risk exposure from fixed-rate Agency RMBS in applicable periods.

Depending on our liquidity levels, investment opportunities, the condition of the credit markets, and other factors, we may from time to time consider the issuance of debt, equity, or other securities. We may also sell investments in order to provide additional liquidity for our operations. While we will attempt to avoid dilutive or otherwise costly issuances, depending on market conditions and in order to manage our liquidity, we could be forced to issue equity or debt securities which may be dilutive to our capital base or our profitability.

Repurchase Agreements

 Our repurchase agreement borrowings are generally renewable at the discretion of our lenders without guaranteed roll-over terms. Given the short-term and uncommitted nature of most of our repurchase agreement financing, we attempt to maintain unused capacity under our existing repurchase agreement credit lines with multiple counterparties which helps protect us in the event of a counterparty's failure to renew existing repurchase agreements either with favorable terms or at all. As of March 31, 2018 , we had repurchase agreement borrowings outstanding with 16 of our 34 available repurchase agreement counterparties at a weighted average borrowing rate of 1.92% compared to 1.67% as of December 31, 2017 . Our repurchase agreement borrowings generally carry a rate of interest based on a spread to an index such as LIBOR.

For our repurchase agreement borrowings, we are required to post and maintain margin to the lender (i.e., collateral in excess of the repurchase agreement financing) in order to support the amount of the financing. This excess collateral is often referred to as a “haircut” (and which we also refer to as equity at risk) and is intended to provide the lender some protection against fluctuations in fair value of the collateral and/or the failure by us to repay the borrowing at maturity. The majority of the collateral pledged to our repurchase agreement counterparties is MBS, the fair value of which fluctuates depending on market conditions. If the fair value of the collateral falls below the haircut required by the lender, the lender has the right to demand additional margin, or collateral, to increase the haircut back to the initial amount. These demands are typically referred to as “margin calls”. Declines in the value of investments occur for any number of reasons including but not limited to changes in interest rates, changes in ratings on an investment, changes in actual or perceived liquidity of the investment, or changes in overall market risk perceptions. Additionally, values in Agency RMBS will also decline from the payment delay feature of those securities. Agency RMBS have a payment delay feature whereby Fannie Mae and Freddie Mac announce principal payments on Agency RMBS but do not remit the actual principal payments and interest for 20 days in the case of Fannie Mae and 40 days in the case of Freddie Mac. Because these securities are financed with repurchase agreements, the repurchase agreement lender generally makes a margin call for an amount equal to the product of their advance rate on the repurchase agreement and the announced principal payments on the Agency RMBS. A margin call made by a lender reduces our liquidity until we receive the principal payments and interest 20 to 40 days later. 

If we fail to meet any margin call, our lenders also have the right to terminate the repurchase agreement and sell any collateral pledged. Therefore, we attempt to maintain cash and other liquid securities in sufficient amounts to manage our exposure to margin calls by lenders. The lender also has the right to change the required haircut at maturity of the repurchase agreement (if the term is renewed) which would require us to post additional collateral to the lender. The following table presents the weighted average minimum haircut contractually required by our counterparties for MBS pledged as collateral for our repurchase agreement borrowings as of the dates indicated:
 
March 31, 2018
 
December 31, 2017
 
September 30, 2017
 
June 30, 2017
 
March 31, 2017
Agency CMBS and RMBS
4.8
%
 
4.9
%
 
5.0
%
 
5.0
%
 
5.0
%
Non-Agency CMBS and RMBS
%
 
15.0
%
 
15.0
%
 
18.0
%
 
15.8
%
CMBS IO
13.7
%
 
14.6
%
 
15.0
%
 
15.0
%
 
15.3
%

The counterparties with whom we have the greatest amounts of equity at risk may vary significantly during any given period due to the short-term and generally uncommitted nature of the repurchase agreement borrowings. Equity at risk represents the potential loss to the Company if the counterparty is unable or unwilling to return collateral securing the repurchase agreement borrowing at its maturity. Please refer to Note 3 for information regarding counterparties with whom we have the greatest amount of equity at risk as of March 31, 2018.

The following table discloses our repurchase agreement amounts outstanding and the value of the related collateral pledged by geographic region of our counterparties as of the dates indicated:

44


 
March 31, 2018
 
December 31, 2017
($ in thousands)
Amount Outstanding
 
Market Value of Collateral Pledged
 
Amount Outstanding
 
Market Value of Collateral Pledged
North America
$
1,749,522


$
1,899,680

 
$
1,551,758

 
$
1,700,582

Asia
418,138


440,063

 
489,376

 
515,593

Europe
446,232


464,026

 
524,768

 
548,924

 
$
2,613,892

 
$
2,803,769

 
$
2,565,902

 
$
2,765,099


Certain of our repurchase agreement counterparties require us to comply with various operating and financial covenants. The financial covenants include, among other things, requirements that we maintain minimum shareholders' equity (usually a set minimum, or a percentage of the highest amount of shareholders' equity since the date of the agreement), limits on maximum decline in shareholders' equity (expressed as a percentage decline in any given period), and limits on maximum leverage (as a multiple of shareholders' equity). Operating requirements include, among other things, requirements to maintain our status as a REIT and to maintain our listing on the NYSE. Violations of one or more of these covenants could result in the lender declaring an event of default which would result in the termination of the repurchase agreement and immediate acceleration of amounts due thereunder. In addition, some of the agreements contain cross default features, whereby default with one lender simultaneously causes default under agreements with other lenders. Violations could also restrict us from paying dividends or engaging in other transactions that are necessary for us to maintain our REIT status.

We monitor and evaluate on an ongoing basis the impact these customary financial covenants may have on our operating and financing flexibility. Currently, we do not believe we are subject to any covenants that materially restrict our financing flexibility.

Derivative Instruments

We are party to certain types of financial instruments that are accounted for as derivative instruments including interest rate swaps, Eurodollar futures and long and short positions in TBA securities. Certain of these derivative instruments may require us to post initial margin at inception and daily variation margin based on subsequent changes in their fair value. The collateral posted as margin by us is typically in the form of cash or Agency MBS. In addition, counterparties may have to post variation margin to us. Generally, as interest rates decline, we will be required to post collateral with counterparties on our interest rate derivatives, and vice versa as interest rates increase. As of March 31, 2018 , we had cash of $58.3 million posted as collateral under these agreements.

As of March 31, 2018 , approximately $160 million of the Company’s interest rate swaps were entered into under bilateral agreements which contain cross-default provisions with other agreements between the parties. In addition, these bilateral agreements contain financial and operational covenants similar to those contained in our repurchase agreements, as described above. Currently, we do not believe we are subject to any covenants that materially restrict our hedging flexibility.
Our TBA contracts are subject to master securities forward transaction agreements published by the Securities Industry and Financial Markets Association as well as supplemental terms and conditions with each counterparty. Under the terms of these agreements, we may be required to pledge collateral to, or have the right to receive collateral from, our counterparties when initiated or in the event the fair value of our TBA contracts declines. Declines in the fair value of TBA contracts are generally related to such factors as rising interest rates, increases in expected prepayment speeds, or widening spreads. Our TBA contracts generally provide that valuations for our TBA contracts and any pledged collateral are to be obtained from a generally recognized source agreed to by both parties. However, in certain circumstances, our counterparties have the sole discretion to determine the value of the TBA contract and any pledged collateral. In such instances, our counterparties are required to act in good faith in making determinations of value. In the event of a margin call, we must generally provide additional collateral on the same business day.

Dividends

As a REIT, we are required to distribute to our shareholders amounts equal to at least 90% of our REIT taxable income for each taxable year after consideration of our tax NOL carryforwards. We generally fund our dividend distributions through our cash flows from operations. If we make dividend distributions in excess of our operating cash flows during the period, whether for purposes of meeting our REIT distribution requirements or other strategic reasons, those distributions are generally funded either through our existing cash balances or through the return of principal from our investments (either through repayment or sale). 


45


We have a net operating tax loss ("NOL") carryforward that we could use to offset our REIT taxable income distribution requirement. This NOL carryforward had an estimated balance of $89.8 million as of March 31, 2018 . We also have deferred tax hedge losses on terminated derivative instruments, which will be recognized over the original periods being hedged by those terminated derivatives. These losses have already been recognized in our GAAP earnings but will reduce taxable income over the next ten years as noted in the following table:
($ in thousands)
Tax Hedge Loss Deduction
2018
$
20,788

2019
17,155

2020
7,162

2021 - 2028
5,102

 
$
50,207


If any of the deferred tax hedge losses for the years noted in the table above result in dividend distributions to our shareholders in excess of REIT taxable income, the excess dividends distributed will be considered a return of capital to the shareholder. Approximately 100% of our common stock dividends declared during the three months ended March 31, 2018 will represent a return of capital to shareholders and not a distribution of REIT taxable income, principally as a result of the amount of the tax hedge loss deduction.

Contractual Obligations
 
The following table summarizes our contractual obligations by payment due date as of March 31, 2018 :
($ in thousands)
 
Payments due by period
Contractual Obligations:
 
Total
 
< 1 year
 
1-3 years
 
3-5 years
 
> 5 years
Repurchase agreements (1)
 
$
2,664,164

 
$
2,664,164

 
$

 
$

 
$

Non-recourse collateralized financing (2)
 
5,362

 
1,233

 
2,240

 
1,223

 
666

Operating lease obligations
 
438

 
107

 
331

 

 

Total
 
$
2,669,964

 
$
2,665,504

 
$
2,571

 
$
1,223

 
$
666

(1) Includes estimated interest payments calculated using interest rates in effect as of March 31, 2018 .
(2) Amounts shown are for principal only and exclude interest obligations as those amounts are not significant. Non-recourse collateralized financing represents securitization financing that is payable solely from loans and securities pledged as collateral. Payments due by period were estimated based on the principal repayments forecasted for the underlying loans and securities, substantially all of which is used to repay the associated financing outstanding.

Other Matters

As of March 31, 2018 , we do not believe that any off-balance sheet arrangements exist that are reasonably likely to have a material effect on our current or future financial condition, results of operations, or liquidity other than as discussed above. In addition, we do not have any material commitments for capital expenditures and have not obtained any commitments for funds to fulfill any capital obligations.

RECENT ACCOUNTING PRONOUNCEMENTS

There were no accounting pronouncements issued during the three months ended March 31, 2018 that are expected to have a material impact on the Company’s financial condition or results of operations.

FORWARD-LOOKING STATEMENTS
 
Certain written statements in this Quarterly Report on Form 10-Q that are not historical facts constitute “forward-looking statements” within the meaning of Section 27A of the 1933 Act and Section 21E of the Exchange Act. Statements in this report addressing expectations, assumptions, beliefs, projections, future plans and strategies, future events, developments that we expect or anticipate will occur in the future, and future operating results are forward-looking statements. Forward-looking statements are based upon management’s beliefs, assumptions, and expectations as of the date of this report regarding future events and operating performance, taking into account all information currently available to us, and are applicable only as of

46


the date of this report. Forward-looking statements generally can be identified by use of words such as “believe”, “expect”, “anticipate”, “estimate”, “plan” “may”, “will”, “intend”, “should”, “could” or similar expressions. We caution readers not to place undue reliance on our forward-looking statements, which are not historical facts and may be based on projections, assumptions, expectations, and anticipated events that do not materialize. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statement whether as a result of new information, future events, or otherwise.

Forward-looking statements in this Quarterly Report on Form 10-Q may include, but are not limited to statements about:

Our business and investment strategy including our ability to generate acceptable risk-adjusted returns and our target investment allocations;
Our views on conditions in the investment, credit, and derivatives markets;
Our views on the effect of actual or proposed actions of the U.S. Federal Reserve, the FOMC, or other central banks with respect to monetary policy (including the targeted Federal Funds Rate), and the potential impact of these actions on interest rates, inflation or unemployment;
The effect of regulatory initiatives of the Federal Reserve (including the FOMC), other financial regulators, and other central banks;
Our financing strategy including our target leverage ratios, our use of TBA dollar roll transactions, and anticipated trends in financing costs, and our hedging strategy including changes to the derivative instruments to which we are a party, and changes to government regulation of hedging instruments and our use of these instruments;
Our investment portfolio composition and target investments;
Our investment portfolio performance, including the fair value, yields, and forecasted prepayment speeds of our investments;
Our liquidity and ability to access financing, and the anticipated availability and cost of financing;
Our stock repurchase activity and the impact of stock repurchases;
Our use of and restrictions on using our tax NOL carryforward;
The status of pending litigation;
The competitive environment in the future, including competition for investments and the availability of financing;
Estimates of future interest expenses, including related to the Company’s repurchase agreements and derivative instruments;
The status and effect of legislative reforms and regulatory rule-making or review processes, and the status of reform efforts and other business developments in the repurchase agreement financing market;
Market, industry and economic trends, and how these trends and related economic data may impact the behavior of market participants and financial regulators; and
Market interest rates and market spreads.

Forward-looking statements are inherently subject to risks, uncertainties and other factors that could cause our actual results to differ materially from historical results or from any results expressed or implied by such forward-looking statements. Not all of these risks and other factors are known to us. New risks and uncertainties arise over time, and it is not possible to predict those events or how they may affect us. The projections, assumptions, expectations or beliefs upon which the forward-looking statements are based can also change as a result of these risks or other factors. If such a risk or other factor materializes in future periods, our business, financial condition, liquidity and results of operations may vary materially from those expressed or implied in our forward-looking statements.

While it is not possible to identify all factors that may cause actual results to differ from historical results or from any results expressed or implied by forward-looking statements, or that may cause our projections, assumptions, expectations or beliefs to change, some of those factors include the following:

the risks and uncertainties referenced in this Quarterly Report on Form 10-Q , particularly those set forth under and incorporated by reference into Part II, Item 1A, “Risk Factors”;

47


our ability to find suitable reinvestment opportunities;
changes in domestic economic conditions;
changes in interest rates and interest rate spreads, including the repricing of interest-earning assets and interest-bearing liabilities;
our investment portfolio performance particularly as it relates to cash flow, prepayment rates and credit performance;
the impact on markets and asset prices from the Federal Reserve’s balance sheet normalization process through the reduction in its holdings of Agency RMBS and U.S. Treasuries;
actual or anticipated changes in Federal Reserve monetary policy or the monetary policy of other central banks;
adverse reactions in U.S. financial markets related to actions of foreign central banks or the economic performance of foreign economies including in particular China, Japan, the European Union, and the United Kingdom;
uncertainty concerning the long-term fiscal health and stability of the United States;
the cost and availability of financing, including the future availability of financing due to changes to regulation of, and capital requirements imposed upon, financial institutions;
the cost and availability of new equity capital;
changes in our use of leverage;
changes to our investment strategy, operating policies, dividend policy or asset allocations;
the quality of performance of third-party servicer providers of our loans and loans underlying our securities;
the level of defaults by borrowers on loans we have securitized;
changes in our industry;
increased competition;
changes in government regulations affecting our business;
changes or volatility in the repurchase agreement financing markets and other credit markets;
changes to the market for interest rate swaps and other derivative instruments, including changes to margin requirements on derivative instruments;
uncertainty regarding continued government support of the U.S financial system and U.S. housing and real estate markets; or to reform the U.S. housing finance system including the resolution of the conservatorship of Fannie Mae and Freddie Mac;
the composition of the Board of Governors of the Federal Reserve System;
ownership shifts under Section 382 that further limit the use of our tax NOL carryforward; and
exposure to current and future claims and litigation.

48


ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk is the exposure to losses resulting from changes in market factors. Our business strategy exposes us to a variety of market risks, including interest rate, spread, prepayment, reinvestment, credit, and liquidity risks. These risks can and do cause fluctuations in our comprehensive income and book value as discussed below.

Interest Rate Risk

Investing in interest-rate sensitive investments such as MBS and TBA securities subjects us to interest rate risk. Interest rate risk results from investing in securities that have a fixed coupon or when the coupon may not immediately adjust for changes in interest rates. Interest rate risk also results form the mismatch between the duration of our assets versus the duration of our liabilities and hedges.

The measures of an instrument’s price sensitivity to interest rate fluctuations are its duration and convexity. Duration measures the percentage change in projected market value of our investments and derivative instruments given a change in interest rates. The duration of RMBS and TBA securities tend to increase when interest rates rise and decrease when interest rates fall, which is commonly referred to as negative convexity. This occurs because prepayments of the mortgage loans underlying the RMBS tend to decline when interest rates rise (which extends the life of the security) and increase when interest rates fall (which shortens the life of the security). The fair value of TBA securities react similarly to RMBS to changes in interest rates as they are based on an underlying non-specified pool of fixed-rate RMBS securities. CMBS and CMBS IO, however, generally have little convexity because the mortgage loans underlying the securities contain some form of prepayment protection provision (such as prepayment lock-outs) or prepayment compensation provisions (such as yield maintenance or prepayment penalties) which create an economic disincentive for the loans to prepay.

We attempt to manage our exposure to changes in interest rates that results from the duration mismatch between our assets and liabilities by entering into interest rate swaps and other instruments to hedge this risk. We manage interest rate risk within tolerances set by our Board of Directors. Our portfolio duration changes based on the composition of our investment portfolio and our hedge positions as well as market factors. We calculate our portfolio duration based on model projected cash flows, and such calculated duration can be an imprecise measure of actual interest rate risk. In the case of Agency RMBS and TBA securities, the primary input to the calculated duration is the anticipated prepayment speed of the underlying mortgage loans, which is sensitive to future interest rates and borrowers’ behavior. Estimates of prepayment speeds can vary significantly by investor for the same security and therefore estimates of security and portfolio duration can vary significantly.

During a period of rising interest rates (particularly short term rates in a flattening yield curve environment), normally our borrowing costs will increase faster than our asset yields, negatively impacting our net interest income. The amount of the impact will depend on the composition of our portfolio, our hedging strategy, the effectiveness of our hedging instruments as well as the magnitude and the duration of the increase in interest rates. In addition, our adjustable-rate Agency RMBS reset based on one-year LIBOR and have limits or caps on the initial, aggregate, or periodic amount that an interest rate may reset while our liabilities do not have interest rate reset caps.

As of March 31, 2018 , we had a positive net duration gap in our investment portfolio, which means our liabilities mature or reset sooner than our investments, and we had not fully hedged this difference. Therefore, increases in interest rates, particularly rapid increases, will negatively impact the market value of our investments, thereby reducing our book value. The table below shows the projected sensitivity of our net interest income and net periodic interest costs on our interest rate swaps; the projected sensitivity of the market value of our investments and derivative instruments (including TBA securities); and the percentage change in shareholders’ equity as they existed as of the dates indicated based on an instantaneous parallel shift in market interest rates as set forth in the table below. In light of the low interest rate environment at March 31, 2018 , the only declining rate scenario that we present is a downward shift of 50 basis points.

Changes in types of our investments, the returns earned on these investments, future interest rates, credit spreads, the shape of the yield curve, the availability of financing, and/or the mix of our investments and financings including derivative instruments may cause actual results to differ significantly from the modeled results. There can be no assurance that assumed events used for the model below will occur, or that other events will not occur, that will affect the outcomes; therefore, the tables below and all related disclosures constitute forward-looking statements.

49


 
 
March 31, 2018
 
December 31, 2017
 
 
Percentage Change in
 
Percentage Change in
Parallel Shift in Interest Rates
 
Market Value of Investments (1)
 
Shareholders’ Equity
 
Net Interest Income and Net Periodic Interest Costs (2)
 
Market Value of Investments (1)
 
Shareholders’ Equity
 
Net Interest Income and Net Periodic Interest Costs (2)
+100
 
(1.5
)%
 
(8.4
)%

(6.5
)%
 
(1.7
)%
 
(10.0
)%
 
(8.1
)%
+50
 
(0.6
)%
 
(3.3
)%
 
(2.9
)%
 
(0.7
)%
 
(4.0
)%
 
(3.2
)%
-50
 
0.2
 %
 
1.0
 %
 
1.2
 %
 
0.3
 %
 
1.8
 %
 
0.7
 %
(1)
Includes changes in market value of our investments and derivative instruments, including TBA securities, but excludes changes in market value of our financings because they are not carried at fair value on our balance sheet. The projections for market value do not assume any change in credit spreads.
(2)
Includes changes in net interest income as well as net periodic interest costs on our interest rate swaps recorded in “gain (loss) on derivatives instruments, net”.

During the first quarter of 2018, we increased the net duration of our interest rate swaps in order to reduce our exposure to the impact of higher interest rates on shareholders’ equity, net interest income, and net periodic interest costs as shown in the table above. The weighted-average remaining life of our interest rate swaps was 4.5 years as of March 31, 2018 compared to 3.1 years as of December 31, 2017.
Management also considers changes in the shape of the interest rate curves in assessing and managing portfolio interest rate risk. Often interest rates do not move in a parallel fashion from quarter to quarter. The table below shows the percentage change in projected market value of our investment portfolio net of derivative instruments for instantaneous changes in the shape of the U.S. Treasury (“UST”) curve (with similar changes to the interest rate swap curves) as of the dates indicated:
 
 
March 31, 2018
 
December 31, 2017
Basis Point Change in
 
Percentage Change in
2-year UST
 
10-year UST
 
Market Value of Investments (1)
 
Shareholders’ Equity
 
Market Value of Investments (1)
 
Shareholders’ Equity
+25
 
+50
 
(0.3
)%
 
(1.9
)%
 
(0.5
)%
 
(3.0
)%
+25
 
+0
 
(0.2
)%
 
(1.1
)%
 
(0.2
)%
 
(0.9
)%
+50
 
+25
 
(0.4
)%
 
(2.5
)%
 
(0.5
)%
 
(2.8
)%
+50
 
+100
 
(1.0
)%
 
(5.6
)%
 
(1.3
)%
 
(7.7
)%
-10
 
-50
 
(0.1
)%
 
(0.6
)%
 
0.1
 %
 
0.8
 %
(1)
Includes changes in market value of our investments and derivative instruments, including TBA securities, but excludes changes in market value of our financings because they are not carried at fair value on our balance sheet. The projections for market value do not assume any change in credit spreads.



50


Spread Risk

Spread risk is the risk of loss from an increase in the market spread between the yield on an investment versus its benchmark index. Changes in market spreads represent the market's valuation of the perceived riskiness of an asset relative to risk-free rates, and widening spreads reduce the market value of our investments as market participants require additional yield to hold riskier assets. Market spreads could change based on macroeconomic or systemic factors as well as the factors specific to a particular security such as prepayment performance or credit performance. Other factors that could impact credit spreads include technical issues such as supply and demand for a particular type of security or FOMC monetary policy. Likewise, most of our investments are fixed-rate or reset in rate over a period of time, and as interest rates rise, we would expect the market value of these investments to decrease.

Fluctuations in spreads typically vary based on the type of investment. Sensitivity to changes in market spreads is derived from models that are dependent on various assumptions, and actual changes in market value in response to changes in market spreads could differ materially from the projected sensitivity if actual conditions differ from these assumptions.

The table below is an estimate of the percentage change in projected market value of our investments (including TBA securities) given the indicated change in market spreads as of the dates indicated:
Basis Point Change in Market Spreads
 
Percentage Change in Projected
Market Value of Investments
 
 
March 31, 2018
 
December 31, 2017
+50
 
(3.2
)%
 
(3.1
)%
+25
 
(1.2
)%
 
(1.1
)%
-25
 
1.9
 %
 
1.6
 %
-50
 
3.7
 %
 
3.2
 %

Prepayment and Reinvestment Risk

Prepayment risk is the risk of an early, unscheduled return of principal on an investment. We are subject to prepayment risk from premiums paid on investments, which are amortized as a reduction in interest income using the effective yield method under GAAP. Principal prepayments on our investments are influenced by changes in market interest rates and a variety of economic, geographic, government policy, and other factors beyond our control.

Loans underlying our CMBS and CMBS IO securities typically have some form of prepayment protection provisions (such as prepayment lock-outs) or prepayment compensation provisions (such as yield maintenance or prepayment penalties). Yield maintenance and prepayment penalty requirements are intended to create an economic disincentive for the loans to prepay; however, the amount of the prepayment penalty required to be paid may decline over time, and as loans age, interest rates decline, or market values of collateral supporting the loans increase, prepayment penalties may lessen as an economic disincentive to the borrower. Generally, our experience has been that prepayment lock-out and yield maintenance provisions result in stable prepayment performance from period to period. There are no prepayment protections, however, if the loan defaults and is partially or wholly repaid earlier as a result of loss mitigation actions taken by the underlying loan servicer. Historically, we have experienced low default rates on loans underlying CMBS and CMBS IO.

Because CMBS IO consist of rights to interest on the underlying commercial mortgage loan pools and do not have rights to principal payments on the underlying loans, prepayment risk on these securities would be particularly acute without these prepayment protection provisions. CMBS IO prepayment protection and compensation provisions vary by issuer of the security (i.e. Freddie Mac, Fannie Mae, Ginnie Mae, or non-Agency). The majority of our Agency CMBS IO are issued by Freddie Mac and these securities generally have initial prepayment lock-outs followed by a defeasance period which on average extends to within six months of the stated maturities of the underlying loans. Non-Agency CMBS IO generally have prepayment protection in the form of prepayment lock-outs and defeasance provisions. The following table details the fair value of our CMBS IO portfolio by issuer as of the end of the periods indicated:

51


($ in thousands)
March 31, 2018
 
December 31, 2017
Fannie Mae
$
9,799

 
$
10,419

Freddie Mac
352,286

 
369,886

Non-Agency CMBS IO
296,184

 
312,216

 
$
658,269

 
$
692,521


Prepayments on the loans underlying our RMBS generally accelerate in a declining interest rate environment, as the loans age, and, with respect to ARMS, as the loans near their respective interest rate reset dates, particularly the initial reset date, or if expectations are that interest rates will rise in the future. Our prepayment models anticipate an acceleration of prepayments in these events. To the extent the actual prepayments exceed our modeled prepayments, or, with respect to adjustable-rate RMBS, if we change our future prepayment expectations, we will record adjustments to our premium amortization which may negatively impact our net interest income. In addition, changes in market expectations of prepayments could impact the fair value of our RMBS.

We seek to manage our prepayment risk on our MBS by diversifying our investments, seeking investments which we believe will have superior prepayment performance, and investing in securities which have some sort of prepayment prohibition or yield maintenance (as is the case with CMBS and CMBS IO). With respect to RMBS, when we invest in RMBS at a premium to the security’s par value, we tend to favor securities in which we believe the underlying borrowers have some disincentive to refinance as a result of the size of each loan’s principal balance, credit characteristics of the borrower, or geographic location of the property, among other factors.

We are also subject to reinvestment risk as a result of the prepayment, repayment and sales of our investments. In order to maintain our investment portfolio size and our earnings, we need to reinvest capital received from these events into new interest-earning assets or TBA securities. If we are unable to find suitable reinvestment opportunities or if yields on assets in which we reinvest are lower than yields on existing assets, our results and cash flows could be negatively impacted. In addition, based on market conditions, our leverage, and our liquidity profile, we may decide to not reinvest the cash flows we receive from our investment portfolio even when attractive reinvestment opportunities are available, or we may decide to reinvest in assets with lower yield but greater liquidity. If we retain capital or pay dividends to return capital to shareholders rather than reinvest capital, or if we invest capital in lower yielding assets for liquidity reasons, the size of our investment portfolio and the amount of income generated by our investment portfolio will likely decline.
 
Credit Risk

Credit risk is the risk that we will not receive all contractual amounts due on investments that we own due to default by the borrower or due to a deficiency in proceeds from the liquidation of the collateral securing the obligation. Agency RMBS and Agency CMBS have credit risk to the extent that Fannie Mae or Freddie Mac fails to remit payments on the MBS for which they have issued a guaranty of payment. Given the improved financial performance and conservatorship of these entities and the continued support of the U.S. government, we believe this risk is low. Since Agency CMBS IO represent the right to excess interest and not principal on the underlying loans, these securities are exposed to the loss of investment basis in the event a loan collateralizing the security liquidates without paying yield maintenance or prepayment penalty, which typically occurs when an involuntarily liquidating loan repays all or a portion of its related principal balance.

We are exposed to credit risk on our non-Agency securities and we attempt to mitigate our credit risk through asset selection and by purchasing higher quality non-Agency MBS. Our non-Agency MBS are typically investment grade rated securities which we believe will have strong credit performance. We do not currently seek to purchase heavily discounted, credit sensitive MBS. The majority of our non-Agency securities are CMBS and CMBS IO and the return we earn on these securities is dependent on the credit performance of the underlying commercial loans. In particular, since investments in CMBS IO pay interest from the underlying commercial mortgage loan pools, returns generally are more negatively impacted by liquidations of loans in the underlying loan pool. Please refer to “Financial Condition-Repurchase Agreements” within Part I, Item 2 of this Quarterly Report on Form 10-Q for information regarding the credit ratings on our non-Agency MBS.


52


  Liquidity Risk

We have liquidity risk principally from the use of recourse repurchase agreements to finance our ownership of securities. In general, our repurchase agreements provide a source of uncommitted short-term financing for longer-term assets, thereby creating a mismatch between the maturities of the asset and the associated financing. Our repurchase agreements are renewable at the discretion of our lenders and do not contain guaranteed roll-over terms. If we fail to repay the lender at maturity, the lender has the right to immediately sell the collateral and pursue us for any shortfall if the sales proceeds are inadequate to cover the repurchase agreement financing. In addition, declines in the market value of our investments pledged as collateral for repurchase agreement borrowings may result in counterparties initiating margin calls for additional collateral.

Our use of TBA long positions as a means of investing in and financing Agency RMBS also exposes us to liquidity risk in the event that we are unable to roll or terminate our TBA contracts prior to their settlement date. If we are unable to roll or terminate our TBA long positions, we could be required to take physical delivery of the underlying securities and settle our obligations for cash, which could negatively impact our liquidity position or force us to sell assets under adverse conditions if financing is not available to us on acceptable terms.

For further information, including how we attempt to mitigate liquidity risk and monitor our liquidity position, please refer to “Liquidity and Capital Resources” in Part I, Item 2 of this Quarterly Report on Form 10-Q .

ITEM 4.
CONTROLS AND PROCEDURES
Disclosure controls and procedures.

Our management evaluated, with the participation of our Principal Executive Officer and Principal Financial Officer, the effectiveness of our disclosure controls and procedures, as defined in Exchange Act Rule 13a-15(e), as of the end of the period covered by this report. Based on that evaluation, our Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures were effective as of March 31, 2018 to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Principal Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

Changes in internal control over financial reporting.

Our management is also responsible for establishing and maintaining adequate internal control over financial reporting as defined in Exchange Act Rule 13a-15(f). There were no changes in our internal control over financial reporting during the three months ended March 31, 2018 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



53


PART II.
OTHER INFORMATION
ITEM 1.
LEGAL PROCEEDINGS
On May 7, 2018, the litigation pending in the United States District Court for the Northern District of Texas against the Company and DCI Commercial, Inc. (“DCI”), a former affiliate of the Company and formerly known as Dynex Commercial, Inc., as discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 (the “Suit”), was dismissed. Plaintiffs alleged, among other things, fraudulent transfer of DCI assets to the Company and that DCI and the Company were a single enterprise. The Court found that Plaintiffs’ allegations as it relates to the single enterprise claims were conclusory and merely support a legal conclusion without alleging particular supporting facts. The Court also found that Plaintiffs’ allegations as it relates to fraudulent transfers did not sufficiently allege facts to enable the Court to draw reasonable inference that the Company or DCI acted with constructive or actual fraudulent intent. The Court has granted Plaintiffs 28 days to file an amended complaint.

The Company believes that the Suit against it is baseless and without merit and, if Plaintiffs file an amended complaint, intends to continue to defend itself vigorously in this action. The Company believes, based upon information currently available, that the Suit will be resolved without a material adverse effect on the Company’s consolidated financial statements as a whole. The outcome, however, of any legal proceeding, including the Suit, cannot be predicted with certainty. As such, no assurances can be given that the Company will be successful in its defense of this action on the merits or otherwise. If the Company is not successful in its defense efforts, the resolution of this matter could have a material adverse effect on the Company’s consolidated financial statements as a whole in a given future reporting period.

Other than as described above, to the Company’s knowledge, there are no threatened legal proceedings, which, in management’s opinion, individually or in the aggregate, would have a material adverse effect on the Company’s results of operations or financial condition. The garnishment action related to DCI, discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, is ongoing.



54


ITEM 1A.    RISK FACTORS

Risks and uncertainties identified in our forward-looking statements contained in this Quarterly Report on Form 10-Q together with those previously disclosed in the Annual Report on Form 10-K for the year ended December 31, 2017 or those that are presently unforeseen could result in significant adverse effects on our financial condition, results of operations and cash flows.  See “Forward-Looking Statements” contained in Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” within this Quarterly Report on Form 10-Q as well as Part I, Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2017.

ITEM 2.    UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Issuer Purchases of Equity Securities

The Company has been authorized by its Board of Directors to repurchase up to $40 million of its outstanding shares of common stock through December 31, 2018. Subject to applicable securities laws and the terms of the Series A Preferred Stock designation and the Series B Preferred Stock designation, both of which are contained in our Articles of Incorporation, future repurchases of common stock will be made at times and in amounts as the Company deems appropriate, provided that the repurchase price per share is less than the Company's estimate of the current net book value of a share of common stock. Repurchases may be suspended or discontinued at any time. During the three months ended March 31, 2018 , the Company did not repurchase any shares of common stock under this repurchase authorization.

The following table summarizes repurchases of our common stock that occurred during the three months ended March 31, 2018 :
 
Total Number of Shares Purchased (1)
 
Average Price Paid per Share
 
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs
 
Maximum Number (or Approximate Dollar Value) of Shares that May Yet Be Purchased Under the Plans or Programs
 
 
 
 
 
 
 
(in thousands)
January 1, 2018 - January 31, 2018

 
$

 

 
$
8,518

February 1, 2018 - February 28, 2018
57,135

 

 

 
8,518

March 1, 2018 - March 31, 2018

 
$

 

 
8,518

Total
57,135

 
$

 

 
 
(1)
These shares were withheld from certain employees to satisfy tax withholding obligations arising upon the vesting of restricted shares. Accordingly, these shares are not included in the calculation of approximate dollar value of shares that may yet be purchased under the $40 million repurchase plan authorized by the Company's Board of Directors.

ITEM 3.    DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4.    MINE SAFETY DISCLOSURES
        
None.

ITEM 5.    OTHER INFORMATION

None.


55


ITEM 6.    EXHIBITS

Exhibit No.
Description
3.1
3.2
10.28
12.1
31.1

31.2

32.1
101
The following materials from Dynex Capital, Inc.'s Quarterly Report on Form 10-Q for the three months ended March 31, 2018, formatted in XBRL (Extensible Business Reporting Language), filed herewith: (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Comprehensive Income (Loss), (iii) Consolidated Statements of Shareholders’ Equity, (iv) Consolidated Statements of Cash Flows, and (v) Notes to Unaudited Consolidated Financial Statements.


56


SIGNATURES
 

Pursuant to the requirements 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.
 
 
 
 
 
 
Date:
May 8, 2018
/s/ Byron L. Boston
 
 
Byron L. Boston
 
 
Chief Executive Officer, President,
 
 
Co-Chief Investment Officer, and Director
 
 
(Principal Executive Officer)
 
 
 
Date:
May 8, 2018
/s/ Stephen J. Benedetti
 
 
Stephen J. Benedetti
 
 
Executive Vice President, Chief Financial Officer and Chief Operating Officer
 
 
(Principal Financial Officer)




Exhibit 3.2
 
 
 
 
AMENDED AND RESTATED BYLAWS
 
OF
 
DYNEX CAPITAL, INC.,
a Virginia corporation
 

Adopted as of March 12, 2018
 





TABLE OF CONTENTS
 
 
 
Page No.

 
 
 
ARTICLE I
 
 
 
Offices and Fiscal Year
 
 
 
SECTION 1.01
Principal Office
1

SECTION 1.02
Other Offices
1

SECTION 1.03
Fiscal Year
1

 
 
 
ARTICLE II
 
 
 
Meetings of Shareholders
 
 
 
SECTION 2.01
Places of Meeting
1

SECTION 2.02
Annual Meetings
1

SECTION 2.03
Special Meetings
1

SECTION 2.04
Notice of Meetings
2

SECTION 2.05
Quorum, Manner of Acting and Adjournment
2

SECTION 2.06
Organization
3

SECTION 2.07
Voting
4

SECTION 2.08
Voting Lists
4

SECTION 2.09
Judges of Election
5

SECTION 2.10
Determination of Shareholders of Record
5

SECTION 2.11
Consent of Shareholders in Lieu of Meeting
6

SECTION 2.12
Order of Business
6

 
 
 
ARTICLE III
 
 
 
Board of Directors
 
 
 
SECTION 3.01
Powers
7

SECTION 3.02
Number, Election and Term
7

SECTION 3.03
Resignations
9

SECTION 3.04
Removal
10

SECTION 3.05
Committees of the Board
10

SECTION 3.06
Meetings of the Board of Directors
11

SECTION 3.07
Quorum and Voting
12

SECTION 3.08
Organization
12

SECTION 3.09
Meeting by Conference Telephone
13

SECTION 3.10
Action Without Meeting
13

SECTION 3.11
Compensation of Directors
13

SECTION 3.12
Investment Policies
13

 
 
 
ARTICLE IV
 
 
 
Notice - Waivers - Meetings
 
 
 
SECTION 4.01
What Constitutes Notice
14

SECTION 4.02
Waiver of Notice
14

 
 
 

i    



ARTICLE V
 
 
 
Officers
 
 
 
SECTION 5.01
Number, Qualifications and Designation
14

SECTION 5.02
Election and Term of Office
15

SECTION 5.03
Subordinate Officers, Committees and Agents
15

SECTION 5.04
Resignations
15

SECTION 5.05
Removal
15

SECTION 5.06
Vacancies
15

SECTION 5.07
General Powers
16

SECTION 5.08
The Chairman and Vice Chairman of the Board
16

SECTION 5.09
The President
16

SECTION 5.10
The Vice Presidents
16

SECTION 5.11
The Secretary
16

SECTION 5.12
The Treasurer
17

SECTION 5.13
Officers’ Bonds
17

SECTION 5.14
Salaries
17

 
 
 
ARTICLE VI
 
 
 
Capital Stock
 
 
 
SECTION 6.01
Shares of Stock
17

SECTION 6.02
Stolen, Lost or Destroyed Certificates
19

SECTION 6.03
Transfer Agents and Registrars
19

SECTION 6.04
Transfer of Stock
20

SECTION 6.05
Registered Shareholders
21

SECTION 6.06
Regulations
21

 
 
 
ARTICLE VII
 
 
 
Miscellaneous
 
 
 
SECTION 7.01
Corporate Seal
21

SECTION 7.02
Checks
21

SECTION 7.03
Contracts
21

SECTION 7.04
Deposits
21

SECTION 7.05
Corporate Records
22

SECTION 7.06
Amendment of Bylaws
22

SECTION 7.07
Exclusive Forum
22






ARTICLE I

Offices and Fiscal Year
SECTION 1.01     Principal Office . The principal office of the Corporation shall be located at 4991 Lake Brook Drive, Suite 100, Glen Allen, Virginia 23060, until otherwise established by a vote of a majority of the Board of Directors.
SECTION 1.02     Other Offices . The Corporation also may have offices at such places within or without the Commonwealth of Virginia as the Board of Directors may from time to time designate or the business of the Corporation may require.
SECTION 1.03     Fiscal Year . The fiscal year of the Corporation shall begin on the first day of January and end on the 31st day of December.
ARTICLE II
Meetings of Shareholders
SECTION 2.01     Places of Meeting . All meetings of the shareholders of the Corporation shall be held at such place, either within or without the Commonwealth of Virginia, as from time to time may be fixed by the President or by the Board of Directors in the notice of such meeting.
SECTION 2.02     Annual Meetings . The President or the Board of Directors may fix the date and time of the annual meeting of the shareholders, but if no such date and time is fixed by the President or the Board of Directors, the meeting for any calendar year shall be held on the fourth Monday in April in such year, if not a legal holiday under the laws of Virginia, and, if a legal holiday, then on the next succeeding business day, at 10:00 a.m., and at such meeting the shareholders then entitled to vote shall elect directors and shall transact such other business as  may properly be brought before the meeting. Failure to hold an annual meeting does not invalidate the Corporation’s existence or affect any otherwise valid corporate acts.
SECTION 2.03     Special Meetings . Special meetings of the shareholders of the Corporation for any purpose or purposes may be called at any time by the President, the Chairman of the Board of Directors, by a majority of the Board of Directors, by a majority of the Independent Directors (as defined in Section 3.02 hereof), or by

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shareholders entitled to cast at least twenty-five percent (25%) of the votes which all shareholders are entitled to cast at the particular meeting.
At any time, upon the written request of any person or persons who have duly called a special meeting, which written request shall state the object of the meeting, it shall be the duty of the Secretary to fix the date of the meeting to be held at such date and time as the Secretary may fix, not less than ten nor more than sixty days after the receipt of the request, and to give due notice thereof. If the Secretary shall neglect or refuse to fix the date and time of such meeting and give notice thereof, the person or persons calling the meeting may do so.
SECTION 2.04     Notice of Meetings . Written notice of every meeting of the shareholders, whether annual or special, shall be given to each shareholder of record entitled to vote at the meeting, at least ten and not more than sixty days prior to the day named for the meeting, except that notice of a meeting of shareholders to act on an amendment to the Articles of Incorporation, a plan of merger or share exchange, a proposed sale of assets pursuant to Va. Code § 13.1-724, or the dissolution of the Corporation shall be given not less than twenty-five nor more than sixty days prior to the day named for the meeting. Every notice of a special meeting shall state briefly the purpose or purposes thereof, and no business, other than that specified in such notice and matters germane thereto, shall be transacted at any special meeting without further notice to shareholders not present in person or by proxy.
Whenever the language of a proposed resolution is included in a written notice of a meeting of shareholders, the resolution may be adopted at such meeting with such clarifying or other amendments as do not enlarge its original purpose without further notice to shareholders not present in person or by proxy.
SECTION 2.05     Quorum, Manner of Acting and Adjournment . The presence in person or by proxy of shareholders entitled to cast a majority of the votes which all shareholders are entitled to cast on the particular matter shall constitute a quorum for the purpose of considering such matter. The shareholders present in person or by proxy at a duly organized meeting can continue to do business until adjournment, notwithstanding the withdrawal of enough shareholders from the meeting so that less than a quorum remains.
In the absence of a quorum or for any other reason, the chairman of the meeting or the Board of Directors or the shareholders present in person or by proxy acting by a majority vote and without notice other than by announcement

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at the meeting may adjourn the meeting from time to time but not for a period exceeding 120 days after the original meeting date.
Except as otherwise specified in the Articles of Incorporation or these Bylaws or provided by applicable law, at a duly organized meeting at which a quorum is present in person or by proxy, action on any matter (other than the election of directors) is approved by the shareholders if the votes cast favoring the matter exceed the votes cast opposing the matter.
SECTION 2.06     Organization . Every meeting of shareholders shall be conducted by a director or officer of the Corporation appointed by the Board of Directors or the Chairman of the Board to be chairman of the meeting or, in the absence of such appointment, by the Chairman of the Board or, in the case of a vacancy in the office or absence of the Chairman of the Board, by one of the following officers present at the meeting in the order stated: the Vice Chairman of the Board, if there be one, the President, the Vice Presidents in their order of rank and seniority, or, in the absence of such officers, a chairman chosen by the shareholders by the vote of a majority of the votes cast by shareholders present in person or by proxy. The Secretary, or, in the Secretary’s absence, an assistant secretary, or in the absence of both the Secretary and assistant secretaries, an individual appointed by the Board of Directors or, in the absence of such appointment, an individual appointed by the chairman of the meeting shall act as secretary. In the event that the Secretary presides as chairman at a meeting of shareholders, an assistant secretary, or in the absence of an assistant secretary, an individual appointed by the Board of Directors or the chairman of the meeting, shall record the minutes of the meeting.
At any meeting of shareholders of the Corporation, the chairman of the meeting shall have the right and authority to prescribe such rules, regulations and procedures and to do all such acts and things as are necessary or desirable for the proper conduct of the meeting, including, without limitation, the establishment of procedures for the dismissal of business not properly presented, the maintenance of order and safety, limitations on the time allotted to questions or comments on the affairs of the Corporation, restrictions on entry to such meeting after the time prescribed for the commencement thereof and the opening and closing of the voting polls. Unless otherwise determined by the chairman of the meeting, meetings of shareholders shall not be required to be held in accordance with the rules of parliamentary procedure. This Section 2.06 shall not limit the right of shareholders to speak at meetings of shareholders on matters germane to the Corporation’s business, subject to any rules for the orderly conduct of the meeting imposed by the chairman of the meeting.

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SECTION 2.07     Voting . Every shareholder entitled to vote at a meeting of shareholders or to express consent or dissent to corporate action in writing without a meeting may authorize another person or persons to act for him by proxy. Every proxy shall be executed in writing by the shareholder or by his duly authorized attorney-in-fact and filed with the Secretary of the Corporation. A proxy, unless coupled with an interest, shall be revocable at will, notwithstanding any other agreement or any provision in the proxy to the contrary, but the revocation of a proxy shall not be effective until notice thereof has been given to the Secretary. No unrevoked proxy shall be valid after eleven months from the date of its execution, unless a longer time is expressly provided therein. A proxy shall not be revoked by the death or incapacity of the maker unless, before the authority is exercised, written notice of such death or incapacity is given to the Secretary. A shareholder shall not sell his vote or execute a proxy to any person for any sum of money or anything of value.
Except as provided in Article III of the Articles of Incorporation, each shareholder of record, except the holder of shares which have been called for redemption and with respect to which an irrevocable deposit of funds has been made, shall have the right, at every shareholder meeting, to one vote for every share, and to a fraction of a vote equal to every fractional share.
SECTION 2.08     Voting Lists . After the Board of Directors fixes a record date for a shareholder meeting, the officer or agent of the Corporation having charge of the share transfer books of the Corporation shall prepare an alphabetical list of the shareholders entitled to notice of such meeting. The shareholders’ list for notice shall be available for inspection by any shareholder beginning two business days after notice of the meeting is given for which the list was prepared and continuing through the meeting, at the Corporation’s principal office or at a place identified in the meeting notice in the county or city where the meeting shall be held. Such shareholders’ list shall be arranged by voting group, and within each voting group by class or series of shares, and show the address of and number of shares held by each shareholder. In the event the Board of Directors has fixed a different record date to determine which shareholders are entitled to vote at such meeting, a shareholders’ list for voting, prepared in the same manner as the shareholders’ list for notice, shall be similarly available for inspection promptly after the record date for voting. The Corporation shall make the list of shareholders entitled to vote available at the meeting, and any shareholder, or the shareholder’s agent or attorney, is entitled to inspect the list at any time during the meeting or any adjournment.

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The original share transfer books, or a duplicate thereof, shall be prima facie evidence as to who are the shareholders entitled to examine such list or to vote, in person or by proxy, at any meeting of shareholders.
SECTION 2.09     Judges of Election . The vote upon any matter, including the election of directors, need not be by ballot. In advance of any meeting of shareholders the Board of Directors may appoint judges of election, who need not be shareholders, to act at such meeting or any adjournment thereof. If judges of election are not so appointed, the chairman of any such meeting may, and upon the demand of any shareholder or his proxy at the meeting and before voting begins shall, appoint judges of election. The number of judges shall be either one or three, as determined, in the case of judges appointed upon demand of a shareholder, by shareholders present entitled to cast a majority of the votes which all shareholders present are entitled to cast thereon. No person who is a candidate for office shall act as a judge. In case any person appointed as judge fails to appear or fails or refuses to act, the vacancy may be filled by appointment made by the Board of Directors in advance of the convening of the meeting, or at a meeting by the chairman of the meeting.
If judges of election are appointed as aforesaid, they shall determine the number of shares outstanding and the voting power of each, the shares represented at the meeting, the existence of a quorum, the authenticity, validity and effect of proxies, receive votes or ballots, hear and determine all challenges and questions in any way arising in connection with the right to vote, count and tabulate all votes, determine the result, and do such acts as may be proper to conduct the election or vote with fairness to all shareholders. If there be three judges of election, the decision, act or certificate of a majority shall be effective in all respects as the decision, act or certificate of all.
On request of the chairman of the meeting or of any shareholder or his proxy, the judges shall make a report in writing of any challenge or question or matter determined by them and execute a certificate of any fact found by them.
SECTION 2.10     Determination of Shareholders of Record . The Board of Directors may fix a date, not more than seventy nor less than ten days preceding the date of any meeting of shareholders, and not more than seventy days preceding the date fixed for the payment of any dividend or distribution, or the date for the allotment of rights, or the date when any change or conversion or exchange of shares will be made or go into effect, as a record date for the determination of the shareholders entitled to notice of, or to vote at, any such meeting, or entitled to receive any such

5



allotment of rights, or to exercise the rights in respect to any such change, conversion or exchange of shares; and in such case, if otherwise entitled to notice of, or to vote at, such meeting, or to receive payment of such dividend or distribution or to receive such allotment of rights, or exercise such rights, as the case may be, notwithstanding any transfer of any shares on the books of the Corporation after any such record date fixed as aforesaid.
Unless a record date is fixed by the Board of Directors for such purpose, transferees of shares which are transferred on the books within ten days next preceding the date of such meeting shall not be entitled to notice of, or to vote at, such meeting.
SECTION 2.11     Consent of Shareholders in Lieu of Meeting . Any action which may be taken at a meeting of the shareholders or a class of shareholders of the Corporation may be taken without a meeting if a consent or consents in writing, setting forth the actions so taken, shall be signed by all the shareholders who would be entitled to vote at a meeting of the shareholders or of a class of shareholders for such purpose and shall be filed with the Secretary.
SECTION 2.12     Order of Business . At any meeting of shareholders of the Corporation, only that business that is properly brought before the meeting may be presented to and acted upon by shareholders. To be properly brought before an annual meeting, business must be brought (a) by or at the direction of the Board of Directors or (b) by any shareholder of the Corporation who shall be entitled to vote at such meeting and who complies with the notice procedures set forth in this Section 2.12. At a special meeting of shareholders, no business shall be transacted and no corporate action taken other than that stated in the notice of the meeting.
In addition to any other applicable requirements, for business to be properly brought before an annual meeting by a shareholder, the shareholder must have given timely notice thereof in writing to the Secretary of the Corporation. To be timely, a shareholder’s notice must be given, either by personal delivery or by United States certified mail, postage prepaid, and received at the principal executive offices of the Corporation (i) not less than 90 days nor more than 180 days before the first anniversary of the date of the Corporation’s proxy statement in connection with the last annual meeting of shareholders or (b) if no annual meeting was held in the previous year or the date of the applicable annual meeting has been changed by more than 30 days from the date contemplated at the time of the previous year’s proxy statement, not less than 90 days before the date of the applicable annual meeting. A shareholder’s notice to the Secretary must set forth as to each matter the shareholder proposes to bring before the annual meeting (a) a brief description of

6



the business desired to be brought before the annual meeting, including the complete text of any resolutions to be presented at the annual meeting, and the reasons for conducting such business at the annual meeting, (b) the name and address, as they appear on the Corporation’s share transfer books, of such shareholder proposing such business, (c) a representation that such shareholder is a shareholder of record and intends to appear in person or by proxy at such meeting to bring the business before the meeting specified in the notice, (d) the class and number of shares of stock of the Corporation beneficially owned by the shareholder and (e) any material interest of the shareholder in such business. The Secretary of the Corporation shall deliver each such shareholder’s notice that has been timely received to the Board of Directors or a committee designated by the Board of Directors for review.
Notwithstanding anything in the Bylaws to the contrary, no business shall be conducted at an annual meeting except in accordance with the procedures set forth in this Section 2.12. The chairman of a meeting shall, if the facts warrant, determine that the business was not brought before the meeting in accordance with the procedures prescribed by this Section 2.12, and if he should so determine, he shall so declare to the meeting and the business not properly brought before the meeting shall not be transacted.
In addition to the foregoing provisions of this Section 2.12, a shareholder seeking to have a proposal included in the Corporation’s proxy statement must comply with the requirements of Regulation 14A under the Securities Exchange Act of 1934, as amended (including, but not limited to, Rule 14a-8 or its successor provision). The Corporation shall not have any obligation to communicate with shareholders regarding any business or director nomination submitted by a shareholder in accordance with this Section 2.12 unless otherwise required by law.
ARTICLE III
Board of Directors
SECTION 3.01     Powers . The Board of Directors shall have full power to conduct, manage, and direct the business and affairs of the Corporation, and all powers of the Corporation, except those specifically reserved or granted to the shareholders by statute or by the Articles of Incorporation or these Bylaws, are hereby granted to and vested in the Board of Directors.
SECTION 3.02     Number, Election and Term . The Board of Directors shall consist of five directors, subject to automatic increase in accordance with the Articles of Incorporation. If the Corporation seeks to qualify as a real estate investment trust, the number of directors shall be increased or decreased from time to time by vote of a

7



majority of the Board of Directors; provided, however, that the number of directors may not exceed fifteen nor be less than three except as permitted by law, and provided further, that the tenure of office of a director shall not be affected by any decrease or increase in the number of directors so made by the Board of Directors.
Except as otherwise specified in the Articles of Incorporation or these Bylaws or provided by applicable law, a nominee for director shall be elected to the Board of Directors at any meeting of shareholders at which a quorum is present if the votes cast for such nominee’s election exceed the votes cast against such nominee’s election; provided, however, that nominees for director shall be elected by a plurality of the votes cast at any meeting of shareholders for which the number of nominees exceeds the number of directors to be elected. If a nominee who is an incumbent director is not elected to the Board of Directors and no successor has been elected at such meeting of shareholders, such nominee shall offer his or her resignation promptly to the Board of Directors. Within 90 days following certification of the election results, the Board of Directors will determine whether to accept or reject the offered resignation, or whether to take other action. In making such determination, the Board of Directors shall consider the recommendation of the committee responsible for the nomination of directors, the factors considered by that committee and any additional information and factors that the Board of Directors believes to be relevant. A director who offers a resignation shall not participate in the recommendation of the committee or the decision of the Board of Directors with respect to such director’s resignation.
At all times, except in the case of a vacancy, a majority of the Board of Directors shall be Independent Directors (as hereinafter defined). For purposes of these Bylaws, “Independent Director” shall mean a director of the Corporation who meets the independence requirements under the rules and regulations of the stock exchange upon which the Corporation’s common stock is then listed and the Securities and Exchange Commission, as then in effect and applicable to the Corporation. At each annual meeting, the shareholders shall elect directors to hold office until the next annual meeting or until their successors are elected and qualify. Directors need not be shareholders in the Corporation.
Except as provided in Article III of the Articles of Incorporation, no person shall be eligible for election as a director unless nominated in accordance with the procedures set forth in this Section 3.02. Nominations of persons for election to the Board of Directors may be made by the Board of Directors or any committee designated by the Board of Directors or by any shareholder entitled to vote for the election of directors at the applicable meeting of shareholders who complies with the notice procedures set forth in this Section 3.02. Such nominations, other than those made by

8



the Board of Directors or any committee designated by the Board of Directors, may be made only if written notice of a shareholder’s intent to nominate one or more persons for election as directors at the applicable meeting of shareholders has been given, either by personal delivery or by United States certified mail, postage prepaid, to the Secretary of the Corporation and received (a) not less than 90 days nor more than 180 days before the first anniversary of the date of the Corporation’s proxy statement in connection with the last annual meeting of shareholders, or (b) if no annual meeting was held in the previous year or the date of the applicable annual meeting has been changed by more than 30 days from the date contemplated at the time of the previous year’s proxy statement, not less than 90 days before the date of the applicable annual meeting. Each such shareholder’s notice must set forth (i) as to the shareholder giving the notice, (1) the name and address, as they appear on the Corporation’s share transfer books, of such shareholder, (2) a representation that such shareholder is a shareholder of record and intends to appear in person or by proxy at such meeting to nominate the person or persons specified in the notice, (3) the class and number of shares of stock of the Corporation beneficially owned by such shareholder, and (4) a description of all arrangements or understandings between such shareholder and each nominee and any other person or persons (naming such person or persons) pursuant to which the nomination or nominations are to be made by such shareholder; and (ii) as to each person whom the shareholder proposes to nominate for election as a director, (1) the name, age, business address and, if known, residence address of such person, (2) the principal occupation or employment of such person, (3) the class and number of shares of stock of the Corporation which are beneficially owned by such person, (4) any other information relating to such person that is required to be disclosed in solicitations of proxies for election of directors or is otherwise required by the rules and regulations of the Securities and Exchange Commission promulgated under the Securities Exchange Act of 1934, as amended, and (5) the written consent of such person to be named in the proxy statement as a nominee and to serve as a director if elected. The Secretary of the Corporation shall deliver each such shareholder’s notice that has been timely received to the Board of Directors or a committee designated by the Board of Directors for review. Any person nominated for election as director by the Board of Directors or any committee designated by the Board of Directors shall, upon the request of the Board of Directors or such committee, furnish to the Secretary of the Corporation all such information pertaining to such person that is required to be set forth in a shareholder’s notice of nomination. The chairman of the meeting of shareholders shall, if the facts warrant, determine that a nomination was not made in accordance with the procedures

9



prescribed by this Section 3.02, and if he should so determine, he shall so declare to the meeting and the defective nomination shall be disregarded.
At any time when the Chairman of the Board is not an Independent Director, a lead Independent Director shall be designated by majority vote of the Independent Directors.
SECTION 3.03     Resignations . Any director or member of a committee may resign at any time. Such resignation shall be made in writing and shall take effect at the time specified therein, or if no time be specified, at the time of the receipt by the Chairman of the Board, the President or the Secretary.
SECTION 3.04     Removal . At any meeting of shareholders, duly called and at which a quorum is present, the shareholders may, by the affirmative vote of the holders of a majority of the votes entitled to be cast thereon, remove any director or directors from office with or without cause, and may elect a successor or successors to fill any resulting vacancies for the unexpired terms of removed directors.
SECTION 3.05     Committees of the Board . The Board of Directors may appoint from among its members an executive committee and other committees comprised of three or more members. The composition of each committee, including the total number of members and the number of Independent Directors, shall at all times comply with the listing requirements and rules and regulations of the stock exchange upon which the Corporation’s common stock is then listed and the rules and regulations of the Securities and Exchange Commission, in each case as then in effect and applicable to the Corporation. The Board of Directors may delegate to any committee any of the powers of the Board of Directors except the power to elect directors, declare dividends or distributions on stock, recommend to the shareholders any action which requires shareholder approval, amend the Articles of Incorporation, amend or repeal the Bylaws, approve any merger or share exchange which does not require shareholder approval or issue stock. However, if the Board of Directors has given general authorization for the issuance of stock, a committee of the Board, in accordance with a general formula or method specified by the Board of Directors by resolution or by adoption of a stock option plan, may fix the terms of stock subject to classification or reclassification and the terms on which any stock may be issued.
Notice of committee meetings shall be given in the same manner as notice for special meetings of the Board of Directors.

10



One-third, but not less than two, of the members of any committee shall be present in person at any meeting of such committee in order to constitute a quorum for the transaction of business at such meeting, and the act of a majority present shall be the act of such committee.
The Board of Directors may designate a chairman of any committee, and such chairman or any two members of any committee may fix the time and place of its meetings unless the Board shall otherwise provide. In the absence or disqualification of any member of any such committee, the members thereof present at any meeting and not disqualified from voting, whether or not they constitute a quorum, may unanimously appoint another member to act at the meeting in the place of such absent or disqualified members; provided, however, that in the event of the absence or disqualification of an Independent Director, such appointee shall be an Independent Director.
Each committee shall keep minutes of its proceedings and shall report the same to the Board of Directors at the meeting next succeeding and any action by the committees shall be subject to revision and alteration by the Board of Directors, provided that no rights of third persons shall be affected by any such revision or alteration.
Subject to the provisions hereof, the Board of Directors shall have the power at any time to change the membership of any committee, to fill all vacancies, to designate alternative members to replace any absent or disqualified member, or to dissolve any such committee.
SECTION 3.06     Meetings of the Board of Directors . Meetings of the Board of Directors, regular or special, may be held at any place in or out of the Commonwealth of Virginia as the Board may from time to time determine or as shall be specified in the notice of such meeting.
The first meeting of each newly elected Board of Directors shall be held as soon as practicable after the annual meeting of the shareholders at which the directors were elected. The meeting may be held at such time and place as shall be specified in a notice given as hereinafter provided for special meetings of the Board of Directors, or as shall be specified in a written waiver signed by all of the directors as provided in Article IV, except that no notice shall be necessary if such meeting is held immediately after the adjournment, and at the site, of the annual meeting of shareholders.
Special meetings of the Board of Directors may be called at any time by two or more directors, by any lead independent director (if one has been designated) or by a majority of the members of the executive committee, if one be constituted, in writing with or without a meeting of such committee or by the Chairman of the Board or the President. The lead independent director (if one has been designated) may also call a separate meeting of the directors of the

11



Corporation who are not employees of the Corporation. Special meetings may be held at such place or places in or out of the Commonwealth of Virginia as may be designated from time to time by the Board of Directors; in the absence of such designation, such meetings shall be held at such places as may be designated in the notice of meeting.
Notice of the place and time of every meeting of the Board of Directors shall be delivered by the Secretary to each director personally, by first-class mail, or by telephone, which shall also include voice-mail, or by electronic mail to any electronic address of the director or by any other electronic means, or by leaving the same at his residence or usual place of business at least twenty-four hours before the time at which such meeting is to be held, or if by first class mail, at least four days before the day on which such meeting is to be held. If mailed, such notice shall be deemed to be given when deposited in the United States mail addressed to the director at his post office address as it appears on the records of the Corporation, with postage thereon prepaid.
SECTION 3.07     Quorum and Voting . At all meetings of the Board, a majority of the Board of Directors shall constitute a quorum for the transaction of business, and the action of a majority of the directors present at any meeting at which a quorum is present shall be the action of the Board of Directors unless the concurrence of a greater proportion is required for such action by law, the Corporation’s Articles of Incorporation or these Bylaws. If a quorum is not present at any meeting of directors, the directors present thereat may, by a majority vote, adjourn the meeting from time to time, without notice other than announcement at the meeting, until a quorum is present.
Notwithstanding the first paragraph of this Section 3.07, and except as provided in the Company’s Guidelines (as hereinafter defined) any action pertaining to a transaction involving the Corporation in which any advisor, any director or officer of the Corporation or any affiliate of any of the foregoing persons has an interest shall be approved by a majority of the Independent Directors even if the Independent Directors constitute less than a quorum.
SECTION 3.08     Organization . The Chairman of the Board shall preside at each meeting of the Board of Directors; provided, however, that the lead independent director (if one has been designated) shall preside at any separate meeting of directors of the Corporation who are not employees of the Corporation. In the absence or inability of the Chairman of the Board to preside at a meeting of the Board of Directors, the President, or, in his absence or inability to act, the lead independent director (if one has been designated), or in their absence or inability to act, another director chosen by a majority of the directors present, shall act as chairman of the meeting and preside thereat. The

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Secretary (or, in his absence or inability to act, any person appointed by the chairman of the meeting) shall act as secretary of the meeting and keep the minutes thereof.
SECTION 3.09     Meeting by Conference Telephone . Members of the Board of Directors may participate in a meeting by means of a conference telephone or similar communications equipment if all persons participating in the meeting can hear each other at the same time. Participation in a meeting by such means constitutes presence in person at a meeting.
SECTION 3.10     Action Without Meeting . Any action required or permitted to be taken at any meeting of the Board of Directors or of any committee thereof may be taken without a meeting, if a written consent to such action is signed by all members of the Board or of such committee, as the case may be, and such written consent is filed with the minutes of proceedings of the Board or committee.
SECTION 3.11     Compensation of Directors . Non-employee Directors, in consideration of their serving as such, shall be entitled to receive from the Corporation such amount per annum or such fees for attendance at Board and committee meetings, or both, in cash or other property, including securities of the Corporation, as the Board shall from time to time determine, together with reimbursements for the reasonable expenses incurred by them in connection with the performance of their duties. Nothing contained herein shall preclude any director from serving the Corporation, or any subsidiary or affiliated corporation, in any other capacity and receiving proper compensation therefor. If the Board adopts a resolution to that effect, any non-employee Director may elect to defer all or any part of the annual and other fees hereinabove referred to for such period and on such terms and conditions as may be permitted by such resolution.
SECTION 3.12     Investment Policies . It shall be the duty of the Board of Directors to ensure that the purchase, sale, retention and disposal of the Corporation’s assets, and the investment policies of the Corporation and the limitations thereon are at all times in compliance with the restrictions applicable to real estate investment trusts pursuant to the Internal Revenue Code of 1986, as amended.
The Board of Directors, including a majority of the Independent Directors, shall promulgate and approve guidelines governing the investment policies of the Company (the “Guidelines”). The Guidelines and compliance

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therewith shall be reviewed by the Board of Directors at least annually to determine that the policies then being followed by the Corporation are in the best interest of the shareholders of the Corporation. Each such determination and the basis therefor shall be set forth in the minutes of the meeting of the Board of Directors.
ARTICLE IV
Notice - Waivers - Meetings
SECTION 4.01     What Constitutes Notice . Whenever written notice is required to be given to any person under the provisions of the Articles, these Bylaws, or the Virginia Stock Corporation Act, it may be given to such person, either personally or by sending a copy thereof through the mail, or by telegraph, charges prepaid, to his address appearing on the books of the Corporation, or supplied by him to the Corporation for the purpose of notice. If the notice is sent by mail or by telegraph, it shall be deemed to have been given to the person entitled thereto when deposited in the United States mail or with a telegraph office for transmission to such person. A notice of a meeting shall specify the place, day and hour of the meeting.
SECTION 4.02     Waiver of Notice . Whenever any written notice is required to be given under the provisions of the articles, these Bylaws, or the Virginia Stock Corporation Act, a waiver thereof in writing, signed by the person or persons entitled to such notice, whether before or after the time stated therein, shall be deemed equivalent to the giving of such notice. Except in the case of a special meeting of shareholders, neither the business to be transacted at, nor the purpose of, the meeting need be specified in the waiver of notice of such meeting.
Attendance of a person, either in person or by proxy, or by a telephone conference arrangement which complies with Section 3.09 hereof, at any meeting, shall constitute a waiver of notice of such meeting, except where a person attends a meeting for the express purpose of objecting to the transaction of any business because the meeting was not lawfully called or convened.
ARTICLE V

Officers
SECTION 5.01     Number, Qualifications and Designation . The officers of the Corporation shall be a President, one or more Vice Presidents, a Secretary, a Treasurer, and such other officers as may be elected in accordance

14



with the provisions of Section 5.03 of this Article. One person may hold more than one office. Officers may, but need not be, directors or shareholders of the Corporation. The Board of Directors may elect from among the members of the Board, a Chairman of the Board and Vice Chairman of the Board, neither of whom will be an officer of the Company, unless so designated by the Board.
SECTION 5.02     Election and Term of Office . The officers of the Corporation, except those elected by delegated authority pursuant to Section 5.03 of this Article, shall be elected annually by the Board of Directors, and each officer shall hold his office until the next annual organizational meeting of the Board of Directors and until his successor shall have been duly chosen and qualified, or until his death, resignation, or removal.
SECTION 5.03     Subordinate Officers, Committees and Agents . The Board of Directors may from time to time elect such other officers and appoint such committees, employees or other agents as the business of the Corporation may require, including one or more assistant secretaries, and one or more assistant treasurers, each of whom shall hold office for such period, have such authority, and perform such duties as are provided in these Bylaws, or as the Board of Directors may from time to time determine. The directors may delegate to any officer or committee the power to elect subordinate officers and to retain or appoint employees or other agents.
SECTION 5.04     Resignations . Any officer or agent may resign at any time by giving written notice to the Board of Directors, or to the President or the Secretary of the Corporation. Any such resignation shall take effect at the date of the receipt of such notice or at any later time specified therein and, unless otherwise specified therein, the acceptance of such resignation shall not be necessary to make it effective.
SECTION 5.05     Removal . Any officer, member of a committee, employee or other agent of the Corporation may be removed, either for or without cause, by the Board of Directors or other authority which elected or appointed such officer, member of a committee, employee or other agent whenever in the judgment of such authority the best interests of the Corporation will be served thereby.
SECTION 5.06     Vacancies . A vacancy in any office because of death, resignation, removal, disqualification, or any other cause, shall be filled by the Board of Directors or by the officer or remaining members of the committee to which the power to fill such office has been delegated pursuant to Section 5.03 of this Article, as

15



the case may be, and if the office is one for which these Bylaws prescribe a term, shall be filled for the unexpired portion of the term.
SECTION 5.07     General Powers . All officers of the Corporation as between themselves and the Corporation, shall, respectively, have such authority and perform such duties in the management of the property and affairs of the Corporation as may be determined by resolution of the Board of Directors, or in the absence of controlling provisions in a resolution of the Board of Directors, as may be provided in these Bylaws.
SECTION 5.08     The Chairman and Vice Chairman of the Board . The Chairman of the Board or in his absence, the Vice Chairman of the Board, shall preside at all meetings of the Board of Directors, and shall perform such other duties as may from time to time be requested of him by the Board of Directors.
SECTION 5.09     The President . The President shall be the chief executive officer of the Corporation and shall have general supervision over the business and operation of the Corporation, subject, to the control of the Board of Directors. He shall sign, execute, and acknowledge, in the name of the Corporation, deeds, mortgages, bonds, contracts or other instruments, authorized by the Board of Directors, except in cases where the signing and execution thereof shall be expressly delegated by the Board of Directors, or by these Bylaws, to some other officer or agent of the Corporation, and, in general, shall perform all duties incident to the office of President, and such other duties as from time to time may be assigned to him by the Board of Directors.
SECTION 5.10     The Vice Presidents . The Vice Presidents shall perform the duties of the President in his absence and such other duties as may from time to time be assigned to them by the Board of Directors or by the President.
SECTION 5.11     The Secretary . The Secretary or an assistant secretary shall attend all meetings of the shareholders and of the Board of Directors and shall record all the votes of the shareholders and of the directors and the minutes of the meetings of the shareholders and of the Board of Directors and of committees of the Board in a book or books to be kept for that purpose; shall see that notices are given and records and reports properly kept and filed by the Corporation as required by law; shall be the custodian of the seal of the Corporation and see that it is affixed to all documents to be executed on behalf of the Corporation under its seal; and, in general, shall perform all duties incident

16



to the office of Secretary, and such other duties as may from time to time be assigned to him by the Board of Directors or the President.
SECTION 5.12     The Treasurer . The Treasurer or an assistant treasurer shall have or provide for the custody of the funds or other property of the corporation and shall keep a separate book account of the same to his credit as Treasurer; shall collect and receive or provide for the collection and receipts of monies earned by or in any manner due to or received by the Corporation; shall deposit all funds in his custody as Treasurer in such banks or other places of deposit as the Board of Directors may from time to time designate; shall, whenever so required by the Board of Directors, render an account showing his transactions as Treasurer and the financial condition of the Corporation; and, in general, shall discharge such other duties as may from time to time be assigned to him by the Board of Directors or the President.
SECTION 5.13     Officers’ Bonds . Any officer shall give a bond for the faithful discharge of his duties in such sum, if any, and with such surety or sureties as the Board of Directors shall require.
SECTION 5.14     Salaries . The salaries of the officers elected by the Board of Directors shall be fixed from time to time by the Board of Directors or by such officer as may be designated by resolution of the Board. The salaries or other compensation of any other officers, employees and other agents shall be fixed from time to time by the officer or committee to which the power to elect such officers or to retain or appoint such employees or other agents has been delegated pursuant to Section 5.03 of this Article. No officer shall be prevented from receiving such salary or other compensation by reason of the fact that he is also a director of the Corporation.
ARTICLE VI

Capital Stock
SECTION 6.01     Shares of Stock . The shares of all classes and series of stock of the Corporation may be certificated or uncertificated as provided under Virginia law, and shall be entered in the share transfer books of the Corporation and registered as they are issued.
When shares of stock of the Corporation are represented by certificates, such certificates shall represent and certify the number and kind and class of shares owned by the shareholder in the Corporation and shall be in such form

17



as may be required by law and approved by the Board of Directors. Each certificate shall be signed by the Chairman of the Board or the President or a Vice President and countersigned by the Secretary or an assistant secretary or the Treasurer or an assistant treasurer and may be sealed with the corporate seal or a facsimile thereof. The signatures of the officers upon a share certificate may be facsimiles if the certificate is countersigned by a transfer agent, or registered by a registrar, other than the Corporation itself or an employee of the Corporation. In case any officer who has signed any certificate ceases to be an officer of the Corporation before the certificate is issued, the certificate may nevertheless be issued by the Corporation with the same effect as if the officer had not ceased to be such officer as of the date of its issue. All certificates for the Corporation’s shares shall be consecutively numbered or otherwise identified.
Each stock certificate shall include on its face (i) the name of the Corporation, (ii) that the Corporation is organized under the laws of the Commonwealth of Virginia, (iii) the name of the shareholder, (iv) the number and class or series, if any, of the shares represented by the certificate, and (v) any additional information required by the Virginia Stock Corporation Act to be included on certificates. If the Corporation has authority to issue stock of more than one class, or of more than one series within a class, the stock certificate shall contain on its face or back a full statement or summary of the designations and any preferences, conversion and other rights, voting powers, restrictions, limitations as to dividends, qualifications, and terms and conditions of redemption of the stock of each class which the Corporation is authorized to issue and if the Corporation is authorized to issue any preferred or special class in series, the differences in the relative rights, preferences and limitations between the shares of each series to the extent they have been set, and the authority of the Board of Directors to set the relative rights and preferences of subsequent series. In lieu of such full statement or summary, there may be set forth upon the face or back of the certificate a statement that the Corporation will furnish to any shareholder upon request and without charge, a full statement of such information. A summary of such information included in a registration statement permitted to become effective under the federal Securities Act of 1933, as amended, shall be an acceptable summary for the purposes of this section. Every stock certificate representing shares of stock which are restricted as to transferability by the Corporation shall contain a full statement of the restriction or state that the Corporation will furnish information about the restriction to the shareholder on request and without charge. A stock certificate may not be issued until the stock represented by it is fully paid, except in the case of stock purchased under an option plan as permitted by law.

18



When shares of stock of the Corporation are not represented by certificates, then within a reasonable time after the issuance or transfer of such shares, the Corporation shall send, or cause to be sent, to the shareholder to whom such shares have been issued or transferred a written notice that shall set forth (i) the name of the Corporation, (ii) that the Corporation is organized under the laws of the Commonwealth of Virginia, (iii) the name of the shareholder, (iv) the number and class or series, if any, of the shares so held, and (v) any additional information required by the Virginia Stock Corporation Act to be included on certificates. If the Corporation has authority to issue stock of more than one class, or of more than one series within a class, the written notice shall contain the information required by the previous paragraph with respect to each class or series, or shall contain a statement that the Corporation will furnish such information to any shareholder upon request and without charge. In the event the shares are restricted as to transferability by the Corporation, then the written notice shall contain a full statement of the restriction or state that the Corporation will furnish information about the restriction to the shareholder on request and without charge.
Blank share certificates shall be kept by the Secretary or by a transfer agent or by a registrar or by any other officer or agent designated by the Board of Directors.
SECTION 6.02     Stolen, Lost or Destroyed Certificates . The Board of Directors may direct that a new certificate or certificates be issued, or evidence of the holder’s ownership of shares in uncertificated form be delivered, in place of any certificate or certificates theretofore issued by the Corporation alleged to have been stolen, lost or destroyed, upon the making of an affidavit of that fact by the person claiming the certificate of stock to be stolen, lost or destroyed. When authorizing such issuance of a new certificate or certificates or delivery of evidence of the holder’s ownership of such shares in uncertificated form, the Board of Directors may, in its discretion and as a condition precedent to the issuance or delivery thereof, require the owner of such stolen, lost or destroyed certificate or certificates, or his legal representative, to advertise the same in such manner as it shall require, to give the Corporation a bond, with sufficient surety, to the Corporation to indemnify it against any loss or claim which may arise by reason of the issuance of a new certificate or delivery of evidence of the holder’s ownership of such shares in uncertificated form, and to comply with any other terms the Board of Directors may lawfully prescribe.
SECTION 6.03     Transfer Agents and Registrars . The Board of Directors shall appoint one or more transfer agents and/or registrars of the shares of stock of the Corporation; and, upon such appointments being made,

19



no certificate representing shares shall be valid until countersigned by one of such transfer agents and registered by one of such registrars.
SECTION 6.04     Transfer of Stock . The Corporation, or its designated transfer agent or other agent, shall keep a book or set of books to be known as the share transfer books of the Corporation, containing the name of each shareholder of record, together with such shareholder’s address and the number and class or series of shares held by such shareholder. Such information may be stored or retained on discs, tapes, cards or any other approved storage device relating to data processing equipment; provided that such device is capable of reproducing all information contained therein in legible and understandable form, for inspection by shareholders or for any other corporate purpose.
No transfers of shares of stock of the Corporation shall be made if (i) void ab initio pursuant to any Article of the Corporation’s Articles of Incorporation, (ii) the Board of Directors, pursuant to such Article, shall have refused to tender such shares, or (iii) the transferee is a nonresident alien individual or foreign entity. A permitted transfer of shares shall be made and recorded on the share transfer books of the Corporation upon the receipt of proper transfer instructions as prescribed by the Board of Directors, the payment of all taxes thereon, and, in the case of transfers of shares which are represented by one or more certificates, only upon receipt of such certificate(s) with proper endorsement or duly executed stock transfer power, from the registered holder of record or from such holder’s attorney thereunto authorized by power of attorney duly executed and filed with the Secretary or with a transfer agent or transfer clerk. In the event a certificate representing shares to be transferred cannot be surrendered because it has been stolen, lost, or destroyed, the transferor shall comply with the requirements imposed by the Board of Directors as set forth in Section 6.02 of these Bylaws in lieu of surrendering a properly endorsed certificate. Upon satisfactory completion by the transferor of the requirements set forth in this Section 6.04, as to any transfer not prohibited by the Articles of Incorporation or by action of the Board of Directors thereunder, all certificates for the transferred shares shall be cancelled, new certificates representing the transferred shares (or evidence of the transferee’s ownership of the transferred shares in uncertificated form) shall be delivered to the transferee, and the transaction shall be recorded on the share transfer books of the Corporation. Except as otherwise provided by law, no transfer of shares shall be valid as against the Corporation, its shareholders or creditors, for any purpose, until it shall have been entered in the share transfer books of the Corporation by an entry showing from and to whom transferred.

20



SECTION 6.05     Registered Shareholders . The Corporation shall be entitled to recognize the exclusive right of a person registered on its share transfer books as the owner of shares (whether or not such shares are represented by certificates) to receive dividends, and to vote as such owner, and to hold liable for calls and assessments, if any, a person registered on its share transfer books as the owner of shares, and shall not be bound to recognize any equitable or other claim to or interest in such share or shares on the part of any other person, whether or not it shall have express or other notice thereof, except as otherwise provided by law.
SECTION 6.06     Regulations . The Board of Directors may make such additional rules and regulations, not inconsistent with these Bylaws, as it may deem expedient concerning the issue, transfer and registration of shares of stock of the Corporation (whether or not such shares are represented by certificates).

ARTICLE VII

Miscellaneous
SECTION 7.01     Corporate Seal . The Corporation shall have a corporate seal in the form of a circle containing the name of the Corporation and such other details as may be required by the Board of Directors.
SECTION 7.02     Checks . All checks, notes, bills of exchange or other orders in writing shall be signed by such person or persons as the Board of Directors may from time to time designate.
SECTION 7.03     Contracts . Except as otherwise provided in these Bylaws, the Board of Directors may authorize any officer or officers, agent or agents, to enter into any contract or to execute or deliver any instrument on behalf of the Corporation, and such authority may be general or confined to specific instances.
SECTION 7.04     Deposits . All funds of the Corporation shall be deposited from time to time to the credit of the Corporation in such banks, trust companies, or other depositories as the Board of Directors may approve or designate, and all such funds shall be withdrawn only upon checks signed by such one or more officers or employees as the Board of Directors shall from time to time determine.

21



SECTION 7.05     Corporate Records . There shall be kept at the principal office of the Corporation an original or duplicate record of the proceedings of the shareholders and of the directors, and the original or a copy of the Bylaws including all amendments or alterations thereto to date, certified by the Secretary. An original or duplicate share transfer book shall also be kept at the registered office or principal place of business of the Corporation, or at the office of a transfer agent or registrar, giving the names of the shareholders, their respective addresses and the number and class of shares held by each. The Corporation shall also keep appropriate, complete and accurate books or records of account, which may be kept at its registered office or at its principal place of business.
SECTION 7.06     Amendment of Bylaws . These Bylaws may be amended or replaced, or new Bylaws may be adopted, either (1) by the vote of the shareholders entitled to cast at least a majority of the votes which all shareholders are entitled to cast thereon at any duly organized annual or special meeting of shareholders, or (2), with respect to those matters which are not by statute reserved exclusively to the shareholders, by vote of a majority of the Board of Directors, including a majority of the Independent Directors of the Corporation in office at any regular or special meeting of directors. It shall not be necessary to set forth such proposed amendment, repeal or new Bylaws, or a summary thereof, in any notice of such meeting, whether annual, regular or special.
SECTION 7.07     Exclusive Forum . Unless the Corporation consents in writing to the selection of an alternative forum, the United States District Court for the Eastern District of Virginia, Richmond Division, or in the event that court lacks jurisdiction to hear such action, the Circuit Court of the City of Richmond, Virginia, shall be the sole and exclusive forum for (i) any derivative action or proceeding brought on behalf of the Corporation, (ii) any action asserting a claim of breach of a legal duty owed by any current or former director, officer or other employee or agent of the Corporation to the Corporation or the Corporation’s shareholders, (iii) any action asserting a claim against the Corporation or any director or officer or other employee of the Corporation arising pursuant to any provision of the Virginia Stock Corporation Act or the Articles of Incorporation or these Bylaws (as any may be amended from time to time), or (iv) any action asserting a claim against the Corporation or any current or former director or officer or other employee or agent of the Corporation governed by the internal affairs doctrine.



22



Exhibit 12.1


DYNEX CAPITAL, INC.
Ratio of Earnings to Fixed Charges and
Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends
 
 
Three Months Ended
 
Year Ended December 31,
($ in thousands, except ratios)
March 31, 2018
 
2017
 
2016
 
2015
 
2014
 
2013
Fixed charges:
 
 
 
 
 
 
 
 
 
 
 
Interest expense
$
11,595

 
$
36,178

 
$
25,231

 
$
22,605

 
$
25,915

 
$
39,028

Preferred dividend requirements
2,940

 
10,794

 
9,185

 
9,176

 
9,176

 
7,902

Total
$
14,535

 
$
46,972

 
$
34,416

 
$
31,781

 
$
35,091

 
$
46,930

 
 
 
 
 
 
 
 
 
 
 
 
Earnings:
 
 
 
 
 
 
 
 
 
 
 
Income from continuing operations
$
44,307

 
$
33,893

 
$
43,099

 
$
16,544

 
$
27,806

 
$
68,069

Add:
 
 
 
 
 
 
 
 
 
 
 
Distributed income of equity method investee

 

 
1,316

 

 

 
721

Fixed charges, excluding preferred dividend requirements
11,595

 
36,178

 
25,231

 
22,605

 
25,915

 
39,028

Less: Equity in income of equity investee

 

 
(481
)
 
(835
)
 

 
(721
)
Total
$
55,902

 
$
70,071

 
$
69,165

 
$
38,314

 
$
53,721

 
$
107,097

 
 
 
 
 
 
 
 
 
 
 
 
Ratio of earnings to fixed charges
4.82x
 
1.94x
 
2.74x
 
1.69x
 
2.07x
 
2.74x
 
 
 
 
 
 
 
 
 
 
 
 
Ratio of earnings to fixed charges and preferred stock dividends
3.85x
 
1.49x
 
2.01x
 
1.21x
 
1.53x
 
2.28x





Exhibit 31.1

CERTIFICATIONS

I, Byron L. Boston, certify that:
1.
I have reviewed this Quarterly Report on Form 10-Q of Dynex Capital, Inc.;
2.
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.
The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
(a)
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b)
Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
(c)
Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
(d)
Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and
5.
The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):
(a)
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and
(b)
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.
Date:  
May 8, 2018
 
 
 
/s/ Byron L. Boston
 
 
Byron L. Boston
 
 
Principal Executive Officer





Exhibit 31.2

CERTIFICATIONS

I, Stephen J. Benedetti, certify that:
1.
I have reviewed this Quarterly Report on Form 10-Q of Dynex Capital, Inc.;
2.
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.
The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
(a)
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b)
Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
(c)
Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
(d)
Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and
5.
The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):
(a)
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and
(b)
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.
Date:  
May 8, 2018
 
 
 
/s/ Stephen J. Benedetti
 
 
Stephen J. Benedetti
 
 
Principal Financial Officer





Exhibit 32.1


CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER AND PRINCIPAL FINANCIAL OFFICER
PURSUANT TO SECTION 906


In connection with the Quarterly Report on Form 10-Q of Dynex Capital, Inc. (the “Company”) for the three months ended March 31, 2018 , as filed with the Securities and Exchange Commission on the date hereof (the “Report”), the undersigned, as the Principal Executive Officer of the Company and the Principal Financial Officer of the Company, respectively, certify, pursuant to and for purposes of 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to their knowledge:
(1)
The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and
(2)
The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.
Date:  
May 8, 2018
/s/ Byron L. Boston
 
 
Byron L. Boston
 
 
Principal Executive Officer
 
 
 
 
 
 
Date:  
May 8, 2018
/s/ Stephen J. Benedetti
 
 
Stephen J. Benedetti
 
 
Principal Financial Officer