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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC  20549

FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934

For the quarterly period June 30, 2007

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.)
   
4551 Cox Road, Suite 300, Glen Allen, Virginia
23060-6740
(Address of principal executive offices)
(Zip Code)
   
(804) 217-5800
(Registrant’s telephone number, including area code)
 
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           þ           No           o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer           o           Accelerated filer           o           Non-accelerated filer               þ

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

On July 31, 2007, the registrant had 12,136,262 shares outstanding of common stock, $.01 par value, which is the registrant’s only class of common stock.



DYNEX CAPITAL, INC.
FORM 10-Q

INDEX


     
Page
PART I.
FINANCIAL INFORMATION
  
       
 
Item 1.
  
       
   
1
       
   
2
       
   
3
       
   
4
       
 
Item 2.
12
       
 
Item 3.
28
       
 
Item 4.
30
       
PART II.
OTHER INFORMATION
  
       
 
Item 1.
31
       
 
Item 1A.
32
       
 
Item 2.
32
       
 
Item 3.
32
       
 
Item 4.
33
       
 
Item 5.
33
       
 
Item 6.
33
       
34





      
        i      
    

PART I.  FINANCIAL INFORMATION
 
Item 1.  Financial Statements
 
DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED
BALANCE SHEETS
(amounts in thousands except share data)

   
June 30,
    
December 31,
  
   
2007
    
2006
  
   
(Unaudited)
        
ASSETS
            
Cash and cash equivalents
   $
62,556
     $
56,880
  
Other assets
    
4,096
      
6,111
  
     
66,652
      
62,991
  
Investments:
                
Securitized mortgage loans:
                
Commercial, net
    
220,109
      
228,466
  
Single-family, net
    
99,398
      
117,838
  
     
319,507
      
346,304
  
Investment in joint venture
    
39,296
      
37,388
  
Securities
    
13,446
      
13,143
  
Other investments
    
2,239
      
2,802
  
Other loans
    
3,438
      
3,929
  
     
377,926
      
403,566
  
                 
    $
444,578
     $
466,557
  
                 
LIABILITIES AND SHAREHOLDERS' EQUITY
                
LIABILITIES
                
Securitization financing
   $
201,046
     $
211,564
  
Repurchase agreements secured by securitization financing
    
80,965
      
95,978
  
Obligation under payment agreement
    
16,829
      
16,299
  
Other liabilities
    
6,352
      
6,178
  
     
305,192
      
330,019
  
                 
Commitments and Contingencies (Note 12)
                
                 
SHAREHOLDERS' EQUITY
                
Preferred stock, par value $0.01 per share, 50,000,000 shares authorized,
                
9.5% Cumulative Convertible Series D, 4,221,539 shares issued
                
and outstanding, ($43,218 aggregate liquidation preference)
    
41,749
      
41,749
  
Common stock, par value $0.01 per share, 100,000,000 shares authorized,
                
12,136,262 and 12,131,262 shares issued and outstanding, respectively
    
121
      
121
  
Additional paid-in capital
    
366,716
      
366,637
  
Accumulated other comprehensive income
    
793
      
663
  
Accumulated deficit
     (269,993 )     (272,632 )
     
139,386
      
136,538
  
                 
    $
444,578
     $
466,557
  
                 
See notes to unaudited condensed consolidated financial statements.
                


1

DYNEX CAPITAL, INC.
CONDENSED CONSOLIDATED STATEMENTS
OF OPERATIONS AND COMPREHENSIVE INCOME (UNAUDITED)
(amounts in thousands except share and per share data)

   
Three Months Ended
    
Six Months Ended
  
   
June 30,
    
June 30,
  
   
2007
    
2006
    
2007
    
2006
  
                         
Interest income:
                        
Securitized finance receivables
   $
6,848
     $
13,139
     $
13,873
     $
27,025
  
Securities
    
284
      
426
      
608
      
973
  
Other investments
    
787
      
463
      
1,526
      
690
  
Other loans
    
104
      
164
      
231
      
270
  
     
8,023
      
14,192
      
16,238
      
28,958
  
                                 
Interest and related expenses:
                                
Securitization financing
    
3,537
      
10,201
      
7,632
      
21,189
  
Repurchase agreements
    
1,162
      
1,519
      
2,420
      
3,034
  
Obligation under payment agreement
    
386
      
-
      
753
      
-
  
Other
     (25 )     (71 )    
9
       (96 )
     
5,060
      
11,649
      
10,814
      
24,127
  
                                 
Net interest income
    
2,963
      
2,543
      
5,424
      
4,831
  
Recapture of provision for loan losses
    
702
      
-
      
1,225
      
119
  
                                 
Net interest income after provision for loan losses
    
3,665
      
2,543
      
6,649
      
4,950
  
                                 
Equity in income of joint venture
    
672
      
-
      
1,302
      
-
  
Gain on sale of investments, net
    
6
      
116
      
-
      
140
  
Other (expense) income
     (478 )    
121
       (1,018 )    
230
  
General and administrative expenses
     (1,163 )     (1,165 )     (2,290 )     (2,492 )
                                 
Net income
    
2,702
      
1,615
      
4,643
      
2,828
  
Preferred stock charge
     (1,003 )     (1,003 )     (2,005 )     (2,039 )
                                 
Net income to common shareholders
   $
1,699
     $
612
     $
2,638
     $
789
  
                                 
Change in net unrealized gain (loss) on :
                                
Investments classified as available-for-sale
     (602 )    
84
       (476 )    
448
  
Investment in joint venture
     (223 )    
-
      
606
      
-
  
                                 
Comprehensive income
   $
1,877
     $
1,699
     $
4,773
     $
3,276
  
                                 
Net income per common share:
                                
Basic and diluted
   $
0.14
     $
0.05
     $
0.22
     $
0.06
  
                                 
See notes to unaudited condensed consolidated financial statements.
                          



2



DYNEX CAPITAL, INC.
 
 
OF CASH FLOWS (UNAUDITED)
 
(amounts in thousands)
 

   
Six Months Ended
  
   
June 30,
  
   
2007
    
2006
  
Operating activities:
            
Net income
   $
4,643
     $
2,828
  
Adjustments to reconcile net income to cash
                
provided by operating activities:
                
Equity in earnings of joint venture
     (1,302 )    
-
  
Recapture of provision for loan loss
     (1,225 )     (119 )
Gain on sale of investments
    
-
       (141 )
Amortization and depreciation
     (183 )    
346
  
Stock based compensation expense
    
79
      
104
  
Net change in other assets and other liabilities
    
2,615
      
752
  
Net cash and cash equivalents provided by operating activities
    
4,627
      
3,770
  
                 
                 
Investing activities:
                
Principal payments received on securitized mortgage loans
    
27,702
      
51,479
  
Purchase of securities
     (5,590 )     (16,642 )
Payments received on securities, other investments and other loans
    
5,836
      
26,238
  
Proceeds from sales of securities and other investments
    
129
      
1,136
  
Other
    
305
       (561 )
Net cash and cash equivalents provided by investing activities
    
28,382
      
61,650
  
                 
Financing activities:
                
Principal payments on securitization financing
     (9,496 )     (26,555 )
Net repayments on repurchase agreement
     (15,832 )     (19,743 )
Repurchase of common stock
    
-
       (220 )
Redemption of preferred stock
    
-
       (14,072 )
Dividends paid
     (2,005 )     (2,373 )
Net cash and cash equivalents used for financing activities
     (27,333 )     (62,963 )
Net increase in cash and cash equivalents
    
5,676
      
2,457
  
Cash and cash equivalents at beginning of period
    
56,880
      
45,235
  
Cash and cash equivalents at end of period
   $
62,556
     $
47,692
  
                 
                 
See notes to unaudited condensed consolidated financial statements.
                





3

DYNEX CAPITAL, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
June 30, 2007
(amounts in thousands except share and per share data)
 
 
NOTE 1 – BASIS OF PRESENTATION
 
The accompanying condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and do not include all of the information and notes required by accounting principles generally accepted in the United States of America, hereinafter referred to as “generally accepted accounting principles,” for complete financial statements.  The condensed consolidated financial statements include the accounts of Dynex Capital, Inc. and its qualified real estate investment trust (REIT) subsidiaries and taxable REIT subsidiary (together, “Dynex” or the “Company”).  All intercompany balances and transactions have been eliminated in consolidation.
 
The Company consolidates entities in which it owns more than 50% of the voting equity and control does not rest with others.  The Company follows the equity method of accounting for investments with greater than 20% and less than a 50% interest in partnerships and corporate joint ventures or when it is able to influence the financial and operating policies of the investee but owns less than 50% of the voting equity.  For all other investments, the cost method is applied.
 
The Company believes it has complied with the requirements for qualification as a REIT under the Internal Revenue Code (the “Code”).  To the extent the Company qualifies as a REIT for federal income tax purposes, it generally will not be subject to federal income tax on the amount of its income or gain that is distributed as dividends to shareholders.
 
In the opinion of management, all significant adjustments, consisting of normal recurring accruals considered necessary for a fair presentation of the condensed consolidated financial statements have been included. The financial statements presented are unaudited.  Operating results for the three and six months ended June 30, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007.  Certain information and footnote disclosures normally included in the consolidated financial statements prepared in accordance with generally accepted accounting principles have been omitted.  The unaudited financial statements included herein should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006, filed with the Securities and Exchange Commission.
 
The preparation of financial statements, in conformity with generally accepted accounting principles, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period.  Actual results could differ from those estimates.  The primary estimates inherent in the accompanying condensed consolidated financial statements are discussed below.
 
The Company uses estimates in establishing fair value for its financial instruments. Securities classified as available-for-sale are carried in the accompanying financial statements at estimated fair value. Estimates of fair value for securities are based on market prices provided by certain dealers, when available.  When market prices are not available, fair value estimates are determined by calculating the present value of the projected cash flows of the instruments using market-based assumptions such as estimated future interest rates and estimated market spreads to applicable indices for comparable securities, and using collateral based assumptions such as prepayment rates and credit loss assumptions based on the most recent performance and anticipated performance of the underlying collateral.
 

4

The Company also has credit risk on loans in its portfolio as discussed in Note 4.  An allowance for loan losses has been estimated and established for currently existing losses in the loan portfolio, which are deemed probable as to their occurrence.  The allowance for loan losses is evaluated and adjusted periodically by management based on the actual and estimated timing and amount of probable credit losses.  Provisions made to increase or decrease the allowance for loan losses are presented as provision for loan losses or recapture of provision for loan losses, respectively, in the accompanying condensed consolidated statements of operations.  The Company’s actual credit losses may differ from those estimates used to establish the allowance.
 
Certain amounts for 2006 have been reclassified to conform to the presentation used in 2007.
 
Adoption of New Accounting Standards
 
Effective January 1, 2007, the Company adopted Financial Accounting Standards Board (FASB) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48).  FIN 48 prescribes a recognition threshold and measurement attributes for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.  The Company’s adoption of FIN 48 did not have a material impact on the Company’s financial statements.
 
Effective January 1, 2007, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 156, “Accounting for Servicing of Financial Assets — An Amendment of FASB Statement No. 140.” This Statement amends FASB Statement No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”, with respect to the accounting for separately recognized servicing assets and servicing liabilities. This Statement requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations and to initially measure those servicing assets and servicing liabilities at fair value, if practicable. The Company elected the option to measure its servicing rights at fair value at each reporting date with changes in fair value recorded in its earnings.  The Company’s adoption of FAS 156 did not have a material impact on the Company’s financial statements.
 
Effective January 1, 2007, the Company adopted SFAS No. 155, “Accounting for Certain Hybrid Instruments” (FAS 155), an amendment to FAS 133 and FAS 140. Among other things, FAS 155: (i) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; (ii) clarified which interest-only strips and principal-only strips are not subject to the requirements of FAS 133; (iii) established a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; (iv) clarified that concentrations of credit risk in the form of subordination are not embedded derivatives; and (v) amended FAS 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument.
 
Securitized interests which only contain an embedded derivative that is tied to the prepayment risk of the underlying prepayable financial assets and for which the investor does not control the right to accelerate the settlement of such financial assets are excluded under a scope exception adopted by the FASB.  None of the Company’s assets were subject to FAS 155 as a result of this scope exception. Therefore, the Company has continued to record changes in the market value of its investment securities through other comprehensive income, a component of stockholders’ equity. Therefore, the adoption of FAS 155 did not have any impact on the Company’s financial position, results of operations or cash flows. However, if future investments by the Company in securitized financial assets do not meet the scope exception to FAS 155, the Company’s results of operations may exhibit future volatility if such investments are required to be bifurcated or marked to market value in their entirety through the income statement.
 

5

NOTE 2 – NET INCOME PER COMMON SHARE
 
Net income per common share is presented on both a basic and diluted per common share basis.  Diluted net income per common share assumes the conversion of the convertible preferred stock into common stock, using the if-converted method, and stock appreciation rights and options, to the extent that they are outstanding, using the treasury stock method, but only if these items are dilutive.  The Series D preferred stock is convertible into one share of common stock for each share of preferred stock.  The following table reconciles the numerator and denominator for both basic and diluted net income per common share for the three and six months ended June 30, 2007 and 2006.
 
   
Three Months Ended June 30,
    
Six Months Ended June 30,
  
   
2007
    
2006
    
2007
    
2006
  
   
Income
    
Weighted-
Average
Number
Of Shares
    
Income
    
Weighted-
Average
Number
Of Shares
    
Income
    
Weighted-
Average
Number
Of Shares
    
Income
    
Weighted-
Average
Number
Of Shares
  
Net income
   $
2,702
           $
1,615
           $
4,643
           $
2,828
        
Preferred stock charge
     (1,003 )           (1,003 )           (2,005 )           (2,039 )      
Net income to common shareholders
   $
1,699
      
12,136,262
     $
612
      
12,138,469
     $
2,638
      
12,134,715
     $
789
      
12,150,011
  
                                                                 
Net income per share:
                                                                
  Basic
           $
0.14
             $
0.05
             $
0.22
             $
0.06
  
  Diluted
           $
0.14
             $
0.05
             $
0.22
             $
0.06
  
                                                                 
Reconciliation of shares included
in calculation of earnings per share
due to dilutive effect
          
Expense and incremental shares of stock options
   $
–
      
3,173
     $
–
      
–
     $
–
      
1,909
     $
–
      
–
  
    $
–
      
12,139,435
     $
–
      
–
     $
–
      
12,136,627
     $
–
      
–
  
                                                                 
Reconciliation of shares not
included in calculation of earnings
per share due to anti-dilutive effect
          
Series D preferred stock
   $
1,003
      
4,221,539
     $
1,003
      
4,221,539
     $
2,005
      
4,221,539
     $
2,039
      
4,291,510
  
Expense and incremental shares of stock options
    
–
      
1,417
      
–
      
16,360
      
–
      
3,061
      
–
      
18,151
  
    $
1,003
      
4,222,956
     $
1,003
      
4,237,899
     $
2,005
      
4,224,600
     $
2,039
      
4,309,661
  
                                                                 

 
NOTE 3 – SECURITIZED FINANCE RECEIVABLES
 
The following table summarizes the components of securitized finance receivables at June 30, 2007 and December 31, 2006:

   
June 30,
2007
    
December 31, 2006
  
Collateral:
            
Commercial mortgage loans
   $
209,075
     $
225,463
  
Single-family mortgage loans
    
97,855
      
116,060
  
     
306,930
      
341,523
  
Funds held by trustees, including funds held for defeased loans
    
13,570
      
7,351
  
Accrued interest receivable
    
2,216
      
2,380
  
Unamortized discounts and premiums, net
     (404 )     (455 )
Loans, at amortized cost
    
332,312
      
350,799
  
Allowance for loan losses
     (2,805 )     (4,495 )
    $
319,507
     $
346,304
  

The commercial securitized finance receivables are encumbered by non-recourse securitized financing.
 
6
NOTE 4 – ALLOWANCE FOR LOAN LOSSES
 
The following table summarizes the aggregate activity for the allowance for loan losses for the three-month and six-month periods ended June 30, 2007 and 2006, respectively:
 
   
Three Months Ended
June 30,
    
Six Months Ended
June 30,
  
   
2007
    
2006
    
2007
    
2006
  
Allowance at beginning of period
   $
3,538
     $
18,913
     $
4,495
     $
19,035
  
Recapture of provision for loan losses
     (702 )    
–
       (1,225 )     (119 )
Charge-offs, net of recoveries
     (31 )     (4,044 )     (465 )     (4,047 )
Allowance at end of period
   $
2,805
     $
14,869
     $
2,805
     $
14,869
  

The Company identified $14,389 of impaired commercial loans at June 30, 2007, none of which were delinquent, compared to $13,266 of impaired commercial loans at December 31, 2006, one of which was delinquent and had an unpaid principal balance of $3,170.  This delinquent commercial loan was purchased at foreclosure by a third party in March 2007 resulting in a charge-off of $437.
 

NOTE 5 — INVESTMENT IN JOINT VENTURE
 
The Company holds a 49.875% interest in a joint venture, Copperhead Ventures, LLC, which it accounts for using the equity method, under which it recognizes its proportionate share of the joint venture’s earnings and comprehensive income.  The joint venture had total assets at June 30, 2007 of $77,439, which were comprised primarily of $40,339 of cash and cash equivalents, $36,976 of investments backed by commercial mortgage loans, and other assets of $124.  The Company’s interest in the earnings of the joint venture were $672 and $1,302 for the three and six months ended June 30, 2007, respectively.
 
 
NOTE 6 – SECURITIES
 
The following table summarizes the fair value of the Company’s securities classified as available-for-sale at June 30, 2007 and December 31, 2006:

   
June 30, 2007
    
December 31, 2006
  
   
Fair
Value
    
Effective Interest Rate
    
Fair
Value
    
Effective Interest Rate
  
Securities, available-for-sale:
                        
Adjustable-rate mortgage securities
   $
2,048
       5.44 %   $
–
       – %
Fixed-rate mortgage securities
    
9,839
       7.16 %    
11,362
       7.22 %
Equity securities
    
1,151
              
1,151
          
     
13,038
              
12,513
          
Gross unrealized gains
    
434
              
636
          
Gross unrealized losses
     (26 )             (6 )        
    $
13,446
             $
13,143
          

7


NOTE 7 – OTHER INVESTMENTS
 
The following table summarizes the Company’s other investments at June 30, 2007 and December 31, 2006:
 
   
June 30,
2007
    
December 31,
2006
  
Delinquent property tax receivable securities
   $
1,712
     $
2,227
  
Real estate owned
    
527
      
575
  
    $
2,239
     $
2,802
  

Delinquent property tax receivable securities includes an unrealized loss of $213 at June 30, 2007 and an unrealized gain of $41 at December 31, 2006, respectively.  Real estate owned is acquired from foreclosures on delinquent property tax receivables. During the six months ended June 30, 2007, the Company collected $306 on the delinquent property tax receivable securities, including the net proceeds from the sale of the related real estate owned.
 
NOTE 8 – OTHER LOANS
 
The following table summarizes Dynex’s carrying basis for other loans at June 30, 2007 and December 31, 2006, respectively.
 
   
June 30,
2007
    
December 31, 2006
  
Single-family mortgage loans
   $
2,819
     $
3,345
  
Multifamily and commercial mortgage loan participations
    
945
      
962
  
     
3,764
      
4,307
  
Unamortized discounts
     (326 )     (378 )
    $
3,438
     $
3,929
  
 
NOTE 9 –SECURITIZATION FINANCING
 
Dynex, through limited-purpose finance subsidiaries, has issued bonds pursuant to indentures in the form of non-recourse securitization financing.  Each series of securitization financing may consist of various classes of bonds, either at fixed or variable rates of interest.  Payments received on securitized finance receivables and any reinvestment income earned thereon are used to make payments on the securitization financing.  The obligations under the securitization financings are payable solely from the securitized finance receivables and are otherwise non-recourse to Dynex.  The stated maturity date for each class of bonds is generally calculated based on the final scheduled payment date of the underlying collateral pledged.  The actual maturity of each class will be directly affected by the rate of principal prepayments on the related collateral.  Each series is also subject to redemption at Dynex’s option according to specific terms of the respective indentures.  As a result, the actual maturity of any class of a series of securitization financing is likely to occur earlier than its stated maturity.  If Dynex does not exercise its option to redeem a class or classes of bonds when it first has the right to do so, the interest rates on the bonds not redeemed will automatically increase by 0.30% to 0.83%.
 

8

The components of non-recourse securitization financing along with certain other information at June 30, 2007 and December 31, 2006 are summarized as follows:

   
June 30, 2007
    
December 31, 2006
  
   
Bonds Outstanding
    
Range of Interest Rates
    
Bonds Outstanding
    
Range of Interest Rates
  
Fixed-rate classes
   $
196,982
       6.6%-8.8 %   $
206,478
       6.6%-8.8 %
Accrued interest payable
    
1,362
              
1,428
          
Deferred costs
     (2,226 )             (2,848 )        
Unamortized bond premium, net
    
4,928
              
6,506
          
    $
201,046
             $
211,564
          
                                 
Range of stated maturities
    
2024-2027
              
2024-2027
          
Estimated weighted average life
  
3.9 years
            
4.3 years
          
Number of series
    
2
              
2
          

At June 30, 2007, the weighted-average coupon on the fixed rate classes was 6.9%.  The average effective rate on non-recourse securitization financing was 7.1% and 8.1% for the six months ended June 30, 2007 and the year ended December 31, 2006, respectively.  This decrease was due to additional amortization of bond premium due to the prepayment of three commercial loans in the second quarter 2007 and the derecognition of a securitization back by commercial loans in the third quarter 2006.
 
NOTE 10 – REPURCHASE AGREEMENTS
 
The Company uses repurchase agreements, which are recourse to the Company, to finance certain of its investments.  The Company had repurchase agreements of $80,965 and $95,978 at June 30, 2007 and December 31, 2006, respectively, which are collateralized by certain of the Company’s retained interests in its securitizatized single-family mortgage loans.  The repurchase agreements mature monthly and have a weighted average rate of 0.10% over one-month LIBOR (5.32% at June 30, 2007). The securitization financing bonds collateralizing these repurchase agreements had a fair value, as determined by the repurchase agreement counterparty, of $89,958 at June 30, 2007.
 
NOTE 11 – PREFERRED STOCK
 
At each of June 30, 2007 and December 31, 2006, the total liquidation preference on the Series D Preferred Stock was $43,218, which includes $1,003 ($0.2375 per share) of accrued dividends payable on the Series D Preferred Stock at each of June 30, 2007 and December 31, 2006, respectively.
 
NOTE 12 – COMMITMENTS AND CONTINGENCIES
 
As discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006, the Company and certain of its subsidiaries are defendants in litigation. The following discussion is the current status of the litigation.
 

9

One of the Company’s subsidiaries, GLS Capital, Inc. (“GLS”), and the County of Allegheny, Pennsylvania (“Allegheny County”), are defendants in a class action lawsuit filed in 1997 in the Court of Common Pleas of Allegheny County, Pennsylvania (the “Court of Common Pleas”).  Plaintiffs allege that GLS illegally charged the taxpayers of Allegheny County certain attorney fees, costs and expenses, and interest, in the collection of delinquent property tax receivables owned by GLS.  Plaintiffs were seeking class certification status, and in October 2006, the Court of Common Pleas certified the class action status of the litigation. In its Order certifying the class action, the Court of Common Pleas left open the possible decertification of the class if the fees, costs and expenses charged by GLS are in accordance with public policy considerations as well as Pennsylvania statute and relevant ordinance.  The Company successfully sought the stay of this action pending the outcome of other litigation before the Pennsylvania Supreme Court in which GLS is not directly involved but has filed an Amicus brief in support of the defendants.  Several of the allegations in that lawsuit are similar to those being made against GLS in this litigation.  Plaintiffs have not enumerated its damages in this matter, and we believe that the ultimate outcome of this litigation will not have a material impact on the Company’s financial condition, but may have a material impact on its reported results for the particular period presented.
 
Dynex Capital, Inc. and Dynex Commercial, Inc. (“DCI”), a former affiliate and now known as DCI Commercial, Inc., are appellees (or “respondents”) in the Court of Appeals for the Fifth Judicial District of Texas at Dallas, related to the matter of Basic Capital Management et al  (collectively, “BCM” or “the Plaintiffs”) versus Dynex Commercial, Inc. et al.  The appeal seeks to overturn a judgment from a lower court in the Company’s and DCI’s favor which denied recovery to Plaintiffs and to have a judgment entered in favor of Plaintiffs based on a jury award for damages, all of which was set aside by the trial court as discussed further below.  In the alternative, Plaintiffs are seeking a new trial.  The appeal relates to a suit filed against the Company and DCI in 1999, alleging, among other things, that DCI and Dynex Capital, Inc. failed to fund tenant improvement or other advances allegedly required on various loans made by DCI to BCM, which loans were subsequently acquired by the Company; that DCI breached an alleged $160 million “master” loan commitment entered into in February 1998; and that DCI breached another alleged loan commitment of approximately $9 million.  The original trial commenced in January 2004, and, in February 2004, the jury in the case rendered a verdict in favor of one of the Plaintiffs and against the Company on the alleged breach of the loan agreements for tenant improvements and awarded that Plaintiff damages in the amount of $0.25 million. The jury entered a separate verdict against DCI in favor of BCM under two mutually exclusive damage models, for $2.2 million and $25.6 million, respectively. The jury found in favor of DCI on the alleged $9 million loan commitment, but did not find in favor of DCI for counterclaims made against BCM. The jury also awarded the Plaintiffs attorneys’ fees in the amount of $2.1 million.  After considering post-trial motions, the presiding judge entered judgment in favor of the Company and DCI, effectively overturning the verdicts of the jury and dismissing damages awarded by the jury.  DCI is a former affiliate of Dynex Capital, Inc., and management does not believe that the Company will have any obligation for amounts, if any, awarded to the Plaintiffs as a result of the actions of DCI. The Court of Appeals heard oral arguments in this matter in April 2006 but has not yet rendered its decision.
 
Dynex Capital, Inc. and MERIT Securities Corporation, a subsidiary, are defendants in a putative class action complaint alleging violations of the federal securities laws in the United States District Court for the Southern District of New York (“District Court”) by the Teamsters Local 445 Freight Division Pension Fund ("Teamsters"). The complaint was filed on February 11, 2005, and purports to be a class action on behalf of purchasers between February 2000 and May 2004 of MERIT Series 12 and MERIT Series 13 securitization financing bonds (the “Bonds”), which are collateralized by manufactured housing loans.  The complaint seeks unspecified damages and alleges, among other things, misrepresentations in connection with the issuance of and subsequent reporting on the Bonds. The complaint initially named the Company’s former president and its current Chief Operating Officer as defendants.   In February 2006, the District Court dismissed the claims against the former president and current Chief Operating Officer, but did not dismiss the claims against Dynex Capital, Inc. or MERIT (“together, the Corporate Defendants”). The Corporate Defendants moved to certify an interlocutory appeal of this order to the United States Court of Appeals for the Second Circuit (“Second Circuit”). On June 2, 2006, the District Court granted the Corporate Defendants’ motion. On September 14, 2006, the Second Circuit granted the Corporate Defendants’ petition to accept the certified order for interlocutory appeal. On March 2, 2007, the parties completed briefing in the Second Circuit and are awaiting oral argument.  The Company has evaluated the allegations made in the complaint and believes them to be without merit and intends to vigorously defend itself against them.

10

Although no assurance can be given with respect to the ultimate outcome of the above litigation, the Company believes the resolution of these lawsuits will not have a material effect on our consolidated balance sheet but could materially affect our consolidated results of operations in a given year.
 
 
NOTE 13 – STOCK BASED COMPENSATION
 
Pursuant to Dynex’s 2004 Stock Incentive Plan, as approved by the shareholders at Dynex’s 2005 annual shareholders’ meeting (the “Stock Incentive Plan”), Dynex may grant to eligible officers, directors and employees stock options, stock appreciation rights (“SARs”) and restricted stock awards.  An aggregate of 1,500,000 shares of common stock is available for distribution pursuant to the Stock Incentive Plan.  Dynex may also grant dividend equivalent rights (“DERs”) in connection with the grant of options or SARs.

On May 25, 2007, Dynex granted options to acquire an aggregate of 25,000 shares of common stock to its directors under the Stock Incentive Plan.  The options vested immediately, expire on May 25, 2012 and have an exercise price of $9.02 per share, which was 110% of the closing price of the stock on the grant date. The weighted average grant-date fair value of the options granted was $1.69 on the grant date using the assumptions set forth below.

As of June 30, 2007, Dynex has three outstanding SARs grants and two outstanding option grants with a total of 280,222 SARs shares and 95,000 option shares outstanding. The portion of these shares that are fully vested are 82,399 SARs shares and 95,00 option shares.  Dynex recognized stock based compensation expense of $135 and $78 for the three months ended June 30, 2007 and 2006, respectively, and $207 and $223 for the six months ended June 30, 2007 and 2006, respectively.  The total compensation cost related to non-vested awards not yet recognized was $518 and $352 at June 30, 2007 and 2006, respectively.

The fair value of SARs and options awarded is estimated on the date of grant using the Black-Scholes option valuation model using the assumptions in the table below.

 
Options Granted
SARs Granted
 
May 25, 2007
January 3, 2005
January 12, 2006
January 3, 2007
Expected volatility
15.7%
16.3%–17.0%
16.3%–20.6%
19.8%–26.4%
Weighted-average volatility
15.7%
16.3%
18.0%
21.6%
Expected dividends
0%
0%
0%
0%
Expected term (in months)
30
14
13
11
Risk-free rate
4.80%
4.92%
4.94%
4.96%

 
NOTE 14 – RECENT ACCOUNTING PRONOUNCEMENTS
 
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS 159 permits entities to choose to measure many financial instruments, and certain other items, at fair value. SFAS 159 applies to reporting periods beginning after November 15, 2007. We are currently evaluating the potential impact on adoption of SFAS 159.
 
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007 and all interim periods within those fiscal years. We are currently evaluating the impact, if any, that SFAS 157 may have on our financial statements.


11


In June 2007, the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position (“SOP”) 07-01, “Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies” (“SOP 07-1”). SOP 07-1 provides guidance for determining whether an entity is within the scope of the AICPA Audit and Accounting Guide Investment Companies. The SOP is effective for fiscal years beginning on or after December 15, 2007. While the Company maintains an exemption from the Investment Company Act of 1940, as amended and is therefore not regulated as an investment company, it is none-the-less in the process of assessing whether SOP 07-1 is applicable.

 
Item 2.                      Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following discussion and analysis of the financial condition and results of operations of the Company as of and for the three-month and six-month periods ended June 30, 2007 should be read in conjunction with the Company’s Condensed Consolidated Financial Statements  (unaudited) and the accompanying Notes to Condensed Consolidated Financial Statements (unaudited) included in this report.
 
The Company is a specialty finance company organized as a real estate investment trust (REIT) that invests in loans and securities consisting principally of single family residential and commercial mortgage loans.  The Company finances these loans and securities through a combination of non-recourse securitization financing, repurchase agreements, and equity. Dynex employs financing in order to increase the overall yield on its invested capital.
 
The Company continues to focus its efforts in the near-term on managing its current investment portfolio to maximize cash flow, while evaluating longer-term opportunities for redeployment of its capital.  Recent disruptions in the fixed income markets, particularly the residential mortgage market, may present investment opportunities for the Company in the near term.  These disruptions have caused volatility in asset prices, causing such asset prices to decline, correspondingly increasing yields.  Equity prices on companies which originate or invest in these securities have also declined.  Management and the Board of Directors remain focused on finding investments with acceptable risk-adjusted returns, and believe volatility in the fixed income markets will continue for the foreseeable future.
 
CRITICAL ACCOUNTING POLICIES
 
The discussion and analysis of the Company’s financial condition and results of operations are based in large part upon its consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America.  The preparation of the financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period.  Actual results could differ from those estimates.
 
Critical accounting policies are defined as those that are reflective of significant judgments or uncertainties, and which may result in materially different results under different assumptions and conditions, or the application of which may have a material impact on the Company’s financial statements.  The following are the Company’s critical accounting policies.
 
Consolidation of Subsidiaries. The consolidated financial statements represent our accounts after the elimination of intercompany transactions.  We consolidate entities in which we own more than 50% of the voting equity and control of the entity does not rest with others.  We follow the equity method of accounting for investments in which we own greater than a 20% and less than a 50% interest in partnerships and corporate joint ventures or when we are able to influence the financial and operating policies of the investee but own less than 50% of the voting equity.  For all other investments, the cost method is applied.
 

12

Securitization. We have securitized loans and securities in a securitization financing transaction by transferring financial assets to a wholly owned trust, and the trust issues non-recourse bonds pursuant to an indenture.  Generally, we retain some form of control over the transferred assets, and/or the trust is not deemed to be a qualified special purpose entity.  In instances where the trust is deemed not to be a qualified special purpose entity, the trust is included in our consolidated financial statements.  A transfer of financial assets in which we surrender control over those assets is accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange.  For accounting and tax purposes, the loans and securities financed through the issuance of bonds in a securitization financing transaction are treated as our assets, and the associated bonds issued are treated as our debt as securitization financing.  We may retain certain of the bonds issued by the trust, and we generally will transfer collateral in excess of the bonds issued.  This excess is typically referred to as over-collateralization.  Each securitization trust generally provides us with the right to redeem, at our option, the remaining outstanding bonds prior to their maturity date.
 
Impairments.  We evaluate all securities in our investment portfolio for other-than-temporary impairments.  A security is generally defined to be other-than-temporarily impaired if, for a maximum period of three consecutive quarters, the carrying value of such security exceeds its estimated fair value and we estimate, based on projected future cash flows or other fair value determinants, that the fair value will remain below the carrying value for the foreseeable future.  If an other-than-temporary impairment is deemed to exist, we record an impairment charge to adjust the carrying value of the security down to its estimated fair value.  In certain instances, as a result of the other-than-temporary impairment analysis, the recognition or accrual of interest will be discontinued and the security will be placed on non-accrual status.
 
We consider impairments of other investments to be other-than-temporary when the fair value remains below the carrying value for three consecutive quarters. If the impairment is determined to be other-than-temporary, an impairment charge is recorded in order to adjust the carrying value of the investment to its estimated value.

Allowance for Loan Losses.  We have credit risk on loans pledged in securitization financing transactions and classified as securitized finance receivables in its investment portfolio.  An allowance for loan losses has been estimated and established for currently existing probable losses.  Factors considered in establishing an allowance include current loan delinquencies, historical cure rates of delinquent loans, and historical and anticipated loss severity of the loans as they are liquidated.  The allowance for loan losses is evaluated and adjusted periodically by management based on the actual and estimated timing and amount of probable credit losses, using the above factors, as well as industry loss experience.  Where loans are considered homogeneous, the allowance for loan losses is established and evaluated on a pool basis.  Otherwise, the allowance for loan losses is established and evaluated on a loan-specific basis.  Provisions made to increase the allowance are a current period expense to operations.  Single-family loans are considered impaired when they are 60-days past due.  Commercial mortgage loans are evaluated on an individual basis for impairment.  Generally, a commercial loan with a debt service coverage ratio of less than one is considered impaired.  However, based on the attributes of the respective  loan, or the attributes of the underlying real estate which secures the loan, commercial loans with a debt service coverage ratio less than one may not be considered impaired; conversely, commercial loans with a debt service coverage ratio greater than one may be considered impaired.  Certain of the commercial mortgage loans are covered by loan guarantees that limit the Company’s exposure on these loans.  The level of allowance for loan losses required for these loans is reduced by the amount of applicable loan guarantees.  The Company’s actual credit losses may differ from the estimates used to establish the allowance.
 


13

 
 
FINANCIAL CONDITION
 
Below is a discussion of the Company's financial condition.

(amounts in thousands except per share data)
  
June 30,
2007
    
December 31, 2006
  
Investments:
            
Securitized mortgage loans
   $
319,507
     $
346,304
  
Investment in joint venture
    
39,296
      
37,388
  
Securities
    
13,446
      
13,143
  
Other investments
    
2,239
      
2,802
  
Other loans
    
3,438
      
3,929
  
                 
Securitization financing
    
201,046
      
211,564
  
Repurchase agreements
    
80,965
      
95,978
  
Obligation under payment agreement
    
16,829
      
16,299
  
                 
Shareholders’ equity
    
139,386
      
136,538
  
Common book value per share
    
8.01
      
7.78
  

Securitized finance receivables.Securitized finance receivables decreased to $319.5 million at June 30, 2007 compared to $346.3 million at December 31, 2006. This decrease of $26.8 million is primarily the result of $27.7 million of principal payments during the period, including $16.2 million and $5.2 million of unscheduled principal payments on single-family and commercial mortgage loans, respectively.  These decreases were partially offset by a decrease in the allowance for loan losses of $1.0 million net of collateral losses.

Investment in joint venture.  Investment in joint venture increased to $39.3 million at June 30, 2007 from $37.4 million at December 31, 2006.  This increase of $1.9 million is primarily the result of the Company recognizing its interest in the earnings of the joint venture of $1.3 million and its proportionate interest in the increase in the value of the joint venture’s available for sale securities of $0.6 million over the six month period ended June 30, 2007, which is included in other comprehensive income.
 
Securities.Securities increased during the six months ended June 30, 2007 by $0.3 million, to $13.4 million at June 30, 2007 from $13.1 million at December 31, 2006 due primarily to the purchase of a $5.6 million adjustable-rate mortgage backed security.  This increase was partially offset by principal payments of $5.1 million received on this and other securities during the period.
 
Other investments.  Other investments decreased from $2.8 million at December 31, 2006 to $2.2 million at June 30, 2007. This decrease is primarily the result of net collections on delinquent property tax receivables, including proceeds from the sale of real estate owned of $0.3 million during the period and a decrease in the value of the delinquent tax lien security of $0.3 million, which was recorded as an unrealized loss in accumulated other comprehensive income.
 
Other loans.  Other loans decreased by $0.5 million from $3.9 million at December 31, 2006 to $3.4 million at June 30, 2007 primarily as the result of scheduled and unscheduled principal payments during the period.
 
Securitization financing.  Securitization financing decreased $10.5 million, from $211.6 million at December 31, 2006 to $201.0 million at June 30, 2007. This decrease was primarily a result of principal payments of $9.5 million received on the associated securitized finance receivables pledged which were used to pay down the securitization financing in accordance with the respective indentures and $1.0 million of net amortization of bond premiums and  deferred costs associated with the financing.
 
14

Repurchase Agreements. The balance of repurchase agreements declined to $81.0 million at June 30, 2007 from $96.0 million at December 31, 2006. The decrease was due to net repayments of $15.0 million during the period as a result of principal received on the underlying investments being financed.
 
Obligation under payment agreement. The obligation under payment agreement increased to $16.8 million at June 30, 2007 from $16.3 million at December 31, 2006.  The increase was primarily a result of an increase in the Company’s estimated future payments to be made under this agreement of $0.6 million and $0.8 million of discount amortization during the quarter.  Those increases were partially offset by payments made under the agreement of $0.8 million during the quarter.
 
Shareholders’ equity.  Shareholders' equity increased to $139.4 million at June 30, 2007 from $136.5 million at December 31, 2006 primarily as a result of the Company’s earnings of $4.6 million for the period, which was partially offset by preferred stock dividends of $2.0 million for the same period.
 
Supplemental Discussion of Investments
 
The Company evaluates and manages its investment portfolio in large part based on its net capital invested in that particular investment.  Net capital invested is generally defined as the cost basis of the investment net of the associated financing for that investment.    For securitized finance receivables, unless otherwise noted, the securitization financing is recourse only to the finance receivables pledged and is, therefore, not a general obligation of the Company, the risk on the Company’s investment in securitized finance receivables from an economic point of view is limited to its net retained investment in the securitization trust.
 
Below is the net basis of the Company’s investments as of June 30, 2007.  Included in the table is an estimate of the fair value of the net investment.  The fair value of the net investment in securitized finance receivables is based on the present value of the projected cash flow from the collateral, adjusted for the impact and assumed level of future prepayments and credit losses, less the projected principal and interest due on the securitization financing bonds owned by third parties.  The fair value of securities is based on quotes obtained from third-party dealers, or, as is the case for the majority of our investments, calculated by discounting estimated future cash flows at market rates.  For securities and other investments, the Company may employ leverage to enhance its overall returns on the net capital invested in these particular assets.
 

15
 
   
June 30, 2007
  
(amounts in thousands)
  
Amortized
cost basis
    
Financing
    
Net basis
    
Fair value
of net basis
  
Securitized finance receivables: (1)
                        
Single family mortgage loans (2)
   $
99,683
     $
80,965
     $
18,718
     $
19,097
  
Commercial mortgage loans
    
222,629
      
201,046
      
21,583
      
20,553
  
Allowance for loan losses
     (2,805 )    
–
       (2,805 )    
–
  
     
319,507
      
282,011
      
37,496
      
39,650
  
Securities: (3)
                                
Investment grade single-family
    
11,478
      
–
      
11,478
      
11,608
  
Non-investment grade single-family
    
324
      
–
      
324
      
510
  
Equity and other
    
1,237
      
–
      
1,237
      
1,328
  
     
13,039
      
–
      
13,039
      
13,446
  
                                 
Investment in joint venture(4)
    
39,296
      
–
      
39,296
      
38,628
  
Obligation under payment agreement(1)
    
–
      
16,829
       (16,829 )     (16,729 )
Other loans and investments(3)
    
5,889
      
–
      
5,889
      
6,360
  
Net unrealized gain
    
195
      
–
      
195
      
–
  
                                 
Total
   $
377,926
     $
298,840
     $
79,086
     $
81,355
  
                                 

 
(1)
Fair values for securitized finance receivables and the obligation under payment agreement are based on discounted cash flows using assumptions set forth in the table below, inclusive of amounts invested in redeemed securitization financing bonds.
 
(2)
Financing for single-family mortgage loans consists of repurchase agreements.
 
(3)
Fair values of securities are based on dealer quotes, if available.  Where dealer quotes are not available, fair values are calculated as the net present value of expected future cash flows, discounted at 16%.  Expected cash flows for both securitized finance receivables and securities were based on the forward LIBOR curve as of June 30, 2007, and incorporate the resetting of the interest rates on the adjustable rate assets to a level consistent with projected prevailing rates. Increases or decreases in interest rates and index levels from those used would impact the calculation of fair value, as would differences in actual prepayment speeds and credit losses versus the assumptions set forth above.
 
(4)
Fair value for investment in joint venture represents Dynex’s share of the joint assets valued using methodologies and assumptions consistent with Note 1 and 3 above.

16

The following table summarizes the assumptions used in estimating fair value for our net investment in securitized finance receivables and the cash flow related to those net investments during 2007.
 
 
Fair Value Assumptions
  
Loan type
Weighted-average prepayment speeds
Losses
Weighted-average
discount rate(1)
Weighted average
maturity (months)
(amounts in thousands)
2007 Cash Flow (2)
           
Single-family mortgage loans
30% CPR
0.2% annually
16%
195
$      5,078
           
Commercial mortgage loans(3)
(4)
0.8% annually
16%
(5)
$      1,222

 (1)
Represents management’s estimate of the market discount rate that would be used in a transaction between a willing buyer and a willing seller.
(2)
Represents the excess of the cash flows received on the collateral pledged over the cash flow required to service the related securitization financing.
(3)
Includes loans pledged to two different securitization trusts.
(4)
Assumed CPR speeds generally are governed by underlying pool characteristics, prepayment lock-out provisions, and yield maintenance provisions.  Loans currently delinquent in excess of 30 days are assumed liquidated in six months at a loss amount that is calculated for each loan based on its specific facts.
(5)
Cash flow termination dates are modeled based on the repayment dates of the loans or optional redemption dates of the underlying securitization financing bonds.  The assumed weighted average maturity for MCA1 and CCA2 is 133 months and 83 months, respectively.

The following table presents the Net Basis of Investments included in the “Estimated Fair Value of Net Investment” table above by their rating classification.  Investments in the unrated and non-investment grade classification primarily include other loans that have not been given a rating but that are substantially seasoned and performing loans.  Securitization over-collateralization generally includes the excess of the securitized finance receivable collateral pledged over the outstanding bonds issued by the securitization trust.
 
(amounts in thousands)
  
June 30, 2007
  
       
Investments:
      
AAA rated and agency MBS fixed income securities
    
19,764
  
AA and A rated fixed income securities
    
1,246
  
Unrated and non-investment grade
    
7,704
  
Securitization over-collateralization
    
11,076
  
Investment in joint venture
    
39,296
  
    $
79,086
  
         

 
Supplemental Discussion of Common Equity Book Value

We believe that our shareholders, as well as shareholders of other companies in the mortgage REIT industry, consider book value per common share an important measure.  Our reported book value per common share is based on the carrying value our assets and liabilities as recorded in the consolidated financial statements in accordance with generally accepted accounting principles.  A substantial portion of our assets are carried on a historical, or amortized, cost basis and not at estimated fair value.  The table included in the “Supplemental Discussion of Investments” section above compares the amortized cost basis of our investments to their estimated fair value based on assumptions set forth in the table.
 

17

We believe that book value per common share, adjusted to reflect the carrying value of investments at their fair value (hereinafter referred to as “Adjusted Common Equity Book Value”), is also a meaningful measure for our shareholders, representing effectively our estimated going-concern value.  The following table calculates Adjusted Common Equity Book Value and Adjusted Common Equity Book Value per share using the estimated fair value information contained in the “Estimated Fair Value of Net Investment” table above.  The amounts set forth in the table in the Adjusted Common Equity Book Value column include all of our assets and liabilities at their estimated fair values, and exclude any value attributable to our tax net operating loss carryforwards and other matters that might impact our value.  Amounts included in this table are not meant to represent the liquidation value of the Company.
 
   
June 30, 2007
  
(amounts in thousands)
  
Book Value
    
Adjusted Common Equity Book Value
  
             
Total investment assets (per table above)
   $
79,086
     $
81,355
  
Cash and cash equivalents
    
62,556
      
62,556
  
Other assets and liabilities, net
     (2,256 )     (2,256 )
     
139,386
      
141,656
  
Less:  Preferred stock redemption value
     (42,215 )     (42,215 )
Common equity book value and adjusted book value
   $
97,171
     $
99,441
  
                 
Common equity book value per share and adjusted book value per share
   $
8.01
     $
8.19
  

 
 
RESULTS OF OPERATIONS
 
(amounts in thousands except per share information)
  
Three Months Ended
June 30,
    
Six Months Ended
June 30,
  
   
2007
    
2006
    
2007
    
2006
  
                         
Net interest income
   $
2,963
     $
2,543
     $
5,424
     $
4,831
  
Recapture of provision for loan losses
    
702
      
–
      
1,225
      
119
  
Net interest income after provision for loan losses
    
3,665
      
2,543
      
6,649
      
4,950
  
Equity in earnings of joint venture
    
672
      
–
      
1,302
      
–
  
Other (expense) income
     (478 )    
121
       (1,018 )    
230
  
General and administrative expenses
     (1,163 )     (1,165 )     (2,290 )     (2,492 )
Net income
    
2,702
      
1,615
      
4,643
      
2,828
  
Preferred stock charge
     (1,003 )     (1,003 )     (2,005 )     (2,039 )
Net income to common shareholders
    
1,699
      
612
      
2,638
      
789
  
                                 
Net income per common share:
                                
Basic  and diluted
   $
0.14
     $
0.05
     $
0.22
     $
0.06
  
                                 


18

Three Months Ended June 30, 2007 Compared to Three Months Ended June 30, 2006.

Net interest income increased from $2.5 million to $3.0 million for the quarter ended June 30, 2007 from the same period in 2006 primarily as a result of the derecognition of a pool of securitized commercial mortgage loans in the third quarter of 2006 that contributed $0.4 million of net interest expense for second quarter of 2006, an increase in the net amortization of asset discounts and liability premiums of $0.2 million related to increased commercial loan prepayments, and a $0.3 million increase in interest income on cash and cash equivalents related to an increase in both the average balance and rate on cash equivalents. These increases were partially offset by $0.4 million of interest expense recognized on the obligation under payment agreement during the second quarter of 2007, which was not outstanding during the second quarter of 2006.

Net interest income after recapture of provision for loan losses for the three months ended June 30, 2007 increased to $3.7 million from $2.5 million for the same period for 2006.  Recapture of provision for loan losses increased $0.7 million for the second quarter of 2006 primarily due to improvement in the performance of our commercial mortgage loan portfolio and decreased single-family mortgage loan delinquencies compared to the second quarter of 2006.

The Company recognized $0.7 million of equity in the earnings of a joint venture, which it formed in the third quarter of 2006.  The joint venture’s earnings are primarily derived from interest income earned on commercial mortgage backed securities and cash equivalents.

Other income decreased $0.6 million from other income of $0.1 million for the second quarter of 2006 to other expense of $0.5 million for the second quarter of 2007.  The decrease is primarily due to a $0.4 million charge taken to adjust mortgage servicing rights and obligations to estimated fair value, which resulted from a decrease in estimated loss rate on the underlying loans.  In addition, included in the second quarter 2006 was $0.2 million of other income received on certain of its securitized commercial mortgage loans that did not recur in 2007.

Six Months Ended June 30, 2007 Compared to Six Months Ended June 30, 2006.

Net interest income increased from $4.8 million for the six months ended June 30, 2006 to $5.4 million for the same period in 2007 primarily as a result of the derecognition of a pool of securitized commercial mortgage loans in the third quarter of 2006 that contributed $1.0 million of net interest expense for six months ended June 30, 2006 compared to the same period in 2007, an increase in the net amortization of asset discounts and liability premiums of $0.6 million related to increased commercial loan prepayments, and a $0.8 million increase in interest income on cash and cash equivalents related to an increase in both the average balance and rate on cash equivalents.   These increases were partially offset by $0.8 million of interest expense recognized on the obligation under payment agreement during the six months ended June 30, 2007, which was not outstanding during the same period in 2006 and a $1.0 million decrease in net interest income related to decreases in our non-cash investment portfolio as those investments have paid down.

Net interest income after recapture of provision for loan losses for the six months ended June 30, 2007 increased to $6.6 million from $4.9 million for the same period for 2006. Recapture of provision for loan losses increased $1.1 million to $1.2 million for the six months ended June 30, 2007 primarily due to improvement in the performance of our commercial mortgage loan portfolio and decreased single-family mortgage loan delinquencies compared to 2006.

The Company recognized $1.3 million of equity in the earnings of its joint venture.

Other income decreased $1.2 million from other income of $0.2 million for the six months ended June 30, 2006 to other expense of $1.0 million for the same period in 2007.  The decrease is primarily related to a $0.6 million charge taken during the period to increase the obligation under payment agreement for an increase in the estimated future payment to be made under the agreement; and a $0.3 million charge taken to adjust our mortgage servicing rights and obligations to estimated fair value, which resulted from a decrease in estimated loss rate on the underlying loans.  In addition, included in the second quarter 2006 was $0.3 million of other income received on certain of its securitized commercial mortgage loans that did not recur in 2007.


19

General and administrative expense decreased to $2.3 million for the six months ended June 30, 2007 from $2.5 million for the same period in 2006. This decrease was primarily the result of the reductions in expenses associated with the Company's tax lien servicing operations and a decline in litigation related expenses.
 
The following table summarizes the average balances of interest-earning assets and their average effective yields, along with the average interest-bearing liabilities and the related average effective interest rates, for each of the periods presented. Assets that are on non-accrual status are excluded from the table below for each period presented.
 
Average Balances and Effective Interest Rates
 
   
Three Months Ended June 30,
  
   
2007
    
2006
  
(amounts in thousands)
  
Average
Balance
    
Effective
Rate
    
Average
Balance
    
Effective
Rate
  
Interest-earning assets(1):
                        
Securitized finance receivables(2) (3)
   $
326,560
       8.38 %   $
691,725
       7.59 %
Securities
    
13,360
       8.28 %    
16,366
       9.68 %
Other loans
    
3,516
       11.86 %    
4,909
       13.33 %
Total interest-earning assets
   $
343,436
       8.41 %   $
713,000
       7.68 %
                                 
Interest-bearing liabilities:
                                
Securitization financing(3)
   $
202,470
       6.59 %   $
491,666
       8.13 %
Repurchase agreements
    
84,793
       5.42 %    
118,147
       5.09 %
Total interest-bearing liabilities
   $
287,263
       6.24 %   $
609,813
       7.54 %
                                 
Net interest spread (3)
             2.17 %             0.14 %
                                 
Net yield on average interest-earning investments (3) (4)
             3.19 %             1.22 %
                                 
Cash and cash equivalents
   $
59,640
       5.28 %   $
40,905
       4.54 %
Net yield on average interest-earning assets,
including cash and cash equivalents
             3.50 %             1.40 %
                                 

(1)
Average balances exclude adjustments made in accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” to record available-for-sale securities at fair value.
(2)
Average balances exclude funds held by trustees and bond issuance costs for the three months ended June 30, 2007 and 2006, respectively.
(3)
Effective rates are calculated excluding non-interest related securitization financing expenses.
(4)
Net yield on average interest-earning assets reflects net interest income excluding non-interest related securitization financing expenses divided by average interest earning assets for the period, annualized.


20


   
Six Months Ended June 30,
  
   
2007
    
2006
  
(amounts in thousands)
  
Average
Balance
    
Effective
Rate
    
Average
Balance
    
Effective
Rate
  
Interest-earning assets(1):
                        
Securitized finance receivables(2) (3)
   $
334,356
       8.29 %   $
707,712
       7.63 %
Securities
    
13,252
       9.07 %    
25,938
       7.23 %
Other loans
    
3,627
       12.74 %    
5,046
       10.71 %
Total interest-earning assets
   $
351,235
       8.37 %   $
738,696
       7.63 %
                                 
Interest-bearing liabilities:
                                
Securitization financing(3)
   $
205,435
       7.13 %   $
499,530
       8.31 %
Repurchase agreements
    
88,652
       5.43 %    
123,243
       4.90 %
Total interest-bearing liabilities
   $
294,087
       6.62 %   $
622,773
       7.63 %
                                 
Net interest spread (3)
             1.75 %             0.00 %
                                 
Net yield on average interest-earning investments (3) (4)
             2.82 %             1.20 %
                                 
Cash and cash equivalents
   $
27,703
       5.25 %   $
30,408
       4.53 %
Net yield on average interest-earning assets,
including cash and cash equivalents
             3.17 %             1.33 %
                                 

(1)
Average balances exclude adjustments made in accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” to record available-for-sale securities at fair value.
(2)
Average balances exclude funds held by trustees and bond issuance costs for the six months ended June 30, 2007 and 2006, respectively.
(3)
Effective rates are calculated excluding non-interest related securitization financing expenses.
(4)
Net yield on average interest-earning assets reflects net interest income excluding non-interest related securitization financing expenses divided by average interest earning assets for the period, annualized.


The net interest spread increased 203 basis points to 2.17% for the three months ended June 30, 2007 from 0.14% for the same period in 2006. The net yield on average interest earning assets for the three months ended June 30, 2007 increased to 3.19% from 1.22% for the same period in 2006.  The net interest spread increased 175 basis points to 1.75% for the six months ended June 30, 2007 from 0.00% for the same period in 2006. The net yield on average interest earning assets for the six months ended June 30, 2007 increased relative to the same period in 2006, to 2.82% from 1.20%. The increase in the Company's net interest spread for the three months ended June 30, 2007 compared to the same period in 2006 can be attributed primarily to an increase of 72 basis points (80 basis points for the six months ended June 30) as a result of the derecognition of $279.0 million of commercial mortgage loans contributed to a joint venture in 2006, and an increase of 94 basis points (51 basis points for the six months ended June 30) resulting from increase in amortization of premiums on securitization financing due to the prepayment of three commercial mortgage loans in June 2007.  In addition, net interest spread on the Company’s variable-rate single-family loan portfolio increased by 26 basis points (28 basis points for the six months ended June 30) as LIBOR-based securitization financing rates flattened beginning in June 2006 while adjustable-rate securitized receivables continued to reset.


21

The following table summarizes the amount of change in interest income and interest expense due to changes in interest rates versus changes in volume:

   
Three Months Ended June 30, 2007 vs. 2006
  
(amounts in thousands)
  
Rate
    
Volume
    
Total
  
   
 
    
 
    
 
  
Securitized finance receivables
   $
1,241
     $ (7,529 )   $ (6,288 )
Securities
     (54 )     (65 )     (119 )
Other loans
     (16 )     (43 )     (59 )
                         
Total interest income
    
1,171
       (7,637 )     (6,466 )
                         
Securitization financing
     (1,620 )     (5,035 )     (6,655 )
Repurchase agreements
    
94
       (451 )     (357 )
                         
Total interest expense
     (1,526 )     (5,486 )     (7,012 )
                         
Net interest income
   $
2,697
     $ (2,151 )   $
546
  
                         


   
Six Months Ended June 30, 2007 vs. 2006
  
(amounts in thousands)
  
Rate
    
Volume
    
Total
  
   
 
    
 
    
 
  
Securitized finance receivables
   $
2,154
     $ (15,299 )   $ (13,145 )
Securities
    
198
       (535 )     (337 )
Other loans
    
46
       (85 )     (39 )
                         
Total interest income