Edgar Filing: DYNEX CAPITAL INC

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

þ	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2008

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.)

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, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer	o	Accelerated filer	þ
Non-accelerated filer	o (Do not check if a smaller reporting company)	Smaller reporting company	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 þ

On October 31, 2008, the registrant had 12,169,762 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
PART I.	FINANCIAL INFORMATION

	Item 1.	Financial Statements

		Condensed Consolidated Balance Sheets at September 30, 2008 (unaudited) and December 31, 2007	1

		Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2008 and 2007 (unaudited)	2

		Condensed Consolidated Statement of Shareholders’ Equity for the nine months ended September 30, 2008 and 2007 (unaudited)	3

		Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2008 and 2007 (unaudited)	4

		Notes to Unaudited Condensed Consolidated Financial Statements	5

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	19

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	46

	Item 4.	Controls and Procedures	48

PART II.	OTHER INFORMATION

	Item 1.	Legal Proceedings	48

	Item 1A.	Risk Factors	49

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	49

	Item 3.	Defaults Upon Senior Securities	49

	Item 4.	Submission of Matters to a Vote of Security Holders	49

	Item 5.	Other Information	50

	Item 6.	Exhibits	50

SIGNATURES

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

DYNEX CAPITAL, INC.

CONDENSED CONSOLIDATED

BALANCE SHEETS

(amounts in thousands except share data)

	September 30,			December 31,
	2008			2007
	(unaudited)
ASSETS
Agency RMBS:
Pledged to counterparties, at fair value	$	283,976		$	–
Unpledged, at fair value		16,916			7,456
		300,892			7,456

Securitized mortgage loans, net		252,507			278,463
Investment in joint venture		10,448			19,267
Other investments		17,340			28,549
		581,187			333,735

Cash and cash equivalents		16,411			35,352
Other assets		5,495			5,671
	$	603,093		$	374,758
LIABILITIES AND SHAREHOLDERS’ EQUITY
LIABILITIES
Repurchase agreements	$	265,819		$	4,612
Securitization financing		185,184			204,385
Obligation under payment agreement		10,079			16,796
Other liabilities		2,377			7,029
		463,459			232,822

Commitments and Contingencies (Note 13)

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, 12,169,762 and 12,136,262 shares issued and outstanding, respectively		122			121
Additional paid-in capital		366,793			366,716
Accumulated other comprehensive (loss) income		(6,041	)		1,093
Accumulated deficit		(262,989	)		(267,743	)
		139,634			141,936
	$	603,093		$	374,758

See notes to unaudited condensed consolidated financial statements.

DYNEX CAPITAL, INC.

CONDENSED CONSOLIDATED STATEMENTS

OF OPERATIONS (UNAUDITED)

(amounts in thousands except per share data)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2008			2007			2008			2007
Interest income:
Investments	$	7,719		$	6,836		$	20,375		$	21,548
Cash and cash equivalents		158			637			659			2,163
		7,877			7,473			21,034			23,711
Interest expense		5,090			5,016			13,325			15,830
Net interest income		2,787			2,457			7,709			7,881
(Provision for) recapture of loan losses		(449	)		127			(796	)		1,352

Net interest income after (provision for) recapture of loan losses		2,338			2,584			6,913			9,233

Equity in (loss) income of joint venture		(3,462	)		576			(5,153	)		1,878
Gain on sale of investments, net		331			21			2,381			21
Fair value adjustments, net		1,461			–			5,519			–
Other income (expense)		3,862			305			6,954			(713	)
General and administrative expenses		(1,485	)		(800	)		(3,954	)		(3,089	)

Net income		3,045			2,686			12,660			7,330
Preferred stock dividends		(1,003	)		(1,003	)		(3,008	)		(3,008	)

Net income to common shareholders	$	2,042		$	1,683		$	9,652		$	4,322

Net income per common share:
Basic	$	0.17		$	0.14		$	0.79		$	0.36
Diluted	$	0.17		$	0.14		$	0.77		$	0.36

See notes to unaudited condensed consolidated financial statements.

DYNEX CAPITAL, INC.

CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY (UNAUDITED)

Nine Months Ended September 30, 2008 and 2007

(amounts in thousands)

	Preferred Stock		Common Stock		Additional Paid-in Capital		Accumulated Other Comprehensive (Loss) Income			Accumulated Deficit			Total
Balance at December 31, 2007	$	41,749	$	121	$	366,716	$	1,093		$	(267,743	)	$	141,936

Cumulative effect of adoption of SFAS 159		–		–		–		–			943			943
Net income		–		–		–		–			12,660			12,660
Other comprehensive income:
Change in market value of securities and other investments		–		–		–		(4,753	)		–			(4,753	)
Reclassification adjustment for net gains included in net income		–		–		–		(2,381	)		–			(2,381	)
Total comprehensive income														5,526

Dividends on common stock		–		–		–		–			(5,841	)		(5,841	)
Dividends on preferred stock		–		–		–		–			(3,008	)		(3,008	)
Stock option issuance		–		–		13		–			–			13
Grant and vesting of restricted stock		–		1		64		–			–			65

Balance at September 30, 2008	$	41,749	$	122	$	366,793	$	(6,041	)	$	(262,989	)	$	139,634

	Preferred Stock		Common Stock		Additional Paid-in Capital		Accumulated Other Comprehensive (Loss) Income			Accumulated Deficit			Total
Balance at December 31, 2006	$	41,749	$	121	$	366,637	$	663		$	(272,632	)	$	136,538

Net income		–		–		–		–			7,330			7,330
Other comprehensive income:
Change in market value of securities and other investments		–		–		–		433			–			433
Reclassification adjustment for net gains included in net income		–		–		–		(21	)		–			(21	)
Total comprehensive income														7,742

Dividends on preferred stock		–		–		–		–			(3,008	)		(3,008	)
Stock option exercise		–		–		37		–			–			37
Stock option issuance		–		–		42		–			–			42

Balance at September 30, 2007	$	41,749	$	121	$	366,716	$	1,075		$	(268,310	)	$	141,351

See notes to unaudited condensed consolidated financial statements.

DYNEX CAPITAL, INC.

CONDENSED CONSOLIDATED STATEMENTS

OF CASH FLOWS (UNAUDITED)

(amounts in thousands)

	Nine Months Ended
	September 30,
	2008			2007
Operating activities:
Net income	$	12,660		$	7,330
Adjustments to reconcile net income to cash provided by operating activities:
Equity in loss (income) of joint venture		5,153			(1,878	)
Distribution of joint venture earnings		–			1,125
Provision for (recapture of) loan losses		796			(1,352	)
Gain on sale of investments, net		(2,381	)		(21	)
Fair value adjustments, net		(5,519	)		–
Amortization and depreciation		(1,694	)		(1,518	)
Stock based compensation (benefit) expense		(263	)		42
Net change in other assets and other liabilities		(4,134	)		2,883
Net cash provided by operating activities		4,618			6,611

Investing activities:
Principal payments received on securitized mortgage loans		28,008			51,517
Purchases of Agency RMBS		(343,941	)		–
Purchases of other investments		(9,988	)		(16,398	)
Payments received on Agency RMBS and other investments		21,171			8,230
Proceeds from sales of Agency RMBS		29,744			–
Proceeds from sales of other investments		19,188			452
Return of capital from joint venture		–			17,095
Other		(2,882	)		931
Net cash (used) provided by investing activities		(258,700	)		61,827

Financing activities:
Principal payments on securitization financing		(17,217	)		(27,119	)
Net borrowings under (repayments of) repurchase agreements		261,207			(59,781	)
Proceeds from sale of common stock		–			37
Dividends paid		(8,849	)		(3,008	)
Net cash provided (used) by financing activities		235,141			(89,871	)

Net decrease in cash and cash equivalents		(18,941	)		(21,433	)
Cash and cash equivalents at beginning of period		35,352			56,880
Cash and cash equivalents at end of period	$	16,411		$	35,447


See notes to unaudited condensed consolidated financial statements.

DYNEX CAPITAL, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2008

(amounts in thousands except share and per share data)

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

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 and variable interest entities in which it is determined to be the primary beneficiary in accordance with Financial Interpretation (“FIN”) 46(R). 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 of 1986, as amended (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 nine months ended September 30, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008. 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, 2007, filed with the Securities and Exchange Commission (the “SEC”).

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. All of the Company’s securities are considered available-for-sale and are therefore carried in the accompanying financial statements at estimated fair value. Estimates of fair value for agency mortgage-backed securities are based on market prices provided by multiple dealers. Estimates of fair value for other securities are based on market quotes for equity securities and dealer quotes for certain fixed income securities, where available. When market prices are not available for fixed income securities, 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.

The Company evaluates all securities and other investments in its investment portfolio for other-than-temporary impairments. An investment is generally defined to be other-than-temporarily impaired if, for a maximum period of three consecutive quarters, the carrying value of such security exceeds its estimated fair value, and the Company estimates, based on projected future cash flows or other fair value determinants, that the fair value will remain below the carrying value for the foreseeable future. If an other-than-temporary impairment is deemed to exist, the Company records an impairment charge to adjust the carrying value of the investment 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 investment will be placed on non-accrual status.

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 the allowance for loan losses are presented as provision for loan losses or recapture of loan losses, in the accompanying condensed consolidated statements of operations. The Company’s actual credit losses may differ from those estimates used to establish the allowance.

The Company includes all cash and highly liquid investments with original maturities of three months or less in cash and cash equivalents. As of September 30, 2008, cash and cash equivalents included $1,453 of restricted cash, which was cash held by counterparties as collateral against the Company’s repurchase agreements.

New Accounting Standards

In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51” (“SFAS 160”). SFAS 160 addresses reporting requirements in the financial statements of non-controlling interests to their equity share of subsidiary investments. SFAS 160 applies to reporting periods beginning after December 15, 2008. The Company is currently evaluating the potential impact that the adoption of SFAS 160 will have on the Company’s financial statements.

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS 141(R)”) which revised SFAS No. 141, “Business Combinations.” This pronouncement is effective as of January 1, 2009. Under SFAS No. 141, organizations utilized the announcement date as the measurement date for the purchase price of the acquired entity. SFAS 141(R) requires measurement at the date the acquirer obtains control of the acquiree, generally referred to as the acquisition date. SFAS 141(R) will have a significant impact on the accounting for transaction costs, restructuring costs, as well as the initial recognition of contingent assets and liabilities assumed during a business combination. Under SFAS 141(R), adjustments to the acquired entity’s deferred tax assets and uncertain tax position balances occurring outside the measurement period are recorded as a component of the income tax expense, rather than goodwill. As the provisions of SFAS 141(R) are applied prospectively, the impact cannot be determined until the transactions occur. The Company does not believe this pronouncement will have a material effect on its financial statements.

On March 20, 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133” (“SFAS 161”). SFAS 161 provides for enhanced disclosures about how and why an entity uses derivatives and how and where those derivatives and related hedged items are reported in the entity’s financial statements. SFAS 161 also requires certain tabular formats for disclosing such information. SFAS 161 is effective for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. SFAS 161 applies to all entities and all derivative instruments and related hedged items accounted for under SFAS 133. Among other things, SFAS 161 requires disclosures of an entity’s objectives

and strategies for using derivatives by primary underlying risk and certain disclosures about the potential future collateral or cash requirements as a result of contingent credit-related features. The Company is currently evaluating the impact, if any, that the adoption of SFAS 161 will have on the Company’s financial statements.

On February 20, 2008, the FASB issued FASB Staff Position (“FSP”) 140-3, “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions,” (“FSP 140-3”), which provides guidance on accounting for transfers of financial assets and repurchase financings. FSP 140-3 presumes that an initial transfer of a financial asset and a repurchase financing are considered part of the same arrangement (i.e., a linked transaction) under SFAS No. 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“SFAS 140”). However, if certain criteria, as described in FSP 140-3, are met, the initial transfer and repurchase financing shall not be evaluated as a linked transaction and shall be evaluated separately under SFAS 140. If the linked transaction does not meet the requirements for sale accounting, the linked transaction shall generally be accounted for as a forward contract, as opposed to the current presentation, where the purchased asset and the repurchase liability are reflected separately on the balance sheet. FSP 140-3 is effective on a prospective basis for fiscal years beginning after November 15, 2008, with earlier application not permitted. The Company is currently evaluating the impact, if any, that the adoption of FSP 140-3 will have on the Company’s financial statements.

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 Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies” (“SOP 07-1”) which provides guidance for determining whether an entity is within the scope of the guidance in the AICPA Audit and Accounting Guide for Investment Companies. On February 6, 2008, the FASB indefinitely deferred the effective date of SOP 07-1.

On October 10, 2008, the FASB issued FSP No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP 157-3”). FSP 157-3 clarifies the application of SFAS 157, “Fair Value Measurements” (“SFAS 157”) in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. The issuance of FSP 157-3 did not have any impact on the Company’s determination of fair value for its financial assets.

NOTE 2 – NET INCOME PER COMMON SHARE

Net income per common share is presented on both a basic and diluted 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 options, 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 tables reconcile the numerator and denominator for both basic and diluted net income per common share for the three and nine months ended September 30, 2008 and 2007.

	Three Months Ended September 30,
	2008					2007
	Income			Weighted-Average Common Shares		Income			Weighted- Average Common Shares
Net income	$	3,045				$	2,686
Preferred stock dividends		(1,003	)				(1,003	)
Net income to common shareholders		2,042			12,169,762		1,683			12,136,262
Effect of dilutive items		–			2,761		–			2,369
Diluted	$	2,042			12,172,523	$	1,683			12,138,631

Net income per share:
Basic				$	0.17				$	0.14
Diluted				$	0.17				$	0.14

Reconciliation of shares included in calculation of income per share due to dilutive effect:
Net effect of dilutive:
Convertible preferred stock		–			–		–			–
Stock options		–			2,761		–			2,369
	$	–			2,761	$	–			2,369

	Nine Months Ended September 30,
	2008					2007
	Income			Weighted-Average Common Shares		Income			Weighted- Average Common Shares
Net income	$	12,660				$	7,330
Preferred stock dividends		(3,008	)				(3,008	)
Net income to common shareholders		9,652			12,165,483		4,322			12,135,236
Effect of dilutive items		3,008			4,227,296		–			2,079
Diluted	$	12,660			16,392,779	$	4,322			12,137,315

Net income per share:
Basic				$	0.79				$	0.36
Diluted				$	0.77				$	0.36

Reconciliation of shares included in calculation of income per share due to dilutive effect:
Net effect of dilutive:
Convertible preferred stock		3,008			4,221,539		–			–
Stock options		–			5,757		–			2,079
	$	3,008			4,227,296	$	–			2,079

The following securities were excluded from the calculation of diluted income per share, as their inclusion would be anti-dilutive:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2008		2007		2008		2007
Shares issuable under stock option awards		85,000		60,000		50,000		60,000
Convertible preferred stock		4,221,539		4,221,539		–		4,221,539

NOTE 3 – SECURITIZED MORTGAGE LOANS, NET

The following table summarizes the components of securitized mortgage loans at September 30, 2008 and December 31, 2007:

	September 30, 2008			December 31, 2007
Securitized mortgage loans:
Commercial mortgage loans	$	171,028		$	185,998
Single-family mortgage loans		73,230			86,088
		244,258			272,086
Funds held by trustees, including funds held for defeased commercial mortgage loans		10,091			7,225
Accrued interest receivable		1,664			1,940
Unamortized discounts and premiums, net		6			(67	)
Loans, at amortized cost		256,019			281,184
Allowance for loan losses		(3,512	)		(2,721	)
	$	252,507		$	278,463

All of the securitized mortgage loans are encumbered by securitization financing bonds (see Note 9).

NOTE 4 – ALLOWANCE FOR LOAN LOSSES

The allowance for loan losses is included in securitized mortgage loans, net in the accompanying condensed consolidated balance sheets. The following table summarizes the aggregate activity for the allowance for loan losses for the three-month and nine-month periods ended September 30, 2008 and 2007:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2008			2007			2008			2007
Allowance at beginning of period	$	3,066		$	2,805		$	2,721		$	4,495
Provision for (recapture of) loan losses		449			(127	)		796			(1,352	)
Charge-offs, net of recoveries		(3	)		(30	)		(5	)		(495	)
Allowance at end of period	$	3,512		$	2,648		$	3,512		$	2,648

Of these amounts, $3,341 and $2,520 relate to securitized commercial mortgage loans and $171 and $128 relate to securitized single-family mortgage loans at September 30, 2008 and 2007, respectively.

The Company identified $16,853 of impaired commercial loans at September 30, 2008, which included one delinquent loan with an amortized cost basis of $1,763, compared to $13,792 of impaired commercial loans at December 31, 2007, none of which were delinquent.

The following table presents certain information on impaired commercial mortgage loans at December 31, 2007 and September 30, 2008:

	Investment in Impaired Loans		Allowance for Loan Losses		Investment in Excess of Allowance
December 31, 2007	$	13,792	$	2,590	$	11,202
September 30, 2008		16,853		3,341		13,512

NOTE 5 – AGENCY MORTGAGE-BACKED SECURITIES

The Company’s agency mortgage-backed securities (“Agency RMBS”) are debt securities collateralized by single-family mortgage loans, on which the payment of principal and interest has been guaranteed by Federal National Mortgage Corporation (“Fannie Mae”) or Federal Home Loan Mortgage Corporation (“Freddie Mac”). The Company’s Agency RMBS are comprised primarily of hybrid RMBS, which have interest rates that are fixed for a specified period and generally reset annually thereafter (“Hybrid Agency RMBS”). At September 30, 2008, the Company’s Hybrid Agency RMBS securities were $300,627 and had a weighted average of 22 months to reset. The Company also had fixed rate Agency RMBS with a carrying value of $265 at September 30, 2008.

The following table presents the components of the Company’s investment in Agency RMBS as of September 30, 2008 and December 31, 2007:

	September 30, 2008			December 31, 2007
Principal/par value	$	299,012		$	7,400
Purchase premiums		3,688			14
Purchase discounts		(3	)		(4	)
Amortized cost		302,697			7,410
Gross unrealized gains		68			46
Gross unrealized losses		(1,873	)		–
Fair value	$	300,892		$	7,456

Weighted average yield		5.15	%		5.43	%

Principal/par value includes principal payments receivable on Agency RMBS of $2,014 and none as of September 30, 2008 and December 31, 2007, respectively.

The Company purchased approximately $343,941 of Agency RMBS during the nine-month period ended September 30, 2008 and financed the purchases primarily with repurchase agreements. Of the Agency RMBS balances at September 30, 2008 and December 31, 2007, Agency RMBS with a fair value of $283,976 and none were pledged as collateral under the repurchase agreements, respectively. The Company sold $29,869 of Agency RMBS during the third quarter of 2008 at a net loss of $125.

NOTE 6 — INVESTMENT IN JOINT VENTURE

The Company, through a wholly-owned subsidiary, holds a 49.875% interest in a joint venture, Copperhead Ventures, LLC, primarily between the Company and DBAH Capital, LLC, an affiliate of Deutsche Bank, A. G.

The Company accounts for its investment in the joint venture using the equity method, under which it recognizes its proportionate share of the joint venture’s earnings and comprehensive income. The condensed financial statements of the joint venture are as follows:

Condensed Statements of Operations
	Three Months Ended September 30,						Nine Months Ended September 30,
	2008			2007			2008			2007
Interest income	$	903		$	1,551		$	3,392		$	4,468
Fair value adjustment		(1,584	)		(57	)		(5,846	)		75
Other-than-temporary impairment		(6,073	)		–			(7,277	)		–
Other expense		(6	)		(25	)		(59	)		(62	)
Net (loss) income	$	(6,760	)	$	1,469		$	(9,790	)	$	4,481

Change in unrealized loss on investments classified as available for sale		1,276			(591	)		(6,589	)		624
Comprehensive (loss) income	$	(5,484	)	$	878		$	(16,379	)	$	5,105

The other-than-temporary impairment of $6,073 in the third quarter of 2008 is related to the joint venture’s investment in subordinate commercial mortgage-backed securities (“CMBS”), which is accounted for by the joint venture in accordance with Emerging Issues Task Force No. 99-20 (“EITF 99-20”). Based on the current and expected near term market conditions, the joint venture determined that there had been an adverse change with regard to the timing and amount of the estimated future cash flows for this security and so an other-than-temporary impairment was recorded to adjust the joint venture’s basis in the security to its fair value at September 30, 2008.

Condensed Balance Sheets
	September 30, 2008			December 31, 2007
Assets:
Cash and cash equivalents	$	7,582		$	5,592
Investments		12,801			32,207
Accrued interest receivable and other assets		264			173
	$	20,647		$	37,972

Total liabilities	$	–		$	–
Members’ capital:
Members capital		38,402			38,402
Accumulated other comprehensive loss		(7,829	)		(1,239	)
Retained (deficit) earnings		(9,926	)		809
	$	20,647		$	37,972

The joint venture’s investments at September 30, 2008 were comprised of $2,722 of available-for-sale subordinate CMBS and a financial instrument backed by commercial mortgage loans accounted for under SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” with a fair value of $10,079.

NOTE 7 – OTHER INVESTMENTS

The following table summarizes the Company’s other investments at September 30, 2008 and December 31, 2007:

	September 30, 2008						December 31, 2007
	Carrying Value			Weighted Average Yield			Carrying Value			Weighted Average Yield
Other securities:
Non-agency mortgage-backed securities	$	7,051			7.17	%	$	7,684			6.85	%
Corporate debt securities		–			–	%		4,722			11.75	%
Equity securities of publicly traded companies		7,653						7,704
		14,704						20,110
Gross unrealized gains		448						2,361
Gross unrealized losses		(923	)					(696	)
		14,229						21,775
Other loans and investments		3,111						6,774
	$	17,340					$	28,549

Other securities

Non-agency mortgage-backed securities consist principally of fixed rate securities collateralized by single-family residential loans originated in 1994.

The Company sold approximately $10,020 of equity securities during the nine months ended September 30, 2008, on which it recognized a gain of $2,698, and purchased approximately $9,988 of equity securities during that period. The Company also sold the corporate debt security during the second quarter of 2008, on which it recognized a loss of $187.

Other loans and investments

Other loans and investments is comprised principally of unsecuritized mortgage loans and property tax receivables. The mortgage loans are well seasoned, having been originated predominately between 1986 and 1997. Of the approximately 40 mortgage loans that make up the balance, only three loans were 60 days or more delinquent as of September 30, 2008, which represent approximately 12% of the outstanding unpaid principal balance of the loans. These three loans are carried at discounts to their principal balances such that no losses are anticipated. The property tax receivables had a balance of $375 and $2,127 at September 30, 2008 and December 31, 2007, respectively.

NOTE 8 – FAIR VALUE MEASUREMENTS

On January 1, 2008, the Company adopted the provisions of SFAS 157 for all assets that are measured at fair value and for its obligation to joint venture under payment agreement liability. Fair value is defined as the price at which an asset could be exchanged in a current transaction between knowledgeable, willing parties. A liability’s fair value is defined as the amount that would be paid to transfer or settle the liability. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available, valuation models are applied. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency for the instruments or market and the instruments’ complexity.

Assets and liabilities recorded at fair value in the condensed consolidated balance sheets are categorized based upon the level of judgment associated with the inputs used to measure their fair value. Hierarchical levels, defined by

SFAS 157 and directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities, are as follows:

Level 1 — Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date. The types of assets and liabilities carried at Level 1 fair value generally are equity securities listed in active markets.

Level 2 — Inputs (other than quoted prices included in Level 1) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life. Fair valued assets and liabilities that are generally included in this category are Agency RMBS.

Level 3 — Inputs reflect management’s best estimate of what market participants would use in pricing 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. Generally, assets and liabilities carried at fair value and included in this category are non-agency mortgage-backed securities, delinquent property tax receivables and the obligation under payment agreement liability.

The following table presents the Company’s assets and liabilities at September 30, 2008, which are carried at fair value, segregated by the hierarchy level of the fair value estimate:

			Fair Value Measurements
	Fair Value		Level 1		Level 2		Level 3
Assets:
Agency RMBS	$	300,892	$	–	$	300,892	$	–
Non-agency RMBS		6,822		–		–		6,822
Equity securities		7,407		7,407		–		–
Other		375		–		–		375
Total assets carried at fair value	$	315,496	$	7,407	$	300,892	$	7,197

Liabilities:
Obligation under payment agreement	$	10,079	$	–	$	–	$	10,079
Total liabilities carried at fair value	$	10,079	$	–	$	–	$	10,079

The following tables present the reconciliations of the beginning and ending balances of the Level 3 fair value estimates for the three and nine month periods ended September 30, 2008:

	Level 3 Fair Values
	Non-agency RMBS			Corporate debt securities		Other			Total assets			Obligation under payment agreement
Balance at July 1, 2008	$	7,012		$	–	$	547		$	7,559		$	11,663
Total realized and unrealized gains (losses)
Included in earnings		–			–		(2	)		(2	)		(1,584	)
Included in other comprehensive income (loss)		(229	)		–		143			(86	)		–
Purchases, sales, issuances and other settlements, net		39			–		(313	)		(274	)		–
Transfers in and/or out of Level 3		–			–		–			–			–
Balance at September 30, 2008	$	6,822		$	–	$	375		$	7,197		$	10,079

	Level 3 Fair Values
	Non-agency RMBS			Corporate debt securities			Other			Total assets			Obligation under payment agreement
Balance at January 1, 2008	$	7,726		$	4,347		$	2,127		$	14,200		$	15,473
Total realized and unrealized gains (losses)
Included in earnings		–			(187	)		(4	)		(191	)		(5,394	)
Included in other comprehensive income (loss)		(272	)		375			143			246			–
Purchases, sales, issuances and other settlements, net		(632	)		(4,535	)		(1,891	)		(7,058	)		–
Transfers in and/or out of Level 3		–			–			–			–			–
Balance at September 30, 2008	$	6,822		$	–		$	375		$	7,197		$	10,079

There were no assets or liabilities which were measured at fair value on a non-recurring basis during the three or nine months ended September 30, 2008.

NOTE 9 – SECURITIZATION FINANCING

The Company, through limited-purpose finance subsidiaries, has issued bonds pursuant to indentures in the form of non-recourse securitization financing. Each series of securitization financing may consist of various classes of bonds, either at fixed or variable rates of interest and having varying repayment terms. The Company, on occasion, may retain bonds or redeem bonds and hold such bonds outstanding for possible future resale or reissuance. Payments received on securitized mortgage loans and any reinvestment income earned thereon are used to make payments on the bonds.

The obligations under the securitization financings are payable solely from the securitized mortgage loans and are otherwise non-recourse to the Company. The stated maturity date for each class of bonds is generally calculated based on the final scheduled payment date of the underlying collateral pledged. The actual maturity of each class will be directly affected by the rate of principal prepayments on the related collateral. Each series is also subject to redemption at the Company’s option according to specific terms of the respective indentures. As a result, the actual maturity of any class of a series of securitization financing is likely to occur earlier than its stated maturity.

The Company has three series of bonds remaining outstanding pursuant to three separate indentures. One series with a principal amount of $29,376 is collateralized by $73,230 in single-family mortgage loans. The two remaining series with principal amounts of $22,319 and $132,986, respectively, are collateralized by commercial mortgage loans with unpaid principal balances at September 30, 2008 of $27,088 and $143,939, respectively.

The components of non-recourse securitization financing along with certain other information at September 30, 2008 and December 31, 2007 are summarized as follows:

	September 30, 2008						December 31, 2007
	Bonds Outstanding			Range of Interest Rates			Bonds Outstanding		Range of Interest Rates
Fixed-rate classes	$	155,305			6.6% - 8.8	%	$	167,398		6.6% - 8.8	%
Variable-rate classes		29,376			2.8	%		34,500		5.1	%
Accrued interest payable		1,056						1,186
Unamortized net bond premium and deferred costs		(553	)					1,301
	$	185,184					$	204,385

Range of stated maturities		2024-2027						2024-2027
Estimated weighted average life	3.0 years						3.3 years
Number of series		3						3

At September 30, 2008, the weighted-average effective rate of the coupon on the bonds outstanding was 6.2%. The average effective rate on the bonds was 6.8% and 7.2% for the nine months ended September 30, 2008 and the year ended December 31, 2007, respectively.

The variable-rate bonds pay interest based on one-month LIBOR plus 30 basis points.

On June 15, 2008, the Company redeemed one fixed rate bond outstanding at par as permitted by the related securitization trust’s indenture. This bond had an unamortized premium of $1,247 on the redemption date, which the Company recognized as income and reported in “Other income (expense)” in the condensed consolidated statement of operations for the nine months ended September 30, 2008.

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 $265,819 and $4,612 at September 30, 2008 and December 31, 2007, respectively, which were collateralized by securities with a fair value of $281,962 and $42,975 at September 30, 2008 and December 31, 2007, respectively.

At September 30, 2008 and December 31, 2007, the repurchase agreements had a weighted average interest rate of 4.45% and 5.07%, respectively. At September 30, 2008 and December 31, 2007, all repurchase agreements had maturities of 30 days or less.

NOTE 11 – OBLIGATION UNDER PAYMENT AGREEMENT

Obligation under payment agreement represents the fair value of estimated future payments due to the joint venture discussed in Note 6. The amounts due under the payment agreement are based on the amounts received monthly by the Company on certain securitized mortgage loans with an unpaid principal balance of $143,939 at September 30, 2008, after payment of the associated securitization financing bonds outstanding with an unpaid principal balance of $132,986 at September 30, 2008. The present value of the payment agreement was determined based on the total estimated future payments discounted at a weighted average rate of 31.9%. Factors which significantly impact the valuation of the payment agreement include the credit performance of the underlying securitized mortgage loans, estimated prepayments on the loans and the weighted average discount rate used on the cash flows.

NOTE 12 – PREFERRED AND COMMON STOCK

The Company is authorized to issue up to 50,000,000 shares of preferred stock. For all series issued, dividends are cumulative from the date of issue and are payable quarterly in arrears. The dividend per share is equal to the greater of (i) the per quarter base rate of $0.2375 for Series D, or (ii) the quarterly dividend declared on the Company’s common stock. One share of Series D preferred stock is convertible at any time at the option of the holder into one share of common stock. The series is redeemable by the Company at any time, in whole or in part, (i) at a rate of one share of preferred stock for one share of common stock, plus accrued and unpaid dividends, provided that for 20 trading days within any period of 30 consecutive trading days the closing price of the common stock equals or exceeds the issue price of $10, or (ii) for cash at the issue price, plus any accrued and unpaid dividends.

In the event of liquidation, the holders of the Company’s Series D preferred stock will be entitled to receive out of the Company’s assets, prior to any such distribution to the common shareholders, the issue price per share in cash, plus any accrued and unpaid dividends. If the Company fails to pay dividends for two consecutive quarters or if the Company fails to maintain consolidated shareholders’ equity of at least 200% of the aggregate issue price of the Series D preferred stock, then these shares automatically convert into a new series of 9.50% senior notes. The Company paid dividends of $0.95 per share of Series D preferred stock for each of the years ended December 31, 2007, 2006 and 2005.

The following table presents the changes in the number of preferred and common shares outstanding:

	Shares
	Preferred
	Series D		Common
December 31, 2007		4,221,539		12,136,262
Restricted shares granted		-		33,500
September 30, 2008		4,221,539		12,169,762

The following table presents the preferred and common dividends paid from January 1, 2008 through September 30, 2008:

Declaration	Record	Payment	Dividend per Share
Date	Date	Date	Common		Preferred
Common Stock
February 5, 2008	February 15, 2008	February 29, 2008	$	0.10		–
May 12, 2008	May 22, 2008	May 30, 2008		0.15		–
August 18, 2008	August 29, 2008	September 30, 2008		0.23		–

Preferred Stock
March 19, 2008	March 31, 2008	April 30, 2008		–	$	0.2375
June 18, 2008	June 30, 2008	July 31, 2008		–		0.2375
September 18, 2008	September 30, 2008	October 31, 2008		–		0.2375

Shelf Registration

On February 29, 2008, the Company filed a shelf registration statement on Form S-3, which became effective on April 17, 2008. The shelf registration permits the Company to sell up to $1.0 billion of securities, including common stock, preferred stock, debt securities and warrants. No shares had been sold or otherwise issued under this shelf registration as of September 30, 2008.

NOTE 13 – COMMITMENTS AND CONTINGENCIES

The Company and its subsidiaries may be involved in certain litigation matters arising in the ordinary course of business from time to time. Although the ultimate outcome of these matters cannot be ascertained at this time, and the results of legal proceedings cannot be predicted with certainty, the Company believes, based on current knowledge, that the resolution of these matters will not have a material adverse effect on the Company’s financial position or results of operations.

Information on litigation arising out of the ordinary course of business is described below.

One of the Company’s subsidiaries, GLS Capital, Inc. (“GLS”), and the County of Allegheny, Pennsylvania are defendants in a class action lawsuit (“Pentlong”) filed in 1997 in the Court of Common Pleas of Allegheny County, Pennsylvania (the "Court of Common Pleas"). Between 1995 and 1997, GLS purchased delinquent county property tax receivables for properties located in Allegheny County. Plaintiffs allege that GLS did not enjoy the same rights as its assignor, Allegheny County, to recover from delinquent taxpayers certain attorney fees, costs and expenses and interest in the collection of the tax receivables. Class action status has been certified in this matter, but a motion to reconsider is pending. This Pentlong litigation has been stayed pending the outcome of similar litigation before the Pennsylvania Supreme Court in which GLS is not a defendant. In that case, styled Konidaris v. Portnoff Law Offices, plaintiff Konidaris disputed the application of curative legislation enacted in 2003 but retroactive to 1996 which specifically set forth the right to collect reasonable attorney fees, costs, and interest which were properly taxable as part of the tax debt owed. In September 2008, the Pennsylvania Supreme Court issued an opinion in favor of the defendants in the Konidaris matter, which the Company believes will favorably impact the Pentlong litigation by substantially reducing Pentlong Plaintiffs’ universe of actionable claims of illegal actions by GLS in connection with the collection of the tax receivables. No timetable has been set by the Court of Common Pleas for the recommencement of the litigation. Pentlong Plaintiffs have not enumerated their damages in this matter, and the Company believes that the ultimate outcome of this litigation will not have a material impact on its 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 of the Company 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 DCI et al. as previously discussed by the Company in prior filings. There has been no material change in this litigation since the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2008 filed on August 11, 2008.

As discussed in prior filings, Dynex Capital, Inc. and MERIT Securities Corporation, a subsidiary, were 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 7, 2005, and purported 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, which are collateralized by manufactured housing loans. After a series of rulings by the District Court and an appeal by the Company and MERIT, on February 22, 2008 the United States Court of Appeals for the Second Circuit on February 22, 2008 dismissed the litigation against the Company and MERIT but with leave for Teamsters to amend and replead. Teamsters filed an amended complaint on August 6, 2008 with the District Court which essentially restated the same allegations as the original complaint and added the Company’s former president and its current Chief Operating Officer as defendants. The Company is currently evaluating the amended complaint and intends to vigorously defend itself in this matter. Although no assurance can be given with respect to the ultimate outcome of this matter, the Company believes the resolution of this matter will not have a material effect on its consolidated balance sheet but could materially affect its consolidated results of operations in a given year or period.

NOTE 14 – STOCK BASED COMPENSATION

Pursuant to the Company’s 2004 Stock Incentive Plan, as approved by the shareholders at the Company’s 2005 annual shareholders’ meeting (the “Stock Incentive Plan”), the Company may grant to eligible officers, directors and employees stock options, stock appreciation rights (“SARs”) and restricted stock awards. An aggregate of 1,500,000 shares of common stock is available for distribution pursuant to the Stock Incentive Plan. The Company may also grant dividend equivalent rights in connection with the grant of options or SARs.

On February 4, 2008, the Company granted 33,500 shares of restricted common stock to certain of its employees and officers under the Stock Incentive Plan. Of the restricted stock granted, 3,500 shares vest 25% per quarter in 2008. The remaining 30,000 shares of restricted stock vest 25% per year (on the grant date anniversary) over the next four years. The weighted average grant date fair value of the restricted stock grants was $8.80 per share for a total compensation cost of $294, which will be recognized evenly over the vesting period. The Company recognized expense related to the restricted stock granted of $24 and $64 for the three and nine month periods ended September 30, 2008, respectively.

On May 16, 2008, the Company granted options to acquire an aggregate of 25,000 shares of common stock to its directors under the Stock Incentive Plan for which the Company recognized an expense of approximately $13. The options vested immediately, expire on May 16, 2013 and have an exercise price of $9.81 per share, which was 110% of the closing price of the Company’s common stock on the grant date. The weighted average grant-date fair value of the options granted was $0.50 on the grant date.

The following table presents a summary of the SAR activity for the Stock Incentive Plan:

	Three Months Ended				Nine Months Ended
	September 30, 2008				September 30, 2008
	Number of Shares		Weighted-Average Exercise Price		Number of Shares		Weighted- Average Exercise Price
SARs outstanding at beginning of period		278,146	$	7.27		278,146	$	7.27
SARs granted		–		–		–		–
SARs forfeited or redeemed		–		–		–		–
SARs exercised		–		–		–		–
SARs outstanding at end of period		278,146	$	7.27		278,146	$	7.27
SARs vested and exercisable		149,860	$	7.41		149,860	$	7.41

The following table presents a summary of the option activity for the Stock Incentive Plan:

	Three Months Ended				Nine Months Ended
	September 30, 2008				September 30, 2008
	Number of Shares		Weighted-Average Exercise Price		Number of Shares		Weighted- Average Exercise Price
Options outstanding at beginning of period		120,000	$	8.60		95,000	$	8.28
Options granted		–		–		25,000		9.81
Options forfeited or redeemed		–		–		–		–
Options exercised		–		–		–		–
Options outstanding at end of period		120,000	$	8.60		120,000	$	8.60
Options vested and exercisable		120,000	$	8.60		120,000	$	8.60

The Company recognized a stock based compensation benefit of $135 and $341 for the three and nine months ended September 30, 2008, respectively, and stock based compensation benefit of $24 and expense of $141 for the three and nine months ended September 30, 2007, respectively. The total compensation cost related to non-vested awards was $63 and $377 at September 30, 2008 and 2007, respectively, and will be recognized as the awards vest.

As required by SFAS No. 123(R) “Share-Based Payment”, stock options, which may be settled only in shares of common stock, have been treated as equity awards, with their fair value measured at the grant date, and SARs, which may be settled in cash, have been treated as liability awards, with their fair value measured at the grant date and remeasured at the end of each reporting period. The fair value of SARs was estimated at September 30, 2008 using the Black-Scholes option valuation model based upon the assumptions in the table below.

The following table describes the weighted average of assumptions used for calculating the fair value of SARs outstanding at September 30, 2008.

	SARs Fair Value
	September 30, 2008
Expected volatility	18.06%-19.45%
Weighted-average volatility	18.71%
Expected dividends	11.93%
Expected term (in months)	45
Risk-free rate	3.97%

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations as of and for the three-month and nine-month periods ended September 30, 2008 should be read in conjunction with our Condensed Consolidated Financial Statements (unaudited) and the accompanying Notes to Unaudited Condensed Consolidated Financial Statements included in this report.

OVERVIEW

Our Business

We are a specialty finance company organized as a real estate investment trust (“REIT”), which invests in mortgage loans and securities on a leveraged basis. We were incorporated in Virginia on December 18, 1987, and commenced operations in February, 1988. We invest in residential mortgage-backed securities (“RMBS”) issued or guaranteed by a federally chartered corporation, such as Federal National Mortgage Corporation (“Fannie Mae”) or Federal Home Loan Mortgage Corporation (“Freddie Mac”), or an agency of the U.S. government, such as Government National Mortgage Association (“Ginnie Mae”). RMBS issued or guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae are commonly referred to as “Agency RMBS”. We initiated our Agency RMBS strategy during the first quarter of 2008.

We also have invested in securitized residential and commercial mortgage loans, non-agency mortgage-backed securities (“non-Agency RMBS”) and, through a joint venture, commercial mortgage-backed securities. Substantially all of these loans and securities, including those owned by the joint venture, consist of or are secured by first lien mortgages which were originated by us from 1992 to 1998. We are no longer actively originating loans.

Given the extraordinary deterioration in global credit markets since the middle of September 2008 which resulted in, on an industry-wide basis, constrained financing and higher funding costs, we temporarily slowed our purchases of additional Agency RMBS. Asset prices also weakened as a result of these conditions, particularly for very short duration Hybrid Agency ARMS with less than 12 months to reset. Since the end of September 2008, as a result of

the coordinated efforts by global central banks, funding costs have declined, access to funding has been less constrained and asset prices appear to have stabilized. We believe that conditions will continue to improve and opportunities will exist to purchase Agency RMBS at good risk-adjusted returns.

We have generally financed our investments through a combination of securitization financing, repurchase agreements and equity capital. We employ leverage in order to increase the overall yield on our invested capital. Our primary source of income is net interest income, which is the excess of the interest income earned on our investments over the cost of financing these investments. We may occasionally sell investments prior to their maturity.

At September 30, 2008, we had total investments of approximately $581.2 million. Our investments consisted of $300.9 million of Agency RMBS, $74.6 million of securitized single-family mortgage loans and $177.9 million of securitized commercial mortgage loans. We have a $10.4 million investment in a joint venture which owns subordinate commercial mortgage-backed securities and cash. We also had $7.4 million of equity securities and $6.8 million in non-Agency RMBS. A discussion of our investments and recent activity is included under “Financial Condition” below.

As a REIT, we are required to distribute to shareholders as dividends at least 90% of our taxable income, which is our income as calculated for tax, after consideration of any tax net operating loss (“NOL”) carryforwards. We had an NOL carryforward of approximately $150 million at December 31, 2007. These tax NOLs were principally generated during 1999 and 2000 and do not begin to meaningfully expire until 2019. Provided that we do not experience an ownership shift as defined under Section 382 of the Code, we may utilize the tax NOLs to offset distribution requirements for our REIT taxable income with certain limitations. If we do incur an ownership shift under Section 382 of the Code then the use of the NOLs to offset REIT distribution requirements may be limited. Our Board of Directors declared a dividend of $0.23 per common share for the third quarter of 2008 and expects to pay a dividend in the fourth quarter of 2008.

Investment Strategy

Our principal investment strategy today involves the investment of our capital in Agency RMBS. We expect to invest most of our capital in Hybrid Agency ARMs and Agency ARMs (both defined below), and to a lesser extent, fixed-rate Agency RMBS.

Hybrid Agency ARMs are RMBS securities collateralized by adjustable mortgage loans. Hybrid adjustable rate mortgage loans are loans which have a fixed rate of interest for a specified period (typically three to seven years) and which then adjust their interest rate at least annually to an increment over a specified interest rate index as further discussed below. Agency ARMs are RMBS securities collateralized by adjustable rate mortgage loans which have interest rates that generally will adjust at least annually to an increment over a specified interest rate index. Agency ARMs may be collateralized by Hybrid Agency ARMs that are past their fixed rate periods.

Interest rates on the adjustable rate loans collateralizing the Hybrid Agency ARMs or Agency ARMs are based on specific index rates, such as the one-year constant maturity treasury (“CMT”) rate, the London Interbank Offered Rate (“LIBOR”) the Federal Reserve U.S. 12-month cumulative average one-year CMT (“MTA”) or the 11th District Cost of Funds Index (“COFI”). These loans will typically have interim and lifetime caps on interest rate adjustments (“interest rate caps”) limiting the amount that the rates on these loans may reset in any given period.

Financing Strategy

We finance our acquisition of Agency RMBS by borrowing against a substantial portion of the market value of these assets utilizing repurchase agreements. Repurchase agreements are financings under which we will pledge our Agency RMBS as collateral to secure loans made by repurchase agreement counterparties. The amount borrowed under a repurchase agreement is limited to a specified percentage of the estimated market value of the pledged

collateral. Under repurchase agreements, a lender may require that we pledge additional assets (i.e., by initiating a margin call) in the event the estimated market value of our existing pledged collateral declines below a specified percentage during the term of the borrowing. Our pledged collateral fluctuates in value due to, among other things, changes in market interest rates, changes in market risk premiums and actual or anticipated principal repayments. We generally expect to maintain an effective debt to equity capital ratio of between five and nine times our equity capital invested in Agency RMBS, although the ratio may vary from time to time depending upon market conditions and other factors.

Generally, repurchase agreement borrowings will have a term of one month and carry a rate of interest based on a spread to an index such as LIBOR. Given the extraordinary deterioration in global credit markets since the middle of September 2008, financing costs for repurchase agreement terms exceeding one week have increased dramatically with the increase in LIBOR rates. In addition, the availability of repurchase agreement financing on an industry-wide basis has declined given the overall balance sheet stress of financial market participants, coupled with the events such as the bankruptcy of Lehman Brothers, the acquisition of Merrill Lynch by Bank of America and the conversion of Goldman Sachs and Morgan Stanley to depository institutions. This decline in availability as well as increasing LIBOR rates has directly impacted us in the form of higher borrowing costs. As of October 31, 2008, our weighted-average original term of repurchase agreement financing was 23 days, and our weighted average borrowing rate was 3.3%. Financial conditions have stabilized somewhat since September 30, 2008, and LIBOR rates have declined improving our overall financing costs. The availability of financing remains an issue on an industry-wide basis. We have maintained access to financing during this period, and we anticipate extending the maturity dates of our repurchase agreement financing. However, our ability to extend financing terms is likely to be limited during the fourth quarter of 2008.

Interest rates on Agency RMBS assets will not reset as frequently as the interest rates on repurchase agreement borrowings. As a result, we are exposed to reductions in our net interest income earned during a period of rising rates. In an effort to protect our net interest income during a period of rising interest rates, we would anticipate extending the interest rate reset dates on our repurchase agreement borrowings by negotiating terms with the counterparty. In addition, in a period of rising rates we may experience a decline in the carrying value of our Agency RMBS, which would impact our shareholders’ equity and common book value per share. In an effort to protect our book value per common share as well as our net interest income during a period of rising rates, we may also utilize derivative financial instruments such as interest rate swap agreements. An interest rate swap agreement would allow us to fix the borrowing cost on a portion of our repurchase agreement financing for a specified period of time. We currently have no swaps outstanding.

We may also use interest rate cap agreements. An interest rate cap agreement is a contract whereby we, as the purchaser, pay a fee in exchange for the right to receive payments equal to the principal (i.e., notional amount) times the difference between a specified interest rate and a future interest rate during a defined “active” period of time. Interest rate cap agreements should protect our net interest income in a rapidly rising interest rate environment.

In the future, we may use other sources of funding in addition to repurchase agreements to finance our Agency RMBS portfolio, including but not limited to, other types of collateralized borrowings, loan agreements, lines of credit, commercial paper or the issuance of equity or debt securities.

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 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 the 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.

Consolidation of Subsidiaries. The consolidated financial statements represent our accounts after the elimination of inter-company 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 and variable interest entities in which we are determined to be the primary beneficiary in accordance with Financial Interpretation (“FIN”) 46(R). We follow 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 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.

Securitization. We have securitized loans and securities in a securitization financing transaction by transferring financial assets to a wholly owned trust, with the trust issuing 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 will generally 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.

Fair Value. Securities classified as available-for-sale are carried in the accompanying financial statements at estimated fair value. Estimates of fair value for Agency RMBS are based on market prices provided by multiple dealers. Estimates of fair value for other securities are based on market quotes for equity securities and dealer quotes for certain fixed income securities, where available. When market prices are not available for fixed income securities, 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.

Amortization of Premiums/Discounts on Agency RMBS. Premiums and discounts on Agency RMBS are amortized into interest income over the life of the related security using the effective yield method, adjusted for actual prepayment activity.

Allowance for Loan Losses. We have credit risk on loans pledged in securitization financing transactions and classified as securitized mortgage loans in our investment portfolio. An allowance for loan losses has been estimated and established for currently existing probable losses. Factors considered in establishing an allowance include current loan delinquencies, historical cure rates of delinquent loans, and historical and anticipated loss severity of the

loans as they are liquidated. The allowance for loan losses is evaluated and adjusted periodically by management based on the actual and estimated timing and amount of probable credit losses, using the above factors, as well as industry loss experience. Where loans are considered homogeneous, the allowance for losses is established and evaluated on a pool basis. Otherwise, the allowance for losses is established and evaluated on a loan-specific basis. Provisions made to increase the allowance are a current period expense to operations. Single-family mortgage 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 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 our exposure on these loans. The level of allowance for loan losses required for these loans is reduced by the amount of applicable loan guarantees. Our actual credit losses may differ from the estimates used to establish the allowance.

FINANCIAL CONDITION

Below is a discussion of our financial condition.

(amounts in thousands)	September 30, 2008		December 31, 2007

Agency RMBS, at fair value	$	300,892	$	7,456
Securitized mortgage loans, net		252,507		278,463
Investment in joint venture		10,448		19,267
Other investments		17,340		28,549

Repurchase agreements		265,819		4,612
Securitization financing		185,184		204,385
Obligation under payment agreement		10,079		16,796

Agency RMBS

Our Agency RMBS investments, which are classified as available-for-sale and carried at fair value, are comprised as follows:

(amounts in thousands)	September 30, 2008		December 31, 2007
Hybrid Agency RMBS:
Fannie Mae Certificates	$	209,534	$	–
Freddie Mac Certificates		89,078		–
		298,612		–
Fixed Rate		266		7,456
		298,878		7,456
Principal receivable on Agency RMBS		2,014		–
	$	300,892	$	7,456

Agency RMBS increased from $7.5 million at December 31, 2007 to $300.9 million at September 30, 2008 primarily as a result of our purchase of approximately $343.9 million of Hybrid Agency RMBS during the nine-month period ended September 30, 2008. Partially offsetting the purchases were the receipt of $19.1 million of principal on the securities and the sale of approximately $29.9 million of securities, on which we recognized a net loss of $0.1 million, during the nine month period ended September 30, 2008. At September 30, 2008, our HybridAgency RMBS portfolio had a weighted average of 22 months remaining until the rates on the underlying loans collateralizing the Agency RMBS reset. The weighted average coupon on our portfolio of Agency RMBS was 5.65% as of September 30, 2008. Approximately $284.0 million of the Hybrid Agency RMBS is pledged to counterparties as security for repurchase agreement financing.

The average quarterly constant prepayment rate (“CPR”) realized on our Agency RMBS portfolio was 20.9% and 27.3% for the third and second quarters of 2008, respectively.

Adjustable rate mortgage loans collateralize our Hybrid Agency RMBS portfolio. The interest rates on the adjustable rate mortgage loans are typically fixed for three to five years and then adjust annually to an increment over a specified interest rate index. The following tables present information about the lifetime and interim caps on our Hybrid Agency RMBS portfolio as of September 30, 2008:

Lifetime Caps on ARM RMBS		Interim Interest Rate Caps on ARM RMBS
	% of Total		% of Total
9.0% to 10.0%	19.79%	2.0%	44.90%
>10.0% to 11.0%	54.27%	5.0%	55.10%
>11.0% to 12.0%	25.94%		100.00%
	100.00%

Securitized Mortgage Loans, Net

Securitized mortgage loans are comprised of loans secured by first deeds of trust on single-family residential and commercial properties. The following table presents our net basis in these loans at amortized cost, which includes accrued interest receivable, discounts, premiums, deferred costs and reserves for loan losses, by the type of property collateralizing the loan.

(amounts in thousands)	September 30, 2008		December 31, 2007
Securitized mortgage loans, net:
Commercial	$	177,922	$	190,570
Single-family		74,585		87,893
		252,507		278,463

Securitized commercial mortgage loans includes the loans pledged to two securitization trusts, which were issued in 1993 and 1997 and have outstanding principal balances of $27.1 million and $143.9 million, respectively, at September 30, 2008. The decrease in these loans was primarily related to principal payments of $15.2 million, $9.1 million of which were unscheduled, during the nine months ended September 30, 2008 partially offset by $3.1 million of defeased funds held by trustee and $0.3 million of net discount amortization.

Securitized single-family mortgage loans includes loans pledged to one securitization trust, which was issued in 2002 using loans that were principally originated between 1992 and 1997. The decrease in the securitized single-family mortgage loans was primarily related to principal payments on the loans of $12.9 million, $10.5 million of which were unscheduled, during the nine months ended September 30, 2008.

Investment in Joint Venture

Investment in joint venture declined during the nine months ended September 30, 2008 as a result of our interest in the net loss of the joint venture of $9.8 million and other comprehensive loss of the joint venture of $6.6 million. For discussion of the net loss of the joint venture see discussion under “Results of Operations.” Other comprehensive loss of $6.6 million relates primarily to an increase in the unrealized losses on a subordinate commercial mortgage backed security (“CMBS”) owned by the joint venture accounted for under EITF 99-20. The unrealized loss on this investment primarily related to widening credit spreads during 2008.

At September 30, 2008, the joint venture owns various subordinate interests in subordinate CMBS issued by two securitization trusts created in 1997 and 1998. The carrying value of these securities at September 30, 2008 was $10.1 million and $2.7 million respectively, relative to their principal balances of $149.6 million and $216.9 million. The joint venture also had cash and cash equivalents of $7.6 million at September 30, 2008.

Other Investments

Our other investments are comprised of other securities, which are classified as available-for-sale and carried at fair value, and other loans and investments, which are stated at amortized cost, as follows: