3Q14 Form 10-Q

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC  20549
FORM 10-Q
  x
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2014
or
  o
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
Commission File Number: 1-9819
DYNEX CAPITAL, INC.
(Exact name of registrant as specified in its charter)
Virginia
52-1549373
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification No.)
 
 
4991 Lake Brook Drive, Suite 100, Glen Allen, Virginia
23060-9245
(Address of principal executive offices)
(Zip Code)
 
 
(804) 217-5800
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes           x           No           o

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, 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
x
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           x

On November 3, 2014, the registrant had 54,736,663 shares outstanding of common stock, $0.01 par value, which is the registrant’s only class of common stock.


DYNEX CAPITAL, INC.
FORM 10-Q
INDEX
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated Balance Sheets as of September 30, 2014 (unaudited) and December 31, 2013
 
 
 
 
 
 
Consolidated Statements of Comprehensive Income (Loss) for the three and nine months ended September 30, 2014 (unaudited) and September 30, 2013 (unaudited)
 
 
 
 
 
 
Consolidated Statements of Shareholders' Equity for the nine months ended September 30, 2014 (unaudited)
 
 
 
 
 
 
Consolidated Statements of Cash Flows for the nine months ended September 30, 2014 (unaudited) and September 30, 2013 (unaudited)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 







i

PART I.
FINANCIAL INFORMATION
ITEM 1.    FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.
CONSOLIDATED BALANCE SHEETS
(amounts in thousands except share data)
 
September 30, 2014
 
December 31, 2013
ASSETS
(unaudited)
 

Mortgage-backed securities (including pledged of $3,420,668 and $3,873,584, respectively)
$
3,615,393

 
$
4,018,161

Mortgage loans held for investment, net
41,454

 
55,423

Cash and cash equivalents
56,639

 
69,330

Restricted cash
32,755

 
13,385

Derivative assets
7,297

 
18,488

Receivable for securities sold
16,321

 
—

Principal receivable on investments
11,124

 
12,999

Accrued interest receivable
20,986

 
21,703

Other assets, net
11,542

 
7,648

Total assets
$
3,813,511

 
$
4,217,137

 
 
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
 

 
 

Liabilities:
 

 
 

Repurchase agreements
$
3,150,254

 
$
3,580,754

Payable for unsettled mortgage-backed securities
—

 
10,358

Non-recourse collateralized financing
11,194

 
12,914

Derivative liabilities
18,058

 
6,681

Accrued interest payable
1,492

 
2,548

Accrued dividends payable
15,621

 
16,601

Other liabilities
2,845

 
1,405

 Total liabilities
3,199,464

 
3,631,261


 
 
 
Shareholders’ equity:
 

 
 

Preferred stock, par value $.01 per share, 8.5% Series A Cumulative Redeemable; 8,000,000 shares authorized; 2,300,000 shares issued and outstanding ($57,500 aggregate liquidation preference)
55,407

 
55,407

Preferred stock, par value $.01 per share, 7.625% Series B Cumulative Redeemable; 7,000,000 shares authorized; 2,250,000 shares issued and outstanding ($56,250 aggregate liquidation preference)
54,251

 
54,251

Common stock, par value $.01 per share, 200,000,000 shares
authorized; 54,734,817 and 54,310,484 shares issued and outstanding, respectively
547

 
543

Additional paid-in capital
763,228

 
761,550

Accumulated other comprehensive income (loss)
16,462

 
(33,816
)
Accumulated deficit
(275,848
)
 
(252,059
)
 Total shareholders' equity
614,047

 
585,876

Total liabilities and shareholders’ equity
$
3,813,511

 
$
4,217,137

See notes to unaudited consolidated financial statements.

1

DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)
 (amounts in thousands except per share data)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2014
 
2013
 
2014
 
2013
Interest income:
 
 
 
 
 
 
 
Mortgage-backed securities
$
25,207

 
$
30,820

 
$
79,104

 
$
95,827

Mortgage loans held for investment
793

 
846

 
2,255

 
2,711

 
26,000

 
31,666

 
81,359

 
98,538

Interest expense:
 
 
 
 
 
 
 
Repurchase agreements
6,028

 
8,477

 
20,187

 
29,860

Non-recourse collateralized financing
30

 
241

 
76

 
760

 
6,058

 
8,718

 
20,263

 
30,620

 

 
 
 
 
 
 
Net interest income
19,942

 
22,948

 
61,096

 
67,918

Provision for loan losses
—

 
—

 
—

 
(261
)
Gain (loss) on derivative instruments, net
4,842

 
(24,019
)
 
(31,654
)
 
(12,683
)
Gain (loss) on sale of investments, net
9,057

 
(825
)
 
5,273

 
2,597

Fair value adjustments, net
42

 
150

 
162

 
(590
)
Other income, net
897

 
748

 
1,108

 
761

General and administrative expenses:
 
 
 
 
 
 
 
Compensation and benefits
(2,351
)
 
(2,282
)
 
(7,232
)
 
(6,948
)
Other general and administrative
(1,563
)
 
(1,347
)
 
(4,620
)
 
(4,284
)
Net income (loss)
30,866

 
(4,627
)
 
24,133

 
46,510

Preferred stock dividends
(2,294
)
 
(2,294
)
 
(6,882
)
 
(5,608
)
Net income (loss) to common shareholders
$
28,572

 
$
(6,921
)
 
$
17,251

 
$
40,902

 
 
 
 
 
 
 
 
Other comprehensive income:
 
 
 
 
 
 
 
Change in fair value of available-for-sale investments
$
(6,867
)
 
$
(2,671
)
 
$
50,212

 
$
(112,037
)
Reclassification adjustment for (gain) loss on sale of investments, net
(9,057
)
 
825

 
(5,273
)
 
(2,597
)
Change in fair value of cash flow hedges
—

 
—

 
—

 
16,381

Reclassification adjustment for cash flow hedges (including de-designated hedges)
1,442

 
2,583

 
5,339

 
11,379

Total other comprehensive (loss) income
(14,482
)
 
737

 
50,278

 
(86,874
)
Comprehensive income (loss) to common shareholders
$
14,090

 
$
(6,184
)
 
$
67,529

 
$
(45,972
)
 
 
 
 
 
 
 
 
Weighted average common shares - basic and diluted
54,731

 
54,904

 
54,690

 
54,728

Net income (loss) per common share - basic and diluted
$
0.52

 
$
(0.13
)
 
$
0.32

 
$
0.75

Dividends declared per common share
$
0.25

 
$
0.27

 
$
0.75

 
$
0.85

See notes to unaudited consolidated financial statements.

2

DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(UNAUDITED)
(amounts in thousands)
 
Preferred
Stock
 
Common
Stock
 
Additional
Paid-in
Capital
 
Accumulated Other
Comprehensive (Loss) Income
 
Accumulated
Deficit
 
Total
Balance as of
 December 31, 2013
$
109,658

 
$
543

 
$
761,550

 
$
(33,816
)
 
$
(252,059
)
 
$
585,876

Stock issuance
—

 
1

 
215

 
—

 
—

 
216

Granting and vesting of restricted stock
—

 
4

 
2,041

 
—

 
—

 
2,045

Amortization of stock issuance costs
—

 
—

 
(72
)
 
—

 
—

 
(72
)
Adjustments for tax withholding on share-based compensation
—

 
(1
)
 
(506
)
 
—

 
—

 
(507
)
Net income
—

 
—

 
—

 
—

 
24,133

 
24,133

Dividends on preferred stock
—

 
—

 
—

 
—

 
(6,882
)
 
(6,882
)
Dividends on common stock
—

 
—

 
—

 
—

 
(41,040
)
 
(41,040
)
Other comprehensive income
—

 
—

 
—

 
50,278

 
—

 
50,278

Balance as of September 30, 2014
$
109,658

 
$
547

 
$
763,228

 
$
16,462

 
$
(275,848
)
 
$
614,047

See notes to the unaudited consolidated financial statements.

3

DYNEX CAPITAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(amounts in thousands)
 
Nine Months Ended
 
September 30,
 
2014
 
2013
Operating activities:
 
 
 
Net income
$
24,133

 
$
46,510

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

 
 

Decrease in accrued interest receivable
717

 
906

Decrease in accrued interest payable
(1,056
)
 
(462
)
Provision for loan losses
—

 
261

Loss on derivative instruments, net
31,654

 
12,683

Gain on sale of investments, net
(5,273
)
 
(2,597
)
Fair value adjustments, net
(162
)
 
590

Amortization of investment premiums, net
104,293

 
97,860

Other amortization and depreciation
7,007

 
4,398

Stock-based compensation expense
2,045

 
1,762

Other operating activities
(3,708
)
 
(3,907
)
Net cash and cash equivalents provided by operating activities
159,650

 
158,004

Investing activities:
 

 
 

Purchase of investments
(457,008
)
 
(1,325,082
)
Principal payments received on investments
404,464

 
742,551

Proceeds from sales of investments
376,278

 
327,962

Principal payments received on mortgage loans held for investment, net
14,150

 
10,775

Net payments on derivatives not designated as hedges
(9,086
)
 
(23,644
)
Other investing activities
(8
)
 
5,402

Net cash and cash equivalents provided by (used in) investing activities
328,790

 
(262,036
)
Financing activities:
 

 
 

(Repayments of) borrowings under repurchase agreements, net
(430,743
)
 
110,409

Principal payments on non-recourse collateralized financing
(1,753
)
 
(9,502
)
Increase in restricted cash
(19,370
)
 
(15,849
)
Proceeds from issuance of preferred stock
—

 
54,251

Proceeds from issuance of common stock, net of issuance costs
144

 
7,375

Cash paid for repurchases of common stock
—

 
(5,965
)
Payments related to tax withholding for share-based compensation
(507
)
 
(545
)
Dividends paid
(48,902
)
 
(52,343
)
Net cash and cash equivalents (used in) provided by financing activities
(501,131
)
 
87,831

 
 
 
 
Net decrease in cash and cash equivalents
(12,691
)
 
(16,201
)
Cash and cash equivalents at beginning of period
69,330

 
55,809

Cash and cash equivalents at end of period
$
56,639

 
$
39,608

Supplemental Disclosure of Cash Activity:
 

 
 

Cash paid for interest
$
15,703

 
$
22,065

See notes to unaudited consolidated financial statements.

4

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


NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization

Dynex Capital, Inc., ("Company”) was incorporated in the Commonwealth of Virginia on December 18, 1987 and commenced operations in February 1988. The Company primarily earns income from investing on a leveraged basis in mortgage-backed securities ("MBS") that are issued or guaranteed by the U.S. Government or U.S. Government sponsored agencies ("Agency MBS") and MBS issued by others ("non-Agency MBS").

Basis of Presentation

The accompanying unaudited consolidated financial statements of Dynex Capital, Inc. and its subsidiaries (together, “Dynex” or the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to the Quarterly Report on Form 10-Q and Article 10, Rule 10-01 of Regulation S-X promulgated by the Securities and Exchange Commission (the “SEC”). Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all significant adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation of the consolidated financial statements have been included. Operating results for the three and nine months ended September 30, 2014 are not necessarily indicative of the results that may be expected for any other interim periods or for the entire year ending December 31, 2014. The unaudited consolidated financial statements included herein should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 filed with the SEC.

Reclassifications

Certain items in the prior periods' consolidated financial statements have been reclassified to conform to the current year’s presentation. The Company's consolidated balance sheet as of December 31, 2013 now presents its "securitized mortgage loans, net" and "other investments, net" together as "mortgage loans held for investment, net". In addition, the Company has combined the presentation of its consolidated statements of income and its consolidated statements of other comprehensive income together as one financial statement which is now titled "consolidated statements of comprehensive income". The Company's "interest income - securitized mortgage loans" and "interest income-other investments" on its consolidated statements of income for the three and nine months ended September 30, 2013 is now presented together as "interest income-mortgage loans held for investment" on its consolidated statements of comprehensive income for the three and nine months ended September 30, 2013. These presentation changes have no effect on reported total assets, total liabilities, results of operations, or cash flow activities.

Consolidation
 
The consolidated financial statements include the accounts of the Company and the accounts of its majority owned subsidiaries and variable interest entities for which it is the primary beneficiary. All significant intercompany accounts and transactions have been eliminated in consolidation.

In accordance with Accounting Standards Codification ("ASC") Topic 810, the Company consolidates certain trusts through which it has securitized mortgage loans as a result of not meeting the sale criteria under GAAP at the time the financial assets were transferred to the trust. Additional information regarding the accounting policy for its securitized mortgage loans is provided below under "Mortgage Loans Held for Investment, Net".

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

5

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



Income Taxes
 
The Company has elected to be taxed as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986 and the corresponding provisions of state law. To qualify as a REIT, the Company must meet certain tests including investing in primarily real estate-related assets and the required distribution of at least 90% of its annual REIT taxable income to stockholders after consideration of its net operating loss carryforward and not including taxable income retained in its taxable subsidiaries. As a REIT, the Company generally will not be subject to federal income tax on the amount of its income or gain that is distributed as dividends to shareholders.
The Company assesses its tax positions for all open tax years and determines whether the Company has any material unrecognized liabilities in accordance with ASC Topic 740. The Company records these liabilities, if any, to the extent they are deemed more likely than not to have been incurred.
Mortgage-Backed Securities
 
In accordance with ASC Topic 320, the Company has designated its investments in MBS as available-for-sale ("AFS"). All of the Company’s MBS are recorded at fair value on the consolidated balance sheet. Changes in fair value for the Company's AFS securities are reported in other comprehensive income ("OCI") until each security is collected, disposed of, or determined to be other than temporarily impaired. Although the Company generally intends to hold its AFS securities until maturity, it may sell any of these securities as part of the overall management of its business. Upon the sale of an AFS security, any unrealized gain or loss is reclassified out of accumulated other comprehensive income ("AOCI") into net income as a realized "gain (loss) on sale of investments, net" using the specific identification method.

The Company’s MBS pledged as collateral against repurchase agreements and derivative instruments are included in MBS on the consolidated balance sheets with the fair value of the MBS pledged disclosed parenthetically.

Interest Income, Premium Amortization, and Discount Accretion. Interest income on MBS is accrued based on the outstanding principal balance (or notional balance in the case of interest-only, or "IO", securities) and their contractual terms.  Premiums and discounts on Agency MBS as well as any non-Agency MBS rated 'AA' and higher at the time of purchase are amortized into interest income over the expected life of such securities using the effective yield method and adjustments to premium amortization are made for actual cash payments as well as changes in projected future cash payments in accordance with ASC Topic 310-20. The Company's projections of future cash payments are based on input and analysis received from external sources and internal models, and includes assumptions about the amount and timing of credit losses, loan prepayment rates, fluctuations in interest rates, and other factors. On at least a quarterly basis, the Company reviews and makes any necessary adjustments to its cash flow projections and updates the yield recognized on these assets.

The Company holds non-Agency MBS that were rated less than 'AA' at the time of purchase by at least one national rating agency. These non-Agency MBS were purchased at discounts to their par value, which management does not believe to be substantial. The Company accretes the discount into income over the security's expected life, which reflects management's estimate of the security's projected cash flows in accordance with ASC Topic 325-40. Future changes in the timing of projected cash flows or differences arising between projected cash flows and actual cash flows received may result in a prospective change in the effective yield on those securities.

Determination of MBS Fair Value. The Company estimates the fair value of the majority of its MBS based upon prices obtained from third-party pricing services and broker quotes. The remainder of the Company's MBS are valued by discounting the estimated future cash flows derived from cash flow models that utilize information such as the security's coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected losses, and credit enhancements as well as certain other relevant information. Refer to Note 7 for further discussion of MBS fair value measurements.

Other-than-Temporary Impairment. MBS is considered impaired when its fair value is less than its amortized cost. The Company evaluates all of its impaired MBS for other-than-temporary impairments ("OTTI") on at least a quarterly basis. An impairment is considered other-than-temporary if: (1) the Company intends to sell the MBS; (2) it is more likely than not that the Company will be required to sell the MBS before its fair value recovers; or (3) the Company does not expect to recover the full

6

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


amortized cost basis of the MBS. If either of the first two conditions is met, the entire amount of the impairment is recognized in earnings. If the impairment is solely due to the inability to fully recover the amortized cost basis, the security is further analyzed to quantify any credit loss, which is the difference between the present value of cash flows expected to be collected on the MBS and its amortized cost. The credit loss, if any, is then recognized in earnings, while the balance of impairment related to other factors is recognized in other comprehensive income.

Following the recognition of an OTTI through earnings, a new cost basis is established for the security. Any subsequent recoveries in fair value may be accreted back into the amortized cost basis of the MBS on a prospective basis through interest income. Please see Note 3 for additional information related to the Company's evaluation for OTTI.

Mortgage Loans Held for Investment, Net

Mortgage loans held for investment, net consist of mortgage loans originated or purchased by the Company from 1992-1998, and these mortgage loans are reported at amortized cost in accordance with ASC Topic 310-10. Substantially all of these loans have been pledged as collateral to support the repayment of securitization financing bonds issued by the Company. The associated securitization financing bonds are treated as debt of the Company and are presented as "non-recourse collateralized financing" on the consolidated balance sheet. Securitized mortgage loans can only be sold subject to the lien of the respective securitization financing indenture. An allowance has been established for currently existing and probable losses on the Company's mortgage loans held for investment.

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

Derivative Instruments

The Company's derivative instruments, which currently include interest rate swaps and Eurodollar futures, are accounted for in accordance with ASC Topic 815, which requires an entity to recognize all derivatives as either assets or liabilities in the balance sheet and to measure those instruments at fair value. All periodic interest costs and other changes in fair value, including gains and losses recognized upon termination, associated with derivative instruments are recorded in "gain (loss) on derivative instruments, net" on the Company's consolidated statement of comprehensive income.

Effective June 30, 2013, the Company discontinued cash flow hedge accounting for derivative instruments which had previously been accounted for as cash flow hedges under ASC Topic 815. Activity up to and including June 30, 2013 for those agreements previously designated as cash flow hedges was recorded in accordance with cash flow hedge accounting as prescribed by ASC Topic 815, which states that the effective portion of the hedge relationship on an instrument designated as a cash flow hedge is reported in the current period's other comprehensive income while the ineffective portion is immediately reported as a component of the current period’s net income. The balance remaining in AOCI related to the de-designated cash flow hedges is amortized into the Company's net income as a portion of "interest expense" over the remaining life of the interest rate swap agreements. Subsequent to June 30, 2013, changes in the fair value of the Company's derivative instruments, plus periodic settlements, are recorded in the Company's net income as a portion of "gain (loss) on derivative instruments, net".

The use of derivatives creates exposure to credit risk relating to potential losses that could be recognized in the event that the counterparties to these instruments fail to perform their obligations under the contracts. The Company attempts to minimize

7

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


this risk by limiting its counterparties to major financial institutions with acceptable credit ratings, monitoring positions with individual counterparties and adjusting posted collateral as required.

Although MBS have characteristics that meet the definition of a derivative instrument, ASC 815 specifically excludes these instruments from its scope because they are accounted for as debt securities under ASC 320.

Share-Based Compensation

Pursuant to the Company’s 2009 Stock and Incentive Plan ("SIP"), the Company may grant share-based compensation to eligible employees, directors or consultants or advisers to the Company, including stock awards, stock options, stock appreciation rights, dividend equivalent rights, performance shares, and restricted stock units. The Company's restricted stock currently issued and outstanding under this plan may be settled only in shares of its common stock, and therefore are treated as equity awards with their fair value measured at the grant date and recognized as compensation cost over the requisite service period with a corresponding credit to shareholders' equity as required by ASC Topic 718. The requisite service period is the period during which an employee is required to provide service in exchange for an award, which is equivalent to the vesting period specified in the terms of the share-based based award. None of the Company's restricted stock awards have performance based conditions. The Company does not currently have any share-based compensation issued or outstanding other than restricted stock.
 
Contingencies
 
In the normal course of business, there are various lawsuits, claims, and other contingencies pending against the Company. On a quarterly basis, the Company evaluates whether to establish provisions for estimated losses from those matters in accordance with ASC Topic 450, which states that a liability is recognized for a contingent loss when: (a) the underlying causal event has occurred prior to the balance sheet date; (b) it is probable that a loss has been incurred; and (c) there is a reasonable basis for estimating that loss. A liability is not recognized for a contingent loss when it is only possible or remotely possible that a loss has been incurred, however, possible contingent losses shall be disclosed. If the contingent loss (or an additional loss in excess of any accrual) is at least a reasonable possibility and material, then the Company discloses a reasonable estimate of the possible loss or range of loss, if such reasonable estimate can be made. If the Company cannot make a reasonable estimate of the possible material loss, or range of loss, then that fact is disclosed.

The Company and its subsidiaries are parties to various legal proceedings of which the ultimate outcome cannot be ascertained at this time. Although the results of those legal proceedings cannot be predicted with certainty, the Company believes, based on current knowledge, that the resolution of any of these proceedings will not have a material effect on the Company’s consolidated financial condition or liquidity. However, the resolution of any of those proceedings could have a material impact on consolidated results of operations or cash flows in a given future reporting period as the proceedings are resolved.

The Company has not been named as a party to any additional legal proceedings during the three or nine months ended September 30, 2014.

Recent Accounting Pronouncements

In June 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-11, Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures, which changes the accounting for repurchase-to-maturity transactions and repurchase financing arrangements. The guidance eliminates sale accounting for repurchase-to-maturity transactions and supersedes the guidance under which a transfer of a financial asset and a contemporaneous repurchase financing could be accounted for on a combined basis as a forward agreement, which has resulted in outcomes referred to as off-balance-sheet accounting. All of the Company's repurchase agreement transactions are accounted for as secured borrowings; therefore the accounting changes required by ASU No. 2014-11 do not impact the Company's consolidated financial statements. ASU No. 2014-11 also requires two additional disclosures about repurchase agreements and other similar transactions. The first disclosure requires an entity to disclose information on transfers accounted for as sales in transactions that are economically similar to repurchase agreements. The Company does not account for any of its repurchase agreement transactions as sales; therefore this new disclosure does not impact the Company's current disclosures. The second disclosure requires the following disclosures for repurchase agreements, securities lending transactions, and repurchase-to-maturity transactions that are accounted for as secured borrowings: a disaggregation of the gross obligation by the class of collateral pledged;

8

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


the remaining contractual tenor of the agreements; and a discussion of the potential risks associated with the agreements and the related collateral pledged, including obligations arising from a decline in the fair value of the collateral pledged and how those risks are managed. The Company already provides these disclosures in its "Notes to the Unaudited Consolidated Financial Statements" and within "Liquidity and Capital Resources" in Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Quarterly Report on Form 10-Q. The amendments provided in ASU No. 2014-11 are effective for public business entities for the first interim or annual period beginning after December 15, 2014. ASU No. 2014-11 will not have a material impact on the Company's consolidated financial statements.

In addition, the FASB issued ASU No. 2014-12, Compensation - Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period. The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. The Company has not issued and does not anticipate issuing any share-based payments with terms that require a performance-based target; therefore this ASU will not have an impact on the Company's consolidated financial statements.

The FASB issued ASU No. 2014-13, Consolidation (Topic 810): Measuring the Financial Assets and the Financial Liabilities of a Consolidated Collateralized Financing Entity, which provides an alternative to Topic 820, Fair Value Measurement, for measuring the financial assets and the financial liabilities of a consolidated collateralized financing entity to eliminate the difference in the fair value of the financial assets of a collateralized financing entity, as determined under GAAP, when they differ from the fair value of its financial liabilities even when the financial liabilities have recourse only to the financial assets. When the measurement alternative is elected, both the financial assets and the financial liabilities of the collateralized financing entity should be measured using the more observable of the fair value of the financial assets or the fair value of the financial liabilities. The amendments clarify that when the measurement alternative is elected, a reporting entity's consolidated net income (loss) should reflect the reporting entity's own economic interests in the collateralized financing entity, including; (1) changes in the fair value of the beneficial interests retained by the reporting entity, and (2) beneficial interests that represent compensation for services. The measurement alternative provided in ASU No. 2014-13 may be applied using a modified retrospective approach by recording a cumulative-effect adjustment to equity as of the beginning of the annual period of adoption. The amendments may also be applied retrospectively to all relevant prior periods beginning with the annual period in which ASU No. 2009-17 was initially adopted. ASU No. 2014-13 is effective for public entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2015, and early adoption is permitted as of the beginning of an annual period. Management has evaluated ASU No. 2014-13 and has determined that if the Company elects to adopt this measurement alternative in the future for its currently existing consolidated collateralized financing entity, it will not have a material impact on the Company's consolidated financial statements.

The FASB issued ASU No. 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern, which provides guidance about management's responsibility under GAAP to evaluate whether there is substantial doubt about an organization's ability to continue as a going concern and to provide related footnote disclosures. Specifically, the ASU (1) provides a definition of the term "substantial doubt", (2) requires an evaluation by management every reporting period including interim periods, (3) provides principles for considering the mitigating effect of management's plans, (4) requires certain disclosures when substantial doubt exists regardless of the success of any mitigating plans or actions, (5) requires an express statement and other disclosures when substantial doubt is not alleviated, and (6) requires an assessment for a period of one year after the date that the financial statements are issued. The amendments in this ASU are effective for the annual period ending after December 15, 2016, and for annual periods and interim periods thereafter. Early application is permitted. Management intends to comply with the requirements set forth in ASU No. 2014-15.

NOTE 2 – NET INCOME (LOSS) PER COMMON SHARE
 
Net income (loss) per common share is presented on both a basic and diluted basis. The Company does not currently have any potentially dilutive securities outstanding. Because the Company's Series A Cumulative Redeemable Preferred Stock and Series B Cumulative Redeemable Preferred Stock are redeemable at the Company's option for cash only, and may convert into shares of common stock only upon a change of control of the Company, the effect of those shares is excluded from the calculation of diluted net income (loss) per common share. Holders of unvested shares of the Company's issued and outstanding restricted common stock are eligible to receive non-forfeitable dividends. As such, these unvested shares are considered participating securities as per ASC 260-10 and therefore are included in the computation of basic net income (loss) per share using the two-class method.

9

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


Upon vesting, restrictions on transfer expire on each share of restricted stock, and each such share of restricted stock is converted to one equal share of common stock.

The following table presents the calculation of the numerator and denominator for both basic and diluted net income (loss) per common share for the periods indicated:

 
For the Three Months Ended
 
September 30, 2014
 
September 30, 2013
 
Net 
Income
 
Weighted-Average Common Shares
 
Net Loss
 
Weighted-
Average
Common
Shares
Net income (loss)
$
30,866

 
 
 
$
(4,627
)
 
 
Preferred stock dividends
(2,294
)
 
 
 
(2,294
)
 
 
Net income (loss) to common shareholders
28,572

 
54,731,414

 
(6,921
)
 
54,903,637

Effect of dilutive instruments
—

 
—

 
—

 
—

Diluted net income (loss) to common shareholders
$
28,572

 
54,731,414

 
$
(6,921
)
 
54,903,637

Net income (loss) per common share:
 
 
 
 
 
 
 
Basic and diluted
 

 
$
0.52

 
 

 
$
(0.13
)


 
For the Nine Months Ended
 
September 30, 2014
 
September 30, 2013
 
Net 
Income
 
Weighted-Average Common Shares
 
Net 
Income
 
Weighted-
Average
Common
Shares
Net income (loss)
$
24,133

 
 
 
$
46,510

 
 
Preferred stock dividends
(6,882
)
 
 
 
(5,608
)
 
 
Net income (loss) to common shareholders
17,251

 
54,689,762

 
40,902

 
54,727,950

Effect of dilutive instruments
—

 
—

 
—

 
—

Diluted net income (loss) to common shareholders
$
17,251

 
54,689,762

 
$
40,902

 
54,727,950

Net income (loss) per common share:
 
 
 
 
 
 
 
Basic and diluted
 

 
$
0.32

 
 

 
$
0.75




10

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


NOTE 3 – MORTGAGE-BACKED SECURITIES
 
The following tables present the components and weighted average coupon ("WAC") for the portion of the Company’s MBS designated as AFS as of September 30, 2014 and December 31, 2013:
 
September 30, 2014
 
Par
 
Net Premium (Discount)
 
Amortized Cost
 
Gross Unrealized Gain
 
Gross Unrealized Loss
 
Fair Value
 
WAC
Agency:
 
 
 
 
 
 
 
 
 
 
 
 
 
RMBS
$
2,200,149

 
$
120,667

 
$
2,320,816

 
$
7,593

 
$
(31,105
)
 
$
2,297,304

 
3.14
%
CMBS
305,566

 
19,186

 
$
324,752

 
13,803

 
(224
)
 
338,331

 
5.22
%
CMBS IO (1)
—

 
400,886

 
$
400,886

 
10,944

 
(113
)
 
411,717

 
0.83
%
Total Agency AFS:
$
2,505,715

 
$
540,739

 
$
3,046,454

 
$
32,340

 
$
(31,442
)
 
$
3,047,352

 


 
 
 
 
 
 
 
 
 
 
 
 
 
 
Non-Agency:
 
 
 
 
 
 
 
 
 
 
 
 
 
RMBS
$
9,522

 
$
(4
)
 
$
9,518

 
$
118

 
$
(81
)
 
$
9,555

 
4.20
%
CMBS
266,596

 
(12,374
)
 
254,222

 
16,397

 
(346
)
 
270,273

 
4.89
%
CMBS IO (1)
—

 
282,890

 
282,890

 
5,636

 
(313
)
 
288,213

 
0.69
%
Total non-Agency AFS:
$
276,118

 
$
270,512

 
$
546,630

 
$
22,151

 
$
(740
)
 
$
568,041

 


 
 
 
 
 
 
 
 
 
 
 
 
 


Total AFS securities
$
2,781,833

 
$
811,251

 
$
3,593,084

 
$
54,491

 
$
(32,182
)
 
$
3,615,393

 
 
(1)
The notional balance for Agency CMBS IO and non-Agency CMBS IO was $9,461,823 and $7,246,832, respectively, as of September 30, 2014.
 
December 31, 2013
 
Par
 
Net Premium (Discount)
 
Amortized Cost
 
Gross Unrealized Gain
 
Gross Unrealized Loss
 
Fair Value
 
WAC
Agency:
 
 
 
 
 
 
 
 
 
 
 
 
 
RMBS
$
2,591,568

 
$
154,220

 
$
2,745,788

 
$
6,104

 
$
(59,742
)
 
$
2,692,150

 
3.22
%
CMBS (1)
273,830

 
19,061

 
292,891

 
10,793

 
(900
)
 
302,784

 
5.07
%
CMBS IO (2)
—

 
453,766

 
453,766

 
9,895

 
(3,334
)
 
460,327

 
0.83
%
Total Agency AFS:
2,865,398

 
627,047

 
3,492,445

 
26,792

 
(63,976
)
 
3,455,261

 


 
 
 
 
 
 
 
 
 
 
 
 
 
 
Non-Agency:
 
 
 
 
 
 
 
 
 
 
 
 
 
RMBS
13,845

 
(338
)
 
13,507

 
338

 
(80
)
 
13,765

 
4.61
%
CMBS
375,703

 
(18,277
)
 
357,426

 
15,366

 
(3,511
)
 
369,281

 
5.10
%
CMBS IO (2)
—

 
150,518

 
150,518

 
2,618

 
(1,999
)
 
151,137

 
0.66
%
Total non-Agency AFS:
389,548

 
131,903

 
521,451

 
18,322

 
(5,590
)
 
534,183

 


 
 
 
 
 
 
 
 
 
 
 
 
 


Total AFS securities
$
3,254,946

 
$
758,950

 
$
4,013,896

 
$
45,114

 
$
(69,566
)
 
$
3,989,444

 
 
(1)
As of December 31, 2013, the Company had Agency CMBS with an amortized cost of $26,920 and fair value of $28,717 which were designated as trading securities and are not included in this table. The Company changed the designation of these Agency CMBS to AFS during the three months ended June 30, 2014. Changes in the fair value of these MBS while they were designated as trading were recognized in net income within "fair value adjustments, net". Changes in the fair value of these MBS, which are now designated as AFS, are recognized in "other comprehensive income". As of September 30, 2014, the Company does not have any MBS designated as trading.
(2)
The notional balance for the Agency CMBS IO and non-Agency CMBS IO was $10,160,502 and $4,274,957, respectively, as of December 31, 2013.


11

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


The following table presents certain information for those Agency MBS in an unrealized loss position as of September 30, 2014 and December 31, 2013:
 
September 30, 2014
 
December 31, 2013
 
Fair Value
 
Gross Unrealized Losses
 
# of Securities
 
Fair Value
 
Gross Unrealized Losses
 
# of Securities
Continuous unrealized loss position for less than 12 months:
 
 
 
 
 
 
 
 
 
 
 
Agency MBS
$
155,501

 
$
(1,142
)
 
25
 
$
1,912,937

 
$
(43,543
)
 
150
Non-Agency MBS
74,239

 
(427
)
 
17
 
162,558

 
(5,435
)
 
39
 
 
 
 
 
 
 
 
 
 
 
 
Continuous unrealized loss position for 12 months or longer:
 
 
 
 
 
 
 
 
 
 
 
Agency MBS
$
1,701,638

 
$
(30,299
)
 
129
 
$
670,402

 
$
(20,433
)
 
67
Non-Agency MBS
31,348

 
(313
)
 
8
 
6,310

 
(155
)
 
6

Because the principal and interest related to Agency MBS are guaranteed by the government-sponsored entities Fannie Mae and Freddie Mac which have the implicit guarantee of the U.S. government, the Company does not consider any of the unrealized losses on its Agency MBS to be credit related. Although the unrealized losses are not credit related, the Company assesses its ability and intent to hold any Agency MBS with an unrealized loss until the recovery in its value. This assessment is based on the amount of the unrealized loss and significance of the related investment as well as the Company’s current leverage and anticipated liquidity. Based on this analysis, the Company has determined that the unrealized losses on its Agency MBS as of September 30, 2014 and December 31, 2013 were temporary.

The Company also reviews any non-Agency MBS in an unrealized loss position to evaluate whether any decline in fair value represents an OTTI. The evaluation includes a review of the credit ratings of these non-Agency MBS and the seasoning of the mortgage loans collateralizing these securities as well as the estimated future cash flows which include projected losses. The Company performed this evaluation for the non-Agency MBS in an unrealized loss position and has determined that there have not been any adverse changes in the timing or amount of estimated future cash flows that necessitate a recognition of OTTI amounts as of September 30, 2014 or December 31, 2013.

NOTE 4 – REPURCHASE AGREEMENTS
    
The following tables present the components of the Company’s repurchase agreements as of September 30, 2014 and December 31, 2013 by the fair value and type of securities pledged as collateral:
 
 
September 30, 2014
Collateral Type
 
Balance
 
Weighted
Average Rate
 
Fair Value of
Collateral Pledged
Agency RMBS
 
$
2,081,924


0.36
%
 
2,168,095

Agency CMBS
 
258,024

 
0.33
%
 
302,352

Agency CMBS IOs
 
351,518

 
0.94
%
 
411,686

Non-Agency RMBS
 
7,724

 
1.67
%
 
8,803

Non-Agency CMBS
 
198,203

 
1.16
%
 
240,802

Non-Agency CMBS IO
 
242,458

 
1.03
%
 
288,202

Securitization financing bonds
 
10,403

 
1.50
%
 
11,885

 
 
$
3,150,254

 
0.53
%
 
$
3,431,825



12

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


 
 
December 31, 2013
Collateral Type
 
Balance
 
Weighted
Average Rate
 
Fair Value of Collateral Pledged
Agency RMBS
 
$
2,522,503


0.42
%
 
2,598,158

Agency CMBS
 
246,849

 
0.39
%
 
306,318

Agency CMBS IOs
 
369,948

 
1.16
%
 
449,072

Non-Agency RMBS
 
10,569

 
1.80
%
 
12,746

Non-Agency CMBS
 
303,674

 
1.27
%
 
367,859

Non-Agency CMBS IOs
 
106,803

 
1.27
%
 
136,227

Securitization financing bonds
 
20,651

 
1.59
%
 
19,686

Deferred costs
 
(243
)
 
n/a

 
n/a

 
 
$
3,580,754

 
0.61
%
 
$
3,890,066


The combined weighted average original term to maturity for the Company’s repurchase agreements was 106 days as of September 30, 2014 compared to 114 days as of December 31, 2013. The following table provides a summary of the original maturities as of September 30, 2014 and December 31, 2013:
Original Maturity
 
September 30,
2014
 
December 31,
2013
Less than 30 days
 
$
574,164

 
$
4,736

30 to 90 days
 
566,959

 
1,176,631

91 to 180 days
 
1,514,454

 
1,439,225

181 to 364 days
 
329,232

 
960,405

1 year or longer
 
165,445

 
—

Deferred costs
 
—

 
(243
)
 
 
$
3,150,254

 
$
3,580,754


As of September 30, 2014, shareholders' equity at risk did not exceed 10% for any of the Company's counterparties. The Company had $131,275 of its repurchase agreement balance as of September 30, 2014 outstanding under a two-year repurchase facility with Wells Fargo Bank National Association. This facility provides an aggregate maximum borrowing capacity of $250,000 and matures on August 6, 2015, subject to early termination provisions contained in the master repurchase agreement. The facility is collateralized primarily by CMBS IO, and its weighted average borrowing rate as of September 30, 2014 was 1.06%.

As of September 30, 2014, the Company had repurchase agreement amounts outstanding with 21 of its 33 available counterparties. The Company's counterparties, as set forth in the master repurchase agreement with the counterparty, require the Company to comply with various customary operating and financial covenants, including, but not limited to, minimum net worth, maximum declines in net worth in a given period, and maximum leverage requirements as well as maintaining the Company's REIT status. In addition, some of the agreements contain cross default features, whereby default under an agreement with one lender simultaneously causes default under agreements with other lenders. To the extent that the Company fails to comply with the covenants contained in these financing agreements or is otherwise found to be in default under the terms of such agreements, the counterparty has the right to accelerate amounts due under the master repurchase agreement. The Company was in compliance with all covenants as of September 30, 2014.

Please see Note 6 for the Company's disclosures related to offsetting assets and liabilities.


13

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


NOTE 5 – DERIVATIVES

     The Company utilizes derivative instruments to economically hedge a portion of its exposure to market risks, primarily interest rate risk. The Company primarily uses pay-fixed interest rate swaps and Eurodollar contracts to hedge its exposure to changes in interest rates and uses receive-fixed interest rate swaps to offset a portion of its pay-fixed interest rate swaps in order to manage its overall hedge position. The objective of the Company's risk management strategy is to mitigate declines in book value resulting from fluctuations in the fair value of the Company's assets from changing interest rates and to protect the Company's earnings from rising interest rates. Please refer to Note 1 for information related to the Company's accounting policy for its derivative instruments.
    
The table below summarizes information about the Company’s derivative instruments treated as trading instruments on its consolidated balance sheet as of the dates indicated:  
 
 
September 30, 2014
 
 
Derivative Assets
 
Derivative Liabilities
Trading Instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Interest rate swaps
 
$
6,958

 
$
800,000

 
$
(437
)
 
$
150,000

Eurodollar futures (1)
 
339

 
3,900,000

 
(17,621
)
 
12,700,000

Total
 
$
7,297

 
$
4,700,000

 
$
(18,058
)
 
$
12,850,000

 
 
December 31, 2013
 
 
Derivative Assets
 
Derivative Liabilities
Trading Instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Interest rate swaps
 
$
18,488

 
$
575,000

 
$
(1,336
)
 
$
215,000

Eurodollar futures (1)
 
—

 
—

 
(5,345
)
 
9,000,000

Total
 
$
18,488

 
$
575,000

 
$
(6,681
)
 
$
9,215,000

(1)
The Eurodollar futures aggregate notional amount represents the total notional of the 3-month contracts with expiration dates from 2015 to 2020. The maximum notional outstanding for any future 3-month period did not exceed $1,300,000 as of September 30, 2014 and $1,175,000 as of December 31, 2013.

The following table summarizes the contractual maturities remaining for the Company’s outstanding interest rate swap agreements as of September 30, 2014:
Remaining
Maturity
 
Pay-Fixed Interest Rate Swaps
 
Pay-Fixed
Weighted-Average Rate(1)
 
Receive Fixed Interest Rate Swaps
 
Receive-Fixed
Weighted-Average Rate
37-48 months
 
$
185,000

 
0.92
%
 
$
—

 
—
%
49-60 months
 
235,000

 
1.45
%
 
250,000

 
1.91
%
61-72 months
 
25,000

 
1.61
%
 
—

 
—
%
73-84 months
 
50,000

 
2.20
%
 
—

 
—
%
85-96 months
 
—

 
—
%
 
—

 
—
%
97-108 months
 
30,000

 
1.93
%
 
—

 
—
%
109-120 months
 
150,000

 
2.17
%
 
25,000

 
2.71
%

The following table summarizes the volume of activity related to derivative instruments for the periods indicated:

14

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


For the nine months ended September 30, 2014:
Beginning of Period Notional Amount
 
Additions
 
Settlement, Termination, Expiration or Exercise
 
End of Period Notional Amount
Receive-fixed interest rate swaps
$
—

 
$
275,000

 
$
—

 
$
275,000

Pay-fixed interest rate swaps
790,000

 
75,000

 
(190,000
)
 
675,000

Eurodollar futures
9,000,000

 
7,600,000

 
—

 
16,600,000

 
$
9,790,000

 
$
7,950,000

 
$
(190,000
)
 
$
17,550,000


The table below provides detail of the Company's "gain (loss) on derivative instruments, net" by type of interest rate derivative for the periods indicated:
 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
Type of Derivative Instrument
 
2014
 
2013
 
2014
 
2013
Receive-fixed interest rate swaps
 
$
339

 
$
—

 
$
339

 
$
—

Pay-fixed interest rate swaps
 
646

 
(6,225
)
 
(20,056
)
 
5,111

Eurodollar futures
 
3,857

 
(17,794
)
 
(11,937
)
 
(17,794
)
Gain (loss) on derivative instruments, net
 
$
4,842

 
$
(24,019
)
 
$
(31,654
)
 
$
(12,683
)

Effective June 30, 2013, the Company de-designated certain interest rate swap agreements as cash flow hedges under ASC Topic 815. There is a net unrealized loss of $4,026 remaining in AOCI on the Company's consolidated balance sheet as of September 30, 2014 which represents the activity related to these interest rate swap agreements while they were previously designated as cash flow hedges, and this amount will be recognized in the Company's net income as a portion of "interest expense" over the remaining contractual life of the agreements. All forecasted transactions associated with interest rate swap agreements previously designated as cash flow hedges are expected to occur. No amounts have been reclassified to net income in any period in connection with forecasted transactions that are no longer considered probable of occurring. The Company estimates the portion of existing net unrealized loss on discontinued cash flow hedges expected to be reclassified to net income within the next 12 months is $4,156.

The table below describes the components of the reclassification adjustments out of AOCI related to certain interest rate swaps that were formerly designated as cash flow hedges and recognized as a portion of "interest expense" on the Company statements of comprehensive income for the periods indicated:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2014
 
2013
 
2014
 
2013
Reclassification adjustment due to amortization of de-designated cash flow hedges
$
1,442

 
$
2,583

 
$
5,339

 
$
2,583

Reclassification adjustment due to recognition of interest expense from cash flow hedges
—

 
—

 
—

 
8,796

Total reclassification adjustment related to cash flow hedges
$
1,442

 
$
2,583

 
$
5,339

 
$
11,379


Many of the Company's interest rate swaps were entered into under bilateral agreements which contain various covenants related to the Company’s credit risk. Specifically, if the Company defaults on any of its indebtedness, including those circumstances whereby repayment of the indebtedness has not yet been accelerated by the lender, or is declared in default of any of its covenants with any counterparty, then the Company could also be declared in default under the bilateral agreement. Additionally, these agreements allow those counterparties to require settlement of its outstanding derivative transactions if the Company fails to earn GAAP net income excluding derivative gains and losses greater than one dollar as measured on a rolling two quarter basis. These

15

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


interest rate agreements also contain provisions whereby, if the Company fails to maintain a minimum net amount of shareholders’ equity, then the Company may be declared in default on its derivative obligations. The Company was in compliance with all covenants under bilateral agreements on September 30, 2014.
Please see Note 6 for the Company's disclosures related to offsetting assets and liabilities.

NOTE 6 – OFFSETTING ASSETS AND LIABILITIES

The Company's derivatives and repurchase agreements are subject to underlying agreements with master netting or similar arrangements, which provide for the right of offset in the event of default or in the event of bankruptcy of either party to the transactions. The Company reports its assets and liabilities subject to these arrangements on a gross basis. The following tables present information regarding those assets and liabilities subject to such arrangements as if the Company had presented them on a net basis as of September 30, 2014 and December 31, 2013:
 
Offsetting of Assets
 
Gross Amount of Recognized Assets
 
Gross Amount Offset in the Balance Sheet
 
Net Amount of Assets Presented in the Balance Sheet
 
Gross Amount Not Offset in the Balance Sheet
 
Net Amount
Financial Instruments Received as Collateral
 
Cash Received as Collateral
September 30, 2014:
 
 
 
 
 
 
 
 
 
 
 
Derivative assets
$
7,297

 
$
—

 
$
7,297

 
$
(478
)
 
$
(2,672
)
 
$
4,147

 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2013:
 
 
 
 


 
 
 
 
 


Derivative assets
$
18,488

 
$
—

 
$
18,488

 
$
(193
)
 
$
(12,141
)
 
$
6,154



 
Offsetting of Liabilities
 
Gross Amount of Recognized Liabilities
 
Gross Amount Offset in the Balance Sheet
 
Net Amount of Liabilities Presented in the Balance Sheet
 
Gross Amount Not Offset in the Balance Sheet
 
Net Amount
Financial Instruments Posted as Collateral
 
Cash Posted as Collateral
September 30, 2014:
 
 
 
 
 
 
 
 
 
 
 
Derivative liabilities
$
18,058

 
$
—

 
$
18,058

 
$
(777
)
 
$
(17,281
)
 
$
—

Repurchase agreements
3,150,254

 
—

 
3,150,254

 
(3,150,254
)
 
—

 
—

 
$
3,168,312

 
$
—

 
$
3,168,312

 
$
(3,151,031
)
 
$
(17,281
)
 
$
—

 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2013:
 
 
 
 
 
 
 
 
 
 
 
Derivative liabilities
$
6,681

 
$
—

 
$
6,681

 
$
(1,299
)
 
$
(5,382
)
 
$
—

Repurchase agreements
3,580,754

 
—

 
3,580,754

 
(3,580,754
)
 
—

 
—

 
$
3,587,435

 
$
—

 
$
3,587,435

 
$
(3,582,053
)
 
$
(5,382
)
 
$
—

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


16

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


NOTE 7 – FAIR VALUE OF FINANCIAL INSTRUMENTS
 
ASC Topic 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 clarifies that fair value should be based on the assumptions market participants would use when pricing an asset or liability and also requires an entity to consider all aspects of nonperformance risk, including the entity's own credit standing, when measuring fair value of a liability. ASC Topic 820 established a valuation hierarchy of three levels as follows:
 
•
Level 1 – Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities as of the measurement date.
•
Level 2 – Inputs include quoted prices in active markets for similar assets or liabilities; quoted prices in inactive markets for identical or similar assets or liabilities; or inputs either directly observable or indirectly observable through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.  
•
Level 3 – Unobservable inputs are supported by little or no market activity. The unobservable inputs represent management’s best estimate of how market participants would price the asset or liability at the measurement date.  Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.  
The following table presents the fair value of the Company’s assets and liabilities presented on its consolidated balance sheets, segregated by the hierarchy level of the fair value estimate, that are measured at fair value on a recurring basis as of the dates indicated:
 
September 30, 2014
 
Fair Value
 
Level 1 - Unadjusted Quoted Prices in Active Markets
 
Level 2 - Observable Inputs
 
Level 3 - Unobservable Inputs
Assets:
 
 
 
 
 
 
 
Mortgage-backed securities
$
3,615,393

 
$
—

 
$
3,563,819

 
$
51,574

Derivative assets
7,297

 
339

 
6,958

 
—

Total assets carried at fair value
$
3,622,690

 
$
339

 
$
3,570,777

 
$
51,574

Liabilities:
 

 
 

 
 

 
 

Derivative liabilities
$
18,058

 
$
17,621

 
$
437

 
$
—

Total liabilities carried at fair value
$
18,058

 
$
17,621

 
$
437

 
$
—

 
December 31, 2013
 
Fair Value
 
Level 1 - Unadjusted Quoted Prices in Active Markets
 
Level 2 - Observable Inputs
 
Level 3 - Unobservable Inputs
Assets:
 
 
 
 
 
 
 
Mortgage-backed securities
$
4,018,161

 
$
—

 
$
3,944,681

 
$
73,480

Derivative assets
18,488

 
—

 
18,488

 
—

Total assets carried at fair value
$
4,036,649

 
$
—

 
$
3,963,169

 
$
73,480

Liabilities:
 

 
 

 
 

 
 

Derivative liabilities
$
6,681

 
$
5,345

 
$
1,336

 
$
—

Total liabilities carried at fair value
$
6,681

 
$
5,345

 
$
1,336

 
$
—



17

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


The Company did not have assets or liabilities measured at fair value on a non-recurring basis as of September 30, 2014 or December 31, 2013.

The Company's derivative assets and liabilities include interest rate swaps and Eurodollar futures. Interest rate swaps are valued using the income approach with the primary input being the forward interest rate swap curve, which is considered an observable input and thus their fair values are considered Level 2 measurements. Eurodollar futures are valued based on closing exchange prices on these contracts. Accordingly, these financial futures are classified as Level 1.

Agency MBS, as well a majority of non-Agency MBS, are substantially similar to securities that either are currently actively traded or have been recently traded in their respective market. Their fair values are derived from an average of multiple dealer quotes and thus are considered Level 2 fair value measurements. The Company’s remaining non-Agency MBS are comprised of securities for which there are not substantially similar securities that trade frequently, and their fair values are therefore considered Level 3 measurements. The Company determines the fair value of its Level 3 securities by discounting the estimated future cash flows derived from cash flow models using assumptions that are confirmed to the extent possible by third party dealers or other pricing indicators. Significant inputs into those pricing models are Level 3 in nature due to the lack of readily available market quotes. Information utilized in those pricing models include the security’s credit rating, coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected credit losses, and credit enhancement as well as certain other relevant information. Significant changes in any of these inputs in isolation would result in a significantly different fair value measurement. Generally Level 3 assets are most sensitive to the default rate and severity assumptions.

The table below presents information about the significant unobservable inputs used in the fair value measurement for the Company's Level 3 non-Agency CMBS and RMBS as of September 30, 2014:
 
Quantitative Information about Level 3 Fair Value Measurements (1)
 
Prepayment Speed
 
Default Rate
 
Severity
 
Discount Rate
Non-Agency CMBS
20 CPY
 
2.0
%
 
35.0
%
 
9.4
%
Non-Agency RMBS
10 CPR
 
1.0
%
 
20.0
%
 
6.6
%
(1)
Data presented are weighted averages.


The following table presents the activity of the instruments fair valued at Level 3 during the three and nine months ended September 30, 2014:
 
Level 3 Fair Values
 
Three Months Ended
 
Nine Months Ended
 
September 30, 2014
 
September 30, 2014
 
Non-Agency CMBS
 
Non-Agency RMBS
 
Total assets
 
Non-Agency CMBS
 
Non-Agency RMBS
 
Total assets
Balance as of beginning of period
$
62,744

 
$
2,498

 
$
65,242

 
$
70,733

 
$
2,747

 
$
73,480

Unrealized gain (loss) included in OCI
878

 
(15
)
 
863

 
1,078

 
(138
)
 
940

Principal payments
(14,290
)
 
(298
)
 
(14,588
)
 
(22,598
)
 
(753
)
 
(23,351
)
Accretion
57

 
—

 
57

 
176

 
329

 
505

Balance as of end of period
$
49,389

 
$
2,185

 
$
51,574

 
$
49,389

 
$
2,185

 
$
51,574






18

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


The following table presents a summary of the recorded basis and estimated fair values of the Company’s financial instruments as of the dates indicated:
 
September 30, 2014
 
December 31, 2013
 
Recorded Basis
 
Fair Value
 
Recorded Basis
 
Fair Value
Assets:
 
 
 
 
 
 
 
Mortgage-backed securities
$
3,615,393

 
$
3,615,393

 
$
4,018,161

 
$
4,018,161

Mortgage loans held for investment, net (1)
41,454

 
36,590

 
55,423

 
46,383

Derivative assets
7,297

 
7,297

 
18,488

 
18,488

Liabilities:
 

 
 

 
 

 
 

Repurchase agreements (2)
$
3,150,254

 
$
3,150,254

 
$
3,580,754

 
$
3,580,997

Non-recourse collateralized financing (1)
11,194

 
10,757

 
12,914

 
12,414

Derivative liabilities
18,058

 
18,058

 
6,681

 
6,681

(1)
The Company determines the fair value of its mortgage loans held for investment, net and its non-recourse collateralized financing using internally developed cash flow models with inputs similar to those used to estimate fair value of the Company's Level 3 non-Agency MBS.
(2)
The difference between the recorded basis of repurchase agreements and their fair value as of December 31, 2013 is the unamortized deferred costs remaining for the 2-year repurchase facility.

NOTE 8 – SHAREHOLDERS' EQUITY

Preferred Stock

The Company has 2,300,000 shares of its 8.50% Series A Cumulative Redeemable Preferred Stock and 2,250,000 shares of its 7.625% Series B Cumulative Redeemable Preferred Stock issued and outstanding as of September 30, 2014 (collectively, the "Preferred Stock"). The Preferred Stock has no maturity and will remain outstanding indefinitely unless redeemed or otherwise repurchased or converted into common stock pursuant to the terms of the Preferred Stock. Except under certain limited circumstances intended to preserve the Company's REIT status, upon the occurrence of a change in control as defined in Article IIIA, Section 7(d) of the Company’s Articles of Incorporation, or to avoid the direct or indirect imposition of a penalty tax in respect of, or to protect the tax status of, any of the Company’s real estate mortgage investment conduits (“REMIC”) interests or a REMIC in which the Company may acquire an interest (as permitted by the Company’s Articles of Incorporation), the Company may not redeem the Series A Preferred Stock prior to July 31, 2017 or the Series B Preferred Stock prior to April 30, 2018. On or after these dates, at any time and from time to time, the Preferred Stock may be redeemed in whole, or in part, at the Company's option at a cash redemption price of $25.00 per share plus any accumulated and unpaid dividends. The Series A Preferred Stock pays a cumulative cash dividend equivalent to 8.50% of the $25.00 liquidation preference per share each year and the Series B Preferred Stock pays a cumulative cash dividend equivalent to 7.625% of the $25.00 liquidation preference per share each year. Because the Preferred Stock is redeemable only at the option of the issuer, it is classified as equity on the Company's consolidated balance sheet. The Company announced that it will pay its regular quarterly dividends on its Preferred Stock for the third quarter on October 15, 2014 to shareholders of record as of October 1, 2014.
    
Common Stock

The following table presents a summary of the changes in the number of common shares outstanding for the periods presented:

19

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


 
Nine Months Ended
 
September 30,
 
2014
 
2013
Balance as of beginning of period
54,310,484

 
54,268,915

Common stock issued under DRIP
12,459

 
509,831

Common stock issued under ATM program
—

 
180,986

Common stock issued or redeemed under stock and incentive plans
471,210

 
270,158

Common stock forfeited for tax withholding on share-based compensation
(59,336
)
 
(52,385
)
Common stock repurchased during the period
—

 
(751,456
)
Balance as of end of period
54,734,817

 
54,426,049


The Company's Dividend Reinvestment and Share Purchase Plan ("DRIP") allows registered shareholders to automatically reinvest some or all of their quarterly common stock dividends in shares of the Company’s common stock and provides an opportunity for investors to purchase shares of the Company’s common stock, potentially at a discount to the prevailing market price. Of the 3,000,000 shares reserved for issuance under the Company's DRIP, there were 2,454,439 shares remaining for issuance as of September 30, 2014. The Company declared a third quarter common stock dividend of $0.25 per share payable on October 31, 2014 to shareholders of record as of October 3, 2014. There was no discount for shares purchased through the DRIP during the third quarter of 2014.
 
The Company had approximately 7,416,520 shares of common stock that remain available to offer and sell through its sales agent, JMP Securities LLC, under its "at the market", or "ATM" program, as of September 30, 2014.

Of the $50,000 authorized by the Company's Board of Directors for the repurchase of its common stock through December 31, 2014, approximately $42,145 remains available for repurchase at the Company's option as of September 30, 2014.

2009 Stock and Incentive Plan. Of the 2,500,000 shares of common stock authorized for issuance under its 2009 Stock and Incentive Plan, the Company had 1,078,908 available for issuance as of September 30, 2014. Total stock-based compensation expense recognized by the Company for the three and nine months ended September 30, 2014 was $690 and $2,045 compared to $612 and $1,726 for the three and nine months ended September 30, 2013.
  
The following table presents a rollforward of the restricted stock activity for the periods indicated:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2014
 
2013
 
2014
 
2013
Restricted stock outstanding as of beginning of period
746,830

 
526,803

 
520,969

 
448,283

Restricted stock granted
—

 
—

 
457,538

 
255,158

Restricted stock vested
(2,917
)
 
(2,917
)
 
(234,594
)
 
(179,555
)
Restricted stock outstanding as of end of period
743,913

 
523,886

 
743,913

 
523,886


The combined grant date fair value of the restricted stock issued by the Company for the nine months ended September 30, 2014 was $3,703 compared to $2,708 for the nine months ended September 30, 2013. The following table presents the amortization schedule for the Company's non-vested restricted stock remaining to be amortized into compensation expense as of September 30, 2014:

20

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


 
Restricted Stock Amortization
To Be Recognized
Within 12 months
$
2,411

13-24 months
1,663

25-36 months
750

37-48 months
145

Total restricted stock amortization remaining
$
4,969



NOTE 9 – SUBSEQUENT EVENTS

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

21

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

The following discussion should be read in conjunction with our unaudited financial statements and the accompanying notes included in Item 1. “Financial Statements” in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2013. References herein to “Dynex,” the “Company,” “we,” “us,” and “our” include Dynex Capital, Inc. and its consolidated subsidiaries, unless the context otherwise requires. In addition to current and historical information, the following discussion and analysis contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to our future business, financial condition or results of operations. For a description of certain factors that may have a significant impact on our future business, financial condition or results of operations, see “Forward-Looking Statements” at the end of this discussion and analysis.
    

EXECUTIVE OVERVIEW

Company Overview

We are an internally managed mortgage real estate investment trust, or mortgage REIT, which invests in mortgage assets on a leveraged basis. Our common stock is traded on the New York Stock Exchange ("NYSE") under the symbol "DX". We also have two series of preferred stock outstanding, our 8.50% Series A Cumulative Redeemable Preferred Stock (the "Series A Preferred Stock") which is traded on the NYSE under the symbol "DXPRA", and our 7.625% Series B Cumulative Redeemable Preferred Stock (the "Series B Preferred Stock") which is traded on the NYSE under the symbol "DXPRB". Our objective is to provide attractive risk-adjusted returns to our shareholders over the long term that are reflective of a leveraged, high quality fixed income portfolio with a focus on capital preservation. We seek to provide returns to our shareholders primarily through regular quarterly dividends and also through capital appreciation.

We were formed in 1987 and commenced operations in 1988. Beginning with our inception through 2000, our operations largely consisted of originating and securitizing various types of loans, principally single-family and commercial mortgage loans and manufactured housing loans. Since 2000, we have been investing in Agency and non-Agency mortgage-backed securities (“MBS”), and we are no longer originating or securitizing mortgage loans. MBS consist of residential MBS (“RMBS”) and commercial MBS (“CMBS”), including CMBS interest-only ("IO") securities. Agency MBS have a guaranty of principal payment by an agency of the U.S. government or a U.S. government-sponsored entity ("GSE") such as Fannie Mae and Freddie Mac. Non-Agency MBS have no such guaranty of payment.

Our 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 invest our capital pursuant to our Operating Policies as approved by our Board of Directors which include an Investment Policy and Investment Risk Policy as discussed in Part I, Item 1, "Business" under "Company Overview-Operating Policies and Restrictions" in our annual Report on Form 10-K for the year ended December 31, 2013. Our investment policy permits investments in any type of Agency MBS and investment grade non-Agency MBS, legacy securitized mortgage loans, and legacy whole loans. In addition, the Company may make investments not covered by our Investment Policy with prior authorization of the Investment Committee of our Board of Directors.

RMBS. Our Agency RMBS investments include MBS collateralized by adjustable-rate mortgage loans ("ARMS"), which have interest rates that generally will adjust at least annually to an increment over a specified interest rate index, and hybrid adjustable-rate mortgage loans ("hybrid ARMs"), which are loans that have a fixed rate of interest for a specified period (typically three to ten years) and then adjust their interest rate at least annually to an increment over a specified interest rate index as further discussed below. Agency ARMs also include hybrid Agency ARMs that are past their fixed-rate periods or within twelve months of their initial reset period. We may also invest in fixed-rate Agency RMBS from time to time. Additionally, we invest in non-Agency RMBS which generally resemble similar types of Agency ARMs, but lack a guaranty of principal payment by an agency of the U.S. government or a U.S. government-sponsored entity.

Interest rates on loans collateralizing Agency and non-Agency ARMs are based on specific index rates, such as the London Interbank Offered Rate, or LIBOR, the one-year constant maturity treasury rate, or CMT, the Federal Reserve U.S. 12-month

22

cumulative average one-year CMT, or MTA, or the 11th District Cost of Funds Index, or COFI. These loans will typically have interim and lifetime caps on interest rate adjustments, or interest rate caps, limiting the amount that the rates on these loans may reset in any given period.

CMBS. Our Agency and non-Agency CMBS are collateralized by first mortgage loans and are substantially comprised of fixed-rate securities. The majority of the loans collateralizing our CMBS are secured by multifamily properties. Typically these loans have some form of prepayment protection provisions (such as prepayment lock-out) or prepayment compensation provisions (such as yield maintenance or prepayment penalty). Yield maintenance and prepayment penalty requirements are intended to create an economic disincentive for the loans to prepay.

CMBS IO. A portion of our Agency and non-Agency CMBS also include IO securities which represent the right to receive interest payments (but not principal cash flows) based on the unpaid principal balance of the underlying pool of mortgage loans. As these securities have no principal associated with them, the interest payments received are based on the unpaid principal balance of the underlying pool of mortgage loans, which is often referred to as the notional amount. CMBS IO securities generally have some level of prepayment protection in the form of lock-outs, prepayment penalties, or yield maintenance associated with the underlying loans similar to CMBS described above.

Factors that Affect Our Results of Operations and Financial Condition

The performance of our investment portfolio, including the amount of net interest income we earn and fluctuations in investment values, will depend on multiple factors, many of which are beyond our control. These factors include, but are not limited to, the absolute level of interest rates, trends of interest rates, the relative steepness of interest rate curves, actual and estimated future prepayment rates on our investments, competition for investments, economic conditions and their impact on the credit performance of our investments (including multifamily, residential and commercial mortgage markets), and market required yields as reflected by market credit spreads. In addition, the performance of our investment portfolio, the cost and availability of financing and the availability of investments at acceptable return levels could be influenced by actions and policy measures of the U.S. government including the Federal Housing Finance Administration, the U. S. Department of the Treasury (the "Treasury"), and the Board of Governors of the Federal Reserve System (the "Federal Reserve") and could also be influenced by other central banks around the world.

Our business model may also be impacted by other factors such as the availability and cost of financing and the state of the overall credit markets. Reductions in the availability of financing for our investments could significantly impact our business and force us to sell assets that we otherwise would not sell, potentially at losses depending on market conditions. Recent regulatory developments impacting large U.S. domiciled banks and their broker dealer subsidiaries have in some instances reduced their capacity to lend. Broadly, U.S. and international regulators are seeking to force regulated financial institutions to hold more capital against their assets, including reverse repurchase agreements. We have not yet seen a reduction in the availability of financing. We also maintain a diverse set of counterparties including broker dealer subsidiaries of non-U.S. domiciled banks and independent dealers to attempt to mitigate this risk. Other factors also impacting our business include changes in regulatory requirements, including requirements to qualify for registration under the Investment Company Act of 1940, and REIT requirements.

As discussed above, investing in mortgage-related securities on a leveraged basis subjects us to a number of risks including interest rate risk, prepayment and reinvestment risk, credit risk, market value risk and liquidity risk, which are discussed in "Liquidity and Capital Resources" within this Item 2 and in Part I, Item 3 of this Quarterly Report on Form 10-Q as well as in Item 1A, "Risk Factors" of Part I, and in Item 7A, "Quantitative and Qualitative Disclosures about Market Risk" of Part II of our Annual Report on Form 10-K for the year ended December 31, 2013. Please see these Items for a detailed discussion of these risks and the potential impact on our results of operations and financial condition.

Highlights of the Third Quarter of 2014
        
Demand for fixed income assets remained strong during the third quarter of 2014 as volatility remained subdued for most of the quarter. Interest rates in the two to seven year part of the U.S Treasury curve rose while the ten-year Treasury fell as investors positioned for possible changes in Federal Open Market Committee ("FOMC") monetary policy and for the end of its long-term asset purchases. We took advantage of the low volatility environment to sell certain assets in the portfolio most at risk for spread widening from a return of volatility. We sold $233.7 million in CMBS and CMBS IO during the third quarter of 2014 and realized

23

net gains on the sales of these investments of $10.3 million. The sales, coupled with principal payments received on Agency RMBS, resulted in a decline in our debt to shareholders' equity ratio to 5.2x as of September 30, 2014 from 5.6x as of June 30, 2014. Partially as a result of the net gains on the sales of these investments, we reported GAAP net income to common shareholders of $0.52 per common share during the third quarter of 2014 versus core net operating income to common shareholders of $0.25 per common share and a common stock dividend of $0.25 during the same period. Our book value per common share increased modestly to $9.14 per common share as of September 30, 2014 as spread tightening offset declines in the fair values of our investments, net of hedges, due to higher interest rates during the quarter.    

In addition to selling assets, we entered into receive-fixed interest rate swaps to offset a portion of our pay-fixed interest rate swaps during the third quarter of 2014. This repositioning of our hedging portfolio has modestly lowered our overall exposure to higher rates and puts us in a more neutral position to yield curve shifts. Our duration exposure remains predominantly on the short-end of the curve as we continue to expect the FOMC to not raise the targeted Federal Funds rate until 2016. During the quarter we lengthened the maturities of a portion of our repurchase agreements which is consistent with our view that financing costs, particularly on Agency RMBS, may rise independent of any FOMC action. We have been concerned that U.S. domiciled financial institutions may attempt to pass on higher regulatory costs to repurchase agreement borrowers.

Subsequent to September 30, 2014, the U.S. Treasury curve has rallied with the two-year rate down approximately 0.04% to 0.54% and the ten-year rate down approximately 0.13% to 2.39% as of November 6, 2014. The Treasury market has rallied in response to expectations of slower global growth and lower inflation expectations. Credit spreads widened in sympathy with the rally, and we have continued to sell CMBS into the fourth quarter.

Our GAAP net interest spread was down 0.01% from the second quarter of 2014 to the third quarter of 2014 and our adjusted net interest spread continued its recent trend of a modest quarter-to-quarter increase. These measures are discussed further in "Results of Operations". The following table summarizes the average annualized effective yield by type of MBS investment for the third quarter of 2014 and for each of the preceding four quarters:
 
Three Months Ended
 
September 30, 2014
 
June 30, 2014
 
March 31, 2014
 
December 31, 2013
 
September 30, 2013
Average annualized effective yield: