Edgar Filing: DYNEX CAPITAL INC

Document

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, 2016



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 October 31, 2016, the registrant had 49,150,424 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

		Consolidated Balance Sheets as of September 30, 2016 (unaudited) and December 31, 2015	1

		Consolidated Statements of Comprehensive Income (Loss) for the three and nine months ended September 30, 2016 (unaudited) and September 30, 2015 (unaudited)	2

		Consolidated Statement of Shareholders' Equity for the nine months ended September 30, 2016 (unaudited)	3

		Consolidated Statements of Cash Flows for the nine months ended September 30, 2016 (unaudited) and September 30, 2015 (unaudited)	4

		Notes to the Unaudited Consolidated Financial Statements	5

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	48

	Item 4.	Controls and Procedures	53

PART II.	OTHER INFORMATION

	Item 1.	Legal Proceedings	54

	Item 1A.	Risk Factors	54

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	54

	Item 3.	Defaults Upon Senior Securities	54

	Item 4.	Mine Safety Disclosures	54

	Item 5.	Other Information	54

	Item 6.	Exhibits	55

SIGNATURES			56

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

CONSOLIDATED BALANCE SHEETS

($ in thousands except share data)



	September 30, 2016			December 31, 2015
ASSETS	(unaudited)
Mortgage-backed securities (including pledged of $2,974,524 and $3,361,635, respectively)	$	3,110,467		$	3,493,701
Mortgage loans held for investment, net	20,366			24,145
Investment in limited partnership	—			10,835
Investment in FHLB stock	5,260			11,475
Cash and cash equivalents	73,406			33,935
Restricted cash	84,685			51,190
Derivative assets	12,985			7,835
Principal receivable on investments	9,594			6,193
Accrued interest receivable	19,501			22,764
Other assets, net	7,292			7,975
Total assets	$	3,343,556		$	3,670,048

LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
Repurchase agreements	$	2,478,278		$	2,589,420
FHLB advances	263,000			520,000
Non-recourse collateralized financing	7,025			8,442
Derivative liabilities	84,023			41,205
Accrued interest payable	2,163			1,743
Accrued dividends payable	12,259			13,709
Other liabilities	1,889			3,504
Total liabilities	2,848,637			3,178,023

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; 49,148,595 and 49,047,335 shares issued and outstanding, respectively	491			490
Additional paid-in capital	726,701			725,358
Accumulated other comprehensive income (loss)	52,578			(12,768		)
Accumulated deficit	(394,509		)	(330,713		)
Total shareholders' equity	494,919			492,025
Total liabilities and shareholders’ equity	$	3,343,556		$	3,670,048

See notes to the unaudited consolidated financial statements.

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,
	2016			2015			2016			2015
Interest income	$	21,135		$	26,096		$	69,040		$	74,722
Interest expense	6,068			5,859			18,478			16,772
Net interest income	15,067			20,237			50,562			57,950

Gain (loss) on derivative instruments, net	2,409			(52,749		)	(62,153		)	(60,982		)
Gain (loss) on sale of investments, net	—			113			(4,238		)	(70		)
Fair value adjustments, net	34			16			86			75
Other income (expense), net	545			(215		)	898			430
General and administrative expenses:
Compensation and benefits	(1,736		)	(2,327		)	(5,829		)	(6,794		)
Other general and administrative	(1,619		)	(2,052		)	(5,288		)	(6,596		)
Net income (loss)	14,700			(36,977		)	(25,962		)	(15,987		)
Preferred stock dividends	(2,294		)	(2,294		)	(6,882		)	(6,882		)
Net income (loss) to common shareholders	$	12,406		$	(39,271	)	$	(32,844	)	$	(22,869	)

Other comprehensive income:
Change in net unrealized gain on available-for-sale investments	$	769		$	26,674		$	61,260		$	7,951
Reclassification adjustment for (gain) loss on sale of investments, net	—			(113		)	4,238			70
Reclassification adjustment for de-designated cash flow hedges	(99		)	857			(152		)	2,772
Total other comprehensive income	670			27,418			65,346			10,793
Comprehensive income (loss) to common shareholders	$	13,076		$	(11,853	)	$	32,502		$	(12,076	)

Net income (loss) per common share-basic and diluted	$	0.25		$	(0.74	)	$	(0.67	)	$	(0.42	)
Weighted average common shares-basic and diluted	49,147			52,777			49,102			54,043

See notes to the unaudited consolidated financial statements.

DYNEX CAPITAL, INC.

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(UNAUDITED)

($ in thousands)



	Preferred Stock		Common Stock			Additional Paid-in Capital			Accumulated Other Comprehensive (Loss) Income			Accumulated Deficit			Total Shareholders' Equity
Balance as of December 31, 2015	$	109,658	$	490		$	725,358		$	(12,768	)	$	(330,713	)	$	492,025
Stock issuance	—		—			102			—			—			102
Restricted stock granted, net of amortization	—		2			2,064			—			—			2,066
Adjustments for tax withholding on share-based compensation	—		(1		)	(484		)	—			—			(485		)
Stock issuance costs amortization	—		—			(29		)	—			—			(29		)
Common stock repurchased	—		—			(310		)	—			—			(310		)
Net loss	—		—			—			—			(25,962		)	(25,962		)
Dividends on preferred stock	—		—			—			—			(6,882		)	(6,882		)
Dividends on common stock	—		—			—			—			(30,952		)	(30,952		)
Other comprehensive income	—		—			—			65,346			—			65,346
Balance as of September 30, 2016	$	109,658	$	491		$	726,701		$	52,578		$	(394,509	)	$	494,919

See notes to the unaudited consolidated financial statements.

DYNEX CAPITAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

($ in thousands)



	Nine Months Ended
	September 30,
	2016			2015
Operating activities:
Net loss	$	(25,962	)	$	(15,987	)
Adjustments to reconcile net loss to cash provided by operating activities:
Decrease in accrued interest receivable	3,263			241
Increase (decrease) in accrued interest payable	420			(409		)
Loss on derivative instruments, net	62,153			60,982
Loss on sale of investments, net	4,238			70
Fair value adjustments, net	(86		)	(75		)
Amortization of investment premiums, net	112,418			114,398
Other amortization and depreciation, net	1,186			4,143
Stock-based compensation expense	2,066			2,220
Other operating activities	(2,060		)	(3,064		)
Net cash and cash equivalents provided by operating activities	157,636			162,519
Investing activities:
Purchase of investments	(96,816		)	(1,066,461		)
Principal payments received on investments	337,719			384,063
Proceeds from sales of investments	94,033			339,332
Principal payments received on mortgage loans held for investment, net	3,709			12,241
Payment to acquire interest in limited partnership	—			(6,000		)
Distributions received from limited partnership	10,835			—
Net payments on derivatives, including terminations	(24,483		)	(37,502		)
Other investing activities	(105		)	(134		)
Net cash and cash equivalents provided by (used in) investing activities	324,892			(374,461		)
Financing activities:
Borrowings under repurchase agreements and FHLB advances	19,293,243			17,329,870
Repayments of repurchase agreement borrowings and FHLB advances	(19,661,384		)	(17,032,911		)
Principal payments on non-recourse collateralized financing	(1,443		)	(2,249		)
Increase in restricted cash	(33,495		)	(35,916		)
Proceeds from issuance of common stock	102			129
Cash paid for repurchases of common stock	(310		)	(31,051		)
Payments related to tax withholding for stock-based compensation	(485		)	(556		)
Dividends paid	(39,285		)	(46,682		)
Net cash and cash equivalents (used in) provided by financing activities	(443,057		)	180,634

Net increase (decrease) in cash and cash equivalents	39,471			(31,308		)
Cash and cash equivalents at beginning of period	33,935			43,944
Cash and cash equivalents at end of period	$	73,406		$	12,636
Supplemental Disclosure of Cash Activity:
Cash paid for interest	$	18,185		$	14,366

See notes to the unaudited consolidated financial statements.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

($ in thousands except 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, as appropriate, the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to the Quarterly Report on Form 10-Q and Article 10, Rule 10-01 of Regulation S-X promulgated by the Securities and Exchange Commission (the “SEC”). Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all significant adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation of the consolidated financial statements have been included. Operating results for the three and nine months ended September 30, 2016 are not necessarily indicative of the results that may be expected for any other interim periods or for the entire year ending December 31, 2016. 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, 2015 filed with the SEC.

Reclassifications

Certain items in the prior periods' consolidated financial statements have been reclassified to conform to the current period's presentation. The Company's equity in income of limited partnership for the three and nine months ended September 30, 2015 is now included within "other income (expense), net" on the Company's consolidated statements of comprehensive income. This presentation change has 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 ("VIE") for which it is the primary beneficiary. As a primary beneficiary, the Company has both the power to direct the activities that most significantly impact the economic performance of the VIE and a right to receive benefits or absorb losses of the entity that could be potentially significant to the VIE. The Company is required to reconsider its evaluation of whether to consolidate a VIE each reporting period, based upon changes in the facts and circumstances pertaining to the VIE. The Company consolidates certain trusts through which it has securitized mortgage loans as a result of not meeting the sale criteria under GAAP at the time the financial assets were transferred to the trust. All intercompany accounts and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenue and expenses during the reported period. Actual results could differ from those estimates. The most significant estimates used by management include, but are not limited to, 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.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

($ in thousands except 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 ("NOL") carryforward and not including taxable income retained in its taxable subsidiaries. As a REIT, the Company generally will not be subject to federal income tax on the amount of its income or capital gains that is distributed as dividends to shareholders.

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

Net Income (Loss) Per Common Share

The Company calculates basic net income (loss) per common share by dividing net income (loss) to common shareholders for the period by weighted-average shares of common stock outstanding for that period. The Company did not have any potentially dilutive securities outstanding during the three or nine months ended September 30, 2016 or September 30, 2015.

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

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

Cash and Cash Equivalents

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

Restricted Cash

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

Mortgage-Backed Securities

The Company invests in Agency and non-Agency RMBS, CMBS and CMBS IO securities, all of which are designated as available-for-sale ("AFS"). All of the Company’s MBS are recorded at fair value on the consolidated balance sheet. Changes in unrealized gain (loss) on the Company's MBS 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.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

($ in thousands except per share data)

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

Determination of MBS Fair Value. The Company estimates the fair value of the majority of its MBS based upon prices obtained from third-party pricing services and broker quotes. The remainder of the Company's MBS are valued by discounting the estimated future cash flows derived from cash flow models that utilize information such as the security's coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected losses, and credit enhancements as well as certain other relevant information. Refer to Note 6 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 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 2 for additional information related to the Company's evaluation for OTTI.

Secured Borrowings

The Company's repurchase agreements and Federal Home Loan Bank (or "FHLB") advances, which are used to finance its purchases of MBS, 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.

As a result of a final rule issued by the Federal Housing Finance Administration ("FHFA") in January 2016 regarding the exclusion of captive insurance entities from membership in the FHLB, the Company's wholly owned subsidiary, Mackinaw

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

($ in thousands except per share data)

Insurance Company, LLC ("Mackinaw"), must terminate its membership in the FHLB of Indianapolis by February 19, 2017 and will no longer be permitted new advances or renewals of existing advances. FHLB advances outstanding on the Company's consolidated balance sheet as of September 30, 2016 will be repaid before December 31, 2016.

Derivative Instruments

The Company's derivative instruments, which currently include interest rate swaps and Eurodollar futures, are accounted for at fair value. Derivative instruments in a gain position are reported as derivative assets and derivative instruments in a loss position are reported as derivative liabilities on the Company's consolidated balance sheet. All periodic interest costs and changes in fair value of derivative instruments, including gains and losses realized upon termination, are recorded in "gain (loss) on derivative instruments, net" on the Company's consolidated statement of comprehensive income. Cash receipts and payments related to derivative instruments are classified in the investing activities section of our consolidated statements of cash flows in accordance with the underlying nature or purpose of the derivative transactions. Please refer to Note 4 for additional information regarding the Company's accounting for its derivative instruments.

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

Share-Based Compensation

Pursuant to the Company’s 2009 Stock and Incentive Plan, the Company may grant share-based compensation to eligible employees, directors or consultants or advisers to the Company, including stock awards, stock options, stock appreciation rights, dividend equivalent rights, performance shares, and restricted stock units. The Company's restricted stock currently issued and outstanding under this plan may be settled only in shares of its common stock, and therefore are treated as equity awards with their fair value measured at the grant date and recognized as compensation cost over the requisite service period with a corresponding credit to shareholders' equity. The requisite service period is the period during which an employee is required to provide service in exchange for an award, which is equivalent to the vesting period specified in the terms of the time-based restricted stock award. None of the Company's restricted stock awards have performance based conditions. The Company does not currently have any share-based compensation issued or outstanding other than restricted stock.

Contingencies

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

Recent Accounting Pronouncements

The Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2016-02, Leases, which includes the following amendments:


•	for operating and finance leases, a lessee is required to recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments in its consolidated balance sheet;


•	for finance leases, a lessee is required to recognize interest on the lease liability separately from amortization of the right-of-use asset in the statement of comprehensive income;


•	for finance leases, a lessee is required to classify repayments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability and variable lease payments within operating activities in the statement of cash flows;

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

($ in thousands except per share data)


•	for operating leases, a lessee is required to recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term on a generally straight-line basis in the statement of comprehensive income; and


•	for operating leases, a lessee is required to classify all cash payments within operating activities in the statement of cash flows.

Under the new guidance, lessor accounting is largely unchanged. ASU No. 2016-02 is effective for public companies for fiscal years beginning after December 15, 2018, and early adoption is permitted. The Company does not expect this ASU to have a material impact on the Company's consolidated financial statements.

The FASB issued ASU No. 2016-09, Compensation - Stock Compensation, which simplifies several aspects of the accounting for share-based payment award transactions, including income tax consequences, classification of awards as either equity or liabilities, and classification on the statement cash flows. The amendments are effective for public companies for fiscal years beginning after December 15, 2016, and early adoption is permitted. The Company does not expect this ASU to have a material impact on the Company's consolidated financial statements.

The FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses, which replaces the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. For assets measured at amortized cost, the amendments in this ASU eliminate the probable initial recognition threshold in current GAAP and broaden the information that an entity must consider in developing its expected credit loss estimate to include the use of forecasted information. For assets classified as available-for-sale with changes in fair value recorded in other comprehensive income, measurement of credit losses will be similar to current GAAP. However, the amendments in this ASU require that credit losses be presented as an allowance rather than as a write-down, which is referred to in current GAAP as an other-than-temporary impairment. An entity will be able to record reversals of credit losses, if credit loss estimates decline, in net income for the current period. The amendments in this ASU will not permit an entity to use the length of time a debt security has been in an unrealized loss position to avoid recording a credit loss and removes the requirements to consider historical and implied volatility of the fair value of a security as well as recoveries or declines in fair value after the balance sheet date. The amendments in this ASU will affect an entity by varying degrees depending on the credit quality of the assets held by the entity, their duration, and how the entity applies current GAAP. These amendments will become effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years, and early adoption will be permitted as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. An entity will apply the amendments in this ASU through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective. The Company does not currently anticipate this ASU having an impact on its consolidated financial statements.

The FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 320) - Classification of Certain Cash Receipts and Cash Payments, in order to provide guidance for eight cash flow classification issues which are either unclear or do not have specific guidance under current GAAP. The issues identified are as follows:


•	debt prepayment or debt extinguishment costs;


•	settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates insignificant in relation to the effective interest rate of the borrowing;


•	contingent consideration payments made after a business combination;


•	proceeds from the settlement of insurance claims;


•	proceeds from settlement of corporate-owned life insurance policies;


•	distributions received from equity method investees;


•	beneficial interests in securitization transactions; and


•	separately identifiable cash flows and application of the predominance principle.

The amendments in this ASU will become effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years, and early adoption is permitted. The amendments in this ASU should be applied using a retrospective transition method to each period presented. The Company does not expect this ASU to have a material impact on the Company's consolidated financial statements.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

($ in thousands except per share data)

NOTE 2 – MORTGAGE-BACKED SECURITIES

The majority of the Company's MBS are pledged as collateral to cover initial and variation margins for the Company's secured borrowings and derivative instruments. The following tables present the Company’s MBS by investment type as of the dates indicated:



	September 30, 2016
	Par		Net Premium (Discount)			Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss			Fair Value		WAC ⁽¹⁾
RMBS:
Agency	$	1,239,856	$	61,141		$	1,300,997	$	5,270	$	(8,549	)	$	1,297,718	3.04	%
Non-Agency	41,514		(19		)	41,495		109		(54		)	41,550		3.58	%
	1,281,370		61,122			1,342,492		5,379		(8,603		)	1,339,268
CMBS:
Agency	898,317		11,048			909,365		35,901		(62		)	945,204		3.32	%
Non-Agency	82,190		(7,552		)	74,638		8,135		(1		)	82,772		4.89	%
	980,507		3,496			984,003		44,036		(63		)	1,027,976
CMBS IO ⁽²⁾:
Agency	—		385,968			385,968		8,597		(139		)	394,426		0.68	%
Non-Agency	—		344,792			344,792		4,921		(916		)	348,797		0.61	%
	—		730,760			730,760		13,518		(1,055		)	743,223

Total AFS securities:	$	2,261,877	$	795,378		$	3,057,255	$	62,933	$	(9,721	)	$	3,110,467


(1)	The current weighted average coupon ("WAC") is the gross interest rate of the pool of mortgages underlying the security weighted by the outstanding principal balance (or by notional balance in the case of an IO security).


(2)	The notional balance for Agency CMBS IO and non-Agency CMBS IO was $12,226,782 and $10,687,732, respectively, as of September 30, 2016.



	December 31, 2015
	Par		Net Premium (Discount)			Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss			Fair Value		WAC ⁽¹⁾
RMBS:
Agency	$	1,536,733	$	77,617		$	1,614,350	$	4,362	$	(20,190	)	$	1,598,522	3.03	%
Non-Agency	66,003		(45		)	65,958		70		(818		)	65,210		3.25	%
	1,602,736		77,572			1,680,308		4,432		(21,008		)	1,663,732
CMBS:
Agency	876,751		13,252			890,003		10,542		(14,614		)	885,931		3.45	%
Non-Agency	156,218		(8,133		)	148,085		7,039		(941		)	154,183		4.29	%
	1,032,969		5,119			1,038,088		17,581		(15,555		)	1,040,114
CMBS IO ⁽²⁾:
Agency	—		421,857			421,857		5,922		(1,651		)	426,128		0.80	%
Non-Agency	—		365,554			365,554		1,992		(3,819		)	363,727		0.71	%
	—		787,411			787,411		7,914		(5,470		)	789,855

Total AFS securities:	$	2,635,705	$	870,102		$	3,505,807	$	29,927	$	(42,033	)	$	3,493,701


(1)	The current weighted average coupon ("WAC") is the gross interest rate of the pool of mortgages underlying the security weighted by the outstanding principal balance (or by notional balance in the case of an IO security).

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

($ in thousands except per share data)


(2)	The notional balance for the Agency CMBS IO and non-Agency CMBS IO was $12,180,291 and $10,328,628, respectively, as of December 31, 2015.

Actual maturities of MBS are affected by the contractual lives of the underlying mortgage collateral, periodic payments of principal, prepayments of principal, and the payment priority structure of the security; therefore, actual maturities are generally shorter than the securities' stated contractual maturities.

The following table presents information regarding the sales included in "gain (loss) on sale of investments, net" on the Company's consolidated statements of comprehensive income for the periods indicated:



	Three Months Ended
	September 30,
	2016				2015
	Proceeds Received		Realized Gain (Loss)		Proceeds Received			Realized Gain (Loss)
Agency RMBS ⁽¹⁾	$	—	$	—	$	(2,694	)	$	(59	)
Agency CMBS IO	—		—		12,620			172
Non-Agency CMBS IO	—		—		—			—
	$	—	$	—	$	9,926		$	113


(1)	There were no sales of Agency RMBS during the three months ended September 30, 2015. The amounts shown reflect an adjustment to proceeds received and the realized loss recognized during the three months ended September 30, 2015 related to pre-settlement factor changes.



	Nine Months Ended
	September 30,
	2016					2015
	Proceeds Received		Realized Gain (Loss)			Proceeds Received		Realized Gain (Loss)
Agency RMBS	$	54,178	$	(3,010	)	$	153,676	$	(2,256	)
Agency CMBS	—		—			98,887		(822		)
Non-Agency CMBS	33,640		(1,228		)	—		—
Agency CMBS IO	—		—			42,005		1,646
Non-Agency CMBS IO	—		—			44,764		1,362
	$	87,818	$	(4,238	)	$	339,332	$	(70	)

The following table presents certain information for those MBS in an unrealized loss position as of the dates indicated:



	September 30, 2016						December 31, 2015
	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	$	352,253	$	(1,484	)	40	$	1,332,849	$	(19,062	)	109
Non-Agency MBS	24,448		(99		)	5	351,650		(5,347		)	72

Continuous unrealized loss position for 12 months or longer:
Agency MBS	$	379,488	$	(7,266	)	61	$	775,484	$	(17,393	)	72
Non-Agency MBS	84,959		(872		)	28	8,306		(231		)	7

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

($ in thousands except per share data)

Because the principal related to Agency MBS is guaranteed by the government-sponsored entities Fannie Mae and Freddie Mac which have the implicit guarantee of the U.S. government, the Company does not consider any of the unrealized losses on its Agency MBS to be credit related. Although the unrealized losses are not credit related, the Company assesses its ability and intent to hold any Agency MBS with an unrealized loss until the recovery in its value. 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, 2016 and December 31, 2015 were temporary.

The Company reviews any non-Agency MBS in an unrealized loss position to evaluate whether any decline in fair value represents an OTTI. The evaluation includes a review of the credit ratings of 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, 2016 or December 31, 2015.

NOTE 3 – SECURED BORROWINGS

The Company’s secured borrowings, which consist of repurchase agreements and FHLB advances, that were outstanding as of September 30, 2016 and December 31, 2015 are summarized in the table below:



	September 30, 2016
Collateral Type	Balance		Weighted Average Rate		Fair Value of Collateral Pledged
Agency RMBS	$	1,156,635	0.70	%	$	1,204,542
Non-Agency RMBS	38,613		1.88	%	41,082
Agency CMBS	594,661		0.69	%	643,207
Non-Agency CMBS	69,687		1.50	%	82,573
Agency CMBS IO	322,632		1.38	%	378,875
Non-Agency CMBS IO	290,626		1.45	%	343,900
Securitization financing bond	5,424		1.86	%	5,882
Total repurchase agreements	$	2,478,278	0.91	%	$	2,700,061
FHLB advances ⁽¹⁾	263,000		0.51	%	274,953
Total secured borrowings	$	2,741,278	0.88	%	$	2,975,014

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

($ in thousands except per share data)



	December 31, 2015
Collateral Type	Balance		Weighted Average Rate		Fair Value of Collateral Pledged
Agency RMBS	$	1,439,436	0.47	%	$	1,483,152
Non-Agency RMBS	52,128		1.77	%	64,286
Agency CMBS	301,427		0.49	%	345,728
Non-Agency CMBS	126,378		1.26	%	143,785
Agency CMBS IOs	360,245		1.24	%	421,285
Non-Agency CMBS IOs	302,771		1.33	%	359,351
Securitization financing bond	7,035		1.65	%	8,054
Total repurchase agreements	$	2,589,420	0.75	%	$	2,825,641
FHLB advances ⁽¹⁾	520,000		0.40	%	541,771
Total secured borrowings	$	3,109,420	0.69	%	$	3,367,412

(1) As of September 30, 2016 and December 31, 2015, FHLB advances were collateralized primarily with Agency CMBS.

As of September 30, 2016, the weighted average remaining term to maturity of our repurchase agreements was 18 days compared to 22 days as of December 31, 2015. The remaining balance of FHLB advances is due in October 2016. The following table provides a summary of the original term to maturity of our secured borrowings as of September 30, 2016 and December 31, 2015:



Original Term to Maturity	September 30, 2016		December 31, 2015
Less than 30 days	$	607,051	$	551,643
30 to 90 days	1,143,854		782,393
91 to 180 days	727,373		1,512,384
181 to 364 days	263,000		—
1 year or longer	—		263,000
	$	2,741,278	$	3,109,420

The following table lists the counterparties with whom the Company had over 10% of its shareholders' equity at risk (defined as the excess of collateral pledged over the borrowings outstanding):



	September 30, 2016
Counterparty Name	Balance		Weighted Average Rate		Equity at Risk
Wells Fargo Bank, N. A. and affiliates	$	300,761	1.40	%	$	54,432

Of the amount outstanding with Wells Fargo Bank, N.A. and affiliates, $287,538 is under a committed repurchase facility which has an aggregate maximum borrowing capacity of $350,000 and is scheduled to mature on August 6, 2018, 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, 2016 was 1.39%.

As of September 30, 2016, the Company had repurchase agreement amounts outstanding with 18 of its 32 available repurchase agreement counterparties. The Company's counterparties, as set forth in the master repurchase agreement with the counterparty, require the Company to comply with various customary operating and financial covenants, including, but not 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

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

($ in thousands except per share data)

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. With respect to outstanding repurchase agreement and FHLB advance financings as of September 30, 2016, the Company was in compliance with all covenants.

Please see Note 5 for the Company's disclosures related to offsetting assets and liabilities.

NOTE 4 – DERIVATIVES

The Company utilizes derivative instruments to economically hedge a portion of its exposure to 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 some portion of 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, 2016
	Derivative Assets				Derivative Liabilities
Trading Instruments	Fair Value		Notional		Fair Value			Notional
Interest rate swaps	$	12,985	$	425,000	$	(41,385	)	$	1,355,000
Eurodollar futures ⁽¹⁾	—		—		(42,638		)	6,300,000
Total	$	12,985	$	425,000	$	(84,023	)	$	7,655,000



	December 31, 2015
	Derivative Assets				Derivative Liabilities
Trading Instruments	Fair Value		Notional		Fair Value			Notional
Interest rate swaps	$	7,835	$	460,000	$	(12,108	)	$	2,920,000
Eurodollar futures ⁽¹⁾	—		—		(29,097		)	6,300,000
Total	$	7,835	$	460,000	$	(41,205	)	$	9,220,000


(1)	The Eurodollar futures aggregate notional amount represents the total notional of the 3-month contracts with expiration dates from 2017 to 2020. The maximum notional outstanding for any future 3-month period did not exceed $725,000 as of September 30, 2016 or as of December 31, 2015.

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



For the nine months ended September 30, 2016:	Beginning of Period Notional Amount		Additions		Settlement, Termination, Expiration or Exercise			End of Period Notional Amount
Receive-fixed interest rate swaps	$	425,000	$	—	$	—		$	425,000
Pay-fixed interest rate swaps ⁽¹⁾	2,955,000		1,250,000		(2,850,000		)	1,355,000
Eurodollar futures	6,300,000		—		—			6,300,000
	$	9,680,000	$	1,250,000	$	(2,850,000	)	$	8,080,000

(1) The notional amount of pay-fixed interest rate swaps that were forward starting as of September 30, 2016 was $625,000.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

($ in thousands except per share data)

The table below provides detail of the Company's "(loss) gain on derivative instruments, net" by type of derivative for the periods indicated:



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
Type of Derivative Instrument	2016			2015			2016			2015
Receive-fixed interest rate swaps	$	(2,976	)	$	6,975		$	11,301		$	9,757
Pay-fixed interest rate swaps	2,555			(48,697		)	(59,912		)	(45,797		)
Eurodollar futures	2,830			(11,027		)	(13,542		)	(24,942		)
(Loss) gain on derivative instruments, net	$	2,409		$	(52,749	)	$	(62,153	)	$	(60,982	)

There is a net unrealized gain of $769 remaining in AOCI on the Company's consolidated balance sheet as of September 30, 2016 which represents the activity related to interest rate swap agreements while they were previously designated as cash flow hedges, and this amount will be recognized in the Company's net income as a portion of "interest expense" over the remaining contractual life of the agreements. The Company estimates a credit of $319 will be reclassified to net income as a reduction of "interest expense" within the next 12 months.

A portion of the Company's interest rate swaps were entered into under bilateral agreements which contain cross-default provisions with other agreements between the parties. In addition, these bilateral agreements contain financial and operational covenants similar to those contained in our repurchase agreements, as described in Note 3. With respect to interest rate agreements under which interest rate swaps were entered into as of September 30, 2016, the Company was in compliance with all covenants.

Please see Note 5 for the Company's disclosures related to offsetting assets and liabilities.

NOTE 5 – OFFSETTING ASSETS AND LIABILITIES

The Company's derivatives, repurchase agreements, and FHLB advances 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, 2016 and December 31, 2015:



	Offsetting of Assets
	Gross Amount of Recognized Assets		Gross Amount Offset in the Balance Sheet		Net Amount of Assets Presented in the Balance Sheet		Gross Amount Not Offset in the Balance Sheet ⁽¹⁾					Net Amount
	Gross Amount of Recognized Assets		Gross Amount Offset in the Balance Sheet		Net Amount of Assets Presented in the Balance Sheet		Financial Instruments Received as Collateral			Cash Received as Collateral		Net Amount
September 30, 2016
Derivative assets	$	12,985	$	—	$	12,985	$	(12,985	)	$	—	$	—

December 31, 2015:
Derivative assets	$	7,835	$	—	$	7,835	$	(7,835	)	$	—	$	—

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

($ in thousands except per share data)



	Offsetting of Liabilities
	Gross Amount of Recognized Liabilities		Gross Amount Offset in the Balance Sheet		Net Amount of Liabilities Presented in the Balance Sheet		Gross Amount Not Offset in the Balance Sheet ⁽¹⁾						Net Amount
	Gross Amount of Recognized Liabilities		Gross Amount Offset in the Balance Sheet		Net Amount of Liabilities Presented in the Balance Sheet		Financial Instruments Posted as Collateral			Cash Posted as Collateral			Net Amount
September 30, 2016
Derivative liabilities	$	84,023	$	—	$	84,023	$	(16,253	)	$	(67,770	)	$	—
Repurchase agreements	2,478,278		—		2,478,278		(2,478,278		)	—			—
FHLB advances	263,000		—		263,000		(263,000		)	—			—
	$	2,825,301	$	—	$	2,825,301	$	(2,757,531	)	$	(67,770	)	$	—

December 31, 2015:
Derivative liabilities	$	41,205	$	—	$	41,205	$	(9,079	)	$	(32,111	)	$	15
Repurchase agreements	2,589,420		—		2,589,420		(2,589,420		)	—			—
FHLB advances	520,000		—		520,000		(520,000		)	—			—
	$	3,150,625	$	—	$	3,150,625	$	(3,118,499	)	$	(32,111	)	$	15


(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.

NOTE 6 – FAIR VALUE OF FINANCIAL INSTRUMENTS

ASC Topic 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC Topic 820 clarifies that fair value should be based on the assumptions market participants would use when pricing an asset or liability and also requires an entity to consider all aspects of nonperformance risk, including the entity's own credit standing, when measuring fair value of a liability. ASC Topic 820 established a valuation hierarchy of three levels as follows:


•	Level 1 – Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities as of the measurement date.


•	Level 2 – Inputs include quoted prices in active markets for similar assets or liabilities; quoted prices in inactive markets for identical or similar assets or liabilities; or inputs either directly observable or indirectly observable through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.


•	Level 3 – Unobservable inputs are supported by little or no market activity. The unobservable inputs represent management’s best estimate of how market participants would price the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

The 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:

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

($ in thousands except per share data)



	September 30, 2016
	Fair Value		Level 1 - Unadjusted Quoted Prices in Active Markets		Level 2 - Observable Inputs		Level 3 - Unobservable Inputs
Assets:
Mortgage-backed securities	$	3,110,467	$	—	$	3,097,055	$	13,412
Derivative assets	12,985		—		12,985		—
Total assets carried at fair value	$	3,123,452	$	—	$	3,110,040	$	13,412
Liabilities:
Derivative liabilities	$	84,023	$	42,638	$	41,385	$	—
Total liabilities carried at fair value	$	84,023	$	42,638	$	41,385	$	—



	December 31, 2015
	Fair Value		Level 1 - Unadjusted Quoted Prices in Active Markets		Level 2 - Observable Inputs		Level 3 - Unobservable Inputs
Assets:
Mortgage-backed securities	$	3,493,701	$	—	$	3,477,266	$	16,435
Derivative assets	7,835		—		7,835		—
Total assets carried at fair value	$	3,501,536	$	—	$	3,485,101	$	16,435
Liabilities:
Derivative liabilities	$	41,205	$	29,097	$	12,108	$	—
Total liabilities carried at fair value	$	41,205	$	29,097	$	12,108	$	—

The Company did not have assets or liabilities measured at fair value on a non-recurring basis as of September 30, 2016 or December 31, 2015.

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, the fair values of these financial futures are classified as Level 1 measurements.

Agency MBS, as well as 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 pricing indicators or assumptions determined by the Company. 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. Level 3 assets are generally most sensitive to the default rate and severity assumptions.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

($ in thousands except per share data)

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, 2016:



	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	%	10.1	%
Non-Agency RMBS	10 CPR	1.0	%	20.0	%	5.6	%


(1)	Data presented are weighted averages.

The activity of the instruments measured at fair value on a recurring basis using Level 3 inputs is presented in the following table for the period indicated:



	Level 3 Fair Value
	Non-Agency CMBS			Non-Agency RMBS			Total assets
Balance as of December 31, 2015	$	14,903		$	1,532		$	16,435
Unrealized (loss) gain included in OCI	(427		)	19			(408		)
Principal payments	(3,223		)	(182		)	(3,405		)
Accretion	790			—			790
Balance as of September 30, 2016	$	12,043		$	1,369		$	13,412

The following table presents a summary of the carrying value and estimated fair values of the Company’s financial instruments as of the dates indicated:



	September 30, 2016				December 31, 2015
	Carrying Value		Fair Value		Carrying Value		Fair Value
Assets:
Mortgage-backed securities	$	3,110,467	$	3,110,467	$	3,493,701	$	3,493,701
Mortgage loans held for investment, net⁽¹⁾	20,366		16,996		24,145		20,849
Investment in FHLB stock	5,260		5,260		11,475		11,475
Derivative assets	12,985		12,985		7,835		7,835
Liabilities:
Repurchase agreements ⁽²⁾	$	2,478,278	$	2,478,278	$	2,589,420	$	2,589,420
FHLB advances ⁽²⁾	263,000		263,000		520,000		520,000
Non-recourse collateralized financing ⁽¹⁾	7,025		6,802		8,442		8,102
Derivative liabilities	84,023		84,023		41,205		41,205


(1)	The Company determines the fair value of its mortgage loans held for investment, net and its non-recourse collateralized financing using internally developed cash flow models with inputs similar to those used to estimate the fair value of the Company's Level 3 non-Agency MBS.


(2)	The carrying value of repurchase agreements and FHLB advances generally approximates fair value due to their short term maturities.

NOTE 7 – SHAREHOLDERS' EQUITY

Preferred Stock

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

($ in thousands except per share data)

The Company has 2,300,000 shares of its 8.50% Series A Preferred Stock and 2,250,000 shares of its 7.625% Series B Preferred Stock issued and outstanding as of September 30, 2016 (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 14, 2016 to shareholders of record as of October 1, 2016.

Common Stock

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



	Nine Months Ended
	September 30,
	2016		2015
Balance as of beginning of period	49,047,335		54,739,111
Common stock issued under DRIP	15,714		16,862
Common stock issued under stock and incentive plans	214,878		263,829
Common stock forfeited for tax withholding on share-based compensation	(80,888	)	(67,296	)
Common stock repurchased during the period	(48,444	)	(4,383,716	)
Balance as of end of period	49,148,595		50,568,790

The Company had 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, 2016.

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 2,411,824 shares remaining for issuance as of September 30, 2016. The Company declared a third quarter common stock dividend of $0.21 per share payable on October 31, 2016 to shareholders of record as of October 5, 2016. There was no discount for shares purchased through the DRIP during the third quarter of 2016.

Of the $50,000 authorized by the Company's Board of Directors for the repurchase of its common stock through December 31, 2016, approximately $8,518 remains available for repurchase at the Company's option as of September 30, 2016.

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 860,106 available for issuance as of September 30, 2016. Total stock-based compensation expense recognized by the Company for the three and nine months ended September 30, 2016 was $623 and $2,066 compared to $745 and $2,220 for the three and nine months ended September 30, 2015.

The following table presents a rollforward of the restricted stock activity for the periods indicated:

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

DYNEX CAPITAL, INC.

($ in thousands except per share data)



	Three Months Ended		Nine Months Ended
	September 30,		September 30,
	2016	2015	2016		2015
Restricted stock outstanding as of beginning of period	561,089	696,597	696,597		731,809
Restricted stock granted	—	—	214,878		263,829
Restricted stock vested	—	—	(350,386	)	(299,041	)
Restricted stock outstanding as of end of period	561,089	696,597	561,089		696,597

The combined grant date fair value of the restricted stock issued by the Company for the nine months ended September 30, 2016 was $1,349 compared to $2,167 for the nine months ended September 30, 2015. As of September 30, 2016, the fair value of the Company’s outstanding restricted stock remaining to be amortized into compensation expense is $2,781 which will be recognized over a weighted average period of 1.5 years.

NOTE 8 – 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.

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

The following discussion should be read in conjunction with our unaudited financial statements and the accompanying notes included in Part 1, Item 1. “Financial Statements” in this Quarterly Report on Form 10-Q and our audited financial statements and the accompanying notes included in Part II, Item 8 in our Annual Report on Form 10-K for the year ended December 31, 2015. References herein to “Dynex,” the “Company,” “we,” “us,” and “our” include Dynex Capital, Inc. and its consolidated subsidiaries, unless the context otherwise requires. In addition to current and historical information, the following discussion and analysis contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to our future business, financial condition or results of operations. For a description of certain factors that may have a significant impact on our future business, financial condition or results of operations, see “Forward-Looking Statements” at the end of this discussion and analysis.

For a complete description of our business including our operating policies, investment philosophy and strategy, financing and hedging strategies, and other important information, please refer to Part I, Item 1 of our Annual Report on Form 10-K for the year ended December 31, 2015.

EXECUTIVE OVERVIEW

Company Overview

We are an internally managed mortgage real estate investment trust, or mortgage REIT, which invests in residential and commercial mortgage-backed securities 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 invest in Agency and non-Agency mortgage-backed securities (“MBS”) consisting of residential MBS (“RMBS”), commercial MBS (“CMBS”) and CMBS interest-only ("IO") securities. Agency MBS have a guaranty of principal payment by an agency of the U.S. government or a U.S. government-sponsored entity ("GSE") such as Fannie Mae and Freddie Mac. Non-Agency MBS have no such guaranty of payment. Due to the guaranty of principal payment by a GSE, Agency MBS are the highest credit quality MBS available for investment. We seek to invest in Agency MBS and higher quality non-Agency MBS (typically rated 'A' or better by one or more of the nationally recognized statistical rating organizations) to limit our exposure to credit losses and to minimize fluctuations in fair value from widening in credit spreads. In addition, Agency MBS and higher-rated non-Agency MBS are typically more liquid (i.e., they are more easily converted into cash either through sales or pledges as collateral for repurchase agreement borrowings) than lower-rated MBS.

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. We use leverage to enhance the returns on our invested capital by pledging our investments as collateral for borrowings such as repurchase agreements as discussed further below.

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. 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.

We also invest in non-Agency RMBS, which do not carry a principal guarantee from the U.S. government or a GSE. Non-Agency RMBS are collateralized by non-conforming residential mortgage loans and are tranched into different credit classes of securities with payments to junior classes subordinate to senior classes. Some of the non-Agency RMBS that we invest in may be collateralized by loans which are delinquent, the repayment of which is expected to come from foreclosure and liquidation of the underlying real estate. We generally invest in senior classes of non-Agency RMBS which may include unrated securities. We seek to invest in non-Agency RMBS that we judge to have sufficiently high collateralization to be likely to protect the principal balance of our investment from credit losses on the underlying loans.

CMBS. Our Agency and non-Agency CMBS are collateralized by first mortgage loans and are primarily fixed-rate securities backed by multifamily housing and other commercial real estate property types such as office building, retail, hospitality, and health care. Loans underlying CMBS generally are geographically diverse, are fixed-rate, mature in ten to twelve years and have amortization terms of up to 30 years. 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. Non-Agency CMBS also includes securities that are backed by pools of single-family rental homes which have variable-rates that reset monthly based on an index rate, such as LIBOR.

CMBS IO. CMBS IO are interest-only securities issued as part of a CMBS securitization and represent the right to receive a portion of the monthly interest payments (but not principal cash flows) on the unpaid principal balance of the underlying pool of commercial mortgage loans. We invest in both Agency-issued and non-Agency issued CMBS IO. The loans collateralizing CMBS IO pools are very similar in composition to the pools of loans that generally collateralize CMBS as discussed above. Since CMBS IO securities have no principal associated with them, the interest payments received are based on the unpaid principal balance of the underlying pool of mortgage loans, which is often referred to as the notional amount. Because CMBS IO receive no principal payments, these securities generally have some form of prepayment protection from early repayment of the loan including absolute loan prepayment lock-outs, loan prepayment penalties, or yield maintenance requirements associated with the underlying loans similar to CMBS described above. There are no prepayment protections, however, if the loan defaults and is partially or wholly repaid earlier as a result of loss mitigation actions taken by the underlying loan servicer, and therefore yields on CMBS IO investments are dependent upon the underlying loan performance.

Financing. We finance our investments primarily through the use of uncommitted repurchase agreements. We pledge our MBS as collateral to secure the loans and advances made by the counterparty. Repurchase agreements carry a rate of interest which is usually based on a spread to LIBOR and fixed for the term of the borrowing which is typically 30-180 days. Repurchase agreement financing is provided principally by major financial institutions and broker-dealers.

Our captive insurance subsidiary, Mackinaw Insurance Company, LLC ("Mackinaw"), is a member of the Federal Home Loan Bank ("FHLB") of Indianapolis and as such has access to FHLB advances. In January 2016, the Federal Housing Finance Administration ("FHFA") released a final rule on FHLB membership which excludes captive insurance entities from FHLB membership on a going-forward basis and provides termination rules for current captive insurance members. Under the final rule, Mackinaw's membership in the FHLB of Indianapolis will be terminated in February 2017. Mackinaw had one remaining advance outstanding of $263.0 million as of September 30, 2016 which was repaid in full at its maturity in October 2016.

Hedging. We use derivative instruments to mitigate our exposure to fluctuations in interest rates which could impact our earnings, cash flow or book value. Currently, we use interest rate swap agreements and Eurodollar futures as our principal hedging instruments. Given the nature of our investing and financing activities, in a period of rising interest rates our earnings and cash flow may be negatively impacted by borrowing costs increasing faster than income from our assets, and our book value may decline as a result of declining market values of our MBS. We enter into derivative instruments in an attempt to partially or fully mitigate our exposure to these events.

Factors that Affect Our Results of Operations and Financial Condition

Our financial performance is driven by the performance of our investment portfolio and related funding and derivative hedging activity which are impacted by multiple factors, many of which are related to macroeconomic conditions, geopolitical conditions, central bank and government policy, and other factors beyond our control. These factors include, but are not limited

to, the absolute level of interest rates, the relative steepness of interest rate curves, changes in market expectations of future interest rates, actual and estimated future prepayment rates on our investments, competition for investments, economic conditions and their impact on the credit performance of our investments, and market required yields as reflected by market credit spreads. All of these factors are influenced by market forces and generally are exacerbated during periods of market volatility.

The performance of our investment portfolio, the cost and availability of financing and the availability of investments at acceptable risk-adjusted returns could also be influenced by regulatory actions and regulatory policy measures of the U.S. government including, but not limited to, the FHFA, 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 reactions in U.S. markets from activities of 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. Regulatory developments since the 2008 financial crisis have impacted large U.S. domiciled banks and their broker dealer subsidiaries by requiring such entities to hold more capital against their assets, including reverse repurchase agreements. In general, this has led to reduced lending capacity in the repurchase agreement market and higher costs. We have not yet experienced a reduction in the availability of repurchase agreement financing but have seen indications of higher costs from several lenders. Money market funds supply a large amount of liquidity to the repurchase agreement market, and changes to regulations of these funds may also impact the cost and amount of repurchase agreement financing. Other factors that could also impact our business include changes in regulatory requirements, including requirements to qualify for registration under the 1940 Act, and REIT requirements.

We believe that regulatory impacts on financial institutions, many of which are our trading and financing counterparties, continue to pose a threat to the overall liquidity in the capital markets. In particular, higher capital requirements under U.S. banking regulations adopted in 2013 and 2014 and limitations on the proprietary trading activities of large U.S. financial institutions under the Dodd-Frank Wall Street Reform and Consumer Protection Act ("the "Dodd-Frank Act") could result in reduced liquidity in times of market stress. U.S. federal banking regulators continue to explore further increasing regulatory and capital requirements for large U.S. financial institutions. While the Federal Reserve continues to reinvest principal payments received on its Agency RMBS portfolio, it is unlikely that this activity will provide enough liquidity to the market in times of stress, which could result in volatile asset prices. Further, the impact on market liquidity of our investments and the financing markets could be negatively impacted if the Federal Reserve's Federal Open Market Committee (or "FOMC") suddenly changes market expectations of the targeted Federal Funds Rate or takes other actions which have the effect of tightening monetary policy.

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 of our Annual Report on Form 10-K for the year ended December 31, 2015. Please see these Items for a detailed discussion of these risks and the potential impact on our results of operations and financial condition.

Market Conditions and Recent Activity

At the very end of the second quarter of 2016, U.S. interest rates rallied sharply as the yield curve flattened due in large part to the unexpected results of the Brexit vote (i.e., United Kingdom's decision to leave the European Union). After the initial market shock from the Brexit vote, markets calmed and during the balance of the third quarter, interest rates increased ending near their highs for the quarter, and credit spreads tightened as market volatility ebbed.

The chart below shows the highest and lowest rates during the quarter ended September 30, 2016 as well as the rates as of September 30, 2016 for the indicated U.S. Treasury securities:

The table below shows examples of credit spreads in basis points for certain investment types in our MBS portfolio as of the end of each quarter since September 30, 2015:



Investment Type:	9/30/2015	12/31/2015	3/31/2016	6/30/2016	9/30/2016
Agency ARM 5/1 (Agency RMBS)	26	22	32	38	32
Agency DUS (Agency CMBS)	76	89	86	94	80
Freddie K AAA IO (Agency CMBS IO)	200	225	260	255	230
AAA CMBS IO (Non-Agency CMBS IO)	225	240	265	240	215
Freddie K B (Non-Agency CMBS)	305	350	420	325	265

In our opinion, financial markets are reflecting the uncertainty around the efficacy of the U.S. and global central bank policy as well as the growth trajectory of and expected inflation in the U.S. Volatility in interest rates and credit spreads reflect the extraordinary central bank involvement in the global capital markets, including maintaining shot-term zero or negative interest rate policies, asset purchases, and participation in the short-term funding markets. These actions have added liquidity to the markets, reduced volatility and, in many cases, distorted asset prices. Markets appear on edge for any shift in central bank policy, and recently central bank rhetoric has shifted from emphasizing the role of quantitative easing to emphasizing an increased role for fiscal policy in stimulating growth. In the U.S., measured inflation has stabilized and has the potential to rise as energy and commodity prices are modestly increasing from their lower levels a year ago. Gross domestic product in the U.S. has also rebounded and unemployment rates in the U.S. are reasonably stable. While other economic indicators have exhibited some weakness, given the overall stability in the U.S. economy, the Federal Reserve appears poised to raise the targeted Federal Funds rate in December 2016. We believe that regardless of whether the Federal Reserve raises the Federal Funds rate at that time, the lack of significant progress toward growth and inflation goals of the Federal Reserve and central banks globally will limit the number and frequency of future rate increases by the Federal Reserve in the medium term.

Highlights of the Third Quarter of 2016 and Management's Outlook

Comprehensive income to common shareholders for the third quarter of 2016 was $13.1 million, consisting of net income to common shareholders of $12.4 million and other comprehensive income of $0.7 million. Net income to common shareholders for the third quarter of 2016 included net interest income of $15.1 million, a decline of $(1.7) million compared to the second quarter of 2016. This decline in net interest income resulted primarily from an increase in prepayments on RMBS as well as a smaller investment portfolio versus the second quarter of 2016. Net income to common shareholders also included a net gain on derivatives of $2.4 million for the third quarter of 2016 compared to a net loss on derivatives of $(16.3) million for the prior quarter. This increase of $18.7 million was driven primarily by the impact of rising interest rates during the third quarter of 2016 which favorably impacted the fair value of derivative instruments in our hedging portfolio. Other comprehensive income for the third quarter of 2016 consisted primarily of net unrealized gains on MBS of $0.8 million compared to net unrealized gains on MBS of $23.0 million for the second quarter of 2016. As noted above under "Market Conditions and Recent Activity", credit spreads tightened, particularly on CMBS, increasing the fair value of MBS during the third quarter of 2016; however, the majority of that benefit was offset by the increase in interest rates which put downward pressure on MBS prices during the third quarter.

Core net operating income to common shareholders is a non-GAAP measure management uses as an estimate of the net interest earnings of the Company's investments, including net periodic interest costs of effective derivative instruments, after operating expenses. Core net operating income declined $(0.8) million to $9.7 million for the third quarter of 2016 from $10.5 million for the second quarter of 2016, primarily due to the decline in net interest income as discussed above. Lower net periodic interest costs on derivative instruments during the third quarter of 2016 partially offset the decline in net interest income due to the Company's termination of $500.0 million in net pay-fixed interest rate swaps earlier in the year. The Company had terminated these instruments given management's view at that time that the Federal Reserve was unlikely to increase the Federal Funds rate in the near term and likely not until the fourth quarter of 2016 or early 2017. The Company's operating expenses were also lower during the third quarter of 2016 compared to the prior quarter, mainly due to lower general and administrative expenses. Please see "Non-GAAP Financial Measures" at the end of "Executive Overview" of Part 1, Item 2 of this Quarterly Report on Form 10-Q for additional important information about non-GAAP measures as well as a reconciliation of core net operating income to GAAP net income (loss) for the periods discussed.

Book value per common share increased $0.07 during the third quarter to $7.76 as of September 30, 2016 compared to $7.69 as of June 30, 2016, an increase driven primarily by the positive impact of higher interest rates on the fair value of our derivatives as well as the positive impact of tighter credit spreads on the fair value of MBS, which more than offset the decline in fair value of MBS from higher interest rates. During the third quarter of 2016, we continued to maintain lower leverage and a long duration portfolio position while reinvesting marginally through limited purchases of high quality assets.

We believe that the long-term fundamentals that have anchored global bond yields at low (and in some cases, negative) interest rates have not dissipated, and there are still several factors that will limit a sustained rise in long-term interest rates in the U.S. In particular, excessive global leverage in our opinion continues to destabilize growth around the world. In addition, we believe inflation is limited by overcapacity and the inability of countries to stimulate aggregate demand without the expansion of credit. Demographic trends should also bolster demand for fixed income assets into the future, keeping long-term yields lower. Given our view that high global debt, moderate inflation, and favorable demographic trends will prevent a sustainable move toward significantly higher interest rates, we have positioned our portfolio for the expected continued low interest rate environment and also to protect against excessive volatility in asset prices and interest rates, primarily by investing in higher quality assets and reducing our leverage. High quality CMBS and CMBS IO investments reduce our exposure to credit risk versus lower rated investments and provide less exposure to prepayment volatility versus RMBS, while our investments in Agency RMBS provide balance if short-term interest rates rise and provide complementary cash flows with little extension risk.

As interest rates have increased subsequent to the end of the third quarter of 2016, we have seen better investment opportunities. So far in the fourth quarter of 2016, we have added investments with a combined book value of over $266 million. We expect to modestly grow our investment portfolio and modestly increase leverage in the fourth quarter of 2016 to mitigate the negative impact on earnings from the expected Federal Funds interest rate hike in December 2016. While we did not adjust our hedging portfolio in the third quarter of 2016, we expect to more actively manage our hedging portfolio for the balance of

2016 to reduce the impact on the Company from higher interest rates. We have added forward starting interest rate swaps subsequent to September 30, 2016 to mitigate a portion of our exposure to higher interest rates, including additional exposure from the assets purchased so far in the fourth quarter.

Non-GAAP Financial Measures

In addition to the Company's operating results presented in accordance with GAAP, the information presented within "Executive Overview" and "Results of Operations" contains the following non-GAAP financial measures: core net operating income to common shareholders (including per common share), adjusted interest expense and adjusted cost of funds, and adjusted net interest income and spread. Management uses core net operating income (including per common share) as an estimate of the net interest earnings from our investments after operating expenses. In connection with core net operating income, management uses adjusted interest expense, adjusted cost of funds, adjusted net interest income, and adjusted net interest spread because management considers net periodic interest costs related to the Company's derivative instruments as an additional cost of using repurchase agreements to finance investments. Because these measures are used in the Company's internal analysis of financial and operating performance, management believes that they provide greater transparency to our investors of management's view of our economic performance. Management also believes that the presentation of these measures, when analyzed in conjunction with the Company's GAAP operating results, allows investors to more effectively evaluate and compare the performance of the Company to that of its peers even though peer companies may present non-GAAP measures on a different basis than the Company's. Because these non-GAAP financial measures exclude certain items used to compute GAAP net income to common shareholders and GAAP interest expense, these non-GAAP financial measures should be considered as a supplement to, and not as a substitute for, the Company's GAAP results as reported on its consolidated statements of comprehensive income. In addition, because not all companies use identical calculations, the Company's presentation of non-GAAP financial measures may not be comparable to other similarly-titled measures of other companies.

Schedules reconciling adjusted interest expense, adjusted cost of funds, adjusted net interest income, and adjusted net interest spread to their related GAAP financial measures are provided within "Results of Operations". The following table presents a reconciliation of our GAAP net income (loss) to our core net operating income for the periods presented:



	Three Months Ended
	September 30,			June 30,
($ in thousands, except per share amounts)	2016			2016
GAAP net income (loss) to common shareholders	$	12,406		$	(5,525	)
Amortization of de-designated cash flow hedges ⁽¹⁾	(99		)	(80		)
Change in fair value of derivative instruments, net	(2,564		)	15,811
Loss on sale of investments, net	—			297
Fair value adjustments, net	(34		)	(28		)
Core net operating income to common shareholders	$	9,709		$	10,475

Weighted average common shares outstanding	49,147			49,119
Core net operating income per common share	$	0.20