Dynex Capital Inc (DX) 2003 Q2 法說會逐字稿

Welcome to the Dynex Capital second quarter 2003 earnings results conference call. (CALLER INSTRUCTIONS). I would now like to turn the conference over to Steve Benedetti, Executive VP and CFO. Please go-ahead, sir.

Thank you operator. Welcome everybody. First, let me review the customary Safe Harbor statement and the SEC rules regarding the use of non generally accepted accounting principles or non GAAP financial measures. I will review the forward looking statement disclosure first. This conference call may contain forward-looking statements within the meaning of the private securities litigation at of 1995. The words believe, expect, forecast, anticipate, estimate, project, plan and similar expressions identify forward-looking statements and are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. The Company's actual results and timing of certain events could differ materially from those projected in or contemplated by these forward-looking statements as a result of unforeseen external factors. As discussed in the Company's filings with the SEC, these factors may include but are not limited to changes in general economic and market conditions, disruptions in the capital markets, fluctuations in interest rates, the accuracy of subjective estimates used in determining the fair value of certain financial assets of the Company, the impact of recently issued financial accounting standards, increases in costs and other general competitive factors.

In regards to non GAAP disclosure, we will attempt to reconcile non GAAP numbers on this call to GAAP numbers. Any such reconciliation will also be included in the 10-Q for the quarter.

Let me start off by welcoming our Chairman, Tom Akin, who is on the call today. Tom, welcome.

Thank you very much Steve. I am traveling so I am on a cell phone so I hope to be able to participate as much as I can today.

Okay, thanks. Let me briefly touch on the highlights that were noted on the press release and we'll discuss these each later in the call. Cash flow from the investment portfolio was $15.5 million for the quarter. We announced we were early redeeming 10 million of our senior notes. Legislation was enacted in Pennsylvania which is very favorable to our property tax lien collections and we also agreed on terms to service 7.5 million of tax liens for a regional utility. We called and sold 26.5 million of mortgage securities and sold the underlying mortgage loan collateral at a gain of $1 million. We declared a dividend in order to maintain REIT status on our series A, B and C preferred stock and we reported book value per common share of $8.97 at June 30 versus $8.57 at December 31.

Touching first on the cash flow, cash flow as I mentioned was 15.5 million for the quarter. 10.4 million of that was from our collateralized bond securities, 3.1 million was property tax lien collections and the other 2 million was from other loans and other securities in our investment portfolio. The $1 million net in gain from the call and sale of the mortgage-backed securities is excluded from that 15.5, so in total, the portfolio cash flows are 16.5.

I think as everyone knows our cash flows from our collateralized bond security portfolio principally result from our net investment in the security and is related to or is the surplus cash flow from that structure. We include for our most of our collateralized bond securities the cash flow information by security in our 10-Q.

Cash flow was utilized for the debt service payments on the notes, funding operating expenses and whatever dividends may be necessary to maintain REIT status. Otherwise, the cash flow that we generate from the investment portfolio is available to use for strategic alternatives. I will discuss briefly later in the call the outlook for the investment portfolio and cash flow for 2003.

Touching on the results for the first -- second quarter, excuse me, net interest margin before provision for losses was 7.1 million versus 10.1 million last quarter and 12.3 million for the second quarter of '02. The net interest margin before provision decreased principally as a result of the decline in overall interest earning assets which declined during this quarter by approximately $87 million and from 2002 to 2003 by approximately $400 million. We still have arm assets or adjustable-rate assets in our investment portfolio that continue to re-set down and they have been re-setting at approximately 50 basis points per quarter. And then this quarter was the first quarter where we had the full interest carry costs on the 9.5 percent senior notes and that carry cost was approximately 730,000.

For the third quarter of '03, we expect net interest margin to benefit from the 25 basis point FED reduction in June and that benefit actually did not occur in July based on the way that most of our security structures work, we will not pick that benefit up until beginning in August, and as we redeem the notes early and also make the normal amortization payments, we will be reducing the carry costs on the senior notes. These benefits to net interest margin will be offset at least partially, by the re-sets on the arm assets as well as continued prepayments in the investment portfolio.

After provision for losses net interest margin was $10.3 million. Provision for loan losses was a little over -- excuse me, was $18 million this quarter and I think as everyone is aware, provision for loan losses is provided for those investments that are loans, not securities where the Company has credit risk. As it relates to our collateralized bond securities, loans are included in merit series 12 1 and 13, sasco (ph) 2002 9 and CCA 1 series 1 2 and 3. That really only leaves merit series 11 which consists of securities and not loans. And therefore, merit for merit series 11, there are no provision for losses. Instead, any losses on that security are evaluated relative to impairment charges. That's a separate line item in our financial statements, so I wanted to make that distinction that the provision for loan losses relates only to loans in the investment portfolio.

We took a charge this quarter of approximately 14.4 million. It's a change in estimate in accordance with generally accepted accounting principles to provide reserves for loans that are current as to payment, meaning they are not delinquent. We prepared an analysis during the quarter and reviewed it with our accounting firm, Deloitte & Touche, and based on that analysis we were able to demonstrate under GAAP, that certain current loans are currently impaired and impairment is very narrowly defined in GAAP and again, we had undertaken analysis to be able to demonstrate it, and we actually benefited from the fact that the loans that we provided these losses on relate to static pools and they are actually all manufactured housing loans and loans that are contained in merit series 12 1 and 13.

After the provision for losses this quarter, we had 18.4 million in credit risk exposure remaining on our manufacturing and housing loans which is unreserved. I'll touch a little bit later on the call as to why that amount remains unreserved and our expectations for how we will reserve that out in the go forward quarters.

We would expect provision for loan losses in the third quarter to resume a run rate closer to that of the first quarter unless there is a material change in the manufactured housing market conditions, one way or another in the very near-term.

I should also mention that provision for loan losses in the second quarter includes approximately 1.1 million for commercial mortgage loans and single-family mortgage loans. We have credit risk on those assets as well so we do provide reserves for them.

Briefly touching on impairment charges, that line item declined from last quarter as well as the second quarter 2002. Again impairment charges are taken on the securities and the major debt securities that we would be taking impairment charges on is our merit series 11 which is predominantly a manufactured housing loan backed security although it does have some single-family assets in it. This particular quarter, there were no impairment charges. Our forecasts given our basis in that security relative to the expected performance of that security over the next four quarters does not suggest that we will be taking any impairment charges. However again, that could change with changes in the manufactured housing market.

Gain on sale, I already mentioned, we called and sold single-family mortgage loans at a gain of $1 million. That gain was partially reduced by some losses on our real estate owned portfolio which comes from our tax lien collections. We also, I will mention here that we have called another security in July and sold that, it was a $20 million security and sold the collateral out on an all loan (ph) basis as much as we did last quarter. We also called a security that had a gross rack (ph) of 7.5 percent, that had a principal balance of $3 million and given its size we decided to retain the loans from that security in our portfolio. Excluding those securities we called in July, we still have approximately 60 million of securities left to call. Other security holders own the right to call 30 million of these securities and there's no guarantee that the Company will be successful in calling all or part of this $30 million.

Briefly touching on G&A, G&A costs were 2.2 million in this quarter versus 2 million last quarter. This quarter was in line with our expectations. We would expect for the balance of '03 the first quarter run rate to approximate the run rate for the third and fourth quarters and I think as we discussed in the past, broadly our G&A expenses can be roughly divided half between our tax lien servicing operations and the other half between our corporate and portfolio management.

Touching briefly on the balance sheet, obviously the investment portfolio continues to decline from prepayments of assets since we're not generally adding investments to our portfolio. This quarter, most of the paydowns came from our single-family portfolio. They were approximately $46 million. Approximately 26 million of paydowns related to our manufactured housing loans and approximately 4 million related to our commercial mortgage loans. Obviously, those are scheduled payments as well as prepayments.

The (indiscernible) for collateralized bond at June 30 now consists of 491 million in single-family mortgage loans, 723 million in manufactured housing loans and 770 million in commercial mortgage loans. Our net unreserved credit exposure on these assets is approximately $109 million and I will touch on that a little more later in the call. At June 30, fixed-rate loans and securities were 1.6 billion and adjustable-rate loans and securities were 426 million.

Other investments as we mentioned in the past include property tax receivables, approximately 46.6 million of other investments is property tax receivables and 4.9 million is the related real estate owned. I already briefly mentioned that collections and (indiscernible) sales proceeds on the tax liens was 3.1 million this past quarter. The aggregate redemptive value of the property tax receivables at June 30 is approximately 113 million. We will touch a little bit more on our GLS tax lien receivable portfolio and GLS Capital Services which is our tax lien servicing operations headquartered in Pennsylvania a little later in the call.

Collateralized bonds decreased. Basically principal payments we received on the collateral is used to pay down the bonds. We also have two deals where performance triggers are not being met and surplus cash on those deals is being retained within the bond structure to pay down collateralized bonds. That surplus cash retained approximated 1.3 million during the quarter. We would expect this surplus cash to continue to be trapped (ph) by the deal structure in the future. And other collateralized bonds approximately 1.2 billion are fixed rate and approximately 640 million are variable-rate bonds.

Briefly, shareholders equity declined -- has declined for the year by approximately $58 million principally as a result of the tender offer in the preferred stock which we completed during the first quarter and then the net loss for the six-month period has offset slightly by some slight improvement in our accumulated other comprehensive loss, which is the mark to market adjustments on our securities portfolio and hedge instruments which currently are 150 million of interest rate swaps.

Briefly touching on the mark to market, there are 295 million of balance sheet assets that we mark to market this quarter. The total accumulated other comprehensive loss for these assets was 13.2 million versus 16 million at the end of last quarter and 17.5 million at the end of 2002. This change is really due principally to the improved rate environment at June 30. The mark to market is a snapshot mark to market in time and is based on the rate environment, both the current rate environment as well as the forward LIBOR curve is incorporated in our mark to market and then we also project out losses, credit losses and prepayments on the assets that we mark to market.

As I mentioned previously, the accumulated comprehensive loss also includes the mark to market on our interest rate swaps which at the end of June, was approximately a loss of 5.6 million and given the recent backup in rates, we would expect that if that holds, we would expect that to improve during this third quarter.

We do provide very detailed information in our 10-Q on our mark to market for our collateralized bond portfolio. I won't go into that in detail here. I'll refer you to the Q for that. We do provide in our Q enough information or information related to our book value per share, assuming that we mark those collateralized bond securities to market. You may recall, back in 2002, we restated our financial statements to move certain assets from a fair value reporting to a historical cost reporting. This is an attempt to basically move it back from historical cost to fair value. At the end of June the book value per common share assuming all collateralized bond securities are carried at estimated fair value, is approximately $7 million. As required by the SEC rules, the following is a reconciliation of that $8.97 which is included in the GAAP financial statements to the estimated $7 per common share assuming all collateralized bond securities carried at fair value.

Common book to equity as reported by GAAP was 164.71 million. The preferred stock liquidation preference which is the -- includes the dividend in (indiscernible) is 67.13 million at June 30. So the common equity and book value per common share for -- under generally accepted accounting principles at June 30 is 97.583 million or $8.97 a share. Subtracting 21.45 million or $1.97 per share from the GAAP numbers for the mark to market or fair value adjustment of those collateralized bond securities that are carried at historical cost equates to a common book -- common equity and book value per share for GAAP -- excuse me, non GAAP after the fair market value adjustment of 76.13 million or $7 a share.

Briefly touching on our credit performance and our remaining credit risk, overall, we have net unreserved credit risk of approximately $109 million. That net unreserved credit risk is defined basically as the principal balance of our net investment in these collateralized bond structures less reserved for losses on loans and impairment charges previously recorded on securities. Again, details on this can be found in the Q. From an economic point of view, we view this 109 million actually -- we reduce that 109 million for 36 million in premiums on collateralized bonds related to CMBS (ph) securitization which we allocate on an economic basis against 109 million in effect from an economic standpoint, bringing the net credit exposure to the Company to $73 million. GAAP doesn't allow you to present it this way. GAAP makes you present effectively the 109 and show the 36 million as premium that is amortized into earnings over the life of the structure.

Focusing on the 73 million, 44.2 million of it relates to manufactured housing loans and securities, 18.4 million of which relates to the manufactured housing loans and 25.8 million relates to manufactured housing, actually manufactured housing and single-family securities.

On the 18.4, we'll continue to provide reserves for the 18.4 million. We expect to reserve that out over the next four quarters. Again, it is not a situation where the Company -- though the Company views there is a low probability that we will recover much if anything, from the 18.4 million, following the generally accepted rules and impairment rules and generally accepted accounting principles, we can only reserve for those loans where we can demonstrate that there are currently existing losses as of the balance sheet date, that being June 30.

That being said, based on our knowledge of the portfolio, based on the performance of the portfolio, based on the manufactured housing market conditions today, we would expect to continue to provide reserves to eventually reserve that $18 million out and again, we expect to do that over the next four quarters.

I mentioned earlier, attached briefly on the GLS Capital Services and our tax lien operations. Collections were up this quarter from last quarter. While they are below plan they did improve and we expect continued improvement over the balance of the year. Collections in Pennsylvania have been hampered due to the litigation that was disclosed in the 10-Q in which the recently enacted legislation was meant to address effectively a retroactive application of law which addresses the issues that were raised in the litigation and that were effectively suspending our ability to collect on certain liens. We would expect -- we anticipate that being able to collect these liens now, how fast we benefit if you will from the litigation depends on how fast we're able to process the liens that were previously suspended and how much we will redeem voluntarily versus how many we will have to take through the foreclosure process.

I also should mention that for the last year we've been attempting to secure some third party servicing for our GLS Capital Services subsidiary to leverage the expertise that we've built up in that operation and to spread the cost to service our own portfolio over a larger base and to generate some fee income. We've agreed to terms with a regional utility to service liens on real estate. The current terms provide for compensation to the company based on the results of our efforts. The size of the pool is approximately $7.5 million. The incremental cost for adding the servicing really is marginal, given the infrastructure that the company already currently has in place in Pennsylvania.

Let me briefly touch on the outlook for the quarter. Obviously, our focus will be -- will continue to be on generating cash flow from the investment portfolio, managing the credit risk in our balance sheet, managing our collections and our property tax receivable portfolio and attempting to secure additional third party servicing. We would expect a modest decline in the third quarter of our cash flow as a result of run off and adjustments in our re-sets and adjustable-rate assets. This decline could be wholly or partially offset by increased tax lien collections as a result of the legislation. We would also expect some pickup from the easing in June as I previously mentioned, the 25 basis point reduction in June. We won't start seeing the benefit of that until this month. The market expectations are that short-term rates will stay the same for the balance of 2003 which will obviously continue to benefit our cash flow and actually, the backup in the longer end of the curve and the steepening of the curve is beneficial to us from the standpoint that it may slow prepayments on the investment portfolio and we'll enjoy then this spread on those assets for a longer period of time.

We will continue to focus on calling the securities that I mentioned earlier. We're pursuing financing for these calls. There is no guarantee that we will obtain the financing and if we don't obtain financing, we will likely just call and bid the collateral out on an whole loan (ph) basis as we've done in the past. On a long-term basis, the board will continue to evaluate the most attractive alternative available for the use of the Company's capital and we mentioned in the press release they formed a committee to review various alternatives. We believe that the Company's financial flexibility and flexibility with respect to strategic alternatives available to us continues to improve.

Operator, that concludes my prepared remarks. I would like to open it up for questions please.

(Caller Instructions). Scott Peters of Tradewind Financial.

Hi, Steve. How are you?

I'm fine. How about yourself?

I'm doing great. First I would like to complement you on giving us a more transparent press release and description of some of the things going on inside the Company. I think it will do a lot to improve the understanding of what's going on at the Company right now.

Can you talk about the ruling in Pennsylvania and what that means for the way that you are going to treat the tax liens? Does it change the accounting? Does it make it easier to change the marks on these things? I'm just looking for some in-depth color, what this means on a practical level.

Okay, sure. It won't change the accounting at least in the near term. I didn't mention on the call but we mentioned it in the cost and it is certainly in our disclosure that these assets are all non-accrual, so basically a principal recovery method, as we collect cash, we apply it against our investment. The legislation addressed actually the results of the Supreme Court ruling in Pennsylvania, relative to certain aspects of our ability to collect fees, costs, and interest on certain -- or on the liens that we take through foreclosure there. The uncertainty with that they actually decided in certain areas and remanned it back to the lower trial court in other areas, what fees and costs can be allocated or paid to the Company and what interest rate we can charge under certain circumstances. That caused basically a suspension or a change in our collection process. As we've collected these liens, we've basically had to give people options as to what they want to pay including an option to basically suspend paying us until this is finally resolved. With the legislation that should be basically the final resolution. It's possible that a taxpayer would go in front of a court and challenge the legislation, the retroactivity of it. We don't think that would be a successful challenge, so our anticipation is there are a number of liens that have basically been in suspended collection status that we will focus on immediately. They are high-value properties or low lien to value type liens that we will focus on immediately that should generate immediate benefits to us, in terms of cash flow and collections. On a longer-term basis, it really removes an uncertainty and allows us actually to collect attorney's fees which was one of the bigger issues under the litigation that was basically suspended. And so it'll allow us to collect those which will result in a reimbursement of legal fees for in-house counsel, as well as a reimbursement, a payment of the legal fees for external counsel when we use external counsel. So for now, it's more of a benefit to us from the liens that were in suspended status but going forward, it means recovering costs that we might not otherwise have recovered if the litigation result had stood.

Okay that's helpful. A simple example here, so maybe you could walk me through the accounting of how you process these things as they are collected. I think most of these liens are marked at around 40 cents on the dollar, so when you get paid the $100 plus the accrued interest, what are the accounting entries that you make and how does that show up on the income statement?

Basically, the whole 100 is applied against our investment at this point. There is no income statement affect for any -- for recovering a discount or recovering the accrued interest.

So you just keep writing down the average basis of the whole portfolio then?

That's right.

All right. That helps a lot. An unrelated question but maybe not, the strategic alternatives that you're considering, the NOL is obviously a big component of what someone might look at when they are looking at Dynex. Can you talk about how that could be applied if someone else was trying to joint venture or possibly acquire the company? What's the rule on what kind of transaction it needs to be?

Well, the rules on net operating loss usage fall under section 382 of the Internal Revenue Code and they're fairly complex and they're fairly restrictive and were designed to basically prevent the trafficking of NOL companies, if you will. Essentially, if more than 50 percent of the company changes hands in any 3 year, rolling 3 year period, the usage of the NOLs is limited. It's not eliminated, it's just limited. So in terms of somebody acquiring the Company, it would be virtually impossible for them to structure a transactions where they acquire the entire company obviously but you could buy up to (ph) and you would have to evaluate this relative to how there has been a change of ownership by others that own the company. In terms of a joint venture, there are instances where we have seen, we have at least seen research where you could -- folks, a company that has a net operating loss has joint venture with another company and takes a disproportionate share of the income off the venture and then eventually, that basically flips around sometime far out into the future, in an effort to basically utilize the NOL down at the venture level and the venture partner gets the benefit of the NOL that Dynex has on it's balance sheet.

Hey Steve, this is Tom. Let me discuss this (inaudible)

Tom, we're losing you here.

Can you here me?

Now we can.

The NOL as Steve mentioned is usable in some formats. I know in the recent transaction going on between American Home and Apex Mortgage, they are going to try and use that NOL. The strategic committee is going to be reviewing all of the ways that we can use that to enhance shareholder value and we are in the process of taking a look at a number of different structures right now.

Okay, thank you both.

(Caller Instructions). I am showing no further questions at this time. Please continue with your presentation or any closing remarks.

Thank you very much operator. I'd like to thank everybody for joining our second quarter 2003 conference call and as usual, I am around if anyone has any specific questions. Feel free to give me a call. Thank you very much.

(Caller Instructions).