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MBS – then and now, analogy from a small mortgage REIT

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Dynex Capital Inc. is a rather small US based real estate investment trust with its principal investments in securitized residential and commercial mortgage loans and non-agency MBS. The REIT’s portfolio is managed through a combination of short term debt, securitization financing, and equity capital. Dynax provides a glimpse into the current state in short term financing of mortgage backed securities.

This type of financial wizardry in combination with a deterioration in loan underwriting standards has driven the financial industry and the world economy to the brink of disaster. The subprime debacle has forced private capital to flee securitization markets of residential and commercial mortgages.

As of June 30, 2009, Dynex Capital had carrying assets of $245.1 million in non-Agency MBS, that contrasts with $531.5 million in Agency MBS. During the most recent episode of credit contraction, which is still ongoing, impairment of government guaranteed Agency MBS was less severe than of non-Agency MBS.

In the quarter $245.1 million of non-Agency MBS portfolio was associated with $192.5 million securitization financing and short term debt repurchase agreements. Shareholders’ equity amounted to $52.6 million or 21.5% of the total portfolio. In the non-Agency MBS portfolio leverage of equity capital was about 5 times in the end of the second quarter.

Chairman Thomas Akin commented on the quarter, “The story of this quarter is the performance of our Agency MBS investment portfolio. We earned a net interest spread of 3.70% on Agency MBS as our borrowing costs continued to decline (thanks to Bernanke)….Our highly seasoned non-Agency investments continue to generate solid earnings and cashflow for the Company.”  (() emphasize added)

Net interest spread between annualized yield and annualized costs of funds was a record 3.70% in the quarter ended June 30, 2009. In the year earlier quarter the spread was much smaller, only 1.45%. The conditional prepayment rate (CPR) also decreased from 27.3% a year earlier to 19.9% during the last quarter.

Thanks to Fed chair Bernanke’s monetary easing borrowing costs for the financial services industry are almost zero, yet lending rates remain high causing the spreads to widen. According to CEO Akin the joint venture in $6.1 million non-Agency CMBS may be eligible for financial assistance from the government’s TALF program.

There is something suspicious about this joint venture. Could this be a bad bank with potentially impaired investments taken off the REIT owner’s and ultimately its shareholders hands? Akin obviously expects to get help from the government.

In bank land many financial institutions are still getting sicker. At the end of the first quarter the FDIC had still 305 of them (could be less by now) on its problem bank list with about $220 billion in combined assets. Investors in the financial services industry are abandoning their free market principles and line up for a multitude of accommodative government support, yet their commitments to regulation and prudence in compensation are nothing but lip service.

A revealing report by NY Attorney General Cuomo showed that many of the banks which lost billions in 2008 continued to reward its employees with generous bonuses. Financial institutions of all sorts have adopted a motto of ‘heads I win, tails you loose’ . This attitude is rooted in the almost guaranteed government bailouts that have spread all over the Western hemisphere during the last two decades.  

An Icelandic bank lending huge amounts of money mostly to its biggest shareholders shortly before it collapsed, or governors of their states in Germany promising radical changes in compensation policy while asking for public funds to bail out the Landesbanken are just two examples of the prevailing bigotry in the financial services industry. Needless to say top management continued to receive lavish compensations to this day.

This kind of compensation and also lately the marked improvement in earnings for some institutions leave the overall financial health of the industry in doubt. Maybe things aren’t as bad as they seem?! Dynex Capital reported in its press release that delinquencies on securitized mortgage loans increased from April to June of 2009 to $15.0 million from $9.1 million at December 31, 2008, but the company incurred no credit loss during the quarter. That’s payments on about 6.1% of non-Agency MBS loans are 60 to 90 days late.

Finance blogger Calculated Risk has a nice monthly chart with historical data of 90+day delinquency rates for Orange County (CA), one of the hardest hit regions of the U.S. housing bust. The chart above shows 6+% delinquency rate of residential mortgages for June, 2009, and compares with what Dynex reported during the quarter (commercial and single family loans combined).

Interestingly, going back into the archives of financial statements from Dynex, revealed a similar delinquency rate of commercial loans with 5.15% delinquent 90 days and over in the June 2006 quarter. The single family loan portfolio performed much butter, only 2.68% of the loans were delinquent 90 days and over. The commercial loan portfolio is not unlike the non-Agency loan performance during the most recent quarter, although commercial and single family combined.

In general Dynex was substantially less invested in government guaranteed Agency bonds reflecting a more opportunistic environment before hell broke loose in the summer of 2007.  The securitized finance receivables were collateralized with $535.5 million of commercial loans and $136.9 million of single family loans. $487.4 million of commercial loans were financed with non-recourse securitization, and $113.4 million of single family loans were financed with monthly recourse repurchase agreements. The finance strategy was similar then and now, though different in the magnitude of dollar amounts invested.

Shareholder equity was $136.3 million during the quarter, or 20.2% of the $672.4 millions of the commercial and single family loan collateral combined. During the summer of 2006 non-Agency portfolio leverage of equity capital was therefore about 5 times, essentially unchanged to the most recent quarter.

Net interest spread between interest earning assets (average 7.55%) and interest bearing liabilities (average 7.54%) was substantially lower before the crisis, only 0.01% for all investments combined in the portfolio. Thanks to Bernanke, at last something he can be proud of, this margin has improved substantially. For Dynex it was a record 3.7% in the quarter ending June 30, 2009.

The portfolio is certainly more cautious today then it was before the crisis. Government guaranteed mortgage loans have significantly replaced more risky private sector loans. Yet, credit quality benchmarks have not changed that dramatically at all as one would expect.

The following table summarizes the allocation of the Company’s $154.6 million of shareholders’ equity as of June 30, 2009:

REIT-Dynex

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