| DYNEX CAPITAL INC ITEM 1A RISK FACTORS Our business is subject to various risks, including the risks described below |
| Our business, operating results and financial condition could be materially and adversely affected by any of these risks |
| Please note that additional risks not presently known to us or that we currently deem immaterial may also impair our business and operations |
| We may be unable to invest in new assets with attractive yields, and yields on new assets in which we do invest may not generate attractive yields, resulting in a decline in our earnings per share over time |
| Since 2004 we have sold investments or assets have otherwise paid down in the amount of dlra1cmam097 million |
| Asset yields today are generally lower that those assets sold or repaid, due to lower overall interest rates and more competition for these assets |
| We have generally been unable to find investments which have acceptable risk adjusted yields |
| As a result, our 4 _________________________________________________________________ net interest income has been declining, and may continue to decline in the future, resulting in lower earnings per share over time |
| In order to maintain our investment portfolio size and our earnings, we need to reinvest a portion of the cash flows we receive into new interesting earning assets |
| Our ownership of certain subordinate interests in securitization trusts subjects us to credit risk on the underlying loans, and we provide for loss reserves on these loans as required under GAAP As the result of our ownership of the overcollateralization portion of the securitization trust, the predominant risk to us in our investment portfolio is credit risk |
| Credit risk is the risk of loss to us from the failure by a borrower (or the proceeds from the liquidation of the underlying collateral) to fully repay the principal balance and interest due on a loan |
| A borrower’s ability to repay and the value of the underlying collateral could be negatively influenced by economic and market conditions |
| These conditions could be global, national, regional or local in nature |
| Upon securitization of the pool of loans or securities backed by loans, the credit risk retained by us from an economic point of view is generally limited to the overcollateralization tranche of the securitization trust |
| We provide for estimated losses on the gross amount of loans pledged to securitization trusts included in our financial statements as required by GAAP In some instances, we may also retain subordinated bonds from the securitization trust, which increases our credit risk above the overcollateralization tranche from an economic perspective |
| We provide reserves for existing losses based on the current performance of the respective pool or on an individual loan basis |
| If losses are experienced more rapidly, due to declining property performance, market conditions or other factors, than we have provided for in our reserves, we may be required to provide for additional reserves for these losses |
| Certain investments employ internal structural leverage as a result of the securitization process, and are in the most subordinate position in the capital structure, which magnifies the potential impact of adverse events on our cash flows and reported results |
| Many of the loans that we own have been pledged to securitization trusts which employ a high degree of internal structural leverage and concentrated credit, interest rate, prepayment, or other risks |
| We have generally retained the most subordinate classes of the securitization trust |
| As a result of these factors, net interest income and cash flows on our investments will vary based on the performance of the assets pledged to the securitization trust |
| In particular, should assets meaningfully underperform as to delinquencies, defaults, and credit losses, it is possible that cash flows which may have otherwise been paid to us as a result of our ownership of the subordinate interests, may be retained within the securitization trust |
| No amount of risk management or mitigation can change the variable nature of the cash flows and financial results generated by concentrated risks in our investments |
| None of our existing securities at December 31, 2005 have reached these predetermined levels, but such levels could be reached in the future |
| Our efforts to manage credit risk may not be successful in limiting delinquencies and defaults in underlying loans or losses on our investments |
| Despite our efforts to manage credit risk, there are many aspects of credit that we cannot control |
| Third party servicers provide for the primary and special servicing of our loans |
| We have a risk management function, which oversees the performance of these services and provides limited asset management capabilities |
| Our risk management operations may not be successful in limiting future delinquencies, defaults, and losses |
| The securitizations in which we have invested may not receive funds that we believe are due from mortgage insurance companies and other counter-parties |
| Loan servicing companies may not cooperate with our risk management efforts, or such efforts may be ineffective |
| Service providers to securitizations, such as trustees, bond insurance providers, and custodians, may not perform in a manner that promotes our interests |
| The value of the properties collateralizing residential loans may decline |
| The frequency of default, and the loss severity on loans upon default, may be greater than we anticipated |
| If loans become “real estate owned” (REO), servicing companies will have to manage these properties and may not be able to sell them |
| Changes in consumer behavior, bankruptcy laws, tax laws, and other laws may exacerbate loan losses |
| In some states and circumstances, the securitizations in which we invest have recourse as owner of the loan against the borrower’s other assets and income in the event of loan default; however, in most cases, the value of the underlying property will be the sole source of funds for any recoveries |
| 5 _________________________________________________________________ Prepayments of principal on our investments, and the timing of prepayments, may impact our reported earnings and our cash flows |
| We own many of our securitization finance receivables at premiums to their principal balances, and have issued associated securitization financing bonds at discounts |
| Prepayments of principal on loans and the associated bonds, whether voluntary or involuntary, impact the amortization of premiums and discounts under the effective yield method of accounting that we use for GAAP accounting |
| Under the effective yield method of accounting, we recognize yields on our assets and effective costs of our liabilities based on assumptions regarding future cash flows |
| Variations in actual cash flows from those assumed as a result of prepayments, and subsequent changes in future cash flow expectations, will cause adjustments in yields on assets and costs of liabilities as a corresponding charge to earnings |
| In a period of declining interest rates, loans and securities in the investment portfolio will generally prepay more rapidly (to the extent that such loans are not prohibited from prepayment), which may result in additional amortization of asset premium |
| In a flat yield curve environment (ie, when the spread between the yield on the one-year Treasury security and the yield on the ten-year Treasury security is less than 1dtta0prca), adjustable rate mortgage loans and securities tend to rapidly prepay, causing additional amortization of asset premium |
| In addition, the spread between our funding costs and asset yields may compress, causing a further reduction in our net interest income |
| We finance a portion of our investment portfolio with short-term recourse repurchase agreements which subjects us to margin calls if the assets pledged subsequently decline in value |
| We finance a portion of our investments, primarily high credit-quality, liquid securities, with recourse repurchase agreements |
| These arrangements require us to maintain a certain level of collateral for the related borrowings |
| If the collateral should fall below the required level, the repurchase agreement lender could initiate a margin call |
| This would require that we either pledge additional collateral acceptable to the lender or repay a portion of the debt in order to meet the margin requirement |
| Should we be unable to meet a margin call, we may have to liquidate the collateral or other assets quickly |
| Because a margin call and quick sale could result in a lower than otherwise expected and attainable sale price, we may incur a loss on the sale of the collateral |
| We may be subject to the risks associated with inadequate or untimely services from third-party service providers, which may harm our results of operations |
| Our loans and loans underlying securities are serviced by third-party service providers |
| As with any external service provider, we are subject to the risks associated with inadequate or untimely services |
| Many borrowers require notices and reminders to keep their loans current and to prevent delinquencies and foreclosures |
| A substantial increase in our delinquency rate that results from improper servicing or loan performance in general could harm our ability to securitize our real estate loans in the future and may have an adverse effect on our earnings |
| Interest rate fluctuations can have various negative effects on us, and could lead to reduced earnings and/or increased earnings volatility |
| Our investment portfolio today is substantially match-funded, and overall we are largely insulated from material risks related to rising, or declining, interest rates |
| In the past however, we have been exposed to material changes in short-term interest rates, and depending on future investments, may again be exposed to these changes |
| Certain of our current investments and contemplated future investments are adjustable-rate loans and securities which have interest rates which reset semi-annually or annually, based on an index such as the one-year constant maturity treasury or the six-month London Interbank Offered Rate (LIBOR) |
| These investments may be financed with borrowings which reset monthly, based upon one-month LIBOR In a rising rate environment, net interest income earned on these investments may be reduced, as the interest cost for the funding sources could increase more rapidly than the interest earned on the associated asset financed |
| In a declining interest-rate environment, net interest income may be enhanced as the interest cost for the funding sources decreases more rapidly than the interest earned on the associated assets |
| To the extent that assets and liabilities are both fixed-rate or adjustable rate with corresponding payment dates, interest-rate risk may be mitigated |
| 6 _________________________________________________________________ Our reported income depends on accounting conventions and assumptions about the future that may change |
| Accounting rules for our assets, and for the various aspects of our current and future business change from time to time |
| Changes in GAAP, or the accepted interpretation of these accounting principles, can affect our reported income, earnings, and shareholders’ equity |
| Interest income on our assets, and interest expense on our liabilities, may in part be based on estimates of future events |
| These estimates can change in a manner that harms our results or can demonstrate, in retrospect, that revenue recognition in prior periods was too high or too low |
| We use the effective yield method of GAAP accounting for many of our investments |
| We calculate projected cash flows for each of these assets incorporating assumptions about the amount and timing of credit losses, loan prepayment rates, and other factors |
| The yield we recognize for GAAP purposes generally equals the discount rate that produces a net present value for actual and projected cash flows that equals our GAAP basis in that asset |
| We change the yield recognized on these assets based on actual performance and as we change our estimates of future cash flows |
| The assumptions that underlie our projected cash flows and effective yield analysis may prove to be overly optimistic, or conversely, overly conservative |
| In these cases, our GAAP yield on the asset, or cost of the liability may change, leading to changes in our reported GAAP results |
| Failure to qualify as a REIT would adversely affect our dividend distributions and could adversely affect the value of our securities |
| We believe that we have met all requirements for qualification as a REIT for federal income tax purposes and we intend to continue to operate so as to qualify as a REIT in the future |
| However, many of the requirements for qualification as a REIT are highly technical and complex and require an analysis of factual matters and an application of the legal requirements to such factual matters in situations where there is only limited judicial and administrative guidance |
| Thus, no assurance can be given that the Internal Revenue Service or a court would agree with our conclusion that we have qualified as a REIT or that future changes in our factual situation or the law will allow us to remain qualified as a REIT If we failed to qualify as a REIT for federal income tax purposes and did not meet the requirements for statutory relief, we could be subject to federal income tax at regular corporate rates on our income and we could possibly be disqualified as a REIT for four years thereafter |
| Failure to qualify as a REIT could force us to sell certain of our investments, possibly at a loss, and could adversely affect the value of our common stock |
| Maintaining REIT status may reduce our flexibility to manage our operations |
| To maintain REIT status, we must follow certain rules and meet certain tests |
| In doing so, our flexibility to manage our operations may be reduced |
| For instance: · If we make frequent asset sales from our REIT entities to persons deemed customers, we could be viewed as a “dealer,” and thus subject to 100prca prohibited transaction taxes or other entity level taxes on income from such transactions |
| · Compliance with the REIT income and asset rules may limit the type or extent of hedging that we can undertake |
| · Our ability to own non-real estate related assets and earn non-real estate related income is limited |
| Our ability to own equity interests in other entities is limited |
| If we fail to comply with these limits, we may be forced to liquidate attractive assets on short notice on unfavorable terms in order to maintain our REIT status |
| · Our ability to invest in taxable subsidiaries is limited under the REIT rules |
| Maintaining compliance with this limit could require us to constrain the growth of our taxable REIT affiliates in the future |
| · Meeting minimum REIT dividend distribution requirements could reduce our liquidity |
| Earning non-cash REIT taxable income could necessitate our selling assets, incurring debt, or raising new equity in order to fund dividend distributions |
| · Stock ownership tests may limit our ability to raise significant amounts of equity capital from one source |
| 7 _________________________________________________________________ We may fail to properly conduct our operations so as to avoid falling under the definition of an investment company pursuant to the Investment Company Act of 1940 |
| We also conduct our operations so as to avoid falling under the definition of an investment company pursuant to the Investment Company Act of 1940 |
| If we were determined to be an investment company, our ability to use leverage would be substantially reduced, and our ability to conduct business may be impaired |
| Under the current interpretation of the staff of the Securities and Exchange Commission (“SEC”), in order to be exempted from regulation as an investment company, a REIT must, among other things, maintain at least 55prca of its assets directly in qualifying real estate interests |
| In satisfying this 55prca requirement, a REIT may treat mortgage-backed securities issued with respect to an underlying pool to which it holds all issued certificates as qualifying real estate interests |
| If the SEC or its staff adopts a contrary interpretation of such treatment, the REIT could be required to sell a substantial amount of these securities or other non-qualified assets under potentially adverse market conditions |
| We are dependent on certain key personnel |
| We have only one Executive Officer, Stephen J Benedetti, who serves as our Executive Vice President and Chief Operating Officer |
| Benedetti previously served as our Chief Financial Officer |
| Benedetti has been with us since 1994 and has extensive knowledge of us, our operations, and our current investment portfolio |
| He also has extensive experience in managing a portfolio of mortgage-related investments, and as an executive officer of a publicly-traded mortgage REIT The loss of Mr |
| Benedetti could have an adverse effect on our operations |