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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC  20549
FORM 10-K
Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 2020
or
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)
Virginia52-1549373
(State or other jurisdiction of incorporation or organization)(I.R.S. Employer Identification No.)
4991 Lake Brook Drive, Suite 100
Glen Allen,Virginia23060-9245
(Address of principal executive offices)(Zip Code)
(804)217-5800 
(Registrant’s telephone number, including area code) 

Securities registered pursuant to Section 12(b) of the Act:
Title of each classTrading Symbol(s)Name of each exchange on which registered
Common Stock, par value $0.01 per shareDXNew York Stock Exchange
7.625% Series B Cumulative Redeemable Preferred Stock, par value $0.01 per shareN/ANone
6.900% Series C Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock, par value $0.01 per shareDXPRCNew York Stock Exchange

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes           o           No           x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.
Yes           o           No           x

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                   No           

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files).
Yes                        No           




Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filerAccelerated filer
Non-accelerated filerSmaller reporting company
Emerging growth company
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  

Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report.  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes                      No            

As of June 30, 2020, the aggregate market value of the voting stock held by non-affiliates of the registrant was approximately $315,650,564 based on the closing sales price on the New York Stock Exchange of $14.30.

On February 25, 2021, the registrant had 26,860,470 shares outstanding of common stock, $0.01 par value, which is the registrant’s only class of common stock.

DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Definitive Proxy Statement for the registrant’s 2021 Annual Meeting of Shareholders, expected to be filed pursuant to Regulation 14A within 120 days from December 31, 2020, are incorporated by reference into Part III.




DYNEX CAPITAL, INC.
FORM 10-K
TABLE OF CONTENTS



Page
PART I.
Item 1.Business
Item 1A.Risk Factors
Item 1B.Unresolved Staff Comments
Item 2.Properties
Item 3.Legal Proceedings
Item 4.Mine Safety Disclosures
PART II.
Item 5.Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities
Item 6.Selected Financial Data
Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 7A.Quantitative and Qualitative Disclosures About Market Risk
Item 8.Financial Statements and Supplementary Data
Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Item 9A.Controls and Procedures
Item 9B.Other Information
PART III.
Item 10.Directors, Executive Officers and Corporate Governance
Item 11.Executive Compensation
Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13.Certain Relationships and Related Transactions, and Director Independence
Item 14.Principal Accountant Fees and Services
PART IV.
Item 15.Exhibits and Financial Statement Schedules
Item 16.Form 10-K Summary
SIGNATURES





i



CAUTIONARY STATEMENT – This Annual Report on Form 10-K contains “forward-looking” statements within the meaning of Section 27A of the Securities Act of 1933, as amended (or “1933 Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (or “Exchange Act”). We caution that any such forward-looking statements made by us are not guarantees of future performance, and actual results may differ materially from those expressed or implied in such forward-looking statements.  Some of the factors that could cause actual results to differ materially from estimates expressed or implied in our forward-looking statements are set forth in this Annual Report on Form 10-K for the year ended December 31, 2020. See Item 1A. “Risk Factors” as well as “Forward-Looking Statements” set forth in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Annual Report on Form 10-K.
 
In this Annual Report on Form 10-K, we refer to Dynex Capital, Inc. and its subsidiaries as the "Company,” “we,” “us,” or “our,” unless we specifically state otherwise or the context indicates otherwise.  


PART I.

ITEM 1.    BUSINESS

COMPANY OVERVIEW

Dynex Capital, Inc. commenced operations in 1988 and is an internally managed mortgage real estate investment trust (“REIT”), which primarily invests in residential and commercial mortgage-backed securities (“MBS”). We finance our investments principally with borrowings under repurchase agreements. 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 the payment of regular dividends and through capital appreciation of our investments.
We are primarily invested in Agency MBS including residential MBS (“RMBS”), commercial MBS (“CMBS”) and CMBS interest-only (“IO”) securities. Agency MBS have an implicit 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. We also have investments in non-Agency MBS, which consist mainly of CMBS IO. Non-Agency MBS are issued by non-governmental enterprises and do not have a guaranty of principal payment.

INVESTMENT STRATEGY

Our investment strategy and the allocation of our capital to a particular sector or investment is driven by a “top-down” framework that focuses on the risk management, scenario analysis, and expected risk-adjusted returns of any investment. Key points of this framework include the following:

understanding macroeconomic factors, including monetary and fiscal policies, and possible evolving outcomes, including but not limited to, the current state of the U.S. and global economies;
understanding the regulatory environment, competition for assets, and the terms and availability of financing;
sector analysis including understanding absolute returns, relative and risk-adjusted returns, and supply/demand metrics within each sector;
security and financing analysis including sensitivity analysis on credit, interest rate volatility, liquidity, and market value risk; and
managing performance and inherent portfolio risks, including but not limited to interest rate, credit, prepayment, and liquidity risks.

In allocating our capital and executing our strategy, we seek to balance the risks of owning specific types of investments with the earnings opportunity on the investment. At various times during the last decade, we have allocated capital to a variety of investments including adjustable-rate and fixed-rate Agency RMBS, Agency CMBS, investment grade and unrated non-Agency RMBS and CMBS, Agency and non-Agency CMBS IO, and residual interests in securitized mortgage loans. Our investments in non-Agency MBS are generally higher quality senior or mezzanine classes (typically rated 'A' or better by one or more of the nationally recognized statistical rating organizations) because they are typically more liquid (i.e., they are more easily converted into cash either through sales or pledges as collateral for repurchase agreement
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borrowings) and have less exposure to credit losses than lower-rated non-Agency MBS. We regularly review our existing operations to determine whether our investment strategy or business model should change, including through capital reallocation, changing our targeted investments, and shifting our risk position.

The performance of our investment portfolio will depend on many factors including but not limited to interest rates, trends of interest rates, the steepness of interest rate curves, prepayment rates on our investments, demand for our investments, general market liquidity, and economic conditions and their impact on the credit performance of our investments. In addition, our business model may be impacted by other factors such as the state of the overall credit markets, which could impact the availability and costs of financing. See “Factors that Affect Our Results of Operations and Financial Condition” below, Item 1A of Part I, “Risk Factors”, and Item 7A of Part II, “Quantitative and Qualitative Disclosures About Market Risk” of this Annual Report on Form 10-K for further discussion.

RMBS. As of December 31, 2020, the majority of our investments in RMBS were Agency-issued pass-through securities collateralized primarily by pools of fixed-rate single-family mortgage loans. Monthly payments of principal and interest made by the individual borrowers on the mortgage loans underlying the pools are "passed through" to the security holders, after deducting GSE or U.S. Government agency guarantee and servicer fees. Mortgage pass-through certificates generally distribute cash flows from the underlying collateral on a pro-rata basis among the security holders. Security holders also receive guarantor advances of principal and interest for delinquent loans in the mortgage pools.

We also purchase to-be-announced securities (“TBAs” or “TBA securities”) as a means of investing in non-specified fixed-rate Agency RMBS, and from time to time, we may also sell TBA securities as a means of economically hedging our book value exposure to Agency RMBS. A TBA security is a forward contract (“TBA contract”) for the purchase (“long position”) or sale (“short position”) of a fixed-rate Agency MBS at a predetermined price with certain principal and interest terms and certain types of collateral. The actual Agency securities to be delivered are not identified until approximately 2 days before the settlement date. We hold long and short positions in TBA securities by executing a series of transactions, commonly referred to as “dollar roll” transactions, which effectively delay the settlement of a forward purchase (or sale) of a non-specified Agency RMBS by entering into an offsetting TBA position, net settling the paired-off positions in cash, and simultaneously entering into an identical TBA long (or short) position with a later settlement date. TBAs purchased or sold for a forward settlement date are generally priced at a discount relative to TBAs settling in the current month. This price difference, often referred to as “drop income”, represents the economic equivalent of net interest income (interest income less implied financing cost) on the underlying Agency security from trade date to settlement date. When the financing costs imputed in TBA dollar roll transactions fall lower than the average repurchase agreement financing rate, this is commonly referred to in the industry as TBA dollar rolls “trading special” or “dollar roll specialness”. Dollar roll specialness happens primarily as a result of supply/demand imbalances or volatility in market prepayment expectations. We account for all TBAs (whether net long or net short positions, or collectively “TBA dollar roll positions”) as derivative instruments because we cannot assert that it is probable at inception and throughout the term of an individual TBA transaction that its settlement will result in physical delivery of the underlying Agency RMBS, or that the individual TBA transaction will not settle in the shortest period possible.

CMBS. Substantially all of our CMBS investments as of December 31, 2020 were fixed-rate Agency-issued securities backed by multifamily housing loans. The loans underlying CMBS are generally fixed-rate with scheduled principal payments generally assuming a 30-year amortization period, but typically requiring balloon payments on average approximately 10 years from origination. These loans typically have some form of prepayment protection provisions (such as prepayment lock-out) or prepayment compensation provisions (such as yield maintenance or prepayment penalty), which provide us compensation if underlying loans prepay prior to us earning our expected return on our investment. Yield maintenance and prepayment penalty requirements are intended to create an economic disincentive for the loans to prepay, which we believe makes the fair value of CMBS less costly to hedge relative to RMBS.

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 Agency-issued CMBS IO pools are similar in composition to the pools of loans that collateralize CMBS as discussed above. Non-Agency issued CMBS IO are backed by loans secured by a number of different property types including office buildings, hospitality, and retail, among others. Since CMBS IO securities have no principal associated with
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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. Yields on CMBS IO securities are dependent upon the performance of the underlying loans. Similar to CMBS described above, the Company receives prepayment compensation as most loans in these securities have some form of prepayment protection from early repayment; however, there are no prepayment protections if the loan defaults and is partially or wholly repaid earlier because of loss mitigation actions taken by the underlying loan servicer. Because Agency CMBS IO generally contain higher credit quality loans, they have a lower risk of default than non-Agency CMBS IO. The majority of our CMBS IO investments are investment grade-rated with the majority rated ‘AAA’ by at least one of the nationally recognized statistical rating organizations.

FINANCING STRATEGY

We use leverage to enhance the returns on our invested capital by pledging our investments as collateral for borrowings primarily through the use of uncommitted repurchase agreements. The amount of leverage we utilize depends upon a variety of factors, including but not limited to general economic, political and financial market conditions; the actual and anticipated liquidity and price volatility of our assets; the gap between the duration of assets and liabilities, including hedges; the availability and cost of financing the assets; our opinion of the credit worthiness of financing counterparties; the health of the U.S. residential mortgage and housing markets; our outlook for the level, slope and volatility of interest rates; the credit quality of the loans underlying our investments; the rating assigned to securities; and our outlook for asset spreads. Repurchase agreements generally have original terms to maturity of overnight to six months, though in some instances we may enter into longer-dated maturities depending on market conditions. We pay interest on our repurchase agreement borrowings at a rate usually based on a spread to short-term interest rates and fixed for the term of the borrowing. Borrowings under uncommitted repurchase agreements are renewable at the discretion of our lenders and do not contain guaranteed roll-over terms.

Repurchase agreement financing is provided principally by major financial institutions and broker-dealers acting as financial intermediaries for short-term cash investors including money market funds and securities lenders. Repurchase agreement financing exposes us to counterparty risk to such financial intermediaries, principally related to the excess of our collateral pledged over the amount borrowed. We seek to mitigate this risk by diversifying our repurchase agreement lenders and limiting borrowings from lesser capitalized or lightly regulated counterparties. In limited instances, a money market fund or securities lender has directly provided funds to us without the involvement of a financial intermediary typically at a lower cost than we would incur borrowing from the financial intermediary. Borrowing directly from these sources also reduces our risk to the financial intermediaries. Please refer to "Risk Factors-Risks Related to Our Financing and Hedging Activities" in Item 1A of Part I of this Annual Report on Form 10-K for additional information regarding significant risks related to repurchase agreement financing.

From time to time, we will analyze and evaluate potential business opportunities that we identify or are presented to us, including possible partnerships, mergers, acquisitions, or divestiture transactions that might be a strategic fit for our investment strategy or asset allocation or otherwise maximize value for our shareholders. Pursuing such an opportunity or transaction could require us to issue additional equity or debt securities.

HEDGING STRATEGY

We use derivative instruments to economically hedge our exposure to adverse changes in interest rates resulting from our ownership of primarily fixed-rate investments financed with short-term repurchase agreements. Changes in interest rates can impact net interest income, the market value of our investments, and therefore, our book value per common share. In a period of rising interest rates, our earnings and cash flow may be negatively impacted by borrowing costs increasing faster than interest income from our assets, and our book value may decline as a result of declining market values of our MBS. We frequently adjust our hedging portfolio based on our expectation of future interest rates, including the absolute level of rates and the slope of the yield curve versus market expectations.

Currently, we are primarily using U.S. Treasury futures, options on U.S. Treasury futures, and options on interest rate swaps (“interest rate swaptions”) to mitigate adverse impacts of interest rate changes on the market value of our investment portfolio. Prior to the first quarter of 2020, we primarily utilized interest rate swaps to mitigate such adverse impacts on the market value of our investment portfolio as well as our net interest earnings. However, during the first quarter
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of 2020, the novel coronavirus (“COVID-19”) was declared a pandemic in the U.S., resulting in significant market disruptions that resulted in interest rates declining significantly and our counterparties increasing margin requirements on our interest rate swap agreements. As a result, during 2020 we either terminated our interest rate swap agreements or allowed outstanding agreements to mature without replacement. Given Federal Open Market Committee (“FOMC”) monetary policy statements made during 2020, management expects funding costs to remain low in the near-term, and so the Company is not currently hedging interest rate risk to its net interest earnings.

In conducting our hedging activities, we intend to comply with REIT and tax limitations on our hedging instruments which could limit our activities and the instruments that we may use. We also intend to enter into derivative contracts only with the counterparties that we believe have a strong credit rating to help mitigate the risk of counterparty default or insolvency.

OPERATING POLICIES AND RISK MANAGEMENT

We invest and manage our capital pursuant to Operating Policies approved by our Board of Directors. Our Operating Policies set forth investment and risk limitations as they relate to the Company's investment activities and set parameters for the Company's investment and capital allocation decisions. They also require that we manage our operations and investments to comply with various REIT limitations (as discussed further below in “Federal Income Tax Considerations”) and to avoid qualifying as an investment company as such term is defined in the Investment Company Act of 1940 (the "1940 Act") or as a commodity pool operator under the Commodity Exchange Act.

Our Operating Policies place limits on certain risks to which we are exposed, such as interest rate risk, prepayment risk, earnings at risk, and shareholders’ equity at risk from changes in fair value of our investment securities. As part of our risk management process, our Operating Policies require us to perform a variety of stress tests to model the effect of adverse market conditions on our investment portfolio value and our liquidity.

Our Operating Policies limit our investment in non-Agency MBS that are rated BBB+ or lower at the time of purchase by any of the nationally recognized statistical ratings organizations to $250 million in market value and limit our shareholders’ equity at risk with respect to such investments to a maximum of $50 million. We also conduct our own independent evaluation of the credit risk on any non-Agency MBS, such that we do not rely solely on the security’s credit rating. Our Operating Policies also set forth limits for the Company’s overall leverage.

Within the overall limits established by our Operating Policies, our investment and capital allocation decisions depend on prevailing market conditions and other factors and may change over time in response to opportunities available in different economic and capital market environments. The Board may adjust the Operating Policies of the Company from time to time based on macroeconomic expectations, market conditions, and risk tolerances among other factors.

Factors that Affect Our Results of Operations and Financial Condition

Our financial performance is largely driven by the performance of our investment portfolio and related financing and hedging activity and may be impacted by a number of factors including, but not limited to, the absolute level of interest rates, the relative slope of interest rate curves, changes in interest rates and market expectations of future interest rates, actual and estimated future prepayment rates on our investments, supply of and competition for investments, the influence of economic conditions on the credit performance of our investments, and market required yields as reflected by market spreads. All of the above factors are influenced by market forces beyond our control such as macroeconomic and geopolitical conditions, market volatility, U.S. Federal Reserve (“Federal Reserve”) policy, U.S. fiscal and regulatory policy, and foreign central bank and government policy. In addition, our business may be impacted by changes in regulatory requirements, including requirements to qualify for registration under the 1940 Act, and REIT requirements.

Our business model is also impacted by the availability and cost of financing and the state of the overall credit markets. Reductions or limitations in the availability of financing for our investments could significantly impact our business or force us to sell assets, potentially at losses. Disruptions in the repurchase agreement market outside of our control may also directly impact our availability and cost of financing. Repurchase agreement lending by larger U.S. domiciled banks has declined in recent years due to increased regulation and changes to regulatory capital requirements. Their repurchase market
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participation has been replaced by smaller independent broker dealers that are generally less regulated and by U.S. domiciled broker dealer subsidiaries of foreign financial institutions.

Regulatory authorities including the Securities and Exchange Commission (“SEC”) and the Federal Reserve are evaluating whether and how much the short-term funding markets, including the repurchase agreement market, may have exacerbated the market volatility experienced in the first and second quarters of 2020. Financial regulators, including the Federal Reserve, continue to closely monitor the short-term funding markets, particularly during times of market stress. In evaluating the short-term funding markets, regulatory authorities are reviewing participants in these markets, including mortgage REITs. The outcome of these evaluations is unknown, but it is possible that the SEC, the Federal Reserve or another regulatory body could impose restrictions on mortgage REITs or structurally change short-term funding markets, which could materially impact our borrowing costs in the repurchase agreement market or the availability of repurchase agreement financing.

The ICE Benchmark Administration Limited, the administrator of the London Interbank Offered Rate (“LIBOR”), has announced that it will cease the publication of one-week and two-month USD LIBOR immediately after December 31, 2021 and will cease the publications of the remaining tenors of USD LIBOR (one, three, six, and 12-month) immediately after June 30, 2023. In the U.S., the Alternative Reference Rates Committee, which was formed by the Federal Reserve Board and the Federal Reserve Bank of New York (“FRBNY”), has promoted the use of the Secured Overnight Financing Rate (“SOFR”), an index calculated by reference to short-term repurchase agreements backed by U.S. Treasury securities, as a preferred alternative rate for USD LIBOR. To the extent we enter into contracts in the future, such as interest rate swaps, we expect such contracts to be based on SOFR. Nonetheless, given the historical importance of LIBOR as a short-term interest rate benchmark, we continue to monitor and evaluate for potential impacts of LIBOR cessation on our business and the markets as a whole.

Please refer to Item 1A, "Risk Factors" as well as Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Item 7A, "Quantitative and Qualitative Disclosures about Market Risk" of this Annual Report on Form 10-K for additional discussions of factors that have the potential to impact our results of operations and financial condition.

COMPETITION

The business models of mortgage REITs range from investing only in Agency MBS to investing substantially in non-investment grade MBS and originating and securitizing mortgage loans and investing in mortgage servicing rights. Some mortgage REITs will invest in RMBS and related investments only, some in CMBS and related investments only, and some in a mix. Each mortgage REIT will assume various types and degrees of risk in its investment strategy. In purchasing investments and obtaining financing, we compete with other mortgage REITs, broker-dealers and investment banking firms, GSEs, mutual funds, banks, hedge funds, mortgage bankers, insurance companies, governmental bodies, including the Federal Reserve, and other entities, many of which have greater financial resources and a lower cost of capital. Increased competition in the market may reduce the available supply of investments and may drive prices of investments to levels which would negatively impact our ability to earn an acceptable amount of income from these investments. Competition can also reduce the availability of borrowing capacity at our repurchase agreement counterparties as such capacity is not unlimited, and many of our repurchase agreement counterparties limit the amount of financing they offer to the mortgage REIT industry.

FEDERAL INCOME TAX CONSIDERATIONS

As a REIT, we are required to abide by certain requirements for qualification as a REIT under the Internal Revenue Code of 1986, as amended (the “Code”). To retain our REIT status, the REIT rules generally require that we invest primarily in real estate-related assets, that our activities be passive rather than active, and that we distribute annually to our shareholders amounts equal to at least 90% of our REIT taxable income, after certain deductions. Dividend distributions to our shareholders in excess of REIT taxable income are considered to be a return of capital to the shareholder.

We use the calendar year for financial reporting in accordance with GAAP as well as for tax purposes. Income determined under GAAP differs from income determined under U.S. federal income tax rules primarily because of
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temporary differences in income and expense recognition. The primary differences between our GAAP net income and our taxable income are (i) unrealized gains and losses on derivative instruments, which are recognized in net income for GAAP purposes but are excluded from taxable income until realized; and (ii) realized losses on derivatives that are designated as tax hedges which are recognized in net income for GAAP purposes upon termination or expiration of the instrument but are deferred and amortized for tax purposes.

One of the timing differences between our GAAP net income and taxable income is the losses we realize from terminating derivatives prior to their maturity, which occurs as part of our portfolio and hedge management activities. Deferred tax hedge losses on terminated derivative instruments are recognized over the original periods designated by those terminated derivatives. Recognition of certain deferred tax hedge losses may be also be accelerated if the underlying instrument originally hedged is terminated or paid off. The following table provides the tax hedge losses as of December 31, 2020 that have already been recognized in our GAAP earnings but which will reduce taxable income over the periods indicated:
Tax Year of Recognition for Remaining Hedge LossesDecember 31, 2020
($ in thousands)
2021$23,548 
2022 - 202449,255 
2025 and thereafter68,636 
$141,439 

We also have tax net operating loss (“NOL”) carryforwards which were all generated prior to January 1, 2018. We have $17.4 million of NOL carryforward remaining as of December 31, 2020, which will expire over the next 5 years if not used.

The following table summarizes our dividends declared per share and their related tax characterization for the periods indicated:
Tax CharacterizationTotal Dividends Declared Per Share
OrdinaryCapital GainReturn of Capital
Common dividends declared:
Year ended December 31, 2020$— $1.66000 $— $1.66000 
Year ended December 31, 2019$0.36723 $— $1.64277 $2.01000 
Preferred Series A dividends declared:
Year ended December 31, 2020$— $0.87951 $— $0.87951 
Year ended December 31, 2019$2.12500 $— $— $2.12500 
Preferred Series B dividends declared:
Year ended December 31, 2020$— $1.90625 $— $1.90625 
Year ended December 31, 2019$1.90625 $— $— $1.90625 
Preferred Series C dividends declared:
Year ended December 31, 2020$— $1.12150 $— $1.12150 
Year ended December 31, 2019$— $— $— $— 

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Qualification as a REIT

Qualification as a REIT requires that we satisfy a variety of tests relating to our income, assets, distributions and ownership. The significant tests are summarized below.

Sources of Income. To continue qualifying as a REIT, we must satisfy two distinct tests with respect to the sources of our income: the “75% income test” and the “95% income test.” The 75% income test requires that we derive at least 75% of our gross income (excluding gross income from prohibited transactions) from certain real estate-related sources. In order to satisfy the 95% income test, 95% of our gross income for the taxable year must consist of either income that qualifies under the 75% income test or certain other types of passive income.

If we fail to meet either the 75% income test or the 95% income test, or both, in a taxable year, we might nonetheless continue to qualify as a REIT, if our failure was due to reasonable cause and not willful neglect and the nature and amounts of our items of gross income were properly disclosed to the Internal Revenue Service (the “IRS”). However, in such a case we would be required to pay a tax equal to 100% of any excess non-qualifying income.

Nature and Diversification of Assets. At the end of each calendar quarter, we must meet multiple asset tests. Under the “75% asset test,” at least 75% of the value of our total assets must represent cash or cash items (including receivables), government securities or real estate assets. Under the “10% asset test,” we may not own more than 10% of the outstanding voting power or value of securities of any single non-governmental issuer, provided such securities do not qualify under the 75% asset test or relate to taxable REIT subsidiaries. Under the “5% asset test,” ownership of any stocks or securities that do not qualify under the 75% asset test must be limited, in respect of any single non-governmental issuer, to an amount not greater than 5% of the value of our total assets (excluding ownership of any taxable REIT subsidiaries).

If we inadvertently fail to satisfy one or more of the asset tests at the end of a calendar quarter, such failure would not cause us to lose our REIT status, provided that (i) we satisfied all of the asset tests at the close of the preceding calendar quarter and (ii) the discrepancy between the values of our assets and the standards imposed by the asset tests either did not exist immediately after the acquisition of any particular asset or was not wholly or partially caused by such an acquisition. If the condition described in clause (ii) of the preceding sentence was not satisfied, we still could avoid disqualification by eliminating any discrepancy within 30 days after the close of the calendar quarter in which it arose.

Ownership. In order to maintain our REIT status, we must not be deemed to be closely held and must have more than 100 shareholders. The closely held prohibition requires that not more than 50% of the value of our outstanding shares be owned by five or fewer persons at any time during the last half of our taxable year. The "more than 100 shareholders" rule requires that we have at least 100 shareholders for 335 days of a twelve-month taxable year. If we failed to satisfy the ownership requirements, we would be subject to fines and be required to take curative action to meet the ownership requirements in order to maintain our REIT status.

Under current U.S. federal income tax laws, the highest marginal individual income tax rate is 37% and individuals, estates and trusts may deduct up to 20% of certain pass-through income, including ordinary REIT dividends that are not “capital gain dividends” or “qualified dividend income,” subject to certain limitations. For taxpayers qualifying for the full deduction, the effective maximum tax rate on ordinary REIT dividends is 29.6% (plus a 3.8% surtax on net investment income, if applicable). The maximum rate of withholding with respect to our distributions to certain foreign owners that are treated as attributable to gains from the sale or exchange of U.S. real property interests is 21%.

HUMAN CAPITAL STRATEGY

The Company views its employees as its most important asset and as the key to managing a successful business for the benefit of all of our stakeholders. Our human capital strategy is designed to create a supportive environment where our employees can grow professionally and contribute to the success of the Company. We believe a collaborative, engaging and
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equitable culture is key to attracting and retaining skilled, experienced and talented employees as well as fostering the development of the Company’s next generation of leaders.

We are committed to promoting diversity within our workforce and believe diversity extends beyond gender, race, ethnicity, age and sexual orientation to include different perspectives, skills, and experiences and socioeconomic backgrounds. We hire based on qualifications and evaluate, recognize, reward and promote employees based on performance without regard to race, religion, color, national origin, disability, gender, gender identity, sexual orientation, stereotypes or assumptions based thereon. In addition, equity is fundamental to our philosophy of fair and equitable treatment. We regularly review and analyze our compensation practices and engage in ongoing efforts to ensure pay equity within all levels of employment.

As of December 31, 2020, we had 19 full and part-time employees, of which 53% are women or self-identified minorities. Our voluntary turnover rate was 0% for the three years ended December 31, 2020 and the average tenure of our employees is 13.5 years as of December 31, 2020. None of our employees are covered by any collective bargaining agreements, and we are not aware of any union organizing activity relating to our employees.

The Company strives to offer its employees a healthy work-life balance and an open environment in which they are encouraged to offer thoughts and opinions. Employees have a wide selection of resources available to help protect their health, well-being, and financial security, including an on-site gym (currently with limited access as a precaution during the COVID-19 pandemic) coverage of a substantial portion of their health insurance, and a competitive 401(k) company match. In addition, we have historically offered flexible working arrangements to accommodate the individual needs of our employees who request it. Due to the COVID-19 pandemic, all employees are currently encouraged to work from home, and substantially all do, at least on a part-time basis. Like many companies, COVID-19 has increased our focus on health and safety efforts to protect our employees and their families from potential virus exposure, while ensuring that our critical operations remain fully supported. Since the beginning of the COVID-19 pandemic, we have taken precautionary measures and implemented procedures aligned with the Centers for Disease Control and Prevention to protect, manage, and communicate with our workforce to contain the impacts of the virus.

Recognizing the vital role that human capital management serves in the long-term success of the Company, we have initiated a Human Capital Strategy Planning process, which is overseen by the Board, to formalize the process for management and development of employees. In addition to talent management and development initiatives, the Human Capital Strategy Planning process included the following in 2020:

development of organizational core values and a plan to integrate these values into a variety of human
capital processes and practices;
offering of a personal development program in which all employees were encouraged to participate;
initiation of a formalized process for determining current and future human capital requirements;
implementation of improved performance measures designed to better determine individual and team developmental needs.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE INITIATIVES

We believe that environmental, social, and corporate governance ("ESG") practices and initiatives are important in sustaining and growing the Company. We believe ESG initiatives create value by improving the environment and lives of our employees, investors, business partners, and the community. The following are notable ESG policies we had in place as of December 31, 2020 as well as targets we have established for 2021:

The Company's Board of Directors follows our Corporate Governance Guidelines, adopted in accordance with the requirements of the New York Stock Exchange (“NYSE”), which provide a framework to assist directors in fully understanding and effectively implementing their functions while assuring the Company’s ongoing commitment to high standards of corporate conduct and compliance. These Corporate Governance Guidelines cover specific issues including, among other things, the Board's key responsibilities, criteria for membership and selection, committees of the Board, meetings with management, director continuing education, director performance evaluations and compensation, and management succession planning.
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Our Code of Business Conduct and Ethics ("Code of Conduct") applies to all of our employees, officers and directors and covers a wide range of business practices and procedures designed to foster the highest ethical standards in all business relationships. This policy covers, among other things, compliance with applicable laws, conflicts of interest, confidentiality, fair dealing, discrimination and harassment, health and safety, reporting of suspected violations, and enforcement of our Code of Conduct.
Our Whistleblower Policy provides a structured and formal process to facilitate confidential, anonymous submissions by employees of the Company and others with concerns or complaints regarding the Company's accounting, internal accounting controls, auditing matters or violations of the Company’s Code of Conduct.
Our Nominating and Corporate Governance Committee is responsible for overseeing our ESG strategies, policies, activities, and communications, including for purposes of risk management.
In September 2020, our Board of Directors adopted a Board Refreshment and Diversity Policy to ensure a relevant, inclusive and diverse membership on the Board; to provide the Board with the best combination of knowledge, skills, experience and perspectives among its members (including with respect to gender, age, race, culture and experience); and to oversee and support our strategy for the future.
We adopted the Sustainability Accounting Standards Board (“SASB”) Conceptual Framework in 2020 and are committed to reporting within such framework in 2021.
We established a Steering Committee in 2020, which is actively developing ESG guidelines and has begun prioritizing measurable ESG goals for the Company for 2021 in response to surveys of our employees. The Steering Committee also intends to survey our Board of Directors, investors and community members to assess the materiality and importance of various ESG matters to these stakeholders.

Community Commitment

We believe that supporting the communities where we work and live is a meaningful commitment to both our employees and our neighbors. With the help of our employees, we strive to create a positive impact in our communities through charitable contributions and financial support that encourages the future development and well-being of our local communities. Employees are encouraged and given opportunities to donate time and funds to community organizations of their choice, and the Company offers a matching gift program for employee charitable contributions. In addition, the Company has historically supported the following areas to which it feels strongly connected:

affordable housing
financial literacy
children’s health and social services; and
career counseling in underprivileged communities.

Additional details regarding our ESG initiatives, including our community commitments, will be available in our 2021 Proxy Statement.

AVAILABLE INFORMATION

We are subject to the reporting requirements of the Exchange Act and its rules and regulations. The Exchange Act requires us to file reports, proxy statements, and other information with the SEC. These materials may be obtained electronically by accessing the SEC’s home page at www.sec.gov.

Our website can be found at www.dynexcapital.com. Our annual reports on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K, and amendments to those reports, filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, are made available free of charge through our website as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC.

Our Code of Conduct is available on our website, along with our Audit Committee Charter, our Whistleblower Policy, our Nominating and Corporate Governance Committee Charter, and our Compensation Committee Charter. We will post on our website amendments to the Code of Conduct or waivers from its provisions, if any, which are applicable to any of our directors or executive officers in accordance with the requirements of the SEC or the NYSE.
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ITEM 1A.    RISK FACTORS

The following is a summary of the risk factors that we believe are most relevant to our business. These are factors which, individually or in the aggregate, we think could cause our actual results to differ significantly from anticipated or historical results. In addition to understanding the key risks described below, investors should understand that it is not possible to predict or identify all risk factors, and consequently, the following is not a complete discussion of all potential risks or uncertainties.

RISKS RELATED TO OUR INVESTMENT ACTIVITIES
Fluctuations in the market value of our investments could negatively impact our net income, comprehensive income, shareholders’ equity, book value per common share, dividends, and liquidity.
Our investments fluctuate in value due to a number of factors including, among others, market volatility (including, as an example, market volatility in the first half of 2020 due to the COVID-19 outbreak), changes in credit spreads, spot and forward interest rates, and actual and anticipated prepayments. Our investments may also fluctuate in value due to increased or reduced demand for the types of investments we own. The level of demand may be impacted by, among other things, interest rates, capital flows, economic conditions, and government policies and actions, such as purchases and sales by the FRBNY.
Changes in credit spreads represent the market’s valuation of the perceived riskiness of assets relative to risk-free rates, and widening credit spreads reduce the market value of our investments because market participants typically require additional yield to hold riskier assets. Credit spreads could change based on macroeconomic or systemic factors specific to a particular security such as prepayment performance or credit performance. Other factors that could impact credit spreads include technical issues such as supply and demand for a particular type of security, market psychology, and FOMC monetary policies. In addition, most of our investments are fixed rate or reset in rate over a period of time, and as interest rates rise, the market value of these investments will typically decrease. If market values decrease significantly, we may experience a material reduction in our liquidity if we are forced to sell assets at losses in order to meet margin calls from our lenders to repay or renew repurchase agreements at maturity, or otherwise to maintain our liquidity. A material reduction in our liquidity could lead to a reduction of the dividend or potentially the payment of the dividend in Company stock subject to the Code.
Fluctuations in interest rates could negatively impact our net interest income, comprehensive income, book value per common share, dividends, and liquidity.
Fluctuations in interest rates impact us in multiple ways. For example, in a period of rising rates, particularly increases in the targeted U.S. Federal Funds Rate (“Federal Funds Rate”), we may experience a decline in our profitability from borrowing rates increasing faster than interest coupons on our investments reset or our investments mature. We may also experience a decline in profitability from our investments adjusting less frequently or relative to a different index from our borrowings (repurchase agreements are typically based on shorter-term rates). Once the Federal Reserve announces a higher targeted range or if markets anticipate that the Federal Reserve is likely to announce a higher targeted range for the Federal Funds Rate, our borrowing costs are likely to immediately increase, thereby negatively impacting our results of operations, financial condition, dividend and book value per common share.
Fluctuations in interest rates may also negatively affect the market value of our securities, resulting in declines in comprehensive income, book value per common share, and liquidity. Since our investment portfolio consists substantially of fixed rate instruments, rising interest rates will reduce the market value of our MBS as a result of higher yield requirements by the market for these types of securities, and reductions in the market value of our MBS could result in margin calls from our lenders. Conversely, while declining interest rates are typically more favorable for us, we may experience increasing prepayments, which would increase amortization expense of any premiums we pay to acquire our investments and thereby result in a decline in net interest income. Declining interest rates may also result in declining market value on RMBS as market participants factor in potentially faster prepayment rates in the future.
We invest in to-be-announced, or TBA, securities and execute TBA dollar roll transactions. It could be uneconomical to roll our TBA contracts or we may be unable to meet margin calls on our TBA contracts, which could negatively affect our financial condition and results of operations.
We execute TBA dollar roll transactions which effectively delay the settlement of a forward purchase (or sale) of a TBA by entering into an offsetting TBA position, net settling the paired-off positions in cash, and simultaneously entering an
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identical TBA long (or short) position with a later settlement date. Under certain market conditions, TBA dollar roll transactions may result in negative net interest income whereby the Agency RMBS purchased (or sold) for forward settlement under a TBA contract are priced at a premium to Agency RMBS for settlement in the current month. Market conditions could also adversely impact the TBA dollar roll market and, in particular, shifts in prepay expectations on Agency RMBS or changes in the reinvestment policy on Agency RMBS by the Federal Reserve. Under such conditions, it may be uneconomical to roll our TBA positions prior to the settlement date, and we could have to take physical delivery of the underlying securities and settle our obligations for cash, or in the case of a short position, we could be forced to deliver one of our Agency RMBS, which would mean using cash to payoff any repurchase agreement amounts collateralized by that security. We may not have sufficient funds or alternative financing sources available to settle such obligations. In addition, pursuant to the margin provisions established by the Mortgage-Backed Securities Division (“MBSD”) of the Fixed Income Clearing Corporation, we are subject to margin calls on our TBA contracts and our trading counterparties may require us to post additional margin above the levels established by the MBSD. Negative income on TBA dollar roll transactions or failure to procure adequate financing to settle our obligations or meet margin calls under our TBA contracts could result in defaults or force us to sell assets under adverse market conditions or through foreclosure and adversely affect our financial condition and results of operations.
As a result of monetary easing policies, the Federal Reserve has lowered the Federal Funds Rate and now owns substantial amounts of longer-term Treasury securities and fixed-rate Agency MBS in order to put downward pressure on interest rates. If the Federal Reserve begins tightening monetary policy or if the FRBNY were to sell these securities or even announce that it intends to sell these securities, longer-term interest rates are likely to increase dramatically which could negatively impact the market value of our investments. In addition, an announcement by the Federal Reserve of its intention to increase the targeted Federal Funds rate, or the market’s anticipation of such an announcement, is likely to increase our borrowing costs.
In response to the COVID-19 pandemic, and in order to mitigate its implications for the U.S. economy and financial system, the Federal Reserve aggressively eased monetary policy in 2020 by reducing the Federal Funds Rate to a range of between 0% and 0.25%. The Federal Reserve is also seeking to provide monetary policy stimulus by expanding the holdings of longer-term securities in its portfolio, including large-scale purchases of Treasury securities and fixed-rate Agency RMBS. The purchases were intended to lower longer-term interest rates in general and mortgage rates in particular and ensure the continued smooth functioning of markets. The Federal Reserve is one of the largest holders of Agency RMBS and, as of February 2021, is committed to purchasing at least $40 billion per month in newly issued Agency RMBS until substantial progress has been made toward the Federal Reserve's maximum employment and price stability goals. The purchase activity in Agency RMBS has materially improved market prices in these securities over the balance of 2020. Markets anticipate continued purchases by the Federal Reserve for the foreseeable future given continued economic hardship attributable to the negative impacts of the COVD-19 pandemic. If the Federal Reserve tapers or announces an intention to taper its purchases or it undertakes outright sales of its securities portfolio, the price of Agency RMBS could materially decline, negatively impacting the market value of our investments and thereby, our comprehensive income, book value per common share, and our liquidity.
In addition, by keeping the Federal Funds Rate at the range of between 0% and 0.25%, the Federal Reserve has kept short-term interest rates low which has benefited our borrowing costs. Once the Federal Reserve announces a higher targeted range or if markets determine that the Federal Reserve is likely to announce a higher target range, our borrowing costs are likely to increase which will negatively impact our results of operations and could impact our financial condition and book value.
We invest in assets that are traded in over-the-counter (“OTC”) markets which are less liquid and have less price transparency than securities exchanges. Owning securities that are traded in OTC markets may increase our liquidity risk, particularly in a volatile market environment, because our assets may be more difficult to borrow against or sell in a prompt manner and on terms acceptable to us, and we may not realize the full value at which we previously recorded the investments and/or may incur losses upon sale of these assets.
Though Agency MBS are generally deemed to be very liquid securities, turbulent market conditions, such as market conditions following the COVID-19 outbreak, may significantly and negatively impact the liquidity and market value of these assets. Non-Agency MBS are typically more difficult to value, less liquid, and experience greater price volatility than Agency MBS. In addition, market values for non-Agency MBS are typically more subjective than Agency MBS. Given the trading of our investments in OTC markets, in times of severe market stress, a market may not exist for certain of our assets at any price. If the MBS market were to experience a severe or extended period of illiquidity, lenders may refuse to accept
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our assets as collateral for repurchase agreement financing, which could have a material adverse effect on our results of operations, financial condition and business. A sudden reduction in the liquidity of our investments could limit our ability to finance or could make it difficult to sell investments if the need arises. If we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the fair value at which we have previously recorded our investments which would result in lower than anticipated gains or higher losses.
Prepayment rates on the mortgage loans underlying our investments may adversely affect our profitability, the market value of our investments, and our liquidity. Changes in prepayment rates may also subject us to reinvestment risk.
We are subject to prepayment risk to the extent that we own investments at premiums to their par value or at yields at a premium to current market yields. We amortize the premiums we pay on a security using the effective yield method, which is impacted by borrower prepayments of principal on the loans. Prepayments can occur both on a voluntary basis (i.e., the borrower elects to prepay the loan along with related prepayment fees, if applicable) and involuntary basis (i.e., a loan default and subsequent foreclosure and liquidation). RMBS have no prepayment protection while CMBS and CMBS IO have voluntary prepayment protection in the form of a prepayment lock-out on the loan for an initial period, or by yield maintenance or prepayment penalty provisions which serve as full or partial compensation for future lost interest income on the loan. In certain circumstances, compensation for voluntary prepayment on CMBS IO securities may not be sufficient to compensate us for the loss of future excess interest as a result of the prepayment. Prepayments on our investments are impacted by economic and market conditions, the level of interest rates, the general availability of mortgage credit, and other factors.
We have no protection from involuntary prepayments. The impact of involuntary prepayments on high premium investments including CMBS IO and higher coupon Agency CMBS is particularly acute since the investment consists entirely of premium. An increase in involuntary prepayments will result in the loss of investment premiums at an accelerated rate which could materially reduce our profitability and dividend. Involuntary prepayments typically increase in periods of economic slowdown or stress, such as the slowdown in economic activity experienced as a result of COVID-19, and actions taken as a result by the GSEs and federal, state and local governments. Defaults in loans underlying our CMBS IO, particularly loans in non-Agency CMBS IO securities collateralized by income producing properties such as retail shopping centers, office buildings, multifamily apartments and hotels, may increase as a result of economic weakness, such as that brought on by the COVID-19 pandemic.
Prepayments on Agency CMBS, which are often collateralized by a single loan, could result in margin calls by lenders in excess of our available liquidity, particularly for larger balance investments. Typically, there is a 20-day delay between the announcement of prepayments and the receipt of the cash from the prepayment; however, the repurchase agreement lender may initiate a margin call when the prepayment is announced. If we do not have liquidity available to cover the margin call at that time, we may be in default under the repurchase agreement until we receive the cash from the prepayment. Alternatively, we could be forced to sell assets quickly and on terms unfavorable to us to meet the margin call.
Increases in actual prepayment rates or market expectations of prepayment rates (voluntary or involuntary) could negatively impact our profitability and the market value of our investments, negatively impacting our book value. We are also more likely to experience margin calls from our lenders as a result of the decline in value of our securities, which would negatively impact our liquidity. Typically, prepayments will increase when interest rates are declining which can lead to reinvestment in lower yielding investments leading to lower net interest income and reduced profitability.
We may be subject to the risks associated with inadequate or untimely services from third-party service providers, which may negatively impact our results of operations. We also rely on corporate trustees to act on behalf of us and other holders of securities in enforcing our rights.
Loans underlying non-Agency MBS we own are serviced by third-party service providers. These servicers provide for the primary and special servicing of these securities. In that capacity these service providers control all aspects of loan collection, loss mitigation, default management and ultimate resolution of a defaulted loan including as applicable the foreclosure and sale of the real estate owned. The servicer has a fiduciary obligation to act in the best interest of the securitization trust, but significant latitude exists with respect to certain of its servicing activities. We have no contractual rights with respect to these servicers. If a third-party servicer fails to perform its duties under the securitization documents, this may result in a material increase in delinquencies or losses to the securities. As a result, the value of the securities may be impacted, and we may incur losses on our investment.
In addition, should a servicer experience financial difficulties, it may not be able to perform its obligations. Due to application of provisions of bankruptcy law, servicers who have sought bankruptcy protection may not be required to make
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advance payments required under the terms of the agreements governing the securities of amounts due from loan borrowers. Even if a servicer were able to advance amounts in respect of delinquent loans, its obligation to make the advances may be limited to the extent that is does not expect to recover the advances due to the deteriorating credit of the delinquent loans. As a result of the COVID-19 outbreak, as well as the loan forbearance programs instituted by the GSEs, many servicers are experiencing financial distress and there is an increased risk that servicers may declare bankruptcy. For Agency MBS, we expect that the GSEs will transfer the servicing or otherwise make the investors in Agency MBS whole. For non-Agency MBS, financial difficulties with the servicer could lead to a material increase in delinquencies or losses to the securities. As a result, the value of the securities may be impacted, and we may incur losses on our investment.
We also rely on corporate trustees to act on behalf of us and other holders of securities in enforcing our rights. Under the terms of most securities we hold we do not have the right to directly enforce remedies against the issuer of the security, but instead must rely on a trustee to act on behalf of us and other security holders. Should a trustee not be required to take action under the terms of the securities, or fail to take action, we could experience losses.
Provisions requiring yield maintenance charges, prepayment penalties, defeasance, or lock-outs in CMBS IO securities may not be enforceable.
Provisions in loan documents for mortgages in CMBS IO securities in which we invest requiring yield maintenance charges, prepayment penalties, defeasance, or lock-out periods may not be enforceable in some states and under federal bankruptcy law. Provisions in the loan documents requiring yield maintenance charges and prepayment penalties may also be interpreted as constituting the collection of interest for usury purposes. Accordingly, we cannot be assured that the obligation of a borrower to pay any yield maintenance charge or prepayment penalty under a loan document in a CMBS IO security will be enforceable. Also, we cannot be assured that foreclosure proceeds under a loan document in a CMBS IO security will be sufficient to pay an enforceable yield maintenance charge. If yield maintenance charges and prepayment penalties are not collected, or if a lock-out period is not enforced, we may incur losses to write-down the value of the CMBS IO security for the present value of the amounts not collected, and we will experience lower yields and lower interest income. This would also likely cause margin calls from any lender on the CMBS IO impacted which could have a material adverse effect on our liquidity.
We invest in securities guaranteed by Fannie Mae and Freddie Mac which are currently under conservatorship by the Federal Housing Finance Authority (“FHFA”). The ultimate impact on the operations of Fannie Mae and Freddie Mac from the conservatorships and the support they receive from the U.S. government is not determinable and could affect Fannie Mae and Freddie Mac in such a way that our business, operations and financial condition may be adversely affected.
As conservator, the FHFA has assumed all the powers of the shareholders, directors and officers of the GSEs with the goal of preserving and conserving their assets. At various times since implementation of the conservatorship, Congress has considered structural changes to the GSEs. The U.S. Treasury published the Treasury Housing Reform Plan in 2019 outlining proposed changes to the U.S. housing finance system, which could lead to the release of the GSEs from conservatorship. Furthermore, the FHFA released its Strategic Plan in October 2019, which included in part an outline for the GSEs exiting conservatorship. Recent events related to the COVID-19 outbreak and the associated economic slowdown have raised concerns at the FHFA that the GSEs may need additional capital in order to meet their obligations as guarantors on trillions of dollars of MBS. The market value of Agency MBS today is highly dependent on the continued support of the GSEs by the U.S. government. If such support is modified or withdrawn, if the U.S. Treasury fails to inject new capital as need, or if the GSEs are released from conservatorship, the market value of Agency MBS could significantly decline, making it difficult for us to obtain repurchase agreement financing and could force us to sell assets at substantial losses. Furthermore, any policy changes to the relationship between the GSEs and the U.S. government may create market uncertainty and have the effect of reducing the actual or perceived credit quality of securities issued by the GSEs. It may also interrupt the cash flow received by investors on the underlying MBS
Finally, reforms to GSEs could also negatively impact our ability to comply with the provisions of the 1940 Act (see further discussion below regarding the 1940 Act).
All of the foregoing could materially adversely affect the availability, pricing, liquidity, market value and financing of our assets and materially adversely affect our business, operations, financial condition and book value per common share.
Credit ratings assigned to debt securities by the credit rating agencies may not accurately reflect the risks associated with those securities. Changes in credit ratings for securities we own or for similar securities might negatively impact the market value of these securities.
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Rating agencies rate securities based upon their assessment of the safety of the receipt of principal and interest payments on the securities. Rating agencies do not consider the risks of fluctuations in fair value or other factors that may influence the value of securities and, therefore, the assigned credit rating may not fully reflect the true risks of an investment in securities. Also, rating agencies may fail to make timely adjustments to credit ratings based on available data or changes in economic outlook or may otherwise fail to make changes in credit ratings in response to subsequent events, so the credit quality of our investments may be better or worse than the ratings indicate. We attempt to reduce the impact of the risk that a credit rating may not accurately reflect the risks associated with a particular debt security by not relying solely on credit ratings as the indicator of the quality of an investment. We make our acquisition decisions after factoring in other information that we have obtained about the loans underlying the security and the credit subordination structure of the security. Despite these efforts, our assessment of the quality of an investment may also prove to be inaccurate and we may incur credit losses in excess of our initial expectations.
Credit rating agencies may change their methods of evaluating credit risk and determining ratings on securities backed by real estate loans and securities. These changes may occur quickly and often. The market’s ability to understand and absorb these changes, and the impact to the securitization market in general, are difficult to predict. Such changes may have a negative impact on the value of securities that we own.
RISKS RELATED TO OUR FINANCING AND HEDGING ACTIVITIES
Our use of leverage, including repurchase agreements, to enhance returns to shareholders increases the risk of volatility in our results and could lead to material decreases in net interest income, net income, comprehensive income, dividends, book value per common share, and liquidity.
Leverage increases returns on our invested capital if we can earn a greater return on investments than our cost of borrowing but can decrease returns if borrowing costs increase and we have not adequately hedged against such an increase. Further, using leverage magnifies the potential losses to shareholders’ equity and book value per common share if our investments’ fair market value declines, net of associated hedges.
Repurchase agreements are typically uncommitted short-term financings with no guaranty of renewal at maturity and changes to terms of such financing may adversely affect our profitability and our liquidity. Our ability to fund our operations, meet financial obligations, and finance targeted asset acquisitions may be impacted by an inability to secure and maintain our financing through repurchase agreements or other borrowings with our counterparties. Because repurchase agreements are short-term commitments of capital, lenders may respond to adverse market conditions in a manner that makes it more difficult for us to renew or replace on a continuous basis our maturing short-term borrowings and have, and may continue to, impose more onerous conditions at renewal. Furthermore, in times of adverse market conditions, we may have to dispose of assets at significantly depressed prices and at inopportune times, which could result in significant losses, or we may be forced to curtail our asset acquisition activities if certain events occur including, for example, if we:
are unable to renew our existing or are otherwise unable to access new funds under our financing arrangements;
are unable to arrange for new financing on acceptable terms;
default on our financial covenants contained in our financing arrangements; or
become subject to larger haircuts under our financing arrangements requiring us to post additional collateral.
In addition, if the regulatory capital requirements imposed on certain of our lenders change, those lenders may be required to significantly increase the cost of the financing that they provide to us, or to increase the amounts of collateral they require as a condition to providing us with financing. At various times, our lenders have revised, and may continue to revise, their eligibility requirements for the types of assets that they are willing to finance or the terms of such financing arrangements, including increased haircuts and requiring additional cash collateral, based on, among other factors, the regulatory environment and a particular lender’s management of actual and perceived risk. Moreover, the amount of financing that we receive under our financing agreements will be directly related to our lenders’ valuation of the assets subject to such agreements. Typically, the master repurchase agreements that govern our borrowings under repurchase agreements grant the lender the absolute right to reevaluate the fair market value of the assets subject to such repurchase agreements at any time. These valuations may be different than the values that we ascribe to these assets and may be influenced by recent asset sales at distressed levels by forced sellers. If a lender determines in its sole discretion that the value of the assets has decreased, it has the right to initiate a margin call, which would require us to transfer additional assets to the lender without any advance of funds from the lender for such transfer or to repay a portion of the outstanding borrowings. We would also be required to post additional collateral if haircuts increase under a repurchase agreement. Furthermore, if we
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move financing from one repurchase agreement counterparty to another with larger haircut requirements, we would have to repay more cash to the original counterparty than we would be able to borrow from the new counterparty. In these situations, we could be forced to sell assets at significantly depressed prices to meet such margin calls and to maintain adequate liquidity, which could cause significant losses. Significant margin calls could have a material adverse effect on our results of operations, financial condition, business, liquidity, and ability to make distributions to our shareholders, and could cause the value of our capital stock to decline.
Our ability to access leverage in the conduct of our operations is impacted by the following:
market conditions and overall market volatility and liquidity;
regulation of our lenders and other regulatory factors;
disruptions in the repurchase agreement market generally, or the infrastructure that supports it;
the liquidity of our investments;
the market value of our investments;
maintaining our REIT status;
the advance rates by our lenders on investment collateral pledged;
the available liquidity and capital of our lenders, and;
the willingness of our lenders to finance the types of investments we choose.
Many of these factors are beyond our control and are difficult to predict, which could lead to sudden and material adverse effects on our results of operations, financial condition, business, liquidity, and ability to make distributions to shareholders, and could force us to sell assets at significantly depressed prices to maintain adequate liquidity. Market dislocations, including those resulting from the COVID-19 outbreak or as a result of other future outbreaks involving other highly infectious or contagious diseases, could limit our ability to access funding or access funding on terms that we believe are attractive, which could have a material adverse effect on our financial condition.
For more information about our operating policies regarding our use of leverage, please see “Liquidity and Capital Resources” within Part II, Item 7 of our Annual Report on Form 10-K, “Management’s Discussion and Analysis of Financial Condition and Results of Operation.”
Our repurchase agreements and agreements governing certain derivative instruments may contain financial and nonfinancial covenants. Our inability to meet these covenants could adversely affect our financial condition, results of operations, and cash flows.
In connection with certain of our repurchase agreements and interest rate swap agreements, we are required to maintain certain financial and non-financial covenants. As of December 31, 2020, the most restrictive financial covenants require that we have a minimum of $30 million of liquidity and declines in shareholders’ equity no greater than 25% in any quarter and 35% in any year. In addition, virtually all of our repurchase agreements and interest rate swap agreements require us to maintain our status as a REIT and to be exempted from the provisions of the 1940 Act. Compliance with these covenants depends on market factors and the strength of our business and operating results. Various risks, uncertainties and events beyond our control, including significant fluctuations in interest rates, market volatility and changes in market conditions, could affect our ability to comply with these covenants. Failure to comply with these covenants could result in an event of default, termination of an agreement, acceleration of all amounts owed under an agreement, and generally would give the counterparty the right to exercise certain other remedies under the repurchase agreement, including the sale of the asset subject to repurchase at the time of default, unless we were able to negotiate a waiver in connection with any such default related to failure to comply with a covenant. Any such waiver could be conditioned on an amendment to the underlying agreement and any related guaranty agreement on terms that may be unfavorable to us. If we are unable to negotiate a covenant waiver or replace or refinance our assets under a new repurchase facility on favorable terms or at all, our financial condition, results of operations and cash flows could be adversely affected. Further, certain of our repurchase agreements and interest rate swap agreements have cross-default, cross-acceleration or similar provisions, such that if we were to violate a covenant under one agreement, that violation could lead to defaults, accelerations, or other adverse events under other agreements, as well.
Our use of hedging strategies to mitigate our interest rate risk may not be effective and may adversely affect our net income, comprehensive income, liquidity, shareholders’ equity and book value per common share.
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We may use a variety of derivative instruments to help mitigate increased financing costs and volatility in the market value of our investments from adverse changes in interest rates. Our hedging activity will vary in scope based on, among other things, our forecast of future interest rates, our investment portfolio construction and objectives, the actual and implied level and volatility of interest rates, and sources and terms of financing used. No hedging strategy can completely insulate us from the interest rate risks to which we are exposed. Interest rate hedging may fail to protect or could adversely affect our results of operations, book value and liquidity because, among other things:
the performance of instruments used to hedge may not completely correlate with the performance of the assets or liabilities being hedged;
available hedging instruments may not correspond directly with the interest rate risk from which we seek protection;
the duration of the hedge may not match the duration of the related asset or liability given management’s expectation of future changes in interest rates or a result of the inaccuracies of models in forecasting cash flows on the asset being hedged;
the value of derivatives used for hedging will be adjusted from time to time in accordance with GAAP to reflect changes in fair value and downward adjustments, or “mark-to-market losses,” will reduce our earnings, shareholders’ equity, and book value;
the amount of income that a REIT may earn from hedging transactions (other than through taxable REIT subsidiaries) to offset interest rate losses may be limited by U.S. federal income tax provisions governing REITs;
interest rate hedging can be relatively expensive, particularly during periods of volatile interest rates;
the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and
the party owing money in the hedging transaction may default on its obligation to pay.
Our hedging instruments can be traded on an exchange or administered through a clearing house or under bilateral agreements between us and a counterparty. Bilateral agreements expose us to increased counterparty risk, and we may be at risk of loss of any collateral held by a hedging counterparty if the counterparty becomes insolvent or files for bankruptcy.
Clearing facilities or exchanges may increase the margin requirements we are required to post when entering into derivative instruments, which may negatively impact our ability to hedge and our liquidity.
We are required to post margin when entering into a hedging instrument that is traded on an exchange or administered through a clearing house. The amount of margin is set for each derivative by the exchange or clearinghouse and in prior periods, exchanges have required additional margin in response to events having or expected to have adverse economic consequences, such as the COVID-19 pandemic. In the event that future adverse economic developments or market uncertainty (including those due to governmental, regulatory, or legislative action or inaction) result in increased margin requirements for our hedging instruments, it could materially adversely affect our liquidity position, business, financial condition and results of operations.
If a lender to us in a repurchase transaction defaults on its obligation to resell the underlying security back to us at the end of the transaction term, or if we default on our obligations under a repurchase agreement, we will incur losses.
Repurchase agreement transactions are legally structured as the sale of a security to a lender in return for cash from the lender. These transactions are accounted for as financing agreements because the lenders are obligated to resell the same securities back to us at the end of the transaction term. Because the cash we receive from the lender when we initially sell the securities to the lender is less than the value of those securities, if the lender defaults on its obligation to resell the same securities back to us, we would incur a loss on the transaction equal to the difference between the value of the securities sold and the amount borrowed from the lender including accrued interest. The lender may default on its obligation to resell if it experiences financial difficulty or if the lender has re-hypothecated the security to another party who fails to transfer the security back to the lender. Additionally, if we default on one of our obligations under a repurchase agreement, the lender can terminate the transaction, sell the underlying collateral and cease entering into any other repurchase transactions with us. Any losses we incur on our repurchase transactions could adversely affect our earnings and reduce our ability to pay dividends to our shareholders.
In the event of bankruptcy either by ourselves or one or more of our third-party lenders, under the U.S. Bankruptcy Code, assets pledged as collateral under repurchase agreements may not be recoverable by us. We may incur losses equal to the excess of the collateral pledged over the amount of the associated repurchase agreement borrowing.
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In the event that one of our lenders under a repurchase agreement files for bankruptcy, it may be difficult for us to recover our assets pledged as collateral to such lender. In addition, if we ever file for bankruptcy, lenders under our repurchase agreements may be able to avoid the automatic stay provisions of the U.S. Bankruptcy Code and take possession of and liquidate our collateral under our repurchase agreements without delay. In the event of a bankruptcy by one of our lenders, or us, we may incur losses in amounts equal to the excess of our collateral pledged over the amount of repurchase agreement borrowing due to the lender.
RISKS RELATED TO OUR QUALIFICATION AS A REIT AND TAX RELATED OR OTHER REGULATORY MATTERS
If we fail to properly conduct our operations, we could become subject to regulation under the 1940 Act. Conducting our business in a manner so that we are exempt from registration under and compliance with the 1940 Act may reduce our flexibility and could limit our ability to pursue certain opportunities.
We seek to conduct our operations to avoid falling under the definition of an investment company pursuant to the 1940 Act. Specifically, we seek to conduct our operations under the exemption provided under Section 3(c)(5)(C) of the 1940 Act, a provision available to companies primarily engaged in the business of purchasing and otherwise acquiring mortgages and other liens on and interests in real estate. According to SEC no-action letters, companies relying on this exemption must ensure that at least 55% of their assets are mortgage loans and other qualifying assets, and at least 80% of their assets are real estate-related. The 1940 Act requires that we and each of our subsidiaries evaluate our qualification for exemption under the 1940 Act. Our subsidiaries will rely either on Section 3(c)(5)(C) or other sections that provide exemptions from registering under the 1940 Act, including Sections 3(a)(1)(C) and 3(c)(7) of the 1940 Act. We believe that we are operating our business in accordance with the exemption requirements of Section 3(c)(5)(C) of the 1940 Act.
Under the 1940 Act, an investment company is required to register with the SEC and is subject to extensive restrictive and potentially adverse regulations relating to, among other things, operating methods, management, capital structure, leverage, dividends, and transactions with affiliates. If we were determined to be an investment company, our ability to use leverage and conduct business as we do today would be substantially impaired. This would severely impact our profitability and ability to pay dividends to our shareholders.
We have not established a minimum dividend payment level and we may not have the ability to pay dividends in the future. Furthermore, our monthly dividend strategy could attract shareholders that are especially sensitive to the level and frequency of the dividend. If we were to reduce the dividend or change back to a quarterly payment cycle, our share price could materially decline.
We currently intend to pay regular dividends to our common shareholders and to make distributions to our shareholders in amounts such that all or substantially all of our taxable income, subject to certain adjustments including utilization of our NOL, is distributed. However, we have not established a minimum dividend payment level, and the amount of our dividend is subject to fluctuation. Our ability to pay dividends may be adversely affected by the risk factors described herein. All distributions will be made at the discretion of our Board of Directors and will depend on our GAAP and tax earnings, our financial condition, the requirements for REIT qualification and such other factors as our Board of Directors may deem relevant from time to time. We may not be able to make distributions, or our Board of Directors may change our dividend policy in the future. To the extent that we decide to pay dividends in excess of our current and accumulated tax earnings and profits, such distributions would generally be considered a return of capital for federal income tax purposes. A return of capital reduces the basis of a shareholder’s investment in our common stock to the extent of such basis and is treated as capital gain thereafter.
Our strategy of paying a monthly dividend is designed in part to attract retail shareholders that invest in stocks which pay a monthly dividend. The ownership of our stock may become overly concentrated in shareholders who only invest in monthly dividend paying stocks. These shareholders may be more sensitive to reductions in the dividend or a change in the payment cycle and our share price could materially decline if we were to reduce the dividend or change the payment cycle of our dividend.
Qualifying as a REIT involves highly technical and complex provisions of the Code, and a technical or inadvertent violation could jeopardize our REIT qualification. Maintaining our REIT status may reduce our flexibility to manage our operations.
Qualification as a REIT involves the application of highly technical and complex Code provisions for which only limited judicial and administrative authorities exist. Even a technical or inadvertent violation could jeopardize our REIT
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qualification. Our qualification as a REIT will depend on our satisfaction of certain asset, income, organizational, distribution, shareholder ownership and other requirements on a continuing basis. Our operations and use of leverage also subject us to interpretations of the Code, and technical or inadvertent violations of the relevant requirements under the Code could cause us to lose our REIT status or to pay significant penalties and interest. In addition, our ability to satisfy the requirements to qualify as a REIT depends in part on the actions of third parties over which we have no control or only limited influence, including in cases where we own an equity interest in an entity that is classified as a partnership for U.S. federal income tax purposes.
Maintaining our REIT status may limit flexibility in managing our operations. 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 100% prohibited transaction taxes or other entity level taxes on income from such transactions.
Compliance with the REIT income and asset requirements may limit the type or extent of hedging that we can undertake and could limit our ability to invest in TBA securities.
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 limitation could require us to constrain the growth of future taxable REIT affiliates.
Notwithstanding our NOL carryforward, 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.
If we do not qualify as a REIT or fail to remain qualified as a REIT, we may be subject to tax as a regular corporation and could face a tax liability, which would reduce the amount of cash available for distribution to our shareholders. We would also violate debt covenants in certain repurchase and derivative agreements which could put us in default on these agreements.
We intend to operate in a manner that will allow us to qualify as a REIT for federal income tax purposes. Our qualification as a REIT will depend on our satisfaction of certain asset, income, organizational, distribution, shareholder ownership and other requirements on a continuing basis. Our ability to satisfy the asset tests depends upon our analysis of the characterization and fair market values of our assets, some of which are not susceptible to a precise determination, and for which we will not obtain independent appraisals. Our compliance with the REIT income and quarterly asset requirements also depends upon our ability to successfully manage the composition of our income and assets on an ongoing basis.
If we were to fail to qualify as a REIT in any taxable year, we would be subject to federal income tax, after consideration of our NOL carryforward but not considering any dividends paid to our shareholders during the respective tax year. If we could not otherwise offset this taxable income with our NOL carryforward, the resulting corporate tax liability could be material to our results and would reduce the amount of cash available for distribution to our shareholders, which in turn could have an adverse impact on the value of our common stock. Unless we were entitled to relief under certain Code provisions, we also would be disqualified from taxation as a REIT until the fifth taxable year following the year for which we failed to qualify as a REIT. In addition, many of our repurchase agreement lenders and derivative counterparties require us to maintain our REIT status. If we were to lose our REIT status, these lenders would have the right to terminate any repurchase agreement borrowings and derivative contracts outstanding at that time. This would further stress our liquidity position, reduce the amount of cash available for distribution to our shareholders and could further exacerbate the adverse impacts on the value of our common stock described above.
Dividends payable by REITs do not qualify for the reduced tax rates available for some dividends.
The maximum tax rate applicable to “qualified dividend income” payable to U.S. shareholders that are taxed at individual rates is lower than corresponding maximum ordinary income tax rates. Dividends payable by REITs, however, are generally not eligible for the reduced rates on qualified dividend income. Rather, under the Tax Cuts and Jobs Act (the “TCJA”), qualified REIT dividends constitute “qualified business income” and thus a 20% deduction is available to individual taxpayers with respect to such dividends, resulting in a 29.6% maximum federal tax rate (plus the 3.8% surtax on net investment income, if applicable) for individual U.S. shareholders. Additionally, without further legislative action, the
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20% deduction applicable to qualified REIT dividends will expire on January 1, 2026. The more favorable rates applicable to regular corporate qualified dividends could cause investors who are taxed at individual rates to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the value of the shares of REITs, including our common stock.
Legislative or other actions affecting REITs could materially and adversely affect us and our shareholders.
The rules dealing with U.S. federal income taxation are constantly under review by persons involved in the legislative process and by the IRS and the U.S. Treasury. Furthermore, members of the U.S. Congress and the Biden administration have expressed intent to pass legislation to change or repeal parts of currently enacted tax law. Changes to the tax laws, with or without retroactive application, could materially and adversely affect us and our shareholders. We cannot predict how changes in the tax laws might affect us or our shareholders. New legislation, U.S. Treasury regulations, administrative interpretations or court decisions could significantly and negatively affect our ability to qualify as a REIT or the U.S. federal income tax consequences of such qualification.
In addition, the effect of substantive changes made by the TCJA is highly uncertain, both in terms of their direct effect on the taxation of an investment in our common stock and their indirect effect on the value of our assets. Furthermore, many of the provisions of the TCJA will require guidance through the issuance of U.S. Treasury regulations in order to assess their effect. There may be a substantial delay before such regulations are promulgated, increasing the uncertainty as to the ultimate effect of the statutory amendments on us. It is also likely that there will be technical corrections legislation proposed with respect to the TCJA, the timing and effect of which cannot be predicted and may be adverse to us or our shareholders.
Our ability to invest in and dispose of TBA securities could be limited by our REIT status, and we could lose our REIT status as a result of these investments.
The Code is unclear regarding whether TBA securities are qualifying assets for the 75% asset test and whether income and gains from dispositions of TBA securities are qualifying income for the 75% gross income test. In addition, there is uncertainty under the Code pursuant to the “5% asset test,” whereby ownership of any stocks or securities that do not qualify under the 75% asset test must be limited, in respect of any single non-governmental issuer, to an amount not greater than 5% of the value of our total assets (excluding ownership of any taxable REIT subsidiaries). Given the uncertainty regarding the tax treatment of TBAs, we will seek to limit our investment in TBAs and any other non-qualifying assets to no more than 25% of our assets at the end of any calendar quarter and will limit our investments in TBAs with a single counterparty to no more than 5% of our total assets at the end of any calendar quarter. Further, we will attempt to limit our gains from TBA transactions and any other non-qualifying income to no more than 25% of our gross income for each calendar year. Accordingly, our ability to invest in TBAs utilizing dollar roll transactions could be limited.
We could be subject to a penalty tax or we could fail to qualify as a REIT if (i) the value of our TBAs, together with our other non-qualifying assets for the 75% asset test, exceeded 25% of our gross assets at the end of any calendar quarter or if the value of our investments in TBAs with a single counterparty exceeded 5% of our total assets at the end of any calendar quarter or (ii) our income and gains from the disposition of TBAs, together with our other non-qualifying income for the 75% gross income test, exceeded 25% of our gross income for any taxable year. Any such penalty tax or failure to qualify as a REIT could adversely affect our business operations, financial condition or results of operations.
For REIT test purposes, we treat repurchase agreement transactions as financing of the investments pledged as collateral. If the IRS disagrees with this treatment our ability to qualify as a REIT could be adversely affected.
Repurchase agreement financing arrangements are structured legally as a sale and repurchase whereby we sell certain of our investments to a counterparty and simultaneously enter into an agreement to repurchase these securities at a later date in exchange for a purchase price. Economically, these agreements are financings which are secured by the investments sold pursuant thereto. We believe that we would be treated for REIT asset and income test purposes as the owner of the securities that are the subject of any such sale and repurchase agreement, notwithstanding that such agreement may legally transfer record ownership of the securities to the counterparty during the term of the agreement. It is possible, however, that the IRS could assert that we did not own the securities during the term of the sale and repurchase agreement, in which case we could fail to qualify as a REIT.
Even if we remain qualified as a REIT, we may face other tax liabilities that reduce our cash flow and our profitability.
Even if we remain qualified for taxation as a REIT, we may be subject to certain federal, state and local taxes on our income and assets, including taxes on any undistributed income, tax on income from some activities conducted as a result of a
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foreclosure or considered prohibited transactions under the Code, and state or local income taxes. Any of these taxes would decrease cash available for distribution to our shareholders. In addition, in order to meet the REIT qualification requirements, or to avert the imposition of a 100% tax that applies to certain gains derived by a REIT from prohibited transactions, we may hold some of our assets through a taxable REIT subsidiary (“TRS”) or other subsidiary corporations that will be subject to corporate-level income tax at regular rates to the extent that such TRS does not have an NOL carryforward. Any of these taxes would decrease cash available for distribution to our shareholders.
Recognition of excess inclusion income by us could have adverse consequences to us or our shareholders.
Certain of our securities have historically generated excess inclusion income and may continue to do so in the future. Certain categories of shareholders, such as foreign shareholders eligible for treaty or other benefits, shareholders with NOLs, and certain tax-exempt shareholders that are subject to unrelated business income tax, could be subject to increased taxes on a portion of their dividend income from us that is attributable to excess inclusion income. In addition, to the extent that our stock is owned by tax-exempt “disqualified organizations,” such as certain government-related entities and charitable remainder trusts that are not subject to tax on unrelated business income, we may incur a corporate level tax on a portion of our income. In that case, we may reduce the amount of our distributions to any disqualified organization whose stock ownership gave rise to the tax.
The stock ownership limit imposed by the Code for REITs and our Restated Articles of Incorporation (“Articles of Incorporation”) may restrict our business combination opportunities. The stock ownership limitation may also result in reduced liquidity in our stock and may result in losses to an acquiring shareholder.
To qualify as a REIT under the Code, not more than 50% in value of our outstanding stock may be owned, directly or indirectly, by five or fewer individuals (as defined in the Code to include certain entities) at any time during the last half of each taxable year. Our Articles of Incorporation, with certain exceptions, authorize our Board of Directors to take the actions that are necessary and desirable to qualify as a REIT. Pursuant to our Articles of Incorporation, no person may beneficially or constructively own more than 9.8% of our capital stock (including our common stock, or any Series of our Preferred Stocks). Our Board of Directors may grant an exemption from this 9.8% stock ownership limitation, in its sole discretion, subject to such conditions, representations and undertakings as it may determine are reasonably necessary. Our Board of Directors has waived this ownership limitation with respect to FMR LLC. Per the terms of the waiver, FMR LLC may own up to 20% of our outstanding capital stock.
Whether we would waive the ownership limitation for any other shareholder will be determined by our Board of Directors on a case by case basis. Our Articles of Incorporation’s constructive ownership rules are complex and may cause the outstanding stock owned by a group of related individuals or entities to be deemed as constructively owned by one individual or entity. As a result, the acquisition of less than these percentages of the outstanding stock by an individual or entity could cause that individual or entity to own constructively in excess of these percentages of the outstanding stock and thus be subject to the ownership limit. The Board of Directors has the right to refuse to transfer any shares of our capital stock in a transaction that would result in ownership in excess of the ownership limit. In addition, we have the right to redeem shares of our capital stock held in excess of the ownership limit.
The ownership limits imposed by the tax law are based upon direct or indirect ownership by “individuals,” but only during the last half of a tax year. The ownership limits contained in our Articles of Incorporation apply to the ownership at any time by any “person,” which includes entities, and are intended to assist us in complying with the tax law requirements and to minimize administrative burdens. However, these ownership limits might also delay or prevent a transaction or a change in our control that might involve a premium price for our stock or otherwise be in the best interest of our shareholders.
The stock ownership limit imposed by the Code for REITs and our Articles of Incorporation may impair the ability of holders to convert shares of our outstanding preferred stock into shares of our common stock upon a change of control.
The terms of our outstanding preferred stock provide that, upon occurrence of a change of control (as defined in the Articles of Incorporation), each holder of our outstanding preferred stock will potentially have the right to convert in conjunction with a change in control all or part of such outstanding preferred stock held by such holder into a number of shares of our common stock per share of outstanding preferred stock, respectively, based on formulas set forth in our Articles of Incorporation. However, the stock ownership restrictions in our Articles of Incorporation also restrict ownership of shares of our outstanding preferred stock. As a result, no holder of outstanding preferred stock will be entitled to convert such stock into our common stock to the extent that receipt of our common stock would cause the holder to exceed the ownership
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limitations contained in our Articles of Incorporation, endanger the tax status of one or more real estate mortgage investment conduits in which we have or plan to have an interest, or result in the imposition of a direct or indirect penalty tax on us. These provisions may limit the ability of a holder of outstanding preferred stock to convert shares of preferred stock into our common stock upon a change of control, which could adversely affect the market price of shares of our outstanding preferred stock.
If we fail to abide by certain Commodity Futures Trading Commission (“CFTC”) rules and regulations, we may be subject to enforcement action by the CFTC.
On December 7, 2012, the CFTC’s Division of Swap Dealer and Intermediary Oversight (the “Division”) issued no-action relief from commodity pool operator (“CPO”) registration to mortgage REITs that use CFTC-regulated products (“commodity interests”) and that satisfy certain enumerated criteria. Pursuant to the no-action letter, the Division will not recommend that the CFTC take enforcement action against a mortgage REIT if its operator fails to register as a CPO, provided that the mortgage REIT (i) submits a claim to take advantage of the relief and (ii) the mortgage REIT: (a) limits the initial margin and premiums required to establish its commodity interest positions to no greater than 5% of the fair market value of the mortgage REIT’s total assets; (b) limits the net income derived annually from its commodity interest positions, excluding the income from commodity interest positions that are “qualifying hedging transactions,” to less than 5% of its annual gross income; (c) does not market interests in the mortgage REIT to the public as interests in a commodity pool or otherwise in a vehicle for trading in the commodity futures, commodity options or swaps markets; and (d) either: (A) identified itself as a “mortgage REIT” in Item G of its last U.S. income tax return on Form 1120-REIT; or (B) if it has not yet filed its first U.S. income tax return on Form 1120-REIT, it discloses to its shareholders that it intends to identify itself as a “mortgage REIT” in its first U.S. income tax return on Form 1120-REIT.
We believe that we have complied with all of the requirements set forth above as of December 31, 2020. If we fail to satisfy the criteria set forth above, or if the criteria change, we may become subject to CFTC regulation or enforcement action, the consequences of which could have a material adverse effect on our financial condition or results of operations.
OTHER RISK FACTORS RELATED TO OUR BUSINESS
Impacts from COVID-19may continue to adversely affect market conditions which in turn could further impact our business, financial condition, liquidity and results of operations. Furthermore, we cannot predict the effect that government policies, laws, and plans adopted in response to the COVID-19 outbreak or other future outbreaks involving highly infectious or contagious diseases and resulting recessionary economic conditions will have on us.
The COVID-19 pandemic caused significant volatility and disruption in the economy and financial markets both globally and in the United States, including as a result of efforts to contain and mitigate the spread of COVID-19. Significant uncertainty remains as to the continued severity of the COVID-19 pandemic and its impact on the domestic and global economy and financial markets. If COVID-19 continues to spread, efforts to contain COVID-19 are unsuccessful, or the United States experiences another highly infectious or contagious disease in the future, our business, financial condition, liquidity and results of operations could be materially and adversely affected. The ultimate severity and duration of such effects will depend on future developments that are highly uncertain and difficult to predict, including the geographic spread of the disease, the overall severity of the disease, the duration of the outbreak, the measures that may be taken by various governmental authorities in response to the outbreak (such as quarantines and travel restrictions), scientific and medical developments, particularly including the efficacy and distribution of vaccines, and the possible further impacts on the national and global economies. The continued spread of COVID-19, or an outbreak of another highly infectious or contagious disease in the future, could also negatively impact the availability of key personnel necessary to conduct our business.
The COVID-19 outbreak and certain of the actions taken to reduce the spread of the disease, based both on governmental mandates and recommendations and individual behavior patterns - including restrictions on travel, restrictions on the ability of individuals to assemble in groups, restrictions on the ability of certain businesses to operate, emergency legislative and regulatory responses, and mandatory and voluntary “social distancing” practices by individuals and businesses - have resulted in lost business revenue, rapid and significant increases in unemployment, and changes in employer and consumer behavior, all of which have materially and adversely affected economic conditions in the U.S. and globally. These adverse effects of the COVID-19 pandemic on the economy may continue or worsen throughout the course of the outbreak. Future outbreaks involving other highly infectious or contagious diseases could have similar adverse effects.
Government policies, laws, and plans intended to address the COVID-19 outbreak and adverse developments in the credit, financial, and mortgage markets may not be effective, sufficient, or have any positive impact on the economy, the
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credit, financial and mortgage markets, or our business. Moreover, certain actions taken by U.S. or other governmental authorities that are intended to ameliorate the macroeconomic effects of COVID-19 or an outbreak due to any highly infectious or contagious disease in the future could harm our business.
As part of the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act passed by the U.S. Congress, both Fannie Mae and Freddie Mac have implemented mortgage forbearance policies that allow borrowers to delay their mortgage payments for up to 15 months and have placed a moratorium on foreclosures on certain types of residential mortgages through March 31, 2021. Individual states also have adopted or may adopt forbearance policies addressing loan payments, rent payments, foreclosures and evictions. These policies may impact our investments in many ways, some that are foreseeable, others that are not. The impact of high levels of forbearance on our MBS could range from immaterial to significant depending upon not only actual losses incurred on underlying loans but also future public policy choices and actions by the GSEs, their regulator the FHFA, the Federal Reserve, and federal and state governments. The nature and timing of any such future public policy choices and actions are unpredictable, including the potential impact on MBS prices and prepayment speeds.
Due to the federal and state recommendations issued and mandates implemented to control the spread of COVID-19, the vast majority of our personnel, as well as the third-party service providers that provide services to us, are working remotely. If these personnel are unable to work effectively as a result of the COVID-19 outbreak, including because of illness, quarantines, office closures, ineffective remote work arrangements, or technology failures or limitations, our operations would be adversely impacted. Further, remote work arrangements may increase the risk of cybersecurity incidents and cyber-attacks on us or our third-party service providers, which could have a material adverse effect on our business and results of operations, due to, among other things, the loss of investor or proprietary data, interruptions or delays in the operation of our business, and damage to our reputation.
The replacement of LIBOR with an alternative reference rate may adversely affect our profitability, liquidity, and financial condition.
The United Kingdom’s Financial Conduct Authority (“FCA”) has announced that it will phase out LIBOR as a benchmark by the end of 2021. The FCA and other official sector bodies have strongly advised end-users of the need to transition from LIBOR by December 31, 2021. On November 30, 2020, the ICE Benchmark Administration Limited (“IBA”), the administrator of the LIBOR, announced that it would consult on its plan to cease the publication of one-week and two-month LIBOR immediately after December 31, 2021 and to cease the publications of the remaining tenors of LIBOR (one, three, six, and 12-month) immediately after June 30, 2023. The Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Company also issued a statement to encourage banks to transition away from LIBOR as soon as practicable. It is unclear whether new methods of calculating LIBOR will be established such that it continues to exist after 2021. If LIBOR ceases to exist, we will need to amend or terminate certain of our agreements referencing LIBOR rates. Our repurchase agreement borrowings generally carry a rate of interest based on short-term rate indices that have historically closely tracked LIBOR. Additionally, the terms of our outstanding shares of 6.900% Series C Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock (“Series C Preferred Stock”) reference LIBOR rates but contain fallback provisions that would apply in the event that LIBOR rates are no longer calculated and published. The phasing out of LIBOR could impact short-term market rates in general which could potentially increase the cost of our repurchase agreement borrowings. The impact of phasing out LIBOR on these and other financial instruments is uncertain and may negatively impact their value, liquidity or effectiveness. The transition to an alternative rate will require careful and deliberate consideration and implementation so as not to disrupt the stability of financial markets. There is no guarantee that a transition from LIBOR to an alternative will not result in, among other things, financial market disruptions, significant increases in benchmark rates, or short-term interest rates, any of which could have an adverse effect on our profitability, liquidity, and financial condition.
We may change our investment strategy, operating policies, dividend policy, and/or asset allocations without shareholder consent and/or in a manner in which shareholders, analysts, and capital markets may not agree, which could adversely affect our financial condition, results of operations, the market price of our common stock, and our ability to pay dividends to our shareholders.
A change in our investment strategy or asset allocation may materially change our exposure to interest rate and/or credit risk, default risk and real estate market fluctuations. These changes could have a material impact on our ability to continue to pay a dividend at a level that we had previously paid before the change in strategy. Furthermore, if any change in investment strategy, asset allocation, operating or dividend policy is perceived negatively by the markets or analysts covering our stock, our stock price may decline. Part of our investment strategy includes deciding whether to reinvest payments
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received on our existing investment portfolio. Based on market conditions, our leverage, and our liquidity profile, we may decide to not reinvest the cash flows we receive from our investment portfolio. If we retain, rather than reinvest, these cash flows, the size of our investment portfolio and the amount of net interest income generated by our investment portfolio will likely decline. In addition, if the assets we acquire in the future earn lower yields than the assets we currently own, our reported earnings per share will likely decline over time as the older assets pay down or are sold.
Competition may prevent us from acquiring new investments at favorable yields, and we may not be able to achieve our investment objectives which may potentially have a negative impact on our profitability.
Our net interest income, net income and comprehensive income will largely depend on our ability to acquire mortgage-related assets with acceptable risk-return profiles at favorable spreads over our borrowing costs. The availability of mortgage-related assets meeting our investment criteria depends upon, among other things, the level of activity in the real estate market and the quality of and demand for securities in the mortgage securitization and secondary markets. The size and level of activity in real estate lending markets depends on various factors, including interest rates, regional and national economic conditions, and real estate values. In acquiring investments, we compete with other purchasers of these types of investments, including but not limited to other mortgage REITs, broker-dealers, hedge funds, banks, insurance companies, mutual funds, GSEs including federal home loan banks and other entities that purchase assets similar to ours. In addition, beginning in March 2020, as a result of economic factors related to the COVID-19 outbreak, the Federal Reserve Bank resumed purchases of Agency RMBS and began purchasing Agency CMBS. Many of these competing entities have greater resources and access to lower cost capital. Because of these factors, we may not be able to acquire sufficient assets at acceptable yields over our borrowing costs, which would adversely affect our profitability.
We are highly dependent on information and communication systems and third parties, and systems failures or cybersecurity incidents could significantly disrupt our business or lead to significant losses, which may, in turn, negatively affect the market price of our common and preferred stocks and our ability to operate our business.
Our business is highly dependent on communications and information systems particularly as it relates to the custodians of our investments and our lenders. Any failure or interruption of our communication or information systems, or any cyber-attack or security breach of our networks or systems, could cause delays or other problems in our trading or borrowing activities, including MBS trading and repurchase agreement borrowing activities, or could lead to unauthorized trading activity, any of which could have a significant adverse effect on our financial condition or results of operations. A disruption or breach could also lead to unauthorized access to and release, misuse, loss or destruction of our confidential information or personal or confidential information of our employees or third parties, which could lead to regulatory fines, costs of remediating the breach, reputational harm, and fewer third parties that are willing to conduct business with us. In addition, we also face the risk of operational failure, termination or capacity constraints of any of the third parties with which we do business or that facilitate our business activities, including custodians, clearing agents or other financial intermediaries we use to facilitate our securities transactions, if their respective communication or information systems experience failure, interruption, cyber-attacks, or security breaches. We may face increased costs as we continue to evolve our cyber defenses in order to contend with changing risks and to monitor our systems for cyber-attacks and security threats. These costs and losses associated with these risks are difficult to predict and quantify and could have a significant adverse effect on our results of operations.
Computer malware, viruses, computer hacking. and phishing attacks have become more prevalent and may occur on our systems. Even with all reasonable security efforts, not every breach can be prevented or even detected. Though we have not detected a material cybersecurity breach to date, there is no assurance that we, or the third parties that facilitate our business activities, have not or will not experience a breach. It is difficult to determine what, if any, negative impact may directly result from any specific interruption or cyber-attacks or security breaches of our networks or systems (or the networks or systems of third parties that facilitate our business activities) or any failure to maintain performance, reliability and security of our technical infrastructure, but such computer malware, viruses, and computer hacking and phishing attacks may negatively affect our operations. We rely heavily on our financial, accounting and other data processing systems, and any failure to maintain performance, reliability and security of these systems and our other technical infrastructure could have a significant adverse effect on our financial condition or results of operations.
Furthermore, because substantially all of our employees are working remotely from their homes due to the COVID-19 pandemic, there is an increased risk of disruption to our operations because they are utilizing residential networks and infrastructure which may not be as secure as in our office environment.

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ITEM 1B.    UNRESOLVED STAFF COMMENTS
None.

ITEM 2.    PROPERTIES
The Company does not own or lease any physical properties that are material to its business, financial condition or results of operations.

ITEM 3.    LEGAL PROCEEDINGS
As previously disclosed in the Company’s 2019 Form 10-K, the Company and DCI Commercial, Inc. (“DCI”), a former affiliate of the Company and formerly known as Dynex Commercial, Inc., were defendants in litigation filed by Basic Capital Management, Inc., et al. (the “DCI Plaintiffs”) regarding the activities of DCI while it was an operating subsidiary of an affiliate of the Company (the “DCI Litigation”). Final judgment in the principal amount of $46.5 million, including damages of $25.6 million and attorneys' fees and post-judgment interest of $20.9 million, was entered in the DCI Litigation against DCI (the “DCI Judgment”) in 2015. The DCI Plaintiffs filed suit in Texas state court against the Company seeking to recover from the Company the $46.5 million under legal theories of fraudulent transfer and alter ego. The case was removed to the U.S. District Court, Northern District of Texas (the “Northern District Court”). The Northern District Court twice dismissed without prejudice the DCI Plaintiffs’ claims against the Company for failure to state a claim under Federal Rule of Civil Procedure 12(b)(6), and granted the DCI Plaintiffs two opportunities to replead. On October 28, 2019, the Northern District Court dismissed with prejudice the DCI Plaintiffs’ fraudulent transfer claims as untimely under the statute of repose and their alter ego claim based on res judicata. The Northern District Court also denied the DCI Plaintiffs’ requests for exemplary damages and attorneys’ fees. On December 2, 2019, the Northern District Court entered a final judgment that the DCI Plaintiffs “take nothing” on their claims against the Company “and that those claims are dismissed with prejudice.” The DCI Plaintiffs filed a Notice of Appeal to the United States Court of Appeals for the Fifth Circuit (the “Fifth Circuit”) on November 25, 2019. Following briefing and oral argument, on October 2, 2020 the Fifth Circuit affirmed the dismissal of the DCI Plaintiffs’ fraudulent transfer and alter ego claims by the Northern District Court. The DCI Plaintiffs did not file for a rehearing with the Fifth Circuit or request a hearing before the U.S. Supreme Court within the allowed timeframe and the Company considers this matter closed.
Also as previously disclosed in the Company’s 2019 Form 10-K, the receiver for one of the DCI Plaintiffs (the “Receiver”) in the DCI Litigation filed a separate claim (the "Receiver Litigation") in May 2018 against the Company seeking payment of $11.3 million in connection with the DCI Judgment, alleging that the Company breached a litigation cost sharing agreement, as amended (the “Cost Sharing Agreement”), entered into initially in December 2000 between the Company and DCI. The case is pending in the Northern District Court. On November 21, 2019, the Northern District Court granted in part and denied in part summary judgment on the Receiver’s claim and the Company’s claim for offset and recoupment. The Northern District Court found that the Company breached the Cost Sharing Agreement and therefore must pay damages to the Receiver. The Northern District Court simultaneously granted the Company’s motion for summary judgment finding that DCI also breached the Cost Sharing Agreement and that the Company can recover amounts due to it from DCI under the Cost Sharing Agreement. The Northern District Court ordered the parties to submit evidence supporting their damages claimed by January 10, 2020. The Receiver subsequently filed a claim for damages with the Northern District Court of $12.6 million, while the Company filed claims for damages ranging from $13.3 million to $30.6 million, including interest. The Receiver filed objections (the "Objections") with the Northern District Court to, among other things, the Company recovering amounts incurred prior to entry into the Cost Sharing Agreement and amounts incurred under the Cost Sharing Agreement after January 31, 2006, including interest, which is the date that DCI’s corporate existence ceased under Virginia law. The Company subsequently objected to $0.3 million of the Receiver’s claim related to attorneys' fees incurred by the Receiver which the Company asserts is not collectible under Virginia law. The Company has further disputed the Receiver's Objections as not supportable under Virginia law, and has further refined its damages claim to $16.0 million based on simple interest and $22.8 million based on a combination of simple and compound interest as of December 31, 2020, which the Company believes is supportable under Virginia law. Both claim amounts include $1.3 million plus accrued interest for the advancement of attorneys' fees to DCI in 1999 and 2000 in connection with the DCI Litigation prior to the effective date of the Cost Sharing Agreement. There were no material developments during the year ended December 31, 2020.
24


The Company records a contingent liability when, in the opinion of management, the likelihood of loss is probable and the amount of the loss can be reasonably estimated. After consultation with litigation counsel, the Company believes, based upon information currently available and its evaluation of applicable state law that the likelihood of loss in connection with the Receiver Litigation is not probable, and given the range of potential claims for damages by the Company to offset the Receiver's claims, the amount of possible loss in the Receiver Litigation cannot be reasonably estimated and, therefore, no contingent liability has been recorded for either matter.
The Company believes that the Receiver Litigation will be resolved without a material adverse effect on the Company’s consolidated financial statements as a whole. The outcome, however, of any legal proceeding, including this matter, cannot be predicted with certainty. As such, no assurances can be given that the Company will be successful in its defense of this action on the merits or otherwise. If the Company is not successful in its defense efforts, the resolution of this matter could have a material adverse effect on the Company’s consolidated financial statements in a future reporting period.
Other than as described above, to the Company’s knowledge, there are no pending or threatened legal proceedings, the resolution of which, in management’s opinion, individually or in the aggregate, could have a material adverse effect on the Company’s results of operations or financial condition.

ITEM 4.    MINE SAFETY DISCLOSURES
None.
25


PART II.


ITEM 5.    MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is traded on the NYSE under the trading symbol “DX”. The common stock was held by approximately 340 holders of record as of February 24, 2021. On that date, the closing price of our common stock on the NYSE was $18.99 per share. The Company currently pays a monthly dividend on its common stock. When declaring dividends, the Board of Directors considers the requirements for maintaining our REIT status and maintaining compliance with dividend requirements of the Series C Preferred Stock. In addition, the Board considers, among other things, the Company's long-term outlook, the Company’s financial condition and results of operations during recent financial periods, and trends in the investment and financing markets.
The following graph is a five-year comparison of shareholders’ cumulative total return, assuming $100 invested at the close of trading on December 31, 2015 with reinvestment of all dividends, in each of: i) our common stock, ii) the stocks included in the Standard & Poor’s 500 Index (“S & P 500”); iii) the stocks included in the S&P 500 Financials Index; iv) the stocks included in the FTSE NAREIT Mortgage REIT Index; v) the stocks included in the Bloomberg Mortgage REIT Index; and vi) the stocks included in SNL U.S. Finance REIT Index. The Company is adding the S & P 500 Financials Index because it is a broad index of stocks of companies in the financial sector. The Company is replacing the Bloomberg Mortgage REIT Index with the FTSE NAREIT Mortgage REIT Index because we believe the latter is more useful as a benchmark for peer comparison. In addition, the Company will no longer be using the SNL U.S. Finance REIT Index in this comparison as this index will no longer be published by S & P Global.

dx-20201231_g1.jpg

26


Cumulative Total Stockholder Returns as of December 31,
Index (1)
201520162017201820192020
Dynex Capital, Inc. Common Stock$100.00 $121.23 $137.86 $126.14 $140.20 $164.05 
S&P 500 Index$100.00 $111.95 $136.38 $130.39 $171.44 $200.51 
S&P 500 Financials Index$100.00 $122.75 $149.93 $130.38 $172.21 $169.18 
FTSE NAREIT mREIT Index$100.00 $122.83 $147.16 $143.32 $173.81 $141.53 
Bloomberg Mortgage REIT Index$100.00 $122.27 $147.05 $142.77 $176.50 $137.41 
SNL U.S. Finance REIT Index$100.00 $123.18 $143.73 $138.16 $166.58 $135.75 
(1) The sources of this information are Bloomberg and SNL Financial.

The historical information set forth above is not necessarily indicative of future performance. Accordingly, we do not make or endorse any predictions as to future share performance.
The Company’s Board of Directors has authorized the repurchase up to $40 million of the Company’s outstanding shares of common stock through March 31, 2022. Subject to applicable securities laws and the terms of the Series C Preferred Stock designation, which is contained in our Articles of Incorporation, future repurchases of common stock will be made at times and in amounts as the Company deems appropriate, provided that the repurchase price per share is less than the Company's estimate of the current net book value of a share of common stock. Repurchases may be suspended or discontinued at any time. The Company did not repurchase any shares during the three months ended December 31, 2020.
The Company has an at-the-market agreement ("ATM") whereby the Company may offer and sell through its sales agents up to $104.6 million of aggregate value of shares of the Company’s 7.625% Series B Cumulative Redeemable Preferred Stock (“Series B Preferred Stock”) and Series C Preferred Stock. During the year ended December 31, 2020, the Company did not issue any shares of its Series B or Series C Preferred Stock through its ATM program. The Company also has an ATM agreement whereby the Company may offer and sell through its sales agents up to approximately 8.3 million shares of common stock. During the year ended December 31, 2020, the Company issued 553,364 shares of its common stock through its ATM program at an aggregate value of $9.9 million, net of $0.1 million in broker commissions, all of which were issued during the three months ended December 31, 2020.

ITEM 6.    SELECTED FINANCIAL DATA
Omitted pursuant to amendments to Regulation S-K Item 301 that eliminated the requirement to disclose selected financial data.


ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our financial statements and the related notes included in Item 8, "Financial Statements and Supplementary Data” in this Annual Report on Form 10-K.
This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors including, but not limited to, those disclosed in Item 1A, “Risk Factors” elsewhere in this Annual Report on Form 10-K and in other documents filed with the SEC and otherwise publicly disclosed. Please refer to “Forward-Looking Statements” contained within this Item 7 for additional information. This discussion also contains non-GAAP financial measures, which are discussed further below in the section “Non-GAAP Financial Measures”.
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 Item 1 of Part I of this Annual Report on Form 10-K.

27


EXECUTIVE OVERVIEW
Though 2020 began with an improved interest rate environment for our business and industry as a whole, the impact of the global response to the coronavirus (“COVID-19”) pandemic on the financial markets resulted in unprecedented market disruption. Treasury yields moved sharply lower during the first quarter, a trend which continued throughout 2020 until moving higher later in the year as the U.S. Food and Drug Administration’s approvals of coronavirus vaccines were announced. During the first and second quarters of 2020, economic conditions contracted sharply, and the prices of risk assets declined dramatically as market participants sought liquidity to protect their capital and meet margin calls. In response, the Federal Reserve rapidly reduced the targeted Federal Funds rate and expanded its holdings of U.S. Treasuries and Agency RMBS to support the normal functioning of those markets while other central banks around the globe added liquidity to financial markets. In addition, the U.S. Congress passed the CARES Act to provide economic relief to individuals, businesses, state and local governments, and the health care system. The combination of market interventions by the Federal Reserve and other central banks and the passing of the CARES Act helped to stabilize markets over the balance of the year. Credit spreads and pricing on risk assets also improved throughout the year.
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 December 31, 2019:
Investment Type:12/31/20209/30/20206/30/20203/31/202012/31/2019
Agency RMBS: (1)
2.0% coupon(1)36 54 — 
2.5% coupon(2)(2)30 30 
3.0% coupon36 35 32 30 
3.5% coupon28 30 30 34 37 
4.0% coupon51 64 48 27 49 
Agency DUS (Agency CMBS) (2)
36 45 58 95 60 
Freddie K AAA IO (Agency CMBS IO) (2)
140 180 275 400 135 
AAA CMBS IO (Non-Agency CMBS IO) (2)
165 190 300 450 113 
(1) Option adjusted spreads for RMBS are Company estimates using third-party models and market data. UMBS 2.0% coupon was not available in the model until the first quarter of 2020.
(2) Data represents the spread to swap rate on newly issued securities and is sourced from JP Morgan.
The charts below show the highest and lowest U.S. Treasury and swap rates during the year ended December 31, 2020 as well as the rates as of December 31, 2020 and December 31, 2019:    
dx-20201231_g2.jpg




dx-20201231_g3.jpg

Our 2020 Performance
For 2020, we generated a total economic return of 15.2% for our common shareholders, which consisted of $1.66 in common dividends declared and an increase of $1.07 in book value per common share to $19.08 as of December 31, 2020. The increase in book value and our comprehensive income of $66.5 million, or $2.88 per common share, for the year ended December 31, 2020 were primarily driven by improving asset valuations as a result of the credit spread tightening and declining funding costs as a result of the reduction in the targeted Federal Funds rate mentioned above. Realized and unrealized gains from MBS and TBA securities, net of hedges were approximately $1.83 per common share, driving a large part of our comprehensive income and total economic return for the year. Our net interest income increased 14% from the year ended December 31, 2019 despite a 29% decline in the average balance of interest earning assets and a 66 basis point decline in effective yield on our assets. The increase in net interest income is due to a smaller average balance of borrowings at a lower cost of financing for 2020 versus 2019. Despite the increase in net interest income, our core net operating income to common shareholders, a non-GAAP measure, declined 9% versus 2019 primarily due to higher general and administrative and other operating expenses. In addition, though our drop income for 2020 increased $8.8 million compared to 2019, it was outpaced by a decline of $(14.5) million in net periodic interest benefit from interest rate swaps.
Dynex’s results for 2020 reflect how actively we managed our portfolio and risk position as well as the strategic allocation of our capital, which enabled us to take advantage of opportunities that arose during the evolving economic conditions discussed above. As we indicated at the beginning of 2020, we foresaw a higher risk environment building in the global financial markets, so we prepared Dynex to weather increased volatility by increasing liquidity and decreasing leverage. In early March, we strategically timed the sale of approximately 38% of our portfolio, primarily Agency RMBS, monetizing gains of $84.8 million before asset prices began to fall during the market’s initial response to the onset of the COVID-19 pandemic in the U.S. In April, we monetized additional gains of $193.1 million from sales of Agency CMBS as credit spreads on those assets had tightened relative to spreads at the time of purchase. Beginning in May, we doubled the investment portfolio balance to capture wider spreads and returns in Agency RMBS just prior to credit spread tightening in the latter half of the second quarter. These purchases combined with the sales of Agency CMBS in April shifted our asset allocation back to predominantly Agency RMBS and TBA securities. Throughout the remainder of 2020, we maintained a diversified investment portfolio, positioning the balance sheet to reap the benefit of recovering asset prices through year-end. We shifted into lower coupon specified pools of Agency RMBS in order to mitigate the impact of prepayment risk on our earnings, realizing an additional gain of $9.4 million from sales of a portion of our higher coupon Agency RMBS. We also invested in lower coupon TBA securities in order to take advantage of dollar roll specialness. As credit spreads tightened further toward the end of the year, we realized gains of $20.8 million through sales of additional Agency CMBS whose asset prices we believed were not reflecting potential cash flow disruptions that may occur over time.
The changes made to the size and composition of our investment portfolio during 2020 warranted continuous risk management, and, as a result, our portfolio of hedging instruments as of December 31, 2020 is substantially different from



that of December 31, 2019. As interest rates rallied in the first quarter of 2020 and we sold assets, and because margin requirements increased substantially on interest rate swaps, we either terminated our interest rate swap agreements or chose not to replace these agreements upon expiration. The termination of the majority of our interest rate swaps during the first quarter comprised the majority of our net loss of $182.9 million on those instruments during 2020 with those losses being more than offset by gains on the investments being hedged. Because we anticipate funding costs to remain low in the near-term due to the Federal Reserve’s indication that it will maintain the targeted Federal Funds Rate at 0% to 0.25% for an extended period of time, we have shifted our interest rate hedging strategy to focus on capital preservation. As we re-invested our capital over the balance of the year, we began using interest rate swaptions, U.S. Treasury futures, and options on U.S. Treasury futures because we believe these hedging instruments have better liquidity and more favorable margin requirements than interest rate swaps. We believe U.S. Treasury futures and options on U.S. Treasury futures protect book value from rising interest rates but minimize risk of liquidity loss if interest rates fall better than interest rate swaps. Interest rate swaptions also mitigate interest rate volatility and convexity risk, but over a longer term versus U.S. Treasury options.
Current Outlook
We believe the current investment environment is favorable, and there is potential for continuing improvement in the second half of 2021. Borrowing rates remain very low with short-term interest rates near 0% and market volatility remains somewhat muted given the historic monetary stimulus measures of the Federal Reserve. Nonetheless, we continue to maintain our discipline of planning for future economic or market surprises. The global economy is largely supported by central banks and global debt continues to increase excessively, which pushes against lower interest rates and makes markets more vulnerable to exogenous shocks. Though fiscal stimulus in the U.S. as a result of the COVID-19 pandemic has helped bolster economic activity, the efficacy and outcome of these actions are unknown, and the risk for policy mistakes remains high.
In the near term, uncertainty remains as to how quickly and efficiently the current vaccines will positively offset the negative impacts of the pandemic. In the medium term, we believe the stimulus coupled with the impact of more vaccinations will eventually lead to a period of higher growth as more of our services-driven economy is able to reboot. Longer-term, we believe the world has been permanently reshaped by the global pandemic, and its impact will continue for years across broad segments of our economy, and therefore we continue to factor its lasting impact in shaping our macroeconomic view.
Currently, we believe one of the more probable scenarios for 2021 is a steepening yield curve, which typically offers better opportunities to invest at higher yields, especially as prepayments slow. While financing costs are expected to remain at close to 0% through 2023, we believe longer-term interest rates will likely face pressure from the increased supply of U.S. Treasuries as well as possible increases in real and expected inflation as the economy begins recovery. We expect this will likely result is higher long-term Treasury yields. In addition to slower prepayments, Agency RMBS spreads typically widen in a steeper yield curve environment because of increased competition with other assets, such as higher yielding Treasuries. Furthermore, we believe realized volatility is usually higher in a steeper yield curve environment, which has the potential to further increase our rate of return.
While we believe a steepening yield curve is probable in 2021, we have planned for other potential scenarios that may unfold, including the risk of an exogenous event which we believe remains high. As a result, we continue to focus on maintaining a highly liquid position and investing in Agency MBS where the Federal Reserve is providing material support. Also, though we do not expect dollar roll specialness to continue at the same level as what we experienced in the latter half of 2020, we do expect our 2021 results to benefit from our continued investment in TBA securities, but to a lesser degree. Our leverage targets, including TBA securities, remain between 6-9 times shareholders’ equity, and we will actively increase or decrease leverage based on the risk environment and the expected rate of return on available assets. Longer term, we maintain our belief that the demographics behind the housing sector continue to support our investment thesis of investing in high quality, highly liquid U.S.-based housing assets, and we maintain our focus on capital preservation while generating returns over the long term.

Non-GAAP Financial Measures
In addition to the Company's operating results presented in accordance with GAAP, the information presented above and within Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Annual Report on Form 10-K contains the following non-GAAP financial measures: core net operating income to common shareholders (including per common share), adjusted net interest income and the related metric adjusted net interest spread.



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 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, although the Company's presentation of its non-GAAP measures may not be comparable to other similarly-titled measures of other companies. Reconciliations of core net operating income to common shareholders and adjusted net interest income to the related GAAP financial measures are provided below and within “Results of Operations”.
Management views core net operating income to common shareholders as an estimate of the Company’s financial performance based on the effective yield of its investments, net of financing costs and other normal recurring operating income/expense, net. In addition to the non-GAAP reconciliation set forth below, which derives core net operating income to common shareholders from GAAP comprehensive income (loss) to common shareholders, core net operating income to common shareholders can also be determined by adjusting net interest income to include interest rate swap periodic interest benefit/cost, drop income on TBA securities, general and administrative expenses, and preferred dividends. Drop income generated by TBA dollar roll positions, which is included in "gain (loss) on derivatives instruments, net" on the Company's consolidated statements of comprehensive income, is included in core net operating income and in adjusted net interest income because management views drop income as the economic equivalent of net interest income (interest income less implied financing cost) on the underlying Agency security from trade date to settlement date. Management also includes interest rate swap periodic interest benefit/cost, which is also included in "gain (loss) on derivatives instruments, net", in adjusted net interest income because interest rate swaps are used by the Company to economically hedge the impact of changing interest rates on its borrowing costs from repurchase agreements, and therefore represent a cost of financing in addition to GAAP interest expense. However, these non-GAAP measures do not provide a full perspective on our results of operations, and therefore, their usefulness is limited. For example, these non-GAAP measures do not include gains or losses from available-for-sale investments, changes in fair value of and costs of terminating interest rate swaps, as well as realized and unrealized gains or losses from other instruments used by management to economically hedge the impact of changing interest rates on the fair value of the Company’s portfolio and book value per common share. As a result, these non-GAAP 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.
For the Year Ended December 31,
Reconciliations of GAAP to Non-GAAP Financial Measures:202020192018
($ in thousands except per share data)
Comprehensive income (loss) to common shareholders$66,472 $43,950 $(31,860)
Less:
Change in fair value of available for sale investments(214,539)(203,995)$50,218 
Change in fair value of derivative instruments, net (1)
188,936 209,256 23,977 
(Gain) loss on investments, net(20)56 (52)
Preferred stock redemption charge3,914 — — 
Core net operating income to common shareholders$44,763 $49,267 $42,283 
Average common shares outstanding (2)
23,106,200 23,620,125 19,234,939 
Comprehensive income (loss) per common share$2.88 $1.86 $(1.66)
Core net operating income per common share (2)
$1.94 $2.09 $2.20 
GAAP net interest income$63,853 $56,057 $50,477 
Add:
TBA drop income (3)
15,067 6,231 14,686 
Net periodic interest benefit of interest rate swaps1,579 16,075 5,830 
Less: accretion of de-designated cash flow hedges (4)
— (165)(237)
Adjusted net interest income$80,499 $78,198 $70,756 
Adjusted net interest spread 1.87 %1.30 %1.48 %



(1) Amount includes unrealized gains and losses from changes in fair value of derivatives and realized gains and losses on terminated derivatives and excludes net periodic interest benefit/cost incurred on effective interest rate swaps outstanding during the period and TBA drop income.
(2) Amounts have been adjusted to reflect the effect of the 1-for-3 reverse stock split.
(3) TBA drop income is calculated by multiplying the notional amount of the TBA dollar roll positions by the difference in price between two TBA securities with the same terms but different settlement dates. The impact of TBA drop income on adjusted net interest spread includes the implied average funding cost of TBA dollar roll transactions during the periods indicated.
(4) Amount recorded as a portion of "interest expense" in accordance with GAAP related to the amortization/accretion of the balance remaining in accumulated other comprehensive loss as a result of the Company's discontinuation of cash flow hedge accounting effective June 30, 2013.


FINANCIAL CONDITION

Investment Portfolio
As of December 31, 2020, our investment portfolio is comprised mostly of Agency fixed-rate investments. Since December 31, 2019, we have shifted our investment portfolio away from Agency CMBS and as of December 31, 2020, our portfolio is predominantly comprised of Agency RMBS which offers more liquidity and in our view a more attractive risk/return profile versus Agency CMBS in the current market environment. We sold the majority of our Agency CMBS in 2020 as risk spreads declined sharply, leading to higher prices and diminishing returns on this type of investment. The following chart compares the composition of our MBS portfolio including TBA securities as of the dates indicated:
dx-20201231_g4.jpg
(1) Includes TBA positions at their implied market value as if settled which are accounted for as “derivative assets (liabilities)” on our consolidated balance sheet.
(2) Total includes other non-Agency MBS investments of $1.3 million and $1.7 million for the respective periods shown.

RMBS. As noted in the table below, as of December 31, 2020, we are invested in lower coupon investments to mitigate the risk of loss of premiums due to early prepayment given the lower interest rate environment in 2020 while keeping a modest allocation to specified pools of 4.0% coupon as protection in case interest rates rise. Our lower coupon investments also have lower premiums relative to higher coupon assets which further protects our earnings when prepayments occur. Additionally, since December 31, 2019, we have increased our investment in TBA securities, including 15-year fixed-rate TBA, as implied financing rates for dollar roll transactions have been lower than the financing rates for



repurchase agreement borrowings we typically use to finance specified pools. Because TBA securities have higher relative liquidity, these transactions allow more flexibility should we decide or find it necessary to reduce leverage.

The following tables compare our fixed-rate Agency RMBS investments including TBA dollar roll positions as of the dates indicated:
December 31, 2020
Par/Notional-Long (Short)
Amortized Cost/
Implied Cost
Basis (1)(3)
Fair
Value (2)(3)
Weighted Average
Coupon
Loan Age
(in months)(4)
3 Month
CPR (4)(5)
Estimated Duration (6)
30-year fixed-rate:($ in thousands)
TBA 2.0%$765,000 $789,945 $792,957 n/an/a4.89
2.0%620,238 635,096 646,744 87.7 %5.31
2.5%938,334 973,116 995,889 1013.5 %3.53
4.0%280,474 288,831 303,758 3346.8 %2.48
15-year fixed-rate:
TBA 1.5%250,000 255,068 257,305 n/an/a4.73
TBA 2.0%500,000 519,047 522,687 n/an/a3.09
Total$3,354,046 $3,461,103 $3,519,340 1317.1 %4.10 

December 31, 2019
Par/Notional-Long (Short)
Amortized Cost/
Implied Cost
Basis (1)(3)
Fair
Value (2)(3)
Weighted Average
Coupon
Loan Age
(in months)(4)
3 Month
CPR (4)(5)
Estimated Duration (6)
30-year fixed-rate:($ in thousands)
2.5%$110,610 $109,341 $109,409 — %5.15 
3.0%307,380 310,486 314,159 25 9.4 %4.04 
3.5%538,551 549,735 562,921 11 10.9 %2.64 
4.0%1,352,730 1,384,913 1,429,547 20 23.5 %2.28 
4.5%254,413 264,979 272,037 13 29.9 %1.55 
TBA 2.5%135,000 133,059 133,513 n/an/a5.10 
TBA 3.0%300,000 308,268 308,648 n/an/a1.90 
TBA 4.0%(500,000)(519,143)(520,117)n/an/a1.28 
Total $2,498,684 $2,541,638 $2,610,117 17 18.9 %2.91 
(1) Implied cost basis of TBAs represents the forward price to be paid (received) for the underlying Agency MBS.
(2) Fair value of TBAs is the implied market value of the underlying Agency security as of the end of the period.
(3) TBAs are included on the consolidated balance sheet within “derivative assets/liabilities” at their net carrying value which is the difference between their implied market value and implied cost basis. Please refer to Note 5 of the Notes to the Consolidated Financial Statements for additional information.
(4) TBAs are excluded from this calculation as they do not have a defined weighted-average loan balance or age until mortgages have been assigned to the pool.
(5) Constant prepayment rate (“CPR”) represents the 3-month CPR of Agency RMBS held as of date indicated. Securities with no prepayment history are excluded from this calculation.
(6) Duration measures the sensitivity of a security's price to the change in interest rates and represents the percent change in price of a security for a 100-basis point increase in interest rates. We calculate duration using third-party financial
33


models and empirical data. Different models and methodologies can produce different estimates of duration for the same securities.
CMBS. During the second and third quarters of 2020, we sold a substantial portion of our Agency CMBS, realizing gains on investments on which credit spreads had tightened and for which we believed risks of continued investment outweighed potential returns. The overall composition of the CMBS in our investment portfolio has shifted to more seasoned investments with a higher probability of appreciation in the underlying collateral versus newer issue bonds.
The following table presents information about our CMBS investments by year of origination as of the dates indicated:
December 31, 2020December 31, 2019
($ in thousands)Par ValueAmortized Cost
Months to Estimated Maturity (1)
WAC (2)
Par ValueAmortized Cost
Months to Estimated Maturity (1)
WAC (2)
Year of Origination:
Prior to 2009$9,132 $8,964 365.69 %$13,441 $13,080 305.74 %
2009 to 201211,424 12,085 655.56 %28,141 29,153 344.99 %
2013 to 20149,865 10,033 443.61 %11,294 11,528 593.65 %
2015155,760 157,137 692.85 %175,219 177,023 872.86 %
2016— — — %19,910 19,742 1092.62 %
201730,907 31,294 913.18 %340,638 342,158 1013.07 %
2018— — — %330,180 329,984 1273.68 %
201919,702 19,988 1513.12 %972,646 983,435 1343.27 %
$236,790 $239,501 773.19 %$1,891,469 $1,906,103 1203.30 %
(1) Months to estimated maturity is an average weighted by the amortized cost of the investment.
(2) The weighted average coupon (“WAC”) is the gross interest rate of the security weighted by the outstanding principal balance.

CMBS IO. The following table presents our CMBS IO investments by year of origination as of the periods indicated:

December 31, 2020
AgencyNon-Agency
($ in thousands)Amortized CostFair Value
Remaining WAL (1)
Amortized CostFair Value
Remaining WAL (1)
Year of Origination:
2010-2012$12,037 $11,932 $3,237 $3,263 
201322,367 24,165 13 10,875 10,912 15 
201424,841 25,749 22 50,777 51,175 20 
201531,875 33,404 26 53,176 54,020 27 
201623,072 24,203 31 16,705 16,906 16 
201726,493 27,952 42 7,733 7,808 34 
20183,792 3,983 62 — — — 
201988,757 91,303 60 — — — 
20203,203 3,264 53 — — — 
$236,437 $245,955 39 $142,503 $144,084 24 

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December 31, 2019
AgencyNon-Agency
($ in thousands)Amortized CostFair Value
Remaining WAL (1)
Amortized CostFair Value
Remaining WAL (1)
Year of Origination:
2010-2012$27,610 $27,609 12 $7,710 $7,869 11 
201335,794 37,047 16 16,401 16,629 19 
201434,077 35,027 25 68,811 69,886 24 
201541,549 42,987 29 66,954 69,062 30 
201627,956 28,891 35 20,065 20,442 36 
201730,409 31,633 46 9,304 9,529 38 
20184,117 4,287 66 — — — 
201997,388 98,144 64 — — — 
$298,900 $305,625 40 $189,245 $193,417 27 
(1) Remaining weighted average life (“WAL”) represents an estimate of the number of months of contractual cash flows remaining for the investments by year of origination.

The weighted average interest rate for our CMBS IO was 0.56% as of December 31, 2020 and 0.65% as of December 31, 2019.
Effective yields on CMBS IO securities are dependent upon the performance of the underlying loans. Our return on these investments may be negatively impacted if the loans default, resulting in foreclosures, or liquidations of the loan collateral. Non-Agency-issued securities are generally expected to have a higher risk of default than Agency CMBS IO. We are mostly invested in senior tranches of these securities where we have evaluated the credit profile of the underlying loan pool and can monitor credit performance in order to mitigate our exposure to losses. The majority of our non-Agency CMBS IO investments are investment grade-rated with the majority rated ‘AAA’ by at least one of the nationally recognized statistical rating organizations. All of our non-Agency CMBS IO were originated prior to 2017, the majority of which we believe have had underlying property value appreciation.
Since the economic impacts of COVID-19 began in March, servicers are reporting an increase in delinquencies on loans underlying our non-Agency CMBS IO and have taken loss mitigation actions including loan forbearance or allowing the borrower to make loan payments using replacement reserve or similar property related funds. Most of the increases in delinquencies thus far have been in the retail and hotel sectors and have nominally impacted cash flows and yields on the securities. Considering the characteristics of our non-Agency CMBS IO and the actions taken by servicers so far to work with borrowers through various relief measures, we have not seen evidence of and do not currently expect a material adverse effect on our future cash flows for non-Agency CMBS IO. However, the ultimate impact of COVID-19 on the global economy and on the loans underlying any of our securities remains uncertain and cannot be predicted at this time.

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Non-Agency issued CMBS IO are backed by loans secured by a number of different property types which are shown in the table below as of December 31, 2020:
December 31, 2020
($ in thousands)Fair ValuePercentage of Portfolio
Property Type:
Retail$39,934 27.7 %
Office30,904 21.4 %
Multifamily25,658 17.8 %
Hotel19,240 13.4 %
Mixed use9,646 6.7 %
Other (1)
18,702 13.0 %
Total non-Agency CMBS IO$144,084 100.0 %
(1) Other property types collateralizing non-Agency CMBS IO do not comprise more than 5% individually.


Repurchase Agreements 
We use leverage to enhance the returns on our invested capital by pledging our investments as collateral for borrowings primarily through the use of uncommitted repurchase agreements with major financial institutions and broker-dealers. Repurchase agreements generally have original terms to maturity of overnight to six months, though in some instances we may enter into longer-dated maturities depending on market conditions. We pay interest on our repurchase agreement borrowings based on short-term rate indices that historically closely track LIBOR and are fixed for the term of the borrowing.
Please refer to Note 4 of the Notes to the Consolidated Financial Statements contained within this Annual Report on Form 10-K as well as “Results of Operations” and “Liquidity and Capital Resources” contained within this Item 7 for additional information relating to our repurchase agreement borrowings.

Derivative Assets and Liabilities
We use derivative instruments to economically hedge our exposure to adverse changes in interest rates resulting from our ownership of primarily fixed-rate investments financed with short-term repurchase agreements. Changes in interest rates can impact net interest income, the market value of our investments, and book value per common share. We regularly monitor and frequently adjust our hedging portfolio in response to many factors including, but not limited to, changes in our investment portfolio as well as our expectation of future interest rates, including the absolute level of rates and the slope of the yield curve versus market expectations. As of December 31, 2020, approximately 62% of our MBS portfolio including TBA securities were hedged with these interest rate derivatives. Please refer to Note 5 of the Notes to the Consolidated Financial Statements for details on our interest rate derivative instruments as well as “Quantitative and Qualitative Disclosures about Market Risk” in Item 7A of this Annual Report on Form 10-K.


RESULTS OF OPERATIONS
The discussion below includes both GAAP and non-GAAP financial measures that management utilizes in its internal analysis of financial and operating performance. Please read the section “Non-GAAP Financial Measures” contained in “Executive Overview” of Item 7 of this Annual Report on Form 10-K for additional important information about these measures.
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Net Interest Income for the Year Ended December 31, 2020 Compared to the Year Ended December 31, 2019
Net interest income increased by $7.8 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 because we held a smaller average balance of repurchase agreement borrowings at a lower financing rate, which resulted in a decline of $(81.5) million in our interest expense. We borrowed less because we held a smaller average balance of investments during the year ended December 31, 2020 compared to the same period in the prior year. By the end of the first quarter of 2020 as interest rates rallied and asset prices began to fall, we sold approximately 67% of our Agency RMBS in order to monetize gains as asset prices began to fall, increase our liquidity position, and decrease our leverage, and we sold an additional $1.8 billion of mostly Agency CMBS during the second quarter of 2020. We partially replaced these assets through subsequent purchases of $1.9 billion in primarily 30-year Agency RMBS with lower coupons. We also borrowed less because we increased our investment in TBA securities, which do not require repurchase agreement borrowings as these investments are financed implicitly through dollar roll transactions. As a result of our smaller average balance of lower yielding investments held during 2020 compared to 2019, our interest income declined $(73.7) million. Please refer to “Executive Overview” for a discussion of how market factors such as interest rates and supply/demand dynamics influenced investment portfolio changes made by management during 2020.
The following table presents certain information about our interest-earning assets and interest-bearing liabilities and their performance for the year ended December 31, 2020 and December 31, 2019:
Year Ended
December 31,
20202019
($ in thousands)Interest Income/Expense
Average Balance (1)(2)
Effective Yield/
Cost of
Funds (3)(4)
Interest Income/Expense
Average Balance (1)(2)
Effective Yield/
Cost of
Funds (3)(4)
Interest-earning assets:
Agency RMBS$50,546 $2,142,690 2.36 %$92,671 $2,780,832 3.33 %
Agency CMBS25,292 856,869 2.91 %51,933 1,586,730 3.23 %
CMBS IO (5)
19,361 433,863 4.46 %21,534 492,567 4.37 %
Non-Agency MBS and other investments (6)
1,269 9,125 8.64 %4,030 11,791 16.61 %
Total:$96,468 $3,442,547 2.78 %$170,168 $4,871,920 3.44 %
Interest-bearing liabilities: (7)
32,615 $3,190,726 1.01 %114,111 $4,570,837 2.46 %
Net interest income/net interest spread$63,853 1.77 %$56,057 0.98 %
(1) Average balance for assets is calculated as a simple average of the daily amortized cost and excludes unrealized gains and losses as well as securities pending settlement if applicable.
(2) Average balance for liabilities is calculated as a simple average of the daily borrowings outstanding during the period.
(3) Effective yield is calculated by dividing the sum of gross interest income and scheduled premium amortization/discount accretion (both of which are annualized for any reporting period less than 12 months) and prepayment compensation and premium amortization/discount accretion adjustments (collectively, "prepayment adjustments"), which are not annualized, by the average balance of asset type outstanding during the reporting period.
(4) Cost of funds is calculated by dividing annualized interest expense by the total average balance of borrowings outstanding during the period with an assumption of 360 days in a year.
(5) Includes Agency and non-Agency issued securities.
(6) Interest income for non-Agency and other investments for the year ended December 31, 2020 and December 31, 2019 includes $0.5 million and $2.1 million, respectively, of interest income from cash and cash equivalents. Average balance and yields exclude cash and cash equivalents.
(7) Interest-bearing liabilities consist primarily of repurchase agreement borrowings.

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Rate/Volume Analysis. The following table presents the estimated impact on our net interest income due to changes in rate (effective yield/cost of funds) and changes in volume (average balance) of our interest-earning assets and interest-bearing liabilities for the periods indicated:
Year Ended
December 31, 2020 Compared to December 31, 2019
Increase (Decrease) Due to Change InTotal Change in Interest Income/Expense
($ in thousands)RateVolume
Prepayment Adjustments (1)
Interest-earning assets:
Agency RMBS$(20,869)$(21,331)$75 $(42,125)
Agency CMBS(2,248)(23,322)(1,071)(26,641)
CMBS IO (2)
188 (2,172)(189)(2,173)
Non-Agency MBS and other investments(1,823)(82)(856)(2,761)
Change in interest income$(24,752)$(46,907)$(2,041)$(73,700)
Change in interest expense(46,415)(35,081)— (81,496)
Total net change in net interest income$21,663 $(11,826)$(2,041)$7,796 
(1) Prepayment adjustments represent effective interest amortization adjustments related to changes in actual prepayment speeds and prepayment compensation, net of amortization adjustments for CMBS and CMBS IO.
(2) Includes Agency and non-Agency issued securities.

Adjusted Net Interest Income for the Year Ended December 31, 2020 Compared to the Year Ended December 31, 2019
Management includes drop income from TBA dollar roll transactions and net periodic interest benefit/cost of interest rate swaps in a non-GAAP financial measure “adjusted net interest income” when evaluating the economic performance of its investments and financings. Please refer to “Non-GAAP Financial Measures” at the end of the “Executive Overview” section of this Annual Report on Form 10-K for additional information.
Year Ended
December 31,
20202019
($ in thousands)AmountRateAmountRate
Net interest income$63,853 1.77 %$56,057 0.98 %
Add: TBA drop income (1) (2)
15,067 0.05 %6,231 (0.03)%
Add: net periodic interest benefit (3)
1,579 0.05 %16,075 0.35 %
De-designated cash flow hedge accretion (4)
— — %(165)— %
Adjusted net interest income$80,499 1.87 %$78,198 1.30 %

(1) TBA drop income is calculated by multiplying the notional amount of the TBA dollar roll positions by the difference in price between two TBA securities with the same terms but different settlement dates.
(2) The impact of TBA drop income on adjusted net interest spread includes the implied average funding cost of TBA dollar roll transactions during the periods indicated.
(3) Amount represents net periodic interest cost/benefit of effective interest rate swaps outstanding during the period and excludes realized and unrealized gains and losses from changes in fair value of derivatives.
(4) Amount recorded as a portion of "interest expense" in accordance with GAAP related to the accretion of the balance remaining in accumulated other comprehensive loss as a result of the Company's discontinuation of cash flow hedge accounting effective June 30, 2013.

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Adjusted net interest income increased $2.3 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 because the increase in TBA drop income outpaced the decline in net periodic interest benefit from interest rate swaps. We increased our investment in TBA securities during the year ended December 31, 2020 because the financing costs imputed in TBA dollar roll transactions for most of the year were lower than the average repurchase agreement financing rate, which is commonly referred to in the industry as TBA dollar rolls “trading special” or “dollar roll specialness”. Dollar roll specialness happens primarily as a result of supply/demand imbalances or volatility in market prepayment expectations, and in management’s view, the pace of bank and Federal Reserve purchases was the most significant contributor, resulting in an implied negative financing cost during the majority of 2020. The Company’s implied financing rate for its TBA long positions was (0.04)% for the year ended December 31, 2020 compared to 2.43% for the year ended December 31, 2019. The decline in net periodic interest benefit from interest rate swaps is discussed below in “Loss on Derivative Instruments, Net”.

Gain (Loss) on Sale of Investments, Net
Sales of our investments happen in the ordinary course of business as we manage our risk, capital and liquidity profiles, and as we reallocate capital to various investments. However, our sales during the year ended December 31, 2020 increased significantly compared to prior years. When interest rates rallied early to mid-March of 2020 as the markets initially responded to the COVID-19 pandemic, we chose to realize gains on our Agency RMBS as asset prices began to fall and we chose to de-lever our balance sheet. We used a portion of those proceeds to re-invest in Agency CMBS, the majority of which we sold in subsequent quarters in order to realize gains as asset premiums increased due to spread tightening and to shift our portfolio allocation back to predominantly Agency RMBS as the market stabilized. None of our investment sales during the year ended December 31, 2020 or December 31, 2019 were made under duress. The following tables provide information related to our realized gains (losses) on sales of investments for the periods indicated (1):
Year Ended
December 31,
20202019
($ in thousands)Amortized cost basis soldGain (loss) on sale of investments, netAmortized cost basis soldGain (loss) on sale of investments, net
Agency RMBS$2,312,343 $82,689 $796,193 $506 
Agency CMBS2,021,878 225,395 219,692 (6,493)
Agency CMBS IO— — 22,936 232 
$4,334,221 $308,084 $1,038,821 $(5,755)
(1) Information regarding unrealized gains (losses) on investments during the periods indicated is included under "Results of Operations-Other Comprehensive Income (Loss)" within this Item 7.


Loss on Derivative Instruments, Net
Changes in the fair value of derivative instruments and net periodic interest benefits/costs are impacted by changing market interest rates and adjustments that we may make to our hedging positions in any given period. Because of the changes made to our derivatives portfolio from one reporting period to the next, results of any given reporting period are generally not comparable to results of another.
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The following table provides information on our financial instruments accounted for as derivative instruments for the periods indicated:
Year Ended
December 31,
($ in thousands)20202019
Interest rate swaps:
Net periodic interest benefit$1,579 $16,075 
Change in fair value (184,521)(218,525)
Total loss on interest rate swaps, net(182,942)(202,450)
Change in fair value of other derivatives used as hedges:
Interest rate swaptions680 (5,607)
Options on U.S. Treasury futures(26,186)(1,422)
U.S. Treasury and Eurodollar futures(15,046)2,250 
Total loss on derivatives used as hedges of interest rate risk(223,494)(207,229)
TBA dollar roll positions:
Change in fair value (1)
36,137 14,049 
TBA drop income (2)
15,067 6,231 
Total TBA dollar roll gain, net51,204 20,280 
Total loss on derivative instruments, net$(172,290)$(186,949)
(1) Changes in fair value for TBA dollar roll positions include unrealized gains (losses) from open TBA contracts and realized gains (losses) on paired off or terminated positions.
(2) TBA drop income represents a portion of the change in fair value and is calculated by multiplying the notional amount of the net TBA dollar roll positions by the difference in price between two TBA securities with the same terms but different settlement dates.

Changes in fair value of our derivative instruments consist of unrealized gains (losses) on instruments held as of the end of the period and realized gains (losses) from instruments terminated or paired off during the period. The following tables provide information regarding realized gains (losses) on derivative instruments for the periods indicated:
Year Ended
December 31,
20202019
($ in thousands)Realized Gain (Loss)Realized Gain (Loss)
Interest rate swaps$(185,985)$(209,107)
Interest rate swaptions(1,934)(4,246)
U.S. Treasury and Eurodollar futures(13,519)1,032 
Options on U.S. Treasury futures(24,376)— 
TBA long positions53,192 25,424 
TBA short positions(11,016)1,234 
Total$(183,638)$(185,663)

Please refer to “Federal Income Tax Considerations” in Part I, Item 1 of this Annual Report on Form 10-K for information regarding recognition of deferred tax hedge losses for terminated derivative instruments.
Our net periodic interest benefit from interest rate swaps decreased $(14.5) million for the year ended December 31, 2020 compared to the year ended December 31, 2019 because, as mentioned previously, we discontinued the use of interest
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rate swaps to hedge the impact of interest rate risk on our earnings due to management’s expectation for our borrowing cost to remain low in the near term given current FOMC monetary policy. The table below shows our interest rate swap hedge position as a percentage of our average repurchase agreement borrowings and long TBAs outstanding and details about our net (pay) receive rates for the periods indicated:
Year Ended
December 31,
($ in thousands)20202019
Average repurchase agreement borrowings outstanding$3,189,269 $4,567,716 
Average TBA long positions outstanding - at cost (1)
750,887 550,796 
Average borrowings and TBA long positions outstanding3,940,156 5,118,512 
Average notional amount of interest rate swaps outstanding899,126 4,003,063 
Ratio of average interest rate swaps to average borrowings and TBA long positions outstanding (1)
0.20.8 
Average interest rate swap pay-fixed rate(1.41)%(2.07)%
Average interest rate swap receive-floating rate1.57 %2.44 %
Average interest rate swap net (pay) receive rate0.16 %0.37 %
(1) TBA long positions are included in this ratio because we use interest rate swaps to hedge a portion of the impact of changing interest rates on the fair value and implied financing cost of our TBA long positions and our repurchase agreement financing costs.

General and Administrative Expenses
General and administrative expenses increased $5.1 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 due primarily to changes made in 2020 to the payment structure of the executive compensation program that impact the timing of recognition of expenses and higher overall performance-based bonus compensation from management meeting its corporate goals and expenses for the year.

Other Comprehensive (Loss) Income
Other comprehensive loss of $(93.5) million for the year ended December 31, 2020 was due to the reclassification of $308.1 million in realized gains on the sale of investments during the year which were reclassified to net income in accordance with GAAP. The gross change in fair value of the Company’s MBS for the year ended December 31, 2020 was $214.5 million and resulted primarily from credit spread tightening for Agency RMBS and CMBS. Other comprehensive income of $209.6 million for the year ended December 31, 2019 was comprised mostly of net unrealized gains in Agency RMBS and CMBS due to the overall decline in longer-term interest rates throughout most of 2019. The following table provides detail on the changes in fair value by type of available-for-sale investment which are recorded as unrealized gains (losses) in other comprehensive income (loss) on our consolidated statements of comprehensive income for the periods indicated:
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Year Ended
December 31,
($ in thousands)20202019
Agency RMBS$(19,270)$85,982 
Agency CMBS(74,161)117,165 
CMBS IO (1)
203 6,486 
Non-Agency other (2)
(317)117 
Unrealized (loss) gain on available-for-sale investments (3)
(93,545)209,750 
Reclassification adjustment for de-designated cash flow hedges— (165)
Total other comprehensive (loss) income$(93,545)$209,585 
(1) Includes Agency and non-Agency issued securities.
(2) Includes non-Agency CMBS and RMBS.
(3) Information regarding realized gains (losses) on investments sold during the periods indicated are included under "Results of Operations-Gain (loss) on Sale of Investments, Net" within this Item 7.

Please refer to Dynex's Annual Report on Form 10-K for the year ended December 31, 2019 for the discussion of results of operations for the year ended December 31, 2019 compared to the year ended December 31, 2018.

LIQUIDITY AND CAPITAL RESOURCES
 Our primary sources of liquidity include borrowings under repurchase arrangements and monthly principal and interest payments we receive on our investments. Additional sources may also include proceeds from the sale of investments, equity offerings, and payments received from counterparties for derivative instruments. We use our liquidity to purchase investments and to pay our operating expenses and dividends on our common and preferred stock. We also use our liquidity to meet margin requirements for our repurchase agreements and derivative transactions, including TBA contracts, under the terms of the related agreements. We may also periodically use liquidity to repurchase shares of the Company’s stock.
Our liquidity fluctuates based on our investment activities, our financing and capital raising activities, and changes in the fair value of our investments and derivative instruments. Our most liquid assets include unrestricted cash and cash equivalents and unencumbered Agency RMBS, CMBS, and CMBS IO which were $415.3 million as of December 31, 2020 compared to $224.0 million as of December 31, 2019.
We analyze our liquidity under various scenarios based on changes in the fair value of our investments and derivative instruments due to market factors such as changes in the absolute level of interest rates and the shape of the yield curve, credit spreads, lender haircuts, and prepayment speeds. In performing these analyses, we will also consider the current state of the fixed income markets and the repurchase agreement markets in order to determine if market forces such as supply-demand imbalances or structural changes to these markets could change the liquidity of MBS or the availability of financing. The objective of our analyses is to assess the adequacy of our liquidity to withstand potential adverse events, such as the current COVID-19 pandemic. We may change our leverage targets based on market conditions and our perceptions of the liquidity of our investments. Our leverage, which we calculate using total liabilities plus the cost basis of TBA long positions, was 6.3x shareholders’ equity as of December 31, 2020. We include our TBA long positions in evaluating the Company’s leverage because it is possible under certain market conditions that it may be uneconomical for us to roll a TBA long position into future months, which may result in us having to take physical delivery of the underlying securities and use cash or other financing sources to fund our total purchase commitment. Management expects leverage to increase modestly over the first half of 2021 given current expectations of market conditions. In general, our leverage will increase if we are able to purchase investments with higher expected returns than currently exist today.
Our repurchase agreement borrowings are principally uncommitted with terms renewable at the discretion of our lenders and have short-term maturities. As such, we attempt to maintain unused capacity under our existing repurchase agreement credit lines with multiple counterparties, which helps protect us in the event of a counterparty's failure to renew existing repurchase agreements. We did not experience any materially adverse changes in terms or conditions in our repurchase agreement borrowings with our counterparties during the year ended December 31, 2020. As part of our
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continuous evaluation of counterparty risk, we maintain our highest counterparty exposures with broker dealer subsidiaries of regulated financial institutions or primary dealers whom we believe are better capitalized and more durable counterparties.
The following table presents information regarding the balances of our repurchase agreement borrowings for the periods indicated:
Repurchase Agreements
($ in thousands)Balance Outstanding As of
Quarter End
Average Balance Outstanding For the Quarter EndedMaximum Balance Outstanding During the Quarter Ended
December 31, 2020$2,437,163 $2,500,639 $2,594,683 
September 30, 20202,594,683 2,984,946 3,314,991 
June 30, 20203,314,991 2,580,296 4,408,106 
March 31, 20204,408,106 4,701,010 4,917,731 
December 31, 20194,752,348 4,806,826 4,891,341 
September 30, 20194,872,869 4,955,825 5,191,378 
June 30, 20194,815,452 4,562,992 4,815,452 
March 31, 20194,252,893 3,931,335 4,266,684 
December 31, 20183,267,984 2,992,513 3,269,307 

For our repurchase agreement borrowings, we are required to post and maintain margin to the lender (i.e., collateral in excess of the repurchase agreement financing) in order to support the amount of the financing. This excess collateral is often referred to as a “haircut” and is intended to provide the lender some protection against fluctuations in fair value of the collateral and/or the failure by us to repay the borrowing at maturity. Lenders have the right to change haircut requirements at maturity of the repurchase agreement (if the term is renewed) and may change their haircuts based on market conditions and the perceived riskiness of the collateral pledged. If the fair value of the collateral falls below the haircut required by the lender, the lender has the right to demand additional margin, or collateral, to increase the haircut back to the initial amount. These demands are typically referred to as “margin calls”, and if we fail to meet any margin call, our lenders have the right to terminate the repurchase agreement and sell any collateral pledged. Declines in the fair value of investments occur for any number of reasons including but not limited to changes in interest rates, changes in ratings on an investment, changes in actual or perceived liquidity of the investment, or changes in overall market risk perceptions. Additionally, Fannie Mae and Freddie Mac announce principal payments on Agency MBS in advance of their actual remittance of principal payments, and repurchase agreement lenders generally make margin calls for an amount equal to the product of their advance rate on the repurchase agreement and the announced principal payments on the Agency RMBS. A margin call made by a lender reduces our liquidity until we receive the principal payments from Fannie Mae and Freddie Mac. The weighted average haircut for our borrowings collateralized with Agency RMBS, Agency CMBS, and CMBS IO was 4.8%, 4.8%, and 15.6%, respectively, as of December 31, 2020 compared to 4.7%, 4.7%, and 12.8%, respectively, as of December 31, 2019.
The collateral we post in excess of our repurchase agreement borrowing with any counterparty is also typically referred to by us as “equity at risk”. Equity at risk represents the potential loss to the Company if the counterparty is unable or unwilling to return collateral securing the repurchase agreement borrowing at its maturity. The counterparties with whom we have the greatest amounts of equity at risk may vary significantly during any given period due to the short-term and generally uncommitted nature of the repurchase agreement borrowings. As of December 31, 2020, the Company had repurchase agreement amounts outstanding with 20 of its 37 available repurchase agreement counterparties and did not have more than 5% of equity at risk with any counterparty or group of related counterparties.
The following table discloses our repurchase agreement amounts outstanding and the value of the related collateral pledged by geographic region of our counterparties as of the dates indicated:
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December 31, 2020December 31, 2019
($ in thousands)Amount OutstandingMarket Value of Collateral PledgedAmount OutstandingMarket Value of Collateral Pledged
North America$1,988,782 $2,134,484 $2,998,440 $3,182,664 
Asia279,901 297,531 972,457 1,023,780 
Europe168,480 177,060 781,451 818,181 
$2,437,163 $2,609,075 $4,752,348 $5,024,625 

We have various financial and operating covenants in certain of our repurchase agreements including, among other things, requirements that we maintain minimum shareholders' equity (usually a set minimum, or a percentage of the highest amount of shareholders' equity since the date of the agreement), limits on maximum decline in shareholders' equity (expressed as a percentage decline in any given period), limits on maximum leverage (as a multiple of shareholders' equity), and requirements to maintain our status as a REIT and to maintain our listing on the NYSE. Violations of one or more of these covenants could result in the lender declaring an event of default which would result in the termination of the repurchase agreement and immediate acceleration of amounts due thereunder. In addition, some of the agreements contain cross default features, whereby default with one lender simultaneously causes default under agreements with other lenders. Violations could also restrict us from paying dividends or engaging in other transactions that are necessary for us to maintain our REIT status.
We monitor and evaluate on an ongoing basis the impact these customary financial covenants may have on our operating and financing flexibility. Currently, we do not believe we are subject to any covenants that materially restrict our financing flexibility. We were in full compliance with our debt covenants as of December 31, 2020, and we are not aware of any circumstances which could potentially result in our non-compliance in the foreseeable future.

Derivative Instruments
We use certain types of financial instruments that are accounted for as derivative instruments, including interest rate swaps, futures, options, and long and short positions in TBA securities. Certain of these derivative instruments may require us to post initial margin at inception and daily variation margin based on subsequent changes in their fair value. In the case of interest rate swaps, our clearing counterparty has the right to require higher initial margin in volatile market conditions. The collateral posted as margin by us is typically in the form of cash or Agency MBS. Counterparties may have to post variation margin to us. Generally, as interest rates decline, we will be required to post collateral with counterparties on our interest rate derivatives and vice versa as interest rates increase. As of December 31, 2020, we had cash of $7.1 million posted as collateral under these agreements.
Our TBA contracts are subject to master securities forward transaction agreements published by the Securities Industry and Financial Markets Association as well as supplemental terms and conditions with each counterparty. Under the terms of these agreements, we may be required to pledge collateral to, or have the right to receive collateral from, our counterparties when initiated or in the event the fair value of our TBA contracts declines. Declines in the fair value of TBA contracts are generally related to such factors as rising interest rates, increases in expected prepayment speeds, or widening spreads. Our TBA contracts generally provide that valuations for our TBA contracts and any pledged collateral are to be obtained from a generally recognized source agreed to by both parties. However, in certain circumstances, our counterparties have the sole discretion to determine the value of the TBA contract and any pledged collateral. In such instances, our counterparties are required to act in good faith in making determinations of value. In the event of a margin call, we must generally provide additional collateral on the same business day.

Dividends
As a REIT, we are required to distribute to our shareholders amounts equal to at least 90% of our REIT taxable income for each taxable year after certain deductions. We generally fund our dividend distributions through our cash flows from operations. If we make dividend distributions in excess of our operating cash flows during the period, whether for purposes of meeting our REIT distribution requirements or other strategic reasons, those distributions are generally funded
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either through our existing cash balances or through the return of principal from our investments (either through repayment or sale). Please refer to the following sections of this Annual Report on Form 10-K for additional important information regarding dividends declared on our taxable income:
"Federal Income Tax Considerations" within Part 1, Item 1, "Business"
Part 1, Item 1A, "Risk Factors"
Part II, Item 5, "Market For Registrant's Common Equity, Related Stockholder Matters, and Issuer
Purchases of Equity Securities"

Contractual Obligations and Other Matters
As of December 31, 2020, we do not have any material contractual obligations other than the short-term repurchase agreement amounts discussed above, nor do we believe that any off-balance sheet arrangements exist that are reasonably likely to have a material effect on our current or future financial condition, results of operations, or liquidity other than as discussed above. In addition, we do not have any material commitments for capital expenditures and have not obtained any commitments for funds to fulfill any capital obligations.

RECENT ACCOUNTING PRONOUNCEMENTS
There were no accounting pronouncements issued during the year ended December 31, 2020 that are expected to have a material impact on the Company’s financial condition or results of operations. Please refer to Note 1 of the Notes to the Consolidated Financial Statements contained within Item 8 of this Annual Report on Form 10-K for additional information.

CRITICAL ACCOUNTING ESTIMATES

The discussion and analysis of our financial condition and results of operations are based in large part upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of our consolidated financial statements requires management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities. We base these estimates and judgments on historical experience and assumptions believed to be reasonable under current facts and circumstances. Actual results, however, may differ from the estimated amounts we have recorded.
The following discussion provides information on our critical accounting policies that require management's most difficult, subjective or complex judgments, and which may result in materially different results under different assumptions and conditions. Please also refer to Note 1 of our Notes to the Consolidated Financial Statements included within Item 8 of this Annual Report on Form 10-K for additional information related to significant accounting policies.
Fair Value Measurements. Our Agency MBS, as well as a majority of our non-Agency MBS, are substantially similar to securities that either are actively traded or have been recently traded in their respective market. Pricing services and brokers have access to observable market information through trading desks and various information services. MBS prices are based on prices we receive from third-party pricing services and broker quotes. To determine each security's valuation, the pricing service uses either a market approach or income approach, both of which rely on observable market data. The market approach uses prices and other relevant information that is generated by market transactions of identical or similar securities, while the income approach uses valuation techniques to convert estimated future cash flows to a discounted present value. Management reviews the assumptions and inputs utilized in the valuation techniques. Examples of these observable inputs and assumptions include market interest rates, credit spreads, and projected prepayment speeds, among other things.
In addition, management reviews the prices received for each security by comparing those prices to actual purchase and sale transactions, our internally modeled prices that are calculated based on observable market rates and credit spreads, and the prices that our borrowing counterparties use in financing our securities. If the price of a security is obtained from quoted prices for similar instruments or model-derived valuations whose inputs are observable, the security is classified as a level 2 security. The security is classified as a level 3 security if the inputs are unobservable, resulting in an estimate of fair value based primarily on management's judgment. Please refer to Note 6 of the Notes to the Consolidated Financial
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Statements contained within Part II, Item 8 of this Annual Report on Form 10-K for additional information on fair value measurements.

FORWARD-LOOKING STATEMENTS
Certain written statements in this Annual Report on Form 10-K that are not historical facts constitute “forward-looking statements” within the meaning of Section 27A of the 1933 Act and Section 21E of the Exchange Act. Statements in this report addressing expectations, assumptions, beliefs, projections, future plans and strategies, future events, developments that we expect or anticipate will occur in the future, and future operating results, capital management, and dividend policy are forward-looking statements. Forward-looking statements are based upon management’s beliefs, assumptions, and expectations as of the date of this report regarding future events and operating performance, taking into account all information currently available to us, and are applicable only as of the date of this report. Forward-looking statements generally can be identified by use of words such as “believe”, “expect”, “anticipate”, “estimate”, “plan”, “may”, “will”, “intend”, “should”, “could” or similar expressions. We caution readers not to place undue reliance on our forward-looking statements, which are not historical facts and may be based on projections, assumptions, expectations, and anticipated events that do not materialize. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statement whether as a result of new information, future events, or otherwise.
Forward-looking statements in this Annual Report on Form 10-K may include, but are not limited to statements about:
Our business and investment strategy including our ability to generate acceptable risk-adjusted returns and our target investment allocations, and our views on the future performance of MBS and other investments;
Our views on the macroeconomic environment, monetary and fiscal policy, and conditions in the investment, credit, and derivatives markets;
Our views on the effect of actual or proposed actions of the U.S. Federal Reserve, the FOMC, the FHFA, or other central banks with respect to monetary policy (including the targeted Federal Funds Rate), and the potential impact of these actions on interest rates, inflation or unemployment;
The effect of regulatory initiatives of the Federal Reserve (including the FOMC), other financial regulators, and other central banks;
Our financing strategy including our target leverage ratios, our use of TBA dollar roll transactions, and anticipated trends in financing costs including TBA dollar roll transaction costs, and our hedging strategy including changes to the derivative instruments to which we are a party, and changes to government regulation of hedging instruments and our use of these instruments;
Our investment portfolio composition and target investments;
Our investment portfolio performance, including the fair value, yields, and forecasted prepayment speeds of our investments;
The impact of COVID-19 on the economy, as well as certain actions taken by federal, state and local governments in response to the pandemic, on delinquencies in loans underlying our investments;
Our liquidity and ability to access financing, and the anticipated availability and cost of financing;
Our capital stock activity including the impact of stock issuances and repurchases;
The amount, timing, and funding of future dividends;
Our use of and restrictions on using our tax NOL carryforward;
The status of pending litigation;
The competitive environment in the future, including competition for investments and the availability of financing;
Estimates of future interest expenses, including related to the Company’s repurchase agreements and derivative instruments;
The status and effect of legislative reforms and regulatory rule-making or review processes, and the status of reform efforts and other business developments in the repurchase agreement financing market;
Market, industry and economic trends, and how these trends and related economic data may impact the behavior of market participants and financial regulators;
The impact of applicable tax and accounting requirements on the Company;
Our future compliance with covenants in our master repurchase agreements and debt covenants in our debt agreements;
Market interest rates and market spreads; and
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Possible future effects of the COVID-19 pandemic.
Forward-looking statements are inherently subject to risks, uncertainties and other factors that could cause our actual results to differ materially from historical results or from any results expressed or implied by such forward-looking statements. Not all of these risks and other factors are known to us. New risks and uncertainties arise over time, and it is not possible to predict those events or how they may affect us. The projections, assumptions, expectations or beliefs upon which the forward-looking statements are based can also change as a result of these risks or other factors. If such a risk or other factor materializes in future periods, our business, financial condition, liquidity and results of operations may vary materially from those expressed or implied in our forward-looking statements.
While it is not possible to identify all factors that may cause actual results to differ from historical results or from any results expressed or implied by forward-looking statements, or that may cause our projections, assumptions, expectations or beliefs to change, some of those factors include the following:
the risks and uncertainties referenced in this Annual Report on Form 10-K, especially those incorporated by reference into Part II, Item 1A, “Risk Factors”, and in particular the potential adverse effects of the ongoing COVID-19 pandemic and any governmental or societal responses thereto,
our ability to find suitable reinvestment opportunities;
changes in domestic economic conditions;
changes in interest rates and interest rate spreads, including the repricing of interest-earning assets and interest-bearing liabilities;
our investment portfolio performance particularly as it relates to cash flow, prepayment rates and credit performance;
the impact on markets and asset prices from changes in the Federal Reserve’s policies regarding the purchases of Agency RMBS, Agency CMBS, and U.S. Treasuries;
actual or anticipated changes in Federal Reserve monetary policy or the monetary policy of other central banks;
adverse reactions in U.S. financial markets related to actions of foreign central banks or the economic performance of foreign economies including in particular China, Japan, the European Union, and the United Kingdom;
uncertainty concerning the long-term fiscal health and stability of the United States;
the cost and availability of financing, including the future availability of financing due to changes to regulation of, and capital requirements imposed upon, financial institutions;
the cost and availability of new equity capital;
changes in our use of leverage;
changes to our investment strategy, operating policies, dividend policy or asset allocations;
the quality of performance of third-party servicer providers of our loans and loans underlying our securities;
the level of defaults by borrowers on loans we have securitized;
changes in our industry;
increased competition;
changes in government regulations affecting our business;
changes or volatility in the repurchase agreement financing markets and other credit markets;
changes to the market for interest rate swaps and other derivative instruments, including changes to margin requirements on derivative instruments;
uncertainty regarding continued government support of the U.S. financial system and U.S. housing and real estate markets, or to reform the U.S. housing finance system including the resolution of the conservatorship of Fannie Mae and Freddie Mac;
the composition of the Board of Governors of the Federal Reserve System;
systems failures or cybersecurity incidents; and
exposure to current and future claims and litigation.


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ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the exposure to losses resulting from changes in market factors. Our business strategy exposes us to a variety of market risks, including interest rate, spread, prepayment, credit, liquidity, and reinvestment risks. These risks can and do cause fluctuations in our liquidity, comprehensive income and book value as discussed below.

Interest Rate Risk
Investing in interest-rate sensitive investments such as MBS and TBA securities subjects us to interest rate risk. Interest rate risk results from investing in securities that have a fixed coupon or when the coupon may not immediately adjust for changes in interest rates. Interest rate risk also results from the mismatch between the duration of our assets versus the duration of our liabilities and hedges.
We attempt to manage our exposure to changes in interest rates by entering into interest rate hedging instruments. These instruments help offset the impact of changing interest rates on the market value of our assets and our financing costs. Changes in interest rates impact us in a variety of ways. The amount of the impact will depend on the composition of our portfolio, our hedging strategy, the effectiveness of our hedging instruments as well as the magnitude and the duration of the increase in interest rates.
We manage interest rate risk within tolerances set by our Board of Directors. Our hedging techniques are highly complex and are partly based on assumed levels of prepayments of our assets. If prepayments are slower or faster than assumed, the maturity of our investments will also differ from our expectations, which could reduce the effectiveness of our hedging strategies and may cause losses on such transactions and adversely affect our cash flow. Estimates of prepayment speeds can vary significantly by investor for the same security, and therefore estimates of security and portfolio duration can vary significantly.
Changes in types of our investments, the returns earned on these investments, future interest rates, credit spreads, the shape of the yield curve, the availability of financing, and/or the mix of our investments and financings including derivative instruments may cause actual results to differ significantly from the modeled results shown in the tables below. There can be no assurance that assumed events used to model the results shown below will occur, or that other events will not occur, that will affect the outcomes; therefore, the modeled results shown in the tables below and all related disclosures constitute forward-looking statements.
The table below shows the projected sensitivity of our net interest income and net periodic interest benefit/cost as of the dates indicated assuming an instantaneous parallel shift in interest rates and no changes in the composition of our investment portfolio:
Projected Change in Net Interest Income and Net Periodic Interest Benefit/Cost Due To
Decrease in Interest Rates ofIncrease in Interest Rates of
50 Basis Points25 Basis Points25 Basis Points50 Basis Points
December 31, 2020 (1)
(1)
0.4 %(5.9)%(12.9)%
December 31, 2019 (2)
2.3 %1.3 %(2.2)%(4.8)%
(1) Because the Company does not assume financing rates will be less than 0%, a parallel downward shift in interest rates of 50 basis points is not presented as of December 31, 2020.
(2) Projected sensitivity as of December 31, 2019 includes the impact to net periodic interest benefit/cost of interest rate swaps held as of that date.

The projected sensitivity to changes in interest rates on our net interest income and net periodic interest benefit/cost shown in the table above as of December 31, 2020 for an increasing interest rate environment has increased since December 31, 2019 because we terminated all of our interest rate swaps in 2020. Given current FOMC monetary policy, management anticipates funding costs to remain low in the near-term, and as such, we shifted our interest rate hedging strategy to options and futures with the principal intention of capital (book value) preservation as shown in the two tables below.
The table below shows the projected sensitivity of the market value of our financial instruments(1) and the percentage change in shareholders’ equity assuming an instantaneous parallel shift in market interest rates as of the dates indicated:
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December 31, 2020
Decrease in Interest Rates ofIncrease in Interest Rates of
100 Basis Points50 Basis Points50 Basis Points100 Basis Points
Type of
Instrument (1)
% of Market Value% of Common Equity% of Market Value% of Common Equity% of Market Value% of Common Equity% of Market Value% of Common Equity
RMBS1.1 %6.5 %0.9 %5.5 %(1.7)%(10.1)%(3.9)%(22.5)%
CMBS0.3 %1.9 %