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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
|X| Quarterly Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the quarter ended September 30, 1999
|_| Transition Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
Commission file number 33-83524
MERIT SECURITIES CORPORATION
(Exact name of registrant as specified in its charter)
Virginia 54-1736551
(State or other jurisdiction of incorporation)(I.R.S.EmployerIdentification No.)
10900 Nuckols Road, 3rd Floor, Glen Allen, Virginia 23060
(Address of principal executive offices) (Zip Code)
(804) 217-5800
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past ninety days. |X| Yes |_| No
As of October 31, 1999, the latest practicable date, there were 1,000
shares of Merit Securities Corporation common stock outstanding.
The registrant meets the conditions set forth in General Instructions H
(1)(a) and (b) of Form 10-Q and is therefore filing this Form 10-Q with the
reduced disclosure format.
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MERIT SECURITIES CORPORATION
FORM 10-Q
INDEX
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Page Number
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Balance Sheets at September 30, 1999 and
December 31, 1998 3
Statements of Operations for the three and nine months
ended September 30, 1999 and 1998 4
Statement of Shareholder's Equity for the nine months
ended September 30, 1999 5
Statements of Cash Flows for the nine months ended
September 30, 1999 and 1998 6
Notes to Unaudited Financial Statements 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 9
Item 3. Quantitative and Qualitative Disclosures about Market Risk 13
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 15
Item 5. Other Information 15
Item 6. Exhibits and Reports on Form 8-K 15
SIGNATURES 18
</TABLE>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
MERIT SECURITIES CORPORATION
Balance Sheets
(amounts in thousands except share data)
<TABLE>
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September 30, December 31,
1999 1998
------------------ ------------------
ASSETS:
Collateral for collateralized bonds $ 2,987,802 $ 3,350,344
Due from affiliates, net - 5,611
Prepaid shelf registration fees 208 406
Cash 10 10
================== ==================
$ 2,988,020 $ 3,356,371
================== ==================
LIABILITIES AND SHAREHOLDER'S EQUITY
LIABILITIES:
Non-recourse debt - collateralized bonds $ 2,781,735 $ 3,153,060
Due to affiliates, net 41,682 -
------------------ ------------------
2,823,417 3,153,060
------------------ ------------------
SHAREHOLDER'S EQUITY:
Common stock, no par value, $1 stated value
10,000 shares authorized,
1,000 shares issued and outstanding 10 10
Additional paid-in capital 133,241 190,156
Accumulated other comprehensive income 8,037 33,575
Retained earnings (accumulated deficit) 23,315 (20,430)
----------------- ------------------
164,603 203,311
================== ==================
$ 2,988,020 $ 3,356,371
================== ==================
<FN>
See notes to unaudited financial statements.
</FN>
</TABLE>
MERIT SECURITIES CORPORATION
Statements of Operations
(amounts in thousands except share data)
<TABLE>
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<S> <C> <C>
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------- ----------------------------
1999 1998 1999 1998
------------ ------------- ------------- ------------
Interest Income:
Collateral for collateralized bonds $ 51,225 $ 71,119 $ 155,501 $ 191,187
------------- -------------- -------------- -------------
Interest and related expense:
Interest expense on collateralized bonds 42,232 68,066 129,812 191,051
Other collateralized bond expense 590 744 1,513 2,729
--------------
------------- -------------- -------------
42,822 68,810 131,325 193,780
------------- -------------- -------------- -------------
Net interest margin before provision for losses 8,403 2,309 24,176 (2,593)
Provision for losses (3,138) (1,686) (7,704) (4,550)
------------- -------------- -------------- -------------
Net interest margin 5,265 623 16,472 (7,143)
Gain on sale of securities - 6,122 397 7,247
Interest on due to affiliates, net (631) (636) (966) (1,990)
------------- -------------- -------------- -------------
Income (loss) before extraordinary item 4,634 6,109 15,903 (1,886)
Extraordinary item-gain on extinguishment of debt - - 27,842 -
------------- -------------- ============== =============
Net income (loss) $ 4,634 6,109 $ 43,745 $ (1,886)
============= ============== ============== =============
<FN>
See notes to unaudited financial statements.
</FN>
</TABLE>
MERIT SECURITIES CORPORATION
Statement of Shareholder's Equity
(amounts in thousands except share data)
<TABLE>
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<S> <C> <C> <C> <C> <C>
Accumulated other Retained
Additional comprehensive earnings
Common stock paid-in income (accumulated
capital deficit) Total
------------- --------------------------------- --------------- -------------
Balance at December 31, 1998 $ 10 $ 190,156 $ 33,575 $ (20,43) $ 203,311
Comprehensive income:
Net income - - - 43,745 43,745
Change in net unrealized gain on
investments available-for-sale - - (25,538) - (25,538)
------------ -------------- ------------------- -------------- ----------------
Total comprehensive income - - (25,538) 43,745 18,207
Capital distribution - (56,915) - - (56,915)
------------ -------------- ------------------- -------------- ----------------
Balance at September 30, 1999 $ 10 $ 133,241 $ 8,037 $ 23,315 $ 164,603
============ ============== =================== ============== ================
<FN>
See notes to unaudited financial statements.
</FN>
</TABLE>
MERIT SECURITIES CORPORATION
Statements of Cash Flows
(amounts in thousands)
<TABLE>
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<S> <C> <C>
Nine Months Ended
September 30,
1999 1998
------------------- -------------------
Operating activities:
Net income (loss) $ 43,745 $ (1,886)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Gain on sale of securities (397) (7,247)
Provision for losses 7,704 4,550
Gain on extinguishment of debt (27,842) -
Amortization, net 13,616 28,525
Net change in prepaid shelf registration fees 198 (72)
Other (328) (560)
------------------- -------------------
Net cash provided by operating activities 36,696 23,310
------------------- -------------------
Investing activities:
Collateral for collateralized bonds:
Purchase of loans subsequently securitized (628,584) (1,692,780)
Principal payments on collateral 939,933 1,588,220
Proceeds from sale of collateralized bonds 5,250 43,425
Net (increase) decrease in accrued interest receivable and
funds held by trustee (1,473) 1,219
------------------- -------------------
Net cash provided by (used for) investing activities 318,072 (59,916)
------------------- -------------------
Financing activities:
Collateralized bonds:
Proceeds from issuance of collateralized bonds 589,904 1,589,272
Principal payments on collateralized bonds (935,070) (1,581,640)
Increase (decrease) in accrued interest payable 20 (435)
Increase (decrease) in due from affiliates 47,293 (34,795)
(Repayments of) proceeds from capital contributions (56,915) 64,204
------------------- -------------------
Net cash (used for) provided by financing activities (354,768) 36,606
------------------- -------------------
Cash at beginning of period 10 10
------------------- -------------------
Cash at end of period $ 10 $ 10
=================== ===================
Supplemental disclosure of cash flow information:
Cash paid for interest $ 129,067 $ 188,460
=================== ===================
Collateral for collateralized bonds subsequently securitized $ 1,221,456 $ -
=================== ===================
<FN>
See notes to unaudited financial statements.
</FN>
</TABLE>
MERIT SECURITIES CORPORATION
Notes to Unaudited Financial Statements
September 30, 1999
(amounts in thousands except share data)
NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying consolidated financial statements have been prepared in
accordance with the instructions to Form 10-Q and do not include all of the
information and notes required by generally accepted accounting principles for
complete financial statements. The financial statements include the accounts of
Merit Securities Corporation (the "Company"). The Company is a wholly-owned,
limited-purpose finance subsidiary of Issuer Holding Corporation ("IHC"). IHC
was formed on September 4, 1996 to acquire all of the outstanding stock of the
Company and certain other affiliates of Dynex Capital, Inc. ("Dynex"). IHC is a
wholly-owned subsidiary of Dynex. The Company was organized to facilitate the
securitization of loans through the issuance and sale of collateralized bonds
(the "Bonds").
In the opinion of management, all material adjustments, consisting of
normal recurring adjustments, considered necessary for a fair presentation of
the financial statements have been included. The Balance Sheet at September 30,
1999, the Statements of Operations for the three and nine months ended September
30, 1999 and 1998, the Statement of Shareholder's Equity for the nine months
ended September 30, 1999, the Statements of Cash Flows for the nine months ended
September 30, 1999 and 1998, and the related notes to financial statements are
unaudited. Operating results for the nine months ended September 30, 1999 are
not necessarily indicative of the results that may be expected for the year
ending December 31, 1999. For further information, refer to the audited
financial statements and footnotes included in the Company's Form 10-K for the
year ended December 31, 1998.
Certain amounts for 1998 have been reclassified to conform to the
presentation for 1999.
NOTE 2-COLLATERAL FOR COLLATERALIZED BONDS
Pursuant to the requirements of Statement of Financial Accounting Standards
No. 115, Accounting for Certain Investments in Debt and Equity Securities, the
Company has classified collateral for collateralized bonds as
available-for-sale. The following table summarizes the Company's amortized cost
basis and fair value of collateral for collateralized bonds at September 30,
1999 and December 31, 1998, and the related average effective interest rates
(calculated for the month ended September 30, 1999 and December 31, 1998, and
excluding unrealized gains and losses):
<TABLE>
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<S> <C> <C> <C> <C>
- - -------------------------------------------------------------------------------------------------------------------
September 30, 1999 December 31, 1998
- - -------------------------------------------------------------------------------------------------------------------
Effective Effective
Fair Value Interest Rate Fair Value Interest Rate
- - -------------------------------------------------------------------------------------------------------------------
Collateral for collateralized bonds:
Amortized cost $ 2,991,003 7.3% $ 3,333,362 7.3%
Allowance for losses (11,238) (16,593)
- - -------------------------------------------------------------------------------------------------------------------
Amortized cost, net 2,979,765 3,316,769
Gross unrealized gains 33,232 47,244
Gross unrealized losses (25,195) (13,669)
- - -------------------------------------------------------------------------------------------------------------------
$ 2,987,802 $ 3,350,344
- - -------------------------------------------------------------------------------------------------------------------
</TABLE>
Collateral for collateralized bonds consists of debt securities backed
primarily by adjustable-rate and fixed-rate mortgage loans secured by first
liens on single family residential housing, manufactured housing installment
loans secured by either a UCC filing or a motor vehicle title and property tax
receivables. All collateral for collateralized bonds is pledged to secure
repayment of the related collateralized bonds. All principal and interest (less
servicing-related fees) on the collateral is remitted to a trustee and is
available for payment on the collateralized bonds. The Company's exposure to
loss on collateral for collateralized bonds is generally limited to the amount
of collateral pledged in excess of the related collateralized bonds issued, as
the collateralized bonds issued are non-recourse to the Company. The collateral
for collateralized bonds can be sold by the Company, but only subject to the
lien of the collateralized bond indenture.
During the nine months ended September 30, 1999, the Company securitized
$1.8 billion of collateral, through the issuance of two series of collateralized
bonds, of which $1.2 billion related to the collapse and resecuritization of the
collateral from six series of previously issued collateralized bonds. The
collateral securitized was primarily single family mortgage loans and
manufactured housing loans. The securitizations were accounted for as financing
of the underlying collateral pursuant to Statement of Accounting Standards No.
125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities" ("FAS No. 125") as the Company retained call
rights on the bonds which are substantially in excess of a clean-up call as
defined by this accounting standard.
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
The Company was organized to facilitate the securitization of loans through
the issuance and sale of collateralized bonds (the "Bonds"). The Bonds will be
secured primarily by: (i) mortgage loans secured by first or second liens on
residential property, (ii) Federal National Mortgage Association Mortgage-Backed
Certificates, (iii) Federal Home Loan Mortgage Corporation Mortgage-Backed
Certificates, (iv) Government National Mortgage Association Mortgage-Backed
Certificates, (v) other mortgage pass-through certificates or
mortgage-collateralized obligations, (vi) property tax receivables and (vii)
consumer installment loans (collectively, the "Collateral"). In the future, the
Company may also securitize other types of loans.
After payment of the expenses of an offering and certain administrative
expenses, the net proceeds from an offering of Bonds will be used to purchase
Collateral from IHC or various third parties. IHC can be expected to use the
proceeds to reduce indebtedness incurred to obtain such loans or to acquire
additional Collateral. After the issuance of a series of Bonds, the Company may
sell the Collateral securing that series of Bonds, subject to the lien of the
Bonds.
<TABLE>
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FINANCIAL CONDITION
- - --------------------------------------------- ----------------------------------
September 30, December 31,
(amounts in thousands except per share data) 1999 1998
- - --------------------------------------------- ----------------------------------
Collateral for collateralized bonds $ 2,987,802 $ 3,350,344
Non-recourse debt - collateralized bonds 2,781,735 3,153,060
Shareholder's equity 164,603 203,311
Collateralized bond series outstanding 4 8
- - --------------------------------------------- ----------------------------------
</TABLE>
Collateral for collateralized bonds Collateral for collateralized bonds
consists primarily of securities backed by adjustable-rate and fixed-rate
mortgage loans secured by first liens on single family properties, manufactured
housing installment loans secured by either a UCC filing or a motor vehicle
title and property tax receivables. As of September 30, 1999, the Company had 4
series of collateralized bonds outstanding. The collateral for collateralized
bonds decreased to $3.0 billion at September 30, 1999 compared to $3.4 billion
at December 31, 1998. This decrease of $0.4 billion is primarily the result of
$939.9 million in paydowns on collateral, which was principally offset by the
net addition of $628.6 million of collateral as a result of a $1.8 billion
issuance of two series of collateralized bonds in March 1999 and September 1999,
of which $1.1 billion related to the collapse and re-securitization of six
series of previously issued collateralized bonds.
Non-recourse debt - collateralized bonds Collateralized bonds decreased to
$2.8 billion at September 30, 1999 from $3.2 billion at December 31, 1998 as a
result of $935.1 million in paydowns during the nine months ended September 30,
1999. This decrease was partially offset by the issuance of two series of
collateralized bonds, totaling $1.8 billion, of which $1.1 billion was related
to the collapse and re-securitization of six series on collateralized bonds.
Shareholder's Equity Shareholder's equity decreased to $164.6 million at
September 30, 1999 from $203.3 million at December 31, 1998. This decrease was
primarily the result of a $56.9 capital distribution to IHC during the nine
months ended September 30, 1999. In addition, the net unrealized gain on
investments available-for-sale decreased $25.5 million to $8.0 million at
September 30, 1999 from $33.6 million at December 31, 1998, primarily due to
prepayments on the collateral for collateralized bonds, an increase of 50 basis
points in the targeted Fed Funds rate and the approximate 1% increase in
long-term interest rates during 1999.
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RESULTS OF OPERATIONS
- - --------------------------------------------------------------------------------------------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------------------- -----------------------------------
(amounts in thousands) 1999 1998 1999 1998
- - ----------------------------------------------------------------------------------------- -----------------------------------
Interest income $ 51,225 $ 71,119 $ 155,501 $ 191,187
Interest expense on collateralized bonds 42,232 68,066 129,812 191,051
Net interest margin 5,265 623 16,472 (7,143)
Gain on sale of securities - 6,122 397 7,247
Extraordinary item - gain on extinguishment of debt - - 27,842 -
Net income (loss) 4,634 6,109 43,745 (1,886)
- - --------------------------------------------------------------------------------------------------------------------------------
</TABLE>
Interest income on the collateral for collateralized bonds decreased to
$51.2 million for the three months ended September 30, 1999 from $71.1 million
for the same period in 1998. Interest income on the collateral for
collateralized bonds decreased to $155.5 million for the nine months ended
September 30, 1999 from $191.2 million for the same period in 1998. The overall
decrease was primarily a result of the continued impact of prepayments on
interest income, as average collateral for collateralized bonds declined from
$3.5 billion to $3.0 billion for the three months ended September 30, 1998 and
1999, respectively, and from $3.4 billion to $3.0 billion for the nine months
ended September 30, 1998 and 1999, respectively. In addition interest income
decreased as a result of the decrease in the six-month LIBOR rate during the
latter half of 1998.
Interest expense on collateralized bonds decreased to $42.2 million for the
three months ended September 30, 1999 from $68.1 million for the three months
ended September 30, 1998 and decreased to $129.8 million for the nine months
ended September 30, 1999 from $191.1 million for the same period in 1998. The
overall decrease was primarily due to the decrease in the one-month LIBOR rate
during the fourth quarter of 1998 and the decline in average collateralized
bonds due to prepayments on the related collateral for collateralized bonds.
Net interest margin for the three months ended September 30, 1999 increased
to $5.3 million from $0.6 million for the three months ended September 30, 1998.
Net interest margin increased to a positive $16.5 million for the nine months
ended September 30, 1999 from a negative $7.1 million for the same period in
1998. The overall increase was primarily the result of lower premium
amortization caused by lower prepayments during the nine months ended September
30, 1999 than during the same period in 1998.
Gain on sale of securities of $0.4 million during the nine months ended
September 30, 1999 is the result of the recognition of the remaining gain on the
sale of the Merit 11B A-1 class, which had a principal balance of $4.9 million.
Gain on sale of securities during the three and nine months ended September 30,
1998, is the result of the sale of M11 B A-1 class for a gain of $6.1 million
and $7.2 million respectively.
The Company also incurred an extraordinary gain of $27.8 million related to
the recognition of unamortized premiums net of unamortized issuance costs on six
series of collateralized bonds, which were collapsed during the nine months
ended September 30, 1999. The collateral securing these collateralized bonds was
re-securitized in the Company's $1.4 billion securitization in March 1999.
Credit Exposures With collateralized bond structures, the Company retains
credit risk relative to the amount of overcollateralization required in
conjunction with the bond insurance. Losses are generally first applied to the
overcollateralized amount, with any losses in excess of that amount borne by the
bond insurer or the holders of the collateralized bonds. The Company only incurs
credit losses to the extent that losses are incurred in the repossession,
foreclosure and sale of the underlying collateral. Such losses generally equal
the excess of the principal amount outstanding, less any proceeds from mortgage
or hazard insurance, over the liquidation value of the collateral. To compensate
the Company for retaining this loss exposure, the Company generally receives an
excess yield on the collateralized securities relative to the yield on the
collateralized bonds. At September 30, 1999, the Company retained $194.2 million
in aggregate principal amount of overcollateralization, and had reserves, or
otherwise had provided coverage on $45.8 million of this potential credit loss
exposure. $30.3 million of this reserve amount is in the form of a loss
reimbursement guarantee from a third-party rated A by Standards & Poors Ratings
Services, Inc.
Other Matters At September 30, 1999, the Company had securities of
approximately $682.2 million remaining for issuance under a registration
statement filed with the Securities and Exchange Commission. The Company
anticipates issuing additional Bonds in the future.
Year 2000 The Company relies upon its ultimate parent company, Dynex, for
all computer systems operations. Dynex is dependent upon purchased, leased, and
internally-developed software to conduct certain operations. In addition, the
Company relies upon certain counterparties such as banks and loan servicers who
are also highly dependent upon computer systems. The Company recognizes that
some computer software may incorrectly recognize dates beyond December 31, 1999.
The ability of the Company and its counterparties to correctly operate computer
software in the Year 2000 is critical to the Company's viability.
The Dynex computer systems that the Company relies upon to conduct its
business operations are as follows:
The internally-developed investment portfolio analytics, securitization,
and securities administration software
The purchased servicing system for single family and manufactured housing
loans
The purchased general ledger accounting system
In addition, Dynex is involved in data interchange with a number of
counterparties in the normal course of business. Each system or interface that
Dynex relies on is being tested and evaluated for Year 2000 compliance.
Dynex has contacted all of its key software vendors to determine their Year
2000 readiness. We have received documentation from each of the vendors
providing assurances of Year 2000 compliance:
Baan/CODA, vendor of the general ledger accounting system, has provided
confirmation that their current software release is fully Year 2000 compliant.
Interlinq Software, vendor of the single-family and manufactured housing
loan servicing software, has provided assurance that their software is Year 2000
compliant.
All software developed internally by Dynex was designed to be Year 2000
compliant. Nevertheless, Dynex has established a Year 2000 test-bed to ensure
that there were no design or development oversights that could lead to a Year
2000 problem. Initial testing of all key applications was completed in January
of 1999, with only minor issues discovered and subsequently remedied. Critical
applications testing was completed in June of 1999, and new or upgraded
applications will continue to be tested as required through the century date
change.
Dynex has reviewed or is reviewing the Year 2000 progress of its primary
financial counterparties. These counterparties are expected to be in compliance.
Dynex, as master servicer of certain securities including those held on the
Company's books, is in the process of assessing the Year 2000 readiness of its
external servicers, to ensure that these parties will be able to correctly remit
loan information and payments after December 31, 1999.
Dynex believes that, other than its exposure to financial counterparties,
its most significant risk with respect to internal or purchased software is the
software systems used to service manufactured housing loans. Dynex will not be
able to service these loans without the automated system. Should these loans go
unattended for a period greater than three months, the result could have a
material adverse impact on the Company as Dynex services the manufactured
housing loans, which are included in the Company's collateral for collateralized
bonds.
Dynex is also at significant risk if the systems of the financial
institutions that provide Dynex software for cash management services should
fail. In a worst case scenario, Dynex would be unable to fund its operations or
pay on its obligations for an unknown period of failure. This would have
material adverse impact on the Company.
Dynex is also at significant risk if the voice and data communications
network supplied by its provider should fail. In such an instance Dynex would be
unable to efficiently service its Manufactured Housing loans until the problem
is remedied. Dynex is closely monitoring the Year 2000 efforts of its
telecommunications ; the provider has provided assurance that their network is
filly compliant at this time.
Dynex is also at significant risk should the electric utility company for
Dynex's offices in Glen Allen, Virginia, fail to provide power for several
business days. In such an instance, the Company would be unable (i) to
communicate over its telecommunication systems, (ii) would be unable to process
data, and (iii) would be unable to service loans until the problem is remedied.
Dynex continues to monitor the Year 2000 status of its utility provider, who
currently reports 99% completion of remediation and testing and projects 100%
compliance in December 1999.
Dynex uses many other purchased and internally developed systems, including
non-IT, that could fail to perform accurately after December 31, 1999.
Management believes that the functions performed by these systems are either
non-critical or could be performed manually in the event of failure.
Dynex has substantially completed its Year 2000 and remediation efforts.
Management believes that there is little possibility of a significant disruption
in business. The major risks are those related to the ability of vendors and
business partners to complete Year 2000 plans. Dynex expects that those vendors
and counterparties will complete their Year 2000 compliance programs before
January 1, 2000.
The Company will not incur any costs related to Year 2000 as all costs will
be paid by Dynex. Dynex has incurred less than $90,000 in costs to date in
carrying out its Year 2000 compliance program. Dynex estimates that it will
spend less than $100,000. Costs could increase in the event that Dynex
determines that a counter-party will not be Year 2000 compliant.
Dynex has developed contingency plans in the event that a system or
counterparty is not Year 2000 compliant.
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk generally represents the risk of loss that may result from the
potential change in the value of a financial instrument due to fluctuations in
interest and foreign exchange rates and in equity and commodity prices. Market
risk is inherent to both derivative and non-derivative financial instruments,
and accordingly, the scope of the Company's market risk management extends
beyond derivatives to include all market risk sensitive financial instruments.
As a financial services company, net interest income comprises the primary
component of the Company's earnings. As a result, the Company is subject to risk
resulting from interest rate fluctuations to the extent that there is a gap
between the amount of the Company's interest-earning assets and the amount of
interest-bearing liabilities that are prepaid, mature or reprice within
specified periods. The Company's strategy is to mitigate interest rate risk
through the structuring of the related securitization to create a stable yield
profile and reduce interest rate risk.
As the Company's parent, Dynex continuously monitors the aggregate cash
flow, projected net yield and market value of the collateral for collateralized
bonds under various interest rate and prepayment assumptions. Dynex has a
Portfolio Executive Committee ("PEC"), which includes executive management
representatives, monitors and manages the interest rate sensitivity and
repricing characteristics of the balance sheet components consistent with
maintaining acceptable levels of change in both the net portfolio value and net
interest income. Dynex's exposure to interest rate risk is reviewed on a monthly
basis by the PEC and quarterly by the Board of Directors.
Dynex utilizes several tools and risk management strategies to monitor and
address interest rate risk, including (i) a quarterly sensitivity analysis using
option-adjusted spread ("OAS") methodology to calculate the expected change in
net interest margin as well as the change in the market value of various assets
within the portfolio under various extreme scenarios; and (ii) a monthly static
cash flow and yield projection under 49 different scenarios. Such tools allow
Dynex to continually monitor and evaluate its exposure to these risks and to
manage the risk profile of the collateral for collateralized bonds in response
to changes in the market risk. While the Company may use such tools, there can
be no assurance Dynex will accomplish the goal of adequately managing the risk
profile of collateral for collateralized bonds.
Dynex measures the sensitivity of its net interest income to changes in
interest rates. Changes in interest rates are defined as parallel interest rate
movements in 100 basis point increments over a twelve month period. Dynex
estimates its interest income for the next twelve months assuming no changes in
interest rates from those at period end. Once the base case has been estimated,
cash flows are projected for each of the defined interest rate scenarios. Those
scenario results are then compared against the base case to determine the
estimated change to net interest income.
The following table summarizes the Company's net interest margin
sensitivity analysis as of September 30, 1999 and June 30, 1999. This analysis
represents management's estimate of the percentage change in net interest margin
given a parallel shift in interest rates. The "Base" case represents the
interest rate environment as it existed as of September 30, 1999 and June 30,
1999. The analysis is heavily dependent upon the assumptions used in the model.
The effect of changes in future interest rates, the shape of the yield curve or
the mix of assets and liabilities may cause actual results to differ from the
modeled results. In addition, certain financial instruments provide a degree of
"optionality." The model considers the effects of these embedded options when
projecting cash flows and earnings. The most significant option affecting the
Company's portfolio is the borrowers' option to prepay the loans. The model uses
a dynamic prepayment model that applies a Constant Prepayment Rate (CPR) ranging
from 6.0% for fixed-rate manufactured housing loans to 69.1% for single family
ARM loans indexed to the six month certificate of deposit rate. The model varies
the CPR based on the projected incentive to refinance for each loan type in any
given period. While the Company's model considers these factors, the extent to
which borrowers utilize the ability to exercise their option may cause actual
results to significantly differ from the analysis. Furthermore, its projected
results assume no additions or subtractions to the Company's portfolio, and no
change to the Company's liability structure. Historically, the Company has made
significant changes to its assets and liabilities, and is likely to do so in the
future.
<TABLE>
<CAPTION>
<S> <C> <C> <C> <C>
---------------------- --------------------------------------------
Basis Point
Increase (Decrease) % Change in Net Interest Margin from Base
in Interest Rates Case
---------------------- --------------------------------------------
September 30, June 30, 1999
1999
------------------ ---------------------
+200 (20.93)% (17.86)%
+100 (10.24)% (9.40)%
Base - -
-100 10.17% 7.83%
-200 20.51% 16.77%
---------------------- ------------------ --- ---------------------
</TABLE>
The September 30, 1999 analysis illustrates that net interest margin is
slightly more sensitive to interest rate changes than it was at June 30, 1999.
Approximately $1.7 billion of the Company's investment portfolio as of
September 30, 1999 is comprised of loans or securities that have coupon rates
which adjust over time (subject to certain periodic and lifetime limitations) in
conjunction with changes in short-term interest rates. Approximately 63% and 28%
of the ARM loans underlying the Company's collateral for collateralized bonds
are indexed to and reset based upon the level of six-month LIBOR and one-year
CMT, respectively.
Generally, during a period of rising short-term interest rates, the
Company's net interest spread earned on its collateralized bonds will decrease.
The decrease of the net interest spread results from (i) the lag in resets of
the ARM loans underlying the collateral for collateralized bonds relative to the
rate resets on the collateralized bonds and (ii) rate resets on the ARM loans
which are generally limited to 1% every six months or 2% every twelve months and
subject to lifetime caps, while the collateralized bonds have no such
limitation. As short-term interest rates stabilize and the ARM loans reset, the
net interest margin may be restored to its former level as the yields on the ARM
loans adjust to market conditions. Conversely, net interest margin may increase
following a fall in short-term interest rates. This increase may be temporary as
the yields on the ARM loans adjust to the new market conditions after a lag
period. In each case, however, the Company expects that the increase or decrease
in the net interest spread due to changes in the short-term interest rates to be
temporary. The net interest spread may also be increased or decreased by the
proceeds or costs of interest rate swap and cap agreements.
As part of its asset/liability management process, the Company has entered
into interest rate cap and swap agreements. These interest rate agreements are
used by the Company to help mitigate the risk to the collateral for
collateralized bonds of fluctuations in interest rates that would ultimately
impact net interest income. To help protect the Company's net interest income in
a rising interest rate environment, the Company has purchased interest rate caps
with a notional amount of $351 million, which help reduce the Company's exposure
to interest rate risk rising above the lifetime interest rate caps on ARM loans
underlying the collateral for collateralized bonds. These interest rate caps
provide the Company with additional cash flow should the related index increase
above the contracted rates. The contracted rates on these interest rate caps are
based on one-month LIBOR, six-month LIBOR or one-year CMT. The Company has also
utilized interest rate swaps to convert floating rate borrowings to fixed rate
where the associated collateral financed is fixed rate. The interest rate caps
that the Company uses to manage certain interest rate risks represent protection
for the earnings and cash flow of the net collateral for collateralized bonds in
adverse markets. To date, short term interest rates have not risen at the speed
or to the extent such that the protective cashflows provided by the caps and
swaps have been realized.
The remaining portion of the Company's collateral for collateralized bonds
as of September 30, 1999, approximately $1.2 billion, is comprised of loans that
have coupon rates that are either fixed or do not reset within the next 15
months. The Company has limited its interest rate risk on such collateral
primarily through the issuance of fixed-rate collateralized bonds. Overall, the
Company's interest rate risk is primarily related to the rate of change in short
term interest rates, not the level of short term interest rates.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings:
None
Item 5. Other Information:
None
Item 6. Exhibits and Reports on Form 8-K:
(a) Exhibits
3.1 Articles of Incorporation of the Registrant (Incorporated herein by
reference to the Exhibits to Registrant's Registration Statement No. 33-83524 on
Form S-3 filed August 31, 1994).
3.2 Bylaws of the Registrant (Incorporated herein by reference to the
Exhibits to Registrant's Registration Statement No. 33-83524 on Form S-3 filed
August 31, 1994).
3.3 Amended and Restated Articles of Incorporation of the Registrant,
effective April 19, 1995 (Incorporated herein by reference to Exhibit to the
Registrant's Current Report on Form 8-K, filed April 21, 1995).
4.1 Indenture between Registrant and Trustee, dated as of August 1, 1994
(Incorporated herein by reference to the Exhibits to Registrant's Registration
Statement No. 33-83524 on Form S-3 filed August 31, 1994).
4.2 Form of Supplement Indenture between Registrant and Trustee
(Incorporated herein by reference to the Exhibits to Registrant's Registration
Statement No. 33-83524 on Form S-3 filed August 31, 1994).
Copy of the Indenture, dated as of November 1, 1994, by and between the
Registrant and Texas Commerce Bank National Association, as Trustee
(Incorporated herein by reference to Exhibit to the Registrant's Current Report
on Form 8-K, filed December 19, 1994).
Copy of the Series 4 Indenture Supplement, dated as of June 1, 1995, by and
between the Registrant and Texas Commerce Bank National Association, as Trustee
(including schedules and exhibits) (Incorporated herein by reference to Exhibit
to the Registrant's Current Report on Form 8-K, filed July 10, 1995).
4.5 Copy of the Series 10 Indenture Supplement, dated as of December 1,
1997, by and between the Registrant and Texas Commerce Bank National
Association, as Trustee (related schedules and exhibits available upon request
of the Trustee). (Incorporated herein by reference to Exhibit of Registrant's
Current Report on Form 8-K, filed January 6, 1998).
4.6 Copy of the Series 11 Indenture Supplement, dated as of March 1, 1998,
by and between the Registrant and Texas Commerce Bank National Association, as
Trustee (related schedules and exhibits available upon request of the Trustee).
(Incorporated herein by reference to Exhibit of Registrant's Current Report on
Form 8-K, filed June 12, 1998).
4.7 Copy of the Series 12 Indenture Supplement, dated as of March 1, 1999,
by and between the Registrant and Texas Commerce Bank National Association, as
Trustee (related schedules and exhibits available upon request of the Trustee).
(Incorporated herein by reference to Exhibit of Registrant's Current Report on
Form 8-K, filed April 12, 1999).
4.8 Copy of the Series 13 Indenture Supplement, dated as of August 1, 1999,
by and between the Registrant and Texas Commerce Bank National Association, as
Trustee (related schedules and exhibits available upon request of the Trustee).
(Incorporated herein by reference to Exhibit of Registrant's Current Report on
Form 8-K, filed September 13, 1999).
99.1 Standard Provisions to Servicing Agreement (Incorporated herein by
reference to the Exhibits to Registrant's Registration Statement No. 33-83524 on
Form S-3 filed August 31, 1994).
99.2 Form of Servicing Agreement (Incorporated herein by reference to the
Exhibits to Registrant's Registration Statement No. 33-83524 on Form S-3 filed
August 31, 1994).
99.3 Standard Terms to Master Servicing Agreement (Incorporated herein by
reference to the Exhibits to Registrant's Registration Statement No. 33-83524 on
Form S-3 filed August 31, 1994).
99.4 Form of Master Servicing Agreement (Incorporated herein by reference
to the Exhibits to Registrant's Registration Statement No. 33-83524 on Form S-3
filed August 31, 1994).
99.5 Form of Prospectus Supplement of Bonds secured by adjustable-rate
mortgage loans (Incorporated herein by reference to Exhibits to Registrant's
Pre-Effective Amendment No. 4 to Registration Statement No. 33-83524 on Form S-3
filed December 5, 1994).
99.6 Form of Financial Guaranty Assurance Policy (Incorporated herein by
reference to the Exhibits to Registrant's Registration Statement No. 33-83524 on
Form S-3 filed August 31, 1994).
99.7 Form of GEMICO Mortgage Pool Insurance Policy (Incorporated herein by
reference to the Exhibits to Registrant's Registration Statement No. 33-83524 on
Form S-3 filed August 31, 1994).
99.8 Form of PMI Mortgage Insurance Co. Pool Insurance Policy (Incorporated
herein by reference to the Exhibits to Registrant's Registration Statement No.
33-83524 on Form S-3 filed August 31, 1994).
99.9 Form of Prospectus Supplement of Bonds secured by fixed-rate mortgage
loans (Incorporated herein by reference to Exhibits to Registrant's
Pre-Effective Amendment No. 4 to Registration Statement No. 33-83524 on Form S-3
filed December 5, 1994).
99.10 Copy of the Saxon Mortgage Funding Corporation Servicing Guide for
Credit Sensitive Loans, February 1, 1995 Edition (Incorporated herein by
reference to Exhibit to the Registrant's Current Report on Form 8-K, filed March
8, 1995).
99.11 Copy of Financial Guaranty Insurance Policy No. 50364-N issued by
Financial Guaranty Assurance Inc., dated April 7, 1995, with respect to the
Series 3 Bonds (Incorporated herein by reference to Exhibit to the Registrant's
Current Report on Form 8-K, filed April 21, 1995).
99.12 Copy of Financial Guaranty Insurance Policy No. 50382-N issued by
Financial Guaranty Assurance Inc., dated June 29, 1995, with respect to the
Series 4 Bonds (Incorporated herein by reference to Exhibit to the Registrant's
Current Report on Form 8-K, filed July 10, 1995).
99.13 Copy of the Standard Terms to Master Servicing Agreement, June 1,
1995 Edition (Incorporated herein by reference to Exhibit to the Registrant's
Current Report on Form 8-K, filed July 10, 1995).
99.14 Copy of Financial Guaranty Insurance Policy No. 19804 issued by MBIA
Insurance Corporation (Incorporated herein by reference to Exhibit to the
Registrant's Current Report on Form 8-K, filed November 15, 1995).
Copy of Financial Guaranty Insurance Policy No. 20596 issued by MBIA
Insurance Corporation (Incorporated herein by reference to Exhibit to the
Registrant's Current Report on Form 8-K, filed March 21, 1996).
99.16 Copy of Financial Guaranty Insurance Policy No. 21296 issued by MBIA
Insurance Corporation (Incorporated herein by reference to Exhibit to the
Registrant's Current Report on Form 8-K, filed June 19, 1996).
(b) Reports on Form 8-K
Current Report on Form 8-K as filed with the Commission on August 16, 1999,
relating to the Registrant's Series 10 Bonds.
Current Report on Form 8-K as filed with the Commission on August 16, 1999,
relating to the Registrant's Series 11 Bonds.
Current Report on Form 8-K as filed with the Commission on August 16, 1999,
relating to the Registrant's Series 12-1 Bonds.
Current Report on Form 8-K as filed with the Commission on August 20, 1999,
relating to the Registrant's Series 13 Bonds.
Current Report on Form 8-K as filed with the Commission on September 13,
1999, relating to the Registrant's Series 13 Bonds.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
MERIT SECURITIES CORPORATION
By: /s/ Lynn K. Geurin
Lynn K. Geurin
(Principal Executive Officer)
/s/ Teresa G. Eastep
Teresa G. Eastep
(Principal Financial & Accounting Officer)
Dated: November 15, 1999
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-mos
<FISCAL-YEAR-END> Dec-31-1999
<PERIOD-START> Jul-01-1999
<PERIOD-END> Sep-30-1999
<CASH> 10
<SECURITIES> 29,807,802
<RECEIVABLES> 0
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 0 <F1>
<PP&E> 0
<DEPRECIATION> 0
<TOTAL-ASSETS> 0
<CURRENT-LIABILITIES> 0 <F1>
<BONDS> 2,781,735
0
0
<COMMON> 10
<OTHER-SE> 164,603
<TOTAL-LIABILITY-AND-EQUITY> 0
<SALES> 0
<TOTAL-REVENUES> 103,540
<CGS> 0
<TOTAL-COSTS> 0
<OTHER-EXPENSES> 297
<LOSS-PROVISION> 5,100
<INTEREST-EXPENSE> 89,266
<INCOME-PRETAX> 8,877
<INCOME-TAX> 0
<INCOME-CONTINUING> 8,877
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 8,877
<EPS-BASIC> 0.00
<EPS-DILUTED> 0.00
<FN>
F1 The Company's balance sheet is unclassified.
</FN>
</TABLE>
