Dynex Capital Inc (DX) 2012 Q2 法說會逐字稿

Good morning and welcome to the Dynex Capital's second-quarter 2012 earnings conference call. All participants will be in listen-only mode. (Operator Instructions). Please note, this event is being recorded. And I would now like to turn the conference over to Alison Griffin. Please go ahead.

Thank you. Thanks, everyone, for joining Dynex Capital's second-quarter 2012 earnings conference call. The press release associated with today's call was issued and filed with the SEC today, July 30, 2012. You may view the press release on the Company's website at www.dynexcapital.com under Investor Relations and on the SEC's website at www.sec.gov.

Before we began, we would like to remind you that this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words believe, expect, forecast, anticipate, estimate, project, plan and similar expressions identify forward-looking statements that are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified.

The Company's actual results and timing of certain events can differ considerably from those projected in or contemplated by the forward-looking statements as a result of unforeseen external factors or risks. For additional information on these factors or risks, we refer you to our annual report on Form 10-K for the period ended December 31, 2011, as filed with the SEC. The document may be found on our website at dynexcapital.com under Investor Relations and on the SEC's website at sec.gov.

This call is being broadcast live over the Internet with a streaming slide presentation and can be found through a webcast link on the Investor Relations page of our website under IR Highlights. The slide presentation may also be referenced by clicking on the Q2 2012 earnings conference call link on the IR Highlights page of our website.

Now I would like to turn the call over to Chairman and CEO Thomas Akin.

Thanks, Alison, and thanks, everyone, for joining us this morning bright and early on a Monday morning. With me today is Byron Boston, the President and Chief Investment Officer of Dynex Capital; and Steve Benedetti, our Chief Operating Officer and Chief Financial Officer.

I'll be speaking from the slide presentation on the Dynex Capital IR website. And if you can move through the Safe Harbor agreement, I'd like to talk a little bit about the second-quarter highlights.

Our diluted earnings per share were $0.35 and our book value increased from 962 to 966. Our annualized ROE was 14.3% for the quarter, and our net interest spread declined to 2.18% for the quarter. Our constant prepayment rate was 14.3%, and that was down from the previous quarter. Byron will discuss each of these metrics on the portfolio in detail.

Our common dividend of $0.29 represents a yield of 11.18%. The difference between our ROE of 14.3% and our dividend yield of 11.18% is shielded by our NOL, which Steve will discuss in greater detail. As many of you know, we triggered the utilization of that tax loss carryforward in the first quarter.

Our overall leverage remained a constant 6.1%, slightly up from the previous quarter, but we were not fully invested in that quarter. Our goal continues to be right in the 6 range, and the 6.1 is consistent with what we have been at previously.

If you go to the next page, I'd like to talk a little bit about the recent highlights. Maybe you know, last week we sold a preferred stock offering which is actually settling on Wednesday, August 2, and it is currently trading under the symbol DXPPP, but it should be trading under the New York Stock Exchange symbol DXPRA starting on Wednesday, when it settles. The current price of that is right at par, $25 a share, and we're very happy to have that capital.

And with that, I'd like to -- we have a tax loss carryforward, which we discussed. I'd like to have Steve Benedetti take just one minute and go through the details of that.

All right, Tom. Thank you. As Tom mentioned earlier in the call, we've incurred an ownership shift under Section 382 of the Internal Revenue Code as a result of our February 2012 common stock issuance.

So as a result of that ownership shift, our NOLs -- the use of our NOL to reduce our distribution requirement is now limited to $13.4 million per year. Previously, it was unlimited in its use. And of course, the NOL is used to offset the distribution requirement for whatever dividend is not paid; our earnings are not dividended out to our shareholders. We use the NOL to reduce that taxable income so that we do not pay taxes on the remaining amount.

The NOL expires beginning in 2020 and approximates $143 million at December 31, 2011. The $13.4 million amounts to approximately $0.25 per share, and if we utilize this amount we would retain that $0.25 per common share and increase our book value by that amount.

That is it, Tom.

All right. Thank you, Steve. And then the final recent highlight is we have a term financing that we expect to execute this week. And it is a $200 million two-year facility to finance our CMBS IOs. Byron will go into greater detail on that when we get to the portfolio side of our discussion.

Finally, on the next page is a summary of results. As you can see, our dividend has been fairly consistent. From the third quarter of 2011 we were at $0.27; we went up to $0.28, and now we're paying at $0.29. Our earnings remain in excess of that dividend, as we're trying to create a total rate of return scenario. And currently with a 14%-plus ROE, anything over 11% is what I call a deferred earnings. So roughly, we get 11% of taxable income and then another 3% of what I call tax-deferred income stream. As tax rates go up beginning here in 2013, we think that will be a distinct advantage for the Company.

Our book value per share on the right-hand column there has gone consistently up from the third quarter of 2011 -- $9.15, $9.20, $9.62, $9.66. Even though we're at -- spreads widened in the second quarter, we're very happy to report an increase in our book value.

Our net interest spread has declined modestly from the 2.40%, 2.50% range and the 2.18% range in the second quarter. A lot of that was because we had a lot of agency securities that we purchased, and Byron will go into our current expectations for investments. Again, our ROE in that final -- the lower right-hand column has been consistent, in the basically 14% to 15% range over the last four quarters.

And with that, I'd like to turn it over to Byron Boston to discuss our investment portfolio in more detail.

Good morning. Our diversified portfolio strategy proved beneficial this quarter. Overall, as Tom mentioned, our book value remained steadily slightly higher despite materially wider credit spreads in the CMBS sector.

Our prepayment experience remained below expectations as we have allocated our capital appropriately between pre-payment-protected CMBS securities and the premium hybrid sector, and as Tom mentioned, our company-wide ROE remained above 14% despite the decline in interest rates and net spreads.

We continue to find pockets of value given our ability to opportunistically allocate capital in multiple sectors. Our CMBS portfolio continues to provide us an opportunity to deploy capital at higher yields/ROEs without adding prepayment risk to our portfolio.

We are creating strategies to obtain longer-term financing, as Tom mentioned. We are expecting this week to sign a two-year facility for our CMBS IO book, and our diversified strategy continues to generate solid double-digit returns without extending far out of the risk spectrum. The portfolio is constructed to perform well despite the changing market environment.

If you move to slide 7, let's talk about our overall portfolio composition, which has changed only slightly as we deployed our new capital into the most liquid sectors. On the top left, our Agency/non-Agency split -- 82% Agency, 18% non-Agency. That compares to approximately 79% Agency as of December 2011.

And if you move down to our residential/commercial split, you'll see that our resi book comprises 72% of the book versus 28% in CMBS. That's a slight change from 12/31. Again, as we have raised capital this year, and in a normal fashion we move into the most liquid sectors to get our capital deployed, and then slowly over time we reallocate to our higher-yielding bucket, which at the current time happens to be the CMBS sector.

And then if you look over our maturity reset buckets, you can see that we have continued to minimize extension risks by focusing on securities that either mature or reset by our shorter duration assets within 10 years. And within that bucket, you can see that the 60 to 120 bucket has increased as we have increased our investments in 7/1 and 10/1 hybrid paper.

If we move to slide 8, we can take a look at our portfolio from a credit quality and prepayment perspective. Our main source of prepayment protection is in our CMBS portfolio, where securities have explicit prepayment protection. We've paid our highest prices within -- for securities within the CMBS portfolio.

Of the premium exposure in the balance sheet, 76% of our premium exposure in our portfolio has explicit prepayment protection -- again, that is all in the CMBS sector. That's a slight increase from 63% at year-end.

We continue to focus on higher credit quality assets. As you can see, 89% of our book of business continues to have a AAA rating or higher.

If you move to slide 9, our CMBS portfolio is important to our overall strategy by providing us opportunities to invest in higher-yielding assets -- again, with explicit prepayment protection. And that's extremely important at this point in time in the cycle, simply because interest rates are so low and there are several policy changes that continue to roll out of Washington.

Approximately 75% of our CMBS portfolio was originated by one of the government-sponsored entities, Freddie Mac, Fannie Mae, or Ginnie Mae. You can note that in the credit quality graphs, that 73% of the CMBS portfolio is rated AAA; 21% is rated single-A, but that book of business is important for you to understand that even those securities have come through as Agency multi-family program, where we find the best credit quality assets versus multi-family loans originated through other channels.

Overall, historically, if you look at the product -- and we have a graph right after this on graph 10, where we can actually show you the low level of defaults. In the Freddie Mac portfolio, if you compare them directly to the conduit program, there is a material difference in overall credit performance.

We also focus on that multifamily sector because that has been a core competency of Dynex since its inception in 1988. In the 1990s we were a direct lender to the multi-family sector. We continue to like this sector.

There have been some changes -- cap rates have come down. As I mentioned in our last quarterly conference call, we have become concerned, and do more due diligence on loans that are originated today. And throughout our due diligence, we continue to favor this sector; we continue to allocate capital to the multi-family sector.

If you note in the upper right-hand corner, we continue to build our credit both with assets originated outside of the bad years of 2006 through 2008. And within the overall asset type, I really want to point out our Agency CMBS IO portfolio, which is very important to us.

We're getting longer-term financing on those assets. The majority of the assets, both in-Agency and non-Agency IO portfolio, are all shorter duration assets, stripped off the top of the capital stack or off of a Freddie Mac, Fannie Mae, or Ginnie Mae security.

If we go to slide 10, this is just definitely a graph of Freddie Mac's historical multi-family default experience. As you can see that even through the bad years of 2006, 2007, 2008, 2009, Freddie Mac's experience never got above 0.5%.

Now, if you compare that to the conduit sector or loans that are originated outside of the Agencies, we saw our default experience get up to as high as 15% within those sectors. So there's a dramatic difference with the Agency multi-family credit product versus loans that have been originated historically outside of those channels.

Let's move to slide 11. Our prepayment experience to date has been excellent, with speeds remaining below expectations. Nonetheless, we have increased our overall amortization of the portfolio due to our expectations of faster speeds.

We're facing the facts -- rates are really low. Multiple policy changes have taken place. The next two or three months will be important to gauge the effectiveness of these recent policy changes. There are expectations that the HARP-related prepayment speeds will peak this month.

We are waiting to see. We still believe that the securities, the hand-selected securities that we have in our portfolio will out-perform the overall universe.

One of the key things to understand about Dynex Capital is diversification and allocation of capital. Hence, we do not have all of our capital exposed to one type of borrower. We've got the CMBS sector, which has kind of positive takeaway -- is having explicit prepayment protection.

Within the hybrid ARM sector, we have allocated capital across what we'd call different borrower types, whether they happen to be 2006, 2007, 2008, 2009 2010, 2011 -- we have borrowers who took out 5/1s originally, 7/1s originally, or 10/1s. And we believe that diversity will lead to a solid prepayment experience throughout the remainder of the year.

Our leverage remains approximately 6 times, and our overall target -- we think of our leverage ratio being 6 plus or minus something. So you can see some fluctuations around the target 6 level.

Our net spread declined -- it has been drummed throughout the industry over the last couple of weeks. Net spreads are down as the yield curve has flattened; our credit spreads have come in; but again, our opportunistic strategy allows us the chance to find higher-yielding assets throughout the marketplace.

Let me give you an example. By the end of the first quarter, by March of 2012, the CMBS sector had tightened and materially, and we thought as we enter the second quarter that we would not have as many opportunities within the CMBS sector.

As we noted earlier, the CMBS credit spreads widened. There is a good news/bad news story here. The bad news is it put downward pressure on our book value. The positive story happens to be it gave us an opportunity to reinvest capital, and as such, you saw that we did a preferred capital issuance of approximately $50 million. We had the opportunity to pre-invest a good sizable chunk of that capital prior to actually issuing the bond in the marketplace.

If we move to our next slide, slide 12, here is what is important to know here. One, our range of ROEs have declined. But if you notice the upper end of the range, we continue to have the opportunity to find selective investments, yielding, let's say, between 13% and 16%, which has been our range and target for some time now.

Our overall strategy for investing capital has been one of being very selective, and hand-picking the securities that go into our portfolio. As such, you have not seen us to be somewhat of a serial capital raiser, and simply going out and buying large chunks of TBA securities.

If we move to our next slide, it's just simply to emphasize something that we've said over and over again -- that we're focused on capital preservation and managing risk. From a growth/liquidity perspective, we've got 26 counterparties. The amount of availability of credit repo available in the credit markets continues to be very available. However, there are some concerns if some counterparties have -- balance sheets have become somewhat limited.

Overall interest rate risk -- we continue to manage between a 0.5 and 1.5 duration gap. I mentioned earlier a high credit quality portfolio. And we continue to focus on minimizing our overall extension risk.

If we move to slide 14, let me just summarize some of the key points I just made. Our prepayment experience has been below expectation, but we continue to anticipate faster speeds, given the lower interest rate environment and changes to HARP. As a result, we have increased our amortization schedule in our portfolio.

Our credit exposure continues to be focused on the multifamily sector, which is the strongest-performing sector in the commercial real estate market. Our credit IO portfolio is protected from the current prepayment environment. Backed mainly by Agency-produced multifamily loans, it's generating mid-teen ROEs and is a short-duration asset.

We have continued to favor short-duration assets that minimize the extension risks in our portfolio. And here is what is really key -- our portfolio strategy offers us a wider basket of assets to generate our returns, while our portfolio is constructed to protect book value throughout multiple market cycles. So despite the wider credit spreads in this quarter, you can take note there, our book value actually increased. Despite lower net spreads, our diversified opportunistic strategy continues to afford us an opportunity to find attractive investment alternatives.

If you live move to our next slide, essentially breaking down some specifics on the financing within our overall portfolio, we mentioned that we've got a two-year facility that we're close to being put in place to finance our IO portfolio, but we continue to look at the concept of maintaining hedge accounting. Hedge accounting actions limits our ability to really ladder our repo book of business further than, let's say, one month. And so from our perspective, we like to see ourselves have the ability to ladder our portfolio further over a 12-month timeframe. So we're looking at, again, as we mentioned last quarter, whether we want to maintain hedge accounting.

With that, I'm going to turn it back over to Tom to summarize the quarter.

Thanks, Byron. As many of you know who have followed us through the years, we have been a consistent performer, and our goal has been to really continue to utilize lower leverage, high-quality investment strategy, but do that in a fashion that creates niche opportunities.

We have been internally managed and public since 1988. Our diversified investment strategy, particularly the niche opportunities that we've talked about, allow us to avoid some of the pitfalls in the marketplace. We feel that prepayment protection of our portfolio and our core knowledge in the CMBS is going to continue to distinguish us in the coming quarters.

Our tax NOL allows us an opportunity to provide our investors a total rate of return scenario. It is an 11% taxable current yield and approximately a 3% deferred return, which creates the ROE at 14%.

Finally, there is significant insider ownership of the Company by not only the executive team, but the members of the Board of Directors. As such, we feel that we represent our shareholders much more closely than we would if we didn't have this large insider ownership. We use the adage, we basically eat our own cooking. And that is no truer today than it has been over the last five years.

We want to thank all our shareholders for their continued support. We look forward to the next couple of quarters. And with that, Operator, I'd love to open it up for questions.

(Operator Instructions). Douglas Harter, Credit Suisse.

Thanks. I was wondering if you could talk a little bit about that new IO facility -- what kind of cost tradeoffs you are making to get the two-year certainty of financing?

Byron?

There's not a large cost tradeoff, and here's why there's not. It's mainly because a huge portion of our book of business was put on at wider spreads. So if you were to track how we built the CMBS portfolio since the end of 2009, you're going to see a large amount of additions put on at wider spreads, and almost a drop-off to no additions put on as spreads have tightened in. As such, the way the facility is structured, it is not a material difference in terms of overall costs versus what we finance today from a 30-day perspective.

The thing, Doug, that we like more than anything else is really having a more permanent source of capital for our CMBS IO's that we think matches up and creates a more consistent spread product for the portfolio.

And Doug, let me be more specific, really. A good chunk of -- the actual spread the product actually plays a material influence on the overall net cost of the facility. And because IO spreads have tightened in materially from the average spread that we put on our book of business, that's really what influences the overall cost.

Great. And if you could just refresh my memory as to what the type of duration is on those CMBS IOs?

You're talking between 2 and let's call it 3.5 years or so.

Got it. And then just to shift tacks a little bit, with the NOL -- sort of breaching of the -- or triggering of the ownership change, does that change the way you guys will be thinking about the level of your dividend going forward, or is it -- had you always kind of anticipated that?

Well, it's interesting -- maybe coincidence, maybe not, but Steve talked about our approximately $0.25 a year. That's approximately $0.06 a quarter in dividend that we can shelter or defer, let's say. And the fact that we paid $0.29 this quarter and earned $0.35 I wouldn't say is a total coincidence, but the goal is to continue to utilize that to the extent it's humanly impossible that is natural within the marketplace.

Our current preferred offering that we have at 8.5% dividend yield, and we expect to generate substantial returns above that in the open market, should allow it to be accretive to our earnings. And therefore we may get into a situation where we have to increase the dividend again if we earn in excess of that $0.25 a year. But that's the sort of thing we'd like to see.

So is there an official dividend policy that we're going to be following exactly along that line? I can't say there is. But it's going to be a pretty reasonable rule of thumb, Doug.

Great. Thank you for that color.

Trevor Cranston, JMP Securities.

I have a couple of things. First, you guys mentioned that you were able to pre-invest some of that capital raised in the preferred offering. Can you give a little bit more in detail about the kind of assets you bought, whether or not you've added any hedges along with the investment that has gone on there?

Yes, Trevor, we have added hedges throughout -- as rates have come down, we've actually been more aggressive about adding hedges and trying to add some forward-starting swaps, targeting swaps that will be running off and then adding hedges along with the assets.

One of the great opportunities was CMBS widening out in the second quarter. We never turned that machine off throughout the second quarter. We thought we were going to. If you had talked to us on March 31, or March 30, we thought we were going to have that machine turned off on the second quarter, but it did not happen. We continued to invest, and then it has gone through in the end, and headed into July we continue to have those opportunities.

Where we do, as you can see in the numbers, that we were gleaned on 7/1 and 10/1 hybrids. We've also looked for prepayment stories. Those are really hand -- the whole portfolio is hand selected, but this one is even more so, in the sense that we have the ability to really look for stories that will lead us to being below the average speed of a hybrid portfolio.

So the story has been the same. We've been really focused on diversifying our exposure, utilizing the CMBS sector to add extra yield to the portfolio. And the widening of the spreads, again, it was a negative on book value, but it was a real positive for investing our capital, and we did add, and continue to add, swaps.

This is a good time to add swaps. Obviously, rates are lower, if you think of it from the long-term perspective. But I think there is -- if you look at the marketplace as a whole, think we probably get even more opportunities at lower rates to add, to lock in financing.

Okay, that's helpful. And a specific question regarding the swaps. The forward-starting swaps you guys mentioned that settle, I think, in 2013, do you have the settlement dates for those, or -- when exactly they'll be hitting the books in terms of cost of funds?

Trevor, that information actually will be published in the 10-Q. It will be published here in about four, five days.

I'm sorry you have to wait for that.

Okay, perfect. Thanks, guys.

Thanks, Trevor.

Zach Tanenbaum, MLV.

Just wanted to ask about the asset sales in the quarter. Can you give us a little more color around the decision to sell out of some of those assets? And then what your expectations are for sales going forward.

So Zach, we are not a -- let me say first, we're and not one of the hedge fund REITs that basically are -- their whole strategy is designed around trading their portfolio. But we do feel that it has a need from quarter to quarter to potentially sell certain assets.

So what we saw in the second quarter started really in the first quarter. In January we got an opportunity to buy something that really was not considered a good REIT asset but was very similar in terms of credit quality. It was issued by Freddie Mac. It was a short duration instrument. And we always consider the deal we call the placeholder.

So it allowed us to really get some capital back in January, invest it rapidly in the marketplace. And as we got the chance to deploy money into some of our more core assets, we peeled those assets off. So half of it came off in I think March of this year; the other half came off in the second quarter.

If you look forward into the future, I walked in today and gave my guys and idea of a potential swap candidate out of the portfolio. And that's simply trying to manage credit risk, prepayment risk, duration, and trying to generate the highest return for our shareholders.

I'm trying to say, is there a better risk return for being one of the buckets within our portfolio? But it's not a core part of our strategy, and you shouldn't see enormous amounts of that. But there have been some really interesting shifts in terms of relative value that lead us to really look at closer at our portfolio.

If we think that we're overly exposed in terms of prepayment speeds, something we did about a year ago, where we sold probably $200 million to $300 million worth of bonds that we thought were going to be the fastest bonds in our portfolio; we redeployed that into CMBS. So it's not a core part where we're doing this every single quarter. But we're always looking to upgrade whenever we can.

It's one of the advantages, Zach, of having a diversified portfolio -- you can really shift that mix between Agency and non-Agency back and forth. When we raise capital like we did in the first quarter, we are going to initially put the capital to work in the Agency sector, because it's fairly quick and easy. And then you'll see that shift out of the Agency into CMBS, so that we can stay within what we feel is our targeted asset allocation of 60% Agency and 40% non-Agency.

That's helpful, thanks.

Thank you.

David Walrod, Ladenburg.

I just want to -- my question really was -- I guess dovetails well with that. Can you give us an approximation, because you mentioned there was an impact on the spread given the fact that it was more allocated towards the Agencies as you were deploying the capital -- can you give us a feel for when you thought you had the balance sheet right-sized in the quarter so we can get some sort of thoughts on what the margin would be like going forward?

Well, I tell you, David, it is going to depend on how spreads move. So if you get an opportunity like last year, where you have CMBS spreads widen out as much as they did, Agencies kind of sit there, I will take the advantage of that CMBS sector as much as I can and try to allocate more capital there.

If CMBS worked to tighten into their tightest levels, you'll see us allocate less capital and wait for a better opportunity to enter that sector.

So it's hard to predict exactly, to tell you exactly the way we will look. But I think you can look at -- if you go back and look at the past quarterly movements in these numbers, I think it's not hard to just get a feel for how we go about investing this money in an opportunistic fashion. But it's very difficult for me to predict it and say, this is exactly the way the portfolio will look.

And one way to think about it, David, is we have $3.6 billion of assets at the end of June in our investment portfolio. And our average interest-earning investments for the quarter were about $3.34 billion. So the capital base that we have, we would say that -- and Tom said earlier -- the capital that we have at the end of June, we're fully invested here vis-a-vis our leverage targets. So arguably, during the quarter we were somewhat underinvested, but are now entering the third quarter on a more fully-invested basis.

Good, that's helpful. And I was also just curious -- on the rule 382, was that something that you guys had identified was something that would likely take place given the decision to raise capital, or just felt like it was still in the best interest? Or was that something that was more of a surprise?

I'm going to let Steve answer this. I'm just going to say that we feel it's an asset for the Company, the NOL. We feel particularly in a high tax rate environment it's going to be a critical advantage for us. We also did a fair number of -- fair amount of time trying to analyze, can we use that NOL completely? And we did feel that there was a critical damage to being able to not only expand the Company and pick up some assets that were very attractive in the first quarter, but at the same time continue to use the NOL in its entirety. And that is our goal. But Steve, why don't you clarify it further?

Yes, so Tom, there's really not a whole lot to add to what Tom said, other than we tracked and still continue to track the 382 limit, the ownership shift limits, very closely. We had essentially pro formaed the impact of that February raise on the 382 test.

It's hard -- it's a very complicated analysis, but going into that raise we did view that we would trigger the 382 limit, and that was subsequently confirmed by our tax accountant. So we had been tracking that extremely closely and thought going in we were going to trigger it.

Okay, appreciate it, guys. Thanks a lot.

Thanks, David.

Ken Bruce, Bank of America Merrill Lynch.

Byron, I believe in your earlier comments around the financing side of your business, you had seen some constraints on financing. Is that impacting your ability to finance in any capacity, or is it just more of a general market comment? Is there just increasing costs? Could you just maybe elaborate on that for me?

No, it's not impacting our ability to finance, but there are more counterparties that are saying that their balance sheet is limited. At the end of, I guess, the second and first quarter we saw more counterparties needing to get their balance sheets down.

For us, again, we are a moderate-sized company. We're not again -- we're raising moderate amounts of capital. We have not run into an issue where we were not able to finance these positions.

There is some upward pressure on financing costs. That's really a function of the general market with the amount of securities being financed throughout the repo marketplace, and that has put some upward pressure also on mortgage rates. And then you look at the amount of capital that has been raised within the REIT sector, that has allowed also some upward pressure on repo rates. But availability is still there.

So Ken, one thing that we saw this quarter in our yields -- if you look at the hybrid ARM portfolio last year, last quarter to this quarter, just repo rates, we saw about a 4 basis point increase in our borrowing costs, just from the constraints that Byron was mentioning earlier in terms of the overall market capacity, given things like Operation Twist and the like.

Okay, thank you. And then when we are thinking about spread from your -- recognizing it's difficult to know exactly where this market is going to go -- but do you feel like that we're going to be dealing in a market where some of these ROEs are going to be pressured even lower than they are today?

When you look at it, your chart on page 12, anywhere from 8% to 17% type returns or 6% to 17% returns, they're still pretty healthy in the grand scheme of things. But you feel like there's additional downward pressure on that? And you feel like that's going to compromise the 14% ROE target that you are attempting to deliver?

I don't think the 14% is compromised yet. There is downward pressure throughout the entire marketplace in terms of ROEs. And there have to be, right? Because the 10-year's now down -- there's some extremely low levels, and yields throughout the globe are down to some extremely low levels. So you would expect overall the spreads in ROEs to really come down.

Just to use one analogy, I heard someone say about multifamily loans, they said, oh my gosh, the cap rates are low. And I said, well, have you looked in to where overall ROEs are in the global marketplace in general?

So yes, the ROEs are coming -- I don't think we're compromised here on the 14% yet. And that's only because -- it's mainly because I'm still expecting volatility in CMBS spreads, and that volatility tends to give us an opportunity to opportunistically invest capital.

The Agency spreads are going to be in the Agency spreads. We've been trying to minimize any type of extension risk, so we have not gone beyond the hybrid sector at this point. And we obviously continue to try to get our yield from our CMBS.

I'm expecting some volatility there, especially as we move on into the year end, and we start to move toward the overall fiscal toward year end. So that's my expectations today. But you are in a very low global ROE environment.

I think, Ken, also the way to look at it is obviously we've seen some of our competitors, particularly in the Agency side, have to dial back their earnings expectations a little bit and their dividends. We've seen increasing amounts -- use of leverage in the sector.

We're sitting at 6, which is a fairly modest amount, but going forward, we think we're sitting at a moment right now where we haven't seen massive amounts of volatility to our returns. In fact, you might say the returns are pretty optimistic right now.

We're quite hopeful that there will be some sort of dislocation between now and year-end that will give us an opportunity to take advantage of wider spreads, like we have, really, since we started the portfolio in 2008. With all of the backdrop of economic news, macroeconomic, political or otherwise -- obviously this week with basically all the Fed meetings globally, you could see some fireworks come out of this thing. Those are advantages for us, as we can dial the amount of capital we want in the Agency versus non-Agency.

I think as Byron pointed out, right now we have a tendency in this sort of environment to go where the yield is, and that is in the CMBS side right now. But if you can help us manufacture a little bit -- a mini-credit crisis, it would be helpful to really generating the returns going forward.

Okay. And then as we think about the next couple of months in terms of pre-pays and how that ultimately works its way through speed, what would you expect maybe the high watermark to be on HARP refis that in your minds, says, okay, that wave is through now, and we should see pre-pays begin to normalize -- maybe at a higher level?

Let me just answer that for just one second, and I'll let Byron be more complete. But I think Byron has done a spectacular job of basically under-promising and over-delivering. If you take a look at that page that had our pre-payment history, versus our expectations, we've consistently increased our expectations like we have this quarter. We've increased them again, even though our actual prepayments are going down.

We do not want to make pre-payments an issue for our portfolio. We have -- remember, we started in 2008 in an environment where we knew rates were going down, and we've always been very cognizant of the risk of prepayments. So I think that is not going to be huge issue for this portfolio, but Byron, you can comment further.

I'm with you on that, the way you phrased that. To predict -- because so much of this is policy related, I have restrained from trying to predict the exact amount. Here are the things I've been very forceful about saying.

I don't think we've got a 2003 experience. I've been saying that for the last several years, and the reason is because -- in fact, if you go back to 2009 or so, there were others in the marketplace who claimed like we were going to have a 2003 experience.

I don't think we're going to have a 2003 experience. I do think we will hit a peak year at some point. I can't predict exactly when that happens to be, but I have spent some time with the mortgage bankers and the originators who originate these mortgages.

And every time I add up the numbers, I still don't see -- I see more people coming through the pipeline, but I still don't see just everyone coming through the pipeline. So I would expect getting a peak at some point. I'm very, very slow to predict exactly when that happens to be, because rates are just so much lower. And we continue to enjoy a pretty decent net spread despite these speeds. But a huge part of our strategy has been to diversify and not have all of our capital exposed to one type of borrowing.

Understood. All right. Thank you very much for your comments.

Thank you.

Jason Stewart, Compass Point.

Thanks for taking my questions. I have two questions that are more macro related than anything else. One, as it relates to the Fed lowering interest on excess reserves, any potential impact on the [funny] markets there?

And then too, QE3, a lot of people think the odds of it have been priced into the market. Any impact if it does happen on your portfolio specifically?

Yes. Everyone talks about it being priced in the marketplace, but this is the way I look at these. Priced -- everyone let's say, bought securities -- they bought securities, and then as the Fed moves into the market, everyone's got to sell all those securities to move out of the marketplace.

That's not exactly what's going to happen. It's like a room of crowded people, and then a large person comes into the room. So I'm still -- I'm anticipating that the Fed activity will definitively have some impact. It may have an impact on the financing markets also, depending on what they ultimately do.

It's impossible that the Fed's activity on the short end of the curve, if they do make that shift interest on excess reserves, will not have some impact on potentially -- you can say, I often say -- why would it have an effect on lowering rates?

But I think there are some uncertain consequences because of the impact on the money market this year. I'd prefer them not doing anything in that sector, just because of some of the other uncertain factors around it. I've got a better handle around if they do outright purchases of MBS, and obviously, a better handle around if they extend the language.

Great. That's helpful. Thank you.

Thanks, Jason.

Jay Weinstein, Highline Wealth Management.

Jay, I was worried whether you were going to get a word in edgewise.

Unlike my marriage, I like to have the last word occasionally. So I have to get it on a conference call.

Let's see, I have a wide variety of questions. Tom, you actually referred to one of them a second ago about -- it seems to me like in the industry, leverage ratios have been creeping back up, and dividend raises are coming the other direction. You sort of confirmed that, but I wanted to make sure my instinct was right on that issue.

I think that -- I don't have any -- well, I have some examples. I think it looks that way for the Agency guys. The non-Agency guys seem to be doing okay.

Okay. In terms of the tax loss limitation, it strikes me, it's not really a big deal; I mean, I can't remember any years where you've used the full $13.4 million anyway, although you were a much smaller company at the time, so it's really more likely going forward, but it doesn't seem like it's been rolling down that fast anyway. Is that also reasonably accurate?

That's correct.

Okay, because I've been around a lot longer than a lot of people, so I remember -- I know these things. Explain to me the whole excess inclusion income press release. I didn't really understand it. So explain to me what that was exactly.

Well, we've got Steve Benedetti, who's an expert, on the line here. I'll let him take that call.

Jay, how many hours do you have?

Yes, I had a feeling it was going to be a really exciting discussion, so I really -- I have got the rest of the morning. It's all yours.

The long and short of it is, the excess inclusion income is unrelated business taxable income in the hands of certain corporations, generally nonprofits and foreign corporations. The Russell took a position this year that it was a zero-tolerance policy -- no matter if you had $1 of excess inclusion income that could generate UBTI in the hands of someone that might buy into the index, then you are out of the index.

So what we did was essentially drop the securities that were generating the excess inclusion income into our taxable REIT subsidiary, such as that entity would then have -- receive the excess inclusion income to the extent it does, to the extent that there is any excess inclusion income. And the excess inclusion income essentially comes from the ownership of residual interests and securitizations.

Okay.

You might have to take that off-line, Jay; I think that's a real detailed question.

Okay. All right -- like I say, I think it's probably more -- how much -- what was the amount of money in the securities, for instance, that you had to contribute? Is it -- ?

Well, they had very -- they had no book value and essentially no real income. So from a -- it's just really a very technical analysis on these securities. And they end up in the taxable REIT sub, because that entity doesn't really distribute anything. It would just pay taxes to the extent it has taxable income.

We really do not expect it to have any taxable income. We don't think there's going to be any material impact of this. It was really just getting it off the REIT's books so that none of the distribution we make to our shareholders can be classified as excess inclusion income, and therefore UBTI in the hands of our shareholders.

Okay. That's -- .

Most importantly, it had to do with also the Russell 2000.

Right. I said -- we could debate whether or not -- whether the Russell 2000 makes a difference one way or another, but I have no issues with it.

Real quickly, you mentioned tightening of CMBS spreads in the second quarter. Have they tightened since July 1, with last week's big risk-on rally? Have you -- what's gone on in the first month of this quarter?

I think you've got that backwards. They actually widened in the second quarter.

I'm sorry, I meant -- that's what I meant, in case I spoke incorrectly.

Yes, they didn't widen in the second quarter. They have tightened this quarter. Probably most of the tightening happened in the last week or so. Then in the quarter we still saw spreads sitting out there.

The widening in the second quarter was pretty orderly, which is a great way to do it. And so we still -- we're probably a little more selective today than we were a month ago. And we sit and wait, obviously, for a little more volatility in spreads as we approach year end.

Okay. And last but maybe most importantly, just work me through the thought process of issuing the preferred. You used to have the old preferred, which you converted to common. I know you issued a new one, you could have issued more common; you could have borrowed the money; so tell me what analysis and thought process you went through, and then you said okay, this is what we're going to do.

Well, I'm going to let Steve add to this, but we always look for, first and foremost, opportunities in the marketplace to invest our capital. One of the hallmarks, I think, of Dynex, because we are owner operators, is we want to make sure that ROE is an acceptable level and there's not risk associated. So let's just start off at the top line.

The ROE opportunities were there, particularly in our investment strategy. And that is high-quality, short-duration assets. We saw an opportunity to invest in that type of capital class at rates right along the line of what we're used to seeing.

Then it's a question of how much capital do you want to raise. We did not feel that the opportunities were large; as Byron said, we're really playing in the niche markets now. We could have probably taken down 150 or something of equity, but that would have meant at 6 X that we would have had to buy $1 billion roughly of securities. And unfortunately, the niches that we're looking at are not that large.

With $50 million of preferred, we can buy about $300 million of securities at our spread level. So it has to do with that.

Then, finally, you're right; we did have a preferred a couple of years ago. We had a 9.5% preferred. This was an 8.5%. We like the preferred. We like the permanent capital structure of the preferred, and it was going to be accretive to our shareholders. So that's the final thing we look at. We want to make sure it's not dilutive, and this was not dilutive from our perspective.

Steve, have you got anything more to add?

No, Tom, I think that was a good summary. From our point of view, as Tom mentioned, it's a permanent piece of capital. You had mentioned earlier, Jay, in your question, hey, you could've taken leverage off. Obviously, leverage is not permanent. I think it adds more risk to the balance sheet. And in putting this capital in, obviously as direct leverage down to the common shareholder, without -- on a nonrecourse, permanent capital basis.

Okay. And so basically, given the size of the opportunity, so your choice was between taking up leverage and issuing the preferred, and you just opted for the preferred.

Yes, and the common didn't make sense either, because even though it may be not dilutive when we issue it to our book value, when you look at the return opportunities, arguably it would be dilutive to our returns to our common shareholders. So the preferred make more sense at this point in the cycle.

Okay. All right, terrific. That was very helpful. And I hope you guys are enjoying the summer.

Thank you, Jay.

(Operator Instructions). There are no further questions. I would like to turn the conference back over to Thomas Akin for any closing remarks.

Well, great. We want to thank everyone for joining us today. We have consistently tried to perform for our shareholders, and I think this quarter is exemplary of that fact. Our ROEs stay consistent with what we've been expecting, and that's without taking additional leverage or additional -- what I would call investment strategy risk.

I want to point out to everyone that our preferred is trading in the open market under the symbol DXPPP. It will settle on Wednesday, and the symbol will change to DXPRA. It is currently trading sightly above par, but we appreciate all of our shareholders for their time today, and we look forward to next quarter's call.

The conference is now concluded. Thank you for attending today's event. You may now disconnect.