Dynex Capital Inc (DX) 2015 Q2 法說會逐字稿

Good day and welcome to the Dynex Capital Incorporated Second Quarter Earnings Conference Call and Webcast.

All participants will be in listen-only mode. (Operator Instructions) After today's presentation, there will be an opportunity to ask questions. (Operator Instructions) Please note that this event is being recorded.

I would now like to turn the conference over to Alison Griffin, Vice President of Investor Relations. Please go ahead.

Thank you. Good morning, everyone and thank you for joining us.

The press release associated with today's call was issued and filed with the SEC this morning, August 6, 2015. You may view the press release on the Company's website at dynexcapital.com under Investor Center, as well as on the SEC's website at sec.gov.

Before we begin, we wish 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 could differ considerably from those projected, and/or contemplated by those forward-looking statements as a result of unforeseen external factors or risks.

For additional information on these factors or risks, please refer to the Annual Report on Form 10-K for the period ending December 31, 2014 as filed with the SEC. The document maybe found on the Company's website under Investor Center, as well as on the SEC website.

The call is being broadcast live over the Internet with a streaming slide presentation and can be found through a webcast link under Investor Center on our website. The slide presentation may also be referenced by clicking on the Dynex Capital second quarter 2015 earnings conference call link on the presentation page of the website.

With me on the call today, I have Byron L. Boston, CEO, President and Co-CIO; Smriti Popenoe, EVP, Co-CIO; and Steve Benedetti, EVP, CFO and COO. I now have the pleasure of turning the call over to Byron.

Thank you, Alison and good morning.

Our second quarter results for 2015 reflects the complexity of the global financial, economic and geopolitical environment. Movements in the major financial markets have all been challenging for the past one-and-a-half to two years. Global currencies, commodities, interest rates and stock markets have all continued to deliver surprises as corporations, investors, regulators, and politicians work hard to understand a rapidly changing landscape. As a result, I want to take a few moments to review our second quarter earnings, our strategy, and the risk that we take to ensure that our investors understand our approach to the business.

In my 30-year career of managing fixed-income assets, and in my 11-year career managing a mortgage REIT, I have found it necessary from time-to-time to stop and review the business model, the risk that we take on a daily basis, and our long-term approach to the business. Hence, my goal is that you leave our call today with a better understanding of the Dynex, our long-term approach to the business, and why we continue to feel comfortable owning or holding Dynex stock in our personal portfolios.

I will start by asking myself a series of questions with the goal of giving a high-level picture of the business. And after that I will finish and I'll turn it over to Smriti and Steve, who will give you more details regarding the overall results for the quarter.

So first question, what happened during the second quarter of 2015? Simply put, we generated core net income of $0.21, our book value was $8.53, which is down 4.8%. We paid a dividend of $0.24. Our stock yield is currently 13%. What were the drivers of our results in the second quarter? Our earnings were impacted by faster prepayments fees, and our book value was impacted negatively by the rise in interest rates and wider spreads.

Byron, do you still believe the global financial and economic environments are complex? The short answer here to this question is, yes. We have talked about this for the last one-and-a-half years. The future will be full of surprises and we are managing our business from this perspective. How is your portfolio constructed today given the complex global backdrop? First, we are long-term investors, and we have constructed the portfolio to perform in a variety of market environments. Hence, our quarterly results are important to us. But our investment decisions are made for much longer time horizon. We continue to build a diversified portfolio, this has been a major driver of our results for years. Combining the asset-backed by both residential properties and commercial properties has proven to be very profitable and a base for good risk management. We still focus on short duration assets, but we have added a few longer final CMBS. By longer though, I mean 12-year final as opposed to 10-year finals. We sold all our higher risk bond and moved up in credit, all assets added in 2015 are rated AAA are backed by government or by a government agency. The key here is liquidity. We have in effect increased the credit quality of our portfolio and more importantly, we have improved the liquidity of our portfolio. We are concerned about using leverage with lower rated credit bonds in an environment where spreads are tight and asset valuations are high.

So what are you trying to achieve at this point in the business cycle? Simply put, we are balancing risk and reward. We believe that an above-average dividend yield will be a strong contributor to total returns for the foreseeable future. Hence, we're trying to balance the amount of risk we should take to produce an appropriate level of dividend to our shareholders. A major driver of our results would be the size of our balance sheet and our overall leverage. Over the past 2.5 years, our balance sheet has been as low as $3.7 billion and as high as $4.7 billion. Today, our balance sheet is $4.2 billion. We are in the middle of this range somewhat neutral. Over the past 2.5 years, our leverage has been as low as 5.15 times and as high as 6.8 times. Today, we also sit in the middle of this range at 6.2 times. I can see our leverage drift a little downward as we head into the latter part of the year, but this is a dynamic process that will be influenced by multiple factors as Smriti will discuss more on that here in a second.

What other risk will you take given the complex environment? We are assuming a few core risk at this time in our portfolio, duration risk and spread risk with core positions in our book of business. We'll manage this exposure dynamically. We'll continue to manage duration exposure across the yield curve meaning to go back about three or four years ago at one point, we had all of our duration house in the front end of the yield curve, so only over the last couple of years, we have moved that duration -- a portion of that duration out of the longer portion of the yield curve. And again, Smriti will go into more detail in a second.

We'll keep a close watch on our liquidity to ensure that we are protected in any market disruption and that we have the ability to take advantage of the investment opportunities as they develop. We are minimizing our prepayment exposure by focusing on the CMBS sector where prepay risk is mitigated by prepayment penalty, here is an interesting point. This quarter, prepayment speeds actually had a net negative impact on our earnings. However in those numbers, the positive impact of CMBS prepayment materially offset the negative impact as the residential sector prepayment speed, such that the net impact was much lower than what it would have been had we only been exposed to the residential sector. So again, the benefits of diversity.

Another question, does the threat that the Fed raising interest rates concern you enough that you will hedge out all the duration in your portfolio? I believe this is a key question. So I really want to take a second here to answer this. Yes, we are concerned. But no, we have not hedged out all of our durations. The uncertainty around central bank activity is a major concern for us. But global interest rates will be impacted by central bank activity not only in the US, but also in other countries such as China, Japan, Europe and England. We will not hedge all of our duration in our portfolio as long as there is a meaningful risk that rates could drop suddenly. We believe that rates will increase potentially in a very orderly fashion, but that events could evolve where rates could drop suddenly in a much more disorderly now. Hence, we will continue to manage this uncertainty with a positive duration gap.

We further believe that adding more derivatives to reduce our duration gap will only expose us to another set of risk that we do not want to assume at this time. Simply put, hedging out all of your duration in our business model is not a de-risking strategy. It is simply making a bearish call on interest rates. We are not willing to make that call at this point in time.

Another question, will you expand your business as some of the other operationally intensive business strategies such as direct loan origination or servicing? Not at this time. We've continued to look at these strategies, but the return is not sufficient, given the level of complexity, reduced balance sheet liquidity and especially regulatory risk. The market has a dark cloud over the entire mortgage REIT sector. What are the bright spots? Three that I'll point out. Relative yield of our stock in a zero interest rate environment. Please take a look now on slide 3 in our presentation. As we look into the future. We expect the above-average yield generated by Dynex and other mortgage REITs to be a large driver of returns over the next five years. As you look at this chart, you can see and it's highlighted, we are in a relatively a zero interest rate or very low interest rate environment as shown here by the average one-year CDs rate. And as you move out the graph for Dynex stock, you can see what we consider very risky sectors such as the high-yield sector, which offers almost a 50% lower dividend yield and more importantly, the most important point to highlight here is the relative yields and the power of that relative yield over time in terms of driving overall total returns. Second, bright spot financing. We continue to develop alternative financing arrangements away from our traditional Wall Street yield counterparts. We expect these arrangements to be positive as we move forward into the future. This includes our direct relationship with the short-term cash lenders and our relationship with Federal Home Loan Bank of Indianapolis.

Finally and very important, please take a look at the slide on page 4. These are total returns over 12 years for a group of mortgage REIT stocks, which includes Dynex, and the S&P 500. Very important to note, this period includes a two-year period in which the Federal Reserve Board raised interest rates 17 times for a total of 425 basis points, that's back in the period between 2004 and 2006. As you can see that these companies generated attractive relative return over the long-term. Furthermore, during this period, the investors in these companies received a material amount of cash from their investments in these stocks. As we at Dynex, we look to the future. We continue to manage our book of business with a long-term investment perspective. And I hope this chart gives you a better picture of how we think about the long-term or what our overall goals and desires from holding our stock over a long period of time.

With that, I'm going to turn the call over to Steve Benedetti.

Thanks, Byron. For those of you that are following the presentation, I'll be covering parts of slide 6, 7 and 8 with my comments.

As Byron noted, this was a challenging quarter given the volatility in rates and spreads, which is reflected in our results. We reported a comprehensive loss of $0.21 per common share for the quarter and net income of $0.52 per common share. Breaking comprehensive loss into its component parts, we earned core net operating income of $0.21 and had losses on our investments net of their related hedges of $0.42. Core net income to common shareholders of $0.21 was $0.02 lower than the first quarter.

Despite a larger earning asset base during the quarter, core net income was lower, primarily due to three reasons. First, premium amortization was higher from faster prepayments on Agency RMBS. As Byron noted, this was partially offset by prepayment compensation received on our CMBS and CMBS IO portfolios during the quarter, which reflects the benefit of our diversification model. Second, we had a higher hedge cost during the quarter as we added pay-fixed swaps in connection with managing our duration position given changes to the portfolio. And lastly, we had modestly higher operating expenses this quarter versus the first quarter. Partially offsetting these amounts was an increase in earnings for the quarter from our partnership investment in re-performing loans.

Adjusted net interest comp decreased from the first quarter, primarily due to the previously mentioned higher premium amortization on our portfolio coupled with a higher hedging cost. For a similar reason, adjusted net interest spread was lower by 10 basis points, but that also includes the addition of assets during the quarter of lower net interest spreads. Overall, our investment portfolio was flat quarter-to-quarter, but up slightly on an average earning basis as we added Agency CMBS and CMBS IO whose spreads widened early in the quarter, and we sold lower yielding Agency ARMs at the end of the quarter.

On slide 8, we provide a reconciliation of book value per common share. Broadly, the decline in book value was driven by the net decline in fair value in our investments with roughly half of the decline attributable to the steeper yield curve and the other half to spread widening across the portfolio. Book value benefited approximately $0.012 per share from the 845,000 shares we repurchased during the quarter, which is roughly 1.5% of our outstanding common shares. Leverage at the end of the quarter was up to 6.2 times from 5.7 times at the end of the first quarter. Approximately, 60% of this increase is related to the decline in book value and our stock buyback program, and 40% is related to the minor increase in the size of our balance sheet.

Over the last several quarters and continuing into the third quarter, we've been actively managing our hedges, repositioning our duration risk on different points of the curve as noted in the press release and on slides 32 and 33. Smriti will be discussing the reasons for this activity later in the call. On an annualized basis, we're flat for the year on a total economic return to our shareholders as our dividends year-to-date have roughly equaled the book value decline.

During the quarter, our wholly-owned captive insurance subsidiary was approved for membership in the Federal Home Loan Bank of Indianapolis. This is a significant step in diversifying our funding sources and risk managing our business. We added $108 million in advances maturing in 30 days at a weighted average rate of 22 basis points. Return on equity on assets, currently funded at the FHLB, are very similar to the return on equity for repo. As Indianapolis becomes more comfortable with our asset mix, and their regulatory risk with mortgage reinsurance captives, and as we become more comfortable with the FHLB process, we expect significant improvements in equity returns versus repo.

With that, I'll turn the call over to Smriti.

Thanks, Steve. I'm going to discuss macroeconomic factors first, and then drill down to our risk position, and our activity through the quarter referring to slides 12 through 19.

We see an evolution of the complex environment that we've been describing over the last 18 months. This quarter against the backdrop of quantitative easing in Europe and Japan, we saw the existence of the Eurozone threatened by a potential Greek exit. We also saw extreme volatility in Chinese equities, Chinese authorities and central bank took a number of unorthodox and dramatic actions to stem the tide of investor losses. Yet over the quarter, US Treasury yields rose more in the long end of the curve than the short end. Two year rates only rose nine basis points and in contract five and 10-year rates rose 28 and 41 basis points respectively.

Early in the quarter, US markets were driven by moves in German bonds and later in the quarter, market participants believe that little would stand in the way of the Fed raising interest rate. However, the pace and the timing of Fed hikes remain an open question because in spite of the strong desire to move off what's perceived as emergency status of zero interest rates this year. The Fed still remains data dependent and the data thus far still leaves a fair amount of uncertainty in the picture.

Turning to slide 13, where does this leave Dynex? We've assessed this environment as one were the outcomes are really quite divergent and the scenarios with the higher probabilities are likely unforeseen, unknowns surprises. But we also have to plan for a scenario when nothing gets in the way of the Fed raising interest rates as they so desire. We've described this environment as one being -- one in which we don't take outsized risks and our position reflects this view. We are long-duration, as Byron mentioned. As we believe this is an appropriate position in an environment with so many divergent outcomes, some of which could lead to lower interest rates and wider spreads. Being long duration protects our securitized mortgage portfolio from such outcomes. Closing the duration gap in this environment would be (inaudible) to taking a position that interest rates could only rise from this point and would expose us to falling rates scenarios. With that in mind, I want to address our risk position both as it relates to book value, as well as net interest margin.

Please turn to slide 14. Let's start with our book value performance this quarter, a decline of $0.43 since quarter end -- the first quarter end of 4.8%. And if you look on the right hand side of this page we showed last quarter, our portfolio is exposed to a scenario where back-end yields rise more than front end yields called the curve steepener. Now the numbers on this page, just as a reminder to the analyst community reflect that our model duration or option adjusted duration is calculated as the average using cash flows from 500 to1000 interest rate path, and that's basically the metric that we're using to calculate these exposures.

In the middle of the page you can see as of March 31 for a scenario where two-year notes rose 10 basis points and ten-year notes rose 50 basis points, our asset value was projected to decline by 0.04% on the right hand side of the page. This is effectively what happened since March 31. So with leverage of about 6x that translates to about a quarter-percent of equity or $0.02. So if you use the model effective duration, you would see little impact from rate per se.

We also saw last quarter, we also discussed this last quarter that you have to include the impact of spreads and because we're using model effective durations in our calculations, the appropriate metric to use is option adjusted spreads. On page 16, we've shown how option adjusted spreads moved for the quarter and using the bottom table on page 14 using 6x leverage on 25 basis points spread widening for the quarter approximately, that would -- you can see that the book value change then makes sense. You have to consider the impact of rates and spreads when assessing impacts to book value and when you use model duration, option adjusted spreads is the correct metric.

I'd also advise you that going forward, you're going to see impacts to book value on a quarterly basis from hedge costs that are embedded in euro-dollar futures and forward starting swaps that reflect roll-down in the passage of time. My point here is that as we're managing the position more dynamically intra-quarter, it is going to be harder to pin-down exactly where book value will be for a given move in rates.

Now, let's turn to our current interest rate risk position and spread position. The main point I'd like to leave you with here is that our exposure continues to be to a steeper curve, i.e. one where the back end rise is more than the short end. But you can also see on this page that our position is fairly flat when the curve twists or flattens. For example, the yield curve today what's priced into the market today basically have 3.5 rate hikes priced in through December 2016, three more rate hikes through December 2017 and two hikes through December 2018, we only get to 3% LIBOR in December 2020. So effectively, the market has already priced in nine rate hikes or so in the next three years.

Changes to our book value from where we are today are only going to happen to the extent that the market changes its opinion on the pace and the timing of these hikes. To say for example, the market believes the hikes will be sooner and more in magnitude, the front end will respond to that. So those are the scenarios in the middle of this page. For example, with the two-year note rises 25 basis points and the ten-year note really doesn't do much since we're really talking about the pace and timing of very forthcoming set hikes. Our book value, or net asset value exposure is actually pretty limited. On the other hand, if the market believes that the rate hikes will be pushed back, and there is a steepening scenario, these are the first two or three scenarios on this in the second table, we have exposure to those scenarios. In effect, if you add all of those up, we're still talking about a limited percentage of equity at risk for those scenarios.

Now, keep in mind, as we said last time that when the curve steepens or flattens, option adjusted spreads are going to move. So you have to factor in the impact of spreads. Typically, when the curve steepens, option adjusted spreads on assets like hybrid ARMs tend to widen because of cap risk, and because of extension risk. And typically, when the curve flattens, option adjusted spreads on hybrid ARMs tend to narrow, because you basically have less cap risk, and less extension risk. So you need to factor in not only just duration risk, meaning exposure to what the curve is, also where spreads are, if we're in a situation where spreads are already wide, it's highly unlikely that spreads are going to widen further. If we're in a situation where spreads are very tight, you probably want to factor in more spread risk.

All in, what we're trying to do when we manage this position is really try to keep the combination of both duration risk and spread risk fairly limited, and the way we're doing this is that we're buying, and we own securities with relatively low spread volatility. And what we're trying to do is to keep our duration posture long, but still be fairly stable in scenarios where the curve is twisting. So the message here is really that we continue to manage our risk exposure to be able to perform in a wide variety of interest rate environment, but also that our primary exposure continues to beat the spreads.

Now, let's turn briefly to the topic of margins. We continue to be in a situation where we need to manage our swap position dynamically, and we provided an updated picture of our swap position on page 33 of the appendix. What you'll see this quarter is, we actually repositioned our exposure, especially for the year 2016 from euro-dollar futures to forward starting swaps, really because we thought that the curve had flattened to such an extent that we were able to lock in an advantageous rate for the year 2016.

Again, here, the point I want to make, it's against the $3.4 billion or so that we have on repo, there is $2 billion notional and swaps in 2016, and 50% of the remaining $1.4 billion consists of floating rate assets that we'll adjust as short-term rates rise, really leaving our exposure to rising rates and particularly, rates that will affect our net interest margin as being fairly limited. So at this point, we have to have a lot of optionality and carry hedges in the position to cover a wide variety of scenarios, really because of how dynamic the environment is. What you can expect us to do is to manage these positions dynamically both with respect to book value impacts as well as earnings impact from Fed hikes and interest rate changes. And then in terms of dividend, as a reminder, we did take gains as Byron mentioned on our credit sensitive assets last year, which we've used to keep our dividend stable given our more defensive risk posture this year. So with that, I'd like to turn to our investment activity for the quarter on slide 17.

As I just mentioned, we did make a decision to go up in credit and liquidity. This put us in a position of having excess capital and liquidity coming into this quarter and as rates rose and spreads widened, we were actually able to put some of that capital to work. So we added about $400 million in assets, mostly in agency multi-family CMBS, but we also took advantage of non-agency CMBS IOs because they widened towards the end of the quarter. You will see that we began use of our Home Loan Bank Financing facility to the tune of about $100 million and our leverage did go up partially because of our investments and partially because of stock buybacks and the decline in our book value. On the financing side of things, we are seeing a slight increase in our repo rates, particularly for term financing as people build in the possibility of Fed hikes later this year. And you also see in terms of net interest margins, our all-in funding cost that includes the impact of current pace swaps that's going to increase slightly as we continue to actively manage our duration exposure.

On page 18 you can see that our equity and asset allocations continue to migrate to the CMBS sector and at this point over 50% of our equity is in the commercial sector.

On slide 19, I want to talk briefly about our strategy. Let me remind you that our portfolio delevers naturally each month due to prepayments as well as IO run off or extinguishment and in this environment as Byron mentioned, we expect to manage leverage very dynamically. We're finally seeing opportunities to add assets at attractive levels both in the CMBS sector on agency and non-agency. This is primarily being driven by a supply issue, the CMBS markets have really been active this year, particularly agency CMBS market, multi-family market and these are areas that we're actually seeing attractive risk-adjusted return opportunities. And what we're doing here is not only deploying excess capital that we have, but also taking advantage of gains that we have in our current positions, seasoned positions where we believe that the forward risk reward is asymmetric and we're able to actually upgrade the yield quality of our we're very comfortable doing that.

We continue to play in the non-performing, weak performing loan securitization space. And then finally, under our $50 million authorized share repurchase program, we have been and are opportunistically repurchasing shares. So as always, you can expect us to focus on liquidity and capital as Byron mentioned. A brief mention on financing, we've seen some positive developments in the arena of private direct financing. We think we can continue to take advantage of these opportunities as they present themselves, that in combination with our relationship with Home Loan Bank in Indianapolis, in our view, would really help cushion at least a portion of the increase in financing costs as a result of Fed hikes. And the real important issue there is that they enhance the ability for us to manage risks using our financing position rather than relying solely on derivatives to do that.

So I want to leave you with the following main points. First, our book value decline this quarter was a function of both rates and spreads. Our duration position continues to be long. We think that is appropriate in this environment. Our exposure to curb twist, which typically what happens when the Fed starts an interest rate hiking cycle. It's fairly limited and our primary exposure continues to be the spread movements, which is a natural consequence of owning spread assets. And I'd also like to remind you that current valuations of assets in our portfolio, the derivatives in our portfolio, they already priced in eight to nine hikes in the next three years and they already reflect the September rate hike. Any change from these valuations would actually require a substantial change in the data.

Second, we were able to play offense this quarter. We added assets, we continued to see selective opportunities to deploy capital at long-term risk adjusted returns that are attractive. You can expect us to continue to deploy capital when we see opportunities, including the repurchase of shares when appropriate. We are also optimistic on developments in the financing markets, particularly in the private direct financing arena. We think that this is really going to help us cushion some of the impact of the Fed hikes and help us manage our risk position more effectively.

I'll now turn it over to Byron.

Thank you, Smriti.

Can you go to slide 21 and again, I want to put up a long return chart, I want to make a couple of points here.

First off, if you recall back, we've been on this slide -- the earlier slide -- earlier presentation, I went back to 2003, 2004, 2005, 2006 period. One of the other reasons I chose that time period with those [boxes] the environment was somewhat similar in terms of overall psychology in the market. There were some cloud over the mortgage REIT sector because the Fed might be active in the space. Mortgage REIT analysts have all started to get happy about operating business models and credit and the whole loans and servicing in these types of strategies. And so that's one of the main reasons I chose to go back to 2003 because I wanted to capture that period and to just remind you, if you didn't note, to inform you that this type of period has happened before and look at the return that can be generated over time.

You seen here on slide 21, just to bring it back to specifically Dynex, I went back to 2008 because that's where we've started to build the current version of this portfolio. We've tried to give you as much information today as possible, help you understand our strategy and how we see the future. As in the past, we've been willing to buy back our stock and we will continue to be willing to do so if the relative return looks attractive. And again, in this last chart, Dynex versus the S&P 500 and the Russell 2000, because Dynex is included in the Russell 2000 Index. Because we have a long-term investment strategy, we do not allow short-term results to just weigh our overall decision making. We are balancing our risk with the goal of generating an appropriate dividend over time because we believe dividends over time will be a powerful generator or driver of returns.

As always, I will close my comments by reminding you that we continue to own our stock, we will continue to be compensated with material portion of our personal earnings and stock and we will continue to operate as owner operators as we look to the future. With that operator, we'll open the call for questions.

We will now begin the question-and-answer session. (Operator Instructions) Douglas Harter, Credit Suisse.

This is actually Sam Choe filling in for Doug Harter.

I just had a question, I guess, regarding on your positioning of the investment portfolio. This quarter, we've seen the mortgage REIT here is kind of take a more defensive positioning and you guys stated you were more offensive. So I was wondering is that offensive positioning was -- how are you going to continue throughout the year?

So, just look at this real close with the offensive and defensive words. We started last year identifying the environment as being complex. We then made a decision last fall to sell our lower rated credit positions because we feel lower rated credit positions or repo are riskier position. We then made a decision to improve the liquidity of our balance sheet and the overall credit quality by going up in credit and up in liquidity. So in fact we made some major decisions. We don't like to necessarily use the word defensive. We like to use the word discipline. So when we put all those lower credit rating securities, spreads were really, really wide, returns are really, really high. When we sold them they were really, really tight and returns reduced materially, and as such we were warranted to move up in credit quality, such that we reduced our balance sheet going into the end of last year. This year, we've added agency securities and we added AAA securities.

So our positioning reflects our opinion that the global financial environment is complex. And so, again one of the key things we're trying to emphasize to you is that when you talk about defensive or de-risking strategies, you must be very careful in terms of understanding exactly what you're doing because on many situations, you will just take on another set of risk. If it wasn't so complex, you can either make a bearish call on interest rates or you can make a bearish call on the overall environment and just reduce your balance sheet and move into cash. Both of those positions have different set of risks than we have today. What each person is doing and what we're choosing to do is identify a certain set of risk that we're willing to take.

So we've got again high credit quality balance sheet, more liquidity and so, I don't know if the correct words to use is offense or defense, it's neither, it's discipline.

Got it. I guess another question I had was, what's your thoughts on the GSE risk transfer deals and maybe, I mean, how are you thinking about those?

So, I'll take that Byron. I think the main issue on those has been using leverage with credit sensitive assets and the level at which those bonds are currently trading. So we've looked at these in so many ways since issuance and we have not yet found first loss or second loss risk adjusted returns to be long-term attractive for our -- the way we look at the world. Now, that's not to say that they're never going to get there. If these assets are on our radar screen when they get to the right level, we think we'll step in and look, tranches where you have first or second loss that are trading at 3%, 4% yield, you're really getting your return from leverage and spread widening even of [1,500 basis points] is just material -- they are material losses to equity when that happens and we just haven't gotten comfortable with that.

Let me [touch] a couple of other points on that along the lines is my comments a second ago and I appreciate that question and I think that's a very important one. What we did last fall, this is a very important issue to me, putting leverage on the lower credit sensitive assets, we believe to be a high risk strategy, one to be used as we used it in 2011 when spreads were extremely wide. Now, our general opinion on residential credit risk is that it's an excellent asset, these are money good assets because the regulators are hammering on residential originators so hard that this product has been originated in 2015, very attractive assets.

But to the degree that unfortunately spreads and asset value -- spreads is so tight, asset values are so high and there are so many people chasing those deals that we would have to use leverage for those lower credit instruments, that's the exact trade that we walked out of last fall, we walked into the trade in 2009, 2010, 2011, we walked out of that trade last fall, and we moved up in credit quality and up in liquidity. So that is along the same lines, I want you to listen to us from a top-down approach that we take in this market. We believe the market is complex. Why do I say complex? That means it's very difficult to take a bearish or bullish stance on this market.

We also believe that there could be potential liquidity squeezes. In liquidity squeezes, I don't want to have lower credit rated instruments on repo. I prefer having higher credit quality assets on repo. And if you're 100% certain that you're going to have some type of global meltdown, then I don't want any asset at all, I reduce the size of the balance sheet. Hard to make those large restatements in a complex environment, but I want to emphasize that in a credit risk transfer, the key here happens to be for me to get the appropriate return, I'd have to use leverage and the returns aren't attractive enough with leverage to offset, me just buying a much more higher quality instrument put it on repo.

David Walrod, Ladenburg.

Could you expand a little bit on the prepays, what your outlook is going forward, how they came in July?

Sure. So really, again, these prepays are reflecting the market environment in March and April. So March, April, you saw a dip in rates -- 30-year rates below [4 percentile]. And again, on an all-in basis, I think our speeds were somewhere in the mid-teens to high-teens, 16.5 CPR, they are still relatively low, given just where the rate environment is. So we think that in the next couple of quarters, again, since rates have backed up that we're actually going to see those come back down. Does that help?

It does. Thank you.

Yes, let me [store in] one of the points to you again, I always like to chime in with a longer-term perspective.

If you go back to July of 2013, when rates rose, and we had good (inaudible) we went through a long process, probably, the last time I tried to just review -- educate on our business model. One of the factors we talked about being a shock absorber when rates rise are prepayment speeds, and that's exactly what has taken place over the last two years. Rates went up, our prepayment speeds came down materially from somewhere, probably in the mid-30s to almost as low as 10 CPR. We benefited greatly from that period of time. Rates dropped again earlier this year, prepayment speeds, as Smriti pointed out -- prepay speeds increased.

As you move into the fall and the winter months again, we're looking to see a cyclical downturn in terms of speeds. But again, I want to tie this in with our overall strategy, if you listen to us. A couple of years ago, we talked about prepayment speeds being a shock absorber as they slowdown, adding to net income. It's been a huge positive over the last couple of years. And they have a what I would consider a minor tick such as this up, it's something that has taken place. But if you really look closely, you'll see how much the CMBS prepayment positives offset the negatives of the residential prepayment speeds, that portion is a very bright light or shining positive within the results.

Okay, thank you. Turning to the FHLB, how much do you envision borrowing through that group, and what type of assets are you pledging?

So Dave, Steve here. We have a credit limit with Indianapolis at $575 million. Today, we are pledging only agency CMBS. As I mentioned in my call, Indianapolis is not necessarily that familiar with all of our assets. So we're going through the process with them on educating them on our assets, so that we can expand what we're -- what we would be borrowing and pledging against the advances there.

Okay, great. Just couple of other little housekeeping things? Can you give us a little color on your partnership in the re-performing loans?

Sure. That's our investment in a -- and we talked about that in the past. It's a group that buys re-performing loans. We have made investments with them over the last several years. The activity in that partnership on a quarter-to-quarter basis will be a combination of income earned or coupon on the underlying loans as well as in that particular model, there is often sales activity. So you sort of clean up the credit and then sell the credit. So the activity this quarter reflects a combination of those two items, probably around 60% of which is sales activity and the rest is coupon.

Okay. And last thing, Steve, you mentioned in your prepared remarks that G&A expenses were up this quarter. Is there anything one-time of nature in there or is that good run rate going forward?

I would say that that's a good run rate for the next couple of quarters. Yes.

Eric Hagen, KBW.

You guys have been through a tightening cycle before. So I'm just curious as the Fed actually begins to tight, how do you manage hedge book? Are you actually putting on swaps or you kind of running with what you have now, or you've been rolling off? How do you manage something like that?

Are you saying that, in terms of how do we manage through a cycle such as this?

Yes, I mean you're positioned for eventual Fed tightening as of today, but as the Fed actually begins that cycle, what is the hedge book look like?

Okay. So it is a dynamic process, right? So this -- since you brought up history, so let's compare. So in 2004, Smriti and I ran another REIT called Sunset Financial. At that point, and I really want to draw a contrast here, we drove our duration gap to a negative, negative half a year to one year, because it was easy to make to go with the Fed that they were going to raise interest rates and they were going to raise them consistently. So we made a decision and that was a change in strategy right in the middle of the quarter. Peer review analysts could have predicted it that we would change our duration there. That was the right strategy to be extremely profitable over the -- throughout the entire Fed tightening cycle. Very difficult. Now it's contrast that to today.

Our basic argument here is, it's very difficult to make any type of large, let's call it, stance or bet, or place too much money in one direction. We can't make an outright bearish market call. And so, we haven't made that call, because we think it's more dangerous to get caught off guard, if rates drop rapidly though, those type of moves can put a read out on business, whereas an orderly move up in rates, we can dynamically change our position. In effect, we're sitting here saying that we can dynamically change our position.

So if you compare back to -- appreciate the question that 2004 to 2006 period -- in fact, I've traded in every bear market since 1986. And I will put my track record and training to bare walk at against anyone else. But this is a very different situation, we can't -- they're probably going to get you in a bear market. And so it is dynamic. We will adjust our risk position as necessary. We are not afraid to hedge this book down, if you look at this, that's what we're supposed to do, but I want to emphasize Smriti's points earlier, what she said was, it's already priced into the market is about an eight or nine times hike over the next two or three years.

Smriti, do you want to add anything to this?

Yes. So, if you look on page 33, Eric, we've given you our derivative position essentially in a chart, right? And what you'll see is that we have about $1 billion notional for the remainder of 2015. That reflects our view that really, again, if there is a hike coming, that's what we've hedged out of the position, so to speak. You can see that next year, our hedge position increases substantially, right? But again, as Byron always says, I reserve the right to change my mind in the next second, because we have to manage this position versus what's already baked into the market, okay?

So the market saying next year between now and the end of next year, there is going to be three-and-a-half hikes. If we believe that there is going to be two hikes, some of those hedges are going to come off. If we believe that there is going to be five-and-a-half hikes, there is going to be hedges being put on. So we've had to manage that position very dynamically, and right now, the beauty -- the art in what we do now is really managing versus what the market already has priced in.

So, the key thing, and I think a lot of folks don't really focus on this. If you're hedging today, you're hedging against what the market has already baked in. It's not that you're locking in today's rates you have to look it forward, okay? So that's the real difference.

And let me throw in one other point on this. If you look at past tightening cycles, in every situation you saw the curve flat. So the long end outperforming the short end. So now, let's fast forward to today and what happened in the second quarter here. If you go back and I look at Dynex two years ago, all of our duration exposure was in the front end of the curve, that's where we felt most comfortable, that was the right position at that time. Somewhere near beginning of 2014, we started to move some of our duration out to the long end of the curve, meaning between the seven and ten-year part of the yield curve. You know what, it so happens that this second quarter, the yield curve steeping with long rates rising more -- materially more than short rates and as such that had an impact on Dynex. However, again, we are managing for the long term. If it back, the Fed starts to tight and they go one-time or two times or three times, I anticipate this curve will flat unless there is a material change in inflation or inflation expectations. And by material change, I mean, they start to expect inflation at 3% or 4%. Without that, our assumption is that the curve will flatten. We will continue to try to trade from that perspective. So we've got exposure now in the long end of the curve, even though we lost some book value on that position here this second quarter. We believe that's the right position. I try to give you a little hint in terms of how we've adjusted this position over time.

But we have adjusted where we've got some duration in the short end, another chunk in the long end of the curve and the reason it's in the long end, because we're anticipating that potentially we could have the Fed make some type of move either later this year or sometime next year.

That's a really helpful explanation. I'll switch gears a little bit, that's a follow-through question. How do you think a single security from the GSEs will impact the market, if at all?

Yes, I'm very opinionated on this and I have been for 20 years. I applaud the effort to get to a single security, the structure of Freddie Mac or Fannie Mae and then a poorly trading Freddie Mac security makes no sense to me. I think it costs taxpayers over time and it would just be -- I just don't understand why it's taking so long to get to a single security realized that is a value overall. I think that will increase liquidity, there may be some short-term gyrations with long-term (technical difficulty), absolute positive to get into a point where you have a single security, more standardizations and be honestly, I don't see there is any value happens to agency. But the single security is something that's alive, something that they're working toward and I hope they here move as rapidly as possible.

Jay Weinstein, Highline Wealth.

So I took one easy question and one hard one. The easy one is while you were discussing rate movements in the second quarter, spreads and such, that sort of reversed I think since the end of June 30. I saw the two-year I believe is up 1 basis point or 2 basis points and the 10-year down about 13 basis points. So is that offsetting some -- I mean obviously, you pick a point in time, but is that I'm assuming from what happened in the second quarter, is that more beneficial to your positioning?

That's beneficial, this is a positive, but it's not a huge amount. I mean we really -- I mean with the short end and the middle of the curve really rising and some of the euro-dollar positions again doing more of a twist, it's a positive. But it's, you really haven't had the impact that you had for the second quarter of reversal. So that's a very effective -- very, very good question, Jay. The positive impact, it has been positive, but it's not like a ginormous impact as short rates have continued to (multiple speakers).

The 10-year of course is at a strange and you were plummeted for two months, then stood like stone and now literally I think it's back to exactly where it was on January one, correct?

Right.

But it's a very volatile period.

Here is the harder question, Byron. So I know that most mortgage REITs are given and yield oriented. I won't speak with the other people on the call, but I'm a total return guy. I don't care if there is no dividend at all, if the stock actually goes up, it's all the same to me. I think I can make the case that you guys should actually shrink your balance sheet quite dramatically and be repurchasing significant amounts of stock at this discount, assuming you can keep and maybe even take down leverage, obviously it would depend on how much capital you -- which assets are rolling off and capital applied against them etcetera, etcetera, but not in a small -- meaningful amount 10%, 15%, 20% of the overall outstanding. Why is that either a good or bad strategy?

I think that's a very legitimate option, Jay, and it's one that we talk about internally. Again, that's a big decision. So big positions in that category, I'd put that -- when you say this strengthened the balance sheet dramatically, I'd put that in the same category and closing my duration gap of going negative in terms of duration. And so, those are large decisions and what we're trying to do is a slice of salami, I use that analogy.

So we bought back shares and we bought back certain amount of shares. We haven't jumped in and said, look, just buyback everything. We are limited in terms of how much we can buy and main point on any given day. But one key component here is -- one of the biggest challenges of being able to take a large stance of any type, anywhere, I agree with you though, that's very legitimate, Jay. It's a very legitimate strategy for mortgage restock which is trading at discounts of 10% or more. We've got to run the math and compare versus buying our stock versus investing in a fixed-income asset. It's a legitimate strategy, but we have to be very cautious in taking huge stances.

I would say if I'm doing the math right here because as of last trade, you're looking at, I think, over 20% discount to book and on the other hand, the other thing is, the thing I always liked about you and Thomas, you were willing to take those big stances and you've got that right certainly -- you got it right going into 2008, you've got it right during 2008 and coming out in 2009, which is -- if the market is providing that opportunity personally, I'm happy for you to make that big call, but (multiple speakers).

I appreciate that we're not afraid to make a big call, we're not. And the discount as it, which is, it is over the last trade today, this is actually a new zone for us. So what is this new information, so you've got to be something we'll evaluate -- your value going forward, but it is in the development that has happened here today.

I can understand. You've always been quite clear at that. 10% to 15% discount zone is where you got interested because (multiple speakers) versus alternative investments and obviously this makes that more attractive. So anyway, as I think about it, I think probably most other mortgage REITs, they don't want to shrink their balance sheet. It's like shrinking the size of their feet. But you guys kind of work. That's not of interest and I know that. So if it makes your shareholders more money by shrinking the (inaudible), I know you will do it. So that'd been an interesting conversation.

Yes, this is -- we will -- when we hang up the phone calls today, we would be evaluating the world from this perspective as it has evolved. But I can't -- the great thing I like about the team of people I work with that includes Tom, then the professionals that work around me. When we run the analysis and we put it on the chalk board, if it makes sense, and that's still route that we want to take. It makes sense for our shareholders, of which real material shareholders, best route that we would want to take.

I'll be interested to see that discussion plays out, that's why that was the hard question.

Yes. No, I appreciate that, Jay. As always, I do appreciate you as a shareholder, I appreciate your focus, and I appreciate the question.

I guess, that's fine. That's what you pay me for, right? To ask you all those hard questions? All right, thanks, guys.

Thank you.

Thank you.

Thanks, Jay.

This concludes our question-and-answer session. I would like to turn the conference back over to management for any closing remarks.

No closing remarks. We've kept you quite a while today, and we really appreciate it. I hope you understand our efforts trying to give you as much information as possible. We look forward to you joining us for our third quarter conference call. Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.