Dynex Capital Inc (DX) 2019 Q2 法說會逐字稿

Good morning. My name is Matthew, and I will be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital, Inc. Second Quarter 2019 Earnings Conference Call. (Operator Instructions).

Alison Griffin, Vice President of Investor Relations, you may begin your conference.

Thank you, Matthew. Good morning, everyone, and thank you for joining us today. With me on the call, I have Byron Boston, President and CEO; Smriti Popenoe, Chief Investment Officer; and Steve Benedetti, Chief Financial Officer and Chief Operating Officer. The press release associated with today's call was issued and filed with the SEC this morning, July 31, 2019. You may view the press release from the homepage of the Dynex website at dynexcapital.com as well as on 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, 2018, as filed with the SEC. The document may be found on the Dynex website under Investor Center as well as on the SEC's website.

This call is being broadcast live over the Internet with a streaming slide presentation, which can be found through a webcast link on the homepage of our website. The slide presentation may also be referenced under Quarterly Reports on the Investor Center page.

I now have the pleasure to turn the call over to our CEO, Byron Boston.

Thank you, Alison, and thank you all for joining us today. In our first quarter 2017 conference call, we highlighted the fact that we were in a fragile economic environment that increased the probability of Federal Reserve Bank activity similar to 1994, 1995, where interest rates using a 10-year treasuries proxy made a complete round trip up and then back down to where they started within a 2-year period. Our outlook at that time was correct. Rates are -- over the last 2 years have performed similarly to that period and our long-term global macroeconomic view today is not changed. We continue to believe, we are in a fragile global economic environment. We fully expect that our financing costs will be reduced materially over time as the Fed reduces the funds rates, which should lead to a wider net interest margins for our business model. We also continue to believe that global risks are intensifying and the generating cash income from U.S. housing-related assets is one of the best long-term opportunities in the market.

Nonetheless, as we stated last quarter, in the near term, the yield curve has inverted and is putting pressure on our earnings. This is an unusual market environment and that the inversion in the yield curve has been led by longer duration rates dropping over 100 basis points, while our funding costs have remained essentially unchanged. As a result, we feel prudent to reduce our dividend to a level that reflects this unusual curve environment.

Historically, we have observed that inverted curves have lasted 6 to 9 months, and in fact, current markets are pricing a nearly 100 basis point drop in Fed funds between now and the end of 2020. Even though we cannot predict whether these expectations will come to fruition, we hold firm to our long-term macroeconomic view that global economic forces will pressure rates lower and our funding costs will eventually decline.

As in the past, we feel we have set our dividend at an appropriate level for the environment and our risk tolerance. Likewise, as in the past, we expect earnings to fluctuate above and below the dividend. Most importantly, even with our dividend cut, the yield on both Dynex Capital stock and Dynex Capital preferred stock stand out as an extremely attractive in a world where the value of negative yielding debt has increased to over $13 trillion, and most of the high-quality fixed income assets globally yield less than 2.5%.

Our focus continues to be on the long term, and we're hence positioning ourselves for an environment that will eventually see our financing costs decline. Alison -- I'll put it back over to Alison, and she's going to lead us through a few questions, so we can give you a few more specific details.

Great. Thank you, Byron. I'd like to open with asking Steve to walk us through the second quarter results, please.

Thanks, Alison. Our results for the quarter on a GAAP and non-GAAP basis are summarized on Slide 4. In my comments, I'm going to be focusing mainly on core net operating income and book value per share.

As Byron noted, we identified last quarter 2 potential headwinds to near-term core earnings. The curve inversion on the short end and expected faster prepayments from seasonal factors and lower mortgage rates. As expected, those 2 factors played out this quarter in our core earnings. The curve inversion kept our borrowing rates high and relatively flat quarter-to-quarter and reduced the benefit of our hedges. The lower mortgage rate environment and seasonal factors led to a decline in our asset yields and drop income on TBAs. While still contributing to adjusted net interest income, we had lower CMBS and CMBS IO prepayment compensation during the quarter versus last. All in, our adjusted net interest spread declined by 16 basis points, which explains most of the decline in core earnings per share from last quarter.

Looking back to the third quarter 2018, our adjusted net interest spread was 141 basis points. Our net interest spread this quarter versus that quarter in many ways reflects the impact of the Fed tightenings in September and December 2018, together with the lower mortgage rate environment. If the Fed were to reverse these 2 25 basis point increases, we should see margin expansion back toward the third quarter of 2018 depending on asset and hedge performance. From a book value standpoint, most of the 5.5% decline from last quarter is due to the Agency RMBS portfolio, which underperformed related hedges as duration shortened during the quarter from the rallying interest rates. Our Agency CMBS also modestly underperformed hedges giving the magnitude of the move and interest rates over the quarter in the last 6 months.

There are other tactical -- technical factors contributing to Agency RMBS price declines as well, which Smriti will talk about later. Markets have stabilized somewhat since the end of the quarter, and we estimate that we have recovered approximately 1% of book value since quarter end.

During the quarter, we adjusted our portfolio mix modestly, shifting toward Agency CMBS investments, which combined with CMBS IO are in aggregate now approximately 40% of the investment portfolio. We also lifted approximately $1.5 billion on a net basis in interest rate swaps, lowering our overall swap rate going forward to 2.04% at June 30 from 2.38% at March 31 and modestly reducing the weighted average life of our swap up to 5.9 years. These adjustments of investment portfolio in hedge position should benefit our earnings profile in the event that Fed funds rate is reduced in the future.

Finally, total economic return to common shareholders for the quarter was minus 2.6% and for the year, it is a positive 3.8%. For the year we have paid $1.08 in dividends per common share while book value has modestly declined $0.39 since December 31.

Thank you, Steve. Turning now to Byron. Can you describe in a little more detail, what is Dynex's long-term macroeconomic view?

Let me point out 3 quick points regarding our macro view, and if anyone of you would like to have a longer conversation on the phone about it, please call. We've got a very strong view, we've had it for the last 3 or 4 years. So we hope -- from a macroeconomic view that the global economy is fragile because it has been supported by huge increases in global debt and large central bank balance sheets. Simultaneously, the globe has seen major long-term headwind from demographics, technology that will eliminate jobs, human political conflict and a grossly skewed distribution of wealth and income. We believe this complex environment will continue to pressure interest rates lower over time. Nonetheless, we also believe that government policy will drive returns and hence is a complicating factor in the short term. Needless to say, government policy has become less and less predictable and has added to uncertainty throughout the globe. And in the final point, in our last conference call we mentioned that we believe that the 10-year treasury will spend more time trading in a range of 2% to 3%. However, today we believe the probability has materially increased that this range will shift downward to 1.5% to 2.5% with a steeper yield curve and lower financing costs over time.

Alison, you can go to the next question.

Thanks, Byron. Given that view, Smriti, what have we done to position for the future?

Thanks, Alison and Byron. Our focus is on managing liquidity, prepayment and interest rate risk. If you can please turn to Page 7 in our slide presentation. First off, as we said before, our macroeconomic view leads us to be in an open liquidity and open credit position on the assets that we hold. And it also leads us to hold more liquidity on our balance sheet. Second, our view on the interest rate range that Byron just articulated that 10-year yields will spend more time between 2% to 3% with a higher probability now that it will shift down to 1.5% to 2.5% has us very focused on managing prepayment and interest rate risk. We're really doing that with 3 different portfolio construction and portfolio management approaches.

The first is structural diversification of prepayment protection between Agency CMBS and Agency RMBS. The second is coupon diversification and asset selection within Agency RMBS and the third is dynamic hedge management. But another way, we're choosing to buy our positive convexity in the Agency CMBS markets versus the higher pay up specified pool. And the reason is, there is actual structural prepayment lockout in the Agency CMBS market and prepayment compensation that is paid to investors in the event of an early prepayment. This factor leads us to believe that over the long term, we will have reduced hedge cost and better cash flow preservations.

So why are we doing this? If you could turn to Page 8. We're in a unique environment for prepayment. The first chart on Page 8 is showing you where mortgage rates have been by decade. You can see in the '80s, you had a wide distribution of mortgage rates, so at any given point, some loans were in the money and some ones were out of the money. Contrast that to the 2010s decade. You can see that most of the time this decade, mortgage rates have been between 3% and 5%, really more like a 3.5% to 4.5%.

The second chart is showing the refinancing index since 2000. And in that chart what you can really observe is that the last 3 big Refi waves were much, much larger than the 1 we are currently experiencing. There was 1 in 2003, 1 is 2008 and 1 in 2012. So what this leads us to conclude, number one is that there's a pretty high concentration of loans outstanding right now with mortgage rates between 3.5% and 4.5%. The second thing it leads us to believe is that we aren't really in a big spike yet, not one like in 2003 or 2008 or 2012. We believe that mortgage rates would really have to be well below 3.5% to trigger that kind of spike. Now we do have a macroeconomic view that says we could get there, and that's why we talk about and spend a fair amount of time thinking about this risk.

So prepayment risk at this point is more binary, digital, on or off. So this is why we think the structural protection that's offered by CMBS married with good asset selection and coupon diversification in the Agency RMBS market is a superior alternative to navigating through this environment. What you really need is nimbleness, flexibility, active duration management, a diversified portfolio and good asset selection to get through this period. All of this, the management team here at Dynex has a lot of experience doing.

On Page 9, we put this all together. I have a series of tables on this page, and what this shows is the profile of Dynex's asset portfolio across multiple yield curve scenarios. There's a lot of scenarios on the page. The ones with a single number on the scenario heading indicate apparel shift in the yield curve, and those with 2 numbers indicate a yield curve shift, the first being what the 2-year does, and the second being what the 10-year does. And you'll see in each of these is that the Agency RMBS duration moves a lot more as a percentage of the base case duration versus the CMBS duration. So -- and this represents our portfolio, which is about 40% CMBS, 60% Agency RMBS. The CMBS actually acts as a stabilizer. So it reduces the contraction risk as rates decline. It mitigates the extension risk as rates rise. So while the overall duration position moves, it just moves a lot less than pure Agency RMBS.

Finally, in terms of the yield curve, please turn to the hedge position on Page 12. As Steve mentioned, we repositioned our hedges in 2 ways. The first is to take advantage of existing lower financing costs because forward rates are so much lower, and the second, listing higher-cost hedges to save interest expense today and position for a lower realized financing costs in the future as the Fed eases. At quarter end, we've continued to take additional rebalancing actions, including the addition of payer's option to protect against higher rates. What you can expect us to do here is to be dynamically managing the hedge position over the next few quarters to either take advantage of or monetize any opportunity to lock an attractive funding. All of these actions should be positive for net interest margin as the Fed eases.

Thanks, Smriti. Where do you think returns are today for your investment? And then secondly, what are they look like on a forward basis if the market expectations play out with respect to the Fed?

Great. So just turn to the spread charts on Page 23 and 24. They are in the supplemental portion of the presentation. You can see on Page 23, we've given you a chart of Agency CMBS spreads to swaps and Page 24 shows 2 lines, 1 is the spread to swap for 10/9.5 DUS bonds, and the second green line represents the current coupon mortgage yield relative to the 5-year swap rate, more of a nominal spread. So these are just showing you trends of spreads over time, and we've taken the spreads back to prior to 2012, 2010 area. What you can see on Page 24 is that Agency RMBS nominal spreads have widened this year, and that they widened sharply in June, okay? So 4 main factors contributed to the underperformance of third year RMBS in the second quarter. The first is higher perceived prepayment risk. I say perceived because of the factors we just described up on Page 8. The second is uncertainty surrounding government policy regarding how the GSEs might be released from conservatorship, particularly if it did not involve a government guarantee, so that created some spread widening. The third was the increase in run-off from the Feds portfolio, they have a $20 billion cap, and the run-off actually started to approach that $20 billion.

And finally, there was a fair amount of uncertainty regarding the implementation of UMBS. Now since quarter end, we have seen a dissipation in 3 of these 4 factors. UMBS implementation has been a relatively small transition. Director Calabria, has clarified his comments surrounding the release of the GSEs, and in the third quarter, in fact, even as soon as today possibly, the Fed will see run-off from its portfolio, and that's going to limit future net supply from that source. So going forward, we think the Agency RMBS spreads will revert to be more directional as rates go up, spreads tightened, rates go down, spreads widened and be more supply-and-demand driven. And right now, in the Agency RMBS sector, we see hedged core ROEs using nominal spreads in the low- to mid-teens at 9x leverage.

On the Agency CMBS front, those spreads, as you can see on this chart, have been relatively stable and Agency CMBS outperformed Agency RMBS during the second quarter. We continue to believe in this sector that rolldown cushions, temporary spread widening in this sector. And the core ROEs that we're seeing in this Agency CMBS sector are in the low teens range at about 12x leverage.

I'll turn it back to you Alison.

Okay. Thanks, Smriti. Turning back to Byron now. Can you tell us what all of this means for Dynex and our shareholders?

With this, let me just summarize with a couple of quick points, and many of you've heard these before, but let me just point out something to you. At Dynex, we've always managed our business from a long-term perspective. The mortgage REIT business model is cyclical and inverted curves as we're experiencing today have historically preceded material drops in financing costs for companies such as Dynex. As such, we want to continue to position our business for the future. A very, very important point to realize is the interconnectedness of the global capital markets with yield so low around the globe, Dynex stock and preferred stock offer attractive sources of cash income. Furthermore, in a world of growing uncertainty and intensifying global risk, generating cash income from U.S. real estate related assets and the U.S. housing finance system is one of the most attractive investment opportunities available.

With that, we're going to open the line for questions, operator.

(Operator Instructions) The first question comes from the line of Doug Harter from Crédit Suisse.

It's actually Joshua on for Doug. First one on leverage, we saw leverage tick up in the quarter, not totally unexpected, but how comfortable are you running leverage at this level in the mid-9s, and do you have any internal long-term leverage targets?

Let me point out again, back -- there were some things we said in the past. We're pretty adamant, I think the last some -- when in the last year, we started to identify, over a year ago, that we would increase leverage. But we had a really strong opinion that one of the best opportunities continues to be the leverage, high-quality, high-liquid assets, especially those based in the United States. So we've got a firm view on this, and our leverage has really followed along. Let me point out something else, which is that our leverage really -- the last increase in our leverage really happened at the end of May and throughout June. And so the impact to that -- we still, especially as Steve pointed out, that as we're positioning ourselves for reduction in financing cost in the future, so we can take a maximum advantage of that. From there, in terms of overall leverage target, I think with this inverted curve, which is such an unusual inversion, in other words, if the past inversions whether it's the late '80s, '90s or the 2000s, you had the curve invert as yields were rising. So the fit would be vertical by raising financing costs above what longer-term rates. In this situation, you get the Fed really come out with somewhat forward guidance earlier in the year. Late last year, you had long rates actually rally. We considered unusual environment, so we're sitting here at 9-ish type of leverage. We're not necessarily looking to take our leverage up to like 11x, 12x or those types of numbers. So we're comfortable where we are. We believe the benefit will come not from the certainly increasing leverage, but reduction in our financing cost.

Great. That make sense. Thanks for those comments Byron, and then, just one, you were considering the new dividend level, can you talk about what goes into that discussion? And specifically, the decision to set the dividend above the level, slightly above the level of the second quarter core earnings level?

So 1 point in history of Dynex I point out is that, I think, it was in early 2016, a similar situation took place and earnings were under their -- under the dividend level that we had set and there was a lot of conversation about it. And then we proceeded to be above that dividend level for the next, I don't know, couple of quarters, maybe $0.02, maybe in $0.03 at one point, then were back at the same level as dividend. We set the dividend before the environment, fully expecting -- as I mentioned in my comments that earnings will fluctuate above or below. And then, we're looking forward to the future, ultimately, for our financing costs to decrease. As Steve pointed out, referring back to where we were from an ex-spread perspective, 50 basis points ago on terms of financing. So that's the way we think about the dividend. We set it for the overall environment. If this was not such an unusual inverted curve, there's an alternative strategy we're going to take, and we're going to say, hey, let's wait this one out because we think this will be a short 6 to 9 months. Once you throw in, what I mentioned earlier from our macro view, the unpredictable nature of our politicians globally, and that really throws in a complicating factors. So we're being prudent. We believe moving the dividend to this level actually is setting us up for the future. So everything we're doing, everything we're thinking about now is positioning ourselves for the future, and we believe that dividend about being at $0.15, we're happy with that.

Your next question comes from the line of Eric Hagen with KBW.

Just a follow-up on the conversation around extension risk in hedging and particularly, hedging with swaptions, I'm not sure we've seen Dynex do that before. I'm just curious, how that portfolio construction -- how you're thinking about portfolio construction in terms of possibly paying up for specified pools and the more static or predictable prepayment or duration profile that comes with that versus using instruments like swaptions?

All right. So I got some strong opinions on this. And first off, when you come to specified pool, no specified pool will withstand a massive drop in mortgage rates. So I know you guys have talked about a prepayment protected, no specified pool is prepayment protected. All they do is different borrowers will prepay at different times because their incentive is different. So I want to be real clear to help you all -- meaning the analyst community understand prepayments. If you get a 3% mortgage rate, you will end up in a situation where Smriti pointed -- showed you the refinancing index, there's not much prepayments today. If you look at the past prepayment cycles. What happened in 2003, you literally had a 100% of the coupon stack refinance-able. For that to happen, you're going to need to be between probably 3% to definitely sub 3.5% mortgage rate, but closer probably to 3%. So I don't view specified pools as the ironclad and I will tell you that I'm probably one of the most experienced people in this marketplace going all the way back to the '80s and dealing with that topic. So we've structured our portfolio a little different, and I'll let Smriti get into further in to that issue.

Smriti, you want to comment now specifically on the prepayments and then...

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Yes. I mean, so I think, again, there's 2 ways you can buy that protection in the market, or there is more than one way to do it, obviously. Buying a specified pool today, you can buy cash flow protection as long as those mortgage rates don't fall below a particular point. And when you do have that binary nature of prepayment, we find that it's actually more efficient to buy that protection in CMBS relative to where some of the spec pools are trading today, right? So that's number 1. The number 2 thing is that the swaptions that we have are actually with their payer swaption that we put on, as I mentioned earlier, they are more to respect the range that we talked about, the 1.5% to 2.5% or 2% to 3% range, understanding that yes, the Fed can do what the Fed does, but there is fiscal policy actions that could occur other things that basically lead us to want to protect against that scenario. So we're really thinking about the extension risk. The most important thing to remember is that the combination of the RMBS and the CMBS just reduces how much of that extension risk you have to protect on a net basis relative to your base case duration. That's really the big issue.

And let me -- Smriti, let me add one point on that, while you sit there. Right on that point, while Smriti mentioned on the swaption and protecting against that base case, if you walk back to our macro view, we're respecting this down rate scenario, and so if you had my ideal world, I don't want an enormous amount of hedges against the securitized product portfolio of any sort in a major down move in rates, and so when you asked about swaption, it's one of the better instruments for this moment in history in the portfolio as evolution for us to use. And Smriti, you go ahead and get a little more specific. But I want you to understand the theoretical thought process that is attached to our macro view, which is we need to be very careful, and I think anyone else managing securitized products need to be very careful in terms of how large that swap over hedge book happens to be if you truly do get a major move down in rates.

I think the only other point to make on that is specified pools don't protect you from extension risk, right? They still suffer the extension and the underlying TBA coupon, and that would be the other reason to pick a different instrument to protect against that.

Got it. Robust answer. The second question is really just more macro. The Federal in its portfolio implies the net supply hitting the market, if you include what the Fed is likely to be running off in the next -- over the next year is likely to be in the few-hundred billion dollar range. It might be anyone's best guess, but do you have a sense for where that incremental demand in the market is likely to come from?

One of the things that we believe supports valuations in the mortgage market, number 1 is the liquidity out now relative to any other instrument, out in the fixed income market, that's 1. Second, is the steeper yield curve, our macro view is really supportive for the steeper yield curve. In that environment, you will find that investors such as banks will come in and buy mortgage product to support their erosion of net interest margin on their balance sheets as well. The Fed -- the Fed's portfolio is expected to stop running off in September of this year. And I think that's going to be a meaningful technical factor that will support valuations as well. But the other investors that we're thinking about in terms of what makes mortgages attractive are banks.

Got it.

Eric, the other point is, back to what Smriti was saying, the central banks are -- the global economy is truly supported by these large central bank balance sheets. And for the last year, we've gone through an exercise where the larger, one of the most important central banks thought they could reduce liquidity, raise rates and reduce their balance sheets. We don't believe they have the ability to do it without creating habit globally and putting enormous downward pressure on economic growth, and it goes back to the fact that growth is being supported by large debt and large central bank balance sheets. So now we have the global central banks, moving into ease mode again and talking again about buying and purchasing more assets. And so ultimately, the central banks portfolios are supporting overall mortgage spreads, and we still expect them to continue to do it. Every time I try to ask someone, how can we get out of this scenario without paying, I have not found a person yet that could give us a clear answer on this.

Got it...

Also, the only other point I'd make on that, Eric, the spread volatility due to lack of -- due to increased supply, say, for example, you are thinking about the Fed balance sheet running off, and there is peak speeds coming, et cetera, et cetera, those things will be temporary factors that you can basically either take advantage of. But over time, when those returns on third-year mortgages get to a particular level, they just -- they're attractive levels. I mean, it's difficult to argue when third-year mortgages have mid-teens or high teens returns that they don't become compelling investment opportunities for different types of investors, including money managers and others. So they -- could spreads widened, absolutely. Could they widen and stay wide for long periods of time, I just feel like there is a technical support available for that as investors find this sector attractive.

Your next question comes from the line of Trevor Cranston with JMP Securities.

As a follow-up on Eric's question, related to hedging against extension risk. Looking at the rate sensitivity tables on Slide 26, obviously, there is a pretty significant change in your exposure profile from last quarter to this quarter in terms of book value risk up and down rate scenarios. So if you could talk a little bit about sort of how you guys are thinking about protecting the portfolio against unforeseen or unexpected changes in market views. I mean it looks like right now, you're pretty well protected against down rate scenario, which it seems like the market is mostly focused on, but the up rate scenario, there's a lot more exposure. So I was wondering if you could just talk about, how you guys think about managing that particularly portfolio leverages has moved higher recently.

Trevor, let me point out one thing because I think -- I remember, you all have a book value projections and the difference between, I think, where you had our book value for the quarter versus where our book value came out, and it look like you did a great job in terms of projecting where opposition was at the end of the first quarter, we simply adjusted the book. We adjusted the book mid-quarter as rates came down, and we got ourselves longer. We got ourselves longer because first and foremost liquidity, right? Your short swaps, the more swaps you've shorted, rates come down. The liquidity drain will increase. So the first reason was in terms of liquidity. The second high-level point I'll make and I'm going to let Smriti get more specific, as she chooses here. If you ask me longer term, and we try to use the word long-term versus near-term in our conversations now to help all of our investors, and you all understand how we think about this, longer term, we are more concerned with the down rate environment. What we said a couple of years ago, I'm pointing out the round trip was we had a deal with this up rate move, which we felt was not sustainable. So when we think of an up rate move now, when the Fed itself has lowered its long-term target to like 2.4%, it's an enormous move down by the Fed and their projections. So now I've got the risk here from, call it, 206 on the 10-year, the Fed got the risk back 25 to 30 basis points. We're willing to take that risk because we think that's a better risk to take than taking 25 to 50 basis points lower on the 10-year. And we believe that spreads will help cushion us in that type of move because if you look at 4%, 4.5%, even 3.5% mortgage rates, mortgages now have priced in as if you're going to be at some really large refinanced environment in lower rates. So that's how we're managing the book, hope you understand it from a -- really goes back to our top-down approach, our macro view, which has us most concerned -- too many swaps versus the secure-type portfolio in a down rate environment. And then you won't remember it, but over the years we've always said this, and we continue to feel this in terms of structuring the book from this perspective.

Smriti, do you want to add more specifics to it?

Yes. I mean, I did mention in my comments earlier that we have actually worked to rebalance that up rate risk down relative to what we've disclosed here as of June 30, using payer swaption. So that profile is less skewed today than it was at the end of the quarter, so that's thing number 1. Thing number 2 is really this interaction between rates up and spreads, okay? We have seen a decline in mortgage valuations and that's really due to the fundamental reason of higher prepayments that is very real and very present, up 100 a lot of that concerns goes away. And so what you -- the way I kind of think about is if you look at that number, let's just be extreme here, and look at the minus 17.3 number in the upper hundred, you have to marry that with a number on the second page, which has to do with what happens to spreads, what happens to the portfolio with rates up 100. A 10-basis point tightening and spreads from here is a 5% increase to book value. So again rates up 100. You believe spreads can tighten 10-basis points, I would argue they'd probably be somewhere between 10 and 20 basis points tighter. A good portion of that up 100 risk is mitigated with spread tightening. So instead of that number being 17, the number's really something like 7. And that number is what we think about in terms of the hedging out with swaptions or other sort of mitigating instruments today. And then lastly, look, I think we've talked a lot about this environment. It's going to require a lot of nimbleness and hedging to the extent that there is a rapid repricing one way or the other in terms of up rates, we're going to act on that. It's not consistent with the way our macro view is though right now, but obviously, we stand right at the shift that used to be extent that the fundamentals actually warrant that.

Let me point out something else because I think that this is something we talk about internally, a lot. So we're always thinking about, you just brought it up, you used the word unforeseen events. So when we started with this macro view 2 years ago, our number 1 conclusion, this is about 2015 or so, was that surprises are highly probable. So we are operating from that perspective that surprises are highly probable. They've happened multiple times since that time. Here is the 1 thing that we feel very confident. With this amount of global debt, it is enormous at the consumer level, at the corporate level, at the government level. And no, we disagree with all the academic economists, who try to say that the American consumer is in great shape. The Americans are some -- yes, they're wealthy, we're doing great. All of us on this phone are probably doing fantastic, and the enormous amount of the American consumer is heavily leveraged. So what that means is, we'll take that up rate risk because we don't believe the global economy can handle sustained higher interest rates. That is a major core theme of our investments, a long-term investment thesis at this point in time. So does that help a little bit in terms of understanding how we're thinking?

Yes. That's very helpful color. Then my second question is on the financing side. I was wondering if you guys could provide any color on what you've seen in the repo market since the end of June. If there's been any sort of improvement you've noticed between the relationship between repo versus LIBOR? And if that has changed at all recently as we get closer to the potential actualization of a Fed cut?

Right. Yes. That's a great observation, Trevor. I think it's been patchy. Certain repo counterparties were willing to price in the anticipated Fed cut early, and so we saw some release in repo rates post quarter end. Certain others were not willing to do that. Some folks are waiting all the way till today, quite honestly, to make that assessment. So we've really had to be very active in terms of shifting the book around and making sure we're getting the best rates. But it has been very, very patchy with respective people's willingness to really price in the Fed cuts at this point. Going forward, obviously, LIBOR has come down much faster than repo rates have come down. That's been a factor the last 2 quarters, and I think it'll be -- continue to be a factor in the next 2 quarters. We may see it is really going to be depend on how the Fed messages today. If you have a clear message, you might see that release pop into these repo spreads. If you don't have a clear message, we're in the same boat again. So this is the uncertainty we're kind of having to live with at this point in the margin.

Your next question comes from the line of Christopher Nolan with Ladenburg.

My questions have been answered.

(Operator Instructions) Your next question comes from the line of Matthew Howlett with Nomura.

Byron, just -- I really appreciate the -- your view and your -- the global amount of cap that you guys take and you're experienced. So I guess the first one is just you've seen a lot of easing cycles, last one honestly was about 10 years ago during the global financial crisis and then we went out to that Refi wave in '03. If the Fed does start easing, this will be -- is every easing cycle different? Or can you point us to a cycle that might look like the most?

Well, first off, we're not saying that we're in an easing cycle at this point. What we are saying though is that this is our opinion. We believe the Fed went 50 basis points too far. So that's the first point. And if you ask me to advise Jerome Powell, I'm going to say, Jerome, you should cut 50 basis points, you should cut them now, plus your downside, you went 50 too far. And we all know that back -- by the end of last year we consumed some of the havoc that rates being up there, the dollar being where it is globally, et cetera, et cetera, was creating. So when I pointed out the 1994, '95 time period a couple of years ago, that was not an all-out easing cycle as you saw in the '08 period, or even in the early 2000s, which created that 2003 scenario. It was simply as most people call it today insurance. Interest rate cut is about probably 50 basis points. We do believe though the longer term, they're going to be an all-out cutting mode at some point. And that's based off of the global economy is simply being held up by a ginormous increase in global debt since the last financial crisis and by these huge central bank balance sheets. If you look underneath the surface of the global economy, there are cracks. And we pointed out some of those cracks that are there. They will come to fruition over time. If we look back to 2007, I'm sure if we got Ben Bernake here and ask him, Ben Bernake, would you -- do you wish you would've eased more in 2007 because they didn't ease, and at that point, Dorenberg had gone out of business, multiple REITs had gone out of business. They should have eased in 2007. So right now, the most we can say is the Fed should ease. Our opinion would be that they should cut 50 basis points that debt -- whether it's today or this today in September because they went 50 basis points too far. Our long-term view is that the Fed will have to bring rates down. The longer they don't, the more debt would be piled on top. The globe can't handle sustained higher rates with this amount of global debt.

I appreciate that. And just to triangulate that to the earnings power potentially at Dynex. I want to get back to Steve's earlier comments said, the margin -- I missed that the margin, I'll go back to sort of where I was in 3Q '18, is that under the 50 bps scenario? And -- just talk a little bit about the -- what was set on the regards to that margin?

Matt, sure. So if you look at the third quarter 2018, our net spread was about 38 basis points higher. And if you sort of deconstruct that, asset yields are actually up a little bit despite the lower mortgage rate environment and faster prepayment environment and borrowing costs are higher by essentially that 38 basis points, offset modestly by a little bit of swap benefits. So if you just sort of manually reverse that out, right, you could go back from today 103 basis points back toward that 141 basis points of spread, right, so that just basically dropped into our earnings profile going forward if that happens. Now obviously, some of that's going to be dependent on asset performance as well as what we may do with the hedge book and the relationship between 1-month and 3-months LIBOR. But I think directionally, and sort of the size of that move, you can sort of extrapolate that if the FED takes those 50 basis points off as Byron mentioned, we're going to be close to that or certainly near that net spread back in the third quarter.

That's why I want to kind of just focus, I mean, that's clearly pointing to a substantial increase in the Dynex's ROE potentially. And I just -- I guess maybe just Byron, you did said to us that ROE this quarter. We've seen mortgage rates do everything from 2% to 28% ROEs over the cycle. I mean, where could this -- I know you don't give guidance, where could this ROE in this business go, if we do get into 50 bps cut and stability in the long-term rate?

So the first thing that I think about with this, which is why I kept emphasizing our financing costs and every time I talk about our macro view, I drive back ultimately to our financing costs. Because Steve just pointed out, there has been a real one-to-one relationship as the FED has increased rates versus with our financing costs going higher and one of the most misunderstood facts that when I have talked to investors is, they're not understanding, that our financing costs are totally attached to overnight rates and what the Fed happens to do. So you start to bring down the financing cost. You start to see 50 basis points first. We believe, longer term, the worker will be realized, it's a just a matter of when that actually takes place. You're going to see ultimately 100 basis points and potentially more over time from our financing costs, and we believe that, that will be very beneficial to the overall business model. So I am trying to not give exact forward guidance, but I am trying to really lead you in a direction that shows you how powerful it is when our financing costs come down. So we've positioned the portfolio. What we mean by that is that we've gotten ourselves in position, where yes, the leverage is up, but we definitely think it will be beneficial when we see financing costs drop. So I hope that gives you -- and Smriti, I know Smriti has a few more specifics -- you don't? Okay.

The only thing I would say is that over the long-term, if you see a 100 basis points net spread between mortgages and the hedges on a nominal basis then you'll lever that 10x. I mean it's over the long-term, you're looking at that double-digit ROE, that's how I would think about it. And the key is how soon you get to that, the 100 basis points net spread, that all of that is driven by the -- how fast your financing costs actually get to that level.

Matt, can I throw out one that I always like to talk about. I always compare the mortgage REITs business cycle to the seasons of the year winter, spring, summer and fall. And the winter month is when the Fed is increasing our financing costs, the worst part when there happens to be when the curve inverts. And then the best time happens to be in the summer months, when the financing costs are coming down. And that's where -- that's when you see the largest ROEs. And that's where you want the largest ROEs. And over the long-term, when you look at long-term performance, once you go through that recycle and you include the summer months, you'll be very happy that we've been a long-term investor in mortgage REITs, and what we would urge you in Dynex Capital.

Right. And look, I think you position the portfolio for that, I just think people might have looked at the dividend cut here just as a negative signal, but I don't -- from what I can tell, I anticipate what the Fed doing it, it doesn't appear that it's -- you're signaling any limitation in the model going forward?

No. Let me tell you what we're saying. What we're doing is we're showing respect. We're showing respect for the global environment and the uncertainty of a politicians, who have risen to the stage across the globe. And so we can say, let's lean on our view of the 6- to 9-month short-term philosophy, not cut our dividend, give our shareholders some capital back in that process. Or we can simply respect the amount of uncertainty that had been injected into the global system, on the politician side, not on the economic side, long-term we're pretty confident, but I'm telling in the near term, we think about the political environment and how that reverts the rates back to the global asset price levels becomes unpredictable. So it's pure respect that we cut the dividend. We believe it positions us better for the future because we're not carrying too much of that challenge in the short term, and we also know that dividend levels can be cut, as we show, and they can be increased when things get better.

And we have no further questions at this time. I will now turn the call back over to Mr. Byron Boston for any closing remarks.

So thank you all, as always, for joining us. I appreciate the questions. We always like to, on our call, may be longer for some of you, but we do like to explain ourselves. We are an open book. We do have a philosophy, please call us. We'll call you. We're happy to discuss anything in more depth. Thank you again and please join us next quarter for our conference call. Thank you.

This concludes today's conference call. You may now disconnect.