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Executives

Alison Griffin - Vice President, Investor Relations

Thomas Akin - Chairman and Chief Executive Officer

Byron Boston - President and Chief Investment Officer

Steve Benedetti - Chief Operating Officer and Chief Financial Officer

Analysts

Douglas Harter - Credit Suisse

Mike Widner - KBW

Ken Bruce - Bank of America/Merrill Lynch

Trevor Cranston - JMP Securities

David Walrod - Ladenburg

Dynex Capital, Inc. (DX) Q4 2012 Earnings Conference Call February 20, 2013 11:00 AM ET

Operator

Good morning and welcome to the Dynex Capital Fourth Quarter 2012 Earnings Conference Call. All participants will be in listen-only mode. (Operator Instructions) Please note 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.

Alison Griffin - Vice President, Investor Relations

Good morning and thank you for joining the Dynex Capital fourth quarter 2012 earnings conference call. The press release associated with today’s call was issued and filed with the SEC today, February 20, 2013. You may view the press release on the company’s website at www.dynexcapital.com under Investor Relations and on the SEC’s website at www.sec.gov.

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

The company’s actual results and timing of certain events could differ considerably from those projected in or contemplated by the forward-looking statements as a result of unforeseen external factors or risks. For additional information on these factors or risks, we refer you to our Annual Report on Form 10-K for the period ended December 31, 2011 as filed with the SEC. The document may be found on our website under Investor Relations as well on the SEC’s website. This call is being broadcast live over the internet with a streaming slide presentation and can be found through a webcast link on the IR page of our website under IR Highlights. The slide presentation may also be referenced by clicking on the Q4 2012 Earnings Conference Call link, also on that page of our website.

I would now like to turn the call over to our Chairman and CEO, Thomas Akin.

Thomas Akin - Chairman and Chief Executive Officer

Thanks, Alison and welcome to the Dynex conference call. And with me today is Byron Boston, our President and Chief Investment Officer and Steve Benedetti, Chief Operating Officer and CFO of Dynex Capital.

We have the presentation. We are going to be going over some of the slides in the presentations, not all of them. So, if you have that handy, that’s fine, if not you can either go to our website or just follow along. The highlights of the quarter, which on slide four, we are quite pleased with the consistency that we have shown in our overall balance sheet using modest leverage and high quality assets. Our earnings a share of $0.34 very consistent with what we have seen over the last of your four quarters and our book value of $10.30 down $0.01 versus our $9.20 at the end of 2011. We are particularly pleased that we were able to add capital during the year and still increase our book value by $1.10.

Our annualized equity return was 13% for the quarter and 13.8% for the entire year. Our net interest spread while down was down very modestly only 7 basis points from the prior quarter and we see that sort of balancing out as we look at the opportunities right now. Average earning assets were about $4.1 billion versus $3.7 billion and our constant CPR stayed very consistent around the 19% the team’s area, excluding our CMBS IOs. Common dividend represents a unchanged position 11.2% yield versus the closing equity price of 10.37%. Our CMBS allocation at 12/31 was $361 million versus $190 million at the end of ‘11 and that shows our increased commitment to the commercial side of things. Byron will go into that in further detail. And our overall leverage of 5.4 times equity capital is of tad below our stated goal of around 6%, but well within the range of what we’re trying to do.

I would like to go to the next page, page five. Talk a little bit, the summary in a tabular form. I think what we have been trying to basically present to our shareholders since we started up the mortgage REIT side of the business in 2008 would be the consistency of our earnings and the consistency of our results. And I think that shows in the first dividend and earnings for common share, which had stayed very consistently in the $0.33 to $0.35 range. Our book value, we are very pleased last year. We have seen the increase in our book value and it was obviously the purchases in the CMBS. For the most part there was some downward move to interest rates that helped that, but primarily with spread narrowing. Our net interest rate as you can see in the lower left hand column has narrowed, but is starting to moderate and is down only seven basis points quarter-over-quarter.

And with that, I would like to turn it over Byron Boston to talk a little bit more about our investment strategy.

Byron Boston - President and Chief Investment Officer

Good morning, 2012 was a very good year, but before I can start, I do want to ask your apologies of us if we sound boring. We are going to deliver many of the same ideas you have heard for the past five years. We are also delivering many of the results you have seen for the past five years. We have not needed to make dramatic changes to our business model to continually perform in the current market environment. Since 2008, we have structured a diversified portfolio that is expected to perform in a variety of market environments. We believed in a diversified strategy since inception, and we’ll continue to build DX based on this core principle.

What have we done, we identified the risk and return potential of the long-term low-rate environment. We have not reacted in the past or today in the knee-jerk fashion, to the psychology of the market when it becomes concerned about massive movements in rates. From inception, our goal has been to diversify our portfolio away from too much prepayment risk exposure, while strategically exploiting opportunities to add cheap premium securities. We were early to recognize the return potential from the multifamily sector of the CMBS market. We started increasing our CMBS exposure when the market reopened in 2009. Throughout this period, we have maintained a very liquid balance sheet characterized by high quality assets and low leverage.

This diversified approach continues to allow us to identify pockets of value in the marketplace. So, what are the results, since 2008 our book value has increased from approximately $8 per share to $10.30 today. When dividends are included, we have generated an economic total return of 88%. We created a durable net interest spread from a high quality short duration portfolio and we have monitored multiple changes and events in the market without the need to aggressively adjust our overall portfolio philosophy and strategy.

And if you slip over to slide seven, let me just identify couple of key macro environment factors that can define the space in which we are operating. Interest rates are low and they are range bound, volatility has come down steadily over the last two years, credit spreads have tightened, multifamily housing strength continues, single-family housing has stabilized, funding markets are attractive. What’s the key consideration in all of this, global governments are heavily involved in the capital markets.

Let’s move to slide eight and let’s talk about the overall interest rate environment. And I will reiterate that we have structured our portfolio to perform in a variety of market environments, but here is one of the key tools that we look at. We look at the senior treasury rate and we note that in 2011, it’s really around July of 2011, the note, senior yield broke to a new lower range. We have been in that range for the last year and a half between 150 on the 10-year to 250 on the 10-year. There has been a lot of concern in the market about rising rates. You can see since last July, 10-year hits its lows. It’s up about 60 basis points off the lows.

Are we concerned at this point that rates break through the 250 upper band, we are not concerned with that type of a breakout given the current conditions and the fed activity in the marketplace. At some point in the future, we will see a steeper yield curve. We will see rates normalize at some point in the future. We do believe a steeper yield curve will provide us some interesting opportunities to invest money.

If you note on slide nine, you can see the steady decline in volatility over the last two years and then more importantly, if you go to slide 10, one key question I ask when you talk about interest rates. Byron, what happens to Dynex’s portfolio when interest rates go up, well, let’s look what’s happened over the last six months or so. Since the low in July of last year from about 140 on the 10-year, we have seen a 60 basis point rise in interest rates. What has happened to Dynex’s overall book value, we’ve watched our book value increase and hold steady over the last several months. And just so you know from a more recent number to identify as of January 31, we estimate our book value to be steady with our book value as of 12/31/12.

Now, what’s really important is that when you talk about interest rate risk and duration, there are multiple measures that you can use, many of which are very theoretical, what’s important of concern to Dynex Capital is what happens to our overall book value when rates rise and we will reiterate what we have said in the past. Our book of business has been designed to perform in a variety of market environments and there are several factors within our portfolio, whether it happens to be the amount of premium on our books, the short duration of the portfolio, the fact that we have limited negative convexity in the portfolio, because we have CMBS securities that make us very comfortable with any adjustments in the overall interest rate environment.

Let’s move to slide 11, let’s talk about another macro factor that’s always important on everyone’s mind, which happens to be prepayments fees. If you look at the chart to the right, again of the MBA refinancing index, you have seen that in our presentations in the past. I’d like to keep that in front of your face, first and foremost to just keep reiterating that this refi cycle was very different than the 2003 refi cycle. Nonetheless, over the last two years, since you saw that big drop in interest rates back in 2011, you can see there has been a steady increase in the overall MBA Refi Index. Well, back to the question, Byron, what has happened to Dynex Capital’s portfolio throughout this period of time?

If you note on the left, Dynex portfolio CPRs have been relatively steady over the last two years. Here is what’s really important. The top line happens to be our hybrid ARM portfolio. We would expect those to be faster than our total agency portfolio, which is the second line, which includes our CMBS product. What’s really important, if you want to really think about it, the third line is our total portfolio, which includes agency, non-agency, and gives a reflection of the amount of cash that we get back in any given month. We are happy to say that – we have only been getting back between $40 million to $80 million per month in cash, which limits our overall reinvestment risk. So, we just simply have less dollars than need to reinvest in any given month.

If you move to slide 12, let me give you some reasons why we have limited prepayment risk. First and foremost, we mentioned diversity. In other words, we have not put all of our capital in the residential single family sector. Secondarily to that, where we have diversified, we are very concerned with the amount of prepayment protection we have on those assets. Most of that protection for us has been found in the CMBS sector. As you can see on the left as of December 31, 2012, 83% of our overall premium on the balance sheet is exposed to the CMBS sector with only 17% exposed to the RMBS.

Now, here is what’s important to note, you can see that we have had a large increase in our overall premium on the balance sheet. And I want to make sure that you understand this. We have a large exposure to premium CMBS securities. We have been willing to buy premium agency securities. They tend to trade cheaper. Many of the portfolio managers can’t buy them, because our dollar prices are too high. They have explicit prepayment protection.

Here is the other area that we have talked about in the past. CMBS IO has proven to be a very, very attractive asset class for us for the last three years, and we continue to find pockets of value in that sector today. Much of that premium comes because of the CMBS IOs. They are different then residential IO. You do not have the negative convexity characteristics that you have with residential IO. We are not concerned with premature prepayment and/or voluntary prepayments. We are more concerned within voluntary prepayments, which are really driven by credit. So, those are really credit exposure. Those IOs are all for the most part AAA securities. And so we are comfortable with the credit exposure and we are very happy with that instrument. We feel like it fits perfectly inside of a REIT portfolio.

If you move to slide 13, let’s talk about another trend that we have exploited over the last three or four years. I have said this in the past, I’ll say it again. Dynex Capital has been involved in the multifamily space since 1988. I would probably venture that we are one of the longer term investors in this space. This s a trend that we identified, there’s been a lot of chatter about the multifamily trend over hitting the bubble in multifamily has run its course, it is our belief that we’re not in the bubble in the multifamily at this point. It is our belief that we’ve not hit run its course in the multifamily sector. And we continue to exploit opportunity here. Have we had risk increased? Absolutely, risk has increased because interest rates are so low and some of the cap rates have moved down to very low levels within the multifamily sector. So, our concern is a little bit higher, we’ve become a materially more epicure about the assets that we put into the portfolio. But we could continue to exploit this trend which we believe is a strong one and we’ll add some multiple years in the future.

If we move to slide 14, let’s look at two concepts that we talked about in the past where we’d reiterate, our credit quality 90% of the portfolio is AAA, there’s only 1% of the portfolio below single A level. We do have 7% of the portfolio at the A level and here’s what’s important. Both portfolios for the most part are part of the Freddie Mac, brought through and created. They are non-agencies created through the Freddie Mac agency multifamily program. They are far more liquidity than the average CMBS A rated bonds and we’re very comfortable with our overall credit structure of the portfolio and we reiterate again high quality shorter duration book of business.

If you look at the right graph, you will notice something that we said, we’ve shown in the past the maturity reset distribution of the portfolio, the majority of the portfolio are either matures, reset, or have some type of shorter duration within a 120 months to maturity. And what’s really important is when we put a CMBS IO in our portfolio those bonds actually have much shorter duration than the actual legal final maturity on those bonds. You will see the final maturity may be 10 years, but actually the duration may be well inside of five years.

And then finally, let’s look at our equity allocation. You can see again that, especially when you consider the change between 2011 and 2012, we didn’t include this, but what’d really be interesting is look at how this has changed since 2010. When I showed you that graph earlier, the senior treasury, how it’s broken down in December of 2011, the main event at that point was when the fed extended their line so much longer period of time. They started to take a more aggressive approach to easier monetary policy and using some of their more unusual tools and packets in the marketplace. We’ve started at that point to aggressively diversify our portfolio away from prepayment risks. And it’s culminated to this portfolio at the end of 2003 where you can see that 59% of our equity is exposed to the CMBS sector where we have more explicit prepayment protection, 35% to the RMBS sector.

And then let me just point out again, it’s not just that it’s explicit prepayment protection. We know what our durations are. Our durations on the CMBS products really have minimal or if not zero movement from a negative convexity perspective, and let me try and put it in real simple terms. If I buy a seven-year bond, I got a seven-year bond. If you buy a 30-year fixed rate mortgage at this point in time, you’re hedging it into five year and you’ve got a three-handle type coupon, that’s great. I don’t believe that’s a five-year instrument, that instrument will trade at some point in its life more or like a 10-year to 12-year typing instrument. That’s our opinion and we stick with it.

Let me summarize with this issue. Many of you have been kind enough to respond to our request to check with us about some of the strategic issues that we’re thinking about our strategic plan. I just want to make sure that you understand that what we’re trying to do is update our corporate strategic plan to ensure that we have on our radar screens many items and factors in the marketplace that may change on us over the next two to five years. There are going to be some real positive changes that take place and let me just make note that the housing finance system still has a lot of development to take place over the next five years or we want to be in position to exploit that but we also want to make sure that we’re aware of any changes that maybe harmful to Dynex Capital.

I am going to thank you for participating and helping us out from that strategic perspective, but you don’t have to expect to make massive dramatic moves to our portfolio because we believe there is some need to. We will continue to operate in a disciplined fashion looking for the appropriate returns in the right locations. We have a diversified portfolio approach. We believe in investing in residential securities and CMBS. We believe investing in agency and non-agency. You’ll see on our balance sheet that we have both securities and hold loans, so we have a broad view in terms of our asset base and we’re very disciplined in our approach.

With that I’m going to turn it back over to Tom to summarize.

Thomas Akin - Chairman and Chief Executive Officer

Thanks Byron. Going onto slide 16, the Dynex value proposition that we have discussed for years now has not changed. We are internally managed public since ’88. We believe our diversified investment strategy is really starting to come into its own and its showing the real value particularly in this quarter where we have been able to show very consistent results vis-à-vis our competition. We still have a tax NOL, we will be using selectively when appropriate. It gives us the ability to take gains and not payout all of our earnings as dividend and it allows us to continue to increase our book value. We have – continued to have a significant insider ownership in the company and that it does mean that we eat our own cooking. Since the total rate of return slide there shows that since we began this effort we have an 80.61% total rate of return.

Finally, on summarizing, we believe that we haven’t made any massive changes to our investment strategy its remaining consistent, it’s working. There’s an old saying that if it ain’t broke, don’t fix it. And we don’t feel like we have to fix anything at this point. Prepayment risk has been mitigated by a majority of our capital allocation to CMBS, which has explicit prepayment protection and I think that is showing through in our earnings and our book value here in 2013.

We have anticipated monthly reinvestment needs of a very manageable amount. We are not having to reinvest $700 million to $1 billion a month, we’ve got $40 million to $80 million a month. It’s very small, very manageable. That means that we can be picky about the bonds we want to buy and that means that we can get into specific areas that most of our competition can’t. We have a current investment portfolio that supports the dividend policy and as owner operators we are focused on long-term shareholder value, we always have and we always will.

And with that operator, I would like to open it up for questions.

Question-and-Answer Session

Operator

Thank you, Sir. (Operator Instructions) Our first question will come from Douglas Harter of Credit Suisse. Please go ahead.

Douglas Harter - Credit Suisse

Thanks. Byron, can you talk about sort of where you are putting those incremental dollars of reinvestments you have to do today?

Byron Boston

Sure. You can note by some of the book value movements of some of the other reads that agency – some of the pockets and agencies have cheapened up along with the steeper yield curve. So, we have found, and again this has been very targeted some nice attractive sticking with our hybrid ARM strategy since January 1, really that’s probably been the bulk of where the dollars have gone. We have also continued to invest on again on a targeted basis in the CMBS sector. So, if you roll this back, let’s say a year ago. We may have been backing the truck up into CMBS at that point. We continue to add at these tighter levels, we still get some attractive ROEs, but it’s more targeted and are probably smaller amounts. And to be frank with you, our reinvestment needs are also smaller at this point.

We have also one interesting opportunity that we did take advantage of you this quarter. If you noted in the past when we’ve been in business since 1988, we used to originate loans and finance them via the securitization market, we had an opportunity starting back in 2009 to callback some of the bonds that are in the market and in fact refinanced basically 7.5% to 8% coupons at much lower rates. We still had another bond outstanding that we were able to callback this month. That was a very attractive investment for us with a decent amount of capital deployed. So, again back to that targeted approach, looking for pockets of opportunity where we can. But let me just identify as you have seen in some of the other book values, the agencies have cheapened up and provided some opportunity while we found other pockets elsewhere in the CMBS sector.

Douglas Harter - Credit Suisse

Great, thank you, Byron.

Operator

Our next question will come from Mike Widner of KBW. Please go ahead.

Mike Widner - KBW

Yeah, good morning guys.

Thomas Akin

Good morning, Mike.

Mike Widner - KBW

So, I guess my first question everybody is always very interested in the composition of agency portfolios today, and you guys have had a hybrid ARM portfolio for a long time. But just wondering if you could talk about sort of the composition there, what you are buying today in terms of new issue versus older issue. I mean, there is some big prepay speed differences between say pre-2007 vintages and kind of post-2008. So, just wondering if you could talk a little bit more in detail about both what’s in the current portfolio maybe by vintage as well as what you are buying today either new issue or you are kind of seasoned?

Thomas Akin

Alright. Let me just talk, preference this with one theoretical comment, Mike. Fast prepayments are not an issue if the bond is priced correctly. So, 50, 60 CPR bond when priced correctly can generate a very, very attractive return. So, it’s not so much as a seasoned bond that might look like it might have prepayment speeds, the best speeds is where I can actually buy that bond and what price. So, we have always preferred seasoned ARMs. One, the shorter duration, they roll down the curve very nicely. We have always assumed faster prepayment speeds and we have been able to buy them. We bought them when we can assuming those faster speeds. So, we continue to stick with hybrid ARMs. We prefer the season paper 1, because they have higher coupons and they have higher lifetime caps on them. So, some of them are really lowest like two something handle, 10-year final IO ARMs is not necessarily our number one choice to put in the book of business. And what we have been surprised to find really since January, some of the prices have adjusted is to define some of these bonds with premium traded cheaper levels that make them attractive to put in our portfolio without adding much duration, but still adding to our overall net interest spread. So, it’s not that we won’t look at 15-year or 30-year security. We have looked at them constantly for the last five years and every time we have looked at them, we have chosen to say no. There was one time within the last five years where we came close. They got really cheap where we said, it looks like they have extended. Should we buy these? We are a little slow they snapback and so we haven’t looked at those sectors again. We are more concerned with extension risk. Hence we stop with the hybrid ARM sector and we continue to stick there today.

Mike Widner - KBW

Certainly makes sense to me. So, I guess the thing that – knowing that’s been your guided strategy, the thing that I have sort of tried to back into and always have a little bit of challenge here is that with the weighted average time to reset of 53 months, it looks like you’ve got to have either a lot of 7 ones or 10 ones if there is a seasoned concentration in there. There just hasn’t been a lot of that stuff produced in a while. And so I am wondering, so I mean, how do we think about that?

Byron Boston

Okay. So, here is one interesting fact here Mike that you should note. The agency ARM book went down in the fourth quarter of 2012. We might be down. Steve, is it a couple of 100?

Steve Benedetti

Yeah, we are down $228 million.

Byron Boston

We are down $228 million in the fourth quarter of 2012. That capital was redeployed in the CMBS sector. So, we are being very selective when I talk about getting these opportunities in agencies. There is not a lot of bonds here that we are talking. We are only getting $40 million to $80 million back per month in terms of cash. So, we are not talking about a lot of purchases here. Now, if we go out and we issue equity and raise, I don’t know some crazy amount of money, which we designed at the forefront of our mind right now, then that would be the story, say well where would you put all of that money at this point in time? Right now, we are suited for the environment that we are in. We don’t have a lot of cash coming back. We can be very targeting and very selective, but you should note our agency hybrid book decreased in the fourth quarter of 2012 as we focused on putting that cash into the CMBS sector.

Mike Widner - KBW

Yes, I did notice that and appreciate that comment. Let me ask you one more that I get from investors from time-to-time when looking at you guys. If we break out the portfolio in all of the detailed buckets the way you do it, it shows up with pretty high leverage on that agency RMBS book, if we group all of the agency assets together, agency RMBS, CMBS and CMBS IO and run the leverage on that as a sort of a segment if you will, are these bucketed together? It’s a lower number, but I am just wondering if you could talk a little bit about that and what the right way for investors to think about – at what level should investors think about the leverage?

Byron Boston

Here is the way – here is the way we think about it. You look at another portfolio, you compare them to other shops. They have got fixed and floating rate assets in their portfolio. They may have fixed, floating in 15 years, and everybody looks at their agency book of business and they look at what their leverage happens to be on the same or the total book of business. So, it’s exactly the same way we look at our book of business. We have got fixed and we have got floating rate assets. It just so happens that our fixed rate assets are backed by CMBS. But the way we finance them is the same. Therefore, we look at our leverage as being combined, fixed and floating together agency securities. And that’s the leverage that’s most important to us. And so we manage our book of business from liquidity perspective, from a margin management perspective as that book as a whole.

Mike Widner - KBW

Well, I appreciate it, that makes sense to me and congrats on a solid year and a solid quarter.

Thomas Akin

Thank you, Mike.

Operator

The next question will come from Ken Bruce of Bank of America/Merrill Lynch. Please go ahead.

Ken Bruce - Bank of America/Merrill Lynch

Thank you. Good morning. Good morning, Tom. My question really is focused on the CMBS, I understand the explicit call projection. I guess I am interested in understanding the nature of that call protection and what the risk is that the closer you kind of or maybe over a longer period of time that we run with low rates that there is some potential for those borrowers to actually execute a refinance and just pay whatever effectively the cost is to do so. Could you just give me a better sense as to what the explicit call projection is?

Thomas Akin

Hi, Ken. I appreciate you are asking this. Let me give you – give me an opportunity to introduce Todd Kuimjian many other investors have met him, some of you analysts have met him, he runs our CMBS book, and it would just be a great opportunity for him to introduce himself here on the call and be able to talk to your questions.

Todd Kuimjian

Sure, great question, Ken. Majority of our assets are in the Freddie Mac program and the Freddie Mac program allows for refinancings of properties, but in order to do so you need to replace those cash flows, they call it lockout plus to seasons, and the seasons mechanism means, if you want to prepay that’s fine, but you need to go out and buy government securities that mimic the IO cash flows that were due on a particular loan that’s being refinanced. So, net, net, what happens is, your IO cash flow stream doesn’t change at all and now your credit has marginally improved because you now have the government cash flows backing your IO cash flow streams.

Ken Bruce - Bank of America/Merrill Lynch

Okay, well that’s an interesting structure. I hadn’t really realized that that was embedded in that portfolio. Is that only in the CMBS IO or is that also in the smaller CMBS portfolio or is it just a smaller piece of it altogether, so it’s now as big of a focus for ensuring call protection?

Todd Kuimjian

Generally, what you see in your main line CMBS, what I mean by that is, your CMBS with property types beyond multifamily, you will see primarily 95% lockout into seasons, which was what I explained earlier. And that – it’s not just in the IO, that’s in the entire – that’s for the loans. And you think about the remix structure is just a pile of these loans. And if the loans have these lockouts and the lockouts pass through all the securities. So, yes, it’s applicable to all of the securities and Fannie Mae has a slightly different program where they – where they will pay your maintenance, which is the difference between the existing rate and the current rate in that way you will be compensated in that fashion. And in that case you will be compensated immediately. But what happens with the benefit there is that the discounting mechanism is treasury is flat, so you will actually outperform when you see your maintenance payments.

Byron Boston

And Ken, this is Byron again and let me just emphasize one issue Todd brought up. Just the industry, the commercial loan industry, commercial loans are made different than residential loans. Residential borrowers enjoy this wonderful privilege of being able to refinance their mortgages whenever they want and for free pretty much. Whereas on the commercial side generally loans are structured as Todd mentioned, with some type of prepayment protection. One of the core philosophies of why we like mixing the two groups together in terms of a portfolio is obviously because of their different reactions in a variety of interest rate environments. So, we like the fact that we have more stable and more predictable durations because commercial loans are structured in that manner.

Ken Bruce - Bank of America/Merrill Lynch

Great, thank you. That’s very helpful. And then turning to their residential portfolio, yours is different than a lot of what is owned through a lot of other mortgage rates and we’ve seen quite bit of a volatility that had played out in the fourth quarter, basically as there is a lot of volatility in terms of refinance activity and the impact that might have. I guess all that gets digested into the securities prices and we tend to talk about in the context of basis risk. Do you see any of that volatility in the hybrid ARM area, is there something that is kind of I guess conjunctionally similar for that asset class that either concerns you or that we should be just paying attention to?

Byron Boston

Yeah, I’ll tell you the way we look at it. So, hybrid ARMs is what – what do we really, why do we build just a hybrid ARM portfolio? We don’t want to take on extension risk. So, we are sitting here and say, okay how do we avoid extension risk? So, if you look into marketplace and people say, my portfolio is hedged and it’s hedged to five-year duration and you got a 30 or 3 in your book of business. I’m probably going to argue that at in some point the security is light it’s going to trade like a 10 to 12-year bond. And so we don’t want to take that type of extension risk though the hybrid ARMs write-off that, that have limited extension risk because they have these hard reset dates 5, 7 continues out in the future. And so that really is at the core of what’s driving us.

What should you really watch? Is a duration extension path on hybrid ARM? Yes, there is cap risk, so we have caps within our hybrid ARM. We believe that the biggest issue that could force around cap risk and hybrid ARM would be the fed jacking rate similar to they did maybe let’s say in 1994 with a jack rate maybe 300 plus basis points in one year. We believe that as a remote, remote potential event taking place. We don’t believe the global economy can handle the fed tightening rates 300 plus and more basis points for sometime in the future here in the United States. So, that’s a risk that we’re willing to take. Other thing that I would be thoughtful about with hybrid ARMs, hybrid ARM prepayment fees normally in a normalized environment of faster than 30 years, but what we saw in 2003 were that hybrid ARM fees actually in aggregate were slower than 30 years in aggregate and we’re seeing the same thing at this point in time. I know there was a lot of chatter in the marketplace a couple of years ago that hybrid ARM sector was going to blow up because of HARP and because of low rates.

Well, simple answer to that, it hasn’t happened. Our prepayment speeds again have probably peaked, over the last two years, we saw it peak at 25 CPR, we saw it peak at 26 CPR in the hybrid ARM book. That is materially less and I always talk about the 2003 experience where you saw probably 90 CPRs in the hybrid ARM book and if you talk to some old hybrid ARM traders, they probably got beat up back in 2003 and 1994 and they may have in their minds some real fear of dealing in the sector. So, we got a philosophy while we’re here. We don’t want to take it on the expansion risk. We continue with it by diversifying the CMBS to be able to generate solid double-digit returns by staying with the short duration strategy. When we see more extension in some of the fixed rate securities that might give us more comfort in terms of what they may trade over the long-term, you could potentially see us try to take advantage of that, but what I tell you, Ken, if we can generate double-digit returns, maintain a hybrid ARM book short duration portfolio and be prepared for unforeseen movements up in rates, we’ll continue to do so.

Ken Bruce - Bank of America/Merrill Lynch

Okay. And then in this, I guess to stay in that same vein, do you have a sense as to within those hybrid securities, how much or how many of the borrowers are in fact already in a floating rate position. I mean what’s the – I guess where I’m going with this is obviously, rates have been low long enough. There is a lot of people that are caring, what were hybrid fix which are now just floating and at some point they’re going to jump on the other side of the fixed, floating kind of bucket. And I’m just wondering do you have a sense as to kind of how many of those borrowers in your pools are in that position?

Byron Boston

I don’t have the exact number or how many are there. We’ve got a pretty decent portfolio, what I would call currently resetting hybrid.

Thomas Akin

It can for 12 months to what we said or less, our book is around $560 million.

Byron Boston

Alright, and that’s we rolled down the curve with those bonds and let me just put myself in the shoes of those borrowers. That’s been really our slowest bucket for prepayments because those borrowers were all sitting on really low rates and probably some are under water in terms of their homes. That has – we’ve seen a slight increase in those prepayment fees over the last few months and one of the reasons happens to be because of curve is flatten and new issue 51 speeds really close if not in some cases lower than its currently resetting speeds, I think we’ve had an increase in borrowers that do take advantage of the – out of the floating rate security into a fixed rate security, but it hasn’t been any massive amount that has taken place. Here is what I do – I’m concerned with more, it’s not just what I have at ARM, with all these instruments. No one in this business has experienced or seen a market like we’ll see once interest rates go up, let’s call it 100 and 150 basis points. What you will have at that point in time is you will have mortgage rates let’s call them four – somewhere between 4% and 5%. You will have an enormous amount of borrowers that are locked into lower rates and now we are going to predict what will be the behavior of these borrowers at that point in time.

Lots of people have theories around that. I’m concerned that on the fixed rate product you’re going to see some really slow speed on the hybrid product where I think you are going to see at speed. I’m not expecting anything to slow down into the single digits. I’m still expecting to see double-digit type speeds and then may be some borrowers start to face the fear of increases in rates maybe we see some other adjustments at that time. Those are all theories, I’ve got one, other people have them, but no one has experienced in environment like we’ll see when rates go up 150 basis points, okay.

Ken Bruce - Bank of America/Merrill Lynch

Great, well, thank you. Great quarter. And thank you for all your comments and color. I appreciate it.

Operator

(Operator Instructions) The next question will come from Trevor Cranston of JMP Securities. Please go ahead.

Trevor Cranston - JMP Securities

Hi, thanks. You guys had a slide earlier in the deck showing the relatively low level of great volatility. I was just curious if that changes how you’re thinking about hedging the portfolio at all in terms of potentially adding some optional protection or are you guys are still thinking that fixed base swaps are kind of the best way to go about hedging those specific assets?

Thomas Akin

Well, that’s what you’ve identified both are in our opportunity set for hedging the portfolio. We continue to still feel that interest rates swaps are great instrument for hedging the book of business. But there are some changes coming from a regulatory perspective that we’re concerned with – it might make it more expensive to really run our overall slot book so, we’re considering other type of strategies to limit that. We also Trevor, we do consider residential IOs, we’re potentially using it as a hedge in this portfolio which would fit great. We just have not felt the need to add those into the book of business at this point in time. I do think obviously at some point, the volatility will increase and obviously, we would like to think that we’ve had the appropriate amount of swaps to deal with that. At this current point in time, the way we break the book down, we’re most concerned with our longest duration instruments and we allocate our swaps accordingly. And we feel very comfortable that our longest duration instruments are pretty much still covered by swaps. That would leave our book of business with really short duration hybrid ARMs and short duration CMBS type IO securities, which we’re very happy to continue to allow those bonds to roll down the curve and earn the resulting solid net interest income from that. So, long or short, yes swaps options are a potential security that we could use to hedge our book of business.

We have found no reason to change our overall stance at this point in time. My antennas are up for us breaking through that 250 level on the 10-year, and pushing back to a 3% of that, I believe we will do some day. We may take a more aggressive stance toward our book of business, but right now even if we got caught off guard, there are things within our business, our book of business that will help us in a rising rate environment. One, the amount of premium on our book, we believe premium securities will perform better than most people think. Two, the short duration nature of hybrid ARMs will be also be very helpful. And then three, our CMBS book does not extend because interest rates rise. That’s an issue that the guys with 30-year securities have to deal with.

Trevor Cranston - JMP Securities

Yeah, okay. That makes a lot of sense. But also can you just comment may be on what you’re seeing in the repo market since the end of the year?

Byron Boston

Repo rates are down. They have come down since the end of the year.

Trevor Cranston - JMP Securities

Is that both for agencies and non-agencies are that kind of more something that you have seen in the agency market?

Byron Boston

The bigger was been in the agency market. There have been some positives on the non-agency in the sense whether some margin adjustments or more people maybe talking about willing to finance them. But the bigger move really has been on the agency side of the book and the bigger move last year was on the higher, was on the agency side but we didn’t see that much movement on the non-agency, non-standard type products. So, we have seen a repo rates come down. We’d love to see them continue to move in that direction. I think the Street will be slow in terms of their desire to continue to lower those rates, but right now it’s been an attractive opportunity this year.

Trevor Cranston - JMP Securities

Okay, thanks guys.

Thomas Akin

And the prospect is they could go down even further, Trevor. We are seeing that maybe down a dime, we could see them maybe down a little bit more than that. So, that’s making agencies as well as the yield curve becoming more attractive, making agencies more attractive.

Trevor Cranston - JMP Securities

Yeah, understood. Thanks guys.

Operator

And our next question will come from David Walrod of Ladenburg. Please go ahead.

David Walrod - Ladenburg

Well, good morning. I just had a couple of quick questions. First, the CMBS portfolio that we have been discussing is that part of the Freddie Mac K-Series or is that a different group of securities?

Thomas Akin

No, I just ordered Freddie Mac K-Series that’s basically their multifamily program.

David Walrod - Ladenburg

Okay. And then…

Thomas Akin

Just so you understand, David, that’s categorized in the – we are buying the mezzanine bonds that’s categorized as the non-agency in the CMBS.

David Walrod - Ladenburg

Okay, good, good to know. And then just I am assuming, I know the answer of this, but you did announced the smart share buyback in the fourth quarter, is that – I am assuming just there for opportunities if there is dislocation in the market, I guess commenting your thoughts on that?

Thomas Akin

Well, we bought all we could, David. We don’t trade that much in volumes. So, it really restricts what we can do. And I think, Steve, correct me if I am wrong, I think we were only able to buy one day at a price that was attractive to ourselves, but our consistent thesis is that we will buy if there is a dislocation in the market. We have no problem with that. I think we’ve paid what $864 million something like that.

Steve Benedetti

That’s right.

Thomas Akin

And we were shocked to go down that low, but we will participate that we need to.

David Walrod - Ladenburg

Okay. Did you disclose how many shares you brought that is for Q4 in that one day?

Byron Boston

104,000 day.

Thomas Akin

It wasn’t much.

David Walrod - Ladenburg

Okay, well, that’s good. Alright, I appreciate it guys. Thanks.

Thomas Akin

Thanks, David.

Operator

This will conclude our question-and-answer session. I would like to turn the call back over to Mr. Thomas Akin for his closing remarks.

Thomas Akin - Chairman and Chief Executive Officer

I want to thank everybody for being on the call. I think hopefully we reiterated our consistent investment strategy. We don’t see any big meaningful changes in the company. We appreciate your time and look forward to next quarter’s call as well. Thank you much.

Operator

Thank you. The conference has now concluded. We thank you for attending today’s presentation. You may now disconnect your lines.

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