Dynex Capital, Inc. (NYSE:DX)
Q1 2014 Results Earnings Conference Call
May 07, 2014 11:00 AM ET
Byron Boston - President and CEO
Tom Akin - Executive Chairman
Steve Benedetti - Chief Financial Officer
Smriti Popenoe - Co-Chief Investment Officer
Douglas Harter - Credit Suisse
Trevor Cranston - JMP
Mike Widner - KBW
Sterling Edmunds - White Partners
Good morning and welcome to the Dynex Capital Incorporated First Quarter 2014 Earnings Conference Call. All participants will be in listen-only mode. (Operator Instructions). Please note this event is being recorded. After today's presentation, there will be an opportunity to ask questions. (Operator Instructions).
This conference 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 may 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 the contemplated by the forward-looking statements as a result of unseen external factors or risks. For additional information on these factors or risks, please refer you to our Annual Report on Form 10-K for the period ending December 31, 2013 as filed with the SEC.
This document may be found on the company's website under Investor Relations as well as 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 Investor Relations page of the webcast under IR Highlights. The slide presentation may also be referenced by clicking on the Dynex Capital Incorporate first quarter 2014 earnings call link also on IR Highlighted page of the webcast.
I would now like to turn the call over to Byron Boston, President and CEO. You may have the call sir.
Good morning and thank for dialing in for our 2014 first quarter earnings conference call. With me today is Tom Akin, our Executive Chairman, Steve Benedetti, our CFO and Smriti Popenoe, our Co-Chief Investment Officer.
During the first quarter, we continue to manage our capital in a very disciplined manner. We have made no major changes in the assets in which we invest or the overall structure of the portfolio. However, as we mentioned in our prior conference call competition for assets continues to increase and hence our capital deployment in the first quarter has been limited.
In fact, the global financial markets are very complex today driven mainly by the unconventional activities of the global central banking community. Our goal today is to give you a clear picture of a complex environment in which we currently invest and for our shareholders, we would like to leave you for reinforced impression that you can continue to trust your capital with this management team.
For the past 11 years, we've been very disciplined in our approach not being swayed by the hot investment ideas that crop up from time-to-time. Likewise, we have recognized how the current market environment has continued to become more complex. On the one hand, this is a great environment to earn net interest income. Volatility is low, yields are range bound, central banks are trying to be transparent. On the other hand, the central banking community has prompted enormous amount of cash into the global financial market that has led to an extreme reach for REIT for yield.
Risk premiums have declined materially across all asset classes globally. As a result of this dilemma, we continue to scrutinize every investment decision with a much higher level of vigilance. We also continued to examine other strategies to ensure we are not overlooking an opportunity that might benefit our shareholders.
As we move forward through this complex environment we will continue to manage our shareholders’ capital for the long-term, emphasizing diversification, low leverage, conservative liquidity management and prioritizing shorter duration assets and our exposure to the CMBS and multifamily sectors.
Steve Benedetti and Smriti Popenoe will both go into more detail regarding our first quarter performance and the current structure of our portfolio.
Thanks Byron. I am on slide four for those following the presentation. We reported a GAAP net loss per common share of $0.06 mainly due to market value losses on our derivative instruments from declining interest rates along with losses on the sale of securities during the quarter.
On a core basis, we earned $0.25 per common share compared to $0.29 per common share last quarter. Core earnings benefited from an increase in the adjusted net interest spread to 188 basis points from 177 basis points offset by a slightly smaller investment portfolio and higher G&A expenses versus last quarter when we recorded a $0.03 benefit and reduced incentive compensation expense.
As we have noted over the last several quarters, we present the non-GAAP measures in our financial statements as a result of discontinuing GAAP hedge accounting for our derivative instruments, which results in our recording valuation changes in our hedges through the income statement, while asset value changes are recorded through shareholders’ equity.
During the quarter we declared a dividend of $0.25 per common share in line with our core earnings and which represents a current yield of 11.7% based on last night’s closing stock price. Our leverage continued to decline during the quarter by 0.3 times to 5.9 times our shareholders’ equity as a result of the net deleveraging of our investment capital and the net increase in shareholders’ equity of $13 million during the quarter.
On slide 5 we present some non-GAAP financial metrics including core net operating income per share and adjusted interest spread each for the last five quarters. Reconciliations to these amounts are included in slide 33 and 34 in the appendix. The 11 basis point increase in adjusted net interest spread resulted primarily from earning the whole benefit this quarter of adjustments made last quarter to our hedge position.
This quarter we net added hedges as we adjusted our exposure to different points on the curve and several forward starting swaps became effective. Also benefiting our net interest spread were yields on our investments which increased principally as a result of changes to our investment mix.
Agency RMBS pay downs during the quarter were reinvested in non-agency CMBS and CMBS at higher yields and higher anticipated returns on our capital. With respect to book value per common share, we recorded an increase of $0.18 or 2.1% to $8.87.
I’ll now turn the call back over to Byron.
Just to be more specific on some of the issues that we consider making the overall environment complex, if you move to slide 7. We’ve outlined a couple of issues that we think are important to make note of and I am just going to highlight a couple of them and I’ll let Smriti go into more detail on the portfolio.
Overall global inflation levels will become an issue over time and they may become a surprise factor as we move forward. But probably the most dominant factor of all is the excess liquidity from the global monetary policy is unprecedented and has led to asset value distortions. Foreign central bank actions plans remain uncertain and could cause unexpected results. We are aware of this and we are operating our company with this in mind.
And then finally regulatory policy and the mixture of the regulatory policy with the monetary policy is what all adds and creates this complex environment. We’ve all heard a lot about housing finance reform and I want to remind you that Dynex has been -- has 25 year history of making money and successful operator within the U.S. housing finance system. This will change over the next few years and Dynex will be in position to exploit those changes. But it is very uncertain at this point as to how those changes will come about.
And from with this I am going to turn it back over to Smriti to emphasize some of the key changes -- key structure of our portfolio.
Thanks, Byron. Please turn over to slide 8. As we mentioned in our previous calls at Dynex we think about markets in terms of fundamentals, technicals and physiology. Fundamental trends in CMBS particularly multi-family remain solid with rents, vacancies and property prices on a positive trajectory. In the RMBS sector, we have seen a market slowdown in origination activity resulting in slower prepayments that we experienced over the first quarter.
On the funding side, we continue to have access and availability to liquidity at attractive levels. This is being primarily driven by excess balance sheet capacity and a lack of high quality collateral. And finally as Byron mentioned as evidence by more than one headline this week, the nature and timing of GSE reform is still uncertain with no private standalone solutions yet and in place to replace the GSEs.
Technicals are also strong in the markets we invest in. Continued government involvement, abundance of cash and the quest for yield has really resulted in lower risk premiums across the globe. We are seeing this domestically reflected in the strong demand for RMBS. It’s keeping net supply lower for a longer than most people thought. We're seeing a lot of competition in primary loan markets from commercial real estate loans. This has resulted in lower conduit and CMBS and multi-family supply. In fact in the first quarter, the market was expecting about $29 billion in CMBS conduit supply, we only got $22 million. We’re also seeing the abundance of cash reflected in repo funding levels which have fallen almost 10 basis points since their peak in the fourth quarter.
All of this activity has led to much tighter spreads through the first quarter and up to today. If you turn over to page 9, you can see that spreads on 30 and 15 year RMBS are at their tightest levels since mid 2013. In the case of 30 years, the last time spreads were this tight was mid 2010 and for 30 year specifically, aside from those two periods, 30 year MBS have not been this tight since 1996 on a nominal basis.
On slide 10, we showed this trend has continued in the corporate bond market for both investment grade and high yield markets, emerging markets have gone sideways. And on slide 11, we show the same trend of CMBS spreads. It's important to understand the market environment in these time periods. In the 90s and the early 2000s, spreads were tight due to high levels of leverage from securitization and lease securitization. We all know how that will be ended. And in this current environment, spreads are tight because of an abundance of cash being pumped into the system by central banks.
We also know that regulators are working to make sure that over leverage doesn't happen again. And we do know that when the time is right, the Fed will drain all of these excess liquidity.
So as Byron mentioned, the current environment presents a bit of the dilemma for us. As spreads tighten, our book value increases, but it also reduces the return on new capital that’s deployed at these levels. A decision to invest capital in this environment really rest on your risk appetite and your view of spreads.
So let's talk about spreads first. On the CMBS fronts, spreads are tight, but we still see some value in the CMBS IR sector. This quarter as well as throughout last quarter, we saw subscription rates for tranches that we invest in increased two and three fold indicating very strong demand and reflecting the lower supply picture. So the technicals are very strong in this sector. On the other hand, we're also seeing primary market competition driving and expansion of underwriting standards, really illusioning. Where we see this is really manifesting itself as an increase in leverage on each property. While our portfolio is benefited from tightening spreads and book value as written we do see some opportunities to invest but we're trading very carefully to make sure we understand the long-term risk of these levels. In the RMBS market, we see spreads continuing to remain tight as long as net supply remains low or turns negative.
If you flip to page 22 in the appendix, you can see that new supply has been dwarfed by Fed purchases since July 2013 most market participants expect this trend to continue until late this summer. In the ARM market in fact net supply has been negative for sometime and is expected to continue remains so through this summer. This is a tremendous positive near-term technical for RMBS and more so for short duration instruments.
As you see on the spread chart on page 9 and I'm sorry to flip you guys back and forth, but ‘15 year MBS spreads can get tight and stay tight for a long period of time. We could see some spread widening as the Fed exits, but it would really have to be a supply story that drives it. So if you ask of this situation of very bearish bond market psychology, a data driven Fed with potential spikes in volatility you have the complex environment which Byron alluded to.
As we sit here and assess this situation our view is that this is not the environment in which to make big bets one way or the other. Success to us in this environment is really being able to seek and find pockets of value to add on the margin and we think we can continue to do that both on the investing and the financing side. Our portfolio generates a solid double digit return with a profile that we feel puts us in a good position to be around what this movie does and be around for making the sequel.
So going ahead what does this mean Dynex. Let’s turn to page nine. We are maintaining our disciplined approach for capital deployment. We did make investments in the first quarter, our portfolio did delever and keep in mind that some of the delevering happens because our equity value goes up.
We continue to be focused on generating earnings by maintaining our investments in the current portfolio but we are very conscious about the spread risk in the environment. We are maintaining our positive duration in the front end of the yield curve. We’ll have adequate leverage and liquidity which we’ll adjust as necessary. We are focused on creating value through funding in our funding portfolio and we are always going to have this constant disciplined review of risk adjusted returns on the variety of market opportunities that we have in front of us.
Let’s change gears for a little bit and talk about our interest rate risk position for the quarter. As you can see on slide 10 we show you our risk position across the variety of interest rate scenarios. I beg your pardon, on slide 14. We show our profile over a number of different scenarios, parallel shifts as well as non-parallel shifts. We said before that the market never really shifts in a parallel fashion so we’ve shown the impact to our asset position net of hedges across a number of different scenarios versus last quarter our position is down slightly in terms of risk. So up a 100 last quarter our assets and net of hedges would have gone down 1.89%, that number this quarter is 1.46%.
I’d like to bring your attention to two specific scenarios in the bottom chart where we actually stress our portfolio with increasing interest rates in the front end of the yield curve where we have our long duration position and in no scenarios as well our risk is down versus last quarter specifically in the up 25 scenario where the front-end moves up 25 the back-end does not move up. Last quarter our assets would have gone down net of hedges 0.3%, this quarter it’s down about a tenth of a percent to 0.2. So we do have a lower risk position versus last time. As Steve mentioned we opportunistically added hedges in the 7 year part of the curve some of the forward starting swaps also helped us and which is exposure.
The next few slides I’ll just focus on a couple of different things before I turn the call back over to Byron. On page 15, you can see that our equity allocation again primarily in the CMBS sector, the RMBS sector allocation went up versus last quarter really as a function of our liquidity management activities. So it’s not because we added capital to the RMBS sector. You can also see that our net premium is primarily invested in the CMBS sector on page 15.
Page 16; what I would point you to is the bottom right chart, you can see an increase in our non-agency CMBS IO positions versus last quarter. As we’ve mentioned this has been the sector that we’ve primarily seen value. And on page 17 in the RMBS sector, we continue to really have a nice roll down in this portfolio, no real changes versus last one.
Page 18, which is our financing book, really a couple of things to note here, our repo funding cost did decline in the first quarter as the cash markets recovered from the spike in the fourth quarter. As you’ve recall there were debt yielding crises other factors that cause repo rates to spike.
This quarter we have actually reduced our contractual maturity slightly over the last quarter we had a three basis point decline in the average cost of funds and since the peak in the fourth quarter we have seen repo rates really come down about 10 basis points. Availability and liquidity has not been an issue and most of our counterparties continue to show capacity here.
That’s it from me; I will now turn it back over to Byron.
Thank you, Smriti. I would like to leave you with a few concluding thoughts that I want you to remember about Dynex capital. The current market environment is complex. We said that [Smriti] mentioned that in our last conference call for the fourth quarter of 2013 we’re trying to emphasize that today.
Uncertainty around economic growth, regulatory changes, market reaction and global market imbalances required discipline and vigilance. But here is a real key for Dynex. Our investment strategy and thesis has not changed. Our portfolio continues to generate an above average dividend yield with the conservative profile. As you are aware, we have continued to earn and pay a $0.25 dividend as our portfolio continues to season nicely and roll down the curve.
This is only $0.04 lower than our peak dividend payment over the past six years. And as Smriti just mentioned, funding cost have recently declined and there is excess capacity in the system. So, we continue to look for opportunities to diversify and expand our overall financing sources.
And then finally, as I think about the future, Dynex started operations in 1988 and we have been a successful participant in the housing U.S. finance system for 25 years. There are few entrepreneurial REITs like ourselves that have weathered every financial crisis since 1980. The U.S. housing finance system will go through a transition over the next several years and we believe there will be multiple opportunities for Dynex to continue to grow and deliver solid returns to our shareholders. Longer term we see opportunities for investments in both residential and commercial assets and in markets currently dominated by the fed or the GSEs.
At the conclusion of QE3, private capital, for the first time will need to replace the government as a dominant purchaser of MBS. That's one of the simplest strategies that we can pursue in the future. In addition, as the U.S. housing system is reformed, there should be more opportunities to invest in residential credit.
We can be very thoughtful and patient in our evaluation of these opportunities to further diversify investment and funding strategies in the future, because our portfolio continues to perform well today. We want to you trust that our experience has taught us to manage for the long-term and not to take too much risk at any point of time. We believe there will be opportunities to continue to generate above average dividend yields for investors, but we are moving forward in a very cautious and deliberate manner.
And with that operator, I'll turn it back over to you for questions.
Thank you. We would now like to begin the question-and-answer session. (Operator Instructions) First question comes from Douglas Harter from Credit Suisse.
Douglas Harter - Credit Suisse
Thanks. When you look out into the next couple of quarters, how do you see that interest rate risk moving? Is that -- you're comfortable with where it is today or you want to tighten it up more losing it up a little bit?
Yes, it is an interesting one Doug, and I appreciate the question here, because that's why we use the word complex. When we think about the future and you say do you want to tighten up your interest rate risks, one of the main way that you're in the marketplace is, well do you want to take your duration gap to zero.
If you take your duration gap to zero with swaps euro, dollar futures or some other derivative instrument, that's fine. You may take your duration gap to zero, but you’re thinking on another step of risks. And that's why use the word complex, because on one hand you could say let me take my duration gap to zero, but some idea that interest rates may go to 320 to 350. But if rates drop on you with that position you may find yourself in trouble with some other participants found themselves in 2011.
So, we're not making, as I think Smriti mentioned in your best direction, we're very comfortable with this position as it sits today. We deliberately structured our exposure to the front-end of the curve. Even though you will hear a lot of the noise over the next year, year and half with predictions around what the Fed is going to do, we believe that this is the best structure for a portfolio with durations are uncertain. We leaned on the CMBS sector, because durations are more certain in that sector and gives us more confident in our overall hedging strategy.
So, let me just address, I know a lot of buzz in the market, there is an enormous amount of people who are short at this point in time in the marketplace because they have got this believe that interest rates are going to go to 3% to 3.5%. We believe we have got our portfolio structured in the right manner with the right assets to deal with this complex environment.
I think the other point I would make is that that’s not to say that we are not ready to make the change if it becomes appropriate, we just don’t see it yet at this point. We are ready to make the change if we believe that that’s the right thing to do.
But it’s really important for you to understand that with someone said they have got a zero duration gap and then hedge with swaps versus mortgages, they’ve simply taken on another basket of risk.
Douglas Harter - Credit Suisse
Right. And you guys for a while rightfully sort of like the CMBS market as you show slide 11 those spreads have tightened a fair amount, how do you think about the attractiveness of those returns today?
So on the margin, let’s say in the first quarter we were able to put on positions at 11%, 12% return on equity, base case yield. And those spreads have really tightened into where the marginal returns are in the 9%, 10% at this point, so not terribly ugly yet. So that’s really where we see the opportunity at this point. We could still sign bonds that will give us this double-digit return.
So Doug, on a historical basis we were putting a ton of cash in the market in 2011 in CMBS where spreads were out over 500. We’ve written this entire move in, in terms spreads here at Dynex and that’s been an exciting ride. So we don’t get excited when spreads get this tight, but here is the part what’s mentioned in terms of complex. The biggest driver what’s underneath the big movement in spread, it’s not only in CMBS, in an every asset class globally pretty much so is the fact that the central banks have pumped an enormous amount of cash into the global financial systems. So there is ton of cash globally seeking yield. If you want to look at some really unusual situations look at what people pay for Spain, Italy or Greek bonds at this point in time.
So, the spread environment is complex, but here is what we do, we respect is that it’s very technical. And the global central banks have not stopped pumping this type of cash into the system. And so to have a real meaningful long-term move in rates in our opinion would be when you start to see those central banks drain cash from the system. And I think we’re long ways away from that. So, I am saying it’s differently than the buzz word in the market which is the fed will be accommodated for an extended period of time. I am simply saying the actually draining of cash on the system by the global central banks will be a monumental event for the global economy. And I don’t think the global economy will be in shape for that type of draining of reserves for sometime in future.
Douglas Harter - Credit Suisse
Great. Thanks Byron.
Next question comes from Trevor Cranston from JMP.
Trevor Cranston - JMP
Hi, thanks. One follow-up on the point you’ve been making about spread tightening. I appreciate the comments about global liquidity in the system. But I am curious specifically on the agency CMBS sector. Spreads have tightened pretty meaningful amount and it almost seems like the tightening has accelerated recently. So, just curious if you guys have any kind of view on what’s been driving that specifically in the agency CMBS sector and if that’s had -- if you’ve seen an acceleration in the tightening recently and then how that’s kind of impacted the book value since quarter end?
Right. So we have seen an acceleration in the tightening since quarter end. Here is the deal with a lot of these sectors. In 2011, the Freddie K program was pretty much an unknown program. It’s taken a long time for those bonds to be accepted in the marketplace, for people to understand them, for the repo market participants to really understand and finance those securities. And I think what we are seeing right now is let’s say a broader acceptance and market knowledge quite frankly of these bonds. Over the past month though, it does seem like there has been a rapid tightening in these securities. I mean we have been hearing about a large buyer of these securities. That’s what we think is driving it. But it’s not surprising to us. I mean these are agency securities. They go through a very, very stringent underwriting process at Freddie and Fannie. We don’t love the levels at which where people could potentially buy them but it’s not unreasonable that investors should find these bonds attractive.
And then the point that Smriti is making Trevor is that there is a certain amount of the Freddie, the Freddie Ks are unique. So we were one of the earlier investors in the Freddie K program. We’ve been had it now for 4 to 4.5 years or so. And it was an unknown entity product 3 or 4 years ago.
And so up certain of the tightening is a function of more investors becoming more comfortable with the product. One example of it is the products not included any index. And so…
Yes, the P&I bonds included any index that draws more attention to the product. There is more research now being written about the product. So, there is larger investor base that has shown up for the product.
But another factor that also has taken place. So, this is May in 2014; the market has surprised most participants. And not only the absolute yield level surprised most participants, but for those individuals who let’s say they weren’t necessarily short to market, but they had cash and they were waiting for higher yields. There are some participants that are throwing in the towel. There are shorts that are covering their position. And there are guys with cash who are just capitulating and putting money into the marketplace.
So, again back to why we keep emphasizing the word complex is to just want to make sure that you understand the environment in which we're operating and some of the challenges back and forth that we debate in the laws of Dynex about how to deploy the next marginal dollar?
Trevor Cranston - JMP
Got it, that's helpful context. Now on the funding side, there is a few companies now in the mortgage REIT sector that have announced that they form subsidiaries that have become members of the FHLB system. Can you guys comment on if that’s something that Dynex in particular has looked at and how you think that might fit in with your portfolio that exists today?
So, I look at what I have seen in the marketplace. There has been a few announcements about the [resets] have joined FHLB system. We do believe that is a very positive development, though there is many of entities are different in Dynex capital. We pointed out to you earlier that for the last 25 years, we've been part of this housing finance system.
So, when I look at Dynex in the business that we're involved in and our overall focus, we're not a hedge fund, maybe I don't know had issues in waiting, suddenly decided they wanted to start a REIT. We are not a fund company that again woke up one day and suddenly decided they wanted to be a REIT. We are mortgage REIT fully focused on the U.S. housing finance system and all the products that come within. And we believe our future strategies will be completely focused in making money through the U.S. housing finances systems. So I think I's a positive because the federal home loan banks are in the same business that we're in. And so, we are considering this, we are evaluating this and we are developing more information about it.
Trevor Cranston - JMP
Okay. That sounds like we can maybe hope to hear more about that in the future. Thanks for the comments.
(Operator Instructions). Next question comes from Mike Widner from KBW.
Mike Widner - KBW
Good morning, guys.
Mike Widner - KBW
I think you've answered most of the questions. So let me just go a little macro. I mean you guys are articulating a fairly cautious stance and certainly I think a lot of people share your views on what's going to happen if and when central bankers pull back on liquidity. I guess though you made it sound like this is or your view at least is that the market will have a very difficult time handling this. And I guess my question is what are you envisioning that’s sort of beyond the fed? I mean everyone knows tapers happening and we’re probably going finish the fed purchases roundabout October maybe December. But you are talking about a pull back on liquidity, it’s more than that or are you saying just that or kind of what you have in mind?
Mike, let me tell you why we use the word complex and I didn’t give you any more specifics around, it's really complex. I’m not worried about our fed, I've got a pretty good idea about what our fed is doing or may do in the future. But United State is part of much larger, much more complex global financial system. It's what I don't know outside of our borders that concerns me the most. And as far as we're concerned, the structure of global finance doesn't make sense. It’s not sustainable. Changes will have to happen and adjustments will have to happen as the future plays out. And we can’t predict what those will be, it will be a fool’s game to try to predict exactly how this will play out. So we worked through multiple scenario through Dynex to try to see and make sure that we’ve got enough liquidity that we are in good position to deal with it and we want to make sure that we don’t, as Tom Akin would always say get out over our skies, take too much risk such that we are not flexible enough to deal with situations that happens that were not predicted. And let me just say I have been in the business 33 years, Mike, I have been involved in every -- I mean in the capital committee, a material capital committing seat in every major financial crisis since the early 80s. And most were completely unforeseen and uncertain.
So that’s the way we think at Dynex and we’re managing our risk accordingly. So we’re not sitting here saying, oh x is going to happen on December 2nd at 4.30 in the afternoon. We are just respectful that the global financial system is very complex business point.
Right. I don’t think we -- the Taper doesn’t concern us. I mean that’s a large degree is anticipated it’s been very well telegraphed by the Fed it’s really these exogenous factors that and again our risk position is conservative, but we’re still have 5.8 times leverage. We still have spread risk. We still have position that, but we think that it’s just a position that’s going to allow us to sort of live through any of these exogenous shots and come out on the other side and be able to make those investments when that opportunity does arise.
And Mike at this point what’s really great is while we are sitting here managing this position it looks the same philosophy will be there two, three, four years ago. We continue to pay our shareholders a $0.25 dividend yield, I mean I am sorry, we would love it to a dividend yield, the $0.25 quarterly dividend. And so we’re very comfortable. I think the big decision in an environment like this is how much risk do you want to take. And you must be a skilled risk manger to understand as I mentioned a second ago, yes you can take your duration gap to zero with some type of derivative, but you just simply take another basket of risk, because it hurts very badly the market moves in the other direction.
Mike Widner - KBW
Yes. No that is certainly fair. And that make sense. I guess what I am still wondering about is that your tone is certainly more cautious today than it might have been over the past couple of years on average. And that sort of implies that you think this while you can’t predict the day or the exact nature of the event that you feel like it’s closer than it might have been and the likelihood of such an event is high enough that it suggests being more defensive rather than more offensive?
The real big difference though and I think that’s exactly right because two years ago spreads were a lot wider and it was I don’t want to say easier to put capital to work but we were able to put capital to work at a more attractive level. Spreads have tightened so much at this point, where it is more dangerous and that’s the reason that we look at this environment and say you need to be more cautious.
And it’s less margin for air, that’s basically what Smriti is telling you. We’re buying CMBS I/Os 550 to 575 of the curve few years ago and these spreads have come in quite a bit. So there is less margin for air. But here’s how, when you say cautious it’s really we’re being very aggressive as we look and consider opportunities. And so as I know you and everyone else will compare Dynex versus other REITs, their REITs were starting new strategies and they are going and running after this and running after that. We have made a decision, we’re very happy with our portfolio. We are going up a nice cash flow from this portfolio and part of the reason is because when spread was at 575, we were actually putting on assets at very attractive spread levels.
So we have been able to ride this market and ride the curve, ride the spread tightening and I think our shareholders can feel very comfortable that they are earning a decent cash flow that we take a cautious approach. But I am also emphasizing this, I don’t want you to get the wrong impression that we are looking at all the opportunities in a very disciplined manner.
You can go through your list, you can really want to breakeven (inaudible) president of credit risk, we can talk to you about all of those strategies and I’ll emphasize that Dynex over its 25 years of history that’s had every one of those strategies under this root at some point in time. So we are not naïve we are very experienced in these strategies, we’re being very delivered about our approach.
Another minor point you might have also emphasized is that our payments, prepayments on the portfolio are not that large quarter-to-quarter. We had a $133 million in pay down. So there is not a tremendous amount of capital that we have to reinvest in this environmental unless we get rates capital, so…
And that’s the benefit of having the CMBS.
Mike Widner - KBW
So one final one, I mean it sounds like from all your conversation discussion about spreads tightening and kind of where spreads are and relative to where they were and relative to historical levels, are we getting closure to the end of the bond level, is that kind of in general what you are articulating?
I don’t think anyone can predict that Mike. I really don’t think you can predict that Mike at all because now -- in fact I will debate anyone on this issue, either side of the argument. That's really where you’re standing, to predict that there is some in the way of bond level. I think interest rates reflect the current economic situation globally.
There are problems from an economic then globally, not just the United States, I'm not saying that employment is now 200,000 in most of those jobs are McDonald. Let's not think just about the United States, let’s think about the global situation when you consider China, Japan and U.S. and Europe. So making those types of predictions, I think are very, very difficult.
But I think Mike it's -- we think about this a lot because, a scenario that we really respect is that feds could stay tight and remain tight for a while before they wide now, before they have. And they maybe not be a widening out, there may be a grinding widening, we don't know right.
So, the dilemma for us as we mentioned is really how do you put your capital to work in this situation and our strategy is really to be very thoughtful about the next dollar that makes it into the portfolio and that's what we think works here.
There are no easy answers, there is no cheap sector that we can go put our money in and that's why we have to be -- that's the reason for caution. I can't predict when the widening will happen. I may have -- tightening happen from here. But the fact is every dollar that comes in is just going beyond our higher degree of scrutiny even before, that's where we are in spreads.
Mike, I really appreciate you asking this question and given us an opportunity something to explain how we think. At the core, this is a principle, Dynex capital functions its own operators. We have a lot of our personal money in the company; we are in the same boat at our shareholders. We take it very seriously our fiduciary responsibility to manage the share all this capital for the long-term.
And what our trend has thought hard, you look at Tom Akins’ experience, look at my experience, look at Steve Benedetti’s experience and Smriti’s. Long deep history in this capital markets and I experienced sell those to manage for the long-term and be very powerful in terms of risks, but at the end of the day our money and our shareholders’ money and we're active accordingly.
Mike Widner - KBW
Well, I certainly appreciate all that. And I guess there is my final quick one is what I'm trying to think whether what you're describing its feeling like assets or fairly valued meaning that use to be cheap and now there is sort of cheap and they are sort of family-hat makes that your fully valued everyone freeze it versus spreads are too tight therefore employing the things are sort of over value due to global money pumping if you will. And such as that settle distinction between fully value, which I think a lot of people would say whether it would be broader equities or fixed income in general I don't think you get too much argument the things are fully valued. The question is just it doesn't get too (inaudible) until people thing think the things are sort of over value I'm not entirely sure which side of that little divide your kind of articulating if you want?
We think spreads reflecting amount of cash and we really do. Is it fair or Richard achieve relative to history it's expensive. If you really think about we are -- we did a study to going back to the 1960s to figure out where mortgage spreads really are to be 30 to mortgage spreads for example. On average they have treated about a 100 basis points over 10 year treasury. There is no one close to that right now. But here because of the amount of cash in the system right. So versus that on run average they look expensive. But I can see very clearly why they are here. So I have to respect that. Could they go tighter from here? Possibly, as long as there is a lot of this cash out there.
So, we’re not ready to say they are expensive or they look expensive, we’re saying let’s respect the fact that there is a lot of cash in the system and that as we are managing through this environment, be very careful about that factor. And I just have to keep going back, so the next bond that comes in is going to have to be bond that we really want in here or that we really feel like is going to give us long-term value or we can hedge it in a way that we think adds value to the shareholders.
And then I will just add Mike if the spread level truly reflects the current environment, as Smriti said, it reflects the amount of cash in the system. The fed’s QE program, it’s in QE that’s fine that’s not draining cash from the system. If the fed stops reinvesting their run offs, they are still not really draining cash from the system. If the Japanese start QE -- a similar QE program and ECB doing the same, you still have central banks pumping cash into the system. So, if there is cash continuing to be in the system, or cash being pumped in the system, these spread levels reflect that cash. And that’s basically the point we are trying to make. And the great thing at Dynex here is that our portfolio continues to earn a solid return despite taking a more conscious view. And the reason for that is simply we’ve always had a long-term view in terms of how we structure the portfolio. I am sure many people have heard us say it but may not have taken note of it, but we always say that we’re managing and structured our portfolio to perform in a variety of market environments. So back to the fair, richer, cheap; the fact of the matter is spreads reflect the current environment which is best defined by the unconventional activities of the global central banks which have pumped an enormous amount of cash into the global financial system.
Mike Widner - KBW
Well as always, I appreciate the comments and the color. And I think we can all agree that probably the only asset out there that looks cheap is mortgage REITs these days. So thank you.
We appreciate that Mike.
Next question comes from Sterling Edmunds from White Partners.
Sterling Edmunds - White Partners
All right. I appreciate your comments on the complexity, the macro environment, and we’re in the environment the rates are lower than anybody thought, CPRs are probably slower than anybody thought; the CMBS, RMBS historically tight, we beat that to death on this call. But can you talk about what tools are in your toolbox to protect book value going forward specifically related to spreads blooming out from here? What specifically -- what actions can you take to protect against that?
I think the first action is not trying to over lever the book of business at this point. So if you look at the way we behaved since last summer. We tried to buy bonds at the right price. And so let’s just use for example the CMBS deal and go back two years ago, we would bid for $15 million in a deal when we would get 12; now we’ll bid for $15 million and we’ll only get 3. While one decision we could make then is to just simply throwing a towel and run out with our capital and just buy anything just to deploy capital. But as you can see since last summer, our leverage went from a peak of 6.7, we’re down about 5.9. And each quarter we have not reinvested the total amount of our run-off. So that’s one of the key factors is being very selective and being thoughtful about not deploying the overall capital as rapidly.
The other part would be what assets are you investing and do you have enough diversity in book of business such that you are not totally exposed in any one sector or totally exposed to any one type of trade. We do take spread risk as a company and we want to make -- should we acknowledge that and we pointed that out in prior calls that we do take spread risk. And that’s why so it’s important to us to recognize that spreads are at the levels that they are because one of your best strategies obviously is to be in those products where we believe spread widening will be -- has the lower probability.
And so we believe that we are in those types of products at this point. So we do believe the credit environment for CMBS is very strong and we believe that CMBS IOs are probably one of the better places within that capital stack to be. And so if there is any type of spread risk, I think we’re in a better location.
We do believe hybrid ARMs what we said is when rates rise, the hybrid ARMs would grow in their popularity amongst the investor base. We have seen that now. We have seen many investors who were previously buying 30 years, the supply pools [funds] above PBA all of a sudden they are adding more hybrid ARMs to their book of business.
So we do want to be in those locations where we think we may have more spread stability versus other strategies. And that is really one of our biggest arsenals is to take the approach that we are taking and to take the cautious approach that we are towards spreads. And I am going to reemphasize that we do take spread risk but I do believe the success of this company and any other mortgage REIT will heavily hinge on the risk management skills of a management team.
Sterling Edmunds - White Partners
Okay, that make sense Byron. Thank you.
This concludes our question-and-answer session. I would now like to turn the conference back over to Byron Boston for any closing remarks.
Thank you very much for joining us on our conference call today. We really appreciate it and we look forward to our next conference call regarding the second quarter. Thank you very much and we'll see you in about three months.
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.
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