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Executives

Thomas Akin - Chairman & Chief Executive Officer

Byron Boston - President & Chief Investment Officer

Stephen Benedetti - Chief Operating Officer & Chief Financial Officer

Alison Griffin - Vice President, Investor Relations

Analysts

Douglas Harter - Credit Suisse

Trevor Cranston - JMP Securities

Zachary Tanenbaum - MLG

David Walrod - Ladenburg

Ken Lewis - Bank of America/Merrill Lynch

Jason Stewart - Compass Point

Jay Weinstein - Highline Wealth Management

Dynex Capital, Inc. (DX) Q2 2012 Earnings Call July 30, 2012 11:00 AM ET

Operator

Good morning and welcome to the Dynex Capital, second quarter 2012 earnings conference call. All participants will be in listen-only mode. (Operator Instructions).

I would now like to turn the conference over to Alison Griffin. Please go ahead.

Alison Griffin

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

Before we begin I 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 and expect, forecasts, anticipate, estimate, project, plan and similar expressions identify forward-looking statements that are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified.

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

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

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

Thomas Akin

Thanks Alison and thanks everyone for joining us this morning, bright and early on a Monday morning. With me today is Byron Boston, the President & Chief Investment Officer of Dynex Capital and Steve Benedetti our Chief Operating Officer and Chief Financial Officer. I’ll be speaking from the slide presentation on the Dynex Capital IR website and if you could move through the safe harbor agreement, I’d like to talk a little bit about the second quarter highlights.

Our diluted earnings per share were $0.35 and our book value increased from $9.62 to $9.66. Our annualized ROE was 14.3 for the quarter and our net interest per head declined to 2.18 for the quarter. Our constant prepayment rate was 14.3 and that was down from the previous quarter. Byron will discuss each of these metrics on the portfolio in detail.

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

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

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

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

Stephen Benedetti

All right Tom, thank you. As Tom mentioned earlier in the call, we have incurred an ownership shift under section 382 of the Internal Revenue Code as the result of our February 2012 common stock issuance. So as a result of that ownership shift, our NOLs, the use of our NOL to reduce our distribution requirement is now limited to $13.4 million per year. Previously it was unlimited in its use and of course the NOL is used to offset the distribution requirement for whatever dividend is not paid or earnings are not dividended out to our shareholders. We use the NOL to reduce that taxable income, so that we do not pay taxes on the remaining amount.

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

That’s it Tom.

Thomas Akin

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

Finally on the next page is the summary of results. As you can see our dividend has been fairly consistent from the first quarter or the third quarter of 2011. We were at $0.27, we went to $0.28 and now we are paying at $0.29.

Our earnings remain in excess of that dividend, as we are trying to create a total rate of return scenario and currently with a 14 plus ROE, anything over 11% is what I call a differed earnings. So roughly we get 11% of taxable income and then another 3% of what I call tax differed stream, income stream. As tax rates go up beginning here in 2013, we think that will be a distinct advantage for the company.

Our book value per share on the right column there has gone consistently up from the third quarter of ‘11, $9.15, $9.20, $9.62, $9.66. Even though work spreads widened in the second quarter, we are very happy to report an increase in our book value.

Our net interest spread has declined modestly from the $2.40, $2.50 range, to the $2.80 range in the second quarter. A lot of that was because we had a lot of agency securities that we purchased and Byron will go into our current expectations for investments. Again, our ROE in that final lower right hand column has been consistent in the basically 14 to 15 range over the last four quarters.

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

Byron Boston

Good morning. Our diversified portfolio strategy has proved beneficial this quarter. Overall as Tom mentioned, our book value remains steadily to slightly higher, despite materially wider credit spread in the CMBS sectors.

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

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

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

If you move to slide seven, lets talk about overall portfolio composition, which changed only slightly as we deployed our new capital in to the most liquid sectors. We have talked throughout our agency/ non-agency split; 82% agency and 18% non-agency. That compares to approximately 79% agency as of December 2011.

Then if you move down to our residential/commercial split, you’ll see that RMBS comprises 72% of the book, versus 28% in CMBS. That’s a slight change from 1231 again. Some great capital this year and then in a normal fashion we move into the most liquid sections to get our capitals deployed and then slowly over time we reallocate to our higher yielding bucket, which at the current time happens to be the CMBS sector.

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

If you move to slide eight and we can take a look at our portfolio from a credit quality and a prepayment perspective, our main source of prepayment protection is in our CMBS portfolio, where securities have exquisite prepayment protection, and we paid our highest prices within the CMBS portfolio.

Of the premium exposure on the balance sheet, 76% of our premium exposure in our portfolio has explicit prepaid protection, again that’s all in the CMBS sector. That’s a slight increase from 63% at year-end. We continue to focus on hybrid quality assets and as you can see, 89% of our book of business continues to have a AAA rating or higher.

Moving to slide nine, our CMBS portfolio is important to our overall strategy by providing us opportunity to invest in higher yielding assets, again with explicit prepayment protection. That’s extremely important at this point in time in the cycle, simply because interest rates are so low and there are several policy changes that continue to roll out of Washington.

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

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

We also focused on that multi family sector, because that’s been a core competency of Dynex’s and that’s just 1998, in 1990’s we were a direct window to the multi family sector. We continue to like this sector. There have been some changes; cap rates have come down, we mentioned on our last quarterly conference call, we have become a concern and doing more due diligence on loans that are originated to-date and throughout our due diligence we continue to favor this sector; we continue to allocate capital to the multi family sector.

If you note on the upper right hand corner, we continue to build that credit book of assets that originated outside of the bad years of 2006 through 2008 and within the overall asset type. I think I really want to point out our agency CMBS IO portfolio, which is very important to us. We are getting long return financing on those assets. The majority of the assets for the agency and non-agency IO portfolio are all shorter duration assets stripped off the top of the capital spec or off of a Freddie Mac, Fannie Mae or Ginnie Mae security.

If you go to slide 10, this is just definitely a graph of Freddie Mac’s historical multi family default experience. As you can see, that even through the bad year of ’06, ’07, ’08, ’09, Freddie Mac’s experience never got above 0.5%. As you compare that to the conduit sector of loans that originated outside of the agencies, we saw default experience get up to as high as 15% within those sectors. So this is a dramatic difference with the agency multi family credit products versus loans that have been originated historically outside of those channels.

Lets move to slide 11. Our prepayment experience to date has been excellent, with speeds remaining below expectations. Nonetheless, we have increased our overall amortization of the portfolio due to our expectations of faster speed. We are facing the facts, rates are really low, multiple policy changes have taken place, the next two or three months will be important to gauge the effectiveness of these recent policy changes, though our expectations that the heart related prepayment fees will peak this month. We are waiting to see and we still believe the security, the hand selected security that we have in our portfolio will outperform the overall universe.

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

Within the hybrid ARM sector we have allocated capital across what we call different borrower types, whether they happen to be ’06, ’07, ’08, ’09, 2010, 2011, we have borrowers who took out 5/1’s originally, 7/1’s originally and 10/1 and we believe that diversity, what we need to do are follow-up a prepayment experience throughout the remainder of the year.

Our leverage remains approximately six times. In our overall target we think of our leverage ratio being six plus and minus something. So you can see some fluctuations around the target fix level.

Our mix where it declined has been grown throughout the industry over the last couple of weeks. Net spreads are down as the yield curve is flattened, our credit spreads have come in, but again, our opportunistic strategy allows us the chance to find higher yielding assets throughout the market place.

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

As we noted earlier, the CMBS credit spreads widened. There was good news and bad news story here. The bad news is it’s put a lot of pressure on our book value. The positive story happened to begin with an opportunity to reinvest capital and as such, you saw that we did a preferred capital ratio to back in the $50 million. We had the opportunity to pre-invest a good sizable chunk of that capital prior to actually issuing the bond in the market place.

Looking to our next slide, slide 12. Here is what is important to note here; one, the range of ROEs have declined. But if you notice the upper end of the range, we continue to have the opportunity to fly in selective investments, yielding lets say between 13% and 16%, which has been our range and target for sometime now.

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

If you look to our next slide, it’s just something to emphasize, something that used that over and over again, that will focus on capital for invasion and managing risks. From a liquidity perspective, we’ve got 26 counter parties. The amount of availability and credit repo available in the credit markets can continuously be very available, however there are some concerns; there’s some counter parties where balance sheets have become somewhat limited.

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

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

Our credit exposure continues to be focused on the multifamily sector, which is the strongest performing sector in the commercial real-estate market. Our credit IO portfolio is protected from the current prepayment environment, backed mainly by agency produced multi-family loans, is generating the mid- teens ROEs and is a short duration asset.

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

As we move to our next slide, it’s supposed to be breaking down some specifics on the financing within our overall portfolio. We mentioned that we got a two-year facility that we’re close to being put in place to finance our IO portfolio.

We continue to look at the concept of maintaining hedge accounting. Hedge accounting actually limits our ability to really latter our refill book of business further than lets say one month and then so from our perspective, I’m glad that we could see ourselves having the ability to latter our portfolio further over a 12 month timeframe. So we are looking at, again as we mentioned last quarter, why do we want to maintain hedge accounting?

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

Thomas Akin

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

We’ve been internally managed and public since 1998. Our diversified investment strategy, particularly the niche opportunities that we talked about, allows us to avoid some of the pit falls in the market place. We feel the prepayment protection of our portfolio and our core knowledge in the CMBS is going to continue to distinguish us in the coming quarters.

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

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

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Douglas Harter at Credit Suisse.

Douglas Harter - Credit Suisse

Thanks. I was wondering if you could talk a little bit about the new IO facility. What kind of cost trade offs your making to get the two years certainty of financing?

Byron Boston

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

Thomas Akin

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

Byron Boston

And Dough, let me be more specific really; a good chunk of it – the actual spread of the product, actually plays a material influence on the overall net cost of the facility and because IO spreads have tightened in materially from the abstract that we put on our book of business, that’s really what influences the overall cost.

Douglas Harter - Credit Suisse

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

Byron Boston

You’re talking between two and three and a half years or so.

Douglas Harter - Credit Suisse

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

Thomas Akin

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

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

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

Douglas Harter - Credit Suisse

Great. Thank you for that color.

Operator

The next question comes from Trevor Cranston at JMP Securities.

Thomas Akin

Good morning Trevor.

Trevor Cranston - JMP Securities

Hi. Hi Tom, thanks. I have a couple of things. First you guys mentioned that you were able to pre-invest some of the capital raised in the preferred offering. Could you just give a little bit more detail about those assets you bought; whether or not you’ve added any hedges along with the investment that’s gone on there?

Thomas Akin

Yes, Trevor, we have hedges throughout. As rates have come down, we’ve actually been more aggressive about having hedges and trying to add some forward-starting swaps, targeting swaps that will be written off and then any hedges along with the asset. One of the great opportunities was, assuming you guys widened out in the second quarter.

We never turned that machine off throughout the second quarter. We thought we were going to. If you had talked to us on March 31 and March 30, we told them that we have that machine turned off during the second quarter, but it did not happen.

We continued to invest and then it had gone through the end and headed into July and we continued to have those opportunities, where we do – because you can see in the numbers that we were bringing on 7/1 and 10/1 hybrids. We’ve also looked for prepayment stories. Those were really – the (inaudible) but this was even more so and since that we would look for stories that will led us to be below the average speed of a hybrid portfolio.

So the source in the bank, I mean we have been really focused on diversifying our exposure, utilizing the CMBS sector to add extra yield to the portfolio and to widen the spreads again, because it was a negative on book value, but it was real positive for investing our capital and we did add, continue to add swaps. This is a good time to add swaps and obviously bring it lower, as you think of it from a long term perspective, but if look at the market place as a whole, I think we probably get even more opportunities and lower rates here to lock in financing.

Trevor Cranston - JMP Securities

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

Thomas Akin

Trevor that information will actually will be published in the Q. It will be published here in about four or five days. You will probably have to wait for that.

Trevor Cranston - JMP Securities

Okay, perfect. Thanks guys.

Thomas Akin

Thanks Trevor.

Operator

The next question comes from Zachary Tanenbaum of MLG.

Zachary Tanenbaum - MLG

Thanks. Good morning everyone.

Thomas Akin

Hey Zack, how are you?

Zachary Tanenbaum - MLG

Good, thanks. Just wanted to ask about the asset sales in the quarter. Can you give us a little more color around the decision to sell out on some of those and then what your exceptions are for sales going forward?

Byron Boston

So Zack, let me think first, we are not one of hedge fund REITs that basically are the whole strategy designed around kind of trading a portfolio, but we do have the need from quarter-to-quarter to potential sell certain assets.

So what we saw in the second quarter started really in the first quarter. In January we got an opportunity to buy something that really was not considered a good breed asset, but was very similar in terms of credit qualities issued by Freddie Mac’s short duration instrument and we always consider the deal what we call the placeholder. So it allowed us to really get some capital back in January, invest it rapidly in the market place and as we got the chance to deploy money into some of our more core assets, we peeled those assets off. So half of it came off in I think March of this year and the other half came off in the second quarter.

If you look forward into the future, like I walk in today and gave my guys an idea of a potential of swap candidate out of the portfolio and that’s simply trying to manage credit risk, prepayment risk, duration and trying to generate the highest returns to our shareholders. I’m trying to say, these are better risk returns from being one of the buckets within our portfolio, but it’s not a core part of our strategy and we shouldn’t see enormous amounts of that.

But that’s a really interesting shift in terms of relative value that lead us to really look at, look closer in our portfolio. If we think that we are overly exposed in terms of prepayment speed, its something that we did about a year. Well we sold probably 200 million to 300 million worth of bonds that we thought were going to be the fastest bonds in our portfolio, when we deployed that into CMBS. So not a core part. We were doing this, every single report, but we are always looking to upgrade whenever we can.

Thomas Akin

One of the advantages Zack of having a diversified portfolio, you can really shift that mix between agency and non-agency back and forth. When we raise capital like we did in the first quarter, we are going to initially put that capital work in that agency sector, because its fairly quick and easy and then you will see that shift out of the agency into CMBS, so that we can stay. But when what do we feel is our targeted sort of asset allocation, a 60% agency and 40% non-agency.

Zachary Tanenbaum - MLG

That’s helpful thanks.

Thomas Akin

Thank you.

Operator

Our next question comes from David Walrod at Ladenburg.

Thomas Akin

Good morning David.

David Walrod - Ladenburg

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

Thomas Akin

Well, I’ll tell you David, it is going to depend on how spreads move. So if you give me an opportunity like last year where you have CMBS spreads widen out as much as they did, agencies kind sit there, I will take the advantage of that CMBS sector as much as I can and try to allocate more capital there. If CMBS were to tighten into the tightened levels, you will see that allocates less capital and wait for a better opportunity to enter that sector.

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

Byron Boston

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

David Walrod - Ladenburg

Good. That’s helpful, and then I was also just curious, on the rule 382, was that something that you guys had identified was sort of that would likely take place give the decision to raise capital or you just felt like it was still in the best interest or was that something that was more of a surprise.

Thomas Akin

I’m going to let Steve to answer it. I’m just going to say that we feel its an asset for the company, the NOL. We fell particularly in a high tax rate environment, its going to be a critical advantage for us. We also did a fair amount of time trying to analyze, can we use that NOL completely and we did feel that there was a critical advantage to being able, not only to expand the company and pick up some assets that were very attractive in the first quarter, but at the same time continue to use the NOL in its entirety and that is our goal.

But Steve, why don’t you clarify it further?

Steve Benedetti

Yes. So Tom, there’s really not a whole lot to add to what Tom said, other than we tracked and still will continue to track the 382 limits, the ownership limits very closely. We had essentially performer, the impact of that February range on the 382 task. Its hard – it’s a very complicated analysis, but going into that race, we did view that we would trigger the 382 limit and that would subsequently confirm by our tax account. So we had been tracking that extremely closely and though going in, we were going to trigger it.

David Walrod - Ladenburg

Okay. I appreciate it guys, thanks a lot.

Thomas Akin

Thanks David.

Operator

Our next question comes from Ken Lewis, Bank of America/Merrill Lynch.

Thomas Akin

Good morning Ken.

Ken Lewis - Bank of America/Merrill Lynch

Good morning Tom, good morning gentlemen. If I were to believe in your earlier comments around the financing side of your business, you had seen some constrains on financing; is that impacting your ability to finance in any capacity or is it just more of a general market comment, is there just increase in cost. Could you just may be elaborate on that for me.

Thomas Akin

No, it is not impacting our ability to finance, but there are more counter parties that are saying that their balance sheet is limited, and as I guess the second and first quarter we saw more counter parties, they didn’t get their balance sheets down. For us, again we are a moderate size company. We are not again raising moderate amounts of capital. We have not run into an issue where we are not able to finance in position.

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

Byron Boston

So Ken, one thing that we saw this quarter in our yields, if you look just sort of the Hybrid ARM portfolio last year, last quarter to this quarter, just repo rates, we saw about a four basis point increase in our borrowing cost, just from the constraint that Byron was mentioning earlier in terms of the overall markets capacity, given things like operation twist and the like.

Ken Lewis - Bank of America/Merrill Lynch

Okay, thank you. And then when we are thinking about spread from your area, I recognize its difficult to know exactly where this market is going to go. But I mean, do you feel like we are going to be dealing in a market where some of these ROEs are going to be pressured even lower than they are today.

I mean when you look at it, your chart on page 12, anywhere from 8% to 17% type returns or 6% to 17% returns are still pretty healthy in the grand scheme of things, but do you feel like there is additional downward pressure on that and do you feel like that’s going to compromise the 14% ROE target that you are attempting to deliver?

Thomas Akin

I don’t think the 14% is comprised yet. There is downward pressure throughout the entire market place in terms of – we don’t have to be, right. Because it continues down to some extremely low levels and yields throughout the globe were down to some extremely low levels. So you would expect overall spreads in ROEs to really come down.

This is one analogy; I head someone say about multi family loan, they said, oh my gosh, your cap rates are low and I said well, if you look and see where overall ROEs are in the global market place in general. So yes, the ROEs are coming -- I don’t think we are compromised here on the 14% yet and that’s only because, its mainly because I’m still expecting volatility in CMBS spreads and that volatility tends to give us an opportunity to opportunistically invest capital.

The agency spreads are going to be the agency spreads. We’ve been trying to minimize any type of extension risks that we have not gone beyond the hybrid sector at this point and it would obviously continue to try and get our yield from our CMBS. I am expecting some volatility there, especially as we move on into the year-end we start to move towards the overall – fiscal towards the year-end. So that’s my expectations today, but you are in a very low global ROE environment.

Byron Boston

I think Ken, also the way to look at it is obviously we’ve seen some of our competitors, particularly in the agency side had to dial back their earnings expectations a little bit and their dividends. We’ve seen increasing amounts of use of leverage in the sector. You know we are sitting at six, which is a fairly, fairly modest amount, but going forward, we think we are sitting in a moment right now where we haven’t seen massive amounts of volatility to our returns. In fact you might day the returns are pretty optimistic right now.

We are quite hopeful that there will be some sort of dislocation between now and year end that will give us an opportunity to take advantage of wider spreads like we have really since we started the portfolio in ’08. With all of the backdrop of economic news, macro economic, political or otherwise, obviously this week with basically all the fed meetings globally you could see some fireworks come out of this thing. Those are advantages for us, as we can dial the amount of capital we want in the agency versus non-agency.

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

Ken Lewis - Bank of America/Merrill Lynch

Okay, and then as we think about the next couple of months in terms of prepays and how that ultimately works its way through speed, I mean what would you expect, may be the higher water mark to be on HARP REFIs that kind of in your mind says, okay, that wave is kind of through now and we should see prepays begin to normalize, maybe at a higher level.

Thomas Akin

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

We do not want to make prepayments an issue for our portfolio. Remember we started in 2008 in an environment where we knew rates were going down and we’ve always been very cognizant of the risk of prepayments. So I think that it’s not going to be a huge issue for this portfolio, but Byron you can comment further.

Byron Boston

I’m with you on that Tom, the way you phrased that, can’t predict. Because so much of this is policy related, I never restrained from trying to predict the exact amount. Here are the things I’ve been very forceful about saying.

I don’t think we’ve got a 2003 experience. I’ve been saying that the last several years and the reason is because back like ’09 or so, there were others in the market place who were feeling like we are going to have a 2003 experience. I don’t think we are going to have a 2003 experience.

I do think we are going to peak here at some point. I can’t predict exactly when that happens to be. I’ve spent some time with the mortgage bankers and the originators, who originate these mortgages and every time I add up the numbers, I still don’t see – I see more people coming through the pipeline, but I still don’t see just everyone coming through the pipeline.

So I’m expecting a peak a some point. I’m very, very slow to predict exactly when that happens to be, because rates are just so much lower and we’ve continued to enjoy a pretty decent net spread despite the speed. But an acute part of our strategy is going to be diversified and that will have all of our capital exposed to one type of borrowing.

Ken Lewis - Bank of America/Merrill Lynch

Understood. All right, thank you very much for your comments.

Thomas Akin

Thank you

Operator

It’s from Jason Stewart at Compass Point.

Jason Stewart - Compass Point

Hi, good morning, thanks for taking my questions. I have two questions that are more macro related than anything else. One as it relates to the fed lowering interest on excess risers, any potential impact on the funding markets there. And then two, Q3 a lot people think the odds of it have been priced into the market. Any impact, if it does happen on your portfolio specifically?

Thomas Akin

Yes, everyone talks about being priced in the market place, but this is the way. Its priced in, if everyone lets say has run up securities, they bought securities and then as the fed moves into the market or everyone’s got to sell all of those securities to move out of the market place, that’s not exactly what’s going to happen. It’s like a room of crowded people, and a large person comes into the room. So I’m still, I’m anticipating that the fed activity will definitely have some impact. It may some impact on the financing markets also, depending on what they ultimately do.

Its impossible that the feds activity on short inter curves, they do make that shift into some excess reserves will now have some impact potentially. You can say, why would have an impact on lowering rates. Well, I think there are some uncertain consequences, because of the impact on the money market. I prefer to not do anything in that sector, just because of some of the other uncertain factors around it. I got a better handle around it, but they do have right purchases of MBF and obviously a better handle around to extend the language.

Jason Stewart - Compass Point

Great, that’s helpful. That you.

Thomas Akin

Thanks Jason.

Operator

Our next question comes from Jay Weinstein at Highline Wealth Management.

Thomas Akin

Hey Jay, I was worried whether you are going to get a word in hedge wise?

Jay Weinstein - Highline Wealth Management

Unlike my marriage, I like to have the last work occasionally, so I have to go to another conference call. Lets see, I have a wide variety of kind of questions. Tom, you actually referred to one of them a second ago about, it seems to me like in the industry leverage ratios have been sort of creeping back up and divided raises are kind of coming the other direction. You sort of confirmed that, but I just wanted to make sure my instinct was right on that issue.

Thomas Akin

I think, I don’t have – well, I have some examples. I think it looks that way for the agency guys, the non-agency guys seem to be doing okay.

Jay Weinstein - Highline Wealth Management

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

Thomas Akin

That’s correct.

Jay Weinstein - Highline Wealth Management

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

Thomas Akin

Well, we’ve got Steve Benedetti who is an expert on the line here; I’ll let me take that call.

Steve Benedetti

Jay, how many hours do you have?

Jay Weinstein - Highline Wealth Management

Yes, I had a feeling it was going to be a really exciting discussion. So I really – I’ve got the rest of the morning, its all your.

Steve Benedetti

The long and short of it is, the excess inclusion income is unrelated business taxable income in the hands of certain corporations, generally non-profits and foreign corporations.

The Russell took a position this year that it was a zero tolerant policy, no matter if you had a dollar of excess inclusion income that could generate UBTI, in the hands of someone that might buy into the index, then you are out of the index.

So what we did was essentially drop the securities that were generating the excess inclusion income into our taxable re-subsidiary, such as that entity would then have received the excess inclusion income to the extent it does; that is to the extent they are spending excess inclusion income and the excess inclusion incomes essentially comes from the ownership of residual interest and securitizations.

Jay Weinstein - Highline Wealth Management

Okay

Thomas Akin

You might have to take that off line Jay. I think that’s a really detailed question.

Jay Weinstein - Highline Wealth Management

All right, like I say, I think its probably – what was the amount of money of the securities for instances that you had to contribute, is it …

Steve Benedetti

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

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

Jay Weinstein - Highline Wealth Management

Okay. That’s ..

Thomas Akin

And most importantly it had to do with also the Russell 2000...

Jay Weinstein - Highline Wealth Management

I said we could debate whether or not, wheatear the Russell 2000 makes a difference one way or another, but I have no issues with it. Just real quickly, you mentioned timing of CMBS spreads in the second quarter. Have they tightened since 7/1? With last week’s big risk on rally, what’s going on in the first month of this quarter.

Thomas Akin

I think you got that backwards, they actually widened in the second quarter.

Jay Weinstein - Highline Wealth Management

I’m sorry, I meant in the case, I spoke incorrectly.

Byron Boston

Yes, they did widen in the second quarter. They have tightened this quarter; probably most of the tightening happened in the last week or so. At the beginning of the quarter we saw spreads sitting out there. The widening it the second quarter was pretty orderly, which is a great way to do it and so we still, we probably were more selective today than we were a month ago and we said wait obviously for the mobile building its spread as we approach year end.

Jay Weinstein - Highline Wealth Management

Okay, and last but may be most importantly, just work me through the thought process of issuing the preferred. You used to have the old preferred which you converted to common and now you’ve got – you issued a new one. You could have issued more common, you could have borrowed the money. So tell me what analysis and thought process you went through and then you said okay, this is what we are going to do.

Thomas Akin

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

Now the ROE opportunities were there, particularly in our investment strategy and that is high quality short duration assets. We saw an opportunity to invest in that type of capital class at rates right along the line of what we used to think. Then it’s a questions, how much capital do you want to raise?

We did not feel that the opportunities were large. As Byron said, we are really playing in the niche markets now. We could have probably taken down 150 or something of equity, but that would have meant at 6x and we would have had to buy $1 billion roughly of securities and unfortunately the niches that we are looking that are not that large. With $50 million of preferred, we can buy about $300 million of securities at our sort of spread level, so it has to do with that.

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

Steve, do you have anything more to add?

Steve Benedetti

Yes, I think that was a good summary. From our point of view, as Tom mentioned, it’s a permanent piece of capital. You as mentioned early Jay in your question, hey well you could have taken leverage off. Obviously leverage is not permanent. It adds more risk to the balance sheet and in putting this capital in, obviously it adds direct leverage down to the common shareholder on a non-recourse or a permanent capital basis.

Jay Weinstein - Highline Wealth Management

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

Thomas Akin

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

Jay Weinstein - Highline Wealth Management

Okay. All right, terrific, that was very helpful and hope you guys are enjoying the summer.

Thomas Akin

Thank you Jay.

Operator

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

Thomas Akin

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

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

Operator

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

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