Dynex Capital Inc Q1 FY2020 Earnings Call

Thank you for being here, and welcome to the Dynex Capital Inc. First Quarter, 2020 Earnings Results Conference Call. All participants are currently in a listen-only mode. After the presentations, we will have a question-and-answer session. I will now turn the call over to Alison Griffin, Vice President of Investor Relations. Thank you. Please proceed.

Thank you, operator. Good morning everyone, and thank you for joining us today. With me on the call, I have Byron Boston, President and Chief Executive Officer; Smriti Popenoe, Executive Vice President and Chief Investment Officer; and Steve Benedetti, Executive Vice President, Chief Financial Officer and Chief Operating Officer. The press release associated with today's call was issued and filed with the SEC this morning, May 6, 2020. You may view the press release on the homepage of the Dynex website at dynexcapital.com as well as on the SEC's website at sec.gov. Before we begin, we wish to remind you that this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words believe, expect, forecast, anticipate, estimate, project, plan and similar expressions identify forward-looking statements that are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. The Company's actual results and timing of certain events could differ considerably from those projected and/or contemplated by those forward-looking statements as a result of unforeseen external factors or risks. For additional information on these factors or risks, please refer to the annual report on Form 10-K for the period ending December 31, 2019, as filed with the SEC. The document may be found on the Dynex website under Investor Center as well as on the SEC's website. This call is being broadcast live over the internet with a streaming slide presentation, which can be found through a webcast link on the homepage of our website. The slide presentation may also be referenced under quarterly reports on the Investor Center page. I now have the pleasure of turning the call over to our CEO, Byron Boston.

Thank you, Alison, and thank you all for joining us this morning. At Dynex Capital, we operate with a long-term vision. In 2019, we celebrated 30 years as a listed company on the New York Stock Exchange and we formed a new 30-year vision for the future. Such a long-term view, where management is tied and totally committed to the success of Dynex, is very much aligned with the interest of our shareholders, creditors and all the stakeholders. To succeed in managing the mortgage REIT over such a long time horizon, it is imperative that we adjust our risk posture as necessary to fit the complexity of the overall global environment and then we allocate our capital in a very disciplined manner. Multiple years ago, we were high in credit and high in liquidity and we maintain that posture today. Furthermore, we have reduced our leverage in the short-term as we assess the currently evolving health and economic crisis. This current global situation is very different than the great financial crash of 2006 to 2008. And the next several months will be extremely important in assessing our best risk and capital allocation strategies. It is too early to discern the broad-based impact of the current exogenous shocks across the global economy. On our call today, we will cover the first quarter, our macroeconomic view, our view on the economy, business model and we will give you an outlook for a dividend. I’ll now turn it back to Alison, who will lead us to a series of Q&A.

Thank you, Byron. Turning now to Steve, please walk us through the company’s first quarter performance.

Thanks Alison and good morning everyone. Our results for the quarter on both GAAP and non-GAAP basis are highlighted on Slide 7 in the presentation and in the press release we issued this morning. For the first quarter of 2020, we’ve reported a comprehensive loss per common share of $1.45 and core net operating income of $0.51 per common share. While we benefited from the lower interest environment in our repo funding cost during the quarter, our periodic swap benefit declined as rates rallied and we lifted hedges. TBA drop income also fell and we had modestly smaller investment portfolio and lower prepayment compensation on CMBS. Finally, dividends on our preferred stock increased due to the timing delay between the Series C issuance and the redemption of the Series A and a partial redemption in Series B. Book value per common share declined $1.94, 10.8% principally as a result of CMBS IO and Agency CMBS spread widening during the quarter given the tremendous volatility in prices and yields in the later stages of March. As we noted in our call on April 15, we actively managed our dilation position, which lessened the impact of the volatility during the quarter on our book value. We also sold specified pools in early March, monetizing payout gains before spreads widened during the month. The issuance of the Series C preferred stock in February reduced book value by $0.15 per share which saved us approximately 75 basis points in coupon going forward on a blended basis. We estimate book value per common share as of yesterday is relatively unchanged from March 31, so we have now conducted our normal procedures in connection with this estimate. For the first quarter, total economic return was a negative 8.3% versus a positive 2.2% last quarter due largely to the aforementioned decline in book value. For the quarter, we declared and paid $0.45 dividend per common share. Average interest earning assets were modestly lower at $4.9 billion versus $5 billion last quarter. An adjusted leverage was 8.8 times total shareholders’ equity at March 31, lower than then 9.0 times at year-end. As we already mentioned on our update call on April 15, we have further reduced our investment portfolio and leverage post quarter-end. As of April 30, our investment portfolio asset balance is approximately $2.4 billion and leverage is approximately 4 times total shareholders’ equity. Looking forward, we expect our net interest spread on our existing portfolio of $2.4 billion to increase in the second quarter as repo financing rates fully reflect the benefit of the Fed reductions at March of its targeted Fed funds rate. From an earnings standpoint, much of the prepayment risk to our earnings in our Agency RMBS and CMBS portfolios has been reduced at this point as our amortized cost basis on these assets are a combined approximate $102 dollar price. That said our investment portfolio is smaller today. We have capital to invest and ultimately our net interest spread and earnings will be a function of where and when we deploy our excess capital.

Thank you, Steve. Byron, can you describe our macroeconomic outlook?

Sure. We've had a long-term economic view that has not changed. The global economy is fragile and global risks have intensified. The current exogenous shock has only served to increase the probability of future surprises, as risk factors have increased in complexity and number. The entire global economic and financial system is currently increasing leverage enormously to survive this crisis. As such, the post-crisis world will continue to see a drag imposed on growth and inflation from global debt, demographics, technology, human conflict and other risk factors. Global economies and the global financial system cannot stand on their own without the central banks continuing to play a major role. Policy risks have increased and will be a major factor well into the future. How our world will evolve is still uncertain in the short to medium-term. This fragile global economy is currently absorbing the impact of multiple shocks and it is too early to fully discern the broad base impact of these negative developments. We are still in the early stages of a health and economic crisis. The central banks have moved swiftly to avoid a financial crisis, and a potential policy crisis might evolve in the future as the world attempts to manage the side effects of all the new civil and monetary programs that have been implemented. Since our macroeconomic opinion continues to support our investment thesis of being up in credit and up in liquidity.

Thank you, Byron. Turning now to Smriti Popenoe, can you briefly discuss the portfolio adjustments we've made at quarter-end?

Yes, Alison. I'd like you to please turn to Slide 9. We've revamped and rebalanced the portfolio to focus on Agency RMBS. The adjustments we made post quarter end leave us with lower leverage, higher liquidity and a bigger capital position. You can see on this slide our cash and unencumbered asset position was at $312 million. I'll discuss our views on redeploying the capital later on in the call. In March, we shifted our thinking on cash flow risk, and started to evaluate our portfolio for the increased possibility of delinquencies and defaults. While we did not and do not assess the probability of default as high, we felt it prudent to monetize the $200 million in unrealized gains in our Agency CMBS DUS portfolio. Post quarter end, as liquidity and pricing stability returned to the markets, we rapidly reduced our Agency CMBS DUS position. During the month of April, we've reduced that position from $2.1 billion to $800 million. We've realized $166 million in gains and cut over 80% of our premium exposure.

Great. How are you assessing your current investment environment we're operating in? And how do you think this plays out for Dynex’s investment strategy?

As Byron mentioned, Alison, this is a health and economic crisis, but it's layered on top of the already existing fault lines that we identified before the shocks: social factors, global debt, technology, environmental, geopolitical and demographic factors. These were already in place before the pandemic and oil shock. So, we think, right now there are two forces to consider that are working in our position. The first force is the potential for disruption to cash flows. The shutdown of economic activity has led to the loss of employment for over 25 million American workers thus far. Borrowers are seeking forbearance, renters are seeking rent relief. We're seeing a lot of evidence that the financial position of state and local governments, non-profits, and universities are compromised. Against this, you have an opposing force of the rapid and significant fiscal and monetary responses globally. GSEs have responded by providing forbearance for single-family and multi-family borrowers. These actions collectively will probably cushion the economy in the near-term, and may delay cash flow disruption in some sectors. Ultimately, the question we're asking ourselves is whether the government actions will be enough to minimize the disruption to cash flows or not? How do the structural factors evolve as we see the duration and severity of the health and economic crisis play out? How does the return on the investments we are considering back up against these risks? There aren't clear answers yet to these questions. It's still really too early to discern how this crisis will play out. But the next several months will be critical in determining the direction this will take.

So, are there areas to invest today?

Absolutely. We think that being up in credit and up in liquidity is still the place to earn returns. If you turn to Page 11, you'll see our view of where we think returns are stacking up at this point. The Agency RMBS sector is the most attractive in our view. At this point, one of the most important drivers of levered returns is finance costs. We expect that financing costs will be low and stay low for a prolonged period of time, especially for high-quality assets. So that's a major positive for Agency RMBS. We can get financing for these liquid assets at low rates. The agency multi-family sector is also a sector that's currently supported by government policy. But the near-term extent of cash flow disruptions is less certain. So, until this becomes clear, we actually think Agency RMBS has a better relative risk-adjusted return for marginal capital use.

Great. Can you talk about where you see relative value in the markets today and portfolio construction?

Yes, we prefer lower coupons, TBAs and generic pools versus higher coupons and higher payout pools. In the near-term, cash flows are going to be impacted by the forbearance policies of the GSEs. And the first thing that's going to happen is a delay in prepayments. The key beyond the near-term will be the transition from forbearance, either back to performance or to delinquency, and then modification and finally, default. Policy risk is a major factor and how this will all eventually develop, particularly given the GSEs credit risk transfer programs or CRT programs. We’ll now actually get to see how much credit risk was really transferred. In the near-term, we think higher coupons and low balance pools will still offer value. The key on the higher coupons is being able to monetize the premium and sell the pools before default and modification phases begin. We're also respecting the recent severe lack of liquidity in higher coupons, and especially the higher payout pools because of the lack of a natural buyer at very high dollar prices. That favors the lower coupons as well.

What are the returns looking like in the Agency RMBS?

We see attractive returns in this sector. We are by no means at the super cheap levels, but still attractive. In the 15-year sector hedge net interest spreads are in the 80 basis point to 90 basis point range; at 9 times leverage that's 8% to 9% static core ROE. 30-year generic lower coupons, the hedge net interest spreads are in the 110 to 150 range depending on whether you're buying specified pools or more generic pools, so ROEs are in the 10% to 15% range at 9 times leverage. And there's a slight improvement there in TBA for dollar rolls.

Okay. Our reference today is around 4 times, you see attractive returns in a liquid sector. Are you thinking about leverage and balance sheet size? And what kind of earnings power do you think the company has?

Now, let me walk through our portfolio today and potential earnings power as we grow the balance sheet. Our existing portfolio after all the adjustments we made is a subset of the position on Page 10. So let's turn to Page 10. Specifically, the Agency CMBS portion of the portfolio is down to $800 million with a book yield of 2.5%, reflecting the lower premiums in this sector. The approximate weighted average book yield on the assets as of April 30 is 3%. Now turning to the financing side, if you would flip to Page 25, you can see on Page 25, our repo rates were pretty high at the end of last quarter because we had rolled positions through quarter end. We have already seen these repo rates come down substantially and expect to see these rates around 30 basis points to 35 basis points for one month and three months repo for Agency RMBS and the IOs are financing at around one month LIBOR plus 90 basis points on a weighted average basis. So, that gets you to a net spread on the overall portfolio in the low 200 assuming we don't sell or reposition the portfolio. As I mentioned earlier, we think leverage can be taken up to 6 to 7 times, with $1.5 billion to $2 billion in assets at an average spread of 110 basis points. If you include 15 years of mix, it should get you to a weighted average net spread in the mid 100 on about $4 billion balance sheet when you combine the two. There's significant earnings power in the position today, and it's there in about 2 to 3 terms of leverage. It's really a matter of putting the risk on in a disciplined manner, which we feel we can do with the liquidity in the Agency RMBS space.

Very good. Our portfolio is predominantly agency guaranteed. And do you expect to focus on that sector? Can you discuss the investment we have in the non-agency sector CMBS IOs?

Yes, this is a sector in which we have been long-term investors. This is a great investment for REIT. IOs offer good returns for a shorter duration well-structured cash flow at the top of the capital stack. Over 90% of the bonds we own are AAA rated and receive the highest payment priority in the cash flow waterfall. Our non-Agency CMBS position, our IO position is currently 7% of the total portfolio by assets and 7% of our total capital is allocated to this sector. Over the last 12 years, we've had no problems financing this position, and we had no issues financing this position in March. The majority of the position is funded in a committed facility through June 2021. And there were no changes in financing spreads versus LIBOR even through the disruption in March. The remaining average life on the portfolio is about 4 years and the weighted average credit enhancement is in the 25% range. We're at the highest part of the capital stack where we have structural protection, and we own a seasoned portfolio, we're going to be opportunistic in managing this risk. We also factor in the fact that the portfolio pays down about $40 million in market value each year. So, that's a tremendous amount of cash flow. But, the position at this time next year should be about 25% smaller just from the passage of time. We'll have more detail on the credit and portfolio metrics in our 10-Q.

Okay, so shifting back to our overall strategy then, can you put all of that together for us?

Absolutely. The main point to remember is that our financing costs are low, and there is significant earnings power in the company via investments in Agency RMBS. We think we can take leverage up in this environment to 6 to 7 times invested in Agency RMBS at a static ROE of 7% to 8% for 15-year, and 15% for 30-year. We are respecting that we're in the early stages of this economic and health crisis. And we're considering the possible future disruption to cash flows. Our main objective is to take the appropriate amount of risk for the environment. Focus on preserving capital and generating what we view to be an above-average return.

Great. Thank you, Smriti. Now turning to Byron, there's been a lot of questions about the mortgage rate business model since March. What are your thoughts on this topic?

If you would turn to Slide 13, there are some interesting points on this topic. In general, though the mortgage REIT business model is fine. The REIT model is a tax-efficient vehicle that depends on discipline, risk management, and capital allocation. Simply put, liquid assets should always be a core part of your strategy throughout all business cycles. There are times when liquid assets and balance sheet liquidity should be increased in anticipation of potential surprise corrections and asset price levels. For example, coming out of the great financial crisis, we went down in credit and down in liquidity. That was a great opportunity between 2009 and 2015. However, we reversed that strategy and adjusted our focus to emphasize liquidity as we watched the global risks intensify. The events of March 2020 did not imply that there are fundamental flaws in the mortgage REIT business models. Rather, it exposed the illiquidity of a leveraged credit strategy at the wrong point in the credit cycle. The fault lines were apparent well before the pandemic. We have been monitoring them and adjusting our strategy accordingly. There were environmental factors that uniquely impacted each company differently based on their risk posture, but there are not inherent flaws in the business model. In fact, we believe there is a strong case to be made for earning income from high-quality U.S. based real estate assets, especially as global interest rates have collapsed to zero or negative levels.

Thanks, Byron. Now that we've covered our key questions, what's the final message for all of our stakeholders?

The appropriate process for reopening the global economy is in a phased approach. This will allow the world to observe whether our situation is getting better or worse. Likewise, we are reinvesting our capital in a phased approach. We will remain up in credit and liquidity, which always gives us the option of increasing our capital deployment rapidly. Furthermore, with our financing costs anchored at really low levels, we're confident in our ability to generate solid cash flow. The key at this uncertain phase of this global crisis is to manage risk aggressively. Keeping with this approach, we anticipate no change in the dividend for the month of May. As always, our dividend will reflect the earnings power of the company and our risk posture. The final thought I'd like to leave you with today is that we are an internally managed REIT, we are invested in Dynex alongside our shareholders. And we continue to manage our company for the long-term.

Thank you. We will pause for just a moment to compile the Q&A roster. Your first question comes from Mr. Doug Harter from Credit Suisse. Your line is open.

Thanks, Byron. Can you discuss how you're balancing the need for flexibility while maintaining a defensive approach at this time, versus the risk of waiting too long and missing out on some appealing opportunities currently available? How do you view those trade-offs?

Let me begin with a broad overview of the situation. There are several pressing macroeconomic questions that need to be addressed. For example, how many bankruptcies can we expect? What will the number of permanent job losses be? How many individuals will miss their mortgage payments in May? How many renters will struggle to pay rent in that same month? By June, how many people may have lost their jobs for good and consequently stop making payments? Similarly, by July, we might see even more defaulting. There are numerous uncertainties at play, and I recognize your concern regarding this balance. The macroeconomic landscape raises many questions, including the impact on the energy sector and the level of unemployment that might arise from it. As we narrow down from the broader economy to our specific sector, we’ve seen improvements in credit and liquidity strategy. With financing costs remaining at historically low levels, we believe we can generate income effectively. Additionally, with the increasing amount of debt being generated that requires financing and sale, it’s likely that the yield curve will steepen. An increase in the yield curve from 65 to 75 basis points could enhance our future returns, and moving from 65 to 85 basis points would be even more beneficial, especially since our financing costs remain anchored. This gives us numerous possibilities to consider as we navigate the current landscape, balancing our approach with the overall macroeconomic situation while also recognizing the Federal Reserve's support of the mortgage-backed securities market. While we could choose to invest heavily due to the Fed's backing, we are opting for a more disciplined approach.

At this point, mortgage oil prices are probably as tight as they were in early March, and they are not as wide as they were in the middle or late March. However, we are identifying opportunities to invest capital. I believe that being flexible and allocating our resources to sectors with genuine value is possible right now. Currently, the Fed is decreasing its weekly purchases, and there is pent-up demand in terms of mortgage pipelines coming in and the ability to sell forward. Therefore, I anticipate some opportunities to effectively deploy capital.

And Doug, let me add one other thing as you scour the landscape and look at a variety of companies, there are an enormous number of people in positions because they have no choice. They couldn't adjust their position. We're in a position because we want to be here. We've adjusted our position out of RMBS into CMBS, back out of CMBS back into RMBS, we've adjusted our balance sheet from $6 billion back down to $2 billion. Now we're moving it back up again. That's deliberate. We're not here because we have so many low balance bonds and we can't sell them. So we're very proactive in our current situation, but we do find it very intriguing and financing costs are currently at a low level, we don't expect that to change. Every basis point, five basis points, 10 basis points deeper in the curve will be a huge benefit in terms of forward return opportunities. And then you've got an entire macro environment with a health crisis, economic crisis, financial crisis. So we're watching the world to see how we evolve.

Right. Thank you guys for those answers.

Hey, Good morning, guys. Hope you're well and thanks for those really great opening remarks and congrats. All things considered on a great quarter. You guys mentioned being a little bit more constructive on agency RMBS right now, do you guys think you're going to take that position through more of a specified pool position or TBA now? Thank you so much.

Sure. Thanks, Eric. So I think we're going to favor generic specified pools. Not extremely high pay up. And the TBA position. That's what we feel makes more sense at this point. That's not to say we want to own any loan balance or any high payoff pools, but the liquidity and flexibility at this point is really valuable. And so in the lower coupons, by the way, lower coupons doesn't mean you're not taking premium risk, the lowest coupon out there, that's trading as a 2% with almost two points of premium on it. The next highest coupon has almost five points of premium on it. So there's risk. There's risk in all these coupons in terms of premiums, but the lower pay ups, more generic strategies, I think at this point, offer us more flexibility and the TBA as well.

Right, thank you. And Byron, following on quickly on your thoughts on just the mortgage rates and maybe the return that investors can expect over the course of the cycle. I mean, as you guys take leverage lower is that your way of saying that investors at certain points should maybe expect a little bit less return but also potentially much less risk? Thanks.

That's the balancing act. That's literally again, the reason I started off with that long-term vision. It was very important why I started off with the long-term vision is because we want you to know that the only way that you make it over the long-term is first and foremost, you must prioritize risk. And so when we thought about the 30-year vision, what we told ourselves is we must get through 1998 and we must get through a 2008 scenario. Now we've added March 2020 to that. So the first thing we're always thinking is the key for our shareholders that they can stay in the game over the long-term. So as we continue to evaluate the environment moving forward, it is going to be, again, this balancing act between ultimately the risk and return. It's a very easy lever to pull in terms of leverage: your 4 times leverage, your 5 times, 6, or 7. It's a straightforward adjustment process in that sense. Smriti, do you want to add something?

Yes, I think the other thing we think about in terms of returns is that most of the globe has zero or negative yields in fixed income markets. And at this point, you've got to consider the risk environment and the return environment to say, don't reach for yield, don't reach out there and take the types of risks that can really hurt you in a ‘98, ‘08, or March 2020 scenario. And so that does have an impact on taking returns lower.

Thank you guys for the comments.

Hey, thanks. First question. Can you guys talk about the remaining Agency CMBS portfolio? How are you thinking about that if it's something you might look to opportunistically continue selling as spreads have tightened, or if that's something you're comfortable with continuing to hold onto at this point?

Hi, Trevor. Yes, so the book we have left is nicely split between what I would say are more par or slightly above par price bonds and then, some more premium price securities. We're comfortable with that position. We think we can be more opportunistic in terms of taking spread tightening in what's remaining. So, again, our big reason to take down that position in March and in April was really driven by the fact that we had a high premium, high gain position in that portfolio, and we wanted to monetize those gains. The risk is there, but our thought process was more to protect the gains, as opposed to really making a big risk statement about Agency CMBS. So, we feel pretty good about the remaining position. If we get chances to rebalance, or it's going to be a relative value decision between that and pass-throughs.

Hey Trevor, I just want to take a moment to emphasize something regarding our last discussion. A fundamental aspect of our business strategy has always been disciplined capital allocation, and we've practiced this for many years. In the past six months, due to changes in the risk environment, we've had to reallocate our funds more actively than usual. Normally, our team spends a significant amount of time analyzing our portfolio, but if you compare the end of last year’s portfolio to what we had after the first two weeks of March, then to the end of March, and now, you'll see that we've been very careful in how we manage our capital and where we allocate it. We are committed to this disciplined approach. We've been flexible, and as a company of our size, this agility is beneficial. Looking ahead, we intend to continue utilizing the same processes that have served us well in the past.

Okay, thanks for those comments Byron. And then in terms of your interest rate positioning, I think you have had the March 31 numbers in the slide deck. Can you say if those changed with the portfolio reductions in April, and more generally, how you're thinking about the REIT profile of the portfolio going forward, given that interest rates are near zero now? How much risk you're comfortable taking that?

Yes, I think one of the nice things about having the Agency CMBS position is just how simple it is to hedge. So our book, actually from a net duration position, is not that different. And since we sold the bonds, we've actually stayed fairly duration neutral. The positioning at this point, I would say, again, is really going to reflect our broader macro view. And the broader macro view is that at this point, things could go in a number of different directions, right. A lot of people think the curve is going to steepen, and so if that occurs, then you push your hedges back into the yield curve, we have some of that thought process going on. You also have the idea that the front-end of the curve is fairly anchored. So, there's really no point in having hedges in the front-end. We agree with that. So as we're adding assets and growing the balance sheet, we're going to have a bias for adding hedges at the longer end of the curve, and probably, having that front-end position fairly open.

Okay, got you. And then, last question. Can you just provide a brief update on whether or not you guys have actually had any portfolio growth or started adding agencies so far in May?

We've found that mortgage spreads are wider in mid-May, and as we enter the month, we've been adding assets and plan to continue doing so.

Hey, Trevor, the other interesting thing, and I should clear this point it's come across so far; the Fed is adjusting the amount they're purchasing. We're still watching to see how far what it really is in the mortgage market, we don't believe the agency sector will fall out a bit. But, we definitively believe spreads could widen under certain circumstances, especially as I said, brings down their purchases, and it's not a bad widening, that's good widening. It means that prices are just moving where private capital like Dynex Capital, and our shareholders are willing to assume the risk of instruments such as this. So, there's optionality in the future, and I'm just taking a second just to pile on top of Smriti here, and it makes a point.

Okay. Appreciate all the comments. Thank you, guys.

Hey, guys.

Hi Chris.

Can you give an update to book value since March 31?

Hey, Chris. Yes, as we commented, it's not materially different from the end of the quarter.

Great. Thanks, Steve. And then follow-up question would be, given your guidance in terms of leverage and spreads and so forth. I'm sort of ball-parking that it looks like you're targeting a return in the high single-digits for the company or return on equity. Is that fair?

No, what I would say, Chris is going to depend on the risk environment. If you look back at the end of what we are saying, though, is if you look at where we were at the end of last year, and you think about my commentary over the last call a year or two, where I made really strong cases for taking higher leverage in liquid assets, and one of the main reasons was because you have the ability to adjust your portfolio. What we are telling you here, think about us short, medium and long-term. The short-term is the next four, eight weeks, the medium term is through the end of the year, and the long-term is after the end of the year. And literally, we're thinking short, any question you've got, it's a short, medium and long-term approach. In the short-term, the world is evolving. We're not going to leap to where we were at the end of December and say everything's okay, because everything's not okay. The world is evolving, and we're taking a phased approach to reinvest our capital. I couldn't give you that this is something the exact target. What I can tell you is this approach, short, medium, long-term. And we're evolving our way back to a still a philosophy with that we have which is up in credit and up in liquidity is a good strategy. I'd still rather have more leverage on highly liquid assets than lower leverage on less liquid assets. And that's just an argument we've been making for years.

Great. Sounds good, thanks for the clarification. Be well.

Hi, it's Jason. Paul is off today. I wanted to follow up on the question about Agency CMBS and increasing leverage there. It seems like two of the indicators might be lucrative steepening and sudden involvement. How flexible are you in adjusting the levels, and if I'm mistaken about those indicators, what are the correct ones? Additionally, for how long are you willing to make adjustments based on those factors?

I think it's really an interesting trading environment. If you look at how mortgages are trading every day before the Fed comes in, they can sometimes be cheap and sometimes tighter. The Fed influences the prices of MBS during the trading day, and immediately after their operations, the market is affected by originators and other investors. As we observe daily trading, we are discovering pockets of opportunity where there is a lack of liquidity in the sector, allowing us to buy bonds at favorable levels. It's a micro trading day strategy environment right now, and we are finding good windows to add assets. Even though the Fed is active and mortgages are tightening, these opportunities still arise due to the market's microstructure. We are willing to increase our leverage and monitor this closely. If we identify attractive dollar price levels or OAS spread levels, we will take action and invest. Regarding the steepness of the yield curve, this is more of a long-term consideration. If the curve steepens, we expect to see mortgage extensions and an opportunity to take on more duration risk, knowing the front end is anchored. However, we need to be cautious not to wait for such conditions to materialize. We will act on good opportunities to invest.

Okay, that's fair. Between now and the achievement of some medium-term ROE target, how willing are you to let core NOIs sort of slip around the dividend and how does that relate to setting the dividend?

I'll address the question about my level first, and then I'll pass it to Byron. We plan to invest our capital in a disciplined way, which means that core income might be lower than the dividend for a while before it starts to rise again. Right now, our focus is on preserving capital, ensuring we’re not overextending ourselves, and identifying solid opportunities to acquire the assets we believe we will have the chance to purchase.

The key point to understand is that the two aspects are distinct, and there is no direct connection between the core income and the dividend. This separation is a wise choice for effective risk management and long-term planning. Our goal is to generate cash income for our shareholders. We recognize that globally, the options for earning cash income are limited. When considering the decision to maintain the dividend in May, it’s important to approach it with a respectful mindset towards our shareholders. It's also crucial to consider the short, medium, and long term. In the short term, over the next four to eight weeks, we will be processing a significant amount of information alongside other market participants as the virus and the economy continue to evolve, leading to more bankruptcies and complex income statements. Despite these challenges, we are committed to a disciplined risk management approach.

Thank you for the questions and the positive feedback in a challenging environment.

Thank you for taking my question. Good morning, Byron. First, I want to congratulate you on an outstanding quarter. You're likely to achieve the best performance among mortgage rates. I’d like to start by discussing capital management and the available resources. Specifically, I'd like your thoughts on stock buybacks. It seems you're positioned in the mortgage rate sector, which is currently dislocated, affecting everyone in this space, including you, despite your strong sales performance. How should we approach buybacks? Additionally, regarding your policy that has generated significantly higher yields than others, how long do you plan to maintain that if the capital markets don't reward you, assuming you're looking to grow in the future? Please share your insights on capital management and your situation in this dislocated space.

In the first half, maintaining the dividend isn't a significant financial concern. The advantage of having a monthly dividend is that it keeps shareholders informed and allows for more accurate adjustments. Shareholders receive payments monthly, but from a capital management standpoint, it isn't a major issue. We're not holding onto it for any specific rewards; rather, we are taking a phased approach to analyze the current risk landscape, which this decision reflects. We are capable of managing buybacks and have previously mentioned that we evaluate both sides of the balance sheet. We are committed to managing both sides aggressively. When we decide to invest in an agency mortgage-backed security, we simultaneously consider the reasons for buying back stock or preferred shares. Our approach is disciplined; it's important to have a long-term vision and to be strict in our risk management practices. Currently, everyone is in a position of assessing the global environment and determining the best risk-reward strategy for our portfolio. Smriti and Steve, do you want to elaborate on this further?

Yes, regarding the capital markets and the cost of capital, our main focus is on long-term growth, which is a priority for us. We are committed to achieving growth over the long term.

I want to discuss our structure and the impact of the financial crisis. A significant amount of mortgage debt was raised, and you have positioned yourself well despite the challenging equity markets and core markets not cooperating. The focus on buybacks is noteworthy. Regarding the CMBS gains, will there be any taxable income requirements associated with some of these gains, or can they be offset by the losses from derivatives in the first quarter? I'm curious about the taxable income implications, especially as this relates to the buyback strategy.

Yes. So Matt, let me take that one. Last year, we did have some return on capital. This year, the first quarter dividend character would be all capital gain. The way that tax rules work on derivative transactions, your hedges that you lift are amortized over the original period of the hedge. So there are some carry-forward amortizations from prior years, offset some of these gains that we may be taking. So I would think about it as the character for the first quarter is capital; the character for the balance of the year will depend on sort of the further transactions from this point forward, that depending on sort of the size of what we might sell going forward.

Got it. I appreciate it. Congrats and thanks everyone.

Your last question comes from Jay Weinstein from Wealthspire. Your line is open.

And I always like to get the last word in. So this company in its current form is really, as you mentioned earlier, built at a rapid kind of build-up as a portfolio in 2009 and 2010. Having gone into that, 2008 period, if I remember correctly, about two-thirds to one leverage or something like that. I think you really became a much more normal REIT in a pretty quick fashion if I remember correctly.

Correct.

It's hard, now you're in a low leverage position, not under one-to-one, but quite low compared to the industry. It's hard for me to perceive both your comments and with the world, like any kind of catalysts or triggers that would say, okay, the trigger buyer and Smriti to say, okay, we're actually going to take up asset size, take up, go down liquidity, down in credit like you mentioned? Can you see that anything like that in that environment happening? Is there any way that comes through?

Let me start by comparing the current situation to what happened in 2008. We began rebuilding our portfolio in January 2008, right in the middle of a crisis. During the first year or so, we implemented an agency mortgage-backed security strategy, but it was always clear that we were not solely an agency REIT. Given the risk environment at that time, we adopted a short duration, agency-only strategy focused on adjustable-rate mortgages. The significant difference between then and now is that the yield curve was much steeper back in 2008. The Federal Reserve reduced rates to zero, contributing to that steepness, which you can clearly see if you look at the yield curve from then compared to today. There's still profit potential now, but that's a major distinction. Another difference relates to how we approached the 2008 crisis. At that first annual meeting I attended after the crisis began, we were aware of the bad loans being made, especially in the subprime sector, which had collapsed. Since that crisis was an endogenous shock, it originated from within the system, allowing us to make predictions. In contrast, today's situation is an exogenous shock resulting from an external health crisis, and none of us are experts in that field. This fundamentally alters our perception of risk compared to that time. To recap, we initially adopted an agency strategy for about a year and a half before transitioning to a CMBS strategy, focusing exclusively on AAA securities. A couple of years later, we began to invest in the BBB sector and even some non-rated securities, finding fantastic opportunities. At that time, we were often the only buyers, especially in IO and multi-family securities, with very little competition. This time, the Federal Reserve has acted quickly and decisively, which has diminished many of those opportunities because they have provided substantial support to the corporate market and the loan market. There are still some lingering opportunities in non-agency, unrated CMBS or RMBS, but the yield is not sufficient given the broader macroeconomic uncertainties created by the current exogenous shock. I'm looking for a detailed comparison of our current strategy with what we implemented in 2008. The strategy we used back then was tailored for that specific environment. Today’s strategy is designed for now, and one of the significant issues we face is that in the next four to eight weeks, we'll need to assess the impact of the virus on the economy. We're currently unsure about how many people will be permanently unemployed, who will be unable to pay rent or mortgages, and with our leverage, we are at 9x. If we increase that, we would have to be confident about the direction of the market, but we believe it’s not prudent to take such risks now. So, Jay, as a long-term shareholder in Dynex, we're committed to maintaining this business model for the long haul. I appreciate your question regarding the comparison between 2008 and today; I have plenty to say about the investments and thought processes from back then versus our current thinking.

I keep telling people I said they're totally different. So, that was a financial crisis. And at the end of the day, it had a much less of an effect on the real economy for a shorter period of time. While they bailed-out the financial system, this time the financial system has worked incredibly well, given the stress on it. But as you say, this is an exogenous for us that we don't really have any ability to forecast much of anything.

I think I understand everything you just said. Anyway, thank you as always.

Thank you, Jay. We appreciate it.

We have no further questions. I turn the call back over to the presenters for closing remarks.

Thank you all so much for joining us on our call today. You can see there's a lot to talk about. It's simply a fascinating moment in history. Again, at Dynex Capital, we're playing for the long game, we believe the best success will be if we can stay in the game, our shareholders can stay in the game, our creditors can stay in the game and all of our stakeholders can stay in the game. Thank you again. And we'll look forward to you joining us at our next conference call.

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.