Dynex Capital, Inc.
Q3 2013 Earnings Call Transcript

Published: 5 Nov 2013

[Operator:]

Good morning and welcome to the Dynex Capital, Inc. Third Quarter 2013 Earnings Conference Call and Webcast. All participants will be in listen-only mode. (Operator Instructions) After today’s presentation, there will be an opportunity to ask questions. (Operator Instructions) Please note this event is being recorded. Now, I would like to turn the conference over to Alison Griffin. Ms. Griffin, please go ahead.

[Alison G. Griffin:]

Thank you. Good morning and thank you everyone for joining the Dynex Capital third quarter 2013 earnings conference call. The press release associated with today’s call was issued and filed with the SEC today, November 5, 2013. You may view the press release on the company’s website at www.dynexcapital.com under Investor Relations and on the SEC’s website at www.sec.gov. With me today is Chairman and CEO, Thomas Akin; President and CIO, Byron Boston; Chief Financial Officer and Chief Operating Officer, Steve Benedetti. Also available to answer your questions is the company’s Senior Vice President, CMBS Portfolio Manager, Todd Kuimjian. Before we begin, we would like to remind you that this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words believe, expect, forecast, anticipate, estimate, project, plan, and similar expressions identify forward-looking statements that are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. The company’s actual results and timing of certain events could differ considerably from those projected in or contemplated by the forward-looking statements as a result of unforeseen external factors or risks. For additional information on these factors or risks, we refer you to our Annual Report on Form 10-K for the period ended December 31, 2012, as filed with the SEC. The document may be found on our website under Investor Relations as well on SEC’s website. This call is being broadcast live over the Internet with a streaming slide presentation and can be found through a webcast link on the Investor Relations page of our site under IR Highlights. The slide presentation may also be referenced by clicking on the third quarter 2013 earnings conference call link also on the same page. I would now like to turn the call over to Chairman and CEO. Tom Akin.

[Thomas B. Akin:]

Thanks, Alison. Thank you everyone for joining us on this third quarter Dynex conference call. So far this year, we have seen the whole spectrum of sentiments on the direction of interest rates. It was just this April after the announcement of [indiscernible] Japan that the 10-year Treasury at 1.6% and was rumored to be headed to break 1% as the Japanese 10-year touched 60 basis points. Then just a couple of months later, Bernanke whispers the word taper, and the 10-year almost doubled to 3% in just a few short months; only to find most recently that the data didn’t support tapering and the whole exercise was put on hold. Credits spreads have shown similar volatility and asset pricing difficult at that. Mini portfolios with higher leverage and volatility were forced to do delver. I am pleased that our portfolio strategy did not suffer from forced liquidation and is largely intact. Shareholders can expect us to continue to cash flow our existing portfolio and write it down the yield curve. In addition, the improving credit environment for commercial mortgages should enhance value to our portfolio as narrow and maturity shorten. Today, we have global headwinds, a dysfunctional government and a deteriorating phenomenon that is making the market reexamine the growth story for 2014 and beyond. Consequently, interest rate levels are in question as well. We have always promised our shareholders to deliver dividends with the least amount of risk possible. The most recent environment has tested that portfolio and our strategy and that of the entire mortgage REIT universe. We feel that more than ever, our current strategy and portfolio gives the correct combination of risk and return for our shareholders’ capital. As a substantial shareholder in Dynex, I share the pain with every other shareholder who may lose book value, but we felt it was importance to reduce risk in this volatile environment on the longer-part of the curve. I would like to leave you with a thought that our mortgage portfolio values will fluctuate in periods of high volatility and uncertainty, as we have just seen. However, we have structured our portfolio to weather these periods of volatility and we see current excellent opportunities over the medium to long-term. The next few months are likely to see continued volatility with huge policy issues at stake such as monetary, fiscal and regulatory. Clearly, prudence was required in this environment. Now, I’d like to turn the call over to Byron to discuss portfolio specifics.

[Byron L. Boston:]

Thank you, Tom, and thanks to everyone for your interest in Dynex. I’m going to begin by reviewing recently what we discussed in our second quarter call and then I will go through our performance for this quarter and then our outlook. So last quarter, we took you through our business model. As I mentioned then, we have deliberately designed our portfolio to perform in a variety of market environments. We focus on diversification across product, maturity, coupon, credit type and various other characteristics. I also spoke about our focus on short duration, high quality investments and how we have managed leverage conservatively. We discussed the market environment. So for example, for the last five years, we were in an easing cycle represented by a steep yield curve, low funding rates, low volatility and historically low interest rates – absolute interest rates. At Dynex, we always recognize that that was an unusual period skewed by heavy government involvement in financial markets. As such, we employ the strategy with a longer-term view that this unusual environment could ultimately change in some unexpected ways, which it has. Two important components of this strategy are rolling down the curve and credit diversification. The first involves selecting securities with limited extension risk and the ability to take advantage of yield curve roll down. The second is investing in credit sensitive assets to offset the impact of a sudden rise in interest rates. Both components involve taking spread risk, which we also discussed last quarter. If you recall, we described spread risk as the uncertainty in pricing resulting from the expansion and contraction of the securities risk premium over benchmark. So today, we will repeat several things you have heard in the past, because our core strategy, as Tom has mentioned, has not changed. So let’s go to Slide 4 and let me just go through a few of – let me turn to our overall performance and let me just go through the facts. First quarter results were – this is our first quarter results, where we will not be utilizing hedge accounting. It presents some complexities. Steve will step up in the next few minutes and he will go through the both complications to try to ensure that you understand the results completely. So let me just go through some of the facts. GAAP net loss of $0.13 per common share, but our core net operating income of $0.27 per common share was basically equal to the dividend declared this quarter; our GAAP return on average common equity of 5.7%, while our adjusted return on average common equity of 12.3% this quarter; net interest spread of 194 basis points this quarter versus 175 in the second quarter; our adjusted net interest spread was 1.65% versus 1.72% in the second quarter; book value per common share of $8.59 as of Sep 30 versus $8.94 as of June 30; our average CPR was for earning assets of the portfolio was 19.5% and you should take note that the portfolio CPR for October was 12%, so a relatively material drop. We paid a common dividend of $0.27, we are trading with a 12.5% yield based on $8.64 closing price, and our overall leverage, I want to emphasize, is about 6.4x, that’s down 0.4x since the end of the second quarter and that’s something we emphasized in the second quarter that our leverage had not extended much and that as we moved along through the July, August and September, did not reinvest our prepayments, portfolio delevered to 6.4x level. Now, I'll turn it over to Steve to walk you through some of the GAAP versus non-GAAP metrics.

[Stephen J. Benedetti:]

Thanks, Byron. Most of you on the call know that we discontinued hedge accounting effective at the end of the second quarter. We made this change primarily in order to better manage our liability maturities. That also allowed us to use different hedging instruments such as Eurodollar futures, which we added in the third quarter. With the simplicity in the new accounting however comes complexity in reporting, as valuation changes in our derivative instruments are now presented in earnings and not just comprehensive income for GAAP purposes. This quarter and in future quarters, we will be presenting core net operating income as an alternative measure to reported GAAP results. Core net operating income is intended to represent portfolio earnings exclusive of unrealized and realized gains and losses on asset sales and derivative transactions. As Byron just mentioned, we reported core net operating income of $0.27 per common share equal to our common dividend. We have provided a reconciliation of core net operating income on Page 5 of the presentation and in the press release. The reconciliation starts with GAAP net loss to common shareholders and removes unrealized and realized gains and losses and the amortization of losses from de-designated hedges at June 30, 2013. Core net operating income thus reflects the earnings of the investment portfolio less the costs of financing and hedges and the operating costs of the company. With respect to the Eurodollar futures contracts, these instruments represent forward starting three-month LIBOR contracts and allow us to synthetically replicate curves, swap curves and/or hedge specific points on the swap curve, where we may have duration risk. As these contracts represent forward starting contracts, we will include in core earnings only the cost of those contracts that have actually become effective. The bulk of what we have added is forward starting, which can be seen from the table on Page 15 of the presentation. Byron will review this table as part of his presentation. With that, I’ll turn it back over to Byron.

[Byron L. Boston:]

Thanks, Steve. If you go to Slide 6, let’s look at our book value. Our book value for the quarter was down from $8.94 to $8.59, $0.35 a share decline or 3.9%. Let me emphasize something important on this slide and I think it is really important for everyone to understand. In this type of a volatile market environment, 1% to 5% movements in book value are not that unusual. Here is what’s very important, as of the end of October; we’re estimating that much of that book value decline for the third quarter has been recouped. You should note that our pricing process is very disciplined and very rigorous. And as of the end of September, the outside marks that we give for our portfolio were substantially lower than where we had our portfolio mark and likewise at the end of October, the outside marks were substantially higher than we had our portfolio mark. So in any given quarter and any given in the mark, we will have these book value shifts that may not have as much meaning as the overall long-term core value of the balance sheet. And what I can tell you and as I’ll go through further in this presentation is that the core balance sheet of Dynex Capital is in solid shape. We now move to Slide 7. Dynex has had to do very little repositioning of the asset portfolio, as Tom mentioned earlier in his comments. Our asset strategy has not changed, because we managed our portfolio with a view that the fed dominated MBS in treasury markets would someday change. As such, since May, our focus has been limiting the impact of an extremely volatile and technical market on book value. Our shorter duration strategy is focused more – is focused on more predictable cash flows with limited extension risk and potential to roll-down a steep treasury yield curve. This is why we invest in hybrid ARMs. Similarly, we always invested in CMBS, because of the well structured nature of the cash flows and strong credit fundamentals in this sector. Well structured cash flows translate to efficient yield curve roll-down. No extension risk due to changes in interest rates and explicit call protection. It also provides a diversifying impact, because typically as rates rise, credit fundamentals improve and support tightening credit spreads. And then finally, regarding our overall strategy, risk management will be a key to our future success. We have made adjustments to our liability side of our structure to deal with this on this extreme market volatility. Now let’s think about the market from a fundamental, technical and psychology perspective. On Slide 8, the economic fundamentals are uncertain. Sustainability and trajectory of U.S. economic growth is uncertain. The Federal Reserve policy makers are projecting accelerating growth into 2014 and 2015, but economic growth today is only moderate. Moderate economic activity implies a 3.0% to 3.25% rate on the ten-year treasury absent quantitative easing. That equates to approximately two-year to 10-year spread of 270 to 295 basis points. Higher rates have the potential to impede economic activity as current growth is dependent upon low interest rates. Government deleveraging and austerity in the U.S. and Europe could hamper growth in the future and inflation levels are declining and could become a surprise factor. If you move from just the fundamentals in the market and you think about the overall technicals and psychology, which have been the most important factors in 2013. Technicals have been distorted by Federal Reserve participation in the capital markets. Long-term interest rates and spread volatility were artificially low. Taper talk increased both spread and interest rate volatility. This was further exacerbated by debt ceiling and budget negotiating cliffhanger. Other technical factors that were very important to consider, dealer balance sheets and their commitment to make markets have been negatively impacted by regulation and this was a huge factor in the second quarter as we watched ARM spreads widen out and CMBS spreads widen out. Our originator pipelines, which is also a factor in the second quarter have now been reduced given the huge drop-off in the refinance activities and as we have always expected, the hybrid ARM market is gaining in attractiveness as more investors are seeking short-duration assets. I’ve heard over and over again, investors that were relying upon the third-year sector, saying we’re selling 30 years and we’re buying ARMs. This is a trend and a change that we have expected in our overall construction of the portfolio from inception. And then finally, market psychology. Psychology will continue to be influenced by perceptions of economic data and Federal Reserve monetary policy. We believe that year-to-date market behavior has been driven by psychological factors as opposed to technicals and fundamentals. The Fed’s stance on QE3 tapering will continue to drive market movements and the anticipation of tapering will drive market movements in the future. We talked about our performance and strategy. now let’s look at that what we consider to be one of the most important factors, which is government policy. There will be key to the future. In 2009, we said government policy will drive investment returns. We continue to feel that way today. We’re talking monetary policy, regulatory policy and fiscal policy. Under monetary policy, the Federal Reserve is expected to maintain a dovish policy stance holding short rates low for extended period. Steady short-term interest rates should create an environment in which we can deploy capital profitably. On the other hand, QE3 artificially influences long rates lower and QE3 exit strategy today is uncertain. Regulatory policy simply put it’s uncertain, it’s restrictive and it’s changing rapidly. And finally, fiscal policy is creating economic headwinds and unlikely to be resolved in the near future. So what is this mess for the overall market environment, put simply, put market environment is absolutely uncertain and that’s really been the largest driving force behind the volatility. The combined factors of an uncertain economic environment, distorted monetary policy and an unclear fiscal and regulatory policies has and is continuing to foster volatile market environment. On the one hand, short-rates provide us a great business opportunity to earn net interest income. On the other hand, hedging costs are increasing due to the volatility and book value has declined. The Federal Reserve has indicated it is data dependent while markets have become monetary policy dependent. Global uncertainty adds more volatility to the mix. However, market expectations of higher interest rates is becoming supportive of our short-duration hybrid investment portfolio and credit fundamentals supporting our CMBS assets continue to be strong. Market volatility has been high and we will continue – and will continue to be high, as we’ve just mentioned due to the uncertain economic activity, data dependency of the Federal Reserve and the Federal Reserve’s desire to be transparent. So overall, if you look from a top-down perspective, we are dealing with a very uncertain environment, we’re dealing with a very volatile environment, but our overall portfolio construction hasn’t changed. So we want to walk you through how we’re structured today, how we’ve adjusted some of our hedges, and how we view the overall future. If you look on Slide 12, under the investment capital allocation, that should look familiar to you. 39% of our portfolio at capital allocation is allocated to RMBS, while 56% is allocated to the CMBS sector. We have attempted over time to also diversify into non-Agency residential product. but today, we constantly find that sector to be very crowded with very mini players that as exemplified by the attempts by Freddie and Fannie to lay off some of their credit risks. those deals were 10x to 18x oversubscribed. We had attempted to invest in that product. We had to drop out ultimately, because of the returns were too low. Our credit quality continues to be over 90% AAA. Our net premium exposure, which we’ve always had a high premium exposure has been 78% to the CMBS sector where those cash flows are call protected. And then finally, in the lower right-hand – the lower right-hand corner, which has been a major key part of our story, our assets for the most part mature or reset within 10 years. If we move to Slide 13, let me quickly review how we are positioned. Our overall position is consistent with the dovish Fed, low short rates and steep yield curve for the near-term with rising volatility and rates in intermediate and long-term. As such, our position benefits from asset roll-down in the front-end and hedges in the intermediate to long-end of the curve. Our overall portfolio, fundamental portfolio construction hasn’t changed. Our Modeled Duration Gap has always been between 0.5 to 1.5. We’re at the lower end of that range, as we’ve added hedges throughout the quarter. And here is a key point, our portfolio designed to continue to generate cash flow off the short-end of the yield curve and increase in value as the portfolio rolls down the curve over time. Given Federal Reserve policy on short-rates, following third quarter 2013, following after subsequent to quarter-end. we terminated about $765 million of our interest rate swaps and let me tell you what our intention was behind this strategy. These were swaps that were going to mature ultimately in 2014 and 2015. Our goal is to generate carry off to short-end of the yield curve. We felt no reason to have these one and two-year swaps sitting out here with the high coupons that were attached to them of the net result of this, we expect to add $2.2 million in Q4 to our core net operating income. So our philosophy again, and our strategy has been consistent. Our behavior here in terms of how we’re adjusting the right side of the balance sheet is also consistent with the philosophy as trying to earn carry off the shorter-end of the yield curve. And then finally, throughout the third quarter, we modestly delevered, as we mentioned we would do in the second quarter, as we just simply did not reinvest our cash flow, our runoff from our portfolio and we also extended our repo maturities as part of our overall risk management philosophy. If we now move over to Slide 14, you can see the impact of the hedging actions from the prior quarters. Please recall our hedges have been added on the longer-end of the maturity spectrum and therefore are more sensitive to changes in intermediate and long-end of the curve. But if you just simply take note, you can see that, if you compare from the December 31 to September 30, our overall exposure to a 25 or 50 basis point move in rates has been materially reduced. That is in response again, to what I laid out the entire macro picture has become very volatile. Let’s move to Slide 15, here you can see some of the effects of reducing or eliminating hedge accounting. If you look at the amount of hedge or amount of repos that we have maturing 90 days or greater, you’re approximately over $2 billion. That is the largest amount that we have had since we started building this portfolio in 2008. By dropping hedge accounting, it gave us the flexibility to extend our repos. The other reason that we wanted to extend our repo maturities at this point was, dealing with the fiscal problems that we were facing in October. So we started in September and in August attempting to move our repos out beyond year-end. In case, the fourth quarter environment was more volatile than expected due to the fiscal issues in DC. Furthermore on the right side of the slide, you can see from our hedge portfolio, we have increased our hedges, we got a nice ladder of hedges really further out into the future. We are – we continue again, want to emphasize the philosophy behind this strategy, we want to earn our carry off to short-end of the yield curve. My most ideal bond would be a bond where I can earn credit spread of the zero to let’s call it three-year part of the curve. So finally, our outlook and opportunities, we believe there is a business opportunity here. So I don’t want to overemphasize the negative of the microenvironment. The business opportunity is the Federal Reserve is on hold. I will make strong arguments than we did in 2008, while the Federal Reserve would be on hold in terms of short-rates for a longer period of time that most people expect. We still hold to that opinion. Therefore, we built the short duration portfolio. We’re looking to earn carry off the short-end of the curve. We want to take advantage of the steep yield curve roll-down. On the other hand, the market is extremely volatile and when managing a securitized portfolio that comes with increased hedging costs and you’ve seen that hedging costs flow through not only in terms of our overall net interest income that hedging cost will flow through overall from quarter-to-quarter in terms of book value. Few years ago, we were seeing some ROEs in the high teens. Those ROEs don’t exist today, but we still have great opportunities to provide attractive ROEs. We never expected those ROEs to stay, that’s why we constructed this core portfolio that we believe is structured to perform in a variety of market environments. And with that, I’m going to turn it back over to Tom.

[Thomas B. Akin:]

Thanks, Byron. So on conclusion, I’d like to just go over a couple of takeaways from this call for our shareholders. One, our core earnings will have equaled our dividend for the quarter and we are very comfortable going forward that our portfolio and strategy to roll-down the yield curve will continue throughout substantial cash flow. We’d maintain our leverage guidelines around 6x leverage and we haven’t been overlevered or forced to liquidate our portfolio. We have seen our prepay slowdown, as Bryon commented, in October, they were down 12 CPR and we expect that to make significant contributions to our cash flow, if that continues into the future. Our book value declined from the second quarter to third quarter, have largely been recouped as of the end of October. We’ve always managed this company from the long-term. And if everyone would turn to Slide 17, our historical economic return to shareholders have been substantial. We continue to be – feel that our existing portfolio will have a long-term opportunity and be a great value to our shareholders, but we need to be respectful of the interest rate volatility in the near-term. For that reason, we have taken the actions on our portfolio to increase short-term cash flow, but be respectful of long-term volatility. With that, I’d like to open up the call to questions. Operator?

[Operator:]

Thank you. We will now begin the question-and-answer session. (Operator Instructions) And the first question comes from Trevor Cranston with JMP.

[Trevor J. Cranston:]

Hi. Thanks, guys. I guess, the first thing, it sounded to me when you were kind of going over their current market environment, like you guys are kind of maintaining a pretty cautious outlook for the near-term, given all the volatility and uncertainty with the Fed, can you maybe talk about kind of how that’s – how that’s impacting whether or not you’re going to start kind of reinvesting the paydowns in the fourth quarter or whether or not you expect leverage to kind of continue dripping lower over the near-term?

[Thomas B. Akin:]

All right. So, thanks, Trevor for that question. We are going to reinvest some of our cash flow in the fourth quarter. It’s just that I’ve got to find the right instrument. Again, here let me – I want to describe this macroenviroment. The great business opportunity on the short-end of the curve, but it is a very volatile environment. I hate using the word, volatile, because I don’t think it describes it well, to the amount of material uncertainty from fiscal policy, monetary policy and other government policy is extreme. So we are going to reinvest some cash in the fourth quarter and the key here is that we find the right assets. But again, we’re sticking with the short duration. We’re sticking with the CMBS, if we can find some non-Agency resi assets to add some credit exposure we will.

[Trevor J. Cranston:]

Got it. That makes sense.

[Thomas B. Akin:]

There is a if this but that scenario and I hope that gives you a good explanation of it.

[Byron L. Boston:]

Yes. and I just want to add there. Trevor, I mean, we are not unhappy with our existing portfolio and the way it’s – the prepayments are dropping. If they continue to drop the way they have in October, our deleveraging, if you want to call it from 6.8% to 6.4% from the second quarter to third quarter probably is going to be substantially to less than that. So we will – we won’t need to add as many assets as you might think.

[Trevor J. Cranston:]

Right, that makes sense. In terms of the book value gain, you guys mentioned just kind of since the end of September, can you comment on kind of what the drivers of that was, if there’s mostly hybrid ARM spread tightening or if there is meaningful contribution from the CMBS portfolio also?

[Thomas B. Akin:]

Here again, I want to emphasize this one issue on this, when you have this type of market volatility and you have these 1% to 5% type book value moves. at the end of September, we again – we have a very rigorous disciplined marking process for our portfolio and we adhere to it. The outside marks came in materially lower than what we had our portfolio marked in the September. At the end of October, they’re coming in materially higher. Why would there be a difference? It’s simply multiple people trying to keep up with where prices are moving in this type of environment. So when I look at the position, what I’m trying to understand is, I finished the second quarter at $8.94 of book, do I really have any material change in the value of these underlying assets, and the answer to that is really no, there still is still a solid balance sheet. So you have some movement in terms that can attribute to in terms of interest rates, some movement in terms of spreads, but at the end of the day, at the end of September, there was material difference in that mark and at the end of October, there was a material difference in the other way and that’s just really the outside parties really being a little slow in the process. How do you bank on that for where the book value would be in November and December? The only thing I will tell you, Trevor, and for every other analyst on this phone call, your ability to predict book value in this type of volatile market has been – has decreased materially and it’s simply a function of volatility in the marketplace.

[Trevor J. Cranston:]

Yes, totally understood. Those are helpful comments. I guess, the last thing on the prepaid speed drop you’ve seen, do you guys have the number for what the speed was just for the Agency RMBS portfolio?

[Thomas B. Akin:]

Yes, it was 14.8%, Trevor.

[Trevor J. Cranston:]

14.8% for October, okay.

[Stephen J. Benedetti:]

And that may have been down from 21%.

[Thomas B. Akin:]

Yes, I think it was 21.5% for September.

[Trevor J. Cranston:]

Got it. Perfect. Okay. Thanks, guys.

[Operator:]

Thank you. The next question comes from Douglas Harter with Credit Suisse. Douglas M. Harter – Credit Suisse Securities (USA) LLC Thanks. Byron, when you showed the interest rate sensitivity to the 50 basis point move, I was wondering what that would look like if you did that to 100 basis point move and what the actions you did with this swap post quarter and change that number materially?

[Byron L. Boston:]

That’s a good question. I don’t – no, the number on the post quarter end, I don’t think will have a material impact and the reason is because they were so short. So they were swaps we have put on a couple of years ago. They had higher coupons and they were now like within one to two years of maturity. So that’s not where you’re going to feel that in a 100 basis point move, you’re going to feel it further out…. Douglas M. Harter – Credit Suisse Securities (USA) LLC Right.

[Byron L. Boston:]

…the curve.

[Thomas B. Akin:]

The way these charts are put together, they are parallel shifts. So you’d have to make the assumption that it wouldn’t be if they are steepened or it would be a – the Fed would reverse course, change it’s policy and the whole curve would have to ship up – shift up. That’s the way these charts are put together and these are the charts that we end up putting in our 10-Q.

[Byron L. Boston:]

And the reason, just so you know, the reason we’ve put 25 and 50 basis point on here, Doug, is because those are highly probable events. But likewise, what makes it confusing is down 25 basis point to down 50 basis point is also very probable event. So the – I know there’s enormous amount of aberrations in the marketplace, I truly believe it up a 100 move from this level would be a devastating economic event and as such we’re more concerned with this 50 basis point collar. Douglas M. Harter – Credit Suisse Securities (USA) LLC Understood. Thank you.

[Operator:]

Thank you. And the next question comes from Jason Stewart with Compass Point.

[Jason M. Stewart:]

All right, thanks. So I wanted to follow-up on one of the first questions, in terms of pricing, it sounds like a portion of the liquidity discount and the way price you securities has collapsed and I’m wondering if that was across sectors and then if you could relate it a little bit to variance you’ve discussed in the past, permanent versus temporary declines in value and we’ve seen hybrid ARMs recover a portion of their decline, but certainly not all of it. If you could just give us at a high level, how those two are factoring in right now?

[Thomas B. Akin:]

Can you repeat the first part of that again, Jason, in terms of you mentioned liquidity? I am not sure I understood the first part of your question.

[Jason M. Stewart:]

We understand that the pricing to work is as you’re taking some level of an average of prices you received.

[Thomas B. Akin:]

Sure.

[Jason M. Stewart:]

And clearly, when you go to sell a bond in the market, you don’t take the average price, you take the high. So as those prices converge towards a more normal market and liquidity, if spreads decline, I would expect your average to move closer to probably the true mark. Whether that is happening or has happened, maybe you can just start with that?

[Thomas B. Akin:]

Yes, that is true. So what we felt was the September mark was off base. So – but we market exactly, we stuck with our rigorous process. And there’s nothing wrong with the outside pricing service, is it just that the volatility in pricing right now, I especially want you to think about hybrid ARM prices or CMBS prices, it’s volatile. So it’s not unusual to have these type of discrepancies. The reason we simply compared September to October is trying to emphasize that the balance sheet is fine. That was – it’s almost like that movement was noise to some degree, spreads have tightened, the prices as of the end of September 30, still have [indiscernible] spreads wider, still have some CMBS spreads wider, while assets are not all the way back in where they were. Are there stronger bid for assets? Yes. Hybrid ARMs and CMBS are different than 30 years, you may have heard about 30-year pricing, the federal government is definitively is directly involved in that sector. On our end, there have been more interest in hybrid ARMs, you would have heard that on other re-conference calls, if nothing else, guys selling 30 years to buy hybrid ARMs. We have no intention of giving up on our hybrid ARMs. We don’t believe we’ll get them back if we would sell our hybrid ARMs. We think it’s a very valuable portfolio that we’ve put together. So the pricing spreads have tightened. As of September 30, they were still wider than at the end of the second quarter.

[Byron L. Boston:]

Jason, the other thing to realize is that since the taper talk, the market has had to price ARMs in sort of a wide, wide bid that spread, because the Fed is not buying ARMs, okay. And the reason as you know that ARMs are starting to come back into vogue is that there are a lot of people who start to realize that these ARMs are great vehicles in this environment that we’re looking at right now. And so, you are seeing those prices improve, but it really is irrelevant to us, those noises, [indiscernible] in the book that is because unless we have to sell those and I think we’ve pretty much gone through an environment where we proved we don’t have to sell them, we plan on continuing the cash flow of those going forward and it’s a very attractive cash flow yield that we should get off of them.

[Jason M. Stewart:]

Okay. That makes sense. And then the recovery in spread and hybrid ARMs, how would you classify that, I mean, are we halfway back to where you’d expect them to be or do you think that they’re all the way back given the rate environment?

[Thomas B. Akin:]

Okay, I’ll tell you what you won’t get from me here, Jason, because I’ve got enormous respect here for the volatility in this environment. I think we have the potential for spread volatility. Longer-term though, I think, in longer-term, let’s make some assumptions, longer-term, let’s believe in America, believe that the economy will get better and believe that we’ll have some higher interest rates, sometime in the future, I can’t predict when that will happen, I think these hybrid ARMs will be fine. I think they will be in good shape, I think a lot of people will want them and I don’t think there will be that many of more around. So I can’t predict. I won’t go about predicting that specific spread level, just because – and it’s not the word volatility, the market is so uncertain to factors that we’re dealing with and so I hope that helps. Let me – I’m not trying to be evasive, I’m just trying to respect the market environment, spreads are rolling quite a bit, if you set here and you had volatility continues to come down, let’s say you confirmed Janet Yellen, let’s say that you don’t start tapering until March of next year, spreads across risk assets are going to be supported, because volatility will continue to come down.

[Jason M. Stewart:]

Okay, that’s fair. And let me just switch topics, then I’ll jump back in the queue. In the CMBS market, do you think that the FHFA’s mandatory reduction in GSE volumes was a contributing factor to why spreads widened in the second quarter? And then if I could relate that to your thoughts on how you think, the upcoming scorecard might have an impact if at all on the CMBS market?

[Thomas B. Akin:]

All right. So second quarter, the answer is no. Let me tell you what happened in the second quarter and it’s a technical factor that was very unique to that time period. So in June of this year, you had both – and I’m going to use both the hybrid ARM and the CMBS market in same way, you had – in hybrids, you had certain fore sellers of which one of those sellers happened to be originators. On the CMBS side, again, you have a huge increase in the hedging of CMBS portfolios, while simultaneously investors moved to the sidelines temporarily. So you had a temporary, what I will call supply/demand imbalance, where you had sellers –fore sellers, those are conduits looking to hedge their portfolios, you did have Freddie Mac try to come to the market with two deals, but I don’t think that had anything to do per se, with the scorecard, and then you had spreads widen out. And as the quarter has gone on and as investors have come back into the space, both in hybrid ARMs and in CMBS, you start to see those supply/demand imbalances change and start to move forward – more toward where you had more demand than supply. I know you hadn’t asked this, but I’ll add this on to it, in the fourth quarter, we are expecting a pretty hefty CMBS calendar. There is no reason at this point in time for us to believe that the market can’t handle that supply. But I do think unique – June was a unique period where there was a supply/demand imbalance that was exacerbated by the Streets’ unwillingness to put balance sheet to make markets.

[Jason M. Stewart:]

Okay, great. Thanks for the time.

[Operator:]

Thank you. (Operator Instructions) And the next question comes from Mike Widner with KBW.

[Michael R. Widner:]

Good afternoon, guys.

[Thomas B. Akin:]

Hi, Mike.

[Michael R. Widner:]

Let me follow-up on this book value question with just one another nuance to question. In the Table 1 on Page 6, you showed sort of a breakdown on the changes in book value and on there, is a line item $0.21 for changes in credit spreads. This thing you’re talking about where you’re kind of embedding a low mark, so to speak, which is something we’ve actually heard from some other REITs as well. Is that where that would show up?

[Thomas B. Akin:]

Yes. That’s exactly where it would show up.

[Michael R. Widner:]

Okay. And so as we think about the unwinding of that it’s probably mostly that well equal, it can be that $0.21 that we’re talking about sort of unwinding. is that fair interpretation?

[Thomas B. Akin:]

That’s fair interpretation.

[Michael R. Widner:]

All right. Let me ask a bit of a broader question. You guys have talked a lot, we mentioned these several times, really liking the opportunities at the shorter-end of the curve. Can I just ask for some clarity on how do you define shorter-end of the curve, whether in terms of duration or specific example of what it is that you’re saying you like there?

[Thomas B. Akin:]

All right. I will – I’m going to give you, I’m going to – this is the way I think Mike. So I want you to bear with me. I’m going to give you my theoretical ideal bond. It will be a bond that I can accredit bond that I could earn credit spreading matures within five years. Now all resets within five years. I don’t know that I’m going to find exact ideal bond that’s why we tend to focus on CMBS IO where gas holes really are shorter, they’ll amortize faster season hybrid ARMs, we always really love the premium securities where they’re going to reset within five years has been an ideal, we bought some that we set within seven years or 10 years, that the gas hole to roll down the curve nicely. But my ideal bond would be one that offered a decent return that resets within five years. And to the degree, let’s say if I had a CMBS bond with five-year maturity AAA asset that will be perfect, sitting on the short-end of the curve.

[Michael R. Widner:]

So I mean in principle, I suppose that makes sense to me. I guess the things that I’d wrestle with here is, this roll-down the curve notion becoming shorter-duration is – it’s sort of a consistent part of that story, as you talk about the different asset classes. And I guess the thing I can’t help wondering about is – get you and look around in current recent ARMs and agencies in their trade 106, 107 for – if you are trying buy something at that price, obviously it doesn’t well, I would argue that it doesn’t work to buy at that price of an agency REIT, because you are looking at some 100 basis point yield. And I mean I guess the question I wrestle with is how sustainable is that versus how artificial is that just because of zero interest rate policy and the fact that these bonds have floors on them. It’s a long-winded of asking, I mean do we really have any faith that that 106, 107 dollar price is going to be there, when these things really become short reset ARMs eventually or short reset bonds, because if we do have the Fed, it’s a 200, 300, 400 basis points. Are those not fundamentally different price bonds and those not par bonds at that point?

[Thomas B. Akin:]

Well, I’ll tell you what Mike, you’ve mentioned this in that last conference call and I remember it, because I disagree with you on it. And you mentioned that…

[Michael R. Widner:]

There is…

[Thomas B. Akin:]

Yes, I know you mentioned you said that’s the next thing to drop with these short resets. Here is the issue on this; these bonds are really a short bond, right? They have margins, they’re floaters, in effect, annual floaters or some are six month floaters with margins like 175 basis points sum up to 225 basis points. So as the curve is structured today with prepayment speeds really having slowdown on those bonds altogether. I think those bonds are appropriately price, right. They’re really short-duration. At some point, the Fed will somewhere out in the future are just short-rates. When they are just short-rates, short assets are going to start to re-price. No reason those assets won’t re-price also. Now part of our strategy is every other mortgage REIT is dealt to hedging. So right now, we have a strategy and we’ve had it since 2008, we believe they’re rolling down the short-end of the curve, we’re rolling into those short ARMs and we’ve held them. At some point, we may become more conservative. I think that’s well out into the future where we will use short into the curve hedges as opposed to long-end of the curve hedges. And I think these bonds will re-price as the short-end of curve re-prices, because there are short-duration assets. But to just look at those bonds today and think about lot of – what you get from financial advisors, they’ll tell you don’t buy a third-year bond today, and the reason is because they believe longer-term, a 30-year bond is going to be a 5% or 6% type interest rate. And that’s great, but for some long-duration guys, they still need to dig it along, they have a liability that they need to fund out with that type of bond today. They have to fund it today. So as the market is structured today, these short-duration ARMs are fine, when the Fed’s starts to tighten credit, all short assets are going to re-price. Yes. So and to be clear, I mean this is not something that I think is, I forgot how you characterize it. but it’s not something that I would sweep our interest that that’s becoming more and more consensus that everyone wants to rotate into shorter-duration assets and the problem that a lot of mortgage REIT have is everyone would like to have that big currently set ARM portfolio and the only problem is no one can afford it, because no one can make the economics work, which is – it’s suggestive, if I don’t want to say a bubble. But to your point, when the Fed moves these things, we’ll re-price and while I think that’s a long way away, it always bears watching, because we found out earlier this year. the market can change its expectation very, very quickly in a way that maybe very divorced from reality, but that doesn’t stop you from the margin calls when the market prices irrationally even if it’s only for a few months. But anyway, I appreciate the comments and I think most of my other ones have already been covered.

[Thomas B. Akin:]

All right, Mike. Thanks, man.

[Michael R. Widner:]

Thank you.

[Operator:]

Thank you. And as there are no questions at the present time, I’d like to turn the conference back over to Mr. Akin for closing remarks.

[Thomas B. Akin:]

Great, well, we want to thank all our shareholders for being on the call today and the questions. Again, we manage this company for the long-term and we appreciate that there are some short-term volatility characteristics during the portfolio. but we hope we’ve demonstrated over the last five years that our long-term commitment has been consistent and has created value for our shareholders and we look forward to seeing everybody in the fourth quarter call. Thank you very much.

[Operator:]

Thank you. The conference is now concluded. Thank you for attending today’s presentation. you may now disconnect. Have a nice day.