Dynex Capital, Inc. (DX) Q1 2012 Earnings Report, Transcript and Summary

Good morning, and welcome to the Dynex Capital Incorporated First Quarter 2012 Earnings Conference call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Ms. Alison Griffin, Vice President Investor Relations. Please go ahead.

Thank you. Thanks everyone for joining Dynex Capital’s First Quarter 2012 Earnings Conference call. The press release associated with today’s call was issued yesterday and filed with the SEC today, May 3, 2012. Your may view the press release on the company’s website at www.dynexcapital.com under Investor Relations and on the SEC’s website at www.sec.gov. Before we begin, we would like to remind you that this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words believe, expect, forecast, anticipate, estimate, project, plan, and similar expressions identify forward-looking statements that are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. The company’s actual results and timing of certain events could differ considerably from those projected in or contemplated by the forward-looking statements as a result of unforeseen external factors or risks. For additional information on these factors or risks, we refer you to our Annual Report on Form 10-K for the period ended December 31, 2011, as filed with the SEC. The document may be found on our website at www.dynexcapital.com under Investor Relations and on the SEC’s website at www.sec.gov. This call is being broadcast live over the internet with a streaming slide presentation and can be found through a webcast link on the Investor Relations page of our website under IR Highlights. The slide presentation may also be referenced by clicking on the First Quarter 2012 Earnings Conference Call link on the IR Highlights page of our website. Now I would like to turn the call over to Chairman and CEO, Thomas Akin.

Thanks, Alison. With me today is Byron Boston, President and Chief Investment Officer; and Steve Benedetti, our COO and CFO. It’s a busy day. There is a lot going on. I want to thank all of you for attending the conference call this morning. As you’re aware, we’ve released numbers last night. We released diluted earnings of $0.33 per share. Our book value increased from $9.20 to $9.62, and our net interest spread for the quarter was 241 basis points, which is basically similar to our overall net average spread of 245 for all of 2011. Our annualized return on equity for the quarter was 14.7%. We target right in that range, in that 15% range and that’s right within our tolerances. Overall leverage last quarter was about 5.4 which is a little low versus our target leverage of 6. As everyone is well aware in February of this year, we raised approximately $122.5 million in a secondary offering and all of that capital was not fully deployed for the entire quarter. As we stand right now, we are fully invested and we’re back up to our target leverage. Constant prepayment rate was about 15.4%, but Byron is going to go into more detail on that. The bottom line as we continue to execute on our core investment strategy and that is our short duration, high quality investments utilizing modest leverage. We believe that’s going to produce a stable return with lower volatility over the long term. Our current investment opportunity is diversified. There are significant opportunities remaining in the CMBS sector and we continue to focus on that and the Agency sector as well. We believe our track record has been consistent of delivering total rate of return at 12.2% since 2008. On the next slide, we’ve got our summary of results, which is what I’ve just gone over in general. Then I’d like to turn the conference call over to Byron Boston to discuss in detail the investment portfolio. Byron?

Good morning. Thank you for joining us. Let’s first go to Slide 6. And even though some of you may be familiar with Dynex, let me just simply summarize our overall investment approach. We have a diversified portfolio that includes fixed and floating rate assets, Agency and Non-Agency securities backed by residential and commercial loans. Our portfolio is constructed to perform well despite volatile markets given our high quality, short duration assets. Our diversified approach produced solids results in the first quarter, as our CMBS portfolio increased in value even as rates increased during the quarter. Our overall book value per common share increased by almost 5% and we generated a 14.7% return on adjusted equity for the quarter. We have confidence in our risk profile as we have steadily generated double-digit returns without extending far out of the risk spectrum. Selective opportunities continue to exist to reinvest capital, particularly in CMBS. And our RMBS/CMBS capital allocation model has allowed us to find pockets of value. Let’s move to Slide 7. As I go through the slide, I’ll ask myself several questions and I’ll attempt to answer them to give you a clear picture of our performance in the first quarter. As we look at the Dynex portfolio, what has changed since December 2011? Our Agency portfolio has increased, that’s been very typical assets in large capital raises here at Dynex Capital. It allows us to get our capital deployed faster and take a more selective approach towards the Non-Agency and Agency CMBS sector. There was a minor 1% change in our overall CMBS/RMBS mix. We continue to minimize extension risk. So if you look at our charts, and you look at the chart to the right, you will see that and if you add the number, 79% of our portfolio were either resets or matures within 7 years. If you look at the lower left hand chart, you’ll see that 67% of our book of business happens to be backed by residential assets, 33% by CMBS assets, that’s a slight 1% change since December 2011. And if you look at the upper left hand chart, you will take note that the majority of our assets continues to be in Agency sector, both Agency CMBS and Agency RMBS paper was approximately 17% of our book being in Non-Agency securities. Have you tried to diversify further into Non-Agency RMBS? The answer is yes, but the opportunity to find high quality, Non-Agency RMBS paper is limited. And I’ll give you an example. There is one deal that came to the market. We attempted to buy $20 million, we ultimately were allocated $2 million. So we’ve made our attempts in the high grade Non-Agency sector, but the opportunities have been limited. We have -- what is changed in terms of our overall duration picture? I mentioned a second ago, we’ve continued to minimize extension risks, however we have found more attractive opportunities in the 7.1 and 10.1 sector versus the 5.1 and seasoned 5.1 sectors that we have built our portfolio between 2008 and let’s say 2010. If we move to Slide 8, and let’s continue to look at the portfolio, has our credit quality changed since 2011? The answer is no. We continue to focus on high quality assets. Let me draw your attention first to the top chart on the right. You’ll note that this chart you’ve seen before. We continue to emphasize CMBS what we call CMBS 2.0 and 3.0, most of our investments have all been originated since December of 2009. Our prior 2000 category happens to be assets that Dynex has originated, and the 2000 to 2005 category are assets that we originally financed through the government TALF program. We have avoided the 2006 and 2008 period because we consider that to be most -- the worst underrated and structured bonds in the history of the CMBS market. If you notice the lower credit quality -- the lower chart on the lower left, our credit quality 91% AAA, 4% AA, 4% A. And then if you look to the upper left hand corner, we have been willing to take prepayment risks in our portfolio. Our prepayment opinions have not changed. We have not adjusted our strategy. We continue to structure our portfolio or mitigate prepayment risk. And as you can see the 76% of the premium exposure on our balance sheet has explicit prepayment protection. That comes from the CMBS securities which are all structured with either some form of legal lockout or yield maintenance that will compensate us for any type of premature prepayment activity. 5% of our portfolio is represented by post/near reset paper. The prepayment experience on that book of business has been excellent with average prepayments fees of 10% or lower. And then the remainder 19% of our book of business from a premium perspective has been protected or covered by our selected security strategy which I’ll go into detail in the next slide. If you flip to Slide 9, you’ll see what type of strategies specific characteristics we continue to emphasize. We’ve used these charts before. We continue to seek out pools that have low third-party originated loans. Dynex portfolio has a 37.9% of our portfolio is exposed to what we call TPO originated loans. Of course it’s over -- versus 50% to 60% for the universe of ARMs as a whole. And let me clarify something, you’ve heard a low balance loan stories in the marketplace, you’ve heard of state specific stories in the marketplace. In the Hybrid ARMs sector, for the most part, there are no specified pools, originations do not segment low balance loans. They won’t segment state specified pools. The majority of the Hybrid ARM pools are what I would call mixed pools combine a variety of different loans. We take the time and look pool by pool in a very micro manner to minimize those characteristics that are associated with that to prepayment fees. Our favorite again, no third-party originated loans, interest-only loans and emphasizing on non-owner occupied properties. If you go to Slide 10. Let me ask, have we changed our focus on multifamily securities? And the answer is no. Dynex has been heavily involved in the multifamily sector for 20 years. If you’ll note on the slide to the right, 67% of our CMBS portfolio is backed by the multifamily loans, 33% backed by other sectors. Our overall credit quality 81% by AAA, 12% A, most of the 12% of that A bucket has come through the Freddie Mac K program. Again these are loans -- these are securities that have come through a very disciplined process, disciplined agency process. It is the only non-consistent programmatic Non-Agency program in the marketplace. Although multifamily sector has very strong fundamentals, we are more alert today in our due diligence of this sector. We were one of the early investors in this sector. We’ve been involved now in building this portfolio since 2009. However, the majority of the marketplace is now taking notice of the multifamily sector, cap rates have dropped considerably and we are aware that this is type of environment where bad credit and investment decisions can be made. Hence our surveillance in due diligence has increased. We continue -- nonetheless, we continue to find value in the multifamily sector. Let’s move to the next slide. What are the performance facts and what story do they tell? First to the left, the upper left hand chart. Our prepayments results have been excellent. Why do I consider them as excellent? Our average coupon versus many others in the industry is higher and yet our average prepayments fees across the portfolio has actually been lower than many others. What have we done to make a difference? I mentioned a second ago, we selectively pick our pools that go into our portfolio. However, we emphasize diversity. We methodically structure our portfolio not to be exposed or only expose to anyone sector or as we consider any one type of borrower. And as a result, our average fees have been lower and declining over the last 12 months. We do expect fees to increase as most of the originators continue to try to ramp-up their HARP program, nonetheless and our prepayment assumptions for our portfolio are conservative and higher than our actual experience. Nonetheless, we continue to believe that we will not see a 2003 type experience in terms of prepayments fees. We believe they will trend up, but we do not believe that they will be uncontrollable and we believe our portfolio has been constructed to minimize our overall experience. Let’s move to the chart to the right, ROE and Book Value. What do these facts tell you? We have continued to generate solid mid-teens ROE without taking on extensive risk. Our overall leverage for the balance sheet has been below 6% for this quarter. Our overall target is in or around plus or minus a small amount around 6%. As you can see, we generated 14.7% ROE. Our book value increased from $9.20 to $9.62. If we move down to the bottom and consider our net spread. Why did our net spread decrease from 2.56% to 2.41%. It’s a function of math. As in other -- in past capital raises, we emphasized putting the capital to work in the Agency sector, spreads were lower in the Agency sector than the Non-Agency sector and as a result our average net interest spreads decreased. Again back to once you consider the ROE, overall ROE of the portfolio, again a function of math with the lower average leverage for the quarter in a net spread of 2.41%. If you move that leverage number up to 6% and then you take the net spreads, you’ll start to see what I consider the beauty of our strategy to what our ultimate ROE targets will be in the future. Let’s move to the next slide. Are there opportunities to invest capital today? The answer is yes. Spreads have tightened throughout the quarter. Best way to look at this period between 2008 and 2012 is that we’ve experienced excessively high spreads in prior years. Spreads are moving to a more normalized level. ROEs continue to be at the double-digits in most -- in almost all respects, those double-digit ROEs are lower than where they may have been in the past. However our diversified approach affords us a greater opportunity of finding higher ROE investments. We obviously diversify through the residential sector and we diversify and seek out opportunities throughout the CMBS sector. We continue CMBS spreads at the end of -- at the beginning of this quarter widen slightly allowing us even more opportunities to find solid investments in that sector. Let’s move to Slide 13, extension risk. Why do we worry about extension risk when the Fed is on hold? As far as we are concerned at Dynex Capital, extension risk is a very real risk and we at DX have chosen to minimize this risk by emphasizing short duration assets. If you look at the bottom chart, we simply try to give you examples of how much a security might extend. 30-year securities, that’s some point in a higher rate environment could easily extend between 7 to 10 years. 15-years securities can easily extend 3 years, for short duration Hybrid ARMs, we expect minimal extension. Our analysis is based on history. Our analysis is based on our own experience. And as such, we have chosen to minimize the overall extension risk in our portfolio. If we move to Slide 14, now let me structure to a repurchase agreements and your interest rate swap hedges. If you’ll take a note to the bottom of the graph to the left, we have structured our repo book with various maturities across 90 days. Some portion of our book, with the largest portion of our book maturing within zero to 30 days. One of the -- I am sorry, 31 to 60 days. One of the challenges that we have is with our hedge accounting, in many respect, it forces us into structure our repo book with maturities between zero and 30 days or maturing within 30 day. We have debated and considered the idea of should we make some changes to the overall hedge accounting election, we have not made any decisions around that. We continue to look to see, if we put our shareholders in a better risk position, if we make that type of decision, but as we stand today, we continue to elect hedge accounting for our book of business and as such our hedges -- our repo book construction over 90 day period. Throughout the quarter, we continued to add to our swap book. Since quarter end we continue to add to our swap book. We could expect to see our swap percentages slightly increase, as we move to mitigate the overall duration risk in our 5 to 7 year part of our overall portfolio. And if we move to Slide 16, let me simply summarize. Our portfolio has performed well since 2008 and the earnings power today remains relatively intact. Prepayment risk is mitigated by superior portfolio construction and as I mentioned earlier, we believe our prepayment experience to-date given our high average coupon is been excellent and exceeds the industry. We do expect prepayments fees increase as originators continue to focus on HARP 2.0. Our credit risk is mitigated by continued focus on highly-rated securities, superior loan origination years and concentration in multifamily sector. I mentioned in our part multiple times, extension risk is mitigated by the short-duration investment portfolio with 79% of our investments maturing or resetting within 7 years and there continues to be attractive investment opportunities. We’re happy with our first quarter and many respects you can simply say that we’ve continued to do what we’ve always done. And as we look forward to the future, we look forward with great anticipation of continuing to deliver solid double-digit returns. With that I am going to turn it back over to Tom.

Thanks, Byron. And then the final slide is basically the Dynex value proposition, Slide 16. And just the 4 points I’d like to make quickly and that is that we do have high insider ownership which we think aligns the interest of the shareholders with the management of Dynex. Our portfolio strategy has been consistent for the last 4 years. It will continue to be that consistent. As long as we can find securities that offer low volatility and high returns, we feel that it’s a value-added proposition for our shareholders. And finally, we’re committed to the diversified investment strategy. We feel like if we’re going to go into fight, I’d rather fight with 2 arms than just one, so we like the fact that we can use Agencies and Non-Agencies. And then finally, we think the last 3 years that we’ve delivered success has shown our commitment to our strategy and to our shareholders. And with that, I’d like to open up the call to questions.

Thank you. We will now begin the question and answer session. [Operator Instructions] At this time, we will pause momentarily to assemble our roster. Our first question is from Douglas Harter with Credit Suisse.

Byron, I was hoping you could talk a little bit about the various IO investments that you guys made during the quarter?

Sure. One of the -- we have found a lot of value in the CMBS IO over the last, let’s call it, say year and half or so. At the beginning of the quarter, let’s call the last 6 months of last year was somewhat of a dream in the sense that spread widened considerably in CMBS and we were able to put a lot of money to work. As we entered January of 2012, spreads continued to remain wide and we continued to take advantage and emphasize this sector. For those of you who are not familiar with CMBS IO, I want to emphasize that CMBS IO is different than residential IO. These are credit IO securities. We are not exposed to voluntary prepayments that you see on the residential side of the business. We are exposed to involuntary prepayments, meaning that we are exposed to default risk. Why have these securities remained cheap? When the CMBS sector -- when a dealer brings a deal or Freddie Mac K deal which is where we’ve accumulated most of our IO exposed which are to the multifamily sector, most accounts that are demanding the most senior bond in those structures are demanding par bonds. And as a result, there is a cheap to deliver par bonds, dealers have to structure what I would reconsider to be and many in the industry a cheap IO, all right. We have taken advantage of this. We have been heavily involved for sometime on both the Agency and Non-Agency IO sector. So we’ve continued to -- it’s a very strong part of our business, Doug. Both, Ginnie Mae, Fannie Mae, Freddie Mac and Non-Agency IO with the majority of that being backed by multifamily loans.

So just to clarify, is this a new investments that you’ve made this quarter, did you sort of break out the IO separately this quarter?

No, we’ve continued throughout this quarter to invest in the CMBS IO sector.

Doug, in prior quarters, it just would have been sort of buried into the CMBS line.

Perfect.

So it has just been broken out this quarter.

Yes, and so I’ll just add. It’s been, again, we started building to CMBS portfolio in December of 2009. And I would probably argue that we’re one of the longest, most consistent, purchasers of the CMBS IO over the last 2 years. And the reason I say that is just the amount of competition that we found in some of the new deals at certain times. Needless to say spreads have tightened since January and we do find ourselves competing with others for these assets, but they continue to offer attractive returns.

[Operator Instructions] And our next question comes from David Walrod with Ladenburg.

You mentioned that the allocation of the Agency space was a little higher this quarter relative to the fourth quarter, then you also talked about some of the difficulties you had placing in the Non-Agency space. Can we expect that to trend back to more historic levels of where was it in the fourth quarter as you are able to find those opportunities?

David, I’m going to recap again, since June 30 of last year. In June 30 of last year, Non-Agency CD spreads, CMBS spreads widened materially. So from June 30 to December 31, probably 99% of our -- 99.5% of the marginal dollar from Dynex went to the CMBS sector. Starting in January, there has been a large response rate throughout the world with all the risk assets. The CMBS sector however actually lagged a little slower than some of our asset classes in January. And we continued to invest in CMBS. What happens when we do a capital raise is, one, we try to pre-invest capital prior to a raise, but it is far more efficient to focus on putting agencies on your balance sheet and taking our time to subsequently bring the CMBS sector onto the balance sheet. It has worked excellent over the last 2 years. We continue to follow that path. If you look back, you will see that in December 2010 to March 2011, you will see that it’s all the time we actually put 100% of our new capital from the capital raise into Agencies. And then we get an opportunity later to diversify into the CMBS sector. In this situation, we still have opportunities throughout the quarter to add money to the CMBS sector. We continue to have that opportunity today. So we love the diversity it brings between the resi product and the CMBS product and we continue to emphasize that. But I wouldn’t describe it as having difficulty finding the assets. It’s just that there are more people today in April of 2012 than what we found competition in October of 2011. But we still find the opportunity to put money to work.

And David, the other thing is remember that a lot of this asset we’re purchasing is very niche and you don’t see large amounts of it come out all at once. So it just takes time and the Agency securities or a placeholder until that paper is out.

Understood. And then a housekeeping question probably for Steve. Your comp line has run historically for the last 2 years, and the first 3 quarters are kind of consistent and then the fourth quarter, it pops up kind of a catch up for the year. This quarter, the first quarter was pretty close to where the fourth quarter was. Should we assume that’s new run rate for comp going forward or is there something unique in this quarter?

David, this quarter had your typical sort of first quarter Social Security, 401(k) kind of type contribution stuff that bumped up that line by about a $160,000 this quarter. So you won’t see that on a repetitive basis going forward.

Okay.

But otherwise our run rate would be -- which you should expect for our run rate.

This concludes our question and answer session. I would like to turn the conference back over to Mr. Thomas Akin for any closing remarks.

Well, I want to thank everyone for joining the call. Obviously today I think everybody in the mortgage REIT space had earnings last night. And I appreciate the calls, and callers and questions that we got. We look forward to speaking with everyone next quarter. Thank you much.

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