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Edited Transcript of DX earnings conference call or presentation 31-Oct-19 3:00pm GMT

Q3 2019 Dynex Capital Inc Earnings Call

Glen Allen Nov 9, 2019 (Thomson StreetEvents) -- Edited Transcript of Dynex Capital Inc earnings conference call or presentation Thursday, October 31, 2019 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Alison G. Griffin

Dynex Capital, Inc. - VP of IR

* Byron L. Boston

Dynex Capital, Inc. - President, CEO, Co-CIO & Director

* Smriti Laxman Popenoe

Dynex Capital, Inc. - Executive VP & Co-CIO

* Stephen J. Benedetti

Dynex Capital, Inc. - Executive VP, CFO, COO & Secretary

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Conference Call Participants

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* Bose Thomas George

Keefe, Bruyette, & Woods, Inc., Research Division - MD

* Christopher Whitbread Patrick Nolan

Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research

* Douglas Michael Harter

Crédit Suisse AG, Research Division - Director

* Jason Stewart;JonesTrading Institutional Services, LLC;Senior Vice President, Research Analyst

* Matthew Philip Howlett

Nomura Securities Co. Ltd., Research Division - Research Analyst

* Trevor John Cranston

JMP Securities LLC, Research Division - Director and Senior Research Analyst

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Presentation

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Operator [1]

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Ladies and gentlemen, my name is Simon, and I will be your conference operator today. At this time, I would like to welcome everyone to the Dynex Capital Third Quarter 2019 Earnings Conference Call. (Operator Instructions) Ms. Alison Griffin, Vice President of Investor Relations, you may begin your conference.

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Alison G. Griffin, Dynex Capital, Inc. - VP of IR [2]

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Thank you, Simon. Good morning, everyone, and thank you for joining us. With me on the call today is Byron Boston, President and CEO; Smriti Popenoe, Executive Vice President and CIO; and Steve Benedetti, Executive Vice President, CFO and COO. The press release associated with today's call was issued and filed with the SEC this morning, October 31, 2019. 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, 2018, 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.

Additionally, I would like to mention that we will be attending the JMP Securities Financial Services conference in New York on November 14, and we are available for meeting. I now have the pleasure of turning the call over to our CEO, Byron Boston.

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Byron L. Boston, Dynex Capital, Inc. - President, CEO, Co-CIO & Director [3]

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Thank you, Alison. Good morning and thank you for joining our call this morning. I'm going to start with a quick message for our shareholders, and then I'm going to turn it over to Alison, Steve and Smriti to give you details regarding our results.

At Dynex Capital, we continue to manage our company for the long term. Our long-term goal centers around delivering cash dividends to our shareholders through 1 of 2 products: either our common stock; or our preferred stock. Our common stock offers higher yield, but is subject to more book value volatility, whereas our preferred stock offers lower yield with a more stable price profile. In generating dividends for our shareholders, we continue to remain committed to a disciplined, top-down macroeconomic approach to risk management and investment decisions. Over the long term, we believe this approach will succeed in creating shareholder value, and as such, we as the management team and Board, continue to invest in the shares of Dynex.

Several years ago, we identified a more complicated global environment, and we reacted by increasing the liquidity of our assets -- the credit quality of our assets and the overall amount of liquidity on our balance sheet. We continue to favor this strategy today. 2019 has presented a few unique challenges and opportunities. The sudden, unusual inversion of the yield curve, led by the long end of the curve, has been the largest challenge of the year. Nonetheless, we have made multiple tactical decisions to manage through this period. We continue to believe this is a short-term situation as we continue to believe that the Federal Reserve will need to further reduce short-term interest rates, ultimately creating an environment where our financing costs are lower.

Our disciplined approach has resulted in solid quarterly results, which Steve will elaborate on in just a few minutes. One of our decisions this quarter was to take advantage of the mispricing of our common stock by investing in our own shares. We believe the relative value of our shares was compelling compared to investment alternatives given the continued uncertainty in the macroeconomic environment. We fully expect to continue to grow our company over time in a very disciplined manner. But when our stock is grossly mispriced relative to our disclosed risk profile, we will act to benefit our long-term shareholders.

I'll turn it back over to Alison, and she's going to lead us through a few questions so we can give you more specific details. Alison?

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Alison G. Griffin, Dynex Capital, Inc. - VP of IR [4]

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Thank you, Byron. I'd like to open with asking Steve to walk us through the third quarter results, please.

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Stephen J. Benedetti, Dynex Capital, Inc. - Executive VP, CFO, COO & Secretary [5]

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Thanks, Alison. Our results for the quarter on a GAAP and non-GAAP basis are summarized on Slide 5. In my comments, I'm going to focus mainly on core net operating income and book value per share. Results were strong for the quarter. Core net operating income increased $1 million to $11.6 million, and core EPS increased $0.05 to $0.48 per share. There were several drivers of the increase, including multiple tactical decisions we made during the quarter. First, we had an increase in net payments received on our interest rate swaps due to hedge repositioning despite a much lower weighted average notional amount of hedges outstanding during the quarter and lower 3-month LIBOR; second, we bought back 1.7 million shares of stock; third, we managed our G&A expenses; and fourth, we experienced a reduction in our repo borrowing costs by 20 basis points during the quarter.

Also during the quarter, we continued to adjust our portfolio mix, shifting towards Agency CMBS investments, which combined with CMBS IO, now totals approximately half of the investment portfolio, up from 40% last quarter, continuing the trend of portfolio diversification and reduction of our prepayment risk profile. In addition, we adjusted our hedge book during the quarter, resulting in a decline of 50 basis points on our weighted average pay rate to 183 basis points for the third quarter, while lowering our average hedge ratio as a percentage of repo and to-be-announced securities to 60% from 90% last quarter.

At September 30, our overall pay rate is 1.65% versus 2.04% at June 30, on our interest rate swap portfolio. Our adjusted net interest spread increased to 114 basis points versus 103 basis points last quarter. This reverses a trend of declining net interest spread since the fourth quarter of 2017 as we benefited from several important factors, as previously noted, including our capital reallocation decisions to less prepay sensitive CMBS, a reduction in short-term rates and the aforementioned adjustments to our hedge portfolio. From a book value per common share standpoint, the increase of 2.2% to $18.07 was due in part to the benefit of our buyback of 1.7 million shares at an aggregate discount of 18% to book value and in part to adjustments made to change our duration profile through hedge adjustments as bond yields fell during the quarter.

Total economic return to common shareholders for the quarter was a positive 4.9% and is a positive 8.6% for the year. Through 9/30, we have paid $1.56 in dividends per common share.

Looking at our balance sheet, we've reduced our leverage at 9/30 to 9.1x from 9.4x, including our long TBA dollar roll positions and have kept leverage so far lower this -- in the fourth quarter. Repo expenses have declined and continue to decline as the FOMC reduces the targeted Federal fund rate -- funds rate, notwithstanding some of the issues we have seen in the repo markets. Smriti will comment on these issues a little later in the call. That concludes my comments, and I'll turn the call back over to Alison.

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Alison G. Griffin, Dynex Capital, Inc. - VP of IR [6]

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Thank you, Steve. Now turning to Smriti. Smriti, please describe in a little more detail what our current macroeconomic thesis is.

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [7]

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Alison, as we've said before, complexity remains the key theme in the investing environment. Our discipline and our top-down approach have both been invaluable in navigating the markets this year. As we come into the final calendar quarter, multiple factors that we track are shifting in priority and focus. Here's how we're thinking about the near term: first, we believe that recent actions by the Fed to increase liquidity will eventually be highly supportive of the repo market for agency securities, but this could take time. We're approaching the market ready for near-term funding disruptions. Second, in spite of Mr. Powell's comments yesterday, it is not yet clear if we are at the beginning of a longer easing cycle or just ending a mid-cycle adjustment. Either way, whether it's from eases or liquidity from the Fed's balance sheet, the Fed's actions to date will likely improve our financing costs versus today and serve as a tailwind to net interest margin. Finally, in the second quarter, we shifted our thinking to a more probable range of 1.5% to 2.5% for the yield on 10-year treasuries. That's down from 2% to 3% late last year. We continue to see this as the most likely outcome in the near term with a greater chance of staying in the lower part of that range.

Now in the long term, we believe that without major structural changes, we will have slower global growth and inflation in the future than we have had in the last 20 years. This is being driven by aging global demographics and increasing global debt. We also think factors such as human conflict, government policy and climate change will play a greater role in influencing the performance of the global economy. This adds to the complex nature of the environment. And given this type of backdrop, we think earning income from high-quality U.S. real estate assets is an attractive value proposition for Dynex' shareholders. And in total, we believe the mix of these factors are ultimately supportive for Dynex' business model and the mortgage REIT industry in general.

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Alison G. Griffin, Dynex Capital, Inc. - VP of IR [8]

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Given that view, how are we positioned from an investment and risk standpoint?

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [9]

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So first, we have had an up in credit and up in liquidity investment theme for a while now and that remains our focus. In the long run, being up in liquidity and credit gives us the nimbleness and flexibility to change direction, especially if we start to see some disruptive conditions in the markets, and particularly in credit-sensitive asset, so we have the flexibility to change our portfolio composition. Our second portfolio theme is diversification, and that helps us perform in a variety of scenarios. I mentioned the 1.5% to 2.5% range. We want a portfolio that will be resilient through the extremes as well as in the middle of that range. So as you can see on Slide 7, our CMBS, RMBS allocation shifted close to 50-50 over the quarter. We like this mix at the moment, and we feel it gives us a lot of flexibility to manage through this range. I'd like to highlight some information on Slides 8 and 9.

On Slide 8, I just want to point out the size of the unamortized premium on the Agency RMBS portfolio currently sitting at about 2.3%. And that just says the premium over par is 2.3 points. It reflects the timing of some of these investments. And then secondly, on Page 9, want to point out that the overwhelming majority of our unamortized premium is sitting in assets with explicit call protection. And we have prepayment compensation in the form of yield maintenance or similar payments in that part of the portfolio in the CMBS side.

I'll now turn over to hedging. As Steve mentioned, we made some adjustments to our hedge position late in the quarter as the market was pricing in over 100 basis points of ease over the next 18 months. We locked in those rates with plain vanilla interest rate swaps, with a weighted average pay rate now at 1.65% covering 80% of our repo financing versus 61 -- 67% as of the end of last quarter. So these actions, they were deliberate and they were designed to stabilize net interest margin, while still allowing for improvement from actual Fed eases as well as any reduction in the repo rate as well.

So at this point, if the Fed eases or the repo rate begins to improve, these will be further tailwinds to net interest margin. In terms of book value, you can see the impact of our hedging activity on that on Page 10. The sensitivity to both parallel and nonparallel interest rate shocks has declined quarter-over-quarter. For this quarter, we included a new column portfolio duration versus base case, simply showing how our asset portfolio duration changes across scenarios and highlighting the value of diversification within the portfolio.

We've talked about being dynamic in terms of managing the portfolio, Alison. We made significant changes to the book last quarter, we've been active coming into this quarter, and we're going to continue to be active in managing the position.

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Alison G. Griffin, Dynex Capital, Inc. - VP of IR [10]

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There has been a lot of focus on the repo market recently. How did that impact Dynex? And what's the trend going forward?

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [11]

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Yes. The repo market still continues to suffer from a broken transmission mechanism between the Fed and the final users of repo market liquidity, investors like us and other cash providers. And the reason this is happening: number one, is because of bank regulation; the second is because the Fed's quantitative tightening running off of their balance sheet, which they've now stopped; and then the third issue is the issuance of U.S. treasury debt across the maturity spectrum, but particularly in bills. So these 3 in combination, really, have conspired to create the problem that we're in today. Specifically for Dynex, we did not have much exposure to quarter-end repo pressures. Less than 10% of the portfolio's 1-month repo was rolling during that period. We are planning to have very little exposure to the year-end turn because we still believe there are some unresolved issues in the repo market that will need to be worked through before the repo rates really come down more substantially. I will make the point that while repo rates have not declined recently in line with Fed eases, we do believe the issues will eventually be worked out and that will translate to lower repo rates versus where we are today, even if no more Fed eases happen.

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Alison G. Griffin, Dynex Capital, Inc. - VP of IR [12]

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Thank you. What about marginal returns on capital? What do you see today?

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [13]

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We are seeing low teens core ROE, 10% to 11% returns in the longer DUS paper at about 10x to 12x leverage and mid-teens core ROE for pass-throughs at 10x leverage. Mortgage spreads are wider this year. In fact, nominal spreads are as wide as we've seen since mid- to late 2016. So we think this represents a pretty good entry point, but it's not yet clear how they will perform in the second half of this quarter. We're coming up on year-end. You could see some supply/demand imbalances and that might provide a better entry point. I will say this, we're entering this quarter with lower leverage and higher liquidity than where we ended the third quarter, so we expect to be fairly opportunistic in re-adding assets when we see good returns.

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Alison G. Griffin, Dynex Capital, Inc. - VP of IR [14]

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Thanks, Smriti. Turning back to Byron now. Can you tell us what all of this means for Dynex and our shareholders?

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Byron L. Boston, Dynex Capital, Inc. - President, CEO, Co-CIO & Director [15]

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All right, Alison. Let me sum it up like this. Our portfolio has been constructed in a disciplined manner with a long-term macroeconomic view in mind. Obviously, we are very in tune to near-term developments. We believe the structure of the portfolio allows us to be more flexible and nimble, which is important to navigate this environment. You can see that our NIM improved over the last quarter and the adjustments we have made as well as the potential for repo rates to improve should provide support to this trend. We're making active tactical decisions managing this portfolio. We're managing this balance sheet on both sides, both the asset and liability side of the balance sheet. Book value is going to be impacted by several factors: Demand for spread product as well as the level of interest rates across the yield curve. We continue to believe there are strong supportable overall trends in place for Dynex Capital and mortgage REITs in general. There continues to be a growing global demand for high-income stocks. We expect opportunities to evolve for Dynex to create value to our shareholders by being an active participant in these markets. We remain focused on generating long-term value for our shareholders, and we appreciate your engagement. So let's open up the lines for questions, Alison. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) And your first question comes from the line of Doug Harter with Crédit Suisse.

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Douglas Michael Harter, Crédit Suisse AG, Research Division - Director [2]

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I just wanted to get into a little bit more about the swap repositioning that you undertook this quarter. I guess, it seems like those were clearly favorable to, kind of, the current-period earnings and also your ability to, kind of, still benefit from the Fed actions. I guess, can you just talk about, kind of, what were the trade-offs on the other side of that? Or is it just, kind of, a positive all-around repositioning?

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Byron L. Boston, Dynex Capital, Inc. - President, CEO, Co-CIO & Director [3]

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Let me first say, Doug, that we started repositioning this swap book earlier this year. And we have a macro view, we've always had. For multiple years, we said the Fed would do a round trip. We said they're going to try to do something, it's going to look just like the '90s. In fact, 2 or 3 -- maybe 2.5 years ago, when it first started, we put charts up in our quarterly report from 1994, '95. We said it's going to be a round trip just like that. So we started to reposition this book of business. In fact, a year ago, we started to say, the Fed is going -- our financing costs are going to come down compared to really near pause. So all we did really, we started to reposition the swap book to reflect that macro view that we expected rates to come down. And Smriti, I'll let you chime in if you want to talk about some of the more specific detail, but it all -- again, it's a disciplined approach. We have a macro view. We express it in both our hedges and in our assets. Smriti?

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [4]

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Right. I think there's 2 pieces of it, Doug. One is, I don't think without a macro view, you could really make this work in your favor as -- in terms of getting the timing right and everything else. So part of it is simply us feeling like 100 basis points of ease that the market had priced in was fair compensation to lock in those financing rates, and that really was a big driver of the decision. And that's been -- so far, it's been the right call. I will say that all of our repositioning -- and this is why I keep saying it call after call is that, we're going to be dynamic. We're not married to any specific position for any particular time. So things will change.

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Byron L. Boston, Dynex Capital, Inc. - President, CEO, Co-CIO & Director [5]

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And then let me answer that in a little piece. So we talked about a round trip. Well, we've done a round trip. Here we are. We're back below 2% on the 10-year, but short rates are falling, what next? The entire global markets are stuck trying to understand and figure out what's next. The thing you want to know about Dynex is that we are nimble. We have shifted to this more liquid position, so we'd have more options to be able to adjust as more information becomes available to us. We still believe that over the long term, with this amount of global debt, anytime the central banks either try to exit with their balance sheets or raise interest rates, it will create problems that will create a slower economic environment and force rates back down. But where do we go from here right now? I think the entire global markets are locked in a bit of a tug-of-war between multiple factors.

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [6]

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And I think one of the key things we felt was that it wasn't clear that we were at the end of the easing cycle -- at the end of the mid-cycle adjustment or continuing the easing, which is why we've kept the optionality on 20% of the book at the moment to benefit from that.

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Operator [7]

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Your next question comes from the line of Trevor Cranston with JMP Securities.

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [8]

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All right. A follow-up question on the swap repositioning. Can you say if the new swaps you put on this quarter continue to be LIBOR-based and if transitioning to different indexes like OIS or SOFR are things you guys have looked at and think would have any benefits to hedging your book?

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [9]

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Yes. So the swaps we have on currently are LIBOR-based swaps where we pay fixed and receive 3-month LIBOR. That's been relatively advantageous given that LIBOR has taken some time to come down relative to the pay fix position. So most of our swaps at the moment are actually positive carry. We actually generate swap income from the pay fix position. So to that extent, those are beneficial. In terms of SOFR and OIS, we're very much engaged and active in trying to figure out whether either one of those indices makes sense for us. Out of the 2, I would say, probably OIS makes a bit more sense for an investor like Dynex. SOFR swaps, right now, we don't think have really developed to an extent where they'll make an effective hedge relative to our financing. One thing to understand about SOFR, it's a backward-looking index right now, and we're trying to hedge our financing in the future on a forward basis. So that's something that still needs to be worked out in that market. It's also an overnight rate with very little infrastructure in place for term financing-type hedging, and we have very little overnight funding exposure. So we haven't yet found that to be beneficial. And once the term market starts to develop, I think we'll start to really see some activity in that. So right now, we've looked at the SOFR, we don't think that's a great fit just yet. The OIS swaps there, we're sort of in the process of evaluating whether or not we can switch to that. But it is more correlated with our repo financing. So at some point, it might make sense for us to make the switch.

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [10]

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Got it. Okay. Then on the prepay side, on the Agency RMBS portfolio, can you comment on, kind of, where the latest speed print was versus where you averaged for the third quarter? And what your expectations are for where it's likely to come in over the course of the fourth quarter?

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [11]

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I can point you to Page 8 on the earnings deck. We have...

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [12]

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Okay. Actually, I couldn't find the earnings deck just so you guys are aware. So I can't see it right now.

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [13]

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Okay.

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Stephen J. Benedetti, Dynex Capital, Inc. - Executive VP, CFO, COO & Secretary [14]

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The 3-month CPR, Trevor, was 3.6 -- 13.6% across the board. That's on Page 8, and we'll look into why we can't find it. And then we've got the coupon stack broken out. Smriti, I don't have October, but I don't know if you have it or not.

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [15]

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I don't have -- yes, we can follow-up with you, Trevor.

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Byron L. Boston, Dynex Capital, Inc. - President, CEO, Co-CIO & Director [16]

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You were -- Trevor, you were specifically referring to the RMBS book, right?

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [17]

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Yes, exactly.

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Byron L. Boston, Dynex Capital, Inc. - President, CEO, Co-CIO & Director [18]

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Yes. So I'm going to plug something here since you brought this up. When you compare Dynex versus other REITs that have basically 100% agency portfolios or 90% agency RMBS portfolios, our 13% prepayment speed is on just half of our book of business. When you consider what the prepayment impact of the CMBS book, our net overall prepayment exposure for the entire balance sheet is actually effectively lower -- materially lower.

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [19]

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Yes. For our last quarter, Trevor, that was -- it's 9.4% versus 13.6%, if that's what you were asking.

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [20]

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Okay. Got you. And then, I guess, related to Byron's comments about the balance of the CMBS portfolio, was there any prepayment penalty income from the CMBS included in third quarter earnings?

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Stephen J. Benedetti, Dynex Capital, Inc. - Executive VP, CFO, COO & Secretary [21]

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Yes, Trevor. It was a little over $1.2 million, and that's actually fairly consistent over the last several quarters at least.

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [22]

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One other thing that's happening is as the prepayment speeds on the RMBS are increasing, the prepayment income from the penalties is actually mitigating a good portion of that. So you get yield loss on the RMBS side that's being compensated with yield maintenance on the CMBS side. So we're getting a good mix there.

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [23]

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Great. That makes sense. Okay. And then just a last question, since I haven't been able to look through the slide deck yet, can you guys just briefly comment on where your interest rate sensitivity from a book value perspective stood as of September 30?

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [24]

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Sure. Yes, I have that. That's on Page 10. And I'm not sure why the deck isn't downloadable, but we'll fix that. So as of September 30, okay, shareholders -- so exposure to an up 100 rate shock stood at minus 10%. Exposure to an up 50 rate shock stood at minus 4.7%. Exposure to a down 50 rate shock is a positive 2.3% and minus 100. We're actually sitting right at positive 1%. That entire block of sensitivities is down a good 3% to 7% from last quarter all across the board.

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Operator [25]

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Your next question comes from the line of Christopher Nolan with Ladenburg Thalmann.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [26]

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On Trevor's question on prepayments, just for myself. The commercial and mortgage back from the higher (inaudible) prepays because of higher prepayment penalties, is that the way to look at it.

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [27]

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You just cut out there for a second, Chris.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [28]

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Yes, do the CMBS benefit from higher prepays?

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [29]

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Do they benefit from higher prepays? Here's the way it works. So if you do get a prepayment on the CMBS, you are getting compensated for that prepayment because all of the yield you are going to get on that security just comes to you in one big lump upfront, which is fantastic. So what we -- while we don't exactly love having our higher-yielding assets pay off even though we get all the money upfront, that's a nice thing to have when you have the RMBS prepayments increasing at the same time. So it's just a nice balance. But in general, you're not getting hurt, you're actually receiving the full proper economic benefit as if you held that CMBS asset over a life when a prepayment on the CMBS occurs.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [30]

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(inaudible) I'm sorry. Please go ahead.

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Byron L. Boston, Dynex Capital, Inc. - President, CEO, Co-CIO & Director [31]

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One of the main designs of the portfolio is for that type of diversity. For one side of the book offsetting the other side in a high-prepayment environment and then the other part being one side of the book has negative convexity versus positive convexity on the other side of the book.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [32]

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Great. And then leverage. Should we -- how are you guys looking at leverage? Because your leverage ratios are at sort of at the low end of your normal range.

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [33]

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Yes. And then post quarter end, as we mentioned, we're coming into this quarter with even lower leverage and higher liquidity. And we're comfortable with that at the moment, Chris. I think we want to be really ready for any type of disruption coming into the end of the fourth quarter here. We feel like we've stabilized the net-net interest margin with the activities, the actions that we put in place last quarter. And now we're going to -- we're really going to see when it's going to be time to reinvest some of this capital that's come back that we have on the balance sheet right now.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - EVP of Equity Research [34]

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Great. And finally, I need to applaud you guys for the capital management. I thought the buyback that we did was really well done. So congrats on that.

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Byron L. Boston, Dynex Capital, Inc. - President, CEO, Co-CIO & Director [35]

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Thank you, Chris.

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [36]

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Thank you.

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Operator [37]

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Your next question comes from the line of Jason Stewart with Jones Trading.

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Jason Stewart;JonesTrading Institutional Services, LLC;Senior Vice President, Research Analyst, [38]

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One more on prepayment activity. It's at a very high level, you could comment on the interplay between mortgage capacity that you're seeing out there today and how that's going to impact the prepayment cycle? Maybe longer term, any impact on specified pools, whether we're going to see a longer lead time till those are impacted? Just any high-level comments on how you see the interplay between those 2 factors going forward would be helpful.

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [39]

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Right. Yes, Jason. So completely think this is a very apropos topic at the moment. There's a number of things that are going on. Capacity is definitely an issue at the moment with mortgage rates where they are, you're starting to see mortgage pipelines get relatively full. So what that actually does is it lengthens the prepayment cycle, but it doesn't mean that it stops it, right? So that's one issue. So that just means things that would take 2 to 3 months to process, now it's taking 4 to 5 months or 5 to 6 months. Having said that, we're coming into the period of time now where there's slower seasonals. So less people are moving, less people -- there's the holidays, so you will see some slowdown in prepayments. We actually, in our modeling, we don't tend to give ourselves credit for those things, but that is actually an observable phenomenon in terms of lower seasonals. The bigger factor right now that we're seeing in terms of something that's offsetting the impact of the lower capacity is appraisal waivers. So people -- the GSEs have now put in this policy where they're waiving appraisals in order to get through the time line much faster. Those things are all contributing to, sort of, offset potentially any type of slowdown, I would say, from capacity. So there's a number of different factors, and at this point, in our assessment, it's really kind of a wash with maybe seasonals helping to slow speeds down a little bit. In terms of specified pools, we think the specified pools at this point, in terms of prepayment performance, have performed well relative to their TBA counterparts. I think the pay-ups on specified pools maybe ran ahead a little bit of the intrinsic value a few months ago and that's, sort of, going to come down to earth here in a couple of months. But -- so the value is there in the cash flow. The -- whether -- what people end up paying for it, has really moved around a fair amount, but the cash flow value is unquestionable.

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Jason Stewart;JonesTrading Institutional Services, LLC;Senior Vice President, Research Analyst, [40]

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That's very helpful. And then just generically, given the leverage, how long would you be willing to sit at, say lower -- the lower end of the range to wait for a better opportunity? If you thought seasonals would produce greater supply and a weaker technical or spread outlook in the, say, the middle of next year, how long are you willing to sit at the lower leverage levels to take advantage of that?

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [41]

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Yes. I think the -- there's 2 factors that are going to drive that: one is, how quickly repo rates start to come back down towards reflecting the actual Fed eases that have occurred. At this point, I'm very comfortable staying at this level, at least for another quarter or 2, before we feel like we have to get anything done. So we've positioned ourselves right now with the stuff that we did in the third quarter really to stabilize the margin. And then waiting for a good opportunity to put money to work.

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Operator [42]

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Your next question comes from the line of Matthew Howlett with Nomura.

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Matthew Philip Howlett, Nomura Securities Co. Ltd., Research Division - Research Analyst [43]

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Congratulations on some great results. Last quarter, you talked about the margin, the trend was sort of moving back, at some point maybe to Q3 '18 type levels. Just curious with the hedging and the change in the environment, how you see the outlook today versus those comments last quarter?

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [44]

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So Matt, I'll take the first part, and then I'll have Steve tackle the second part. At this point, again, it's really about -- the repo rate is driving a good portion, it's really the tail that's wagging the dog. So -- and at the moment, with the adjustments that we've made in the quarter, we feel very good about the trend in the margin, just to give you an idea of sort of where repo rates are now versus -- let's even the adjusted cost of funds that we reported at the end of last quarter, we had it at 2.47%. I think our marginal repo rate at this point is around 2.10% that we're locking in for the next month, 2 months, 3 months. So there's an improvement in that rate, and that's really the tail that's wagging the dog here. So I hope that gives you some idea of just the trend there.

And Steve, if you want to add?

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Stephen J. Benedetti, Dynex Capital, Inc. - Executive VP, CFO, COO & Secretary [45]

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I'll did just add. I think the third quarter of last year was 141 on an adjusted net spread basis. We had [114] that reflects a 20 basis point decline in repo rates, the Fed's ease now 3x. So that suggests there's, if the repo markets settle down, there's plenty more room to -- for the net interest spread to increase. And then particularly back to the prepay question, when halve your book is prepay protected, even if rates go down from here, you've got the potential for spreads to widen here, even if prepay speeds pick up a little bit on the RMBS book. So there's a lot of, I think, a lot of momentum if repo markets settle down here over the balance of the year for that spread to widen.

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Matthew Philip Howlett, Nomura Securities Co. Ltd., Research Division - Research Analyst [46]

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And on that note, I mean, capital management, you bought back a lot of stock. I want to -- clearly, you got this -- the core numbers above this dividend rate that you have, obviously, biased. It looks like it's to the upside. You've talked about being -- obviously, managing capital. What do you think in terms of next year? I mean, do you think you'll just continue to buy back stock? Would you look to raise the dividend at some point to get more aggressive when you want to reenter into the market? Just sell more dust that have appreciated. Just curious, were you just, sort of, waiting to the end of the year? Just curious is there some type of cadence on how you see this playing out? Because obviously, you've been buying back stock here.

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Stephen J. Benedetti, Dynex Capital, Inc. - Executive VP, CFO, COO & Secretary [47]

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So here's an interesting one, Matt. This was a unique opportunity, and we really feel our stock was mispriced. We felt like there was -- the sentiment around prepayments on a macro level for the industry as a whole had gone too far. There were some capacity issues at originators. And we saw a lot of short-sellers come into the entire sector. And you hear some of these old guys who are used to, like, still thinking about SNLs in the 1980s, and they're just out of touch. So we felt our stock was very much so mispriced, especially given what we had told everyone during our second quarter when the adjustments that we have made -- and we've been very clear and consistent about our macro view. So we thought this was a major mispricing. And when we then assess the macro view of all the multiple global factors that are moving and at risk, along with the returns that were available to take that capital and invest in bonds versus investing our stock, it was a wonderful opportunity. So it is reflective of the unique opportunity that was presented to us. We feel, as we make -- took actions that support the long-term shareholders. Short-term shareholders, they're in or out or short sellers or whatever. But the long-term guys are here with us, and we do have a solid base of long-term shareholders. And we felt that, that was the right thing to do. And that's the principle in which we operate. We say we can have an opportunity to do something for our long-term shareholders because we're long-term thinkers in terms of running this business model, and we're always going to do it. But think of that as a principle.

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Matthew Philip Howlett, Nomura Securities Co. Ltd., Research Division - Research Analyst [48]

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Yes, I appreciate that. And following up, do you look -- I mean, you cut costs, you've got some dry powder, do you look -- you're still at a 10% discount to the book and even bigger to some of your core -- internally managed core peers. If you look at just say we're going to buy back more stock until we get to above book, do we want to raise the dividend and reward our shareholders that way?

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Byron L. Boston, Dynex Capital, Inc. - President, CEO, Co-CIO & Director [49]

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Over time, we believe we want to grow our company. We're not anxious to be one of the largest REITs in this sector, we don't believe that's the right thing for us. But we do believe that we want to, over the long term, grow our company. We do believe that there are shareholders who are involved with us because they do want cash income. But we're also trying to balance cash income versus stabilizing our book value and the overall success of the company and a total economic return perspective over the long term. So I don't know if there's really a black and white easy decision. Say, if this, then that, as much as we do have a principle, which we acted upon this quarter, where it was clear we could do something for our long-term shareholders by buying back that stock. And again, we -- again, think of us as always thinking over the long term. Even if we buy back more stock, we'll still be -- it will be a long-term decision, where we're ultimately -- our goal is to ultimately grow the company over time but in a more disciplined manner. Does that make sense?

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Matthew Philip Howlett, Nomura Securities Co. Ltd., Research Division - Research Analyst [50]

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Great. Made complete sense. I just want to commend you on the buybacks during the 3 quarters and also the expense reduction, it really looks that Dynex is really focused on ROE, and I really applaud you for that.

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Byron L. Boston, Dynex Capital, Inc. - President, CEO, Co-CIO & Director [51]

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Thanks, Matt.

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Operator [52]

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(Operator Instructions) Your next question comes from the line of Bose George with KBW.

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Bose Thomas George, Keefe, Bruyette, & Woods, Inc., Research Division - MD [53]

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Actually, can you just compare the returns on Agency CMBS versus Agency RMBS? And then just the leverage, how you -- the different leverage for the 2 groups?

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [54]

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Yes, I can do that, Bose. So on the agency CMBS, on a marginal basis, we think of that as something that we can run at 12x leverage. And the returns on those at this point are between, I would say, 10% to 12%. And the 10% are more like the standard vanilla 10%, 9.5s, and the 12% are more, sort of, the longer-dated 12%, 11.5%. The leverage on the pass-throughs, we run those between 9x and 10x depending on the risk environment. Those are, at this point, I would say, really, 14% to 15% core ROE, okay? And we look at a number of things, core ROE and obviously, total economic return, which is more contingent upon our spread view. And so if we expect things to widen, obviously, there's always a trade-off between buying now versus when things are wider or is it holding on until things are wider. So does that answer your question?

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Bose Thomas George, Keefe, Bruyette, & Woods, Inc., Research Division - MD [55]

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Yes. That does, yes. I was just curious, at this level, do you see this, Agency CMBS, could that increase or do you see, sort of, the value similarly in both those buckets?

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [56]

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At this -- we really like the 50-50 breakdown at this point. And because we're coming into the quarter with lower leverage and higher liquidity in general, it's -- that's just, sort of, the asset allocation mix we like. From here on out, I would say it's really a relative value issue. Like, if we believe that 30-year RMBS are cheaper and will offer us the higher total economic return over time, I mean, that mix could change. But at the moment, that mix feels pretty good here to run through the next few months.

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Bose Thomas George, Keefe, Bruyette, & Woods, Inc., Research Division - MD [57]

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Okay. And I guess just one -- let me ask one more just on the Fed. Just curious if you think the Fed will need to do more, like potentially add a permanent repo facility at some point?

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [58]

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Yes. I mean, in terms of the liquidity operations, you mean?

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Bose Thomas George, Keefe, Bruyette, & Woods, Inc., Research Division - MD [59]

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Yes, yes.

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Smriti Laxman Popenoe, Dynex Capital, Inc. - Executive VP & Co-CIO [60]

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Yes. I think at this point, they are really looking to the markets to try to find what the gap in the situation is. There's clearly a gap. I mean, these overnight repo operations are oversubscribed. So even though they're pumping a lot of money in, it's just not getting to the final user, the end user. So ultimately, that repo facility, or something of that nature, is going to have to be put in place. Those types of things take time. We haven't heard that they are working on it. I mean, we haven't heard that they aren't either. But those are the types of things that I think, ultimately, the Fed's going to have to consider in order to make these type of adjustments. You heard Chairman Powell yesterday basically say that changing the capital rules was out of the question. So something else has obviously got to come into the works in order to clear up this issue. And our repo -- outstanding repo facility would do that.

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Operator [61]

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Your next question comes from the line of Edgar Moro, who is a private investor.

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Unidentified Participant, [62]

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At the end of the last quarter, we kind of thought we'd go down near the end of the year. But since we've had such a good quarter now, do you think that we're on our way back up or are you still looking over to some downside?

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Byron L. Boston, Dynex Capital, Inc. - President, CEO, Co-CIO & Director [63]

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In terms of?

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Unidentified Participant, [64]

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Price of the stock.

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Byron L. Boston, Dynex Capital, Inc. - President, CEO, Co-CIO & Director [65]

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The price of the stock? You know what, when you look at the -- we don't -- well, first off, we don't give out projections in terms of direction of (inaudible) or price of the stock. But what we will say is, the reason we emphasize the long term is we believe this business, and this business model in general, is a cyclical business model. And often within Dynex, we use the seasons of the year as an analogy for the business model. And the reason we emphasize that we believe our financing costs are coming down, it's kind of, being a -- expressing a view, that we believe we're coming out of the winter months heading into the spring and summer months for the business model. So the Fed reducing our financing cost is a strong positive. We do believe that it'll be a positive for our net interest margin. And so we do believe that there is a positive -- a lot of positive factors for Dynex Capital and other mortgage REITs as we look into the future.

No more questions, right?

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Operator [66]

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No more questions at this time.

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Byron L. Boston, Dynex Capital, Inc. - President, CEO, Co-CIO & Director [67]

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All right. I'm going to turn it back over to Alison, and we'll clear up.

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Alison G. Griffin, Dynex Capital, Inc. - VP of IR [68]

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Thank you, everyone. I just wanted to let you know the presentation is on the website. It was available on the webcast, and it's now available under Quarterly Report. Let me know if you would like for me to send you a copy, happy to do so. Thank you, and we'll talk to you next quarter.

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Operator [69]

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Ladies and gentlemen, this concludes today's conference call. You may now disconnect.