Start Time: 08:15
End Time: 08:53
CYS Investments, Inc. (CYS)
Company Conference Presentation
September 10, 2013, 08:15 AM ET
Kevin E. Grant - President and CEO
Mark DeVries - Barclays Capital Inc.
Mark DeVries - Barclays Capital Inc.
Okay. Good morning. Next up we have CYS. We're very pleased to have Kevin Grant up here with us. We also have Rick Cleary upfront. For those of you who aren't familiar, CYS is an agency mortgage REIT. A little background on Kevin. Kevin helped found the company. He is the CEO. And before founding this, he had a long career at Fidelity in their fixed income department.
So with that I'll hand it over to Kevin.
Kevin E. Grant
Thank you, Mark. Good morning, everybody. I hope everybody's doing well. Here our cautionary paragraph. I'll let you read it on your own. For those listening to the webcast or dialing in, we just filed an 8-K with this deck that we're using here in New York, so feel free to pull it down and follow along. I'll try to remember to give you the page numbers so we can kind of keep in sync.
But just remember that I'll make comments today that by nature are forward-looking and we can work out the draft of this meeting, conditions could change or our views of the market could change and we could change the strategy of the business, so bear that in mind.
So I think a lot of people here are probably very familiar with this story. We're an agency only mortgage REIT. We invest in agency mortgage-backed securities. We've had a heavy focus over the years on 15-year mortgages. That really is a sweet spot for us. I founded the company, it's based just outside of Boston.
One important distinction for our company is we're self managed, so we are an internally managed company and that has lots of important implications. The management team does not get paid for AUM. We get paid for performance. So that means when it comes to capital allocation decisions, we have really a lot more choices in how we choose to allocate capital.
It also has implications for our expense ratio. Over the years I've always said that in a lower rate environment or lower spread environment when the returns are lower on this business, the market really should distinguish between companies that are efficiently run and companies, particularly external guys, with a flat management fee. So we're run highly efficiently and that makes the business very scalable.
On capital allocation, on any given day we look at the choices available to us in the marketplace. We can buy assets. We can obviously hold or trade the assets that we've got. We can buy back stock. On dividend declaration days we can decide how much of cash dividends to distribute to our shareholders within the guidelines of the REIT rules.
In the past six months or so, there have been periods of time where by far the cheapest fixed income asset, the cheapest bond, bond vehicle in the entire world frankly has been companies in the agency mortgage REIT space. So that tells us pretty loudly and clearly that that's a good place for us to allocate.
We don't tell the market when we're in the market buying back our stock. It would really disadvantage our existing shareholders and the people that are sticking around for us, but you'll certainly see it in the Q.
On the dividends, this is further onto the discussion of capital allocations. Last night we declared $0.34. We maintain the dividend from the prior quarter. The earnings power in this spread environment is very, very good. The question is how much of that earnings power do we choose to distribute. And we've got a lot of flexibility this year and certainly going into next year to retain capital.
From a corporate finance mathematical perspective, anybody that would sit down and do the math, we'd say, well, you could distribute a penny at NAV of cash dividend or you could take a penny and reallocate that and just deploy it in stock buyback or what have you. So on a go-forward basis, one of the things that we do every fall is we review what we think the dividend ought to be in the coming several quarters.
So as we go into earnings season here in October, you should expect on the earnings call in October for us to give you some good visibility on what the Board's view is on retention of earnings. Keep in mind that over the years, we've had the practice of basically paying out all the earnings of the business.
This past quarter, Q2, we retained several cents and we've messaged that as part of the earnings call in July. Going forward given the volatility of the market, it's certainly possible that the Board will choose to retain more. But keep in mind that the earnings power is there, it stays in the NAV, it's just a question of what the distribution is.
All right, let's turn to the investing environment. As we all know the bond market has backed up a lot and there are a lot of implications for this – we're calling it a normalization of the yield curve. What we have here is a graph of spreads for the 15-year market. There's two graphs here.
One is the gray line which is really just the invest long borrow short kind of line. That's really not what we do. We try to hedge as best we can. The blue line is the hedged net interest spread and how that's moved. And you can see on this 15-year trade with a swap as a hedge that we're back to basically the tail end of kind of the worst of the crisis. So spreads are actually very, very wide right now.
And then the question is at what leverage do you want to run to take advantage of this spread environment. In the longer term, we're actually quite bullish on mortgages. Here in the short run, they get traded around and there are a lot of – I'm not even going to call them investors but there are people that are using agency mortgage-backed pass-throughs as interest rate trading vehicles. And these are folks that really – it's not their normal space.
The advantage for them or the attraction is that the mortgage is a very easy to trade. It's a forward market, it's much like a derivatives market, it's actually easier and simpler to trade than a futures like a treasury futures, so you can come into the mortgage market and you can just go out and short $1 billion of whatever it is that you want to short as a plan, the 10-year, whether that ultimately works out for you or not is a different question.
And I think a lot of people are discovering that when they short mortgages out in the forward market, it's actually very, very expensive short. But nevertheless, we've got these folks playing around in our market right now. They won't be forever but in the past six months they've certainly made their presence known.
The 30-year market has cheapened; it's actually gone through two steps of cheapening this year. In the spring, it cheapened really just on a spread basis. So it cheapened versus anything else in the mortgage market. And then in the late spring and throughout the summer, the yield curve has actually steepened quite a bit more and this has taken out – taken the 30-year market to even cheaper levels.
The 30-year market right now is very, very cheap, but having said that the hedging costs are higher and we'll talk about this in a little more detail in a minute. Because the yield curve is so steep when you put on a long-dated hedge, number one it's very expensive on just a carry basis but also if you think about the yield curve and the roll down affect, so if you put on a seven-year hedge, bullet hedge, in a year it's a six year. So when it's a six year, it's further down on the yield curve. It's a lower yield, so rates may actually go up but that hedge, because of the roll down affect, may actually go against you.
So the 30-year market no question about it has cheapened a lot in this two-step fashion but the hedging costs for the 30-year market which is really the problematic aspect of the 30-year market has really changed a little bit the ROE equation for 30 years. Obviously 30-year investments are much more volatile than the 15-year security and we take that into account as we make these decisions.
A couple of more comments on the yield curve. On the left clip here and for those on the webcast, this is Page 6. We've got a simple kind of two spots on the yield curve, the five-year swap rate versus one month LIBOR as just an indicator. And I would just observe that the short end of the yield curve kind of five years in has not really re-priced for a meaningful change in Fed policy.
And keep in mind that the Fed's forward rate guidance has not changed. So in 2015 they've said and they haven't changed this guidance but that's the soonest that they would start actually tightening rates. But time marches on. Middle 2015 is getting closer and closer and closer. At some point the belly of the curve, the five-year part of the curve is going to have to start to reflect basically the approaching mid 2015 absent a change in Fed guidance.
The middle clip just gives you the spread in very simple terms of 30-year mortgage securities versus 15-year, and you can see the big cheapening in February, March and you can also see that that cheapening hasn't really reversed. So all the cheapening since then has all been yield curve driven.
Now one last comment on this page, hedging costs I mentioned a minute ago. Over the past couple of years we've started to use caps and we like caps. They're long-dated put options on basically the steepness of the curve, and they're really, really effective. And you love to put them on when the yield curve's flat and implied volatility is low.
Well, implied volatility is still low but the yield curve is not flat. So when you put on a seven-year cap and you're buying all these long-dated options, that's great but caps roll down the yield curve too and the forward curve is at least as steep as the spot curve. So caps, though we really like them, in this environment that roll down affect is just very, very powerful. So right now it's not our preferred hedging vehicle. We have some. We like them. They worked beautifully as best as anything could have worked in the past couple of months. But right now it's not our preferred hedging vehicle.
Let's move to the Fed. No discussion of a mortgage REIT particularly in agency mortgage REIT would be complete without a discussion of the Fed. And there is a lot going on right now. This, on Page 7, is the Fed's publicly available forecast as of last June. They'll put out a fresh one next week. This is very important to watch. I've highlighted and circled a couple of things here and I would just observe that there certainly is economic growth.
There's virtually no inflation pressure whatsoever just given the lack of or the slack in the labor markets. But the economy has really underperformed the Fed projection, and this has been consistent over actually many, many years. So as the Fed's forecast comes down, if that plays out in the next couple of months, it would not be surprising for these forecasts to come down and the Fed's preferred tool at this point is forward rate guidance. So forward rate guidance is going to be the key for Fed watchers going forward.
On Page 8 here, we've got another piece of the Fed forecast that they've put out quarterly. On the left lower plot, this actually comes from the Fed's release. So they do a poll amongst the voters within the Fed and the Board of Governors and so forth. And they basically poll them and say, okay, when would you see the Fed tightening rates and to what level? And you can see on the lower left plot, 2015 I've drawn a circle around just kind of eyeballing kind of where the average is. And I think this is what the market is roughly got priced in.
Keep in mind below my little circle there, there are only – get my glasses – there are four or five dots and that I'll return to in a minute. If you look at the shape of the yield curve over the last 50 years, at times just before the Fed starts tightening, the spread between Fed funds and the 10-year treasury generally gets to the high 300s, maybe around 400 basis points. This is a market pricing in a Fed tightening cycle. It has hardly ever gotten much above 400 basis points.
So the market has already priced in a 4% 10-year two years forward. So if you look at forward rates today, you'll see and if you look at a 10-year two years forward, you will see 4%. And this is a pretty dramatic re-pricing that we've seen in the fall. So then the question we all have to ask is this right? Is the Fed's forecasting track record right or is the economy going to be slower than that? Are there going to be far fewer inflationary pressures than what's build into the market already?
On the right plot here, we've just drawn in a straight line. It seems like this is what the market is concerned about. And what we have to do as a company and the Board of Directors thinks about all the time is what do we do for capital allocation, how do we do asset allocation if this is a scenario that's actually going to unfold? This is a business that is an interest rate risk business. It's as simple as that and our job is to pick the best spots within our playground to find assets to drive returns given the environment that we're in. I don't know that this is going to play out but this is a scenario that we're looking at all the time.
Let's not spend a lot of time on the taper because we're all bombarded with taper talk and tapering the taper and so forth, but let's just look at the consequences that the volatility has imposed on homeowners. So the right plot and once again for people listening, we're on Page 9. The right plot is the primary mortgage rate. So this is a rate that homeowners see if they want to refinance or buy, and this is a conforming mortgage rate. It's pushing 5%.
So from the low at, call it 340 something like that, three and three-eights. The backup has actually been pretty significant. Now there are lags in the effects of the this and the obvious one is you apply for a mortgage, you lock in a rate, you don't close for 60 to 90 days. That's an obvious lag. Once you get the new home then there's a certain amount of spend the consumers do and that kind of jazzes the economy.
Over the past 30 years since I've been doing this, one thing has worked basically like clockwork. Rates drop. People refi their house. The next thing they do within two or three months is they buy or lease a new car. Notice that auto sales are really up. It's basically in phase with this thesis. They continue to basically do the nesting spending, if you will. And then it's over.
So we're quickly coming to that chapter in this cycle of it's over and the real question for all of us is has there been enough stimulus from all of this to spillover to the rest of the economy. And personally I'm very skeptical.
I mentioned this a few minutes ago but the Fed guidance really has not changed. Next week my hope is the Fed provides some clarity on how they're viewing taper and my view also is that I really think they're kind of in this spot where they have to do something which is within the brackets of what the market expects.
Some advocate that they should go to zero right away. I think it'd be way to shocking that would clearly shock the market. There's some merits to the idea but I think as a practical reality, it just doesn't work. And if they do nothing, if they remain silent on this, then the market's just going to freak out and wonder when the next guidance is going to come. So I kind of think they've painted themselves into another corner and they basically have to announce something.
But once again the key is forward rate guidance and next week I'll be looking to any change in the forward rate guidance and also that will scatter plot that they've put out within their forecast for any indications of how this might change.
All right, the staffing of the Fed and the committee. The Chairman of the Fed, this is the most important job for business that there is. The Chairman of the Fed is in charge of an organization that creates money in all its form and creates the pricing mechanisms for that money in all its form. And how that committee and how that Chairman behaves and messages is really the single most important driver of volatility in obviously the REITs market but ultimately how the economy can achieve its growth potential.
We've done a lot of turnover that's already in the cards. We'll talk about Summers versus Yellen in a second but we've got a bunch of people that have already announced retirements and just changing jobs. We've got – it could be five people. Our feeling for whatever its worth is that if somebody other than Janet Yellen is appointed then Professor Yellen is a very professional person and she's probably stick around for a while but I would guess that she'll retire and the Vice Chairman role is another presidential appointee. So there's a lot of uncertainty here and this of course is weighing on the markets.
So I'll spend just one minute talking about what a Larry Summers Fed might look like. I have no insight on whether Professor Summers can get through the Senatorial process or not. There is a very important philosophical interpretive difference between these two people as it relates to employment. And I think this comes down to this notion of hysteresis which is a fancy word but its precedent in Europe where people basically, they become detached, they become unemployed for a long period of time. Government assistance basically puts them in a camp where they really don't want to work because they've got a decent acceptable life and this just goes on and on and through time they become untrained and eventually un-trainable and it just creates this chronic ongoing problem with unemployment.
These two folks have different views and they have different views on what a normalized rate environment might look like. If the economy's better, our take is that Janet Yellen would look for reasons to delay tightening so long as inflation's not present. If inflation's present, there are no doubts [ph]. But so long as inflation is not present, our take is that Janet Yellen would be looking for reasons to delay. She's a big supporter of quantitative easing. She thinks it's worked, she thinks it's been powerful. Would she use it again, I guess if she felt that she really needed to. We're not in the emergency time, so my guess is she probably would not want to use it or implement something new now.
Larry Summers on the other hand sees low interest rate as actually a problem and obviously these views have merit as well. But on hysteresis and structural unemployment he really – my take is that what he sees is very little that the Fed can do about that. So his view is you need to get the market back to a normal curve and then the markets will decide basically what to do with all these folks. This is a big difference and I don't think we'll see any meaningful policy differences in the near term depending on which path this might take.
But longer term as the economy evolves and the committee needs to make decisions and react to how the economy actually grows or doesn't grow, the policy differences could actually be quite significant. I think under Larry Summers' leadership there's a lot more uncertainty in the rates market and therefore a lot more volatility and we need to take that into account.
So what does the approval process look like? I don't know whether you've seen this kind of markup in the past but the way this process works is the President makes a nomination. The nomination is reviewed by the Senate and then there's a hearing. It's the banking committee. There's 22 members on the banking committee. It's democrat majority. There are a few prominent democrats that it's pretty clear that they would be against and really haven't made vocal public statements to that affect, but it's pretty clear.
There are hearings and the way these nomination processes have been working is that after the hearings then there are written questions and the candidate then responds in writing to those written questions, which actually adds a lot of delay and you've noticed that a lot of folks have not gotten through the appointment process. Remember Mel Watt, the nominee for the FHFA. That was, what was that? April that that got going. There's just radio silence on Mel Watt.
The Fed Chairman is a much more important position. It's unlikely that we see those kinds of delays but nevertheless this is what the process looks like. So once all that comes back, then the full Senate takes a vote. And notice that there is no vote in the committee and there is no – I would describe it as accountability from this committee. They basically can throw their rocks and ask their questions and really not answer to the public on how they voted until the full Senate vote happens which actually gives them all political cover to basically play nice at least in the public eye.
This is a long complex process and given the indecisiveness in Washington right now, I think we're going to be living with this decision process for a lot longer than we would all like. Prior to kind of this recent Larry Summers surfacing, our expectation was that the President would make the nomination right after the FOMC meeting next week, but I'm not convinced that that's right. Our take on this is we actually have no idea. We think this can go one of many ways and it potentially could be somebody else.
Central banks around the world, there's been turnover there as well, but central banks around the world are important because they provide liquidity to the market just like the Fed does and of course capital is fungible, it flows around the world in a nanosecond, so it's very important. We've been watching Japan for a long time. The Kuroda Fed under [indiscernible] has been highly accommodative.
Are actually very excited that Tokyo got the Olympics because what that means is there will be a very substantial capital build out over the next six years in Japan and the spend that they're going to do will be enormous in a way that only the Japanese could do it. And boy, I'd love to go to the Olympics in 2020 in Tokyo. But that should be highly stimulative to the Japanese economy. So the central banks around the world have slowly kind of one by one moved to much more double stance [ph], so there continues to be plenty of liquidity around the world and the question mark is the U.S.
Okay, let's switch topics a little bit and talk about GSE reform. There are two bills that are floating around in Washington, actually I correct myself. One's actually a bill, Corker Warner Bill is actually a bill that's gone to the Senate and it's in the markup process now. The [indiscernible] bill also known as PATH on the congressional side is not actually a bill but it's a draft document that is also in markup. The PATH bill to us appears like it really doesn't have support. It's probably not going to go anywhere. It really requires way too much private capital. Beyond the amount of private capital, it's actually available unless mortgage rates are 12% which nobody would like.
There are a few ideas in the PATH bill that may get adopted like Corker Warner and that would be great. There's a few amendments that have been surfaced. It would be good for the mortgage REIT business making more assets eligible which is good. So if Corker Warner actually gets some retraction, what does that do? It would wind down Fannie and Freddie over the next five years, but what it would do is make the existing securities explicit full faith and credit of the U.S. treasury. So under Basel III, they would have improved capital requirements and they basically would become GNMAs.
Right now GNMAs are a little bit on the low side. They trade about a point higher than Fannie Mae and Freddie Mac. Historically GNMAs have been as much as 3 points higher in price than Fannie's and Freddie's. This is very important. This is something that the market just has not really connected the dots on, and I think the reason for that is just kind of too far out. It's probably an event for next year, but that's very, very important.
The Corker Warner Bill would create a new GSE. I'm calling it a GSE. They're not calling it a GSE. It's really an insurance company, but it creates this thing called the Federal Mortgage Insurance Corporation. It would provide insurance. It would not be run by normal corporate executives that are paid for performance. It would be run by a government technocrat but it would create a couple of kinds of securities; one would be government guaranteed securities which presumably would be eligible for us and presumably the Fed would take as collateral for their open market operations and therefore they'd be eligible in the repo market. That's a key question that's still open in my mind.
There'd be no portfolio business. Congress is pretty much tired of a government hedge fund kind of structure. The President has come out and supported most of the ideas in this. He hasn't named the bill. I don't think he wants to identify his support with individuals, but he's come up in support of all the principal ideas in the bill and it's bipartisan. So my expectation and maybe it's way too optimistic is this will get discussed and debated in the fall, probably go nowhere within the Senate in the fall but probably next year will make some headway and get marked up.
The good news for us is I think we'll get to see how the different congressmen and senators actually respond to the different provisions within Corker Warner, and we'll just see how it goes. But I think 2014 there's a real shot that we have some GSE reform. For us this is all pretty good, this is a market that we can play in, there's going to be plenty of securities for us to participate in.
Just a quick few thoughts on the economy. I would say that – it's a little schizophrenic because a Larry Summers Fed is very different than a Janet Yellen Fed and the discussions within both the committee and the staff at the Fed would be very different depending on the leadership within the Fed. Under a Larry Summers Fed I think for those of you that follow the Taylor rule, I think you've got Taylor rule mayhem within the Fed. So remember the Taylor rule is an equation that economists like to use to guide them to where they've set Fed fund and it's driven by inflation, the target inflation rate, unemployment and this thing called NAIRU. So NAIRU is the non-accelerating inflation rate of unemployment which most economists and the Fed right now think is 5%.
Now if you change NAIRU to 4%, you get a widely different answer and if you believe in structural unemployment, you would be inclined to change NAIRU quite a bit lower. And if you did that, you would see a target Fed funds rate of about negative 100 basis points right now. This is a camp that I believe that somebody like Janet Yellen is in and Larry Summers sounds like he should be in because of his structural unemployment, but he hasn't appeared to make the connection. So when he gets to discussions within the Fed and the Fed staff, I think it's going to be quite an interesting intellectual debate.
So enough on that. On the mortgage market, one thing you may or may not be aware of is the mortgage market is shrinking. It has been shrinking and this tells me that tapering asset purchases on the part of the Fed is not really our bigger problem because the mortgage market is shrinking anyway. It's shrinking for the all the reasons that we know. Home prices, they've been stronger recently but they've fallen over the past 10 years. So the need for credit is lower, the availability of credit is lower.
The Mortgage Bankers Association think that their forecast of 2014 origination is 1.1 trillion, that's gross origination and they're estimating the 2013 origination is about 1.9 trillion. So the origination pipeline for next year is coming way down and you see that in lot of the mortgage originators layoff that we've seen recently.
I'm not going to spend a lot of time on forward purchase economics. I think a lot of people in the room have seen this. I'm happy to handle it, the detail in the one-on-ones. What we've got here though is a screenshot of the 15-year market. This is a couple of days old but you can see we're basically a power market these days. So the market has changed quite dramatically in the past six months.
This has actually become kind of stale but this is a quarter end portfolio break down and you can tell from my comments earlier that the 15-year market is a preferable market for us, 30 years are cheap but the hedging costs have gone way up. And then the rest are just some tabular form. This is in the deck if you want to go through the tabular form.
Prepayments, I'll just make one comment on prepayment and then we'll have it over to questions. We got the prepayment numbers late Friday night, early yesterday. Prepayments not surprisingly are down again. The refi spigot has been turned off. I think refi volumes are down, call it 75% something like that. And origination volumes are pretty soft as well or purchase volumes. So not surprisingly prepayments have come way down and this is good news for us.
And then we've broke out in the rest of the deck some of the summary financial information but we can go over that in one-on-ones. So with that, Mark, I'm happy to turn it over to questions.
Mark DeVries - Barclays Capital Inc.
Yes, thanks. First question, you showed the chart where you showed market's expectations for the 10-year looked like heading towards 4 by the end of 2014. But it sounds like you're a little skeptical on growth and maybe that trajectory. Could you talk about your expectations for rates and kind of how that's impacting how you're hedging your book?
Kevin E. Grant
Yes. We have no magic in rate forecast. We haven't got a crystal ball. We just manage to an environmental – set of environmental conditions. And this is a forecast that's impounded in the market, but we think going into latter half of this year and next year the volatility is going to be up because there's a lot of uncertainty around this. I think we would all like the Fed to be more normal and to be more neutral. The question is how long does it take? What's that path look like? How much volatility does that create in the marketplace?
So when volatility is up – one thing that I think people are a little confused about with hedging is if you take an asset that's a long-dated fixed income asset with no credit risk and you hedge out all the interest rate risks, there is no return. There's just a T-bill return. So you still have all the other risks in that security levered up, the liquidity or prepayments or whatever it is. So this is just a reality of the situation. So if you had a perfect foresight and you knew rates were going to go up and you knew they were going to go up rapidly, what would you do? Would you put on a bigger hedge? Probably not. You'd probably just take down leverage.
Our view is in this environment if volatility is up and if uncertainty is up and we know we're not at a normalized yield curve today, we don't know how long it's going to take to get there. If it takes a long time, the returns are very good in that process, I mean very good because spreads are so wide. How do you position the company to get through that normalization process? And our answer is you just run it lower leverage and have less volatility in the assets.
One last comment because I've longwinded [ph] on this. At the end of last quarter we were the lowest levered in this space with one exception which is hard to figure out what the leverage really was. And I think we'll probably continue to be that way. I'm not sure because I don't know the other companies' policies, but I think that's probably how we'll end the quarter.
Mark DeVries - Barclays Capital Inc.
Thanks. So it looks like at least on a hedge adjusted spread basis, 15 years looking more compelling than 30 years. Can you just talk about one, what kind of levered returns you're seeing in both and kind of how's that impacting how you may be allocation your prepayments as they come in?
Kevin E. Grant
Yes. I think the 15-year trade, if you will, with the, let's say, seven times leverage, it gets you to a low teens sort of 12%, 13% return. You can certainly run at lower leverage. One nifty thing about the backup and rates is the return on that piece that's unlevered is higher because just the rate that you're getting on that piece, it's 150 basis points higher. So you can actually run it at lower leverage and have the same return without even thinking about what price has done [ph]. The ROE on the 30 years are in the mid teens but in this environment it's just too volatile to have a lot of those. Got another one or you're good.
Mark DeVries - Barclays Capital Inc.
Kevin E. Grant
Okay. Well, thank you everybody. We've got some one-on-ones and happy to take any other questions you might have. Thanks very much.
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