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Executives

Kevin Grant – Chief Executive Officer

Frances Spark – Chief Financial Officer

Richard Cleary – Chief Operating Officer

William Sheehan – Managing Director of Investments

Analysts

Steve Delaney – JMP Securities

Mark Devries – Barclays

Douglas Harter – Credit Suisse

Stephen Laws – Deutsche Bank

Jim Young – West Family Investments

Vic Agarwal [ph] – Wells Fargo Securities

Arren Cyganovich – Evercore Partners

Cypress Sharpridge Investments, Inc. (CYS) Q2 2012 Earnings Call July 19, 2012 9:00 AM ET

Operator

Good morning and welcome to the CYS Investments, Inc. 2012 Second Quarter Earnings conference call. During management’s presentation, your line will be in a listen-only mode. At the conclusion of management’s remarks, there will be a question and answer session. I will provide you with the instructions to enter the Q&A queue after management’s comments.

Management has asked me to remind you that certain information presented and certain statements made during management’s presentation with respect to the future financial or business performance, strategies or expectations may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements indicate or are based on management’s beliefs, assumptions and expectations of CYS’ future performance, taking into account information currently in the Company’s possession. Beliefs, assumptions and expectations are subject to change, risk and uncertainty as a result of possible events or factors, not all of which are known to management or within its control. If management’s underlying beliefs, assumptions and expectations prove incorrect or change, then the Company’s performance and its business, financial condition, liquidity and results of operations may vary materially from those expressed, anticipated or contemplated in any of their forward-looking statements. In any event, actual results may differ. Management invites you to refer to the forward-looking statement disclaimer contained in the Company’s annual report on Form 10-K filed with the SEC which provides a description of some of the factors that could have a material impact on the Company’s performance and could cause actual results to differ from those that may be expressed in the forward-looking statements.

The Company has asked me to note that the content of this conference call contains time-sensitive information that is accurate only as of today, Thursday, July 19, 2012. The Company does not intend to and undertakes no duty to update the information to reflect future events or circumstances.

For opening remarks and introductions, I will now turn the call over to Rick Cleary, CYS’ Chief Operating Officer; and Mr. Cleary, you have the floor.

Richard Cleary

Thanks, Jeff. Good morning and welcome to CYS’ 2012 Second Quarter Earnings conference call. Today’s call is being recorded and access to the recording of today’s call will be available on the Company’s website at www.cysinv.com, commencing at 3 pm Eastern time this afternoon.

To better understand our results, it would be helpful to have the press release that we issued last night. The release includes information regarding non-GAAP financial measures, including reconciliation of those measures to GAAP measures, which will be discussed on this call.

I’d now like to turn the call over to our CEO, Kevin Grant.

Kevin Grant

Thanks Rick. Thanks Jeff, and good morning and welcome to our second quarter 2012 earnings conference call. As usual, joining Rick and me this morning is our CFO, Frances Spark, and Bill Sheehan from our investment team. We have a few opening comments, and I’ve also asked Bill Sheehan to spend a few minutes on the investing environment, given the historic low yield.

We are pleased to report solid results for the second quarter of 2012. The Company delivered another $0.50 dividend plus $0.38 of NAV appreciation. We have been well positioned to benefit in this environment, and we’ve benefited from some very good asset choices over the past several quarters.

Dollar prices are high in the MBS market, so getting the prepayment story right can really pay off. During the quarter, we were quite active, selling assets priced too high for their prepayment exposure and replacing them with assets with better prepayment protection. The consumer response to the low rates is here as measured by the refi index, and the prepayments will run through the system over the next few months. This activity generated about 61 million in realized capital gains for us, and we think the assets we sold were priced way too high relative to very attractive alternatives in the marketplace.

Keep in mind that the market tends to price mortgages for fast prepayments, so getting the prepayment story right can really pay off. We look at every single asset every day, so we have a very good idea where to look for the best assets and which assets are bid too high for the environment. Currently we are living a lesson in bond math. Prices are up, yields are down. In our case, this means that our NAV is up but our net spread, ROE and therefore dividend are expected to be a bit lower going forward. This is the math of the environment.

In last week’s offering, we indicated that we see the spread environment for new investments is in the 150 to 170 range. This compares to the 171 for us in Q2. We expect leverage on our balance sheet to remain about the same, so that means just doing the math that the ROE should contract by around 100 basis points. The equity raise will continue to help us with our expense ratio, and that will provide a little bit of an offset for this.

Our biggest competitor for assets is the Fed. They have nearly a $900 billion mortgage-backed securities portfolio that is comprised largely of high coupon, HARP-eligible bonds, and we assume that they will be reinvesting the P&I off that fast portfolio back into the mortgage market. As is their history, we believe they will target the 30-year current coupon which should be, believe it or not, a 2.5 or a 3% coupon over the next three months. This is not where we expect to invest, but the Fed’s bid will drive the whole market. This is going to create a lot of demand, so we really do not see a meaningful cheapening in the mortgage-backed market any time soon, or even the bond market more broadly any time soon.

On the offering we priced last week, as you know, we like to buy our target assets right away. We didn’t waste any time, and we have a very sharp pencil on the next few quarters’ dividend. In keeping with our history, we’ve already put all the proceeds to work. The yields were a little better than we expected on the call last week, so we feel pretty good about the execution.

Now I’d like Bill Sheehan to talk a little bit about today’s market environment and the opportunities. Bill?

William Sheehan

Thanks, Kevin, and good morning everyone. First off, a word on prepayments – homeowners are responding to this low interest rate environment, and refi applications are pretty strong. There is some friction in the closing process, but refis are definitely happening. We expect the spike to start in August, and we have moved the portfolio to dodge the fast month and fast-paying bonds.

We may be too conservative in our prepayment assumptions, but at today’s dollar prices it is better to be on the conservative side. The new mortgages homeowners are moving into should prepay very slowly going forward. We like this new vintage of mortgage securities and this is one of the motivators for the equity raise. We continue to like the 15-year mortgages for the stable cash flow characteristics and relatively easy hedging match. These are the bulk of the new purchases because there are few hybrid arms available, and the vintage hybrids have very low yields in the current environment.

Along with the historic low level of interest rates, hedging has become extraordinarily inexpensive. Most importantly, long-dated hedges are very cheap, as cheap as we’ve ever seen. For example, today you can strike a 10-year vanilla interest rate swap at around 160 and a 30-year at 235, I dare say while U.S. homeowners will never likely see a 1.6% fixed rate mortgage, though. This means some amount of 30-year mortgages makes sense to us, since the long-dated hedging costs are so low. Vanilla interest rate swaps are okay, but we prefer the long-dated caps as they are highly positively convex; in other words, we benefit from a hockey stick payoff in a rising rate environment. In a falling rate scenario, which is certainly possible, their market value doesn’t really fall as much since there is so much time value embedded in them. Thirty-year caps can now be struck at 2.35%, just in case you’re curious or tempted.

With that, I’d like to turn it back to Kevin.

Kevin Grant

Thanks, Bill, and now we’d just like to turn it over to questions. It will take a few minutes for the operator to establish a queue. Jeff?

Question and Answer Session

Operator

Yes, no problem. [Operator instructions]

Our first question of the day comes from Steve Delaney with JMP Securities. Please proceed, sir.

Steve Delaney – JMP Securities

Thank you. Good morning, Kevin and everyone. Kevin, I wanted to ask about the gain on sale revenue which you commented on as far as the rationale of overpriced securities, but that’s a larger amount on a per-share basis than we’ve seen with CYS in the past. And I guess I have—I’m wondering if it doesn’t present management and Board with some additional flexibility with respect to the dividend. So if you could just confirm – I mean, this obviously is taxable income for the current year, and in the past it seems the Board is focused on a combination of core plus the drop income, which this quarter was $0.51 and covered your dividend. But maybe if you could just comment on how you will view that $0.52 per share of additional taxable earnings, and if possible could you give us any idea of where on a year-to-date basis where taxable income stands relative to the $1 of dividends paid. Thanks.

Kevin Grant

Thanks for the question, Steve. You know, historically when we focused on core plus drop income, drop income is really an unrealized gain—

Steve Delaney – JMP Securities

Yes, and non-taxable.

Kevin Grant

--and it’s non-taxable, so when you realize it, it’s taxable. So in a lot of ways, this all kind of works out through time. So when we’ve realized these gains, effectively some of those unrealized gains that were coming from the drop income are now realized.

Steve Delaney – JMP Securities

Right.

Kevin Grant

So I think—and this is just me. It’s only the middle of the year, so it’s way too early to make any sort of forecast on this, but the way I’m kind of looking at it right now is I think we’ll probably be distributing the right amount all along the way here. But I think that dividend, at the end of the day, is probably—the way we’re doing it is probably going to be a good estimate for the way the year is going to come out.

But once again, it’s only July, so it’s way too early to make this prediction.

Steve Delaney – JMP Securities

Understood. But I mean, I guess the point you’re saying is that if you had $0.10 or $0.12 a quarter of drop income over a course of a year, and you have $0.50 of realized gains, that in effect those two just offset one another.

Kevin Grant

Exactly.

Steve Delaney – JMP Securities

Okay. All right, thanks very much. I’ll get back in the queue if there is something else that doesn’t get covered. Thank you, Kevin.

Kevin Grant

Thanks, Steve.

Operator

Our next question comes from Mark Devries with Barclays Capital. Please proceed.

Mark Devries – Barclays

Yeah, thanks. First, I just wanted to clarify one point, Kevin. I think you had indicated that the capital you deployed just recently came in slightly above what you expected. Is that you mean that range of 150 to 170 BPs of NAV spread?

Kevin Grant

Yeah, kind of above the average. Probably right in the middle of the range there.

Mark Devries – Barclays

Okay, got it. So is it right in saying that implies pretty close to mid-teens ROEs on that deployed—

Kevin Grant

I would haircut that a little bit, so maybe 100 basis points. There’s not enough visibility right now on the August and September prepayment numbers. We think we’re being conservative; maybe we’re being too conservative, but as we said, it’s better to be too conservative on that.

Mark Devries – Barclays

Okay. And I’d like to get your updated thoughts on the probability of a QEIII and how you’re positioning for that.

Kevin Grant

Well, I think within the Fed – and this is just my read of it – but there’s a lot of resistance to actually ballooning the balance sheet. Obviously there’s a lot of political blowback if they balloon the balance sheet, so I think—and also the diminishing returns. So maybe there will be some QEIII. Don’t know. I think the next data point for Chairman Bernanke is Jackson Hole, so we’re watching that very carefully to see what he comes up with. So I don’t think we’re far off the consensus on QEIII, but I am sensing there’s – and we all are – that there’s a lot of resistance to actually doing it.

Mark Devries – Barclays

Yeah. You know, let’s just assume they go forward and do QEIII. Our securitized products guys are thinking it could be 500 to 600 billion of buying, and with that much demand that while they would continue to target the 30-year, given the supply they’d be forced to buy some 15- and 20-year. Any thoughts on if they did, kind of what that would do to your prices and also your prepayment speeds?

Kevin Grant

Well, that’s a good question. It’s highly speculative. I don’t know – do you want to take a wild guess, Bill?

William Sheehan

Yeah, I think definitely it would just drive the asset prices higher – there’s no question. I mean, they are already the 900-pound gorilla in the room, so it would be—if they spread out to other markets, it’s going to be more of the same.

Mark Devries – Barclays

Are your coupons, do you think, low enough that you wouldn’t be too concerned about the kind of rally there triggering elevated prepayment risk on this?

Kevin Grant

Well, I think the coupons are low enough, but also it’s brand new production or very new production. You know, there’s a seasoning process; and the other thing I’ll just remind everybody that G-fees keep going up. It’s been a while since they’ve gone up, but mortgage insurance is going up, so the more the Fed pours gasoline on the fire, the more basically G-fees kind of soak that up. So do homeowners actually see one-for-one basis point advantage? No, they really don’t.

Mark Devries – Barclays

Got it. Thank you.

Operator

Our next question comes from the line of Douglas Harter with Credit Suisse. Please proceed.

Douglas Harter – Credit Suisse

Thanks. I was wondering first if you could just remind us how you calculate premium amortization. Is it on an as-incurred or do you use a lifetime expectation?

Kevin Grant

It’s as incurred, so it’s built into the yield.

Douglas Harter – Credit Suisse

And then can you just talk a little bit about some of the characteristics that you might have been in the pools that you sold that you didn’t like, versus kind of what you’re preferring today?

William Sheehan

The characteristics are simply we noticed the characteristics, the underlying four or five characteristics, whether they be geography or TPO – third party origination – or other things which develop problems. And once they develop problems, we punt them.

Kevin Grant

It’s probably vintage year is probably a big one.

William Sheehan

And vintage year is another one, yeah. So there are four or five that we look at on every given pool, and once they exhibit some bad tendencies, we’re not mean reverters – in other words, we don’t believe that they’ll necessarily go back to the mean of the group. We’re morel likely to say once a bad pool, always a bad pool, so we will get rid of it.

Douglas Harter – Credit Suisse

Got it. And then just on the capital deployment, are you expecting to add any additional swaps or caps, or do you feel like you’re fully hedged on that new capital deployment?

Kevin Grant

Well, you never feel like you’re fully hedged. There’s always some residual risk, and I think at this point we feel pretty good about the balance. But we would be opportunistic – I mean, if the 10-year treasury had a visit to 1%, I think we might add a little cap.

Douglas Harter – Credit Suisse

Right, thank you.

Operator

Our next question comes from the line of Stephen Laws with Deutsche Bank. Please proceed.

Stephen Laws – Deutsche Bank

Hi, thanks for taking my question. You’ve addressed prepayments and QEIII, so appreciate that. I guess could you hit on the operating expenses? It looks like you’ve continued to do a very nice job of driving that down as a percentage of equity since internalization. Is there anything left you think you can achieve from efficiencies, or is it simply going to be driven lower as we continue to grow the equity base from here?

Frances Spark

Steve, good morning. This is Frances speaking. We are really very much at the edge of—you know, fine edge of all our expenses, and so it’s really an asset-based equation going forward. We have a proportion of fixed expenses and a proportion of asset-based expenses, and so we will continue to see some downward trend on the expense ratio because of the fixed component of the expenses.

Stephen Laws – Deutsche Bank

Great. Thanks for commenting on that.

Operator

Our next question comes from the line of Jim Young with West Family Investments. Please proceed.

Jim Young – West Family Investments

Yeah, hi. Kevin, where are you seeing 30-day repo at current rates and at the current time, and are you also thinking at all about extending your duration of your repo financing?

William Sheehan

Thirty-day repo is running around 38 to 40 basis points right now, and we’re—our book is split between one, two and three months, and we’re definitely in conversations with term repo with many counterparties right now.

Kevin Grant

Jim, I’d just like to add term repo is not the same as term debt, just for people that aren’t familiar. You know, you can get six months and 12-months repo, but it’s not like term debt. It doesn’t relieve you from margin call. It doesn’t relieve you from counterparty problems and so forth, so it’s nice to lock in the capacity, it’s nice to be able to lock in a rate, but it doesn’t relieve you from all those other features—all those other flaws of repo.

Jim Young – West Family Investments

Okay, thank you.

Operator

Our next question comes from the line of Vic Agarwal with Wells Fargo Securities. Please proceed.

Vic Agarwal – Wells Fargo Securities

Good morning, guys. Congratulations on the raise.

Kevin Grant

Morning.

Vic Agarwal – Wells Fargo Securities

You commented on QEIII, which was what my question was, so. And what do you—do you not see value in the hybrid sector at this point?

Kevin Grant

Well, we just don’t see production, and the legacy bonds that are out there are so strongly bid by banks, we were seeing hybrid bonds at 108, 109. They are going to pay really fast.

William Sheehan

All-time highs, yeah.

Kevin Grant

So it’s just a supply of new production question. It’s just not being made.

William Sheehan

We think that homeowners are going from arms into fixed with record low interest rates, so there’s less supply than there’s been in prior times.

Vic Agarwal – Wells Fargo Securities

Okay, thank you guys, and congratulations on the raise.

Operator

As a reminder, ladies and gentlemen, if you have a question, please press star followed by one on your phone. If your question has been answered or you wish to retract your question, press star followed by two. Our next question comes from the line of Arren Cyganovich with Evercore. Please proceed.

Arren Cyganovich – Evercore Partners

Thanks. A common question I got from this recent raise is why raise into this market when spreads are so much lower. It sounds like you got better spreads that what’s currently available in the generic marketplace, but what are your thoughts in terms of trading off income and future dividends for, I guess, assuming that you see some potential book value appreciation coming forward?

Kevin Grant

Well, the question we always face is do we grow the company now or do we wait? And the Fed is really the big buyer and driving spreads tighter, and honestly that’s their mission. So given that, and given the fact that the curve is flatter and spreads are generally tighter anyway, we looked at the market and said, well, it’s better to do this now then wait because we think spreads are probably going even tighter. You can tell that we’re just bullish on the mortgage market for the reasons we’ve described.

So that was the decision process, and ROEs are headed to where ROEs are going to be, and I’d rather get the expense ratio down. And we’ve said many times that—you know, like a year ago when returns were in the high teens, we said nobody cares about he expense ratio now because the returns are so good. But in an environment where the returns are getting squeezed down, people should be focusing on everybody’s expense ratio, and we want to get our expense ratio down. So it’s kind of a combination of all those factors, and we felt it was a good window to grow the company.

And we’ve already—you know, in July we’ve already seen mortgage prices continue to rally here, so we’re very happy about the timing of the execution.

Arren Cyganovich – Evercore Partners

Thanks. And also with respect to your prepayment speed assumption in August that you may see a spike, what do you think that will do to the prices in different coupon stacks? It looks like there’s been a bit of a convergence in the prices of many agency coupon areas. Are you going to see a further convergence, or is it just going to be a bit of a bifurcation with some of the higher coupon versus lower coupon?

Kevin Grant

Well, you would think that a kind of spiky prepayment environment might cause the market to re-price for those high prepayments, but the reality is there’s so much cash getting reinvested and homeowners are basically de-levering and the market is shrinking, so it’s hard to say and hard to know how that’s going to—what the outcome of all that is going to be. But we think the demand for these securities is at a greater pace than anything we’ve ever seen and the market is shrinking, so we think prices are just going up. I wish it weren’t a freight train, but it’s better to be on it than in front of it.

Arren Cyganovich – Evercore Partners

Okay, thank you.

Operator

As a reminder, ladies and gentlemen, please press star followed by one on your phone. To retract, it’s star followed by two. Our next question is a follow-up that comes from the line of Mark Devries with Barclays. Please proceed.

Kevin Grant

You there, Mark?

Mark Devries – Barclays

Sorry, I was muted. Yeah, I’m here. A competitor just announced a preferred offering. I’m just curious on your thoughts about adding some preferred to your capital structure.

Kevin Grant

You know, the thing about preferreds is it’s a relatively small market. I think it’s very helpful in the capital structure, and like all these different financing vehicles, we look at these things all the time. But we just watch the market and see if the pricing makes sense to us. We do the math, you know, every couple of weeks.

Mark Devries – Barclays

Okay, thanks.

Operator

Ladies and gentlemen, since there are no further questions, that concludes the Q&A portion of our event. I’d now like to turn the presentation back over to Mr. Rick Cleary for closing remarks.

Richard Cleary

Thanks, Jeff, and on behalf of Kevin, Frances, Bill and the entire CYS management team, I’d like to thank you for taking the time to participate and speak with us this morning. Thank you for your continued support and interest. Have a good day.

Operator

Ladies and gentlemen, that concludes today’s conference. Thank you for your participation. You may now disconnect. Have a wonderful day.

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