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CYS Investments Inc. (NYSE:CYS)

Q3 2012 Earnings Call

October 18, 2012 9:00 am ET

Executives

Kevin Grant – President, Chief Executive Officer

Frances Spark – Chief Financial Officer

Richard Cleary – Chief Operating Officer

William Sheehan – Managing Director, Investments

Analysts

Steve Delaney – JMP Securities

Stephen Laws – Deutsche Bank

Mark Devries – Barclays

Douglas Harter – Credit Suisse

Joel Houck – Wells Fargo

Mike Widner – Stifel Nicolaus

Ken Bruce – Bank of America Merrill Lynch

Jasper Burch – Macquarie

Eugene Fox – Cardinal Capital Management

Kevin Barry (ph) - Caxton

Jim Fowler – Harvest Capital

Allan Weinstein – (firm inaudible)

Operator

Good morning and welcome to the CYS Investments Inc. 2012 Third 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 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 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 reports on Form 10-K and quarterly reports on Form 10-Q 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 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, October 18, 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. Please go ahead, Mr. Cleary.

Richard Cleary

Thank you, Gary. Good morning and welcome to CYS’ 2012 Third Quarter Earnings conference call. Today’s call is being recorded and access to the recording of the call will be available on the company’s website at cysinv.com beginning 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 a 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

Thank you, Rick, and good morning to everybody. Welcome to our third quarter 2012 earnings conference call. With me this morning is also our CFO, Frances Spark; Bill Sheehan from the investment team; and of course, our Chief Operating Officer, Rick Cleary. As always, we are keen to get to your questions, but first it’s been another very busy and interesting quarter so I wanted to offer some opening remarks.

I think you all know that we have been very close watchers of the Fed. This continues to pay off by giving us the insight to position the company for the distortions created by the heavy hand of the Fed. We had a very strong quarter. We declared a $0.45 dividend and delivered $0.94 of NAV appreciation. We feel very good about the quarter.

For the year-to-date period, the NAV is up $1.44 on top of very nice dividend distribution so far in 2012. We also realized capital gains of $27 million during the quarter and over $93 million year-to-date. Lastly, we’ve gotten the expense ratio down to 93 basis points for the quarter, down from 133 in Q2 and 152 in Q4 of 2011. I said to you all a little over a year ago that I was moving the bar on our expense ratio by internalizing management, and we have accomplished that goal. This expense savings goes straight to over dividend.

We’ve positioned the company nicely for the environment, and we still see good opportunities. During the third quarter, we were very active maneuvering the portfolio to avoid high prepayment sectors and to further set up for QEIII and everything that’s going on. We aggressively culled the portfolio of bond exposed to fast prepayments and we reinvested into bonds with much better prepayment protection, especially if the pay-up was low and, in some cases, zero.

We’ve found plenty of places to reinvest. You’ll notice in our earnings release that our prepayments were very well behaved. This is because we actively manage our portfolio and our asset size is very, very manageable. Dollar prices are high in the mortgage market and everyone is trying to buy prepayment protection. I’d like to say that many specified pool strategies entail very big pay-ups, probably too big, and in some cases these sectors are priced for perfection. We have been a seller into this frothy market and we have been able to find much better bonds away.

I said in the July earnings call that the consumer response to the low rate environment is here, as measured by the refi index. The refi index spiked in July and the refis came through the system peaking in September; however, the recent bump in application volumes is not much above the July bump and it seems to be fading rapidly. These applications should work through the system in December. I would observe that there are two types of refi people: those who are able to refi and who have in fact refinanced two or three and possibly four times, and those who are unable to due to either loss of income and/or equity in their home. This means that there will be a petering out of refi activity and it also means that the Fed probably has shot their last bullet. We’ve already repositioned the company for the current wave of refis.

Currently, we just went through a lesson in bond math. Prices went up in Q3 and yields went down. This is the math of bonds and the math of the environment. As I mentioned in the July call, we indicated then a spread environment for new investments in the 150 to 170 range. Today, it’s probably 150, 155, slightly above our Q3 net interest spread. We think using a range of 140 to 160 is appropriate and conservative, and we expect reinvestments to be neutral with a chance for them being slightly accretive. We expect leverage to remain steady, so that means the ROE should stabilize roughly at current levels; however, the Fed is in the driver’s seat and we really would like them to stop crowding out private capital. At some point, they will, and we really look forward to that day.

The elections in 19 days are very important to this business and this industry. There are many scenarios, but the future of mortgage finance and the future chairmanship of the Fed are likely to be early 2013 topics. Of course, these policy issues are core to our business, so we are monitoring Washington events very, very closely.

Now I’d like to turn it over to questions. It will take Gary just a few moments to organize a queue. Gary?

Question and Answer Session

Operator

Thank you. Ladies and gentlemen, your Q&A session will now begin. To put forward a question, please press star then one on your telephone keypads. If you decide to withdraw your question, press star and two.

As a reminder to attendees, if you do want to put forward an audio question now, please press star and one on your telephone keypads. We have our first question coming from the line of Steve Delaney of JMP Securities. Over to you, Steve.

Steve Delaney – JMP Securities

Good morning. Thanks, Kevin. First, I do want to recognize what you said about the G&A expense ratio breaking below 100 basis points. I know that was a primary goal that you stated way back at the time of the IPO, and the decision to internalize and the subsequent growth, you deserve a lot of credit for that because you’re now a standout, I think, in the mortgage REIT group, and with these slightly lower ROEs expenses matter more today than ever.

So with that, what I really wanted to talk about – you covered spreads so well, that was my question. But I guess related to that, your average repo at September 30 was 42 basis points, up from 39 at June and 35 at March. Can you just give us some color there as to—you know, LIBOR certainly has not been going up effective that funds has gone up a little, but what’s going on here? I’ve heard some rumors that the Fed is actually putting pressure on repo market because of Twist. Just love to hear any thoughts you have about how we got to where we are in repo, and kind of what the outlook, what are you guys using internally for expectations of repo rates going forward. Thanks.

Kevin Grant

Yeah, thanks for the beginning comments, Steve. A couple of things on repo, and I’ll let Bill add to this, but when the Street got downgraded by Moody’s in late Q2, that was basically worth, I don’t know, probably five to 10 basis points in where repo rates were going through. Right now, everybody’s planning for year-end, and believe it or not people were starting to plan for year-end probably in July or August – I know we certainly were. So getting over year-end is something that is probably putting a little bit of pressure on things, and I think that’s really the story.

The Operation Twist issue, yeah, there probably is a little bit of truth to that, a little bit of pressure coming from that, but I wouldn’t say that it’s major.

You want to add anything, Bill?

William Sheehan

Steve, just going forward, we think the bank balance sheets will continue to be more carefully monitored by them as they’re working on their own ROE targets. So we’d expect there to be sort of an ongoing pressure, but we also know that it’s going to be offset on the other side by a little bit of relief of getting over year-end. As Kevin said, I think most of the community will be out over year-end by the early November, if not by November 1, and so we think there’s a potential – to answer the other part of your question – that they could actually drop a little bit going around the turn.

Steve Delaney – JMP Securities

Right. So maybe for the next couple quarters, we should be focused on sort of a range between, say, 40 and 45 basis points. Would that be a safe range?

William Sheehan

I think that’s very reasonable.

Steve Delaney – JMP Securities

Okay. Thanks a lot, guys, and congrats on the great moves you made during the quarter. Thanks.

Kevin Grant

Thanks, Steve.

Operator

Thank you. The next question comes from the line of Stephen Laws of DB Bank. Over to you, Stephen.

Stephen Laws – Deutsche Bank

Thank you. Good morning. Thanks for taking my questions. I want to echo Steve Delaney’s comments on the operating scale you guys have been able to drive with internalization.

To kind of follow up, I think you did a great job explaining spreads and talking about the portfolio and new money. To follow up on Steve’s question about financing costs, can you maybe talk about how you are managing the swap book here, given likely low LIBOR rates but at the same time you do want to manage the interest rate risk. Kind of where those rates are, what duration swaps you’re looking at, just so we can kind of get an idea somewhat of maybe what benefits we get middle of next year. I believe you guys have about 700 million of swaps at a weighted average cost of about 140 basis points maturing. Just kind of thinking about how that financing may be replaced as it matures next year.

Kevin Grant

Well you know, we’re constantly looking for opportunities to extend the duration of whatever hedges that we have on, so we’ve added some very long-dated caps at very nice strikes. Those are really designed to cover sort of tail risk, kind of outside moves. I think generically we tend to like to put on four and five-year swaps, and not sure how we’ll proceed here. The short end of the curve, it doesn’t have the volatility of the long end of the curve, and that’s one thing that’s really important to note. With the Fed’s policy of basically pegging the short end through the middle of 2015, that really has anchored everything inside of, what would you say, four years, maybe even five years, so there’s not a whole lot of volatility and not a big bang for the buck if you’re going to set a four-year swap here, and that’s priced in. I mean, putting on an interest rate hedge for four or five years is very, very inexpensive. It really ought to be inexpensive, given all that.

William Sheehan

Given the Fed outlook, yes. A four-year, if you were modeling a four-year swap right now, 67 basis points, and you received LIBOR opposite that and, as Kevin said, for four years of protection that’s going to be cheaper than what’s rolling off, very clearly.

Stephen Laws – Deutsche Bank

Yeah, no that’s great. Appreciate the color there with kind of using, I guess, a mix of four or five-year swaps is still typically kind of what your hedge book looks like.

Kevin Grant

Yeah, yeah.

Stephen Laws – Deutsche Bank

Great. And then I guess maybe one question on prepayments – I apologize, I missed the first minute or two of your prepared remarks. Obviously the CPR was down slightly. I think it’s pretty widely expected in the markets that CPRs are going to increase in the fourth quarter, and that with the specified pools and other characteristics of your assets, it looks like maybe we’ll see a little bit less prepayment sensitivity than the average for generic securities. But can you maybe talk a little bit more about just kind of how it was flat in second quarter, but your general outlook for Q4. I apologize if I missed that again earlier.

Kevin Grant

No, no, we didn’t really drill down into it. I think a couple of things – one is we gave you the October CPR number too, so you’ve got a little bit of hint of what the Q4 prepayment numbers might be. We do expect them to pick up. Probably December is the peak, given this current bump in refi activity, and after that—you know, rates have backed up here, so it could be that this little refi wave is done.

Stephen Laws – Deutsche Bank

Yeah, I think there’s definitely going to be a finite amount of the refi borrowers. I did catch the comments about the two buckets of borrowers that can refi and those that can’t. Any idea how long you think that impact on prepayments as this finite amount of borrowers works the system – is it one quarter, is it three quarters? Just something we’re going to continue to have to watch rates here for the next couple of weeks to see where coupons settle.

Kevin Grant

I think it’s all a function of rates. In my former days as a quant, we used to talk about models and we talked about path-dependency models, and prepayments are a path-dependent situation. A layman way of looking at it is the homeowner needs to see a new lower rate in order to generate a new greater response to that stimulus, so homeowners have already seen the low rates of the end of September, so in order for refi activity to actually get higher, we’re going actually have to see an even much bigger rally, and this is what’s leading me to offer up the comment that the Fed has probably shot their last bullet.

Stephen Laws – Deutsche Bank

Yeah. I guess with one last question, I’ll turn it over to someone else. But that comment, I think kind of leads into the guarantee fees that are being added in and seem to be increasing. I think there are maybe some on the state level now, and I think another increase in December. But clearly that’s going to have some offsetting impact to coupons in the market, and just kind of maybe leave it at that and love to get your comments on that impact.

Kevin Grant

Oh, that’s definitely true. The FHFA and all sorts of other parts are really interested in getting the g-fees and the credit charges up to where they’re supposed to be, so.

Stephen Lewis – Deutsche Bank

Great. Well, congratulations on a very solid quarter and a great job with the expense ratio, and look forward to talking to you guys soon.

Operator

Thank you. Next question comes from the line of Mark Devries of Barclays.

Mark Devries – Barclays

Yeah, thanks. Just wanted to clarify a point on your expectations for speeds. I think you said, Kevin, you expect them to be up in December, but with October a decent amount below the 3Q rate, would you expect the blended 4Q speeds to be higher, or just started to tick up a little bit at the end of the quarter?

Kevin Grant

Well, I think it’s really hard to quantify it to that level of certainty. I think just to be conservative, we ought to expect that the blended Q3 rate will be up a little bit, but it’s not going to be—I’d be in shock if it was in the high 20s. That would be way out of bounds.

William Sheehan

Maybe high teens?

Kevin Grant

But honestly, it’s a guess. It’s just hard to know what’s going to come through.

Mark Devries – Barclays

Yeah.

William Sheehan

There’s a lot of forces working against each other right now. Obviously we’ve had a backup. We’ve got higher g-fees coming in December. We’re going into a slow seasonal period; but on the other hand, as you said, there’s a continued pipeline that is working its way through the system.

Mark Devries – Barclays

Okay. And I think you indicated you expected net spreads going forward of 140 to 160. Any thoughts on the implications of the trajectory of that, though, if we get a—you know, with a bit of a spike in near-term prepays, could that go a little bit lower before it levels out, at least as reflected in your GAAP results?

Kevin Grant

I suppose it’s possible, but right now we’re experiencing a bit of steepening in the curve – you know, not a big thing, but a little bit of a steepening in the curve and it just seems like the domestic economy feels a little better, so I think we’re all rooting for that, right? So if that were the case, I’ve been describing it as a little bit of a growth scare. That would be a steeper curve and wider spreads, which would be great for us. I think the Fed has been very crystal clear on what they’re going to do with the short end and how they’re going to hold it, at least through middle of 2015, so steeper curve would be really good for us.

Mark Devries – Barclays

Okay. And then did you generate any meaningful undistributed income based on the realized gains in the quarter? Did that mainly just offset kind of the non-taxable drop income that you view as core?

Kevin Grant

Yeah, that’s really the way to look at it. If you’re trying to decide whether you think there will be a special dividend – is that really what you’re getting to?

Mark Devries – Barclays

Yeah, or just whether you’ve got any undistributed income there to kind of pad any kind of near-term margin pressure going forward.

Kevin Grant

Well, that’s not really the way we look at it. It’s really what the taxable income is for the year, and that’s going to drive what we have to distribute. We are realizing gains, so there is taxable income for the year. We won’t be able to do that calculation until—or an estimate of it, anyway, until December. It feels to us like there will be a special dividend, but it’s just way too early to quantify it.

Mark Devries – Barclays

Okay, great. Thanks Kevin.

Operator

Thank you for your question. The next question comes from the line of Douglas Harter of Credit Suisse. Over to you.

Douglas Harter – Credit Suisse

Thanks. Kevin, I was hoping you could talk a little bit about some of the characteristics that you looked to change in the portfolio with the sales, and how that might impact prepays going forward.

Kevin Grant

Yeah. What we like to do is we like to identify features in the mortgage market that just structurally give us prepayment protection. These things kind of ebb and flow, and most of these things don’t last forever, and then the market prices these different features at different premiums through the life history of these different specified pools. So what we like to do is identify things early, have bonds basically built for us to our specifications, and hopefully not pay out for some of those features, and that’s really what you’re seeing in some of the realized gains.

The pay-ups for some of these specialized or spec pools were just extraordinary, and our view is that the prepayment protection doesn’t necessarily last forever so if you sit and kind of price out the value of the prepayment protection, if the market’s going to pay you too much for it, you’re supposed to sell those bonds. So those are some of the bonds that we sold in the quarter.

There are some other ideas that we’ve got right now, and if you don’t mind I’d prefer to keep those proprietary; but there are things to be done in the market, and we still see plenty of opportunities to continue with this strategy.

Douglas Harter – Credit Suisse

Great. And is there any way you can quantify some of the CPR advantages that you’ve gotten with your strategies versus had you just bought the generics?

Kevin Grant

Well, we had to—this is going back to ancient history now. We had some Fannie Mae 5’s, the generic cohort was paying at 36 CPR and our holdings were paying at 25 CPR. And with something at a 108 kind of dollar price, the difference in yield that that generates is 100 basis points. So the value of doing this particularly at these kinds of dollar prices is really pretty meaningful.

Douglas Harter – Credit Suisse

Great. Thank you, Kevin.

Operator

Thank you. Our next question comes from the line of Joel Houck of Wells Fargo. Over to you.

Joel Houck – Wells Fargo

Okay, thanks. I don’t know if this is a fair question or not, but I’ll ask it anyway. In terms of the portfolio today and kind of how you—Kevin, you mentioned you’ve sold a lot of bonds heading into QEIII. Is there a reasonable range we could look at of your 22 being out of portfolio – I mean, how much of that would you characterize as prepayment protected versus non-prepayment protected? And also, if you could give us a sense for where that percentage has kind of moved this year.

Kevin Grant

I would say—it’s a tough question to answer, so I’ll answer it in what’s going to see like a convoluted way. I would say that this is the mortgage market and there is no prepayment protection, period, end of story. Having said that, are there things that we can do to find little nooks and crannies and features that create barriers for homeowners to refi? Absolutely, and we try and do that with every single purchase. So the answer is there’s zero prepayment protection and there is 100% prepayment protection. I think, Joel, that’s the reality of it.

Joel Houck – Wells Fargo

Well, I mean, I understand the essence of your answer. I guess when people generally talk about prepayment protection, they’re talking about low loan balance or things like that. I don’t know if you can quantify those types of features, and maybe you don’t want to because it’s proprietary. But I think that’s more where I was going. I get the gist of the answer.

Let me kind of switch gears. You talked about—and the color around the marginal returns is helpful. If you pull up generic investments today or PBAs, at least in our calculation there is no way you can get even a 10% ROE given where prices are. You guys have kind of suggested that ROEs are going to be stable from current levels, which we calculate around 12%. So I guess I want to understand, is what you guys saying that you’re seeing enough opportunities within your universe or your strategy that you’re comfortable maintaining the current economics that’s embedded in the financials, so that if as prepayments come in we shouldn’t expect to see much, if any, type of impairment to the current ROE levels.

Kevin Grant

Well, from everything that we see and what we’re able to execute in the markets, we think—yeah, we think this current ROE and the net interest spread, we think it’s sustainable for a while here. I’ve got visibility certainly out a quarter. Obviously the more quarters out forward to go, the less visibility we’ve got; but it feels pretty good to us, so.

Joel Houck – Wells Fargo

Okay. And then lastly, the forward purchases, can we assume those all settle in Q4?

Kevin Grant

I think everything pretty much—oh no, we actually—

William Sheehan

We have January.

Kevin Grant

Yeah, we have some January settles.

Joel Houck – Wells Fargo

Can you break out how much is Q4 versus January?

Kevin Grant

It will be in the Q.

Joel Houck – Wells Fargo

Okay. Alright, thanks guys.

Operator

Thank you. The next question comes from the line of Mike Widner of Stifel Nicolaus. Over to you, Mike.

Mike Widner – Stifel Nicolaus

Good morning guys. You know, one of the hazards of being here at the end of the list is I have to ask you questions that no one else has asked. So I’m looking through your portfolio and one thing actually I have a difficult time sort of wrapping my head around, and so just big broad strokes – I mean, you guys have been kind of the 15-year fixed, you know, lower coupon sort of players. And now, I look at your portfolio today and by far the fastest growing segment from an allocation standpoint is 30-year fixed. It’s up to 25% of your portfolio, which is the highest it’s ever been. If I look at the cost basis or the fair value mark, that segment is the highest cost piece of your portfolio. You’re at a 38 average coupon, which is kind of well off the mark of current issue, and if I look at where you’ve got it marked, it looks like it’s fairly generic in terms of not a whole lot of—there’s not a whole lot of premium in the price relative to where generics are trading.

So I guess I’m just trying to figure out what’s going on there. I mean, why that particular segment? That’s a piece that actually has not been a very great performing segment for some of your larger peers that focus on more the 30-year fixed segment. So I don’t know, just looking for some comments on that piece if you could.

Kevin Grant

Happy to share our thinking. We think structurally that the 30-year current coupon, just as an example, so these would be 2.5s and 3s, really are very tough for this business, and it’s the hedging costs because the extension risk in the up-rate scenario is really pretty extraordinary, and if you want to cover that extension risk, it’s just very, very expensive to do it. So 30-year fixed is not a place that we think has a meaningful place in our portfolio.

Now having said that, premiums in the 30-year market, that’s where all the story bonds, all the spec bonds—well, not all but a vast majority of specified pools, that’s really the place where you can distinguish slow payors from fast payors. So that’s number one. Number two is from time to time, tactically – and I mean tactically – we can go in and out of the 30-year market, and if we think the 30-year market is really, really cheap and it’s going to perform reasonably well in the near term, we can go into the 30-year market with a lot of caution. The thing that enabled this trade in the past couple of quarters really was the cheapening of the caps market, so if we can put on a 10-year cap, that is a really good cover, a really good hedge for the extension risk inherent in 30-year fixed, and I would say that was the enabler to make us more comfortable with 30-year fixed.

Longer term, I don’t see us ever having over 50% of the portfolio – I mean, I’d be in shock if we were that tempted. But you know, 20, 25%, I could see that.

Mike Widner – Stifel Nicolaus

So for that category of stuff—and again, sort of looking at this, where you’ve got it marked, and that’s pretty in line with generics so it’s hard to see a whole lot of special story kind of pricing in there; yet as I look at your CPR, the generics in that, at least if you go back prior to 2012 vintage, you’re more in the 30%-plus range. So you’ve got something going on there that’s clearly slowing down the prepays, so is it safe to assume that that’s just all newer vintage stuff or is there—I don’t know. Again, as we look at the portfolios, the big issue, as you’re well aware and you’ve talked about, is the prepayment risk, and while we may not be setting new lows or at least bouncing around new lows, wherever, right now in terms of advertised mortgage rates, clearly the higher the premium in the portfolio, the more you’re at risk, and government policy, you never know who’s going to be allowed to refi this time that might not have been allowed last time. So again, just seeing that as the highest dollar pricing in the portfolio makes me worry, and so—you know, is it new vintage stuff or how are you getting the CPRs that you’re seeing on that, because again they are well below what we see in the market but the prices aren’t really well above, so just trying to square it.

Kevin Grant

Well, all I can tell you is the market is not yet giving us credit for our asset selection. But as you’ve observed, since they are slow payors, it’s just a matter of time before the market will price them for what they’re worth. I don’t know whether it’s two months, a year, but it’s just a matter of time.

Mike Widner – Stifel Nicolaus

So you’ve figured out the special sauce. You hired some people from New York that came up to Boston, I guess.

Kevin Grant

Oh no, we’re organic. We’re Boston all the way.

Mike Widner – Stifel Nicolaus

All right, well thanks Kevin. I appreciate the comments, and congrats on a solid quarter.

Kevin Grant

Okay, thanks Mike.

Operator

Thank you. The next question comes from the line of Ken Bruce of Bank of America Merrill Lynch. Over to you, Ken.

Ken Bruce – Bank of America Merrill Lynch

Thanks, good morning. Kevin, Mike was worried about asking an original question. I’m going to ask probably one that’s been already asked, but I’m going to ask you to repeat yourself. In terms of your comments around the margin stabilizing, I missed the first part of your comments, your prepared remarks, so I apologize for making you repeat yourself. But what is it that gives you the confidence that margins move higher, or at least stabilize at these levels? Is it something with either the growth scare or specifically within the prepay performance within your portfolio, or is it hedging costs that’s ultimately going to drive margin stability from, say, the next three to six months?

Kevin Grant

Well, I’m just looking at the market, and the curve since the end of the quarter has steepened and the mortgage market has cheapened. So I’m just looking at the market just walking in here half an hour ago, and we do a daily calc of where we see ROEs, and it’s better today than it would have been at the end of the quarter. I mean, honestly, it’s just simple market level.

Ken Bruce – Bank of America Merrill Lynch

Right, but I mean you’ve obviously seen that change quite a bit in just a few weeks, so what gives you confidence that it’s going to stay at these levels?

Kevin Grant

Well I mean, the way we run the portfolio is we are opportunistic, so we don’t just programmatically go in and buy X-million bonds every single day, regardless of market level. If we see the market cheapen out, we know that our appetite in a given month or a given quarter is X, and we make the active decision of, okay, do we pounce on this now or do we wait? And yeah, it’s a little bit of market timing, but that’s part of the business.

Ken Bruce – Bank of America Merrill Lynch

Okay. I think I understand that. And then if maybe you could take a stab at how you want to manage capital. There has been at least one move by a peer to establish plans for a buyback. Your stock is trading well below book at these levels. What are your thoughts around how to possibly use buybacks in terms of managing capital at these levels?

Kevin Grant

A couple of things on buybacks and sort of size of company generically – there are two reasons to do a buyback. One is the math and the other is scale and size. On the math, the way we look at it, the way we think about it is it’s the ROE, not just for one year but for as long as we think it’s sustainable, and how much shareholder value that will create versus essentially a one-time bump for buying back your stock at a few point discount. The way we are looking at the math right now is for a while here, it’s going to a low teens ROE business that will compound over—you know, pick your number of years, say three to five years. That generates a heck of a lot of shareholder wealth versus buying back your stock at a couple of point discount. So the way we come out of the math here is it’s much more favorable for us just to continue deploying the capital.

On the size issue, you’ve got to size the business for the market opportunity that you face and your ability to add value in that environment. We’re at a size where we can move this portfolio around and we can really move the needle on asset selection. We’re not so big that that’s an issue at all, and you can tell from our expense ratio that we’re big enough to be very efficient at it. So I think we’re kind of just the right size, and I’m not a billion smart on this but I think we’re kind of right in that sweet spot, so that’s the way we think about it.

Ken Bruce – Bank of America Merrill Lynch

Okay, well let me push a little bit on that. It seems to me that most conventional thinking is that if you believe the market is undervaluing your assets, like you said you have, being able to reinvest in those below book is a good shareholder return opportunity long-term, and yet if you need to grow at some point in the future when the market’s giving you a better valuation, you can do that at that point. Do you not think that that’s correct in this case, or how would you respond to that?

Kevin Grant

It’s not the way the math works right now, because the compound—the three to five-year compound return of—you know, pick a number, 12%. Twelve percent ROE compounded over five years, you’d have to buy your stock back at a 50% discount.

Ken Bruce – Bank of America Merrill Lynch

Okay, I’ll have to work through the math on that, because clearly I don’t see it that way. But maybe lastly, there’s big primary, secondary spreads in the market today. Is there any risk that those essentially either not collapse but tighten up and create another refi wave? I know you said that you don’t expect that and maybe we’re actually through the latest burst, but is there any chance that spreads actually tighten up from here?

Kevin Grant

Well, not really because the sentiment in Washington, the FHFA and so forth, everybody wants g-fees and all the other stuff that’s causing those spreads to be wide to be wider; and politicians can grandstand on election day eve and say we’ve got to get this tightened to help homeowners, but the people in the seats that are trying to basically save the long-term health of consumer mortgage finance are going the other way and encouraging people—actually requiring people to price for credit risk. So I don’t see it.

Ken Bruce – Bank of America Merrill Lynch

Okay, well great. Thank you for the comments. Also, congratulations on a very strong quarter. Appreciate that.

Operator

Thank you. Next question comes from the line of Jasper Burch of Macquarie. Over to you, Jasper.

Jasper Burch – Macquarie

Good morning guys. I want to drill into—I’m surprised by your comments on the prepayments going forward, not necessarily for your specified pool assets but for the broader mortgage market. On the one hand in Washington, yeah, you have slight increases in g-fees that you know over the life of the loan aren’t necessarily that large compared to some of the incentives for a lot of borrowers. And it sounds like you aren’t giving much credence at all to regulatory changes that are coming out, such as rep and warranty relief that’s taking effect in January, and even capacity increasing at the banks allowing tightening of the primary, secondary market spreads. So I guess your comments might make sense for sort of the burnt-out borrowers who just were already very strong credit and benefited from an elbow shift from QEIII, but not for the broader market that it looks like still has a high incentive and possible opening of the credit box. So what’s your view on sort of the broader market and just those other borrowers who might not have access simply because of maybe worse FICO scores right now that could have access in the future?

Kevin Grant

A couple of things. There’s a lot in that question. On the rep and warranty issue, I would observe that the processing frictions are not as bad as they were. There still are processing frictions, and rep and warranty is part of that, which is causing the loan application process to be cumbersome. So all those things seem to be becoming more efficient, but it’s not like it was five years ago by any stretch.

On the rest, really the issue is rate and what kind of rate is the homeowner seeing. And I’m just looking at what mortgage rates have done in the past couple of weeks, and they had this big, visible drop in September going into the announcement of QEIII. That created an enormous media effect, and the media effect is rapidly waning. You start to see it in the refi index, and the refi index has kind of peaked out and it’s kind of dribbling down a little bit, and we expect it to fall again next week.

The purchase index is a different story, and that has implications for the broader economy, but the refi index is probably going to dribble off.

Jasper Burch – Macquarie

Okay. I mean, I guess in terms of—what about the percentage of originator’s propensity to originate lower FICO borrowers, I guess is what I’m drilling down to. You know, there are sort of two lines of thought – one, as capacity continues to increase and the higher FICO borrowers are the first ones that the originators are really targeting and allowing to refi, where there seems like there’s a huge swatch of the market that hasn’t had access to the refinancing opportunity even if they’re LTV below 100 and performing – you know, the sort of sub-720 FICO, if you will.

Kevin Grant

Well, don’t forget we’re talking about the agency world here, so there’s two components. So somebody whose mortgage is in an agency security right now who has become basically a sub-prime borrower for whatever the new mortgage is, yeah, hopefully that person is going to have somebody else that’s going to be willing to make that loan and balance sheet it. But there’s really no securitization market meaningfully functioning right now, so there’s a whole bunch of things that still are not resolved there – you know, risk retention rules, qualified mortgage and qualified residential mortgage rules, all of that kind of stuff that comes out of Dodd-Frank. And maybe it will get clarified after the election – maybe, but as I go down to Washington, there’s just—I don’t think this is all going to get clarified overnight.

Jasper Burch – Macquarie

Okay. I guess it might be a very complicated issue. I personally still see that risk. Moving on, just sort of one more question – looking at the new investment spread that you’re talking about, the 140 to 160, if I back out what your cost of borrowing probably is, your hedged-out cost of borrowing, it looks like you’re still buying assets that you expect to be yielding 220 to 230. I just wanted to know, could you give a little bit more color on what your lifetime prepay assumptions are, one, for that asset? It seems like it would be sort of—it does seem like—I know a previous questioner was talking about it looks a lot like sort of a generic or even current coupon – you know, Fannie. And then second, could you give a little bit more color on how you can continue, not just right now but in the future, if you’re putting on those assets to hedge out the convexity risk on them.

Kevin Grant

So it’s actually pretty straightforward. So we see the yield on a new asset at about 2. We see the financing costs at about 40, and we see the hedging costs at about 10. And that’s really just the way the math works out, so that’s – boom – that’s 150 right there. That hedging cost would be just a generic—probably just a generic four-year swap, and the generic way to look at it is call it a 15-year 3, and if you can’t get to that math, honestly, I think it’s pretty straightforward.

Jasper Burch – Macquarie

No, I mean, that makes sense. I’m just wondering on a 15-year 3, and I’m looking at a broker tear sheet right now from last night, and their projected lifetime yield on that is a lot lower than the 2. I’m just wondering what sort of assumptions are going into that. Like, if a Fannie 3 is probably a little over 105 right now. So what assumptions are going into getting you to that 2% yield?

Kevin Grant

Yeah, I don’t know what broker sheet you’re looking at. I’d have to see it to be able to respond to that.

Jasper Burch – Macquarie

Okay. All right, well thank you guys a lot for your time. You’ve obviously done a really good job in negotiating the frothy waters as they are right now, so I appreciate all your comments.

Operator

Thank you for your question. The next question comes from the line of Eugene Fox of Cardinal Capital Management. Over to you, Eugene.

Eugene Fox – Cardinal Capital Management

Hi Kevin. With respect to the changes in lower credit borrowers, based on the vintages of your portfolio, you really wouldn’t have any exposure to that, or at least certainly nothing material.

Kevin Grant

I think that’s probably right, Gene.

Eugene Fox – Cardinal Capital Management

So I guess my point is going forward, I’m not sure—I guess you’d have the option of buying that paper if you wanted to, but beyond that from a prepayment standpoint, is there any reason to think that that would impact your prepays at all?

Kevin Grant

No, there really isn’t.

Eugene Fox – Cardinal Capital Management

That’s my only question. Thank you, Kevin.

Operator

Thank you. And next question comes from the line of Kevin Barry of Caxton. Over to you, Kevin.

Kevin Barry – Caxton

Good morning. I see that your interest rate spread net of hedge was 1.24% and adjusted was 1.41. Was the 150 to 155 you were talking about settling in at, was that more akin to the 1.24 or to the 1.41?

Kevin Grant

The range for reinvestment, that’s really assuming all the bonds are settled and that the hedge in the bonds are actually in the box, if you will.

Kevin Barry – Caxton

So like a running rate once there’s no more—in a sense, no more new investment.

Kevin Grant

Right, exactly. Yeah.

Kevin Barry – Caxton

So I’m sorry, so that—

Kevin Grant

So it’s comparable to the 1.41.

Kevin Barry- Caxton

Got it, okay. And you guys obviously are giving us some disclosure – have you thought about giving even more disclosure a la AG&C or TWO where analysts could see even more, or do you think they’re giving away too much to their investors, to the market?

Kevin Grant

I’m not sure what particular tables you might like, but we’ve contemplated summarizing some things just to help people not deal with building their own spreadsheets, just to make it convenient for people. So we’ve contemplated that – maybe next year, we will.

Kevin Barry – Caxton

Great. Thanks so much.

Operator

Okay, and next question comes from the line of Jim Fowler of Harvest Capital. Over to you, Jim.

Jim Fowler – Harvest Capital

Hi Kevin. Thanks for taking the question. I’m between a few calls here, so if this has a transcript, I can read it later. But anyway, I did catch how you were hedging a portion of your duration exposure with some caps, which I think you had indicated had gotten cheap, and I think that’s probably—well, a good hedge, per se. But what’s been your experience – I mean, the pay-ups on securities has been high, and I’m just wondering if—and a reduction in the pay-ups would be akin to spread widening, which would result in a reduction in value without an extension in duration. So I’m just wondering how do you think this plays out from here? You’ve got high pay-ups, you’ve got tight spreads, and you’ve got a lot of demand for prepayment protected securities in excess of supply, which is obviously driving prices higher. What’s sort of the pacing that you’re thinking about in terms of how that comes back to a more normalized state, and how do you think about managing through that to maintain value in the portfolio? Thanks.

Kevin Grant

Thanks for the question, Jim. You probably missed the comment at the beginning, but just to clarify a little bit of everybody, we’re a seller into this pay-up environment, and we’ve been a seller and that’s one of the things that’s generated a lot of the gains for us. We think the pay-ups are too high. The market has been very frothy, and historically slow-paying specified pools don’t always stay slow. So when the pay-ups get to a point where it’s just price for perfection, it’s kind of like the S&P being at a 30 price earnings ratio, you know what I mean? So it’s time to kind of sell into that market, particularly if you can find some other things to reinvest the proceeds in.

The way these things tend to unfold is that when you’ve got a low rate environment and generic speeds are fast, the market tends to pay a lot for prepayment protection; and when rates back up even a little bit and refinancing activity kind of disappears from people’s front burners, then those pay-ups kind of disappear. I don’t think the pay-ups are going to disappear just because of where rates are generically, but I don’t think they’re going to stay as frothy as they are.

Operator

Okay, so as a reminder, ladies and gentlemen, if you do want to put forward a question now, please press star and one on your telephone keypads. To withdraw your question, press star and two.

We do have a question from the line of Allan Weinstein of (Inaudible) Investors. Over to you, Allan.

Allan Weinstein

Hey Kevin, how are you?

Kevin Grant

Hey Allan, how are you?

Allan Weinstein

Good. Congratulations on a job well done. I had a quick question. I’ve been following your stock as an investor for quite a while. Recently there was some extreme volatility in the stock and post-the QEIII announcement, the stock price actually moved from about 14.5 to a recent low of 12.30, and on that day – I think it was Monday – volume was about four times the normal daily volume. Can you just comment about what you think the volatility in your stock, and I think it was mirrored somewhat in the sector, but you stock in particular seemed to be even more volatile and more active than most. And then I had a follow-up question to that.

Kevin Grant

Yeah Allan, on that I really don’t know. I don’t begin to understand all the risks and how they get priced in by different players in the equity market. We observed it too, but I don’t really have any insight.

Allan Weinstein

Okay, okay. And then the second question, because I know you are a Fed watcher and follow the markets closely, volatility as measured by the VIX is probably at a five-year low, and I was wondering how much you factor volatility in general into your decision-making, whether you have an opinion about the current pricing of volatility in the marketplace.

Kevin Grant

Yeah, that’s actually an excellent question. We follow volatility. We don’t necessary follow the VIX because it’s just sort of generic indicator; but volatility is key, and these are mortgage securities so there is some level of volatility built into them. And the mortgage market has an awful lot of extension risk, so that’s really key to the way we think about how we manage the book.

The 15-year strategy is a major component of our really defensive posture on volatility, and in a levered mortgage business like this, it’s just part of the business that you are playing with that extension risk, and the way to minimize that extension risk is not just keeping the duration short but keeping the actual cash flow short. And the only way to do that is the 15-year market. Even hybrid arms, they still have a 30-year amortization schedule, so the cash flows can still get really long in an up-rate scenario. But the only way to minimize your exposure to a spike in volatility really is the 15-year market. And we still have the exposure; it’s just less, so any sort of levered mortgage strategy is still going to have the exposure, but it’s just meaningfully less with 15-year assets.

I hope that helps, Allan.

Allan Weinstein

Yeah no, that does. Thank you, Kevin. Last follow-up, if you don’t mind – is it fair to assume that as long as the stock price is at a discount to NAV that we won’t see an increase over stock issuance at prices below book?

Kevin Grant

Well, you know, on growing the company, as I said a little bit earlier, we’re really in the sweet spot for size. So when we do the math on raising capital, we have a very sharp pencil, and we do not get paid for assets under management. We get paid for total shareholder return, which is what gets you paid as a shareholder. So that means that the hurdle for doing an equity raise is very high, and it’s a mathematical calculation – can we raise money well, meaning above book value, and can we invest it well, meaning accretive in all the different metrics that a board of directors would look at and hold us accountable to. And the accountability is total shareholder return.

Allan Weinstein

That’s a great answer. Thank you, Kevin, and keep up the great work.

Kevin Grant

Okay, thanks Allan.

Operator

Thank you. And we don’t have any further questions, so I would now like to turn the call back to Mr. Cleary for closing comments. Thank you.

Richard Cleary

Thanks Gary, 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, and thank you for your continued support and interest. Have a good day.

Operator

Thank you very much. Ladies and gentlemen, that now concludes your conference call for today. You may now disconnect. Thanks very much.

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