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Edited Transcript of CYS earnings conference call or presentation 20-Apr-17 1:00pm GMT

Thomson Reuters StreetEvents

Q1 2017 CYS Investments Inc Earnings Call

NEW YORK Apr 22, 2017 (Thomson StreetEvents) -- Edited Transcript of CYS Investments Inc earnings conference call or presentation Thursday, April 20, 2017 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Jack DeCicco

CYS Investments, Inc. - CFO and Treasurer

* Kevin E. Grant

CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO

* Richard E. Cleary

CYS Investments, Inc. - COO and Assistant Secretary

* William Shean

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Conference Call Participants

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* Douglas Michael Harter

Crédit Suisse AG, Research Division - Director

* Eric Hagen

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

* James Young

West Family Investments, Inc. - Investment Analyst

* Joel Jerome Houck

Wells Fargo Securities, LLC, Research Division - MD and Senior Analyst

* Merrill H. Ross

Wunderlich Securities Inc., Research Division - Senior Analyst

* Steven Cole Delaney

JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst

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Presentation

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Operator [1]

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Good morning, and welcome to the CYS Investments, Inc. 2017 First Quarter Earnings Conference Call. (Operator Instructions).

For opening remarks and introductions, I will now turn the call over to Rick Cleary, CYS' Chief Operating Officer. Please go ahead, Mr. Cleary.

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Richard E. Cleary, CYS Investments, Inc. - COO and Assistant Secretary [2]

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Thank you. Good morning, and welcome to CYS 2017 First Quarter Earnings Conference Call. Today's call is being recorded, and access to the recording of the call will be available on our website at cysinv.com beginning at 3 p.m. Eastern time this afternoon.

Please be reminded that certain information presented and certain statements made during this morning'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 management's 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.

You're invited to refer to the forward-looking statements disclaimer, contained in the company's annual report on Form 10-K and quarterly reports on Form 10-Q filed with SEC which provide a description of some of the factors that could have material impact on the company's performance and could cause actual results to differ from those that may be expressed in forward-looking statements. Also, please note that the content of this conference call contains time-sensitive information that is accurate only as of today, Thursday, April 20, 2017. The company does not intend to and undertakes no duty to update the information to reflect future events or circumstances.

To better understand our results, it would be helpful to have available of the press release that we issued last night as well as the supplemental earnings deck. As in past releases, the earnings release includes information regarding non-GAAP financial measures, including reconciliation of those measures to GAAP measures, which may be discussed on this call.

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

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [3]

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Thank you, Rick, and good morning. And welcome to our 2017 First Quarter Earnings Conference Call.

I'd like to make a few comments first, and have Jack DeCicco, walk through the details of the quarter before we get to your questions. In addition as usual, Bill Shean is with us from our investment team. We look forward to your questions.

As we all know, the results of November's election had a significant impact on the market's expectations for economic growth, inflation and interest rates. The growth scare that the election produced generated a reset in longer-term interest rates in Q4 and as we described last quarter, provided us with a very nice opportunity to rebalance our portfolio. The benefits of that rebalancing have already started to show and they will continue for many quarters to come as the long and of the bond market is already beginning to price for a terminal value of Fed funds. Our portfolio should produce a fairly stable return for quite some time assuming the Fed does not become more significantly aggressive in the tightening cycle. Our expectations for interest rates is not too different from the market consensus. We are planning for two or three more rate hikes in 2017, followed by the Fed publicizing their plan to allow their balance sheet to roll down, mostly through maturities and principal payments on its RMBS. Many within the Fed believe that the Fed's QE activities were the equivalent of 250 basis points of rate moves, so I don't expect the Fed to raise rates aggressively simultaneously. I also don't expect the Fed to have outright sales of their assets for a couple of reasons: number one, the maturities are already quite large in 2018; and number two, their holdings were purchased at higher prices. So realizing losses would actually hit the U.S. federal budget deficit, much like the Fed's interest rate -- interest income is actually a revenue source for the U.S. Treasury. As a side note, interest on the Fed's portfolio is the fourth largest source of revenue to the U.S. Treasury, and the Congressional Budget Office will have to build into their budget scoring process whatever plan the Fed actually announces, once it's actually the announced. The environment I've just described for you is good. It's actually quite good for the agency mortgage REIT industry. We've already planned for rising financing costs on the -- and on the asset side, we'll have a lot of visibility on the future behavior of the market's biggest buyer. This all will keep prepayments at bay, new home purchase volumes light and spreads modestly wider than today's levels, if at all. And recent market activity has been to the contrary of that. This means ROEs for this business in the low teens for as long as the Fed's portfolio is unwinding, probably the next 3 to 5 years. Further, if Janet Yellen is indeed re-upped for another term, that removes a lot of uncertainty about the Fed's future behavior, which is a significant net positive. In short, the equity returns for this business look actually quite good for a while and we feel confident about the dividend given the base case scenario. One last comment before I turn it over to Jack, you probably noticed that since the efforts to repeal and replace the Affordable Care Act failed, the bond market has been in rally mode. That rally has continued since quarter end and prices of Agency Mortgage-Backed Securities are up. Our rebalancing activities in Q4 were very well-timed and will indeed benefit us for a long time. And with prepayments still low, we'll be holding onto those higher-yielding assets for much longer than we would normally expect. At this point, I'd like to turn it over to Jack DeCicco, to take us on a deeper dive of the financial results for Q1.

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Jack DeCicco, CYS Investments, Inc. - CFO and Treasurer [4]

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Thank you, Kevin, and good morning, everyone. I'll summarize the financial results for the quarter before we open up the call for questions. Starting with the GAAP operating results. Net income for the quarter was $28.8 million or $0.19 per share versus $185.4 million net loss or $1.23 per share in the prior quarter. The current quarter results were driven by a $2.6 million net realized and unrealized loss on investments as compared to a $323 million loss in the prior quarter, when the prices of Agency RMBS decline sharply in response to a notable selloffs in rates. The yield curve flattened marginally during the quarter, with an increase in the front-end in response to the Fed rate hike in March, and a 5 basis point decrease in the 10-year U.S. Treasury yield, which ended the quarter at 2.39%. The improved investment performance was offset by $111 million decrease in net realized and unrealized gains on derivative instruments, in response to a much smaller move and swap rates, relative to the prior quarter. Core earnings plus drop income for the quarter was $41.8 million or $0.28 per share, as compared to $36.2 million or $0.24 per share in the prior quarter. The net increase in core earnings plus drop income was largely due to a $9 million decrease in net premium amortization during the current quarter, as a result of a decrease in prepayment speeds, and a $1.3 million increase in drop income, as we utilized the forward market for more purchases, relative to the prior quarter. The weighted average CPR decreased to 8.1% during the quarter from 14.2% in the prior quarter in response to higher rates and seasonality. As Kevin previously mentioned, during the current quarter, we realized the full benefit of actively repositioning the portfolio into higher coupons during the prior quarter, while the weighted average cost of our portfolio declined. We were able to do this in large part because of our size, which we view as a relative competitive advantage. We expect our shareholders to benefit from this move up in coupon at a lower cost basis for many periods to come. During the current quarter, we continued this trend, albeit to a lesser extent than prior quarter by selling lower-yielding and purchasing higher-yielding coupons. The average yield on our debt securities during the quarter was 2.71% as compared to 2.39% in the prior quarter. Interest expense increased by just over $1 million during the quarter. Our current quarter average cost of funds increased only 11 basis points from 81 basis points during the prior quarter, after a 25 basis point Fed funds rate hike in March. This was made possible by the tailwind created as a result of money market reforms during the prior year that have served to increase cash and a financial system seeking government securities as collateral for short-term investments. The increase in interest expense was entirely offset by $1.8 million decrease in swap and cap interest expense, which stems from an increase in 3-month LIBOR, the index for the receive-leg of our swaps. Our interest rate spread net of hedge including drop income increased to 1.57% during the quarter from 1.28% in the prior quarter. During the quarter, operating expenses totaled $6.2 million compared to $5.2 million in the prior quarter. Included in the current quarter operating expense is approximately $600,000 of nonrecurring accelerated restricted stock and other compensation expense related to my predecessor. Excluding the effects of nonrecurring charges, the operating expense ratio for the current quarter was 1.46%. Switching over to the balance sheet, we ended the quarter with a book value of $8.26 per share, down less than 1% from $8.33 per share in the prior quarter, after declaring a $0.25 dividend per share. The current quarter total stockholder return on common equity was 2.16% or about 8.6% on an annualized basis. The overall size of the investment portfolio inclusive of TBA derivatives, increased to $12.5 billion from $12.3 billion at the beginning of the quarter. As previously noted, we continue to strategically recycle out of lower coupons into a higher current production coupons during the quarter. This is clearly illustrated on Slide 8 and 9 of our supplemental earnings presentation. We ended the quarter with total repurchase agreements at $9 billion, down from $9.7 billion in the prior quarter, as we utilized the TBA market for more purchases in the current quarter. Leverage, which reflects TBAs was little changed at 7.15:1 at the end of the current quarter from 7.06:1 in the prior quarter. We ended the current quarter with the hedge ratio of 99% as compared to 92% in the prior quarter, which was a direct result of the decrease in repo, as we made no changes to our hedges during the current quarter. We continue to maintain high levels of liquidity, ending the quarter with liquidity at 69% of stockholder's equity. With the stock trading closer to book, we did not repurchase any shares during the quarter. This concludes my prepared remarks. Operator, please open up the line for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Of our first question comes from the line of Steve Delaney with JMP Securities.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [2]

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Obviously, a lot of things are going well. CPR, obviously, the dip from 14% to about 8% was a big factor, as you commented. Kevin, I noticed, look back last year, we were -- you were below 8% I think in the first quarter, like 7.6%. But then jump to something over 12% -- 12.9% in the second quarter and that was largely before Brexit. So obviously, there's a seasonal impact here, I was wondering if you or Bill could comment on what your expectations are for your portfolio speed as we move into the summer months?

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [3]

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Thanks, Steve. Well part of it is the recycling of the portfolio into newer production, which just naturally pays slower when it's brand-new. Part of it is the back up in rates because it's just -- it's been enough to shut off refi, because the whole mortgage market is pretty much out of the money for the most part at this point. And then the other thing is on the home purchase side of things. 2007 (sic) [ 2017 ] is actually off to a pretty slow start. Inventories of houses available for sale are light. And people are not really fired up generally to buy houses at these prices. So supply volume is actually pretty light. Have I got that about right Bill?

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William Shean, [4]

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Yes. Very much so. The mortgage rate tends to lag, Steve, also and rates fall much quicker than the actual mortgage rates do. So the 10-year (inaudible) about 40 basis points, but it's a little stickier in terms of the mortgage rate offered to homeowners.

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [5]

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I just add one thing Steve, that on the past several weeks, different Fed speakers have started to float the balloons about letting their portfolio run off in 2018. And in the face of multiple Fed speakers talking about, I don't know, what we're going to end up calling it, but let's call it taper for now, spreads have actually tightened in the mortgage market. Once people actually started to look at the numbers and square them against supply and what's going on, on the supply side of things, I think people have realized it. Spreads next year might not be much wider in the face of the balance sheet.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [6]

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Understand. If asset managers are seeing their portfolio shrink and they want to maintain in the same allocation they just going to have to up their purchases and hopefully offset some of what the Fed is not doing. So understood. To be determined, right.

So big picture question. So mortgage REITs have done incredibly well, the REM is up about 11% year-to-date and certainly the best sector within financials and one of the best sectors overall. We are seeing just the agency group on a medium price-to-book something around the 103, 104 level now. So the group -- and I'm not asking about CYS but just your view as a MBS manager. We've -- there is an opportunity for some companies in your line of business to raise capital either equity or converts and to try to take advantage of this opportunity. So when you look at this risk return of managing your existing base versus maybe doubling down or increasing the debt, just curious, your thoughts whether it's better to be bigger or to remain more nimble in this market?

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [7]

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Thanks, Steve. It would be a good -- it'd be actually, in the agency strategy, it'd be a very good time to raise capital if you could do it accretively and we've never done a capital market's transaction that hasn't been meaningfully accretive. As you know, we buy back stock when it's accretive and we might issue when it's accretive. Other companies are in different situation. Our particular size, we could probably triple the size of the company and still be as nimble as we are. What I've said from the beginning, and I still feel this way, I've said this for 12 years, is the right size for the strategy is somewhere between $1 billion and $5 billion of capital. $1 billion gives you enough heft in trading volume in the stock. And for your lenders, you're important to your lenders. You're not too small, but you're not too big, so you're not creating an undue risk for your lenders. Above $5 billion, with kind of normal leverage, then you're getting pretty hefty and you create a risk for your lenders and of course, your portfolio is so large it's hard to move the needle. So I think we're unique in the agency space because our strategy is still very scalable and we're not too big, we're -- our value add, as you see from what we were able to go from Q1, is not diminished. So -- but I think -- our stock is away -- quite a ways away from doing anything accretive. And you try to peg everybody's book value every week. Since the end of the quarter, mortgage prices are up. Those book value -- those multiples are already stale.

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Operator [8]

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And our next question comes from the line of Bose George with KBW.

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Eric Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [9]

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It's Eric on for Bose. When you think about both the shape of the curve as well as the actual level of rates, at what point does your comfort level change in letting your hedges roll down the curve? And what are you looking for with regard to when you might begin rebalancing those hedges against both assets and repo?

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [10]

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Thanks for the excellent question Eric. We're opportunistic on both sides of the market. So if we think rates are low and low-end of the trading range, or whatever judgment we apply to it, we might indeed rebalance the hedges. We didn't do that at all in Q1. But as you probably observed the 10-year treasury has gotten pretty lower recently. Historically, we look at a menu of different choices for hedging, the obvious one of course are generic swaps, we also look at cancelable swaps which basically you're synthetically creating callable debt. And we look at these markets every day and once again, we try to be opportunistic. So when we have this call in July maybe we'll have something to talk about there.

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Eric Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [11]

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And then one big picture question for me too. Historically as the Fed has gone on the tightening cycle, the 10-year is typically, ahead of the Fed to some degree and the yield curve flattens as the Fed continues to tighten. Maybe the biggest difference in their current environment versus historically is simply the fact that the Fed is "normalizing" rates rather than trying to break the back of inflation. But still, what gives you confidence that the curve will continue to have some healthy spread in it even as the Fed tightens rates?

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [12]

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Here's the way I look at it. And this is no new news really. Let's start with potential GDP. So the labor force is projected to grow at about 0.4% for the next 10 years, that's a BLS number. And I look at the 25 to 55 sort of age category because that's really the consumer group. That is way lower than it was in the '60s, '70s, '80s and early '90s. Where it was going 2% year after year after year. Productivity has been running at around 0.9%, which is once again, it's down from the 1.3%, 1.5% in the '90s when computers and the Internet really accelerated productivity growth. So you've got potential GDP growth in the 1.3%, 1.5% ZIP Code. And that actually squares pretty well with what we've been seeing, because the regulatory environment has clamped down leverage, so it's not surprising that GDP growth has actually been very close and very stable around potential. So the question is will the administration's policies allow the system or encourage the system to lever back up and, basically, pull in GDP growth to get to that magical administration's 4% GDP number. And so far, the report card has got a big giant F on all the major initiatives that the administration had set out to get us to 4% GDP growth. But we're not even through 100 days yet. But I look at this and where I am right now is I am not willing to conclude that the administration is going to be successful at relevering the economy to create inflation and ultimately demand pull which what takes. The Fed sees this, they do feel compelled to normalize rates. The question is what is normal. And the 10-year treasury is telling you what normal is. And normal for Fed funds, probably, has a one handle on it, for this environment. And I think the Fed is slowly coming to that conclusion, and over the past couple of years, you noticed in the dot plots, that their the longer-term expectation for Fed funds it, used to be 3%. And every other meeting, it just comes down and down and down. And at some point, they're going to, I think realize what I've just described. I think they already realize it, the question is, can they put it out there. So that's a long answer. But I think what it means is the curve will be upward sloped. And keep in mind, we buy mortgages we don't, we don't really by 10-year treasuries. So there's this spread in mortgages too which we think will -- it has to produce a decent ROE.

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Operator [13]

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And our next question comes from the line of Doug Harter with Credit Suisse.

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Douglas Michael Harter, Crédit Suisse AG, Research Division - Director [14]

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Kevin, just hoping you could talk about your thoughts on duration gap and risk, kind of given -- kind of where we are in the 10-year today versus kind of the recent range it's been in?

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [15]

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Thanks for the question, Doug. I'd like to get to the duration gap down a little bit more. It's a little tricky to do, because we've got this constraint on derivatives just around -- derivatives can't be greater than the amount you are borrowing. So the way to do it -- the only way do it is to go longer in your hedges. And we've got room to do that because some of our hedges have rolled down and have gotten pretty short. So a natural thing for us to do is to unwind some old dead hedges and put new ones on. However, I don't want to expose us to the scenario that everybody is written off, and that is the 10-year treasury blowing through 2%. And that's an environment that I think we would all assign a pretty low probability to. However, it's a dangerous world out there and if the administration truly is not successful in getting growth going in this economy, the way they would like then we can easily go back to the interest rate environment that we had under the prior administration. So what that leads me to is in our hedging activities, we want some optionality in our -- whatever hedge extensions we put on. And we want to get good execution. So we want to wait for the market to get us opportunities, and then, we'll just see what the menu of hedge choices suggests is the most efficient way to do it.

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Douglas Michael Harter, Crédit Suisse AG, Research Division - Director [16]

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In the past you used some, I guess, the cancelable repo, or swaps, I mean, how is -- how does that market look today?

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [17]

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Bill, do you have some numbers?

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William Shean, [18]

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Sure. They are actually unchanged from last about 3 or 4 months each time we've met. They're right around -- like a 5-year, cancelable 1-year is about 32 basis points and a 7-year is about 41 basis points over a generic swap, relative to it. So it's a relative -- it's an interesting option for us.

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Douglas Michael Harter, Crédit Suisse AG, Research Division - Director [19]

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And just for perspective, how does that compare to like the prices when you used them in the past. I mean is that roughly similar? More or less expensive?

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William Shean, [20]

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Yes. That's probably in the middle of the range we've done them in the 20s, we've also -- on the lower-end. And we've done them in the -- they have been higher than that, they have been in the upper 40s. So it's just about in the middle.

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Operator [21]

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(Operator Instructions) Our next question comes from the line of Joel Houck with Wells Fargo.

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Joel Jerome Houck, Wells Fargo Securities, LLC, Research Division - MD and Senior Analyst [22]

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So just to clarify jumped on few minutes late. Did you say Kevin, 3- to 5-year returns are low teens or mid-teens, as it stands now in the agency business?

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [23]

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Well, I mean, I think over that cycle, they'll probably be in the low teens. At this moment, they are a little bit better than that would you agree, Jack?

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Jack DeCicco, CYS Investments, Inc. - CFO and Treasurer [24]

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Yes.

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [25]

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Better than that. But just -- I'm putting -- this is a crystal ball question Joel. But probably, over that period of time, I'm thinking it's low teens.

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Joel Jerome Houck, Wells Fargo Securities, LLC, Research Division - MD and Senior Analyst [26]

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Okay. So if you look at the next 3 or 5 years, and I think, I generally agree with your comments about the long end of the curve probably anchored closer to 2% than 3%, those are my words not yours. But I think the gist of your comments was that given GDP growth, if the Feds -- if the fiscal policies don't come through there's probably further downside in the 10-year. But if the Fed continues normalize, say, 1.25%, does that -- does your low teens ROE take that into account? Or it's just the similar curve?

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [27]

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Yes. That's my -- my expectation -- you may have hopped on late, but I laid out our expectations for Fed funds and kind of what we're building into our calculations and our planning.

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Joel Jerome Houck, Wells Fargo Securities, LLC, Research Division - MD and Senior Analyst [28]

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So basically 2, 3 more rate increase this year. And that would take into account some narrowing of the curve, assuming mortgage spreads stay roughly where they are, you can withstand that and still deliver low teen ROE?

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [29]

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Yes. One thing that folks on this call might not be aware off, repo rates have backed up. But they really anticipated the Fed tightening, many months ago. So you notice that our cost of financing didn't go up by as much as the Fed tightening. The Fed's tightened twice in the four months. And repo hasn't gone up 50 basis points.

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Joel Jerome Houck, Wells Fargo Securities, LLC, Research Division - MD and Senior Analyst [30]

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Yes, I guess the repo market is kind of forward-looking in terms of the Fed curve.

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [31]

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Exactly that.

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Joel Jerome Houck, Wells Fargo Securities, LLC, Research Division - MD and Senior Analyst [32]

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Okay, that's a good point. So in a scenario where the 10-year goes below 2%. Is that a scenario where perhaps, current returns come down, but you're better able to kind of offset that with, obviously, lower prepayments, lower CPR, which has a buffering effect to net interest income? But what about stability of book value. Do you feel -- in the unlikely event, we see further downward pressure, how does book value hold up in that environment?

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [33]

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Well if you don't over hedge, particularly with 10 year swaps, then book value is quite strong. And I'd also point out that if the 10-year is sending that kind of signal, it's probably going to slow down the Fed.

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Joel Jerome Houck, Wells Fargo Securities, LLC, Research Division - MD and Senior Analyst [34]

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So your point is the Fed doesn't operate in a vacuum. They may see -- they may appear to some times to people, but the reality is that they are keenly aware of what's the progress, or lack thereof, in fiscal policy.

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [35]

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Oh, absolutely. They see it in market signals, so for example if the equity market is all fired up because it anticipates a huge tax cut as it has in the past couple of months. That signal emboldens the Fed. And they don't say that they're looking at the equity markets, but they absolutely look at markets for signals.

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Joel Jerome Houck, Wells Fargo Securities, LLC, Research Division - MD and Senior Analyst [36]

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Okay. And then one, one, a follow-on, if I may. So back to the notion of mortgage spreads behaving in light of the Fed, perhaps signaling and unwind quicker than maybe people were thinking. Your point is that it's -- the supply of what the Fed would be running off would be more than met by asset managers and other participants given just the overall level of capital coming back to investors, if they want to maintain the same exposure, that they're going to make up for what the Fed will allow them run off.

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [37]

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Yes, I think the market has spoken on that one. The Fed has -- bunch of speakers have been talking -- the trial balloons, the past several weeks, which cause all the research analysts on The Street to actually look at the numbers, do their publishing as they need to do, and spreads in mortgages have actually tightened.

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Joel Jerome Houck, Wells Fargo Securities, LLC, Research Division - MD and Senior Analyst [38]

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Right. Which, I guess, I would have been -- it has happened, it's a true statement, I guess that I find it a little surprising that that's how it played out. But ...

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [39]

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Well, the roll off of the portfolio just through maturities and natural run down is pretty significant.

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Joel Jerome Houck, Wells Fargo Securities, LLC, Research Division - MD and Senior Analyst [40]

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Yes. But your point is unless the Fed surprises with an outright sale of assets because this is probably priced in?

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [41]

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I'd say it's largely priced in. And in an outright sale of assets it's really problematic for the U.S. budget deficit.

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Operator [42]

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And our next question comes from the line of Jim Young with West Family Investments.

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James Young, West Family Investments, Inc. - Investment Analyst [43]

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Kevin, you mentioned your perspective about the potential GDP as you look at the labor force and productivity going forward. But just kind of curious, how you think about, what is the appropriate neutral interest rate going forward? And do you agree with some of the other people, not from the Fed, who expressed that the current and future interest rate is lower than normalized levels, where it has been historically?

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [44]

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Yes. This whole notion of the normal level of Fed funds really needs to be conditioned upon how much leverage there is in the system. So if the system -- and this consumers, corporates and the U.S. Treasury and states and municipalities for that matter. If there's a lot of leverage in the system, then in the short-term, economic growth, GDP growth can make wild swings around potential GDP growth. And all you're really doing is moving forward, pulling in, spending either consumer or business spending that might have happened in the future anyway. And you can do that from a policy perspective and an amazing number of ways from deductibility of capital spending, it's just a long list of ways.

So historically, until the crisis, the system was much more levered than it is today. And during those growth years in the population, of course, we had 4% GDP growth because the population was growing so much. And the banking system could lever up to meet that growing consumer demand. The environment of the past couple of years is very different, and the regulatory environment has really pushed down leverage across the board, consumers, subprime lending is just one obvious example, bank leverage is a half of what it was. So you've got an environment today where actual GDP growth is around potential GDP growth, which is a much more sustainable system. It's music to the years of regulators, this exactly what they want and they want more stable system. But it's really annoying to politicians who're trying to get elected to office. Because there's something to rail against, the good old days versus current days. So that leads me to believe that much is contingent upon how successful the new administration is getting these growth policies in play. And if they go into play, it'll take quite a while for the system to lever back up. But I think the challenges that we're seeing in Washington are really putting a bucket of cold water on the prospects. And the bond market is telling you that.

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Operator [45]

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(Operator Instructions) our next question comes from the line of Merrill Ross with Wunderlich.

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Merrill H. Ross, Wunderlich Securities Inc., Research Division - Senior Analyst [46]

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Kevin, I wonder if you or Bill would comment on, how you think, the Fed's rebalancing will affect the specialness in the TBA market?

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [47]

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That's a good question Merrill, do you want to -- any thoughts Bill?

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William Shean, [48]

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Yes. That's a really good question and in fact, we'll be talking about that on Monday. The portfolio consists of basically 3s, 3.5s and 4s mostly in 30-year products. And depending on what they do, if you outline a scenario where they just let it roll off but it doesn't affect the spec pool market as much. But if they go into a sell mode, they're going to create a brand-new universe of spec tools for us to potentially buy and operate within. So we'll just have to see what actually happens. But to the extent that they create more of a spec pool market the TBA market will probably be a little weaker. To the extent that they create less of the spec pool market, the TBA market will probably be a little stronger.

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Kevin E. Grant, CYS Investments, Inc. - Chairman of the Board, CEO, President and CIO [49]

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Yes, just to add. I guess I've been doing this almost 30 years, Bill you're kind of similar -- there's always been a good dollar roll market somewhere. It's just that the Fed's activity has magnified those opportunities over the past couple of years.

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Merrill H. Ross, Wunderlich Securities Inc., Research Division - Senior Analyst [50]

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Yes, I agree, I think in their white paper, that they published in January, they said that they had pretty much [ DK-ed ] the idea, the auction as in the MBS. But it also depends, because they project that in 2025, they'll still own maybe up to $950 billion of MBS, or maybe half that. So it's pretty much a moving target.

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William Shean, [51]

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If they just let it roll off, it'll be quite a while.

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Operator [52]

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(Operator Instructions) And I'm showing no further questions at this time. I'd like to turn the call back to Mr. Cleary for closing remarks.

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Richard E. Cleary, CYS Investments, Inc. - COO and Assistant Secretary [53]

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Thanks, Kelly. And on behalf of Kevin, Jack, 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. We thank you for your continued support and interest. Have a nice day.

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Operator [54]

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Ladies and gentleman, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone have a wonderful day.