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CYS > SEC Filings for CYS > Form 10-Q on 19-Oct-2012All Recent SEC Filings

Show all filings for CYS INVESTMENTS, INC.

Form 10-Q for CYS INVESTMENTS, INC.


19-Oct-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
In this Quarterly Report on Form 10-Q, we refer to CYS Investments, Inc. as "we," "us," "our company," or "our," unless we specifically state otherwise or the context indicates otherwise. The following defines certain of the commonly used terms in this quarterly report on Form 10-Q: RMBS refers to residential mortgage-backed securities; agency securities or Agency RMBS refers to our RMBS that are issued or whose principal and interest payments are guaranteed by a federally chartered corporation, such as the Federal National Mortgage Association ("Fannie Mae") or the Federal Home Loan Mortgage Corporation ("Freddie Mac"), or an agency of the U.S. government, such as the Government National Mortgage Association ("Ginnie Mae"); ARMs refers to adjustable-rate mortgage loans that typically have interest rates that adjust annually to an increment over a specified interest rate index; and hybrids refers to ARMs that have interest rates that are fixed for a specified period of time and, thereafter, generally adjust annually to an increment over a specified interest rate index.
The following discussion should be read in conjunction with our financial statements and accompanying notes included in Item 1 of this Quarterly Report on Form 10-Q as well as our Annual Report on Form 10-K for the fiscal year ended December 31, 2011, filed on February 13, 2012. Forward Looking Statements
When used in this Quarterly Report on Form 10-Q, in future filings with the Securities and Exchange Commission ("SEC") or in press releases or other written or oral communications, statements which are not historical in nature, including those containing words such as "believe," "expect," "anticipate," "estimate," "plan," "continue," "intend," "should," "may" or similar expressions, are intended to identify "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and, as such, may involve known and unknown risks, uncertainties and assumptions. The forward-looking statements we make in this Quarterly Report on Form 10-Q include, but are not limited to, statements about the following:
            the effect of movements in interest rates on our assets and
             liabilities (including our hedging instruments) and our net income;


            our investment, financing and hedging strategy and the success of
             these strategies;

the effect of increased prepayment rates on our portfolio;

            our ability to convert our assets into cash or extend the financing
             terms related to our assets;


            the effect of widening credit spreads on the value of our assets and
             investment strategy;

the types of indebtedness we may incur;

our ability to quantify risks based on historical experience;

            our ability to be taxed as a real estate investment trust ("REIT")
             and to maintain an exemption from registration under the Investment
             Company Act of 1940, as amended (the "Investment Company Act");

our assessment of counterparty risk;

our ability to meet short term liquidity requirements with our cash flow from operations and borrowings;

our liquidity;

our asset valuation policies;

our distribution policy; and

the effect of recent U.S. Government actions on interest rates and the housing and credit markets.

Forward-looking statements are based on our beliefs, assumptions and expectations of our future performance, taking into account all information currently available to us. These beliefs, assumptions and expectations are subject to risks and uncertainties and can change as a result of many possible events or factors, not all of which are known to us. If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements. The following factors could cause actual results to vary from our forward-looking statements:
the factors referenced in this Quarterly Report on Form 10-Q;

changes in our investment, financing and hedging strategy;

the adequacy of our cash flow from operations and borrowings to meet our short term liquidity requirements;

the liquidity of our portfolio;


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unanticipated changes in our industry, interest rates, the credit markets, the general economy or the real estate market;

changes in interest rates and the market value of our Agency RMBS;

changes in the prepayment rates on the mortgage loans underlying our Agency RMBS;

our ability to borrow to finance our assets;

changes in government regulations affecting our business;

            our ability to maintain our qualification as a REIT for federal
             income tax purposes;


            our ability to maintain our exemption from registration under the
             Investment Company Act and the availability of such exemption in the
             future; and


            risks associated with investing in real estate assets, including
             changes in business conditions and the general economy.

These and other risks, uncertainties and factors, including those described elsewhere in this report, could cause our actual results to differ materially from those projected in any forward-looking statements we make. All forward-looking statements speak only as of the date on which they are made. New risks and uncertainties arise over time and it is not possible to predict those events or how they may affect us. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Overview
We are a specialty finance company created with the objective of achieving consistent risk-adjusted investment income. We seek to achieve this objective by investing, on a leveraged basis, in Agency RMBS. In addition, our investment guidelines permit investments in collateralized mortgage obligations issued by a government agency or government sponsored entity that are collateralized by Agency RMBS ("CMOs"), although we had not invested in any CMOs as of September 30, 2012. We commenced operations in February 2006, and completed our initial public offering in June 2009. Our common stock and our Series A Cumulative Redeemable Preferred Stock, $25.00 liquidation preference (the "Series A Preferred Stock") trade on the New York Stock Exchange under the symbols "CYS" and "CYS PrA," respectively.
We earn investment income from our investment portfolio, and we use leverage to seek to enhance our returns. Our net investment income is generated primarily from the difference, or net spread, between the interest income we earn on our investment portfolio and the cost of our borrowings and hedging activities. The amount of net investment income we earn on our investments depends in part on our ability to control our financing costs, which comprise a significant portion of our operating expenses. Although we leverage our portfolio investments in Agency RMBS to seek to enhance our potential returns, leverage also may exacerbate losses.
While we use hedging to mitigate some of our interest rate risk, we do not hedge all of our exposure to changes in interest rates. This is because there are practical limitations on our ability to insulate our portfolio from all potential negative consequences associated with changes in short term interest rates in a manner that will allow us to achieve attractive spreads on our portfolio.
In addition to investing in issued pools of Agency RMBS, we regularly utilize forward settling transactions, including forward-settling purchases of Agency RMBS where the pool is "to-be-announced" ("TBAs"). Pursuant to these TBAs, we agree to purchase, for future delivery, Agency RMBS with certain principal and interest terms and certain types of underlying collateral, but the particular Agency RMBS to be delivered is not identified until shortly before the TBA settlement date. For our other forward settling transactions, we agree to purchase, for future delivery, Agency RMBS. However, unlike our TBAs, these forward settling transactions reference an identified Agency RMBS.
We have elected to be taxed as a REIT and have complied, and intend to continue to comply, with the provisions of the Internal Revenue Code of 1986, as amended (the "Internal Revenue Code"), with respect thereto. Accordingly, we generally do not expect to be subject to federal income tax on our REIT taxable income that we currently distribute to our stockholders if certain asset, income and ownership tests and recordkeeping requirements are fulfilled. Even if we maintain our qualification as a REIT, we may be subject to some federal, state and local taxes on our income.
Factors that Affect our Results of Operations and Financial Condition A variety of industry and economic factors may impact our results of operations and financial condition. These factors include:
interest rate trends;

prepayment rates on mortgages underlying our Agency RMBS, and credit trends insofar as they affect prepayment


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rates;
competition for investments in Agency RMBS;

actions taken by the U.S. Government, including the U.S. Federal Reserve (the "Federal Reserve") and the U.S. Treasury;

credit rating downgrades of the United States' and certain European countries' sovereign debt; and

other market developments.

In addition, a variety of factors relating to our business may also impact our results of operations and financial condition. These factors include:
our degree of leverage;

our access to funding and borrowing capacity;

our borrowing costs;

our hedging activities;

the market value of our investments; and

the REIT requirements and the requirements to qualify for a registration exemption under the Investment Company Act.

We anticipate that, for any period during which changes in the interest rates earned on our assets do not coincide with interest rate changes on the corresponding liabilities, such assets will likely change in value more slowly than the corresponding liabilities. Consequently, changes in interest rates, particularly short term interest rates, may significantly influence our net investment income.
Our net investment income may be affected by a difference between actual prepayment rates and our projections. Prepayments on loans and securities may be influenced by changes in market interest rates and homeowners' ability and desire to refinance their mortgages. To the extent we have acquired assets at a premium or discount to par value, changes in prepayment rates may impact our anticipated yield.
Trends and Recent Market Impacts
The volatility in the U.S. interest rate markets in 2011 and 2012 has produced opportunities in our markets. While the performance of the U.S. economy in 2011 was disappointing primarily due to a lack of significant job growth, the first quarter of 2012 appeared to show some improvement in job growth and U.S. real gross domestic product ("GDP") growth. However, this trend has not been sustained and GDP growth expectations have declined in the third quarter of 2012. The Federal Reserve's September 2012 release had their 2012 GDP projection in the range of 1.6% to 2.0%, which is down from their June projection of 1.6% to 2.5%. The Federal Reserve's core personal consumption expenditures inflation projection is low through 2015, at rates ranging from 1.6% to 2.3%. In September 2012, the U.S. Federal Reserve Open Market Committee announced an open-ended program to purchase an additional $40 billion of Agency RMBS per month until the unemployment rate, among other economic indicators, show signs of improvement. This program, when combined with the Federal Reserve's existing programs to extend its holdings' average maturity, and reinvest principal payments from its holdings of agency debt and Agency RMBS into Agency RMBS, is expected to increase the Federal Reserve's holdings of long-term securities by approximately $85 billion per month through the end of 2012. The Federal Reserve also announced that it will keep the target range for the Federal Funds Rate between zero and 0.25% through at least mid-2015, which is six months longer than the Federal Reserve had previously announced.
The Federal Reserve expects these measures to put downward pressure on long-term interest rates. In the short term, these actions have driven Agency RMBS prices to all-time highs, which has further compressed interest spreads, and removed the historical correlation between mortgage rates and U.S. Treasury or interest rate swaps. These factors have contributed to a challenging interest rate hedging environment.
The U.S. unemployment rate declined in recent months from 8.5% in December 2011 to 7.8% in September 2012. However, this downward trend is partly explained by the decrease in the participation rate, which went from 64.0% in December 2011 to 63.6% in September 2012. Uncertainty in the marketplace surrounding the longer-term pace of job creation continues to be a concern for the U.S. economy and likely will remain a primary focus in the upcoming presidential election. While existing home sales have increased recently, with some regions showing a small increase in average home prices, the residential construction sector remains depressed. According to the U.S. Department of Commerce, privately-owned housing units authorized by building permits in August 2012 were at a seasonally adjusted annual rate of 801,000. To put this figure in perspective, the September 2004 annual rate was 2,041,000.


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In addition, the over hang of the European debt crisis and the recent downgrading of a significant number of U.S. banks by Moody's also adds pressure to the U.S. economy and consumer confidence.
Overall inflation and wage pressures have remained relatively muted in recent months despite prices of crude oil and gasoline increasing in the first nine months of 2012.
The following trends and recent market impacts may also affect our business:
Interest Rates
As described above, the actions by the Federal Reserve have decoupled U.S. Treasury rates from mortgage rates. During the nine months ended September 30, 2012, the 10 Year U.S. Treasury rate decreased 24 basis points to 1.64%. This compares with a decrease of 104 basis points in the yield on par-priced Fannie Mae Agency RMBS backed by 30 year fixed rate mortgage loans to 1.84% at September 30, 2012. This demand has come primarily from the Federal Reserve. Based on Agency RMBS issuance data from Fannie Mae, Freddie Mac and Ginnie Mae between July and September 2012, it is estimated that the Federal Reserve could purchase as much as 58% of monthly new issuance through the end of 2012. During the three months ended September 30, 2012 the average yield on the Company's purchases of Agency RMBS was 1.86%. The following table illustrates this market environment by comparing market levels for three benchmark securities or rates, the yield on five year U.S. Treasury Notes, the three year interest rate swap rate and the yield of par-priced Fannie Mae Agency RMBS backed by 15 year fixed rate mortgage loans:

                                                                             Par-priced Fannie
                                 Five Year U.S.       Three Year Interest    Mae 15 year RMBS
Date                              Treasury Note         Rate Swap Rates            Yield
September 30, 2012                       0.625 %                0.439 %                0.820 %
June 30, 2012                            0.718 %                0.624 %                1.706 %
March 31, 2012                           1.039 %                0.758 %                1.997 %
December 31, 2011                        0.832 %                0.820 %                2.102 %
September 30, 2011                       0.952 %                0.736 %                2.124 %
June 30, 2011                            1.761 %                1.147 %                3.143 %
March 31, 2011                           2.277 %                1.571 %                3.494 %
December 31, 2010                        2.006 %                1.279 %                3.401 %

Source: Bloomberg
Short-term rates have remained low, the table below presents 30-Day LIBOR, 3-Month LIBOR and the U.S. Federal Funds Target Rate at the end of each respective fiscal quarter. The availability of repurchase agreement financing is stable with interest rates between 0.34% and 0.53% for 30-90 day repurchase agreements at September 30, 2012. Several of our repurchase agreement counterparties were downgraded by Moody's in the second quarter of 2012. We believe that these downgrades resulted in slightly higher financing costs, and this modestly-incremental cost is likely to remain in place for the foreseeable future.

Date               30-Day LIBOR     3-Month LIBOR    Federal Funds Target Rate
September 30, 2012      0.214 %          0.359 %                     0.25 %
June 30, 2012           0.246 %          0.461 %                     0.25 %
March 31, 2012          0.241 %          0.468 %                     0.25 %
December 31, 2011       0.295 %          0.581 %                     0.25 %
September 30, 2011      0.239 %          0.374 %                     0.25 %
June 30, 2011           0.186 %          0.246 %                     0.25 %
March 31, 2011          0.243 %          0.303 %                     0.25 %
December 31, 2010       0.261 %          0.303 %                     0.25 %

Source: Bloomberg

In 2012, the yield curve has flattened slightly. This has primarily been the result of various Federal Reserve actions since September 2011 designed to maintain the recent low level of the U.S. Federal Funds Target Rate and lower yields on longer term U.S. Treasury securities, which the Federal Reserve expects to consequently lower interest rates that are tied to such


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yields, such as mortgage rates and interest rates on commercial loans. Such programs are described in more detail below under the heading "-Government Activity." Below is a graph of the yield curve at September 30, 2012 and December 31, 2011.

[[Image Removed]]
Prepayment Rates and Loan Buy-back Programs Prepayment rates were very low in the summer of 2011 but have increased since then as mortgages rates continue to push against historical lows. According to data provided by Freddie Mac, the weighted average commitment rate on a 30 year fixed rate mortgage was 3.36% in September 2012, compared to 3.95% in December 2011. However, the continued weak U.S. housing market and high unemployment have reduced many U.S. homeowners' ability to refinance their mortgages. The following table presents the prepayment rates for the population of Fannie Mae Agency RMBS backed by 15 year and 30 year fixed rate mortgages:
        Jan-11    Feb-11    Mar-11    Apr-11    May-11    Jun-11    Jul-11    Aug-11    Sep-11    Oct-11    Nov-11    Dec-11
15 Year  17.8 %    13.6 %    13.7 %    12.2 %    12.2 %    14.7 %    15.6 %    18.4 %    23.0 %    25.2 %    23.2 %    20.8 %
30 Year  19.5 %    15.5 %    15.4 %    13.4 %    13.0 %    14.9 %    14.9 %    16.8 %    21.4 %    24.4 %    25.2 %    23.6 %


        Jan-12    Feb-12    Mar-12    Apr-12    May-12    Jun-12    Jul-12    Aug-12    Sep-12
15 Year  18.8 %    20.9 %    21.6 %    18.7 %    18.5 %    19.2 %    21.0 %    23.6 %    21.0 %
30 Year  21.6 %    25.0 %    25.8 %    23.7 %    24.8 %    25.8 %    28.0 %    31.2 %    28.0 %


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[[Image Removed]]
Source: eMBS
Government Activity

On October 4, 2012, the Federal Housing Finance Authority (the "FHFA") released its white paper entitled "Building a New Infrastructure for the Secondary Mortgage Market" (the "FHFA White Paper"). This release follows up on the FHFA's February 21, 2012 Strategic Plan for Enterprise Conservatorships, which set forth three goals for the next phase of the Fannie Mae and Freddie Mac conservatorships. These three goals are to (i) build a new infrastructure for the secondary mortgage market, (ii) gradually contract Fannie Mae and Freddie Mac's presence in the marketplace while simplifying and shrinking their operations, and (iii) maintain foreclosure prevention activities and credit availability for new and refinanced mortgages.

The FHFA White Paper proposes a new infrastructure for Fannie Mae and Freddie Mac that has two basic goals. The first goal is to replace the current, outdated infrastructures of Fannie Mae and Freddie Mac with a common, more efficient infrastructure that aligns the standards and practices of the two entities, beginning with core functions performed by both entities such as issuance, master servicing, bond administration, collateral management and data integration. The second goal is to establish an operating framework for Fannie Mae and Freddie Mac that is consistent with the progress of housing finance reform and encourages and accommodates the increased participation of private capital in assuming credit risk associated with the secondary mortgage market. The FHFA recognizes that there are a number of impediments to their goals which may or may not be surmountable, such as the absence of any significant secondary mortgage market mechanisms beyond Fannie Mae, Freddie Mac and Ginnie Mae, and that their proposals are in the formative stages. As a result, it is unclear if the proposals will be enacted. If such proposals are enacted, it is unclear how closely what is enacted will resemble the proposals from the FHFA White Paper or what the effects of the enactment will be.

In September 2012, the U.S. Federal Reserve Open Market Committee announced an open-ended program to purchase an additional $40 billion of Agency RMBS per month until the unemployment rate, among other economic indicators, show signs of improvement. This program, when combined with the Federal Reserve's existing programs to extend its holdings' average maturity, and reinvest principal payments from its holdings of agency debt and Agency RMBS into Agency RMBS, is expected to increase the Federal Reserve's holdings of long-term securities by approximately $85 billion per month through the end of 2012. The Federal Reserve also announced that it will keep the target range for the Federal Funds Rate between zero and 0.25% through at least mid-2015, which is six months longer than the Federal Reserve had previously announced.

The Federal Reserve expects these measures to put downward pressure on long-term interest rates. In the short term, these actions have driven Agency RMBS prices to new highs, which has further compressed interest spreads, and caused the historical correlation between mortgage rates and U.S. Treasury or interest rate swaps to no longer exist.
On January 4, 2012, the Federal Reserve released a report titled "The U.S. Housing Market: Current Conditions and


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Policy Considerations" to Congress, which provided a framework for thinking about certain issues and tradeoffs that policy makers might consider. It is unclear how future legislation may impact the housing finance market and the investing environment for Agency RMBS as the method of reform is undecided and has not yet been defined by the regulators.
On September 21, 2011, the Federal Reserve announced its maturity extension program whereby it intended to sell $400 billion of shorter-term U.S. Treasury securities by the end of June 2012 and use the proceeds to buy longer-term U.S. Treasury securities. This program is intended to extend the average maturity of the securities in the Federal Reserve's portfolio. By reducing the supply of longer-term U.S. Treasury securities in the market, this action should put downward pressure on longer-term interest rates, including rates on financial assets that investors consider to be close substitutes for longer-term U.S. Treasury securities, like certain types of Agency RMBS. The reduction in longer-term interest rates, in turn, may contribute to a broad easing in financial market conditions that the Federal Reserve hopes will provide additional stimulus to support the economic recovery. In response to lagging economic growth, in June 2012, the Federal Reserve announced it was adding another $267 billion and extending the duration of the program aimed at lengthening the maturity of its portfolio through the end of 2012 in an effort to put additional downward pressure on long-term interest rates. The Federal Reserve also reaffirmed its policy to reinvest payments of principal and interest from its holdings of Agency RMBS.
In September 2011, the White House announced it is working on a major plan to allow some of the 11 million homeowners who owe more on their mortgages than their homes are worth to refinance. Consequently, in October 2011 the FHFA announced changes to the Home Affordable Refinance Program ("HARP") to expand access to refinancing for qualified individuals and families whose homes have lost value. One such change is to increase the HARP loan-to-value ceiling above 125%. However, this would only apply to mortgages guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. There are many challenging issues to this proposal, notably the question as to whether a loan with a 125% or greater loan-to-value ratio qualifies as a mortgage or an unsecured consumer loan. The chances of this initiative's success and other ideas proposed by the Federal Reserve's white paper, have created additional uncertainty in the RMBS market, particularly with respect to possible increases in prepayment rates. According to information published by the U.S. Department of Housing and Urban Development, 519,500 distressed homeowners were refinanced in the period from January through July of 2012.
In February 2011, the U.S. Department of the Treasury along with the U.S. Department of Housing and Urban Development released a report titled "Reforming America's Housing Finance Market" to Congress outlining recommendations for reforming the U.S. housing system, specifically Fannie Mae and Freddie Mac, and transforming government involvement in the housing market. It is unclear how future legislation may impact the housing finance market and the investing environment for Agency RMBS as the method of reform is undecided and has not yet been defined by the regulators.
On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") into law. The Dodd-Frank Act is extensive, complicated and comprehensive legislation that impacts practically . . .

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