Annaly Capital Management, Inc.

Willa Sheridan Wellington Jamie Denahan-Norris - Chairman and Chief Executive Officer Kevin G. Keyes - President and Director

Steven C. Delaney - JMP Securities LLC, Research Division Arren Cyganovich - Evercore Partners Inc., Research Division Richard B.

Shane - JP Morgan Chase & Co, Research Division Daniel Furtado - Jefferies LLC, Research Division Michael R. Widner - Keefe, Bruyette, & Woods, Inc., Research Division Joel Jerome Houck - Wells Fargo Securities, LLC, Research Division

Good morning, and welcome to the third quarter 2013 earnings call for Annaly Capital Management. Any forward-looking statements made during today's call are subject to risks and uncertainties, which are outlined in the risk factors in our most recent annual and quarterly SEC filings.

Actual events and results may differ materially from these forward-looking statements. We encourage you to read the forward-looking statements disclaimer in our earnings release, in addition to our quarterly and annual filing.

Additionally, the content of this conference call may contain time-sensitive information that is accurate only as of the date of the earnings call. We do not undertake and specifically disclaim any obligation to update or revise this information.

Participants on this morning's call include Wellington Denahan, Chairman and Chief Executive Officer; Kevin Keyes, President; and Glenn Votek, Chief Financial Officer. I will now turn the conference call over to Wellington Denahan, Chairman and Chief Executive Officer.

Thank you, Willa. And welcome to the Annaly Capital Third Quarter 2013 Earnings Call.

And as Willa mentioned, joining me on the call today are Kevin Keyes, our President; and Glenn Votek, our CFO. I will make a few brief remarks before opening the call up for questions.

Former Fed Chairman Alan Greenspan, who famously coined the term irrational exuberance, recently admitted that he was unappreciative of the impact human behavior had on economic outcome. He underestimated the influence and response time of fear, while seemingly ignoring the propulsive power of greed when coupled with easy money.

For an intelligent man who presided over several bubbles, you would think he would have stumbled upon that epiphany sooner. Greenspan was known to have dedicated a tremendous amount of time and energy to reading data, yet he somehow missed the plethora of news articles describing the raw animal spirits being unleashed by both the technology and housing bubbles years before they burst.

Some of these blind spots are understandable, given that so often in economics, we focus on the change in data and not the data itself, the change in the price of an asset and not the price itself. Greenspan is just one of many policymakers who underappreciate the impact, behavior and incentives have on markets and outcomes.

I do not envy the challenges facing our policymakers. But I do hope that they take a moment to question their econometric modeling and the potential for obscure, yet powerful, unintended consequences of an irrational reliance on modeled outcomes.

No doubt, it is a healthy development for regulators to focus on reducing the risks posed by too much leverage in the system. However, it is worthy to note that GDP growth relies heavily on debt growth and debt growth relies heavily on the ability to lever any asset in any market.

There continues to be press regarding mREITs and their participation in the repo markets. As banks are asked to hold more capital against their repo business, the impact on institutions like us, that own high-quality collateral like agency MBS is projected to be far less than the estimated 10% to 20% reduction for the overall market.

All else equal, rates in the repo markets will likely rise 5 to 15 basis points for high-quality collateral to compensate for the increased capital requirements associated with repo activity. This slight adjustment equates to the range of daily volatility in the financing markets prior to the Fed's presence, we have been familiar with for the past 17 years.

As we have mentioned many times on these calls, we have been mindful of the impacts reform and policy uncertainty would have on capital decision and have continued to maintain a fairly conservative stand. As we approach a potential monetary policy inflection point, we have further reduced our leverage to 5.4% from 6.2%; increased our hedges to 74% from 56% of our assets, while also reducing the underlying duration of our mortgage portfolio.

All of which has resulted in a very solid net capital ratio of 14.8% and a stable core earnings profile ranging from $0.32 to $0.28 over the past 5 quarters. We remain on track for our capital investment of approximately $2 billion into the commercial real estate assets by year end.

We have taken advantage of some very attractive opportunities, in large part due to the strength and experience of our team, coupled with our powerful and flexible capital position. On a standalone basis, our commercial business is now one of the largest among the publicly traded commercial REITs.

Our commercial investment portfolio now accounts for roughly 11% of our capital, and at a 9.7% cash-on-cash return is responsible for 11% of our core earnings. As lawmakers continue to solve for the best solutions to housing finance reform, I firmly believe that we remain poised to play a powerful role as a capital provider to the housing market for years to come.

The investment disciplines placed on REIT management team, who have to distribute 90% of their earnings annually who don't have the benefit of retained earnings and rely on capital markets for growth, are unparalleled in most of corporate America. At 1/10 the size, the $600 billion size of the equity REIT market, the mortgage REIT sector could provide the same type of capital solution to mortgage finance that the equity REITs provided to property ownership back in the early '90s.

To transition the $5 trillion agency mortgage market from government's hand, we will need as many cap -- private capital providers the markets can find. We continue to prepare for policymaker blind spots, while keeping our focus on strategic opportunities in the ever-changing investment landscape.

I want to commend our entire team on a job very well done in navigating through a very unique market environment. Thank you, all, for joining us on this call today.

And with that, we will open the call for questions.

I'm going to stay big picture. It's late in the earnings season, I think we're all worn out with nuts and bolts.

So the first thing, just looking at all the mortgage REIT reports over the last 2 or 3 weeks, and there's clearly been a universal de-risking, and whether your agency or hybrid, it's pretty much the same story, lower leverage and lower net durations. And what's interesting to me is that the magnitude of this risk off our portfolio repositioning appears to be have much greater in the third quarter than in the second quarter when we first got the rate spike.

So I was just curious, as you look back over the last -- what are we talking about now, almost 6 months -- 5 or 6 months, why did we get more of a response by portfolio managers like yourself in 3Q rather than in 2Q? Could you help me understand that?

Steve, I would -- that's a great question, by the way. But I do think there is a sea change in the approach to risk-taking with the policy overhang that we've had for so long.

Now in Q2, everybody was convinced that the taper talk was priced in somewhat into the market. They have been talking about it for a while, but I think when they upped the volume of it, the market really got to see the underlying risk that was being placed in the market through policy.

And the midst -- it's across the board. I wouldn't say it's just a mortgage market.

I would say that monetary policy has helped put people into risks at the wrong price. And what I do think you've seen is that everybody was convinced they understood the communications coming from the Fed.

And then, most recently, we had a complete turnaround, and now everybody is kind of trying to figure out exactly where they're going to go with policy. And I don't think that now is the time for -- I don't think anybody, given how many people got it wrong, can sit here and sit before you and say that they know exactly when they're going to taper and they know exactly what the impacts are going to be on mortgage assets and all assets in particular.

So, I just think that you see the benefits of being unprepared for it come through earnings. But I think those are far outweighed by the disadvantages of having too much risk in the book as we potentially change dramatically into an environment that none of us have ever been through.

We've never had the Fed being the size of participants that they are and the possibility. I liken it to, their purchases have been equivalent of a new $6 billion REIT being formed every single month and levering 6 times.

And every single month for the last several years, you've had that kind of participation. And a REIT that doesn't hedge, it just goes long.

And so that's the kind of demand -- the thought of that kind of demand leaving the market at these levels, I think, is enough for significant amount of pause from everybody who participates in the space.

Yes, I mean it's a pretty intimidating withdrawal of liquidity, no question. And I think your point about the Fed, maybe bluffing everyone into paying the wrong prices for risk.

Maybe in May, June, all of us collectively didn't want to admit it, but I think, as the summer went on, that reality hit everybody in the face.

Well, I think everybody was under the understanding that the Fed took duration out of the market. So that there wouldn't be the same amount of duration in the market that there was previous to their participation.

And quite frankly, I think they just changed the profile of what was remaining.

That's helpful. And I've just got a quick follow-up, if I may.

You hit on this in your opening remarks, Wellington, about the press comments about the repo market. Over the years, both you and Mike commented that Annaly maintains sort of rolling informal dialogue with the New York Fed about, just frequently talking about conditions in the repo market.

A lot of press obviously talking about the Fed oversight of REITs. I was just curious on your thoughts on whether you think that, maybe behind the scenes the Fed is quietly being proactive and working with the dealer community just to be doubly sure of stability in the repo markets and maybe even so far as to address this perceived risk that Jeremy Stein [ph] and others have said -- have commented on about potential excessive risk taking by the mortgage REITs specifically.

And I'll leave it with that.

I think, Bernanke made it as part of their policy to incorporate an increased dialogue with the dealer community on their counterparty exposures, and the REITs being one of that. I think it's a tremendously healthy development for there to be a greater understanding of players in the market and the kinds of risks that various participants take.

So we look at it as a healthy development and a lot of what you've heard from us and seen from us in our portfolio over the last couple of quarters, if not years, is this realization of the kinds of reforms that are taking place. And some were just talked about early on, and now you are into the implementation stages.

And so the dialogue has certainly gained some volume. But I think it's very healthy that these discussions are out there.

One thing I would say, we were -- the REITs were mentioned once again in the IMF report most recently, was kind of a rehashing of a lot of the other press that was out there. But all of this liquidity is not, and -- we often talk about it here that there's other structures out there.

I don't know why the REITs would be singled out particularly, but there's other structures out there, whether you're a bond mutual fund that has fairly long-duration asset in a daily liquidity vehicle, or you're an ETF that -- so there's a lot of other forms of potential volatility that I think, Jeremy Stein was right. And REITs were one of the things mentioned, but there was other things in there, and it's right that they should be focused on some of the mismatches, whether it's in maturity mismatch or liquidity mismatch or collateral transformation, transactions, things like that.

So I think it is a healthy development that the Fed and all the regulators are asking more questions and concerned about more things.

Maybe it's a good thing for us not be part, at our industry [ph], meaning mortgage REITs not to be considered part of the shadow banking system, but maybe shed a light on everything so there's no mystery.

No. And we are actively, as a group, working on what kinds of potential increased disclosures we can offer to regulators.

And there's a number of things out there through the financial stability board that have outlined some of the information they'd like to see from all participants in the repo market, not just REITs. And so a lot of that stuff we already provide, but there is -- we can always format it in a way that is easier for regulators to standardize disclosure across all participants, and REITs being one of them.

Steve, this is Kevin. One thing I would add just to your original point on, we're at the tail end here of earnings season for the third quarter versus the second quarter comparisons.

I mean, I think you've realized that we've been setting up for this volatility in this market in the reg reform well before the second quarter. And frankly, what we've done with our portfolio and our leverage just happened, bringing down the portfolio and the leverage well before the second quarter, so that's the first thing.

The second thing, obviously, our diversification into commercial. That was spawned well before the current market conditions and now we have that option that, frankly, no one of our size does.

And we like that. So coupled with our leverage, which is 30% to 40% lower than the space overall, those are 2 big weapons that we have to take advantage of the opportunity now, which is clear and present much more so than, certainly last quarter.

And then lastly, it kind of comes down to just long-term management of the business. We haven't been out in the market raising money during these times with record high valuations and dollar prices that obviously had to be corrected.

So we've stepped away from the market for 28 months now in terms of raising common equity, which is our way to tell the market we're going to be disciplined -- continue to be disciplined for the long-term and not just look for an opportunity from a quarter-to-quarter basis.

Yes, one thing, I think, big picture potential that the company has, and I think it's a little bit lost on some of the participants is this ability. When you're running at low leverage, the liquidity that, that gives you and the optionality that, that gives you, even if you just add another turn where you are today with spreads, it has a meaningful impact on core earnings.

And we have chosen not to do that. And our leverage levels are a choice that we have been making.

When we have a new Fed chairman coming in, we have potentially a different kind of communication strategy with the market. The level of liquidity that, that lower leverage gives you is a tremendous plus and advantage to taking advantage of whatever the new landscape in the mortgage space looks like.

So I think it's a little bit lost on people that turning leverage a few times is very easy to turn it back up. It's not always, and I've know I've said this a million times, it's not always easy to turn it down in a way that it's still profitable for shareholders.

I go little more micro focused with the commercial side of the business, obviously, looks interesting. I wonder if you could just talk a little bit about your strategy there?

If we look at the mix of the loan book that you have on there, it's almost half sub mez debt. What are you targeting to grow that?

Are you focusing more on senior? What kind of profiles are you looking at, 6-city trophy-type areas?

Or just kind of little more thought process on the growing commercial side of the business?

We have mainly concentrated on, and obviously, you see the main concentrations are in the senior and mez space. And we have concentrated on the transitional floater arena right now as we originate first in that space.

And obviously, we continue to concentrate on the main food groups in real estate, but also in the more A-, B-type markets for liquidity reasons. So I think that the team has had an incredible advantage in the speed with which they can execute on transactions, given the nimbleness of the capital base and given the fact to that it ties into the liquidity provided them at the agency position being at a lower leverage level.

And what I would do is I would tell you that recent activity even post-quarter, and our activity in the month of October was basically close to the activity for the entire quarter. So the current portfolio stands close to $1.6 billion.

You saw $1.2 billion and change in our release. And to Wellington's point on capital, I mean I think what we're finding, it's the first quarter -- the third quarter was a first quarter we had a consolidated -- we consolidated CreXus.

So it was the first active quarter where we were all operating for 90 days. But basically, our capital is 3x the size of the largest commercial REIT.

Now granted, we're not moving all of the capital into commercial, but what we're unearthing are bigger opportunities, more unique pricing and structures because of that capital base. So the activity in October, I think, makes us feel pretty good about how the team's not only getting acclimated, but just adding to the duration of our cash flows and adding to the cash-on cash returns of the business overall.

Okay, that's helpful. And then on the hedging side of the equation.

You increased swaps a little bit the swaptions increased quite a bit during the quarter. But it looks like most of them expire within 3 to 4 months-ish.

What are your thoughts about replacing those? Letting them -- are those kind of put around the Fed meetings?

What's your thought process in using swaption? And how expensive would be to replace those?

I think we -- the entire mortgage market post Q2 volatility, it has moved out on the duration spectrum. So the need to just maintain a similar risk position calls for greater hedging of the asset cost, and I think that's across the board for the mortgage space in general.

Now the addition of the swaptions and some of the other things that we have been doing are more tactical in nature to help hedge some of the near-term volatility of the transitioning of Fed activity. So the team is actively engaged in looking at what is the best hedging option and what has the best profile for the expected volatility -- near-term volatility, that we would face for the company.

So you will see some of that stuff being replaced. You will see the composition of some of it changing.

But all-in-all, we continue to have a focus on -- as we -- as I like to think that we are in at an inflection point here, focused on the possibility that we're going to see a pretty good change in the interest rate landscape. I think the Fed make it very clear to -- or at least it seems like they've made it very clear that they want to differentiate between the target rate and they're bond buying activities.

And so for any participant in the space, I think that would be a very healthy transition for the Fed to make and that would allow for the market to become steeper and more normalized.

So -- look, in many ways, this was really one of the most interesting and challenging quarters given the sharp movements in MBS pricing first selling off and then rallying. And I suspect a lot of what we saw was -- we wondered if what we saw in terms of portfolios was people looking at the trend through August thinking first sale is best sale and then giving a little whip-sawed when things rallied so sharply in September.

Do you mind, if you could sort of walking us through the quarter both in terms of how you looked at assets? And how you looked at your swap portfolio?

One of the things that we've observed over the years related to Annaly is that you do have less turnover than some of your peers. And I'd love to hear how you think the quarter played out in terms of what you were doing at different points in time?

Yes. This market environment is unique in many ways.

And one of the greatest challenges, I think -- and I know I've said this many times, that not all spread is created equal. Spread at a par $1 price is very different than spread at a $1.07 price.

And so we've taken the opportunity to try and extract from the market some of the valuations that potentially you will never see again post-Fed activity and post some of the policy influences that were taking place on some of the prepayment pay-ups and things like that. As you probably have noted, it's not a lot of chatter about pay-ups in the market and protection for prepayments.

And a lot of that stuff then that was trading 2 points up now, might be trading 2 points back of TBA. So there's been a tremendous amount of -- I would call it, policy driven volatility that is atypical.

And so it has required a little bit different long-term approach to the short-term opportunities you may have in the portfolio. So with the rates where they are and our swap position being more long-term in nature as we potentially move into different interest rate environment, you can take advantage of where you are today as you -- and deal with those periods where it doesn't look that smart way you just did.

But ultimately, in the long run, as you move through the environment, it will pay dividends to shareholders over years to come. So we've taken the opportunity to try and extract some of those dollar prices out of the market that, potentially, you will never see again, absent policy.

I know it's become commonplace. But unfortunately, I have a little bit longer view and can realize that, that kind of sponsorship at those kind of dollar prices, just as a long-term participant, I know the kinds of disadvantages to being exposed to that over the long term.

So we've try to operate in the environment that we're in. There's no doubt.

There's -- you can't get around it, but trying to be somewhat nimble and conservative in our approach to holding onto those assets or the willingness to trade out of them.

I mean, Rick, what I would just add, is my comment earlier on just long-term management and everything Wellington mentioned about our history. And it kind of is more relevant today than, I think, ever before.

This quarter a year ago, our core dividend was -- core earnings was $0.30. This last quarter, we're at $0.28.

And the 3 quarters in between was a couple of pennies here and there, so up or down. So if you look across the space, not just in the mortgage REITs sector, but in any asset management fixed-income company, that type of stability, with this leverage profile, that's what we're aiming for.

And the market necessarily hasn't really focused on that as much, which is fine with us, but we're building this thing to last beyond just a quarterly -- the next quarter. So we're trying to break it out for people to realize it.

But overall, we just -- we like the new money ROEs now that we can move on much more so than others that don't have our liquidity. And we like our ability to get into commercial and all different parts of the capital stack given our size, and I think we'll just continue to focus more towards this time next year as much as this time next quarter.

No, look, I think that's fair. And one of the things that I definitely acknowledge about you guys is that you really do look very far down the field.

And it's part of the reason I was interested in that question, in terms of how you guys handle this quarter. So I appreciate the answer.

So I got 3, hopefully, relatively quick questions. One is tactical.

And that's when I look at the rate of the asset run-off, the MBS portfolio specifically, without delving into guidance, I'm just curious to -- when we look at the last 3, 4 quarters and the rate of that runoff, like how should we think about the next couple quarters and the potential for additional de-leveraging or de-risking the book?

And you're talking about just prepayment runoff or...

No. I'm talking about, in essence, asset sales.

You've taken -- I think your assets are down about 40% year-over-year from $130 billion -- and I'm looking at the MBS portfolio. About $130 billion to, call it, $80 billion.

And I know it was an important year, and I don't expect that on a go-forward. But are you willing to kind of frame up your thoughts in terms of the MBS portfolio today and how you could potentially see it either steady-state?

Or I mean additional kind of shrinkage? Or are you willing to talk about that at all?

It really would depend, and again, we have a couple of very big changes. And I hate the fact that monetary policy is such an important variable in how we look at things, but that's the reality of today.

I mean it used to be we just cared about the target rate. We -- now, we have to care about this massive position alongside everything that we do.

So as Janet Yellen comes on and as we get a sense of the communication with the market, I do think that -- and I said this before, that the longer the Fed is in it, the longer the Fed will probably need to be in it. We briefly mentioned about GDP growth, and so -- and the reliance that the economy has on this intervention right now.

So it will be interesting to Fed is to deal with a potential exit and what that means for the data that they are looking at. So we will probably remain fairly cautious as they try and work through that and try and establish some kind of willingness for serious price adjustment to be able to take place, not only in the mortgage market, but in other parts of the market, whether it's housing or the rest of the fixed income market and the equity markets as well.

I think it's not fully appreciated how much influence this monetary policy has had on everything -- the entire investment landscape. So it doesn't call for us to say, yes, we have the potential to increase leverage -- increase the position, but I don't think the backdrop would warrant a meaningful increase at this time.

Understood, very sane and logical, in my humble estimation. The second is a strategic question and I think at a high level, we know the answer.

But I just kind of wanted to see, why not materially -- I don't know if over-hedge is the right word, but materially take out, and I know you have, but even to a greater degree, your swap tenor and no-show balance. In essence, you kind of would have a quasi CLO in 3 or 4 years from the standpoint that, that very low cost of funds and you can swap out the assets on the top end.

And I get -- and then if you think, all right, well, we do that if you're right. You have a low -- very low cost, long-term cost of fund.

If you're wrong and rates come in, you've got the leverage to take asset balances up and kind of contain the harm, so to speak, from being over-hedged in a potentially falling-rate environment. Could you just kind of talk to the puts and takes around that?

Yes, I mean, like I said, and this gets back to the very fundamental statement I made about spread. Spread at par is very different than spread at $1.07, even if it's exactly the same spread.

So to have a sizable position at $1.07 hedged out is not the same long-term profile to have a sizable position at par hedged out, even if you're producing the same overall spread. So to approach the market there, I do foresee a time where valuations, and I've made it in my earlier comments, so often we pay attention to the change in the price and not the price itself.

Well, I have to say, I am one of those people that pays attention to the price. And you get a very different profile if you are overly exposed to an asset at the wrong price, even though it might be the right spread.

And so we keep that in mind. I don't know if that's making sense to you.

No, no, it does. And I think there's numerous companies in the market today who have a greater appreciation for that than they did 6 months ago.

Okay. So one of -- a great hedge against that kind of exposure is just to have lower exposure to it.

So I do foresee a market -- and we briefly had it where you could get not only better spread, but at a better price. I liken it to once you put that asset in your balance sheet, it's there at that price.

And that's the price you borrow against it as well. It doesn't change when the market changes.

Right. Understood there.

And then finally, and I don't even know if you take -- care to take a stab at this, but bigger picture, longer-term, the U.S. residential mortgage market.

I mean, as you sit here today and you look out, say, for 5 years, what do you think the biggest structural change or changes will be, outside of Fed intervention, say, 5 years from now? And again, I get it if it's too broad of a question and you need to pass up.

No, I have to say with Freddie writing a $30 billion check to treasury, I don't think they're going to want those guys to go away, regardless of how many people we talk to. I have to say, I don't think, when it comes down to it, those are pretty nice checks to be getting.

So the lawmakers -- and I applaud them for trying to come up with a solution to these agencies, and we can try and separate some of their roles. I firmly believe though the private sector has a fairly sizable role to play here in the U.S.

residential mortgage market for a long time to come. The Fed, right now, sitting with the size position it is, ultimately, that has got to transition somewhere.

And if we don't have Fannie and Freddie in their portfolios to transition it to, it's -- that's a pretty big fundamental change for the market in the way it's held. So realistically, I don't think we see much difference.

The government, I believe, is going to have some kind of role and probably closer than they may want. But I think ultimately, one of my statements is, is regardless of whether you have private insurers come in and take some of the credit risk, ultimately, you are the one writing the check.

I mean AIG and MBIA and Ambac were all private, but treasury wrote the check. So my advice to them is you're in the business anyway, you may as well be getting paid for it.

So Welli, a couple of times, you've mentioned -- what you say is the price itself. So let me just tie a couple of your thoughts together and ask a question.

You talked about Greenspan and bubbles and blindness to what was going on with investor psychology. And that sort of has a hint that we may be in a bond bubble today, which is pretty much consensus view out there.

On the other hand, you talk about weak GDP, GDP requiring debt growth and the Fed supporting a lot of that, but the reality is, we face a lot of challenges and even with the Fed GDP, it's still been very weak and a bit disappointing. So that view suggests that rising rates and economic growth are mutually exclusive options.

So if I tie the 2 of those together, I guess, my question to you is this. Absent the Fed intervention and QE, what do you think assets would be worth today?

And I guess, that's another way of saying, are we really in a bond bubble, or does the market just have this fear that we're in a bond bubble because the Fed has been trying real hard to manipulate asset prices, but maybe in the end, it's really just been pushing on a string. And so absent QE, what do you think things would be worth today?

I think the spring period was a preview somewhat, and it's a hard question to answer because it kind of ties into, and I'll just use the example of the U.S. government getting downgraded, and receives a flight-to-quality bid at the same time.

So it's a question of options and choices that the money will have and the price that it will move into assets. Now I do think, initially, the asset classes that are most closely tied to policy will feel it first.

But I do think there will be a ripple that runs through that then comes back and results to people moving and making that risk decision on moving closer in on the risk curve, maybe exposing themselves to greater volatility via the liquidity of it. So I do think -- if I just look back, there's probably coupons in the mortgage market that shouldn't exist or wouldn't exist outside of Fed participation, and may not have sponsorship outside of Fed participation.

So the cautious approach we've taken in the market is, some of these things probably wouldn't be where they are. But nonetheless, it looks like the Fed may be in a bit of a quandary in its efforts to try to remove itself from the market because what it will potentially mean for GDP and all the other things.

So we may be, rightly or wrongly, in a long-term range here, gravitating between 3.5 and 2.5 on 10s for a period of time. But I do think mortgage participants have had a bit of an awakening to the risks and the volatility of the asset outside of some of the policy influences that may start to wane.

So I don't think you necessarily go back to the days, even if we start to go lower in the 10-year REIT. I don't think you go back to the days of 4-point pay-ups for prepayment protection and things like that.

So -- yes, I mean, I can certainly appreciate that, and as I look into specific bonds, I mean, I certainly understand, at $1.07, you got to scratch your head or at least be cautious about any bond. But yes, and I mean I go back to your point about paying attention to the price itself.

If the view today of rates -- we're sitting 2.63% today on the 10-year, if that's still a manipulated low -- if the participation is that's a manipulated low, I guess I just wonder about that in contrast to Japan's 10-year at 200 basis points lower than that, at 60 bps, or Germany, 100 basis points lower than us at 1.69% this morning. So there's certainly a lot of fixed income instruments spread across the globe that are trading at that yield much lower than where we are here in the U.S.

And again, that's where -- I just can't help but ask the question, is the pricing actually quite reasonable? And the fact that the market is so spooked about it is just because of the perception that the Fed will yank the rug out from under us, and no one -- and I mean, at the end of the day, the question really comes back to is anybody thinking about what the price really should be?

Or is everyone just worried about where the price might go when the Fed yanks the rug out.

I do think people are trying to, obviously, solve for what the price probably should be. And I think the Fed themselves are trying to solve that question, or at least where rates would be without %their participation.

You make a very good point. It is hard to say that 2.60% [ph] is, relative to Japan, Germany and anybody else out there in the ECB cutting today, is that, those look cheap.

And it quite possibly could be. I just think that it's a different kind of profile when you move into callable assets at these pricing levels.

And mortgages, outside of Fed participation, I believe, would typically be much wider. And without policy intervention, maybe not so much.

But I do think that there is a limit to where these assets can go, and if the Fed's not in there buying them. Even Fannie and Freddie were economic participants.

They did have their limits.

So 1 of the quandaries, I guess is that -- and we've talked to other companies on their calls about this, but I'm curious if you guys want to add your two cents is that as taper -- the talk of taper tends to heat up and cool down depending on the macro data print of the week. But as rates go up, and particularly, spreads widen and MBS spreads widen, when we see this period of time when taper looks like it's coming sooner, that creates more attractive opportunities, but you can never be sure what's on the other end of that.

In other words, is the Fed really going to taper? And if they do, you could have massive spread widening.

So I'm curious is your thoughts about you -- clearly, you're very defensively-positioned today and you took steps well before the third quarter. But how do you think about it going forward?

Do you have to stay really defensive until the Fed's completely out? Or do you look at it and say, maybe we could go up to, say, 6.5x at certain levels because we'd be willing to own -- we think these things are fairly priced and we're willing to live with some dislocation until the Fed's completely out of the market.

The thing is, is that, I think what the market needs to see is what -- how does it feel to not have that bid come in religiously into the space. And what kind of demand has been kind of pushed to the sidelines and moved into other asset classes that will reappear at different pricing levels.

This is some of my issue I have with some of the stuff out there about fire sales leading. They just continue to perpetuate the process.

There is a point where money does come in, especially to highly liquid assets like these. And you could argue, outside of my earlier comment, that MBS could potentially be an asset class that is not going to be repeated in the future, at least government guarantee-type stuff or implicit guarantee-type stuff.

So there is a level that demand comes in outside of the usual suspects. So I think what the market needs to see though is what it looks like when that bid that's coming in no matter what doesn't show up.

Not that it's selling, I mean, because that's not what they're talking about. It's just talking about reducing the amount of the bid coming in.

And I don't think you get -- gain anything for trying to be a hero and guess what that's going to be until you actually see what it is. I think everybody was convinced that Fed was going to taper, and they didn't.

And so you have a Fed that believes they're communicating very clearly, or that the market understands what they're trying to do, and yet the market got it pretty wrong. So I prefer to see what the impacts are going to be before going -- I personally do not think once the Fed starts to leave, that prices are going to be a lot higher than they are today.

I will say that.

So one last one. And I mean, this is more kind of a technical, historical perspective, maybe you can help me out.

The Fed is basically buying -- every 2 months, they're buying roughly 80 billion, 85 billion in MBS, which is the equivalent of your size today, which took you guys 20-plus years to build this company. What's the difference between the Fed buying the securities at this pace, versus in the old days, Fannie and Freddie were net buyers in MBS and they grew their balance sheets tremendously.

Isn't the Fed just kind of stepping in for the void left by Fannie and Freddie in terms of their on-balance sheet portfolio. Does that -- I mean, help me understand...

No, I mean, Fannie -- the big difference is Fannie and Freddie hedged, right? So they would sell something against those positions.

And Fannie and Freddie also, they didn't fund in the repo markets, they funded in the debt markets, so they would sell debt against those assets. And so you had offsetting influences of that buying power, which with the Fed, you do not.

You just have a straight -- they go in and buy, they don't do anything else.

So it's just unimaginable that they can unwind themselves from this without there being some major -- like you say maybe the MBS bond investors are more prepared this time, but there's going to be some other -- some major dysfunction somewhere else in the capital markets. It's hard to believe they can exit this thing in any smooth, kind of rational way.

Well, I mean, I think the way they are going to approach it, and the way that they need to approach it, is do it in a gradual fashion in which -- the Fed is not going to sell. I really would say that, that is not something that they are even contemplating.

But just the slowdown in the amount of purchase would be a much more orderly way for them to address their eventual exit. We look at their portfolio and try and gauge how much just in pay downs will they receive in a year and how much their portfolio would just naturally go away.

And they get a significant -- they would get a significant amount of de-leveraging of that portfolio just by not reinvesting principal right now. And so it's -- I don't think they want to be this usually disruptive force.

And I don't think, ultimately, they will. But it will -- we will need to see what it means, even if they say, "We're going to just buy $10 billion less than we did the prior month."

and where that demand hole comes from. We've been pretty vocal all along that absent their activity, yes, we like a steep yield curve, we like lower dollar prices in the market.

And in all likelihood, we would be in front of investors talking them -- talking to them about the opportunity set. I can't realistically say that, that's something -- that's conversation we would want to have right now because we don't know what implications this reduction of participation is going to have.

But the mortgage market and the treasury market are the 2 most liquid markets in the world. And there's been money that's been pushed into other markets because of the level of rates and perceived risks that the Fed is injecting into these markets.

So with the repricing of the 2 most liquid markets in the world, I would imagine you'd see fairly significant sponsorship from a lot of cash that's out there doing other things.

No, I agree. It's -- I can't wait to see Bernanke's mea culpa when he writes his book in 10 years.

I thought Greenspan was...

I know. I actually found it quite comical.

I read it a couple of weeks ago and I just -- I almost passed out. But it was very entertaining.

But I guess we'll have to wait and see what Bernanke has to say 10 years from now [ph].

No, in the -- one of the most upsetting things about it is he was more known for his pulse on anecdotal-type stuff and paying attention to things outside of the data set that he may be looking at. So it is a bit worrisome.

And I do...

Yes, he ran an economics firm, and Bernanke and Yellen are academics, but I mean, you talk about overreliance on theoretical models, then you are going in the wrong direction, I think.

Yes. No, I agree.

Just from our years of using models, there's so many things they don't capture, even in just simple math of a fairly simple strategy. So I can't imagine what is missing from the kinds of models that they're using.

No, again, I want to just thank everybody for participating in this call. I know Twitter's out there and you guys probably care less about us.

But anyway, I just -- I want to, again, thank my team for doing a really tremendous job through some very difficult markets that are unique in many ways, and we look forward to speaking to you at the next earnings call.