AGNC Investment Corp (AGNCN) 2009 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the AGNC shareholders call.

At this time, all participants are in a listen-only mode.

Later we will conduct a question and answer session and instructions will be given at that time.

(Operator Instructions)

As a reminder, this conference is being recorded.

I would now like to turn the conference over to our host, Katie Wisecarver of Investor Relations.

Please, go ahead.

Thanks, Christina, and thank you for joining American Capital Agency's Second Quarter 2009 Earnings Call.

Before we begin, I'd like to review the Safe Harbor Statement.

This conference call and corresponding slide presentation contains statements that to the extent they are not recitations of historical fact, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

All such forward-looking statements are intended to be subject to the safe harbor protection provided by the Reform Act.

Actual outcomes and results could differ materially from those forecast due to the impact of many factors beyond the control of AGNC.

Certain factors that could cause actual results to differ materially are included in the risk factors section of AGNC's 10-K dated February 17, 2009 in periodic reports filed with the Securities and Exchange Commission.

Copies are available on the SEC's website at www.sec.gov.

We disclaim any obligation to update our forward-looking statements.

An archive of this presentation will be available on our website, and the telephone recording can be accessed through August 13th by dialing 800-475-6701, and the replay pass code is 107213.

To view the Q2 slide presentation, turn to our website, agnc.com, and click on the Q2 2009 Earnings Presentation link in the upper right corner.

Select the webcast option for both slides and audio, or the conference call option to view the streaming slide presentation during the call.

If you have any trouble with the webcast during the presentation, please hit F5 to refresh.

Participants on today's call include Malon Wilkus, Chairman, President and Chief Executive Officer, John Erickson, Chief Financial Officer and Executive Vice President, Gary Kain, Chief Investment Officer, and Rich Konzmann, Senior Vice President of Accounting.

At this time, I'd like to turn the call over to Gary Kain.

Good morning, everyone, and thank you for joining us.

We are excited about our results for the second quarter.

A number of the actions and the strategies that we implemented earlier this year, including increasing our leverage, the purchase of higher coupon season norms have paid off for us.

While we are pleased with this performance, we recognize that market conditions do change continuously, and we are committed to actively managing our portfolio in an ongoing effort to optimize the balance between risk, economic returns, and capital preservation.

Today, I'd like to briefly discuss the results for the quarter, and the changes to our portfolio, but I tend to save plenty of time for the most important part of this call, your questions.

I am going to review four key topics on the call -- the Q2 highlights, the market environment during the quarter, changes in the size and the composition of our portfolio, and the business economics.

If you turn to page five, we'll start with the highlights for the quarter.

As you know, we declared dividends of $1.50 per share.

Now that dividend was well above -- well below our GAAP net income of $2.02 per share, and our taxable income of $1.98 for the quarter.

As a result, our undistributed taxable income increased significantly to $0.79 from $0.31 at the end of Q1.

This spillover income will be available for future distribution and we are obviously committed to paying at least 90% of our taxable income for the year as required by the REIT rules.

Moving onto net income, the key drivers of our net income were the slower expected -- slower than expected prepayments, our larger investment portfolio, reduced repo funding costs, and the significantly firm evaluations on hybrid ARMs.

The net income number included $0.72 of other income, which resulted from the combination of realized gains and derivative mark to market, with realized gains making up the vast majority of that.

We also had $0.18 worth of amortization expense associated with terminated swaps.

The earnings net of these two items were $1.48 per share.

As of June 30th, our portfolio totaled $2.6 billion in assets, which was a 17% increase from March 30th.

As in Q1, the bulk of the increase can be attributed to an increase in our holdings of season hybrids, and our leverage was approximately 7.7 times at the end of June.

Book value increased during the quarter by $1.50 per share to $20.76.

This was an increase of 8% for the quarter and 21% year-to-date.

Again, this book value increase is after netting out the $1.50 in the dividend payment.

And our book value benefited from a number of factors, with the largest contributor being the market's realization that prepayment expectations on higher coupon mortgages were too fast.

This realization, coupled with lower risk premiums associated with prepayments, led to significantly higher valuations for premium securities, and higher coupon hybrid ARMs were really one of the largest beneficiaries of that change in mindset.

Our book value also benefited from a strategy we told you about on the Q1 call, which was terminating one, your swaps, and replacing them with longer dated swaps, and the yield curve steepened subsequent to our purchases which benefited us.

Lastly, we did complete the management changes we spoke about on the Q1 Earnings Call.

As such, I, as well as four other individuals, are no longer American Capital employees, and are now employees of a legally separate company dedicated solely to managing AGNC's operations.

We are also now permitted to own AGNC stock.

So, if you turn to slide six, we're gonna review some of the key market developments during the quarter.

As you can see from the table, there was significant price movement during the quarter.

Treasury and swap rates increased with longer term rates rising significantly more than shorter term rates.

Two year swaps rose 15 basis points, while ten year swaps rose 92.

This obviously resulted in a considerably steeper yield curve.

As depicted on the top right, prices of fixed-rate mortgages were mixed on the quarter with 30 year sixes, which comprised the vast majority of our fixed-rate portfolio, still up marginally in price, despite the higher rates, while the prices of 30 year fours were down significantly 3.5 points.

Look, while this is understandable given the increase in rates, the steeper yield curve, and the more benign prepayment expectations, the outcome is sort of interesting against the backdrop of hundreds of billions of government purchases of low coupon fixed-rate mortgages.

As you can see on the bottom right, the prices of hybrid ARMs performed better than those of fixed.

Lower coupon ARMs were up marginally during the quarter, while the prices of higher coupon ARMs were up over a full percentage point.

Again, as you can see in our disclosure on page ten, almost our entire ARM portfolio is comprised of higher coupons, and we concentrated our purchases in this sector because we felt that they offered the best risk-adjusted returns.

I do want to remind you that as we mentioned on the Q1 Earnings Call, the reduced price and interest rate volatility was a key driver behind our decision to go up in coupon in both fixed-rate and on the hybrid side.

And before I move on to look at the changes to our portfolio, I do want to give you a quick update on what has happened since the end of the second quarter to the sectors that we are most involved in.

So, 6% coupon fixed-rate mortgages are up marginally at this point, and swap rates are essentially unchanged, so no big changes there.

Now, it's a little more difficult to pinpoint, but the quotes on hybrid -- higher coupon hybrid ARMs are quoted up about three quarters of a point in the month of July.

So look, while it is early in the quarter and there is plenty of time for conditions to change, these trends are certainly encouraging at this point.

So, let's turn to slide seven, and let's look at how our portfolio evolved during the quarter.

Many of the actions we took were intended to respond to changing market conditions.

We increased the percentage of hybrid ARMs while reducing our holdings of fixed-rate securities.

We also increased both the size and the maturity of our interest rate swaps.

We grew our hybrid ARM portfolio by over $400 million, and this brought the ARM percentage to 50%.

Now, consistent with our strategy from Q1, these purchases, again, were in higher coupons.

We did, however, shorten the reset of our ARMs, and we reduced our holdings of coupons below 5%.

And we did these things to further reduce interest rate sensitivity.

Now, to do this we did two things.

We increased our -- we adjusted our purchase activity, but we also executed sales of longer reset and lower coupon hybrids.

We also sold other hybrids where we believed projected prepayments did not warrant the valuations available in the market at the time where other more attractive securities were available.

Look, some investors may be confused by the sales activity, but the market environment is very dynamic, and we because believe that active portfolio management is critical to maximizing risk-adjusted returns.

Consequently, we do not want to hold on to a position we don't like solely because it has a low cost basis.

Slide ten of this presentation gives you more detailed information regarding the current ARM portfolio.

Now, moving on, we also purchased a little over $120 million in CMOs -- they were backed by hybrid ARM collateral.

These securities have cash flows that are essentially the same as those in our ARM portfolio, but they were available at more favorable valuations.

We're comfortable within the CMO space and I've spent a lot of time there, but for liquidity reasons, we intend to keep our CMO holdings to a small percentage of the portfolio.

Our holdings of fixed-rate securities declined by just over $200 million to 45% of our total assets, and you can get more detail on those holdings on slide nine.

Now, let's turn to page eight, so we can look at a critical driver of our results -- prepayments.

Given the substantial drop in mortgage rates and the introduction of the HAP program during Q1, many market participants expected prepayment fees to get ugly.

On our last call, we were pretty transparent about our view that while prepayment speeds were likely to pick up materially, we believed that the more draconian fears were not going to be realized.

As you can see in the bar graph that displays the performance of 2008, Fannie and Ginnie Mae sixes, the massive speed increase didn't occur.

As the brown bars show, prepayments on Fannie sixes remained around 30% CPR for the last several months.

We also made the point that we were confident that we could continue to source assets that would perform better than generic securities with similar coupons.

Looking at the performance of our portfolio, which is depicted by the light blue bars, our prepayment speeds remain below 20% CPR for the last four months, significantly outperforming generic benchmarks.

Remember, our coupons, again, are very close to a 6%.

Quarter-over-quarter, the realized prepayment speeds on our portfolio dropped from 20% in Q1 to 17% for Q2.

Just to repeat, those prepayment speeds in our portfolio dropped from 20% to 17% during the quarter, and this is despite the lower rates and the HAPs program implemented by the administration.

This demonstrates in my mind the importance of and the value added that can be derived from active portfolio management and individual security selection.

Look, realistically while we were cautiously optimistic about speeds, this outcome was considerably better than even our views.

Remember, as of March 31, we were projecting lifetime speeds of 31% CPR, and again, that allowed for one year speeds well into the 40s.

Given actual realized prepayments, the increase in mortgage rates, and a decline in other indicators -- the refi index, for example -- most market participants, ourselves included, have reduced our speed expectation.

As the quarter ends, we were projecting lifetime speeds in our portfolio of around 21%.

And again, this still allows for one year speeds in the mid to upper 20s.

Look, while we're pleased with the performance of our portfolio, we are going to continue to focus substantial efforts on individual security selection that continue to find assets with favorable prepayment characteristics.

So, let's turn to page 11, and just quickly cover funding, and more importantly, the changes to our swap book.

Repo levels improved materially during the quarter.

Our weighted average repo rate dropped from 81 basis points to 47 basis points during the quarter.

So far in Q3, rates have improved slightly.

A repo availability has also improved, and we currently have repo agreements in place with 18 counterparties, and we have outstanding borrowings with 16.

Moving on to the interest rates swaps, which are on the right side of the page, in an effort to protect the portfolio -- further protect the portfolio against interest rate risk, given the changing market conditions, we increased the notional amount of our swap positions by $250 million.

But as importantly, we increased the maturity of the swap book out to three years.

And consistent with our actions in Q1, we accomplished this by terminating one year swaps and adding swaps with longer maturities.

We continue to feel comfortable with short-term rates over the next year, but are much more concerned after that.

These transactions, coupled with the ones we completed during Q1, paid off for us, given the steepening of the yield curve that we discussed earlier.

Now look, as a quick reminder, our first line of defense against interest rate volatility is our asset selection -- by increasing the percentage of hybrid ARMs, staying up in coupon and fixed-rate and on the ARM side, and by shortening the resets of our ARMs, we significantly limit the inherent price volatility of our holdings.

Now, the changes we made to the swap book are the next step, and they're designed to work in concert with the evolving portfolio.

We also periodically sell TBA fixed-rate mortgages to further complement our risk management activities.

So, now let's turn to page 12 and review the business economics.

As we discussed in the highlights, our margins, net income, and ROE improved materially during the quarter.

Asset yield for the quarter came in at 5.35% versus 5.13% in the prior period.

This asset yield includes the positive impact of 18 basis points of catch-up amortization, resulting from the slow down of our actual and our projected speeds, and our ARM yields benefited from higher forward rates.

Excluding the impact of terminated swaps, funding costs dropped to 1.3%.

This, coupled with the increase in yields, brought margins to 405 basis points or 355 basis points when including terminated swap expense.

Notice that the gross ROE, after inclusion of terminated swap expense, but without including the large positive impact of realized gains, was still over 30%.

Looking ahead, we expect to continue to benefit from low repo rates, and to date have generated realized gains as we continue to actively manage the portfolio.

Before I conclude and move on to your questions, I just want to leave you with a final comment on the risk management side.

As we said last quarter, and as our actions this quarter demonstrate, we remain very focused on limiting extension risk.

That being said, we're not going to be complacent with respect to prepayment risk and will continue to diligently source assets that we will -- that we believe will perform better than generic securities.

We will sell, selectively sell assets that have priced in overly optimistic speed outcomes.

So, with that, that covers my prepared remarks and I'd like to thank all of you for your interest in AGNC, and I'd like to ask the operator to open up the lines for questions.

Thank you.

(Operator Instructions)

We'll go the line of Bose George with KBW.

Hey, good morning.

I had a couple of things.

First, just on leverage, I was wondering how you guys think about leverage right now and should we expect that number to remain fairly stable from here?

Yes, we're comfortable currently with our leverage where it is, call it around 7.5 times.

Right now the repo market, as I mentioned earlier, is very strong, we are very comfortable with the rates that we're getting, and the availability has improved dramatically.

So, we also are comfortable with the carry and the net interest spread we're earning on the assets.

And given the very -- given the improved prepayment performance, we're comfortable with leverage where it is at this point.

But I really want to caution you that we were willing to take leverage down before, and we will evaluate market conditions, and to the extent that things change, we're certainly not committed to any particular area of leverage.

The one other thing that I'd like to add is that we do have a leverage cap that where at 10%, which would require board approval to exceed.

Thanks.

And then switching to the -- I just wanted to see the funding environment for the CMOs you purchased.

Now, how are the haircuts on that versus the pass-throughs?

They're slightly higher, but they're certainly in the range of what we've been getting for pass-throughs over the last three to six months, but they're not on the low end of the range, but they're not outside of it.

Okay.

And then just to confirm on -- the expense on your terminated swaps, the stuff that's being amortized, is that sitting in other comprehensive income on your balance sheet -- all these showing up in book value is just flowing through over time?

Yes.

So, first off, from the book value from the perspective the terminated swaps are -- expense is absolutely included in the book value number.

So, it is a subtraction or the -- that piece is absolutely included.

Now, the -- when you look at GAAP income, what happens is you're forced to amortize the cost of that terminated swap over the original term, and so for those swaps, they -- the original term was through the second quarter of 2010, so you'll see that cost amortized there.

I do want to point out that the new swaps that we put on are also in the swap expense category or in our cost of funds number, so if you don't make an adjustment they're both there.

And the other thing that's also worth pointing out is that it turns out that the total amount of realized gains, and I know a lot of people want to look at those differently, and the total amount of swap termination costs, not what's been expensed, are roughly equal.

And so, there's a lot of logic from an economic perspective to look at those two in the same light.

The up-front cost is roughly $15 million, $16 million on the swaps -- $16 million I think it is -- and then the realized gains were roughly $15 million.

So, over the first two quarters, those two numbers happen to line up relatively well.

Also, just one thing to really keep in mind is, again around symmetry of how you look at it, is that the -- our asset yields incorporate -- are lower because of the fact that low cost basis assets have been sold.

So, that's another thing to keep in mind with what you want to do with the terminated swap expense.

Great.

Thanks a lot, and good quarter, and definitely impressive on the book value side.

Thank you.

Thank you.

And next we'll go to the line of Jason Arnold with RBC Capital Markets.

Hi, guys -- definitely nice results this quarter.

And thanks for the detail on the portfolio activity in the presentation.

I was just wondering if you could also share with us the rough average dollar price paid and maybe the yield on the securities that you bought during the quarter, please?

You know, I don't have the -- I don't have that number for you handy.

It's something we'll -- we haven't disclosed.

But, I will give you some general numbers that are overall cost basis.

Most of what we purchase -- clearly, the vast, vast majority, was on the ARM side, and our overall cost basis on the ARMs is in the low 104s, so 104.1 in decimal form.

And realistically, the recent purchases are going to be above that.

So, clearly our purchases are above the -- that 104.1 and probably upper 104s to -- is probably a more likely guess.

Okay.

That's helpful.

And then I guess are there any more catch-up benefits coming in future quarters from the prepayment outlook revisions you made, or is this just a one-time adjustment, I guess assuming, of course, the prepayments are within expectations going forward as well?

Well, we get an ongoing benefit from the lower prepayment estimates.

So, remember the table that we gave you last quarter and the table that we have this quarter.

It shows that as the prepayment speeds drop, the long-run yields of the securities improves, and that is a lasting benefit that will come in quarter-over-quarter.

There's a specific catch-up benefit, which is an adjustment to the yields you've taken at other points, which is a one-time number, but we -- there is absolutely a lasting benefit to the slower prepayments.

And again, given the securities that we own, it's something that's going to benefit us over the long run.

Okay.

That makes sense on the one-timer -- I was just curious about that.

And then just one quick final one.

On undistributed income of $0.79 per share, do you envision paying all of this out this year or maybe carrying some into 2010?

Really, all I can say with respect to the undistributed income is that we're committed to the -- to comply with the REIT rules and paying out 90% for the year, and it's actually 95% of realized -- of short-term realized gains, and 85% of regular interest income.

But, we are committed to doing that, specifically where that falls out by the end of this year is something we'll evaluate over time.

Okay.

Terrific.

Again, great job.

Thank you.

Thank you.

Next we'll move to the line of John Sites with Sterne Agee.

Okay.

Good morning.

Great quarter, and my question was just asked, so I'll turn it over to someone else.

Thanks.

We'll move to the line of [Mike Widner] with Stifel Nicolaus.

Hey, good morning, guys.

Thanks for taking my question.

Just a first quick one here.

On the income statement, I'm trying to figure out what this $1.22 million gain from derivative instruments is -- if you could elaborate on that a little bit.

So, the $1.2 million in gain from derivative instruments, as I mentioned to you, we supplement our hedge activities with sales of TBA mortgages.

And the logic behind this is moving in and out as market conditions change quickly of -- swap positions is very expensive and mortgage hedges actually make quite a bit of sense.

And so, that number relates to TBA mortgages being classified as derivatives, and so that income -- the income generated from those hedging positions is in that line item.

It's something that we intend to -- that will not be a core percentage income going forward, but it's very valuable from a risk management tool.

So, I'm not entirely sure I follow that.

I understand the purchasing of the TBA market, and I can understand hedging with swaps, but I guess I don't quite understand what the nature of the realized -- it sounds like you're talking about a realized gain, but I'm just not quite sure I understand -- what are the sales transactions that are resulting in that, I guess is the question then.

So, the simple answer would be let's say we sold TBA 6% fixed-rate mortgages, and -- which we, as an example, which we did, and then the market sells off a lot like it did in early June and late May.

And so, that short position is an excellent hedge for some of our long mortgage positions, and so there is a gain when you pair off that position or when that position is marked, and that's what that hedge is.

So, it's very much like a swap that's not in a hedge relationship is probably the easiest way to think about it.

Great.

Okay, I understand.

I mean so basically you're selling TBAs short and when you close out that position, this is the resulting gain.

Absolutely, and again, we do have some fixed-rate instruments to great match-up and it's an excellent way to reduce risk intra quarter.

Got you.

So, I certainly appreciate your views on trading within the portfolio and capturing, basically trading gains and realized gains.

I am not a tax lawyer nor an accountant and I was just wondering if you could talk a little bit about how that fits with the REIT regulations and are there any limitations as to what percentage of your income can be realized gains and trading gains as opposed to what we tend to think of as the more normal sources of income, or is there some point that you end up with a tax liability or a violation of the REIT rules?

Sure.

I'll give you certainly my understanding of it, and all of the assets that we've sold are qualifying REIT instruments, and it is absolutely permissible to sell instruments.

We're certainly not anywhere near or in any way acting like a dealer or a market maker in securities, which I think is -- gets you to a different potential treatment.

But selling positions opportunistically as market conditions change and as valuations change significantly, we've had a lot of volatility in the market place.

So, we're absolutely comfortable that our actions are consistent with our business model and with the REIT regulations, and we feel that it's imperative to be willing to sell instruments that no longer make sense for us over the long run, or whose valuations have increased significantly.

An example is we sold a hybrid ARM, a seasoned hybrid ARM this quarter in the mid-$107 prices, and people were -- a lot of people obviously questioned our cost basis and buying some things lower than that.

We're going to -- we'll continue to look at those opportunities, we think they're absolutely consistent with improving the long-term value of agency.

So, if I understand you correctly, basically capital gains and interest income are effectively the same thing as far as REIT rules go in your view --

Yes.

-- as long as they involve agency securities.

Absolutely.

And we do treat the TBAs as derivative, as we talked about before, and again, they're a small percentage.

Okay, great.

Well, thanks a lot, guys.

I appreciate the color and the comments.

Thank you.

Once again, if you wish to ask a question, press star one at this time.

And we'll go to the line of Matthew Howlett with Fox-Pitt, Kelton.

Thanks for taking my question.

Great job with structuring the portfolio, given the environment.

Gary, how do you look at -- you know the government's been purchasing NBS Treasury and the Fed and that, and I they're going to go up to about $1.25 trillion.

They're going to announce towards the end of the year what they're going to do.

I think they said they weren't going to buy any more, but they potentially could shrink it, sell or not buy anymore, but nevertheless could cause volatility in the market, some dislocation.

How do you structure the portfolio or get ready for that announcement?

That's a great question and I appreciate you asking that.

You know, first off, they increased the size of the program in the middle of the year, actually in March, and so I would say it's not 100% clear -- clearly what they're going to do going forward.

But if you look at what we have done, we have stayed, for the most part, with very few exceptions, away from what the government has been buying.

So, we're not in lower coupon mortgages, we're not in the coupons, even in fixed-rate, that, again, that the government's been active in.

Our portfolio has now moved to higher coupon ARMs and shorter reset ARMs.

We actually feel that if lower coupons get under more pressure, which is likely to occur to the extent that the government doesn't continue the program at some size, then that's going to continue to slow down prepayment estimates on our securities.

Now, that's not to say that prices may not -- may go down, and that discount rates and interest rates will go -- or may go up.

But, we will get an offsetting benefit on -- with respect to the cash flows on slowing prepayment speeds as new mortgages are much less available for people.

So, we feel that the way we've positioned our portfolio by being up in coupons significantly, gives us a lot of protection and a big offset on the prepayment side, and you've seen some of those benefits this quarter as there was kind of a scare along those -- not exactly along those lines, but certainly around interest rates in early June.

Great.

That's great color.

And then you did purchase, you said, a little bit of some seasoned fixed-rate fives -- I mean the prices really -- they really did underperform.

I mean could you see those prices really widening out of the current coupon stuff if the government clearly backs out and that could be an opportune time for you guys to maybe rotate into more current coupon?

Yes, we would look at rotating into current coupon.

I mean given pricing right now, we're probably not looking to do a lot of it.

Again, when we play in fixed-rate, and this is important, we tend to buy pretty seasoned mortgages, in which case the durations and the interest rate sensitivity is lower.

In the case of the fives, with the market backing up and with all the benefits we had received on the prepayment front, we almost thought of it as a reasonable hedge to have some lower coupons which would benefit if lower coupons and current coupon improved in price, and then maybe put a little more pressure on the prepayment side.

So, we looked at it from two perspectives.

One is that prices had dropped, we could buy seasoned securities where the duration wasn't that long and we could have some offset if rates rallied back a lot.

Great.

Makes sense.

And then last question -- I asked this on the last call -- in terms of the buyouts -- you know, the modifications, which we've all been waiting for, and Gary I know you have a deep background with Freddie -- do your assumptions -- I mean obviously you are baking this in your assumptions, and how much of impact is it going to be on prepayments if suddenly we get a wave of modifications and these plans do go through?

How do you bake that into your analysis?

Thanks for that question, because I think the -- my perspective on it's changed slightly from the first quarter.

One is you can get a feel for the amount of either modifications or default or prepayments that can come from those kind of activities, and there are limits -- those are manual processes and there are limits to how many loans can come out that route.

And in the prior environment, going back three to four months, we were very, very confident that those numbers wouldn't -- would be dwarfed by kind of -- call it regular refinancing activity.

Now that refinancing activity is going to be smaller, or I think everyone agrees that it's going to be a smaller percentage, the modification numbers aren't likely to change one way or another, maybe go up some.

But they're still going to be contained.

That being said, there's a little bit more of an incentive to stay away from maybe the worst credit loans in the agency market and be somewhere in between the worst and kind of a good loan because of that impact.

So, a larger relative impact still contains and still not going to produce -- not likely to produce kind of disastrous or really big prepayment numbers.

Great.

Thanks for the color.

Congratulations.

Thank you.

And there are no other questions in queue at this time.

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