AGNC Investment Corp (AGNCN) 2010 Q3 法說會逐字稿

Good morning.

My name is Tiara, and I will be your conference operator today.

At this time I would like to welcome everyone to the Third Quarter AGNC Earnings Conference Call.

(Operator Instructions) Thank you.

Ms.

Wisecarver, you may begin your conference.

Thanks, Tiara, and thank you for joining American Capital Agency's Third Quarter 2010 Earnings Call.

Before we begin, I would 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 facts 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.

All forward-looking statements included in this presentation are made only as of the date of this presentation and are subject to change without notice.

Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of AGNC's 10-K dated February 24, 2010, and periodic reports filed with the Securities and Exchange Commission.

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

We disclaim any obligation to update our forward-looking statements unless required by law.

An archive of this presentation will be available on our website, and the telephone recording can be accessed through November 10 by dialing 800-642-1687, and the conference ID number is 16368819.

To view the Q3 slide presentation, turn to our website, agnc.com, and click on the Q3 2010 Earnings Presentation link in the upper right corner.

Select the webcast option for both sides and audio, or click on the link in the conference call section 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; Chris Kuehl, Senior Vice President of Mortgage Investments; Bernie Bell, Vice President and Controller; and Jason Campbell, Head of Asset and Liability Management.

With that, I'll turn the call over to Gary Kain.

Good morning, and thanks for joining us, and thanks for your interest in AGNC.

On the last call we stressed that we were not in Kansas anymore on the prepayment front, and that asset selection would be critical to performance.

Prepayments on many types of Agency mortgages increased during the quarter in response to record low rates, and these increases were most pronounced on the newer vintages.

Now, despite this backdrop, AGNC's portfolio performed very well this quarter, and a significant component of this was driven by our proactive efforts to source assets with favorable prepayment characteristics.

Now, all interest rates, including mortgage rates, are lower than they were last quarter, and all indications point to the Fed being on hold throughout 2011 and probably even beyond.

So, as such, we continue to believe that managing prepayments to reasonable levels will drive results.

And our demonstrated track record finding relative value should give our investors confidence that we can continue to generate attractive risk-adjusted returns in this both challenging and evolving environment.

Now, the recent addition of Chris Kuehl to our team as head of Mortgage Investments should be a strong indication of how seriously we feel about asset selection.

Chris, a seasoned mortgage veteran with over 10 years in the business, ran one of the largest agency portfolios in the world.

He worked side-by-side with Jason Campbell, our head of Asset Liability Management.

Jason has also spent over 10 years in structured finance, has worked with me since I took over the reins at AGNC.

I am extremely pleased with the senior investment team we have assembled, but I know you care about results, so let's turn to slides 3 and 4 and review the quarter.

So, GAAP net income totaled $1.69 per share.

Other investment-related income, which is comprised mainly of realized investment gains and losses and derivative mark-to-market accounted for a net of $0.59 per share.

Now, excluding this number, portfolio spreading comp increased to $1.11 per share.

Now, it is important to reiterate that we project prepayments in producing our accounting yields on our mortgages.

If we use actual prepayments, which were lower than our longer term projections, the $1.11 would be higher.

Also, for us, running faster than actual prepayment speeds tends to shift some income into realized gains from net interest income for instruments that we sell.

The big picture we feel is preferable to make projections for a number of reasons.

One simple example is that some of our holdings are brand-new securities, which tend to prepay at or near zero for the first several months, and we are uncomfortable running these securities at a lifetime CPR anywhere near zero.

Now, also notice that we did accrue a $0.01 charge for an excise tax.

We believe it is likely that we will carry over a meaningful portion of our undistributed taxable income into next year and thus be required to pay an excise tax.

However, the quarter is far from over, so there is still significant uncertainty here.

Taxable net income came at slightly lower than GAAP income at $1.59 per share.

As you know, we declared a dividend of $1.40.

None of this was paid with our undistributed taxable income, which increased from $37 million to $39 million during the quarter.

Now, we closed the quarter with $0.99 per share of undistributed income, but this does not include the 13.2 million shares issued in our secondary offering, which settled on October 1.

If we include those shares, we have approximately $0.74 per share of undistributed income.

Now, the entire drop in the UTI on a per-share basis is a function of the higher share count.

Again, the dollar amount of our undistributed taxable income increased during the quarter, and our taxable income exceeded our dividend during Q3.

Now, book value per share was down a touch for the quarter at $23.44.

However, when factoring in the accretion from our recent secondary offering, pro forma book value increased to $23.78 from $23.54 at the end of Q2.

Our mortgage portfolio totaled $9.7 billion, and our average leverage during the quarter was up slightly to around $8.5 billion.

Now, because our equity offering didn't settle until October 1, and we purchased some mortgages in anticipation of the closing of the offering, leverage was 9.7 times at September 30, but 7.2 times pro forma when the equity offering was factored in.

Now, importantly, the overall prepayment rate on our portfolio came in at 15% CPR for the quarter despite the lower rates.

Additionally, it was only 17% CPR in the most recent release in early October, which indicates the portfolio continue to hold up well.

Now, before we look at what unfolded during the quarter, let's turn to slide 5 and take a look at another important indicator of shareholder value creation, economic return.

Economic return is essentially a mark-to-market based total return number and is similar to the way a mutual fund, a hedge fund, and many other professionally managed investment vehicles report their results.

We define economic return as the combination of the cash dividends paid plus the change in our net asset value for the mark-to-market of our portfolio.

As such, this measure isn't biased by variations in different prepayment assumptions used in calculating yields, and it treats realized and unrealized gains and losses equally.

It also fully captures any impacts of both settled and unsettled positions.

It is the fixed income market's view of our total value added and therefore a useful tool over time when short-term price movements tend to wash out.

Now, slide 5 depicts the mark-to-market returns that AGNC has produced since the beginning of 2009, broken out by the two components -- dividends and book value increases.

Now, for comparison purposes, we also included the average of the other Agency REITs.

As you can see, AGNC produced total economic returns of 60% in 2009, with a peer group averaging only 45%.

This outperformance can be seen in both dividends paid and in book value expansion.

If we move to 2010 through Q2, AGNC had produced total economic returns of 17% with 34% annualized, which is roughly double that of the average of the peer group.

And, again, outperforming in both dividends paid and growth of NAV.

And for the nine months ended September 30, the economic return is 23%, or annualized at 31%.

Now, most people have this tendency to assume that higher returns must be accompanied by greater risk or substantial volatility of returns.

And since this is the first time we are addressing this topic in any depth, we thought it would be helpful to show the quarter-over-quarter volatility of these mark-to-market returns.

If you turn to slide 6, we can look at the actual results to shed some light on this subject.

Interestingly, the data indicates consistently strong results both in absolute terms and versus the peer set with AGNC's performance essentially at or above the strongest in the space since the second quarter of 2009.

Again, this is market-based pricing information and it is not biased by whether price appreciation is realized or unrealized, or by other account assumptions.

Importantly, this performance occurred during a period of significant quarterly volatility in two of our biggest risk factors -- prepayments and interest rates.

On the prepayment front, despite significant concerns to the contrary, 2009 was actually a relatively benign year where higher coupon, weaker credit mortgages were generally the best performers.

In early 2010, these same securities were the hardest hit by the GSE buyouts, and unless you sold these securities prior to the buyouts, many investors gave back more value than they had extracted from the favorable speeds during 2009.

Now, today the most recent vintages backed by the most creditworthy borrowers are the most exposed to the record low rates, and initial prepayment reports indicate reason for concern on this front.

On the interest rate side of things, the low level of the Fed funds rate has kept funding costs low during the entire period.

However, we have seen significant volatility in other parts of the yield curve.

The graph on the bottom of the page demonstrates this point.

Notice that the 10-year treasury sold off over 150 basis points in 2009, only to recoup most of that in 2010, with material volatility in between.

So, look, I think the key takeaway here is that while the investment landscape has generally been favorable, it has not been anywhere close to a one-way street, nor is it likely to be going forward.

Furthermore, I think it is safe to say that without the benefit of active management and our willingness to reposition our portfolio to address existing and emerging risks or opportunities, we would have been unable to avoid the negative consequences of at least one of these events and our results would have suffered for it.

Now, for this reason we believe active portfolio management is critical to producing enhanced risk-adjusted returns over the long term.

Now, as a word of caution, mark-to-market returns, quarter-over-quarter will tend to be volatile, and we have no expectation that we will outperform either market expectations or our peers every quarter, or even for this quarter, for that matter.

However, we do believe that a combination of our active management, diversification cross products, our ability to source securities with favorable loan characteristics, and our hedging strategies position AGNC to produce attractive returns over the long-term while containing risk and limiting volatility.

So, why don't we move on to slide 7 and look at what happened during the quarter.

For the quarter, interest rates again dropped significantly.

Unlike last quarter, shorter maturity swap rates dropped almost as much as longer term rates.

More specifically, two-year swaps dropped 37 basis points, while 10-year swaps fell 43 basis points.

Most generic, or TBA fixed rate mortgages significantly underperformed both swaps and treasuries.

Lower coupon mortgage prices were higher during the quarter, but not to the extent that would have been forecast given the decline in interest rates.

And higher coupons were generally lower in price despite the drop in rates.

So, for example, look at the 30-year TBA 5% coupon prices on the bottom left.

At the end of the second quarter they were priced at $105.8.

By the end of the third quarter they had dropped 0.5% to $105.3, while treasury prices increased substantial.

The 5.5 coupon right below it performed even worse, dropping a full percentage point.

Now, interestingly, while generic mortgages performed poorly, performance on very specific types of mortgages products performed favorable prepayment characteristics was actually good.

So, let's turn to slide 8 and take a look at some examples of this, because it gets to the importance of asset selection and relative value.

Last quarter we discussed our concerns with generic newer vintage mortgages and highlighted a couple of examples of strategies we felt would provide some incremental protection against prepayments, low loan balance, 15-year, pay interest only ARMs.

For competitive reasons, we didn't discuss our favorite strategy -- new securitizations of 30-year fixed rate mortgage securities backed by 105% to 125% LTV loans.

These pools are originated by Freddie and Fannie and were designed to be under the administration's HARP program.

Because this program was designed to be a one-time opportunity for borrowers with very high LTVs that were current on their mortgages, we were confident that the prepayment rates would be largely unresponsive to changes in interest rates.

Additionally, during the last quarter of 2009 and for the first six months of 2010, you could actually buy these securities at prices lower than TBA securities because they were deemed to be less liquid and not fundable with TBA mortgages.

By the end of the second quarter we owned over $1 billion of these securities and around a third of the total Fannie and Freddie production but the 5% and 5.5% coupons.

Furthermore, this position few to around $1.4 billion earlier in Q3.

Now, the prepayment speeds on these securities have been incredibly low, with our portfolio of these securities prepaying around 2% or less every month this year.

During the third quarter the market woke up and the prices of these securities took off.

Let's look at the graph on the bottom left-hand side of the page, which shows the prices of the 105% to 125% LTV securities versus generic TBA 5% and 5.5% coupon mortgages.

As you can see, the prices of these securities were lower than generic mortgages until the third quarter, as the market was less focused on this prepayment protection.

Now, look at what happened during the third quarter as market participants began to pay more attention to the differences in prepayment speeds.

So, on the prior slide, TBA buys [at 5.5%], dropped in price this quarter.

The 105% to 125% LTV securities, however, increased in price significantly during the same period and outperformed generic mortgages by almost, like, 2 and 2.5 points during the quarter.

Just to put this in some perspective, I don't think I have witnessed a similar relative value move within a quarter within the Agency mortgage market in my 20-plus years in the business.

The prices of low loan balance 15 years and IO ARMs also appreciated versus more generic product.

The movements of IO versus amortizing ARMs are harder to quantify, but the graph on the bottom right shows the appreciation of the lower loan balance 15 years versus their TBA counterparties.

As you can see in the graph, the prices of the lower loan balance 15 years also significantly outperformed during the quarter.

Now, we feel it is important to highlight these results for two reasons -- one is that it is a key theme for the quarter, is the market's realization that these differences exist in terms of prepayments.

And, secondly, these strategies made up a significant percentage of AGNC's holdings of securities.

So, for example, the 105% to 125% LTV and lower loan balance 15-year accounted for roughly two-thirds of our total holdings of fixed rate PSDRs at the start of the quarter, and comprised over 90% of our holdings of newer 2009 and 2010 fixed rate instruments.

Now, we do want to mention that we recently reduced our holdings to the 105% to 125% LTV mortgage securities given the current prices.

While their performance has been stellar and probably will remain so in the near term, the risk return profile given these prices is very different now, and we don't feel comfortable with such a large overweight in these securities anymore.

So, now let's move on and take a look at the overall portfolio as of September 30.

As you can see on slide 9, we maintained significant diversification in our portfolio while growing our assets, given the equity raised during the quarter.

Our percentage of ARMs dropped significantly during the quarter from 50% to 30% of our total holdings as we preferred the risk adjusted return of some components of the 15-year and 30-year fixed-rate markets versus ARMs, given the cheapening of fixed-rate mortgages in the latter part of the quarter.

And, as we discussed earlier, the fixed rate market has now priced in relatively fast speeds, and when you find securities that will perform reasonably well, risk adjusted returns are more attractive than what was available on the ARM front for speeds on most available vintages were and still are concerned.

With respect to activity since quarter-end, we have now largely deployed the capital we raised in the secondary offering, and we continue to prefer fixed rates generally versus ARMs.

Now, let's jump ahead to slide 15 for a look at the business economics.

I am going to concentrate on the realized Q3 numbers this quarter, because the quarter-end numbers are sort of distorted by the timing of the $13 million share offering we settled on October 1.

So, during Q3, our asset yield declined to 3.23% to 3.44% at the end of Q2.

The decline was largely a function of the new acquisitions and the changing composition of the portfolio.

Our cost of funds also dropped to 1.02% from 1.07% at the end of Q2, and should continue to drop slowly as we add new low cost swaps to hedge purchases and as our repo balance increases as positions settle.

Now, this brought our net interest spread to 2.21%, and that translates to a gross ROE of 22% before investment income, other investment income or expenses.

And if you include those two items, the net ROE was 28%.

Now, just quickly before I conclude, I do want to address the foreclosure crisis and our views on its implications for AGNC.

Now, remember, given that all of our holdings have a Freddie, Fannie or Ginnie Mae guarantee, our real exposure is to changes in prepayment speeds that could arise.

In short, we don't think it is a very significant issue for the Agency mortgage market.

Why?

Because Freddie and Fannie now buy out all seriously delinquent loans after 120 days of missed payments.

So, any seriously delinquent loans already out of the pools well before foreclosure.

Thus, any changes to foreclosure timing, costs or process affect the GSE's bottom line, but not ours.

Now, with respect to any secondary effects such as implications for new delinquencies or changes to refinancing behavior, the impacts are a little less clear.

One could argue that the increased liability for servicers will likely push them to charge more and to also be more cautious in making new loans, which would actually slow prepayments.

If this were to be the case, net prepayments would slow, which would actually be good for AGNC.

At this point, I would like to stop and thank you gain for your interest, and then open up the call for questions.

(Operator Instructions) Our first question comes from Jason Arnold with RBC Capital Markets.

Hi.

Good morning, guys.

I was just curious if you could please talk about the characteristics of the 15-year fixed bonds from perhaps a prepay expectation and coupon yield perspective that still make these more appealing to you right now?

Sure.

On the 15-year front, as I mentioned, the vast majority of our 15-year mortgages are lower loan balance, and so we are very happy with the way they have performed.

It is interesting because newer 15-year generic, newer 15-year loans have prepaid actually relatively quickly, and maybe quicker than some expectations.

However, the lower loan balance prepayments have been very contained, and so we are very comfortable with the returns.

Now, you have seen -- we went over the price appreciation of the lower loan balance versus more generic product.

But if you look at our 15-year portfolio on page 10, you can see that the average speed in the last release of the 15 years was 6.4%.

And that portfolio includes some, in this environment, higher coupons, 4% and 4.5%.

So, again, very happy given the types of 15-year we own, but, again, very focused that just generic, newer vintages, especially in 15-year where the borrowers have great credit, you do have to be concerned.

Okay, terrific.

And then I was just curious if you could also offer some thoughts on swaps.

We, of course, have very, very, very low pay fixed rates out there in the market right now and I'm just curious if you can comment on whether you would be inclined to add some more swap exposure given what is out there right now, or are you happy where you're at?

That's a great question and I'm glad you brought it up.

When it comes to hedging decisions, we have two things to think about.

One is rates are low and, yes, you can lock in lower funding.

On the other hand, when rates drop, you also have to be concerned that your mortgage portfolio shortens in terms of its average life and its duration.

So, you have to balance the idea of locking in lower rates with potentially being over-hedged because, again, the duration of your assets drops.

And you could have made a very good argument to increase the percentage of your hedges for the reason that rates are low and it's a nice time to lock in rates.

That wouldn't have worked out that well from a book value perspective and over time.

I will say that as we get down to where we are today in rates, especially for five years and in, the down side of rates -- in other words, how much more they can drop, is pretty limited.

And so you can make a stronger case on the funding side.

And on the margin we are definitely being a little more aggressive about both the maturity of the swaps that we put on and to some degree reducing our, what we call duration gap.

To give you an idea, our duration gap is roughly half of where it was at the end of the third quarter.

Again, that is a number with a lot of caveats, but versus the eight months, we see our current position as a bit lower.

Just one more quick thing to add on that front is that we have added some payer swaptions since quarter-end, and what that does is give us the right to enter into swaps if interest rates were to rise.

So, those purchase options give us protection if rates go up, but it also limits the amount we can lose if rates continue to drop like they have.

Okay, terrific.

And so you would then probably be more focused on having something more in the four- to five-year swap tenor range versus perhaps what you had in the past.

Is that a fair assessment, on the new stuff anyways?

I think there is a marginal tendency to move out on the swap curve a little bit, maybe more to the four to five.

We're certainly not doing two-year swaps.

But our swap portfolio has tended to average around an average maturity of over 2.5 years in the past.

And if you look on page 13, it's at 2.9.

So, you can see a slight tendency to move further out.

But we have been focused on the maturity of our swap portfolio all along.

When we do the swaptions, we tend to do them in either the five- and 10-year area, because that is where we feel limiting the down side if rates go in the other direction is more important.

Okay, terrific.

Thanks so much for the color.

Your next question comes from Mike Taiano with Sandler O'Neill.

Hey, good morning.

I guess I had a question on the 105 to 125 LTV fixed rate securities that you had, the billion, I guess, as of June 30.

I guess I was surprised -- and great color on the relative outperformance of those securities -- but I guess I was surprised given that they were up so strong in the third quarter and such a relatively large percentage of your portfolio that you didn't see it really get reflected in your book value at the end of the quarter.

Was it just some of the other securities sort of countered that or the swap portfolio that countered that?

No, good question.

Bottom line is that fixed rate mortgages in general, as we went over, dropped a lot on the quarter.

And remember, we did have a drop in interest rates, so our hedges were clearly going to cost us money.

And so I think you would have seen pretty weak book value performance to the extent that we had more generic mortgages.

Plus, some of the higher coupon ARMs were kind of flat on the quarter, so they didn't perform that well.

So, to your point, I think this was a quarter where mortgage spreads generally widened and where book values on most would have been under -- we'll call it a decent amount of pressure, and I think par book value was able to stay around the same despite the annual very healthy dividend because of some of these strategies.

Great.

And then just a question on risk and, again, appreciate the chart showing the economic returns relative to peers.

But I guess two metrics that investors tend to look at in trying to assess relative risk you versus your peers are leverage and serve average dollar price of your portfolio, both of which went up during the quarter.

And just curious as to how you would address those concerns.

And then, secondly, I think everybody's view right now seems to be that rates are not going to go up for a long time, and so how do you protect against that, like a potential shock to the system in the rare event that rates actually could go up in the next 12 months?

Okay.

So, let me start with your first question on leverage and dollar prices being indicators of risk, and I'm going to start with the second one, which is dollar price, for a second.

Dollar price is not, or cost basis is not an indication of risk.

So, while people can have different opinions on things, it is the market value of your securities at any point that define your economic risk.

And so I don't think you will see this big difference in the market values of various kind of players in the space, so-to-speak.

And we have said over and over again, our mindset is making sure we have the right securities and securities that are going to perform well.

And that in the end is what protects you on the prepayment risk front.

And I think our results over time should indicate that that is the case.

So, big picture, we feel very strongly that dollar price is not a good defense against prepayment risk, and we are not -- and don't really consider that a strategy we look at.

On the leverage side, I think there is obviously, everything else being equal, leverage clearly is a risk factor, so-to-speak, and, again, everything else being equal, I would agree with you that higher leverage brings about higher risk.

But let's face it, and I think a simple look at the portfolios in the space tells you that off the top everything else is not equal.

And so if you think about our mindset and our strategies, we contain risk via our asset selection and via our hedging strategies.

So, we feel by moving our portfolio around and protecting ourselves from the risks we see at the time, we can operate in a very, kind of, we'll call it consistent manner given the environment at hand maybe with slightly higher leverage.

And keep in mind the diversification of the portfolio and, again, the asset selection strategies are critical on that front.

Because if something bad happens to one sector of the market and that's all you have, then even at lower leverage you can be very negatively impacted.

So, if you go back to the buyouts, having a little lower leverage didn't protect you if your positions were concentrated in those types of securities.

So, big picture, you're right, leverage is one factor that we have to think about on the risk front, but we actually think the other factors tend to dwarf that.

Lastly, on the hedging side, we do purchase options.

We have purchased both receiver swaptions in the past and now we mentioned we purchased a few more payer swaptions.

We protect ourselves from rising rates with our swap portfolio, with our asset selection and the type of assets that we own, generally higher coupons or 15-year other shorter mortgages, and we protect ourselves with the swap book.

And the combination of those will allow us to perform reasonably well even if we are wrong and rates go up.

Great.

That is helpful.

Thanks a lot.

Your next question comes from Dan Furtado with Jefferies.

Thanks, guys.

Great quarter again, Gary.

A couple of questions.

I want to talk about, you make reference to a structured transaction you bring on balance sheet.

Can you just kind of talk about what that is?

I'm a little bit lost there.

The structured transaction was merely we took some of the securities that we had purchased, in this case they were adjustable rate mortgage securities, and we sold off some of the cash flows.

Essentially, we exchanged -- from an economic perspective, we exchanged PSDRs for a CMO class.

But for accounting reasons, we have to consolidate it and treat it like it's not an outright sale and a [buy up] of new security.

We have to treat it like it is financing.

So, big picture, had securities, sold them, bought one security back, but are accounting for it as if we still own the securities and we are financing them with the securities that were sold.

Okay.

And so this is similar to what you did pre-buyouts, where you are going to -- you have securities that you don't necessarily want to sell, but you don't necessarily want the front pay cash flows or back pay, or whatever it happens to be in this case.

Is this kind of a similar strategy here?

Absolutely.

It is exactly along those lines.

And because the structure is different, that what we did before -- and actually the accounting has changed somewhat.

So, when you put those two together, we have to treat it differently from an accounting perspective, but from an economic perspective it is exactly what you described.

Again, it is not a significant component of the portfolio.

Right, right.

And then understanding that you executed the receiver swaption, my take there is that you engaged in both the receiver and the payer swaptions a couple of quarters ago because there was some significant uncertainty if interest rates were going to fake left and go right, in which direction they would go.

They obviously went down significantly, so you exercise -- you are basically getting a fixed pay rate and you are paying a floating rate on this option, is that correct?

Yes.

So, on the receiver swaptions, we had the right to receive a fixed rate at rates that are much higher than where current market rates are.

So, you have two choices at time of expiration.

You can either just receive that cash flow, and we did that in a couple of cases, or you could pair it off and sell the option back and receive cash.

We did that on another one.

So, we have done a little of both.

But essentially, going back to your point, without getting kind of caught up in the specifics, these are purchased options, and purchase options help you when things move a lot in a direction that -- you know, in either direction.

The payer swaptions that we have on the books will expire worthless, but it is interesting that we still feel like we got a fair amount of value on them.

Because the alterative for us would have been to pay on swaps that would have lost much more value than what we lost in the option premium.

So, to your earlier point, they help you for bigger moves in either direction, even if they expire worthless.

Gotcha.

Hey, thanks a lot.

It's always very informative.

Good quarter.

Talk to you soon.

Thanks a lot.

Your next question comes from Mike Widner with Stifel Nicolaus.

Hey, good morning, guys.

I was just wondering if you could talk a little bit more about the amortization expense you guys showed in the quarter.

If I have the numbers here right, you guys indicated about $30.8 million in premium amortization.

That's up from about $23 million last quarter.

And just trying to reconcile that with what you described as a pretty slow prepay environment and wondering what we should look for going forward.

Well, I mean, so amortization expense has two components.

One is -- well, three, really -- the size of your position, the amount of premium, and then your expected prepayment speeds.

In our case, projected prepayment speeds, in our case projected prepayment speeds.

And I made a point to emphasize that while our actual prepayment speeds were very tame, we are projecting a little bit higher in terms of a CPR over kind of light versus what we received.

So, had we used actual prepayments like some other people do, our GAAP earnings, our amortization would have been lower, our GAAP earnings would have been lower, our core earnings would have been higher.

So, that's not the way we do things.

The example I used in our talking points was because some of the securities [pay out] early on, you don't want to use that.

So, big picture, I think the explanation is combination of the projections had it changed that much versus the actual, which were a big drop, the size of our position was bigger, obviously, this quarter.

And when you piece those together, I think those numbers fall out that way.

So, maybe my numbers are a little off and you can correct me there, but if I go back to what you guys had reported in 2Q, at the end of 2Q you had about, call it $310 million of unamortized premium and you amortized basically 10% of that in the quarter, which would correspond necessarily --

That seems high.

What's that?

I don't have the numbers right in front of me.

We're trying to look it up, but basically we should just follow-up on this one offline, but, again, I think we've given you kind of the CPR drivers and actually feel comfortable with the numbers.

No, I mean, I hear you.

It just seems like a really big number given the prepay expectations and the actual, but, yeah, I'll follow-up with that online.

That's all I had.

Most of my others have been asked.

Thanks.

Thanks.

Your next question comes from George Bose with KBS.

Hey, good morning.

This is Bose.

I wanted to follow-up on this swaption discussion.

I mean, it kind of gives you some powerful protection against rate moves.

I'm wondering if there is a way for us to think about the cost side of this, or the economics of entering into swaptions.

Sure.

We give you on our page, we give you the kind of cost number, and I think the overall cost of all the swaptions that we had entered into prior, it has dropped off this number, off this page, because the payers are no longer there.

But I think the number was in the -- call it $4 million type of area.

So, big picture, it's not a big number when you think about it over -- amortizing it over time.

But realistically we have received in kind of value out of those swaps considerably more than that.

So, at this point, if you wanted to think of it as a period-by-period cost, you would be amortizing value back.

But, you're right, over time you kind of straight line it or do something along those lines.

But we give you all those numbers in terms of the total cost.

Okay, great.

Obviously, also, they are captured in book value, and so forth, completely.

Yes.

Just switching to investment opportunities, I mean, you noted the specified pools have had a pretty strong move, so we're just wondering where you see value at the moment?

It's interesting, we definitely feel like some pieces of the market have run, so-to-speak, and some of the easier places to look have changed, but on the other hand, we still feel like there are good opportunities out there.

This quarter what we have seen is that you can find -- if you can find average pools that are priced like kind of bad pools, then there is good value there, and those are sometimes pretty easy to find.

I am going to avoid going into too much detail on kind of what we are interested in right now for competitive reasons.

But you can count on us to keep you up-to-date when we can.

Okay, great.

Thanks a lot.

Your next question comes from Steve DeLaney with JMP Securities.

Hey, Steve, how are you doing?

This is obviously a volatile bond market, MBS included.

And over the last month you talked about the underperformance of the generic TDAs in the last month.

Well, it seems like -- I mean, in the third quarter.

In the last month we have had swaps kind of flat, but we're seeing price trends where we have recovered about a point in these sort of 4.5% to 5.5% generic coupons.

And I was just wondering if you could comment on -- you talked about what went on in third quarter, what are you seeing recently in the market, and what is this move and the generics coming back, what is that telling us?

Is there less prepay fear now, or do you think this has something to do with QE2?

Just would appreciate your thoughts on the current market.

Great question.

Basically, we felt that the weakness in higher coupons was -- and not higher mid coupon fixed rates -- was overdone and we felt there were good opportunities there.

And that was one of the things that factored into our decision to raise equity in the third quarter, because we felt like those opportunities were deep.

And, again, as we mentioned and as you can see in our numbers, we really concentrated on fixed rate mortgages with our equity raised for those reasons.

So, yes, we feel like fixed rates have come back quite a bit as the market, I think, is still concerned about prepayments, but felt like it may have gotten a little overdone.

And one of the drivers may have been the market's kind of obsession with this, call it mega-refi kind of wave that the GSEs could potentially implement.

And I think that has dropped out of the market a fair amount over the last month, and I think that is a driver for it.

So, I think the short answer is people are still concerned about prepayments, because the pay-ups for these specified activities, or these kind of value-added mortgages, have held in despite the fact that TBAs have gone up.

It's not a question of, like, reversing that the specified pools were weaker.

It is really more the matter of the generics catching up, I think I'm hearing you say.

And I think it's a lot of it, to be perfectly honest, is backing out some kind of overreaction to the, to some degree, the mega-refi discussion, plus some of the realized speeds.

It is interesting, though, that in some products, though, the "TBA speed" issues are hitting more this quarter or you're not seeing the same kind of rebound.

So, you are seeing it in 30-year, but you are not seeing it in everything across-the-board.

Okay.

Well, the October speeds that we get next week will be interesting, because I guess August is when rates really dropped, when mortgage rates really started falling.

So, we'll probably get a better read then.

Hey, thanks a lot, Gary, and congrats on continuing to do a great job there.

Thanks, Steve.

Your next question comes from Matthew Kelly with Morgan Stanley.

Hey, guys.

Thanks for taking my question.

Most of mine have already been answered, but I just wanted to get your take on how you think internally about what you are investing in now, what sort of yield you need for two to three years out to maintain an acceptable return?

Like, how you think about that decision and what sort of leverage you put on it.

Well, I guess I'll start in reverse order.

We have kind of given you a feel for kind of our leverage expectations, which again can vary as conditions change.

But big picture again, as yields have come down, funding costs are lower, and so we are more focused on kind of the spread that you can take out and the risks associated with those trades, so-to-speak.

And big picture, we feel like the returns, the risk-adjusted returns are still pretty attractive in the market.

And, again, to an earlier question, they had really widened out in the third quarter, especially on the fixed side, as these kind of prepayment fears escalated in the market.

So, we don't have a particular yield bogey.

We don't have an exact spread bogey.

It depends on what we view the risk of for the trade where the, you know, type of instrument.

But we do feel like the spreads are still very attractive and we continue to produce attractive risk-adjusted returns over the foreseeable future.

Okay, that's it for me.

Thanks, guys.

Your next question comes from Jim Ballan with Lazard Capital.

Thanks a lot.

I just wanted just a little bit of clarification on the amortization question from before.

I mean, maybe you can talk a little bit just about your thought process on -- I mean, you have already talked about you think prepayment speeds are going to slow down here, and I guess that's why you took the projected CPR down going forward.

But can you talk about what you think the impact on earnings will be for that?

And then, also, I just noticed that there is a differential in the premium amortization between the GAAP numbers and taxable numbers.

Can you just talk to me about why there is a differential there?

Is there a different prepayment assumption or something else that I am missing?

No, great questions, and let me start with your latter one, because it is very straightforward.

The taxable assumptions are fixed at the time when you put on the -- you know, when you purchase the instrument.

So, if we buy an instrument three months ago, we essentially lock the prepayment estimates to what we project them to be at that point, whereas, the GAAP numbers are updated as market conditions change.

So, that is kind of the key driver between the taxable amortization and the GAAP amortization.

Now, to your latter point -- your earlier point, I'm sorry, about changing prepayment estimates, I wouldn't say that we feel that prepayments are going to drop in the short run.

And, actually, on many of the securities or types of securities we own, we have increased the prepayment speed expectations.

However, there were some categories of securities such as, the best example, are the 105% to 125% LTVs, where our speed projections given the new -- given the information we were receiving and given kind of the change in the market, our speed projections were just too high, and so those had to be adjusted to be reasonable in this environment.

So, there was really a dichotomy.

In general, we actually increased our prepayment speeds, but there were a couple [classes] of securities where that wasn't the case, because we had been getting just very contradictory information about their performance (inaudible).

Okay.

So, is this -- I mean, I noticed that you made a comment in your press release this quarter that sort of the adjusting of those assumptions going forward, it sounds like this quarter was kind of a -- you were going to have a one-time event, you might say.

But in general, do you keep those speeds generally the same, or is there something that you can make a meaningful adjustment sort of quarter-by-quarter?

No, I mean, we project our prepayment speeds and those are a function of market conditions, but I think what you can look at is that interest rates have fallen to pretty low levels, and so the interest rate impact for most types of securities is largely felt.

And so then most of the adjustments, or whatever, going forward can either be driven by interest rates or they can be driven by actual performance and us changing models.

We base our projections on a very, very reputable state-of-the-art third-party system.

We do make adjustments here or there in consultation with auditors and so forth at times.

But big picture, we're not -- we've got a state-of-the-art model that is kind of the cornerstone for evaluating those.

But there could be adjustments going forward.

One thing I want to reiterate is, again, those projections in most of the cases, even, for example, the 105% to 125% LTVs, are still well above where they are prepaying, okay?

So, there is quite a bit of room for things to increase.

Again, we are just not going to run may things at a 2% or 3% CPR and assume it is going to stay there.

Okay, great.

Thanks a lot, Gary.

Your next question comes from Jasper Birch with Macquarie.

Oh, hey, guys, it's Matt Howlett.

Gary, just on the gain on sale line item, I know you don't give guidance, but did you say the HARP sales were done in the fourth quarter, and what can you tell us sort of -- what can you tell us in terms of sales going forward?

I mean, you've had a pretty high run rate here in the high $20 million range.

I mean, how long can that last?

The bulk of our -- I'll answer the specific questions since I referenced it.

The bulk of our HARP sales, I believe, were the fourth quarter.

However, there were definitely some toward the end of the third quarters as these paydowns exploded.

But, clearly, there have been some HARP sales this quarter and that is what I was referring to.

Outside of that, I mean, again, we are very focused on maintaining a portfolio that works for the environment at hand.

And to the extent that the environment stays the same and we don't see better opportunities or reasons why we feel we have to act to reduce risk, we won't sell anything.

However, we -- generally, that is not the case, and so all of our decisions on transacting relate to trying to improve the performance and the consistency of the performance of the portfolio.

And I think it has worked very well for us doing this and as the economic returns demonstrate, and that is our mindset going forward.

So, specifically, yes, there were sales this quarter.

Probably will continue to be, but they will be in reaction to what we see the risks and the opportunities and how they evolve.

Great.

And then as we approach an announcement for QE2, I don't know, Gary, what's your thoughts on whether the Fed is going to go back to MBS again?

There is talk of them even going into the higher coupon season stuff.

That would be awfully good for your book value.

Would you look at taking more sales?

And then tell us -- I mean, would that be good for sort of acquisitions, if they're out there kind of just buying stuff blindly?

You know, in general, we feel like the Fed mortgage related activities with QE2 will be limited, not necessarily zero.

I think that it is very possible they may choose to reinvest pay-downs.

I don't think they're going to start, so-to-speak, a big new program.

To your point, if they buy, if they do buy mortgages or a lot of mortgages, it will help our book value.

It will on the margin reduce opportunities or make mortgages more expensive, which is a negative for us going forward.

We just don't see, when you look at it over the long run, we think a lot of their activity crowds out other buyers.

So, we don't see it as a huge picture issue over the long run.

And, again, we feel like the long run investment environment in agency mortgages is really good, because (inaudible) the Fed may be a short-term player.

Again, I don't think it's going to be that significant.

Second of all, you've got the GSEs kind of portfolios going away, and then you've got bank and ARP desks kind of reducing in size.

So, over the long run we actually just see the investment environment getting more and more favorable as some of these kind of key players disappear.

Okay, great.

That's great color.

And then last question.

Gary, you worked at Freddie for a long time.

GSE reform is coming late January.

Does it have any really impact to Agency going forward?

I mean, how do you foresee the new structure of the GSEs?

Thanks again.

No, great question.

On the GSE reform issue, we actually don't see it as a very big picture issue for the Agency mortgage market.

Obviously, that sounds ridiculous, but I think -- while we don't know the structure and no one does, and there is clearly a lot of uncertainty on this front, and I think it will drag out longer than people think.

I mean, in the end, what I see at the outcome of this is the Government maintains the role of guaranteeing securities, okay?

So, putting their wrap, could it be -- will the names of Freddie and Fannie change?

Probably.

Could they be merged with Ginny Mae?

Maybe.

But we see basically a securitization, an agency securitization business that stays largely where it is, and we see greatly reduced retained portfolio activity where the portfolios are no longer significant to the market.

And they were our toughest competitors as an agency REIT.

They could lever a lot more than we could.

So, big picture, we think those two components, again, the securitization business will largely stay the way it is.

It will get named differently or structured differently.

And the portfolio is largely going away, and those outcomes, we think, are pretty high probabilities.

So, we don't see it as a big wild card, but we recognize there are going to be (inaudible) bombs left and right.

Great.

Thanks, guys.

Your next question comes from [Elias Sovinsky] with First Allied Securities.

Your dividend at $1.40 seems to be pretty stable right now.

Is the intent to continue to be able to grow that dividend, and what is the dividend payout policy?

Would you comment on your recent secondary's impact on future dividends potentially?

We don't, as a matter of practice, give guidance around the dividends.

Obviously, the information about kind of what we own and our spreads on our portfolio is out there, so it's really hard for me to give you a lot more information on that front.

What I would say is just to reiterate what we said around the secondaries is that irrespective of the share count, our amount of undistributed taxable income has not declined.

On a per-share basis it is lower, but that is only due to the increase in the share count, not due to us using undistributed taxable income to "pay the new shareholders."

The other thing, just to mention, is that the share offerings were accretive to our book value, so you can think of that as the new shareholders paying for the -- sufficiently for the entire value that Agency brings, including the undistributed income.

So, we feel very comfortable about that.

Your next question comes from Henry Coffey with Sterne, Agee.

Good morning, everyone.

Kind of on the back side of that, and really just, kind of, I'm just asking you to go over the same territory.

You've got, what did you indicate, about $1 billion of HARP bonds that you sold or will sell.

Is that accurate?

No, that's not.

We indicated that going into the quarter, and we wanted to give the going into the quarter number, because given the price moves.

I also mentioned that our kind of peak position in the securities was about $1.4 billion, in that neighborhood.

It was lower than that at the end of the quarter.

We're not going to give out that number.

And it is lower than that now.

Again, as I mentioned earlier, we sold a fair amount in October.

So, we're not necessarily going to go to zero on those securities, but the driver of those sales is very straightforward.

When they were lower than TBA and we thought they were going to prepay, it was an automatic.

When they are priced at ultimate points of TBA, there is more downside than upside, and it's not a position that we want to have in that kind of size.

And if I am interpreting your graphs correctly, you were purchasing about 105 and now the value is about 108?

It depends on the coupons.

The better way, I think, to think of it -- I mean, I don't think those prices are necessarily off that you gave, but more importantly, when we were purchasing and the way we think about it is not that the price has gone up, but we're thinking about it that they were cheaper than generic mortgages and now are a lot more expensive.

Right.

No, obviously, we're just trying to guess what the gain in the fourth quarter is going to be, Gary.

Good luck.

All right.

Someone else said the only thing I can tell you about that is whatever number you come up with, it's wrong.

When we look at the $1.40 dividend and what is now about $0.74 of undistributed, obviously the two components of taxable income, one is going to be what you earn, and the second is going to be what's left over.

And then obviously gains are going to factor into that.

So, is it fair to say that on an operating basis you have three or four quarters of undistributed to go and you're still at $1.40, but that number is buttressed and increased by realized gains, or how are you thinking about it?

Well, again, without -- I'm going to be careful not to give any guidance.

Right.

On the other hand, what I can say is that there are three key components, or really two.

There is our taxable earnings on a quarterly basis and what we generate.

And to your point, we are very focused on overall returns to our shareholders and we're not going to obsess about whether it comes through gains or kind of net interest income.

We are worried about the total picture.

And so it is those taxable earnings.

And on the side is the undistributed taxable income which we absolutely expect and will pay out over time, but the other bit of information that we have said is that we reserved a small amount for an excise tax this quarter.

When the RIC BDCs were doing this, the argument always was, well, why don't you just give us all our money now, because the present value of getting the $0.99 or the $0.74 is greater than the future value of getting the $0.74.

I think when you look at our mindset on this is, there are a number of factors that go into that equation.

But I think investors have been very well served by that -- by those funds being reinvested in the Company given the performance and given the attractive environment.

And the dividend that we are paying out, I think to kind of everyone's mindset, is already extremely (inaudible) --

No, no, given that -- you have a good point in that you are probably making a realized ROE of 18% to 20% to higher.

So, I can appreciate the thought process.

Well, thank you very much.

Thank you.

Our final question comes from Robert Slyker, private investor.

Morning, guys.

Nice quarter.

My question is how are the IOs and the CDOs doing last quarter, and what is your outlook for that portion of the portfolio going forward?

Well, first off, I think I heard you say CDOs and we don't have any CDOs.

Everything that Agency has is wrapped or guaranteed by Freddie, Fannie or Ginny Mae.

But CMOs and the IOs are -- the CMOs, first off, are very generic instruments.

They basically perform like ARMs and fixed rates.

They just happen to be in a different package.

And then on the IO front, IOs did not perform very well in the third quarter, and they have improved a little in valuation.

But they are an absolute tiny percentage of our portfolio.

The investment amount that we had at the end of the quarter was in the area of $20 million.

So, I would say it's not at this point going to be material to our bottom line, but I do want to reiterate that that is a sector of the market like others that we look at and feel like there are good opportunities.

We as an agency mortgage REIT should take Agency mortgage cash flows in whatever form we feel produce the best overall returns, and we are going to very seriously look at that sector when we think there are good opportunities.

And the CMOs are much higher dollar amount than -- together the two have declined about 50% in value.

They have declined in that they get paid down, not in terms of kind of -- you know, the CMO position, which is larger.

Again, these are very similar to ARM and fixed rate securities.

They have principal and interest, and they -- what has happened is they have received prepayments, so their face amount has dropped.

And the reason they have dropped as a percentage is we haven't added many of them, and we have added lots of other securities.

So, it is just due to a couple of sales, some paydowns, and then the growth in the other portions of the portfolio.

And, again, any price movements of those are already included in our book value and factored in.

And, again, relative to our expectations, we have been very comfortable with them.

Okay.

I think I can say that you find that portion of the market for IOs and CMOs as not been very productive recently and you're avoiding it for the present.

Again, I think we found -- recently we found better opportunities, or in the third quarter and second and third quarter elsewhere, but it's an important sector that we are committed to.

Thank you.

At this time there are no further questions.

Presenters, are there any closing remarks?

No, thank you.

Thank you for participating in today's AGNC earnings conference call.

This call will be available for replay beginning at 1 p.m.

Eastern Standard Time today through 11:59 p.m.

Eastern Standard Time November 10, 2010.

The conference ID number for the replay is 16368819.

Again, the conference ID number for the replay is 16368819.

The number to dial for the replay is 1-800-642-1687, or 706-645-9291.

This concludes today's conference call.

You may now disconnect.