AGNC Investment Corp (AGNCN) 2011 Q2 法說會逐字稿

Good morning.

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

At this time, I would like to welcome everyone to the Q2 2011 AGNC shareholders call.

All lines have been placed on mute to prevent any background noise.

After the speakers' remarks there will be a question-and-answer session.

(Operator instructions).

I would now like to turn the call over to Ms.

Katie Wisecarver, in investor relations.

You may begin your conference.

Thank you for joining American Capital Agency's second quarter 2011 earnings call.

Before we begin, I would like to review the Safe Harbor statement.

This conference call and corresponding slide presentation contain 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 protections 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 25, 2011, and 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 unless required by law.

An archive of this presentation will be available on our website, and the telephone recording can be accessed through August 10 by dialing 855-859-2056, and the conference ID number is 84890133.

To view the Q2 slide presentation, turn to our website, AGNC.com, and click on the Q2 2011 earnings presentation link in the upper right corner.

Select the webcast option for both slides 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 the call today include Malon Wilkus, Chairman and Chief Executive Officer; John Erickson, Chief Financial Officer and Executive Vice President; Gary Kain, President and Chief Executive Officer; Chris Kuehl, Senior Vice President, mortgage investments; Peter Federico, Senior Vice President and Chief Risk Officer; and Bernie Bell, Vice President and Controller.

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

Thanks, Katie.

Good morning, everyone, and thanks for joining us.

Dj vu is probably the best way to describe this quarter.

The similarities to the second quarter of 2010 are striking, and this only reinforces what we stressed last quarter.

Our portfolio must be able to perform if rates move in either direction.

Therefore, we really do feel good about continuing to produce strong results this quarter despite the unexpected rally in the bond market.

Now, before we discuss the quarter, we realize that many of you have questions around the debt ceiling, the risk of a downgrade of the US government debt and the implications on agency MBS.

And now, while political wrangling clearly seems to dominate the thinking or lack thereof in Washington, we strongly believe that the debt ceiling will be raised at the last minute.

That being said, there is a risk of a downgrade of US debt below its historical AAA rating.

However, we believe the impact on government and agency debt of a downgrade will be limited.

The markets are clearly aware of this risk, and US Treasuries actually rallied with prices higher and yields dropping yesterday.

Additionally, agency mortgages are also holding a reasonably well, given the headlines, and prices of all generic mortgages were higher yesterday.

Lastly, I want to address some misconceptions that seem to be floating around with respect to agency repo.

First of all, the agency repo market is functioning normally, and we have not seen pressure on haircuts.

Agency repo is readily available, and rates remain extremely attractive.

Furthermore, even in the unlikely event that at some point in the future we saw a 1% or 2% increase in haircuts to something like 5% to 6% on agency MBS the from the current levels of near 4%, this would not impact our comfort level with our leverage.

To demonstrate why we are not concerned, remember in early 2009 when the equity market was at its lows, agency repo haircuts averaged around 7% to 8%.

Why is that significant?

Because, at that time, the average leverage in the REIT space was very close to where our leverage currently is.

In other words, we would be comfortable running our current business and could fully fund our positions with ample cushions even if haircuts increased 2% or more.

To further provide comfort here, at the depths of the market in the second half of 2008, agency REITs with eight or more times leverage were able to make it through the worst liquidity period we have witnessed.

In conclusion, we continue to repo at terms consistent with or better than where we were earlier in the year, and our business model can handle any reasonable increase in haircuts.

So with that out of the way, let's move on to a more fun subject, the review of AGNC's performance for the quarter.

First, GAAP net income totaled $1.36 per share.

And if we exclude the net loss of $0.05 a share in other investment income, that leaves $1.41 per share of what some might describe as core income versus the $1.30 per share of last quarter.

Taxable income was $1.56 per average share.

Our undistributed taxable income increased again this quarter by $23 million as our taxable earnings continue to exceed our dividend.

So as of June 30, UTI totaled $78 million or $0.44 per share off of our ending share count of nearly 179 million shares.

Book value rose $0.80 per share to $26.76 during the quarter.

Importantly, our economic return, which is the combination of dividends plus the increase in book value, totaled 8% for the quarter or 34% on an annualized basis.

So as you can see on the next slide, our mortgage portfolio totaled $40 billion as we deployed a large percentage of almost $1.4 billion in accretive equity we raised toward the end of the quarter.

But really, what is most important is that this growth does not come at the expense of asset quality, and Chris will address this in some detail in a few minutes.

But now let's turn to slide 5 and look at what happened in the markets during Q2.

As you can see, in the top two panels on the left, interest rates dropped materially during the quarter with the five-year part of the curve outperforming.

If you look at the changes in swap rates, two-year and 10-year swaps dropped around 30 basis points while five-year swaps dropped by 43 basis points.

Notice that the two-year and five-year swap spreads widened significantly during the quarter as well.

But now let's look at generic mortgage performance.

Overall, we were impressed with the performance of agency mortgages during the quarter.

When rates rally significantly, we assume prepayment fears will escalate, providing resistance to mortgage price increases.

This did end up happening, but only late in the quarter, when the rally appeared to be more powerful and more sustainable.

That being said, while mortgages weakened later in the quarter, their overall performance was quite respectable with 30-year 4.5% coupons increasing by almost 2 points.

Also, as you can see on the bottom left, 30-year 6% coupon mortgages rose by a point in the quarter during the quarter.

Interestingly, the price of that 6% coupon mortgage reached a high of over 110.5 in early June as the market became somewhat complacent about prepayment exposure and risk premiums.

In 15 years shown on the top right, performance was also reasonable as the price of 15-year 3.5%s and 4%s increased by 1.75 and 1.6 points, respectively.

Now, importantly, the prices of prepayment protective mortgages, such as low loan balance and HARP loans, increased by more than generic mortgage products.

As a result, the aggregate performance of our assets outpaced the losses on our total hedge book, which drove a large portion of the increase in our NAV during the quarter.

So now I'm going to turn the call over to Chris, who will discuss why we believe our portfolio is even better positioned going forward.

Thank you, Gary.

As you can see on slide 6, we maintain significant diversification while growing our asset base to approximately $40 billion, given the increase in our equity base.

During the quarter we increased our holdings of select types of 15-year and 30-year mortgage-backed securities with an emphasis on securities with prepayment protection, while maintaining our discipline with respect to extension risk.

As you can see on the bottom-left chart, prepayment speeds on our portfolio remain very well-behaved.

Our portfolio CPR averaged just 9% during the second quarter.

Initially, despite the decrease of interest rates, our portfolio prepaid at only 8% in the most recent release in early July.

The CPR performance is a function of specific attributes of our holdings and, as slide 7 shows, the percentage of securities backed by loans that provide significant prepayment protection increased materially during the quarter.

As you can see in the chart on the top right, prepayment-protected 15-year pools represent our largest holding.

And while 15-year pass-throughs have the obvious benefit of shorter durations, given a shorter amortization schedule, they are also generally backed by borrowers with very high FICOs and low LTVs.

And unfortunately, everything else being equal, very strong credit translates to considerably greater prepayment risk.

To mitigate this risk, more than 85% of our 15-year holdings, up from 76% last quarter, are backed by loans with either low loan balances or were originated through the HARP program.

And while these pools to trade at a premium to TVA, the premium paid is a small fraction of the value of having the more stable cash flows.

We'll show you an example of just how important this is on the next slide.

Now, within the 30-year sector we reduced our holdings of our highest-coupon securities as the valuations of these instruments got to levels where the risk/return equation no longer made sense.

As an example, we sold a significant amount of 30-year 6% pass-throughs and we replaced these assets with newer, lower coupon pools.

The result, as you can see in the chart, more than 65% of our 30-year holdings now have some form of explicit prepayment protection.

This category is comprised primarily of pools backed by HARP originations and, to a lesser extent, are backed by lower loan balances.

As we have discussed on prior calls, we continue to maintain our disciplined approach with respect to evolving the composition of our holdings in response to the ever-changing market environment while maintaining responsible diversification.

As Gary mentioned, the substantial decline in interest rates and the increase in mortgage prices looks very similar to what happened during Q2 and Q3 of 2010, and our strong performance during that period was driven by our asset quality.

While we didn't have this information back then, slide 8 shows just how important it is to own the right assets when rates fall significantly.

The graphs at the top of the page show the prepayment performance of low loan balance versus more generic 15-year securities during 2010.

Even more striking is the difference relative to higher loan balanced 15-year securities.

It's important to recognize that if you purchase TVA or generic 15-year 4s or 4.5s, you have to assume that the dealer will always give you the cheapest to deliver or fastest prepaying security available.

The graphs at the bottom are even more striking, highlighting the difference in performance between the high LTV, 100% refi-backed pools versus more generic 30-year cohort and cheapest to deliver pools.

As a levered investor in mortgage securities, we are only as good as our assets, and so we will continue to optimize our holdings to ensure we are perfectly positioned as markets change.

And with that, I will turn the call over to Peter to discuss our hedging activity on slide 10.

Thanks, Chris.

Let me start by reviewing our interest rate risk management objective.

As we have stressed before, the primary goal of our hedging activities is to maintain our book value within reasonable bands under a wide range of interest-rate scenarios.

Our goal is not to eliminate risk or to lock in a particular net interest margin, but rather preserve book value over a wide range of interest rate scenarios.

Book value and net interest margin are not mutually exclusive measures.

By definition, book value is the present value of all future cash flows.

So by focusing our hedging strategies on protecting book value, we also protect the portfolio's long-run cash flows and net interest margin.

The foundation of our interest rate risk management framework is careful asset selection.

As Chris just discussed in some detail, our current portfolio is comprised mostly of assets that give us significant downgrade protection.

As such, we have structured our hedge portfolio to give us protection against a rise in interest rates.

To do that, we use a combination of instruments such as interest rate swaps, swaptions, treasuries, total return interest-only swaps and TBA mortgages.

As you can see on slide 10, our swap portfolio totaled $22.2 billion at the end of the quarter.

Given the growth in our asset portfolio and the decline in interest rates experienced during the quarter, we increased our swap portfolio by $7.1 billion or 47% during the quarter.

Our swap portfolio had an average maturity of 3.6 years and an average pay fixed rate of 1.68%.

At the end of the quarter, our swap portfolio hedged 62% of our repo balance when accounting for unsettled positions.

During the quarter, we entered into $7.3 billion worth of new paid fixed swaps, which had an average maturity of 3.9 years and an average pay rate of 1.44%.

Our swaption portfolio also increased materially over the quarter.

At quarter end, our portfolio of put swaptions, which give us the right to enter into a paid fixed swap at a predetermined rate, totaled $4.1 billion.

During the quarter, we added $2.7 billion of swaptions at a cost of $36.3 million.

The cost of the outstanding swaption portfolio totaled $53 million at the time of purchase, and at quarter end had a market value of $36.4 million.

While the combination of our swaps, swaptions, TBA securities and other hedges provide considerable protection against a significant rise in interest rates, this is not our expectation.

However, as a levered investor and a steward of your capital, we must endeavor to protect net asset value against this risk, even if it is not our base case expectation, given the current state of the global economy.

To illustrate this point further, let's turn to slide 11, where we show the market value profile of our swaption portfolio over a wide range of interest rates.

As is the case with any long option position, the maximum one can lose is the amount paid for the option.

In the declining rate scenarios on the graph, you can see that the maximum loss on the swaption portfolio is $36 million, corresponding to its current market value.

Conversely, if interest rates increase significantly, our put swaptions will gain considerable value.

If interest rates were to increase by 200 basis points, for example, the market value of our put swaptions would increase by about $240 million or, in per-share terms, the value would increase by about $1.35 per share.

Now let's turn to slide 12 for a brief review of our duration gap.

The net duration gap of our assets and our hedges provides an estimate of the sensitivity of our portfolio to changes in interest rates.

As you can see from the slide, we ended the quarter with a duration gap of 0.6 years, unchanged from the prior quarter.

For a 100-basis point increase in rates, a positive duration gap of 0.6 years implies a loss of approximately $250 million.

As a percentage of our net asset value, the $250 million loss would equate to a loss of approximately 5%.

Of course, as we say on the slide and in our Q and as Gary has said in the past, this excludes the effects of convexity and is only a model-based estimate.

Actual results could obviously differ materially from these estimates.

That being said, these numbers should give investors some broad insight into changes in our interest rate exposure over time.

And with that, I will turn the call back over to Gary.

Thanks, Peter, and I can't stress enough how important it is to have someone like Peter, with over 20 years of market experience, joining our team and leading our risk management activities.

Now on slide 13, let's focus on the left-most column, which depicts the economics of our business as of June 30.

As you can see, our portfolio yields remain essentially unchanged, declining only 2 basis points to 3.45%.

Our cost of funds at quarter end increased from the prior quarter end by 4 basis points, to 1.09%, as a function of the larger swap Peter discussed earlier.

Again, this cost of funds number includes our repo cost, our settled interest-rate swaps and the determinedly effect of any forward starting swaps that begin at any point during the third quarter.

It does not include any of the other supplemental hedge instruments outlined on page 10.

Leverage as of June 30 was 7.5 times when incorporating unsettled trades, which is somewhat below where we would expect to operate and is a function of the timing of our Q2 capital raise and market conditions.

After subtracting our total expenses, you get a net ROE of just over 19%.

So now let's turn to slide 14 because I want to give a quick illustration of how sensitive the ROE of a levered mortgage investment is to prepayments.

I think this example, in conjunction with the prepayment speed history that Chris reviewed with you earlier, should provide more insight into why we obsess about asset quality and why different companies in the same space can produce noticeably different returns.

The table shows the yields under various prepayment or CPR assumptions for a hypothetical levered position in generic 15-year 4% coupon securities.

The table also shows net margin and ROE estimates assuming 1% all-in financing and eight times leverage.

As you can see, the ROE numbers drop off significantly as prepayment speeds increase.

For example, on one end of the spectrum at an 8% CPR, the projected ROE on the levered portfolio is just over 19%.

However, when prepayment speeds increase, the expected returns drop off significantly, as you can see in the table.

So the take-away is actually pretty obvious.

The returns on a levered portfolio of mortgage securities will be a function of how those assets perform in the future, coupled with how effectively the portfolio is hedged.

As such, given the combination of what you heard from Chris and Peter today, we remain very optimistic about our ability to continue to produce strong returns for our shareholders in the current environment.

So with that, I will ask the operator to open up the lines for questions.

(Operator instructions) Bose George, KBW.

-- questions.

The first is just really on sort of the growth that you guys have had lately.

Historically, I was going to characterize your business model as being kind of opportunistic, where you would position your portfolio based on opportunities in the market.

And, given the size of your portfolio now, with over $40 billion in assets, do you think it changes in any way how your business model runs going forward?

Well, Bose, it's a good question, but I think one of the things to look at is, I think that we would describe our business is being dependent on asset selection and being about holding the best assets we can in a given environment.

And as Chris went over today on the call, our asset portfolio, despite the size, has really never been stronger in terms of protection against extension risk with a high percentage of 15-year, in terms of protection against prepayment speeds with the highest percentage of prepayment-protected attributes.

So when you put that together, we are actually extremely comfortable that, as the portfolio is growing, we can maintain a portfolio that has asset qualities that we are extremely comfortable with.

And so, again, I would look at the composition of the portfolio as evidence that it's not an issue.

Okay, great, makes sense, thanks.

And then just switching to the spreads on new investments, I was wondering if the spreads you guys had this quarter, the 245-ish, is that roughly sustainable?

Well, look, as we have always said around spreads, it's very dependent on what assets you deploy into them.

And the yields on 15-year and 30-year mortgages are very different.

They are different on ARMs.

So it's obviously a function of what composition, what assets you find attractive.

But, big picture, spreads in that ZIP code that are not -- you know, you certainly can get them on the higher end of, let's say, the 30-year part of the market.

They are a little lower on 15-year and clearly lower on ARMs.

So again, it depends on what part of the market you focus on.

Okay, great, thanks a lot.

Mike Taiano, Sandler O'Neill.

I guess just the first question on the whole macro issue with the debt ceiling, and I hear what you're saying in terms of what happened in '08, but just curious -- is there any change in how you are operating the business in terms of leverage or type of securities you own as we kind of get into sort of the last leg of this, it looks like, and hopefully in the next week or so?

Or, is there anything you're doing specifically?

Look, we obviously factor in volatility into every decision we make.

But practically speaking, we are very comfortable with our leverage levels.

And first off, around liquidity, by having fixed-rate mortgages, we have extremely liquid assets that are easy to mark and that could be sold if they needed to be sold.

So we really feel very comfortable with our positions.

But remember everything that Peter went over today and everything we've gone over with you in the past.

We set our portfolio up to be in a position to handle big moves in either direction, and that's our daily operating philosophy.

So we really don't feel like we have to do something different in an environment like this because, again, whether it's our government and the debt ceiling or whether it's the European debt crisis or whether it was the big backup in rates in the fourth quarter, we run our business to be in a position to handle those kind of moves.

And I think we've demonstrated that in the past.

So I would say, big picture, we think -- we don't know what the next risk will be.

But we are always running our portfolio to be prepared for it.

Okay, that's fair.

And then just had a question on page 10, where you kind of go through your hedge positions.

I'm probably way oversimplifying this, but just on the payer swaptions, the $3 billion in notional with the pay rate of 3.68% -- so how -- I guess, given that [side] that your yields right now are like at 3.35%, 3.45%, how does that work from the spread perspective if rates were to go up?

So good question, actually.

When you think about -- this really gets to the core of what we have stated as our objective around risk management.

Yes, you could look at that and say, well, that's not a very attractive pay rate.

So does that really provide me a ton of value, so to speak?

But remember, if interest rates go up those options increase in market value quite a bit and provide significant protection of book value.

And so they also actually provide significant interest rate protection.

In that environment, they add duration, essentially, to our hedges.

So yes; while that part of the portfolio you could almost think is a ceiling or cap on our funding costs and not like a benefit to the funding costs in a rising rate environment, the material positive impact on book value is critical to us being able to manage our portfolio in that environment.

So it really does get to why we try to stress the objective of maintaining book value under a wide range of scenarios.

I think it's -- we are comfortable having that percentage of our hedges that's a ceiling on funding costs, if you think of it from that perspective, and getting the benefits in terms of book value.

Okay, so it basically goes back to the book value protection pieces that you guys talked about?

Absolutely.

In that up-rate scenario, in the larger up-rate scenario, protecting book value is job one, and we will prioritize that over NIM any day of the week.

And we've been clear on that.

Just last question, if I can -- just in terms of the HARP and low loan balance securities that you have, can you give us a sense of what sort of the split is between the two?

Is the majority now low loan balance, or is HARP large enough where it actually is a significant piece of those respective portfolios?

Within the 15-year sector, the majority of our holdings are actually low loan balance loans.

And within the 30-year sector, the HARP program is a little more significant as a percentage of issuance.

And the HARP -- loans that were originated through the HARP process represent a larger proportion of those holdings relative to low loan balance loans.

So I think at 30-year, it's roughly, what, like two thirds, probably, of that category is actually HARP versus loan balance.

But in 15-year, the vast majority are low loan balance.

Great, helpful, thanks a lot, guys.

Douglas Harter, Credit Suisse.

I was wondering if you could talk about any political risks that could increase your prepayment speeds.

So I think you are probably referring to the Boxer bill and some of the discussions around some streamlined refinance programs where fees at the GOCs are waived and so forth.

And if you remember, this was like a huge topic a year ago in the mortgage market, and higher-coupon mortgages underperformed because of those.

Our mindset -- I want to be very clear -- our mindset on this is that the government gave this a lot of consideration a year ago and decided it was a nonstarter.

If you think about what has changed since then, the political climate has moved so much further away from kind of doing more with the GSEs to help homeowners and help the economy.

It has gone in the other direction with the white paper saying reduce the GSE presence, increase fees, reduce the footprint.

So we feel pretty strongly that this risk is as low as it has been at any point kind of over the past few years.

Now, that being said, how do you deal with a very low risk that could be significant?

You deal with it from the perspective of diversifying your portfolio and managing the amount of your portfolio that's exposed to some, call it very far out-of-the-money risk.

And actually, our portfolio right now has probably the lowest exposure to something like this than it's had in ages.

And as an example, the entire 15-year part of the portfolio is already very, very good credit mortgages.

They are new, they are higher FICOs, they are lower LTVs.

They can refinance now.

The reason they don't is because they are low loan balances and the fees are -- the cost outside of the GSEs, the closing costs, appraisals and so forth, are a big hurdle on small loans, plus it's not economical for the servicers or the brokers to deal with these borrowers.

So that area would actually be basically unaffected, as with a lot of our 30-year mortgages.

The ones that would be affected are the higher-coupon mortgages and obviously things like IO strips and so forth.

But we have actually reduced our positions because prepayment in those areas pretty materially over the quarter, not because we are worried about this but because earlier, people had really kind of been complacent about generic prepayment risk and the prices of both IOs and higher-coupon mortgages had gotten out of control.

So, big picture, we are not worried about the issue.

We view a cheapening up of higher coupons as more of an opportunity.

But we will balance and diversify our portfolio so that our exposure is manageable.

Great, thank you.

Joel Houck, Wells Fargo.

I'm wondering if you would be willing to kind of handicap the probability of an actual downgrade occurring and then, along with that, your best guess of what would happen to MBS pricing.

And then kind of wrapped into that question is another one, which is, leading into this, have you guys kind of delevered sure balance sheet in the last week or so in anticipation of dislocation?

I heard your earlier comments about haircuts and you are fine, but this is more of an opportunistic question or in that sense that you would have excess capital to deploy if we got a 2- to 3-point sell-off in MBS.

So with respect to if we got a downgrade, in terms of the probability of a downgrade I don't really feel like we have any greater insight into this than the market as a whole, let's say.

But clearly, the market as a whole is saying that the probability of a downgrade is not insignificant, is probably the best way to describe it.

And importantly, once that's the case, then that probability is priced into the market.

And so when you see mortgages and you see treasuries performing as they have, you have to assume that the impact would be relatively muted because people are considering that there is risk on this front of a downgrade.

So, big picture, we expect maybe a modest widening.

But it would be modest and relatively brief.

And so we don't tend to operate our portfolio based on like trying to time leverage decisions to the tune of two weeks here or there.

That being said, again, we do look at long-term risk management and factor those kinds of things into our positioning decisions.

Generally speaking, we try not to give inter-quarter updates on our leverage and so forth.

So I'll kind of avoid giving a specific answer to your question on our current position.

But I would kind of point you to those themes in terms of thinking about how we would respond.

And I'm sorry; I think you had a last piece of that question?

Well, it was more geared toward I hear what you're saying with regards to it's not going to blindside anybody.

However, the very act of a ratings downgrade could force, however a brief period of time, could force some severe selling by pension funds, insurance companies.

Where these entities deploy that capital is anybody's guess.

Just -- there is no other AAA market to replace it with.

So, while your comments about it being kind of temporary, I think, resonate with investors, it still could be quite a huge shock if it actually happened.

Yes, this is Peter; let me add a little bit to Gary's, and I'll pass it back to him in a moment.

I think you're right; I think the risk of volatility is significant in the marketplace.

But I think what is happening right now is I think investors are preparing for that scenario.

And I wouldn't be surprised if people were reviewing their investment guidelines as we speak because, you're right, there really is no other substitute.

So I think everything is going to have to shift, kind of relatively speaking.

And to build on the point about the risk of downgrade and the credit of the mortgage-backed security, I think the market will quickly conclude, it is the superior credit, fixed-income credit product available.

If you think about it, the mortgage-backed security is first backed by a GSE, which is essentially capital neutral.

It's backed by the US government.

And now it's also backed by performing, largely performing mortgages.

So it is a collateralized security, and I think people quickly view it from a credit perspective as being superior even to a treasury.

And one other point, though, to kind of build on your question on being opportunistic.

I just want to talk real quickly on our repo capacity.

As we have mentioned in the presentation, we have 26 repo counterparties.

We have excess -- some amount of excess capacity with every one of those counterparties.

So we have a reasonable amount of excess repo capacity and we also carry a cushion to absorb, in the form of cash or mortgages, to absorb the incremental margin that Gary mentioned earlier.

I think that's a great explanation.

And I just want to reiterate the point Peter made about agency mortgages.

If you worry -- if, at some point down the road, there is a real like worry about US sovereign credit, an agency mortgage-backed security is the safest instrument.

It's collateralized by real loans and houses that are -- and the delinquent loans have already been pulled out.

So when you put that together, that makes it a much safer instrument than a US treasury.

And since we had -- Japan had a downgrade of its debt, interest rates and the lowest levels there are close to the lows in interest rates there.

The yen has performed fine.

I think you just have to be practical that the rating agencies' clout at this point is not what it used to be.

All right, thanks guys, appreciate it.

Mike Widner, Stifel Nicolaus.

So I've got a couple questions for you.

First, I want to just follow up on Bose's question and probably get the same answer, but I'm going to ask it again anyway.

As I look at you guys' strategy and execution over the past -- well, really, since the IPO, this is the first quarter since inception that core earnings, as you referred to it, actually has covered the dividend.

And actually, if we look back over the past six quarters, the percentage of the dividend being covered by trading gains or however you want to phrase, non-core, has been a steadily declining percentage.

[You spent] -- 25% of your dividend was covered by that stuff last year versus effectively zero this quarter.

Obviously, the portfolio is getting larger.

And then another point, as I've listened to you guys talk, the tone of the language certainly seems to be different.

You know what I mean by that, that you are talking a lot more defensively today.

And I don't mean that in a bad way, but things about protecting book value and generating stable or predictable pass-forward and protection from repurchase spikes and whatnot, which is a bit different from the tone that was, I would say, a little more offensive and a little more trading-oriented in terms of seizing opportunities from this pricing.

That language seems to be gone from your discussion right now.

So with all of that said, is there sort of a gradual but strategic shift in the way you guys think about managing the business at this point that is more about longer-term focus and so on and so forth, as opposed to just opportunistically taking advantage of whatever the market gives you today?

Actually, I would say that our approach to the market is not very different from where it was a year ago or year before that.

If you went back to our earnings calls in 2010, we talked about swaptions, we talked about protecting book value and managing book value for bigger moves in interest rates.

And we are proud of the fact that we have been able to do that over those periods.

I think we may be getting, to your point, a little better at maybe kind of communicating it.

But go back to -- we have used swaptions and they have produced material gains for us in the second quarter of 2010.

We talked about them when the big increase in interest rates in the fourth quarter -- a lot of our performance in that up-rate scenario was due to the swaption portfolio and TBA shorts.

So, look, we view it as a key -- we view, in a sense, generating returns for our shareholders as being a combination of price gains or appreciation and net interest income.

And I think we still have that exact same mindset, which is we want to make money for our shareholders.

We are not obsessed about which pocket it comes in through.

And that is the same mindset that we used in the past.

I think, practically speaking, we are in a little bit different of an environment right now, where we are not in the midst of things like GSE buyouts and where the theme has been a little more consistent.

But let's go to a couple things that happened this quarter.

We sold higher-coupon 30-year 6%s.

We basically took off the vast majority of our IO position during the quarter because prepayment risk premiums kind of disappeared from the market and we no longer felt those were good hedges anymore.

So you will see, on the margin, that we are adding, we're continuing to add value through those means.

It's just, there's clearly a difference in terms of the market environment versus other periods of times.

Well, that's certainly fair.

And I guess what I would take away from that is, again, your attitude hasn't changed but the opportunities that it's giving you today appear to be more on the net interest income side, is kind of what I distill from all that.

And that's why it looks like core earnings are getting a bigger share.

But it's not a mind shift so much as that's the environment that looks like it's out there today.

And I would point you -- and I would point you to the last slide that we went over today.

Right?

Look, we don't mind outperforming by holding really good securities.

Right?

It's not about that we have to sell something to add incremental value.

If you look at the last slide, slide 14, that we went over in the presentation, I think that sums up our mindset and our positioning right now.

If we own the best assets and we hedge them appropriately, we will provide extremely attractive returns for our shareholders.

If the market changes and we should hold different assets, we will continue to evolve our portfolio.

And we feel that, even at this current size, that's not going to be a problem.

Great, that makes sense.

So just the second question, then -- so the core income was very solid.

But if I look at that other income line, it's really decomposed into the realized gains on MBS sales and then a combination of unrealized and realized gains on the derivative instruments.

Those two individual components ended up balancing out to about $6 million, which is pretty small for you guys, all things considered.

But the individual line items were actually the largest that we've ever seen from you guys, so $94 million in gains, or about $0.70 a share in realized gains, and then offset more than entirely by the liability side.

So just wondering if you could talk a little bit about those components and sort of -- particularly the realized gains and the realized losses on the derivative side and the asset side.

Sure, no, good point.

Look, the bottom line is that, as we've said in the past, we -- a chunk of our hedges are mark-to-market through income.

So the market rallied, and so it's very logical that, since some of our -- only the swaps are essentially in hedge relationships, the other hedge instrument are mark-to-market.

And in a rally, they will produce negative marks, and that's absolutely expected.

The gains, on the other hand, relate to sales of things like 6%'s and other not-so-well prepayment-protected securities that, given the rally in interest rates, we no longer wanted to hold.

But big picture, this goes exactly back to why what we tell you guys to look at on a consistent basis is dividend plus NAV.

Right?

Because it marks everything.

It's independent of whether we take a realized gain or we see it as an unrealized gain.

It's independent of whether the swap is marked to market through income or OCI or the hedge.

So when you look at NAV, our assets outperformed our hedges in their entirety.

And when you look at the dividend, we paid the dividend and grew book value.

So that's why we continue to fall back and say, that is the best measure to look at on a consistent basis because it really drops off the specific accounting anomalies associated with what gets marked through income and what gets marked through OCI.

Yes, well, certainly can't complain about the performance on that standpoint.

I would agree that the consistency and the high returns have been certainly one of the best in this sector.

Let me -- just one quick follow-up there -- the realized loss or the realized gain from derivative instruments and trading securities -- if I understand that correctly, that is only -- that's the majority of the loss there, the $80 million.

Is that reflecting terminations, or is there things that actually are considered realized even if you don't unwind or roll off or terminate the hedges?

This is Peter.

The majority of the loss, $100 million was associated with our short TBA position.

So that's why it syncs up so well with the realized gain, so the $95 million realized gain was on mortgages that we sold at the same time we unwind a TBA hedge.

And so that's the associated loss associated with it.

The other component in the realized gains and losses were gains or losses predominantly associated with a treasury hedge position that we had.

But one other thing on the TBAs is, because they're monthly contracts, they almost automatically are realized because they move out to another month in the future.

So even if you still had a position on, it would generally be realized as long as it terminated within the quarter.

So it doesn't necessarily mean you, quote, took off the trade or whatever.

So just keep that in mind.

Yes, well, that's crystal clear, actually, just highlighting that it was mostly TBAs explains what I was wondering about.

And thanks for the comments and questions, and congrats on another solid quarter, guys.

Jim Ballan, Lazard Capital Markets.

Gary, as you mentioned already on the call, a recurring theme for you guys has been protection of the book value.

But if you look over the last year plus, you've actually had pretty nice book value growth.

And you've talked about some of this already today, but can you talk a little bit about just the components of the book value growth that you've had and maybe what the opportunity for further growth going forward is?

Look, when it comes to all-in returns, the book value growth essentially is, you pay a dividend, and if the remaining net asset value is higher than it started, then your book value grows.

Obviously, that's the, quote, simple math.

It's obviously -- book value is a function of market conditions.

We've also benefited from accretive capital raises, and that's a factor.

But, big picture, our mindset is one of -- again, just to reiterate -- total performance.

Right?

And so if -- we're not thinking of, okay, how do we grow book value next?

We think about it from the perspective of, if we own the best assets we can own, if we use logical and prudent leverage and then if we hedge the portfolio appropriately, we can generate very strong returns for our shareholders.

And then there is a dividend that you're paying, and then, hopefully, you've got book value growth from there.

We absolutely believe that further book value growth from this point forward is very doable.

When we look at managing our portfolio, though, we look at it from the perspective of we want to protect our shareholders' money.

And so book value growth is actually a very good thing, and we want to see it.

But we are also as focused on trying to maintain book value within a reasonable band if we get some challenging scenarios.

Okay.

I also wanted to ask about -- you mentioned those haircuts back up a couple of percentage points here, for whatever reason, that there really wouldn't need to be any change in your strategy.

Have you thought about what a break point would be where haircuts would have to go before it does have an impact on your strategy, and maybe you would need to unwind some positions?

Look, it's a function of a number of things.

It's a function of not only just haircuts, but market volatility, where are interest rates and other factors.

Where are prepayment speeds, because they also affect your ability to lever.

So actually, let me give you the comparison again.

The early 2009 scenario was haircuts in the 7% to 8% area with expectations around prepayments being much faster than where they currently are, which in a sense added the equivalent of another 1% to 2% haircut versus the prepayment speeds today.

So realistically, at that time this kind of leverage level was the norm in the REIT space, and that was a volatile period as well.

So my mindset is that we've got quite a bit of cushion with respect to changing haircuts and market conditions before kind of leverage policy, so to speak, changes.

And so we feel very well positioned to take advantage of opportunities if they present themselves.

And again, our prepayment-protected assets really help us as well with respect to kind of reducing our aggregate effective haircut, so to speak.

Got it, and just one last question, if I may -- you've talked a lot about how, even with the growth in the book that you had over the last year, you've kind of maintained the strategy.

Is there anything that you've gone through over, say, the last year, with all the growth, that surprised you in terms of any differences in the way you've had to run your business, whether it's managing the book or just running the business in general?

Actually, the one think that would surprise me or that may have surprised us a little bit is how little, in a sense, things have changed in that our outperformance or our mindset was about owning really good assets in the past.

And it's still about owning really good assets.

And, look, having come from managing a $700 billion portfolio, I've seen even the other side of this.

So there's comfort on our side in managing a portfolio from kind of the smallest that AGNC was up to a portfolio that AGNC will never get near.

So we've had experience on both sides of the spectrum.

And I would say what we have been continuously impressed with, so to speak, is the ability to find value-added assets when we need them.

And I think part of that relates to the fact that we view this as a continuous process.

So we're not starting with, okay, we need to go turn over our $40 billion portfolio and buy low loan balance now because we haven't thought about it in the past.

In that case, it would be kind of much, much harder.

But when you kind of incrementally, day in and day out, come in with a focus of keeping your portfolio optimized, it's amazing how much you can move your portfolio in a relatively short period of time, and you can do that in a way without moving market prices.

And you can do it where you're adding incremental value to your shareholders.

All right, terrific, thanks a lot.

[Edward Friedman], [MacLean] & Partners.

People have already asked this, but I was wondering if you could elaborate a little bit more on how will the book value be impacted if the US does get downgraded, let's say, and the [investor] fully declines by, let's say, 5%-10%, if there any precedent in the past?

And what was the impact in previous crises?

We don't really have a precedent in the US for a downgrade from the AAA level.

We do have precedents in other countries.

And generally speaking, and you can even look at it with respect to other securities that have been downgraded, the rating agencies, especially over the last three or four years, have not been perceived to be kind of the market leaders around kind of evaluating credit, whether it's the sovereign credit issues in Europe, whether it was downgrading Japan.

The reality is, the rating agency actions tend to come well after the market has digested any of the information.

And so, big picture, I just want to reiterate that we feel the market is thinking about all these things and is clearly pricing in the risks.

So we don't expect any massive moves.

Remember, if all yields go up, then our hedges also perform very well.

If all yields go down, then what we're worried about is the performance of our assets versus other yields.

So our main exposure, realistically, is the prices of mortgages versus interest rate swaps, for the most part, treasuries to a very small extent.

And going back, just to reiterate Peter's point, we do feel that if the market were to, at some point -- and we don't see this happening anytime soon -- price in true US sovereign credit risk, agency mortgages being collateralized by performing loans and the GSE helping out as well, put them in a much, much stronger position than even Treasury.

So we're optimistic, actually, about the price performance of mortgages over time.

Thank you.

Daniel Furtado, Jefferies.

I just had a real quick mechanical question, and that's back to the swaptions.

How should I think about those in an up-rate scenario?

If we had a shock upwards in rates, do you then hold these to maturity, or do you pair the gains on the swaptions with losses you would have on the portfolio in order to get out of underwater MBS positions at no impact on book value, or theoretically no impact to book?

My answer would be yes, so (Laughter) I know you asked an either/or.

The answer is, that's one of the beauties of having an option.

Right?

So you have the option if you feel that MBS at that point in time, in that scenario, are cheap and that the valuations -- and that you're not really that interested in selling.

Then you would actually exercise that option, and you would be able to put on a swap below where swap rates are at that point in time.

And you can realize the value that way.

Or, if you feel like you don't need that protection or if you want to sell some mortgage assets because they are performing very well in that environment, then you could do that and pair off the swaption at a gain.

So in a sense, it's going to be very dependent on the yield curve of volatility levels' mortgage performance as to how we operate.

But, big picture, the number one thing that we're looking for is that the price performance of those options -- those will be extremely valuable options if a scenario like that were to unfold, and that market value can be achieved one way or another.

Understood, perfect, thank you so much, Gary.

I think that's it, Phyllis, so if you could just close the call, that would be great.

Thank you.

This concludes today's conference.

You may now disconnect.