AGNC Investment Corp (AGNCN) 2013 Q1 法說會逐字稿

Good morning and welcome to the American Capital Agency first-quarter 2013 shareholder call.

All participants will be in listen-only mode.

(Operator Instructions).

After today's presentation, there will be an opportunity to ask questions.

(Operator Instructions).

Please note this event is being recorded.

I would now like to turn the conference over to Hannah Rutman, Investor Relations.

Thank you, Laura, and thank you all for joining American Capital Agency's first-quarter 2013 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 fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

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

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

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 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 May 16 by dialing 877-344-7529 or 412-317-0088, and the conference ID number is 10027585.

To view the slide presentation, turn to our website, agnc.com and click on the Q1 2013 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.

Participants on the call included Malon Wilkus, Chairman and Chief Executive Officer; Sam Flax, Director, Executive Vice President and Secretary; John Erickson, Director, Chief Financial Officer and Executive Vice President; Gary Kain, President and Chief Investment Officer; Chris Kuehl, Senior Vice President, Mortgage Investments; Peter Federico, Senior Vice President and Chief Risk Officer; Bernie Bell, Vice President and Controller.

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

Thanks, Hannah, and good morning, and thanks for your interest in AGNC.

As we will discuss on this call, mortgage price performance was surprisingly weak during the first quarter, and this underperformance was even more pronounced in specified or prepayment protected MBS as fears of an early Fed exit led to extension risks becoming the main focus of mortgage investors.

This weakness in both TBAs and specifieds drove the decline in our book value.

Importantly, these conditions appear to be reversing in Q2, and recent Fed statements have been considerably more balanced.

On our last earnings call, we said that we believed prepayments on our portfolio would continue to be well behaved.

Dollar roll financing would remain favorable.

TBAs were preferable to specified mortgages, and MBS prices would hold up well as the stock effect of the Fed's purchases began to outweigh other technical factors.

It was on this last point where things turned out differently than we expected at least during Q1.

In addition, the price performance of specified mortgages, while directionally consistent, was considerably worse than we anticipated.

On the positive side, dollar roll financing continues to be extremely favorable, and prepayments on our portfolio continue to be benign.

Looking ahead, we see little reason to believe these prepayment or dollar roll trends will change over the near-term, and we are also seeing repo rates beginning to drop as well, which should further benefit our aggregate cost of funds.

It was the combination of these positive factors, along with the more attractive MBS valuations, that led to our decision to raise additional equity in February.

During the first quarter, economic data was surprisingly strong, which prompted hawkish Fed statements about ending QE3 earlier than anticipated.

These concerns put some upward pressure on interest rates and sparked selling of MBS from money managers and foreign investors while keeping banks, largely on the sidelines.

However, over the past month or two, optimism related to the US economy has been tempered.

The global growth picture has weakened again, and inflation expectations have declined.

As such, a midyear tapering or a QE3 exit now looks unlikely.

Against this backdrop, interest rates have come back down, and mortgage valuations have strengthened.

As such, as of month end, our book value had recovered a portion of the Q1 declines.

We also believe the significant weakness in the prices of specified mortgages has created an excellent opportunity to add value-added product at attractive levels.

With that introduction, let's turn to pages four and five and quickly review some key metrics.

First, comprehensive income was a loss of $1.57 per share.

Total net spread income was $1.18 per share when you add the $0.40 of dollar roll income to the $0.78 of on balance sheet spread income.

Taxable income declined to $0.50 per share in Q1.

We would caution investors against projecting this number into the future as a large portion of this was driven by mark-to-market declines in the prices of TBAs that were treated as realized losses for tax purposes.

Since prices were dropping in Q1 and rolling TBAs requires positions to be paired off on a monthly basis, TBA price declines negatively impacted taxable income by approximately $0.55 per share.

This impact is likely to reverse in Q2 given the recent recovery in TBA prices, providing some tailwind to taxable earnings.

Undistributed taxable income dropped as a function of the difference between taxable income and the dividends.

It was also impacted by the mid-quarter equity raise.

But that being said, UTI remains high by historical standards at $1.08 per share.

As I alluded to earlier, book value dropped to $28.93 per share, which, combined with our dividends, drove our first negative economic earnings result of negative 5% for the quarter.

The weakness in generic mortgage prices and in the past for specified MBS were each significant contributors to this decline.

On page five, you can see that leverage inclusive of TBAs remained essentially unchanged during the quarter, and prepayment speeds continued to be well behaved.

Our net interest spread inclusive of dollar rolls but excluding the impacts of treasuries and swaptions increased to 187 basis points during Q1 and 171 basis points at quarter end, buoyed by dollar rolls and soured prepayment performance.

Now moving to slide six, we can quickly review the market environment during Q1.

As you can see on the top left, treasury rates didn't move very much during the quarter.

The two-year treasury actually rallied a basis point, while the five-year sold off 5 basis points.

Even the ten-year moved less than 10 basis points.

Swap rates moved somewhat more as swap spreads widened between 4 and 8 basis points.

However, against this backdrop of these relatively benign moves in interest rates, lower coupon MBS prices dropped materially with the 30-year 3% coupon dropping 1.75 points.

To put this in perspective, the price decline of the five-year treasury was only about 0.25 point.

Even 15-year 2.5% dropped 86 basis points in price or multiples of the move in the five-year.

The next slide shows that specified mortgages performed considerably worse than TBAs, which was also a significant contributor to our book value weakness during Q1.

The table on the top shows the performance of newer $85,000 to $110,000 loan balance pools since the announcement of QE3.

As you can see, payups or the difference in price between a lower loan balance pool and a comparable coupon TBA increased during the fourth quarter but then dropped significantly during Q1.

For example, this category of lower loan balance pools dropped an additional 73 basis points in price more than TBAs.

Thus, the aggregate price decline on these pools was actually 181 basis points in price, 73 basis points for the payup and 108 basis points for the TBA price decline.

As you can see on the bottom chart, the performance of HARP security is actually slightly worse than the 3.5% and 4% coupons.

Again, this almost 2 point price decline in HARP and loan balance 3.5% needs to be put in the context of the five-year treasury and swap hedges increasing in value by less than 0.25 point and 0.5 point respectively.

Unfortunately -- and this is important given the small move in treasury and swap rates -- hedges that were spread out across the yield curve could not offset the weakness in mortgage valuations.

Therefore, as we have stressed in the past, our hedges, including swaptions, are designed to protect us against mortgage price changes that result from large interest rate moves, while our equity is our main cushion against basis risk that is not correlated with rates.

So with that, let me turn the call over to Chris to discuss our current portfolio positioning.

Thanks, Gary.

The most significant change in the composition of our investment portfolio during the quarter is the increase in lower coupon TBA MBS from around $13 billion at year-end to approximately $27 billion as of March 31.

The increase was driven in part by a reduction in specified pools that were effectively converted to dollar roll positions given very attractive implied financing rates relative to on balance sheet repo.

I'll review where roll implied financing rates are in a few minutes, but before we turn the page, I want to highlight the fact that within our higher coupon positions, the vast majority of our holdings are backed by loans with lower loan balances or loans that were originated through the HARP program.

While these securities underperformed from a price perspective this quarter, the prepayment performance continues to be strong, allowing these positions to generate significant carry income.

To this point, I would like to draw your attention to the prepayment graph in the top right.

As you can see, our prepayment speeds remain well contained.

Also, keep in mind that because our lowest coupon positions are TBA forward commitments, they don't factor into our reported CPRs.

Therefore, these speeds are higher than what they otherwise would be if our lower coupon TBA positions were on balance sheet and included in the reported numbers.

Let's turn to slide nine.

As Gary mentioned in his opening remarks, the roll market continues to be an attractive alternative source of financing for certain types of securities.

Here we have two examples to highlight how significant the monthly roll advantage is in lower coupon 30-year and 15-year MBS.

I'm not going to walk through the examples in detail, but I'll quickly summarize the takeaway, which is, as of April 25, the monthly implied financing advantage from rolling 30-year 3% and 15-year 2.5% was approximately 94 basis points and 55 basis points respectively.

Now keep in mind that the carry comparisons shown in this example exclude all hedging costs that are not intended to depict long-term margins for either position but rather to better highlight the relative advantage of role financing versus one-month repo over the near-term.

Furthermore, while we do expect that major differences in roll financing versus repo will persist for some time, probably at least through 2013, investors should expect volatility in month-to-month dollar roll levels.

That said, the monthly carry differences add up quickly and can significantly impact total returns.

The only other point I would like to make around this example is that for purposes of comparability, we are calculating the annualized yields and margin in both examples using a short-term prepayment estimate of 2% CPR.

If we were to use a faster lifetime CPR, the advantage from rolling would be even larger.

The reason for this is that at a faster CPR, the asset yield will drop in the on balance sheet example, while the repo funding costs remains unchanged, therefore reducing the estimated net income.

In the case of the dollar roll example, your monthly income is fixed by the market price drop from the frontlog to the backlog, and therefore, you are completely indifferent to the imputed asset yield.

So on the roll example, while the asset yield will drop at a faster prepayment speed, the implied financing rate will also drop.

Lastly, on the bottom of this slide, I thought it would be helpful to give you some historical perspective on how these two rolls have traded over the last couple of quarters.

The implied financing rates in the bottom chart are quarterly simple averages of the daily close for the front month dollar roll during each respective period.

Now while there is a fair amount of volatility around intraquarter levels, the funding advantage has been material since the onset of QE3.

With that, I'll turn the call over to Peter to discuss hedging and risk management.

Thanks, Chris.

Today I'll briefly review our financing and hedging activities during the first quarter.

Let's start with our financing summary on slide 10.

As Chris discussed, the composition of our asset portfolio shifted during the quarter with our share of on balance sheet assets declining and our share of off-balance-sheet TBA assets increasing.

A favorable consequence of this shift is less reliance on repo funding.

As a result, our repo balance dropped to $66 billion from $74 billion in the prior quarter.

Our repo class also fell during the quarter to 47 basis points, down from 51 basis points the prior quarter.

Looking ahead, we expect this positive trend in funding costs to continue, perhaps resulting in another 5 to 10 basis points of improvement over the remainder of the year.

On slides 11 and 12, we provide a breakdown of our hedge portfolio.

The key takeaway from these slides is that we materially increased our hedge positions during the quarter.

In total, our hedge position at quarter end covered 94% of our liabilities, up from 83% last quarter.

On slide 11, we provide a breakdown of our swap and swaption portfolios.

Our pay-fixed swap portfolio totaled $51 billion at quarter end, up from $47 billion the previous quarter.

Our swaption portfolio grew at an even more -- at even a faster pace over the quarter.

At the quarter end, our swaption portfolio totaled $23 billion or roughly a 60% increase from the prior quarter.

On slide 13 we provide our duration GAAP information.

Rather than reviewing this slide in detail, I want to turn to a new slide we added on the next page, which is intended to provide greater insight into our interest rate risk sensitivity.

On slide 14, we show you how our duration GAAP changes when interest rates increase significantly and instantaneously.

In the current low interest rate environment, all mortgage assets have significant extension risk.

That is the risk that mortgage durations increase materially as interest rates rise.

On the first three lines of the table, we provide an estimate of the extension risk inherent in our mortgage portfolio.

As you can see the duration of our 30-year mortgage position will increase to about seven and a half years in an up 200 basis point rate scenario.

At the same time, our somewhat seasoned 15-year assets will increase to about 4.8 years.

Taken together, the aggregate duration of our assets will increase from 3.6 years today to about 6.6 years in an up 200 basis point rate scenario.

Our challenge from an interest rate risk management perspective is to mitigate this risk.

We hedge a significant portion of our extension risk upfront with interest rate derivatives.

On the fourth line of the table, we show the offsetting duration benefit of our liabilities, swaps and treasury hedges.

The duration of these instruments is aggregated together and expressed in asset units.

We calculate the duration in this way to make it comparable to the asset duration shown above.

As you can see, in the up 200 basis point scenario, the duration of our liabilities, swaps and treasury hedges at 3.5 years offsets about half of our asset duration.

On the second to last line of the table, we show the duration of our swaption portfolio again expressed in asset units.

Swaptions are nothing more than options on swaps, and as rates rise, these options begin to take on the interest rate characteristics of the swaps that underlie them.

As such the duration of our swaption portfolio will naturally extend from 0.3 years today to about 1.3 years in an up 200 basis point rate scenario.

Said another way, our asset durations will likely extend about three years in an up 200 basis point rate scenario.

Our swaption portfolio will hedge a full year of that extension.

An estimate of our net duration GAAP, which includes the impact of all of our hedges, is shown on the last line of the table.

As you can see, in the unlikely scenario where rates immediately increased 200 basis points, our net duration GAAP will increase from negative 0.2 years today to a positive duration GAAP of 1.8 years.

When interpreting these numbers, it is important to consider two critical assumptions.

First, the numbers in the table are model estimates and as such may differ materially from actual results.

Second, we assume that the interest rate moves in this analysis occur instantaneously.

As a consequence, we did not include any benefit from ongoing portfolio rebalancing actions.

In reality, rate moves typically occur over time, and given our active approach to risk management, we expect to take actions on a continuous basis to rebalance the portfolio.

There are two important takeaways from the table.

First, we've hedged a significant portion of our mortgage extension risk upfront with swaps, treasuries and swaptions.

And second, by doing so, we have minimized our ongoing rebalancing needs, which is important for us and important for the market as a whole.

But, again, even without any rebalancing actions, our duration GAAP in the immediate up 200 basis point rate scenario will be less than two years and below where many financial institutions operate on a day-to-day basis.

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

Thanks, Peter.

And before I open up the call for questions, I thought it was important to touch on economic earnings again given the almost 5% decline this quarter.

We have stressed in the past that economic return is the most important performance metric over the long run, and we're not going to change our tune about this, despite a weak quarter by this metric.

If you are interested, slide 25 puts in context this quarter versus the value we have been able to create over the past four years.

But the Fed's massive involvement in the mortgage market is clearly creating significant volatility in our economic earnings, and again economic earnings are the combination of book value changes and the dividend that we pay out.

And you can see that volatility very plainly in our last three quarters of economic earnings, which totaled positive 15% in Q3 2012, positive 1% last quarter and then this quarter's negative 5% result.

But with that said, I just want to reiterate our confidence in the earnings potential of the current portfolio.

We believe that we have the right mix of assets and the right amount of hedges for the current environment.

Our financing position through both repo and TBAs is as good as it's ever been.

Lastly, both TBA and specified MBS have performed well in April, and the combination of these factors gives me confidence in our ability to generate attractive risk adjusted returns for our shareholders in the quarters ahead.

So with that, let me ask the operator to open up the lines for questions.

(Operator Instructions).

Joel Houck, Wells Fargo.

I guess my question has to do around the you know not the viability of the strategy, but just the confidence in the strategy given what seems like a lot more volatility that's induced by the notion whether QE is going to strengthen or weaken.

As we saw in the first quarter when sentiment changes, there are some pretty volatile moves in these specified pools relative to the underlying hedges, which is something that obviously you can't control unless you're going to just sell out a position in a major way.

So I guess the question is, what are your thoughts with respect to maybe running leverages at current levels?

Do you think Q1 was more of an anomaly and that really sentiment is going to be QE3 is going to continue indefinitely, and therefore, the recovery we've seen in April is kind of a durable recovery with respect to the assets that you own.

Thanks.

Sure and very good question, Joel.

Look, when we think about the ability to manage or hedge the portfolio, I just want to reiterate what I said in the prepared remarks.

You know, when interest rates as a whole don't change very much, then by definition specific hedging strategies aren't going to matter that much.

On the other hand, if you really had kind of bigger moves in interest rates or game-changing type of scenarios such as a true exit of QE3 and a true strengthening of the economy, then you would absolutely expect all kind of fixed income instruments or certainly treasuries, interest rate swaps and mortgages to move in the same direction if those moves are big.

And so we -- this does not in any way change our belief that we can effectively hedge our portfolio for larger moves in rates and even for the current, we will call it, day to day.

But we do have to recognize and investors have to recognize that there is basis risk, and basis risk, which is the risk of, you know, the specific mortgages you own versus your hedges -- in this case, interest rate products -- it will show up.

And what you have seen in the past is that is always or almost always presented decent positives in terms of returns.

We absolutely believe that will over time we should be able to continue to create alpha, so to speak, by -- with respect to that basis risk.

Now let's get to specified mortgages, and in a sense the fact that they underperformed in Q1, and what are our thoughts going forward?

Is this temporary?

Is it permanent?

Are these riskier products?

And what I want to be very clear about is the reason we generally own specified products is because prepayments are much slower, and they produce very attractive carry returns or net interest income if you want to use that term month over month and quarter over quarter.

Whereas if you -- we've used the slides in the past where if you have faster prepaying pools, they may be a little more stable in price, but they're not earning you much at all if anything in many environments.

And so realistically our main driver for owning specifieds is the fact that they produce attractive risk adjusted returns, and they produce attractive returns in a base case scenario, even without tightening.

Over time, when you have the right entry point into those securities, then you should be able to benefit from environments where they become more or less attractive, and we feel that there was an overreaction in Q1.

So we do feel that they are still desirable products.

We do think that they got too cheap in Q1, but we do recognize that if interest rates went up 100 basis points, then payups would drop materially even from where they were.

On the other hand, in that scenario, our hedges would kick in and be able to offset that.

But in a more stable rate environment, we feel very comfortable with their valuations at this point.

Okay.

Great.

Thanks for the answer.

You maybe could talk about the equity raise and in concert with what you saw going on in Q1 and where you put the capital to work.

Sure.

I mean look, with respect to the equity raise, I mean if you look at what we just said in terms of the environment in Q1, mortgages cheapened up materially.

They got in a sense over the quarter to back to levels that were unchanged, despite QE3.

So if you compared mortgages to where they were trading prior to QE3, they got back to the levels where they were essentially unchanged, which we viewed given the magnitude of the Fed's purchases as an opportunity and that valuations had gotten back to levels that were very attractive.

So if you had asked us before QE3 if we thought equity raises were going to be likely in a QE3 environment, our answer would've been no.

On the other hand, if you had asked us six months into or five months into QE3 would prices be unchanged relative to where they were, we would've also said no.

So it really the fact that mortgages had cheapened up, specified to cheapen up as well, and we felt good about we will call it the entry point.

Now I do want to get back to where we deployed capital.

And the reality is we actually still put more of our capital into TBAs at that point and not into specifieds.

We did buy some specifieds.

Really, we viewed specifieds as having cheapened up more kind of later in the game.

And so we have been moving -- I would say we have been more interested in specifieds really over the last month and a half as they have continued to kind of stay depressed, despite the fact that the market had rallied back.

And, you know, we feel good about the decision, I mean if you go back to the discussion on TBAs, we did feel that the TBAs offered more value earlier in Q1 and certainly in Q4 than specifieds.

And while -- and clearly that's played out and beyond what we had expected.

All right.

Thank you.

Bose George, KBW.

Just wondering if you could be a little more specific about the improvement in book value since quarter end?

Have specified pools stayed roughly flat in the recoveries from sort of the generic assets?

You know, I can't be much more specific with respect to intraquarter numbers.

We never really try -- we never give them out.

What I would say is that both specifieds and TBAs have improved, let's say, through April, and even over the last couple of days, specifieds appear to be and there is volatility appear to be trading reasonably well.

So the short answer is there has been improvement in both, but let's face it we are early in the quarter and we have seen volatility.

So we have to be careful with respect to kind of throwing numbers out there.

Okay.

Sure.

And then just in terms of the timing for the weakness last quarter from your commentary, it sounds like the specified pool market was the weakness really seen in March, and then was that going to be when it happened?

No, look, I don't want to tell you that all the weakness occurred in March.

It clearly didn't.

We saw weakness kind of throughout the quarter.

What I would say is specifieds relative to interest rates and the way we think about them really started to become more compelling late, we will say, very late in the quarter and even more so as we -- at the very early part of Q2.

But, you know, mortgages performed poorly throughout the quarter, and you know it was not just a March effect.

Okay.

Great and then just one more question on HARP.

Just any thoughts on the potential for the cut-off date for HARP being extended, and if that does happen, just curious about your exposure?

Thanks for the question.

It's a very good one and timely.

Look, we continue to believe that we will, call it, policy risk is relatively low, you know, for our portfolio.

And, you know, we say that against the backdrop of understanding that the President has nominated someone to be the new head of FHFA, and while I don't think we are the best positioned to give political predications with respect to whether or not this gets Senate -- gets approved, our main reason for comfort is, even if they were to -- even if he gets confirmed, even if he was able to convince the GSEs and convince others that FHFA and at the Inspector General that oversees FHFA, even if he were able to convince everyone over there to change their mind, which we think is a high hurdle, some of the numbers that I have seen is like, for instance, with a one-year extension of the HARP cutoff date, we still have less than 5% of our portfolio that would be basically in that window.

And so the reality is, as you have seen from us, we have been concerned.

We were obviously very concerned about the HARP 2.0.

We got out of the way of that really early, and we have kind of continuously on-and-off as there's been this noise looked for opportunities to reduce our exposure to the one-year extension.

And so it's not a big deal for us.

Yes, I mean the thing that would be we'll see a major change from a prepayment perspective would be an unlimited extension of HARP that allows for re-HARPing of all securities.

But I haven't seen that even thrown out from anyone as of late.

Great.

Thanks for the detail.

Jason Arnold, RBC Capital Markets.

Good morning, guys.

Just to follow-up on the last one, I mean understandable that you don't want to get a book value number.

But just curious if you could comment maybe more generically perhaps on the magnitude of improvement in some of those specified pool prices and TBA prices, kind of like maybe with respect to slides seven and eight?

You know, the information is readily available.

Obviously we had an unemployment number today and things are moving around.

So I really don't want to just start throwing out prices.

But I think that information is available.

Mortgages have definitely improved relative to hedges, let's say, since quarter end, and specifieds continue to trade well and even into this morning.

But I think it's we just we want to be practical about the fact that we are little over a month into a three-month quarter, and the reality is book value moves around.

I can repeat what I said, which is, as of the end of April, you know, we felt that we had recovered a portion of what we had lost in book value and will watch things from here obviously.

Okay.

Thanks.

And then just one follow-up.

You know, you had great color on the hedging side of things, and you guys are certainly much more rate protected than I'd say a lot of people tend to believe.

But just a question on some of the other mortgage REITs recently talking about utilizing euro dollar futures as an increasingly attractive way of hedging rates.

So just curious if that is something you would consider as well and maybe pluses and minuses of using that.

Thank you.

Sure.

This is Peter.

We obviously would consider really any hedging instrument, but our goal is to find the instruments that we think will best replicate the market value sensitivity of our assets.

So that's kind of our first hurdle that we look at is trying to find hedges out there that will move in a way that's consistent with our mortgage assets.

And to the extent that there are some exposure to short-term interest rates that euro dollars will allow us to hedge, we would certainly do that.

Euro dollar contracts or short swaps really would have the same sort of interest-rate profile.

So our goal really is to find hedges that will best replicate the market value sensitivity of our assets, and we try to do that and then find the most cost-effective hedge for that.

Okay.

Thank you very much for the color.

Just one other thing just to add around the hedging piece is just to reiterate the choice of using a combination of swaps, treasuries and swaptions is really -- goes back to our concern and what we recognize what we need to be doing on the hedging front is protecting against the really big moves, the gamechangers, the transitions from one environment to another.

And, again, it's not about optimizing performance over 10 and 25 basis point moves.

It's really about having to protection against the big moves, and swaptions are great example, and Peter went over how they work in that environment.

For a move like what we saw this quarter, swaptions are going to do anything, especially if volatility doesn't go up.

But that doesn't mean they are a bad hedge.

That means they're perfect for exactly what we need them to do, which is help us if there was a big move in rates.

Excellent.

Thanks.

Henry Coffey, Sterne Agee.

If we were to look at the decline in book value and break it down into respective buckets, you had the TBA pool, we have the disconnect on obviously on hedges, and then we have what happened in the quote HARPed market.

I was wondering if you could give us a sense of how you'd allocate the depreciation and equity value between those three, or maybe there's a fourth bucket we should be focused on?

Look, I'm not -- we don't have specific numbers, and we don't put out specific allocations.

But I think what you can take away from what we said is hedges net, just to reiterate, were positive, okay?

They weren't positive anywhere near enough, so to speak, but they were net positive.

When you look at the payups and the decline in payups on specified collateral and you look at kind of underperformance of the mortgage basis or generic mortgages, they are in the same neighborhood of each other, okay?

And those are the biggest factors.

Then there is a kind of delta hedging and other kind of intra-quarter activity, you know, in those kind of things, which don't tend to be big numbers.

But the lion's share of this is broken out, and they're reasonably close to each other, the performance of specifieds and the performance of TBAs.

And if we get right and put -- I mean maybe you can't do this.

Is it impossible to look at certain specified pools and put the name HARPed next to some of those pools and see how the relative performance of those pools was versus sort of the whole generic holdings?

Well, what I would point you to in our intent was to give you that information.

Right.

I've seen it.

I'm just trying to figure out the relative contribution to the drop in book value from quote HARP.

Because that's what everyone is asking us about today.

No, look, Henry, we definitely are trying to get you the ability to try to think through those, and so if you take page seven, okay, which -- and now these are not the specific marks our portfolio, but they are kind of generic marks for these buckets, and so they are useful in that regard.

We show you the price difference in terms of the change in payups.

So take as an example, we will do the HARP 95 to 100 LTV, which went from 152 basis -- the payup went from 1.5 points or 152 basis points to 70 basis points during the quarter or a decline of 82 basis points.

Then if you go to page I think it's 23 -- hold on a second -- in the appendix and you don't have to do this now.

We show you a breakdown of our holdings of our portfolio, and we show you what percentage are specified within each coupon bucket.

So you can kind of back into what we held in those areas.

And I think that's an exercise that you might want to consider.

We don't give you -- and I want to be clear -- we have a range of -- in the case of HARP securities, we have a range of LTVs that are from above 80 to basically the group that's above 125 LTV, and we don't give you an actual breakout there.

We do give you kind of weighted average characteristics.

The same is true on the loan balance side.

We give you kind of this -- we will call it an average category, but there is some distribution around us.

And so you're not going to be able to back into it exactly, but you're going to get in the ballpark if you think about it that way.

And then you made the comment that in your view, HARP or HARP sensitive or specified pool bonds have actually started to recover in value in May.

Is that correct?

In April and May, and again, when you're using the term HARPed, I mean these securities the higher LTV securities that have gone through the HARP program, what we label, as you know, HARP securities have definitely improved and you know improved noticeably, as have lower loan balance and the other some of the other main buckets in the specified mortgage group.

So we are seeing a strengthening of those categories of mortgages to date during the quarter, and we do feel that they got to very attractive levels at their lows.

Looking at the other side of the equation, the dividend, you made some comment that there was a lot of expected recovery going on in the second quarter.

Will that be enough to rebuild undistributed taxable earnings and core earnings to the point where you can sustain this dividend at $1.25, or should we begin to look more carefully at that issue?

Look, what I can say with respect -- just let me clarify the comments I made earlier about taxable income.

We don't want you to project the $0.50 number because there were significant influences from declines in PBA prices where the hedges were not all included.

So that part I think should be pretty clear.

And we do expect taxable income to be noticeably stronger in Q2.

In addition, many of the TBAs that create the realized gains and losses actually have already been rolled to the next quarter.

So it's not completely variable with respect to what happens in the market.

Again, a good chunk of those levels have been locked in for the quarter, so to speak.

But there is still uncertainty with respect to kind of what happens in the market as a whole.

And just more specifically with respect to your question around dividend, really what I can say is there are a few things that we have stressed over and over again that go into our mindset with respect to the dividends.

You know, their book value performance and economic earnings.

They are taxable income, and our UTI is certainly an important factor.

And then our confidence in our investment strategies and earnings potential going forward are all things that management and the Board are going to have to think about, you know, when we make a decision next month on the dividend.

Thank you.

I appreciate it.

Merrill Ross, Wunderlich Securities.

As you discussed your strategy, Gary, you said you had some confidence in how you have allocated your equity.

Can you talk about what you might expect?

Can the dollar roll still trade special after the Fed exit?

Because if that isn't trading special at that point, obviously trade could evaporate.

No, look, that's a great question, and you know we talked a lot about this last quarter on the call.

And, you know, Chris reviewed kind of how dollar rolls have been special for kind of since QE came into play.

And so the obvious conclusion is the second QE3 goes away, dollar rolls won't be special anymore.

I do want to just reiterate that if the dollar roll specialness goes away, then you can just take those positions and put them on repo, so to speak, and fund them the other way, and in that environment, rates will be higher, and the lack of prepayment protection probably won't hurt you.

So it's not necessarily like a knockout blow if the roll specialness isn't there as long as you make the assumption that the coupon isn't way overpriced because of the roll specialness.

We feel that after the first quarter, you can probably get comfortable that that is not the case.

Look with respect to what will happen with the rolls when the Fed is done with QE3, rolls are a short-term financing vehicle, and we have, as Chris mentioned and as we mentioned last quarter, we expect that there's a very good chance they will remain special, more meaningfully special through the end of this year.

And it could be beyond that, but it won't be forever.

But I do want to stress that the price of the underlying doesn't necessarily -- again, as long as it's not way overpriced for that financing advantage, doesn't necessarily fall apart after that.

You are just back to a kind of more normalized funding mechanism.

So to your point, what I would say is people should not assume that roll specialness lasts three years.

But practically speaking, even when the Fed is done, it is very possible because the new originations of mortgages will probably be in other coupons, that those coupons could stay special well after a Fed exit.

And we actually saw that with respect to some of the higher coupons when the Fed exited from QE1 that the specialness did not disappear for a long time after the Fed's exit.

Thanks.

That's very useful and the idea that you could just let the roll settle onto your balance sheet in a steeper curve environment is also quite attractive.

Thanks for your comments.

Arren Cyganovich, Evercore.

Thanks.

It's actually along the same lines as the last question.

You generally have a pretty high leverage of 8.1 times when including the TBA.

I would think you'd want to have lower leverage once the Fed does start to taper into QE3.

What is your strategy for dealing with that and essentially being able to take advantage of the cheaper pricing at that time?

Look, I think that you bring up a great point, what's your leverage strategy in a QE3 environment, and again, if you went back and you drew it on the board kind of going into QE3, you would expect that over six months as the Feds -- the stock effect of the Fed's purchases as they absorb more and more of the mortgage market, that mortgages will get richer and richer to the point where you'll want to take leverage down because the risk adjusted returns aren't there, and it's better to wait and leave some earnings on the table to be able to buy at a later date.

Again, given the weakness that we've seen locally, where in a sense QE3 got to the point where it really wasn't priced at all or negligibly to mortgage prices, we don't feel that this is the right time, so to speak.

And, again, we feel at this point, look, these decisions are not always simple, but our view right now is that there is probably a bigger risk to being underinvested if the Fed keeps buying.

And the fact is that you're going to go a long period where you're going to be underinvested.

And I think that realistically our mindset will be when we don't feel that holding the securities produces a reasonable return, then we will delever or we will consider delevering.

But we don't feel that we're anywhere near that point given where prices are.

And I think you can see that we feel that we can continue to generate reasonable risk adjusted returns, and so we will look at that again as things evolve.

Thanks.

And are the TBA forward positions included in slide 14 in the extension risks?

Yes, they are.

Absolutely.

We treat those like any other position, and they absolutely are included in that.

So that is an aggregate position out of our model.

Great.

And then finally in the repo market, you mentioned that there could be a 5 to 10 basis point improvement.

I missed what was driving that, and also what's the general liquidity in the market, and would they be able to easily take on the full amount of your forward TBA position if needed?

Yes, this is Peter.

I'll take that question.

It's a great question, and we've talked about that before.

From a TBA perspective, what we have to do from a funding perspective is always be prepared to take that back on the balance sheet.

And as Gary mentioned, the environment right now from a funding perspective is really good.

Our capacity is as good as it's ever been.

So we don't have any concerns that we couldn't take that position on in kind of traditional balance sheet form.

Really what we're seeing now is I think part of the effect of the Fed, which is they are taking more and more mortgages out of supply, which means that there's fewer mortgages that have to be financed and repoed, and we're seeing new counterparties coming into this space in an effort to find yield in the short-term markets.

So the combination of those two things is starting to take effect.

The termination of Operation Twist at the end of the year we thought would have a positive effect on dealer balance sheets, and that started to show up late in the first quarter.

So the combination of the Fed taking mortgages out, increased demand from investors and the Fed's Operation Twist all point to somewhat improving conditions for repo financing.

And from a capacity perspective, we are in a really strong position.

Great.

Thank you.

Daniel Furtado, Jefferies.

Thank you.

I just had one question, higher level.

And from looking at it from a high level perspective, what is the risk of extrapolating this quarter as a case study for the potential impact to the mortgage REIT industry in general of a QE3 tapering event?

Thank you.

Dan, that's a great question, and I'm glad you asked it.

And I think, again, what I think you really want to keep in mind with respect to looking at this quarter was that post immediately after QE3, there were significant kind of book value gains where there was prices of mortgage-backed securities and specifieds got to pretty elevated levels.

And so you saw a run-up in book values, which I think have gone the other way, but, again, within a very narrow range of interest rates.

And so what you're not seeing is you're only seeing basis risk bouncing around, which is limited in its magnitude, okay, generally speaking in terms of how far can, you know, one government-backed security move versus another.

And, you know, when people extrapolate this to 100 and 150 or 200 basis point moves in interest rates, which we've always told you they are possible, and we are not going to know when it's going to come.

The difference is that the hedging strategies at least I can speak for us that we employ are specifically designed for those kind of scenarios, and again, you can choose different hedging strategies.

You can have a hedging strategy that uses less options that's more tailored around trying to pick up 10 and 15, 20 basis points moves.

Or you can design a strategy that's more around the bigger moves.

And we feel that this is the right strategy to use.

So we feel very confident that we would perform reasonably well in that kind of the real deal scenario, so to speak.

The other thing I would highlight is that some of the stress that was created in Q1 really resulted from the combination of economic numbers really, really picking up very quickly.

So, you know, beyond where most people expected, coupled with Fed chatter, that very quickly I mean the minutes of the December meeting, which was when they kicked off the treasury portion of QE3, was already talking about tapering.

So the discussion was basically a really, really early exit to QE3 as essentially they were beginning it.

And so even if they exit, after they have absorbed a large amount of the mortgage market, I think you can expect more logical performance from mortgages.

I think the issue here was that the discussion came way earlier when people weren't set up for it.

And I think now, as I mentioned earlier, money managers have largely quote sold into the Fed, and so you have a very different landscape with respect to people being able to absorb things.

We've also seen people like foreign investors -- take the Bank of Japan's actions, and you can kind of figure out the impact that would have.

But we've had foreign investors go from pretty large net sellers in Q1 to buyers now.

So we feel like the landscape is very different, and you shouldn't be projecting.

You should think about that when you're projecting performance both to us and maybe to the space.

Thanks, Gary.

I appreciate the insight there.

Bill Carcache, Nomura.

Gary, I was hoping to follow-up on that last question from a slightly different angle.

So it seems like this quarter you will at least give some perspective on what happens when investors -- when the market becomes more focused on extension risk and less focused on prepayment risk and the negative impact that that had on the payups, that that, you know, had associated with the low balance loads and the HARP loans that had been so positive for you previously.

You know, if we fast forward a couple of quarters, a few quarters, whatever the timeframe is, and at some point when the market becomes again concerned about the Fed pulling away and extension risks begin, it becomes more of a focus.

What gives you confidence that we don't find ourselves here all over again?

And maybe perhaps you could talk specifically about the basis risks.

And maybe I don't know if there is a way for you to potentially be able to bifurcate for us how much of the unrealized gain that is inherent in your book currently is associated with payups and potentially risk because it's not really hedgeable, you know, as the Fed transitions away from QE?

Sure.

What I want to actually -- you had a couple of questions in there.

Let me try to make sure I hit them.

But I want to start with the last comment you made about it is not necessarily hedgeable.

I wouldn't take that -- you know, I don't really feel that that's accurate.

I think it is hedgeable to the extent that the changes in payups occur across a wider move in interest rates, okay?

So let's take as an example if you go to page seven of our presentation and you look at the payup as of March 31 of 70 basis points.

If interest rates go up, now that security can't drop below TBA levels.

So the most that security can drop from that mark was 70 basis points.

Now if that occurred over a 50 basis point move or 100 basis point move in rates, you can see, okay, I have got a hedge or I have got to consider the fact that that can drop 70 basis points over, let's say, a 50 to 75 basis point move.

So you can actually choose -- you can have a reasonable hedge ratio for that.

And so from levels of where we are to the extent that those payup declines are concentrated or consistent with interest rate moves, you can hedge them.

To the extent that they curve like they did in Q1 within a 10 or 20 basis point move in rates, then your hedges are not going to pick up much of that.

So that I think is the first thing that you really want to keep in mind.

So you shouldn't take away from the fact that these payups are not hedgeable.

They are hedgeable, but with larger moves in interest rates.

The other thing you should take away from them is that if you just looked at this page as an example, half of the entire payup declined over the course of the quarter if you looked at least the lower coupon buckets, about 3.5 buckets.

And again, the amount of the decline is somewhat limited in terms of how much more it can go.

So you also should keep that in mind with respect to many of these buckets.

So hopefully that answers most of your questions, but if I missed something, let me know.

Yes, no, that's helpful, Gary.

Maybe I will just shift over to my last question on the UTI.

Last quarter dollar roll income helped contribute to an increase in the UTI.

This quarter it seemed like dollar roll income was still very, very favorable.

But the UTI went down, and then looking at the contributors to that, it seemed like there were realized losses that were at least partially contributing to that.

Could you give some color on what drove those realized losses?

And then maybe tying that to the UTI, is that -- is the decrease over the drawing down on the UTI this quarter consistent with a scenario where that's exactly what it's there for and the type of situation that in which you would expect to draw on it, or was it a bit unexpected?

I am just trying to get a sense for, you know, in future quarters to the extent to which when you would expect to draw on that UTI?

Let's first just go back through Q1 and why the UTI or why I'm sorry taxable income was impacted by the dollar rolls.

So what ends up happening is, when you dollar roll a security, in this case, let's use an example of TBA Fannie Mae 3%, and if the price of that security is dropping every month, then you are basically going to be locking in those price declines as if you sold an instrument that was on your balance sheet.

So in a period where TBA prices are dropping, irrespective of whatever you're doing on the hedge side, unless all of those are realized, then you're just kind of realizing price declines, and that's going to net from a taxable income perspective, and that's going to impact your taxable income, and that is what you saw in Q1.

You had an environment where just a price of the underlying, irrespective of the dollar roll level, was declining, and you were locking in these lower prices from the perspective of realized losses.

Now to the extent that prices don't change, you're in an unchanged environment, then that's not going to obviously have much of a hit in impact.

And how much income you pick up from a taxable perspective will really relate to the drop or the attractiveness of the dollar roll income.

In the case where mortgage prices are going up, then you'll be in a situation where you'll actually end up with more taxable income than you probably should in that environment than what's actually implied by the drop.

So you'll have the reverse of that scenario.

And one other thing I want to reiterate that I mentioned earlier with respect to that is that we don't just wait when it comes to dollar rolls for two days before the kind of time when you have to roll it in a particular month.

Many times we're rolling these positions three months in advance or certainly two months in advance and often three months.

And we try to very much spread out our exposure to rolling things, and it's the way to get the best execution.

So, as I mentioned earlier, in a lot of the cases, we have already rolled a good chunk of our position into the next quarter in which case then that reduces the sensitivity from there.

Thanks very much for your insights, Gary.

I appreciate it.

Douglas Harter, Credit Suisse.

Thanks.

You have talked, Gary, you talked a bunch about trying to hedge the basis risk.

Can you talk about the attractiveness of MSRs or IOs to try to sort of minimize some of that basis risk?

No, that's an excellent question.

An IO and MSR really are good ways to maybe offset some basis risk.

They obviously would perform well in a rising rate scenario, in a scenario where extension risk is getting priced into the market.

But importantly, you have got to buy IO off of the right types of instruments, and a lot of the IO that is available in the market, so to speak, the majority of it, tends to be off either specified collateral, which is already priced -- was in particular priced to very low speeds, so you won't get much appreciation in a rising rate environment.

And another big chunk of it is off of the older mortgages that are kind of susceptible to HARP, and those have been two areas where we haven't been that interested in IO.

When you go to MSR, newer MSRs, but not the historical or legacy MSR, is something that could be attractive, and it's something that we have to think about.

Now there are real barriers to entry in terms of being able to participate in that space, but that doesn't mean that should be off the table.

It means that it is something that makes sense relative to an agency mortgage portfolio, and it's something that we absolutely have to think about as we go forward.

Great.

Thank you for that color, Gary.

This will conclude our question-and-answer session.

I would like to turn the call back over to Gary Kain for concluding remarks.

Just want to thank everyone for your interest in AGNC, and we'll talk to you next quarter.

The conference has now concluded.

An archive of this presentation will be available on AGNC's website, and a telephone recording of this call can be accessed through May 16 by dialing 877-344-7529, using the conference ID 10027585.

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