AGNC Investment Corp (AGNCN) 2013 Q3 法說會逐字稿

Good morning and welcome to the American Capital Agency third 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 that this event is being recorded.

I would now like to turn this conference over to Katie Wisecarver in Investor Relations.

Please go ahead.

Thank you Chad.

Thank you all for joining American Capital Agency's third 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 that they are not recitations of historical facts, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

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

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

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

Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of AGNC's 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 a telephone recording can be accessed through November 12th by dialing, 877-344-7529, or 412-317-0088.

And the conference ID number is 10035742.

To view the slide presentation turn to our website at www.AGNC.com and click on the Q3 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 today's call include Malon Wilkus, Chair and Chief Executive Officer, and 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, and Bernie Bell, Vice President and Controller.

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

Thanks Katie.

Good morning everyone.

The third quarter was another very volatile quarter with substantial moves in both Interest rates and mortgage spreads.

However, if you just looked at the quarter-over-quarter changes and ignore what happened intraquarter, things look relatively benign with small moves in rates and modest increases in most MBS prices.

However, that approach to analyzing the quarter is somewhat short-sighted, as any prudent portfolio manager should not have simply just hoped that the Fed was not going to taper, Janet Yellen would get the nod, the last two employment reports would miss the mark, money manager redemptions would slow, and rates would recover.

As we stressed on the Q2 earnings call at the end of July, we would not employ this approach.

We highlighted that our focus in this environment which is characterized by significant idiosyncratic and digital risk, is to take actions to protect book value, and to prioritize risk management over short term returns.

We also highlighted that leverage was declining, our asset competition was evolving, and that we were maintaining a conservative approach to hedging despite the negative short terms earnings impact.

The good news is that these actions worked as intended, and the variability in our book value, was relatively limited intraquarter despite the significant volatility, to this point when the market was at its weakest point during the quarter, and 10-year rates were near 3%, our daily estimates indicated that book value was only about 5% worse than where it ended the quarter.

Thus even if we had closed the quarter at the lows on September 5th, our economic returns would likely have been down only modestly.

In the current environment risk management is still the priority.

But we are willing to increase our duration gap, as we believe the risk return trade off of this position is considerably better now, given that overall market positions are no longer offsides, and because of the new information we have around the direction of the Fed both in terms of leadership and policy.

I want to be clear that a key determinant of our willingness to increase our duration gap is related to the shorter spread sensitivity of our portfolio.

And the fact that our asset portfolio becomes considerably less risky over time.

While we remain relatively positive on the near term spread outlook for mortgages, we are unlikely to proactively take up leverage significantly as we remain more concerned about the intermediate term landscape, and the idiosyncratic nature of the risk inherit in today's market.

Let's turn to slide four so that I can provide some additional color around some of the third quarter results, before handing the call over to the team.

First comprehensive income, which includes both realized and unrealized gains and losses on assets and hedges was positive $0.45 for the quarter.

Net spread income was $0.58, inclusive of a $0.03 loss due to dollar roll expense, and a $0.03 hit due to catch-up amortization associated with slightly faster pre-payment estimates this quarter.

Net spread income declined due to lower leverage, and the continued high cost of funds associated with the large hedge positions that we discussed last quarter.

Additionally, dollar roll income swung to a net loss this quarter as we opportunistically chose to maintain TBA short positions against certain specified pools that had negligible payouts.

As we indicated was likely on our Q2 call, our taxable income declined significantly in Q3 to $0.29.

This figure also excludes about $2.20 of estimated net capital losses that are not deductible from our current taxable income.

These capital losses will be carried forward for up to five years, and apply against future net capital gains.

However, taxable income also excludes around $222 million, or $0.58 per share in net gains related to pairing-off swaptions during the third quarter.

These gains will actually be amortized through ordinary taxable income over the life of the underlying swaps.

It is also important to point out that our taxable income in the fourth quarter is likely to remain under some pressure as we continue to divest of some lower coupon 30 year securities, which are probably not going to fit our investment objectives over the intermediate term.

To this point, we proactively chose to sell a large number of securities, and replace them with other MBS that we believe are better suited to the evolving landscape.

I want to stress that we will continue to prioritize long run economic value over our short term tax and accounting results and earnings geography.

This is the same approach that we have used over the past five years, and it is critical to our ability to generate industry-leading results over the long term.

Book value was down slightly at $25.27 in Q3, book value benefited from the strong performance of the MBS in the latter part of September, but was hurt by the significant volatility that we witnessed during the quarter, which required active rebalancing in order to be true of our approach of prioritizing book value protection over short-term income.

Our economic return for the quarter which include both our dividend and our change in book value was positive 2%.

Economic returns also benefited some from accretion associated with our $260 million of share repurchases.

I want to stress that we remain committed to buying back our stock to the extent that our price to book ratio remains depressed.

The liquidity of our assets gives us the ability to easily sell assets and reduce repo borrowings with minimal transaction costs, to generate capacity for share repurchases without the need to raise leverage.

Therefore, when our price to book ratio is at a significant discount stock buy backs can generate meaningful shareholder value without increasing risk.

This is a key benefit of the agency business model, and we will continue to take advantage of these opportunities as they present themselves in the future.

Now if we turn to slide six, we can see the quarter-over-quarter changes in rates and MBS prices.

As I mentioned in my earlier remarks, this snapshot is a very misleading picture of the quarter given the substantial volatility that we saw in both rates and spreads.

For example, while the ten-year Treasury closed the quarter on 2.61 on September 5th, it touched 3%, likewise 30-year 3.5 ended the quarter up 33 basis points in price at 101.83, but traded in the high 97s on September 5th, essentially 4 points lower than where they were just three weeks later.

These examples highlight the shortcomings of just looking at the quarter-over-quarter numbers.

That said, MBS prices ended the quarter generally up, with mid to higher coupons performing the best.

In 30 years the 4.5 coupon was the strongest performer up almost a full percentage point, in 15 year 3.5s were the best performer up 140 basis points in price, which more than made up for their relatively poor performance the prior quarter.

Now before I turn the call over to the team, I wanted to turn to slide seven, which we hope will give you greater transparency into how we are evaluating the trade-offs inherent in today's environment.

Here we depict two scenarios regarding the near term economic picture, and the timing of anyFed tapering.

On the left we describe the scenario where the employment picture and the economy as a whole quickly regain momentum, allowing the Fed to taper relatively soon, let's say by January.

While the probability of this scenario seems to be dropping with most economists calling for a March taper at the earliest, it is still a possibility.

On the right, we depict another very plausible scenario, which many would argue is a somewhat higher probability, in this scenario, the combination of unimpressive employment growth, lackluster economic activity, and below target inflation expectations, make the Fed reluctant to cut back on their MBS purchases before June of next year at the earliest.

It should be noted that there is a gap in between these two scenarios, which entails the Fed tapering in March or April, which most economists would describe as sort of a base case scenario.

In the scenario it is much less clear exactly what the market reaction would be.

Now that said, if we look at the early tapering scenario on the left, it would be logical to assume that intermediate to longer term interest rates would increase with the ten-year Treasury potentially rising to 2.75%, maybe 3%.

Mortgage spreads would likely also come under some pressure, but we believe the combination of remaining Fed purchases, low origination volumes, and the substantial rebalancing actions that have already been taken by market participants will likely limit the damage to MBS in this scenario.

Lower coupon 30-year fixed rate mortgages are likely to endure the greatest pain, as few participants will want to own these securities in gradually rising rate environment, with diminishing Fed support.

Now if we felt this was the likely scenario, we would want to lower leverage, sell more low coupon 30-year MBS, and increase our hedge ratios, despite the significant headwinds these actions would create with respect to earnings.

Now looking at the scenario to the right, where economic activity is not strong enough for the Fed to tape MBS purchases meaningfully in the first half of 2014, the outcome would be expected to be very different.

In this scenario interest rates are likely to be somewhat lower than they are today, the yield curve flatter, and MBS spreads materially tighter.

Lower coupon30-year are likely to be the best performers in the short run, and longer term hedges will be pretty expensive.

If we felt this were the likely scenario we would have relatively high leverage, a portfolio concentrated in lower to mid coupon 30-year fixed rate, and would decrease our hedge ratios.

The key takeaway from this slide is probably really not that surprising, and that is that the short run picture for MBS is very Fed and data dependent.

Additionally the continuing dysfunction in DC is another idiosyncratic risk that can clearly impact the economy and the Fed.

Now since the strategies one would employ are diametrically opposed and depend on which shorter run scenario you pick, we would err on the side of splitting the difference, because being wrong on either extreme would be very costly.

Now that said, the intermediate to longer term picture is considerably clearer to us, and is really a key driver of how we are structuring our portfolio today.

Slide eight summarizes our view on what we believe the landscape is likely to look like over the next two to five years.

In contrast to the short run, I think most people would agree that the Fed will not be purchasing a significant amount of agency MBS a couple of years from now.

In their place the private sector will have to absorb a growing share of the mortgage market.

As a result ROE expectations will likely be higher than where they are today.

Higher bank capital requirements are likely to create a headwind, which should limit the ability of banks to materially increase their MBS holdings.

Non-agency originations will likely be a growing percentage of the market.

Since most investors cannot use the same amount of leverage on these investments as they can on agencies, more capital will be required per loan than was required in the past, which will further amplify the need to attract additional capital.

Lastly, there will also be a larger amount of mortgage credit risk that will be need to be underwritten by the private sector, as the GOCs continue to layoff credit exposure and shrink market share.

What does all of this tell us?

It tells us that the ROE on agency MBS will likely be considerably more attractive two to five years from now.

While MBS prices and spreads are hard to pinpoint over the next year or so, we want to make sure that we are in a position to be able to commit significant amounts of capital at more opportune times over the immediate term.

This is a conclusion that we feel pretty strongly about.

Overlaying this outlook with a moderately constructed bias related to MBS in the short term forms the foundation of our portfolio construction, which Chris will now talk about.

Thanks Gary.

On the next two slides I will walk through a few examples that demonstrate how we can remain invested over the near term while creating significant flexibility to deploy capital over the intermediate term, even if rates had higher and prepayments speeds slow further.

On slide nine, we show the cumulative pay down over time for both a 15-year and a 30-year mortgage.

The obvious point here is that 15-year mortgage returns principle at a much faster rate, which is mostly a function of the shorter amortization schedule, but also higher minimum pre-payment speeds in a rising rate environment, which is a function of what the mortgage market terms borrower turnover.

Borrower turnover is a term that describes prepayments driven by life events, such as a borrowers decision to move or simply a decision to curtail their mortgage.

While a number of factors can affect turnover, the primary reason a 15-year borrower is more apt to move than a 30-year borrower in a rising rate scenario is that affordability is less likely to be a constraint, since a 15-year borrower always has the option to switch to a lower payment 30-year mortgage.

Additionally 15-year borrowers tend to curtail their mortgages, or make extra principal payments at a much higher rate than borrowers with 30-year mortgages, what is important to recognize is that both amortization and turnover are not highly correlated with interest rates, which means that 15-year MBS provides significantly more principal earlier for reinvestment, especially in higher rate environments, like what is depicted in the bar graph.

Here you can see that by year 5, the 15-year mortgage has returned 57% of the original balance, whereas the 30-year has returned 34%.

To put this into perspective, just in terms of principal that has already been returned, a $10 billion initial investments in 15-year MBS would be down to $4.3 billion 5 years from now, versus $6.6 billion for a 30-year MBS.

While this difference is dramatic, it is only part of the equation.

Turning to slide 10, we take it a few steps further and show how the risk profile of a15-year and 30-year MBS evolve over time.

If you recall last quarter, we compared the spread duration or basis risk of a 15-year versus a 30-year.

On slide 10, we have added the dimension of time to show how the risk profile has evolved.

In the table at the top of the slide we have two hypothetical portfolios, one comprised of 30-year 4s, and the other comprised of 15-year 3.5s, and we are showing the equity exposure of each to spreads widening 25 basis points assuming 7 times leverage.

You can see in the table that the 30-year position continues to have considerable exposure to wider spreads, if spreads were to widen 25 basis points today, the 30-year position is estimated to lose 15.6% of its equity.

If we look five years ahead this exposure drops slightly to 14.1%, roughly a 10% reduction in equity spread risk.

Now in the case of the 15-year position, its exposure drops by more than 30% by year five.

From 9.3% today to 6.5% five years from now.

On a relative basis the 6.5% spread risk estimate for five years from now for the 15-year position is roughly 45% of the spread risk estimate for the 30-year position.

It is also important to recognize that future options costs, or in other words, future cash flow variability across various pre-payment speeds of a 15-year MBS declined substantially relative to a 30-year MBS.

In the table at the bottom of the slide, we have seasoned both positions five years, and you can see that there is still considerable average life variability in the case of the 30-year pass throughs, whereas in the case of the 15-year pass through, its average life moves in a narrow range of 3.5 years at 5 CPR, so 1.9 years at 30 CPR, clearly across a number of different metrics, you can see that the 15-year pass throughs delever or derisk at a much faster rate.

Given today's relatively tight mortgage valuations and the inevitability of a future mortgage market without Fed support, its extremely important to have positions that naturally delever quickly yet still provide reasonable returns today.

Let's turn to slide 11 to discuss how the composition of the investment portfolio changed during the quarter.

As Gary mentioned earlier, the third quarter was volatile with idiosyncratic risk on multiple fronts that had the potential to move the market materially in either direction.

Recognizing this, we proactively reduced leverage in a measured way, and continued migrating the composition of the portfolio to what we believe is balanced and appropriate for today's transitional environment.

As of 9/30 the investment portfolio was $78 billion, which is down from $92 billion at the end of the second quarter.

The majority of the decrease in our asset portfolio is explained by our at-risk leverage which we brought down by a little over 1 turn, and the balance can be attributed to sales associated with share buy backs.

The vast majority of the reduction in leverage came from our TBA position, which was net short approximately $7 billion as of quarter end.

With dollar roll financing levels cheapening during the quarter on lower coupon MBS it was cost effective to temporarily short certain TBA coupons rather than sell specified pools with attributes that have considerable option value and very little pay out risk.

In hindsight this was a good decision, as the market has since rallied materially, and we will likely choose to re-evaluate which pools we end up keeping.

At a high level, the most notable shift in the portfolio composition is that we continued to increase our weighting of 15-year MBS, at the expense of positions with the most exposure to the Fed's QE program, such as lower coupon 30-year MBS.

With 15-year MBS now representing approximately 50% of the investment portfolio, combined with somewhat lower leverage, we have considerably greater reinvestment flexibility over the next two to five years.

With that, I will turn the call over to Peter to discuss our financing and hedging activities.

Thanks Chris.

Today I will briefly review our financing and hedging activity during the quarter.

I will start with our financing summary on slide 12.

Our access to attractive repo funding remain uninterrupted throughout the quarter, despite very volatile market conditions.

Our repo balance increased to $78 billion at quarter end up from $70 billion the previous quarter.

This increase in repo funding follows the shift in our asset composition towards a greater share of on balance sheet MBS, versus off balance sheet TBAs.

Other key repo terms, like rate, maturity, and haircut, were all largely unchanged in the quarter.

Turning to slide 13, I will review our hedge portfolio.

In response to changes in our asset portfolio, we reduced the size of our hedge portfolio to about $70 billion at quarter end, down from $89 billion the previous quarter.

Overall our hedge position relative to our debt balance inclusive of our net TBA position fell to 91% at quarter end, down from 101% in the second quarter.

Given the shift in our asset composition toward a greater share of 15-year MBS, we felt like the third quarter offered a good opportunity to realize some gains in our swaption portfolio, as well as shift the composition of our portfolio toward options that better fit our evolving asset portfolio.

Although the size of our swaption portfolio decreased slightly during the quarter, it continues to provide us significant protection against materially higher interest rates.

Finally, I will review our duration gap sensitivity on slide 14.

Toward the end of the third quarter, we took steps to increase our duration gap, at quarter end our duration gap was close to one year, up from about a half a year last quarter.

We are comfortable with this slightly larger duration gap, because of the lower risk profile of our assets,the minimal extension risk left in our portfolio,the lower interest rate volatility in the market today, and the lower leverage we are currently operating with.

Collectively these factors allow us to begin to move our interest rate risk positions toward more normal operating levels.

As can be seen from the table on this slide, given the composition of our assets and the natural extension benefits of our swaption portfolio, our duration gap will remain relatively flat at about one year, even if the interest rates increase materially.

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

Thanks Peter.

Now before I open up the call to questions, I just wanted to reiterate something on slide 15 that we said on the last call.

It is clear that an open-ended QE 3 introduced substantial volatility in our returns and that 2013 has been a difficult year, but it is important to highlight that our economic returns, which include both our dividends and our book value changes have been noticeably positive for the duration of QE 3, which began in Q3 2012, and going through the end of this third quarter of this year.

This is the case despite the significant rebalancing and derisking activities we have undertaken to transition the portfolio for a somewhat different set of challenges and opportunities.

Lastly, while absolute returns are very important to investors, any investment manager has to care about its performance versus the relative index and its peers.

As slide 16 shows, AGNC's active approach to portfolio management continues to provide industry leading performance over the long term, and even since the onset of QE 3.

With that, let me open up the call at this point.

Certainly, we will now begin the question and answer session.

(Operator Instructions).

At this time we will pause momentarily to assemble our roster.

Our first question comes from Douglas Harter with Credit Suisse.

You guys took up your duration a little bit this quarter, can you talk about where you think that might settle out as you normalize your hedges?

Sure, we took it up as Peter mentioned to around a year from kind of around a half year.

And a key component of being willing to increase duration gap is kind of holding down some of the other risks that we deal with, which obviously are spread risk, and it is also as we kind of highlighted on this call the evolution of the assets over time as well.

And given those factors we don't believe we are at a limit in terms of how much duration risk we are willing to take.

It is going to be dependent on evolving market conditions, it is not that we have a target in mind that we are trying to hit.

We will be responsive to market conditions.

In the end it is really a combination of the types of assets, and it is also a function of the convexity of the position.

So in some ways when we think of the duration gap, we think of it a little less as the number today, and we really think about our exposure to let's say the up 100 case scenario.

Since we have so little extension in the portfolio from the base case to the up 100, it gives us a lot more flexibility with respect to the duration gap.

Practically speaking, we could see that noticeably higher, and that wouldn't concern me.

And you had said also that you did some further repositioning of the portfolio in the fourth quarter.

How do you think that impacts the net spread compared to where you were September 30th?

In the fourth quarter actually, what I said was in the fourth quarter we will likely have some kind of taxable income headwinds, as we deliver securities into some of the short TBAs, but those really aren't big picture rebalancing actions.

The net of the dollar roll levels, and the securities that will be delivered at this point, probably aren't going to be that meaningful.

So at this point our rebalancing or activity in Q4 is not that substantial from an economic perspective.

In other words, our duration gap hasn't come in.

Our leverage hasn't really come down.

And really haven't done anything at a high level.

We haven't done that much to the portfolio.

So--

That could change, sorry, I just want to interject that is where we are today.

And obviously that could change if we see market conditions changing.

As of today the returns you were seeing on September 30th would be comparable to today?

Yes, and I would say the main difference between the portfolio as it might look would be that over time we would likely deliver some pools into some of the TBA shorts.

You should see the TBA shorts likely.

Something could change that, likely disappear by the end of the quarter.

Great.

Thank you.

Our next question comes from Steve DeLaney with JMP Securities.

Good morning.

Thank you.

Gary, just a quick overview of your earnings components third quarter versus second quarter, the thing that jumps off of the page is the declining contribution from drop income, from a positive $0.49 to a negative $0.03.

I was just wondering if you could talk a little bit about that, so that I and maybe others can understand all of the moving pieces of the economic return there?

For starters, my question would be, is it as simple as being the fact that you were net short TBAs at September 30 versus long TBAs, and dollar rolls as of June 30?

I mean that is a key component.

Let me take a step back and just walk through some of the changes there.

In terms of the position as we talked about at the end of the Q2 call, our portfolio at the end of Q3 is smaller than it was, the aggregate TBAs plus on balance sheet assets is smaller than it was.

And our hedge ratios, although they are not higher at the end of Q3 they were very high, they were high at the end of Q2.

That clearly does have a short term earnings impact to the extent that you maintain that.

Those are two kind of pieces which investors should be clear on.

The other is the change in character, so to speak, the 14 or so billion in long TBA positions that we had at the end of Q2, a lot of what happened there was we actually took delivery of those securities.

So they transferred from off balance sheet positions with dollar roll income to on balance sheet held positions.

And so the geography of that income merely changes.

Now why did we do that?

There were good dollar roll opportunities in higher coupon 15-years, as an example.

Well, we did that because there was an unique opportunity in the case of 15 years to take in those rolls, and essentially force the delivery of seasoned pools.

So we got a lot of two to three-year-old 15-year 3s and 3.5s in that process, which to us are much, much more valuable than a brand new 15-year 3 or 3.5, and you can see that in the seasoning of the positions that Chris went over.

They are shorter duration, they are lower risk.

So what we decided to do was sort of pass on short-term incremental income to prioritize having the right assets on balance sheet at the end of the quarter.

Then on the other side of that, the other piece of the TBA short position, really relates to as we were shrinking the 30-year part of the portfolio, we chose to wait, so to speak, in terms of deciding which pools to actually sell out to the market, and so we maintained the TBA short just against the pool so we would have more time to make that decision.

When you think about why you do that, why is that important even if there is a short-term cost, well, it is important because if interest rates move a lot, you may want to hold a very different pool.

If interest rates were 3.25 now, we would wanted to hold the most seasoned pools.

We certainly wouldn't care at all about pre-payment protection, andvice versa.

If we were at 2.25, you would make a very different decision, and in between there is sort of a spectrum.

So that was the reason, and again I want to stress that we are in an environment where we are thinking big picture, we are thinking longer run returns, and we are not just trying to optimize a quarter's numbers.

That is helpful.

When dollar rolls, it is obviously a function of QE 3, when they became attractive and the term you guys use is when they became special, generally speaking do you still see dollar rolls as special?

And if you were to re-risk a little bit with long TBAs, would dollar rolls be one of the tools you might use?

So they are special in some coupons.

So in a sense pre, if you went back to the beginning of this year, what were the most special were the lowest coupons, generally in 15 years and in 30 years, those are really not special now.

And so it is cheaper if you wanted to maintain a short position.

It is not that attractive to maintain a long position that you are rolling.

But in the higher coupons in 30-year yield, or even to some degree now in 3.5s, but 4s and 4.5s, there are opportunities to roll.

In 15 years there are very good opportunities to roll, but then you have got to make tradeoffs about whether or not it is worth it to roll that position, and risk getting back a newer kind of worse security.

So I think you have got a little more decision making to do on the dollar roll side in 15 years than you do in 30 years.

But we expect to make use of dollar rolls, in particular the 4% coupon going forward.

Market conditions could change that.

But we are certainly positioned to do so.

Okay, thanks for the color, Gary.

That is helpful.

No problem.

Our next question comes from Joel Houck with Wells Fargo.

Thanks.

I guess looking at slide eight, this sends a very to pick your adjective, cautious, defensive, posture, but it seems to me as if REITs are selling, reducing their exposure to 30-year MBS, banks don't want to own this stuff, how is the Fed actually going to be able to taper in this environment without 30-year mortgage rates going substantially higher?

I guess the first question is this really, is this more positioning out of the lack of understanding what the Fed is going to do, as opposed to the underlying fundamentals?

Because it would seem that if you just look out over the next year or so, there doesn't seem to be any head room for the Fed to taper in a meaningful way.

To step back and play defense at this point, I don't know if investors are necessarily paying management space, I guess they are paid to create alpha in this slide eight, kind of seems to send the message that we are not sure what is going to happen in the next year or two, so we will just move to the sidelines and clip coupons?

I wonder if you can comment on that.

I think your perspective is interesting.

That is really not the way we are thinking about it.

What we do want to stress, and I think where we are consistent is the short term is idiosyncratic in nature, right?

And it is somewhat digital.

It is dependent on what the Fed decides to do, and yes, that is data-dependent.

But we do take pause in a sense in kind of getting too far in either direction.

So we said that we are kind of marginally, we are somewhat bullish in the near term on mortgage spreads.

For some of the reasons that you talked about, we don't see the Fed exiting that quickly.

We think the odds are they are probably going to be a little around longer than maybe other people are, or than let's say the base case scenario.

But that may not be the case.

I think that it is prudent from our perspective when we don't have any better information about how the economy is going to have adjusted or reacted to the government shutdown and the debt ceiling issues.

To be cautious, because to your point it is going to be, it could be reasonably expensive if you are holding tons of low coupon 30-years when no one really wants to own them.

That is something that we view as a risk that we have to avoid at this point.

We could walk in December and that employment number could be pretty strong, and retail sales could have been strong, and housing could hold up.

And the Fed, I think does want to taper at some point.

So when you put all of that together, that's kind of the short-term picture.

To your point whether our longer or intermediate term picture is cautious or defensive, I think it is actually optimistic, which is we are highly confident that we can make a fair amount of money in a couple of years,running our business.

There is one kind of key element to making that money, is that we have to have capital to deploy at that point.

One thing we don't want to do, okay, is mess that up.

Because we try to perfectly time kind of the Fed's exit.

This is a different environment than other environments, it turns out that has been the case for the last 25 years I have been in the business, that every environment is a little bit different, but that is how we are piecing all of that together.

To go back to circle, to complete that whole picture it is a key driver of why we are not obsessed about whether 15-years are 5 basis cheaper, or richer, or 10 basis points here or there on an option-adjusted spread, big picture they are a really good fit for investors that don't want to be stuck with lower to mid coupon 30-years as a huge percentage of their portfolio going forward, and we don't want to get that big picture issue wrong.

There is another way to think about this Gary, there is a fat tail risk out there that you don't want to be exposed to in the meantime, unless you just return all of the capital to shareholders, you have to own something.

So you can get decent return without exposing shareholders at risk if it never happens, yes, you give up some return, but you live to fight another day, whether it's next year or four years from now.

Yes, but going to your point, we think we can generate short term returns and very reasonable returns given the current environment.

But let's be also clear that across all asset classes this is a generally low return environment.

This is one of the objectives of QE 3. So we feel we can generate reasonable returns, but what I want to be clear about is, look, if the Fed stays in longer we will have very good total returns.

We are maintaining 50% of our portfolio or have it at this point.

It is likely to drop over time, but we are not all out of 30-years.

We will do fine in that environment.

But what it may be is that we would have picked up 10% in book value, and we will pick up 7, or something like that.

I mean, I am not trying to weight those numbers exactly.

But that is fine for us right now.

That is a worthwhile tradeoff versus the scenario where we are sitting here with nine or ten year bonds, and returns two to three years from now are really attractive, and we are not in a position to commit capital.

That is a bigger miss.

Thanks.

I will let others ask, and then I will jump back in the queue.

Thank you, Gary.

Thank you, Joel.

Our next question is from Mike Widner with KBW.

Good morning, guys, and I am going to apologize, but I am going to take over Joel's same question here.

So again, going back to that slide eight, I guess my first reaction to reading it is if you stuck this in the Q3 presentation from 2010, it kind of would have fit right in, and 2011 and 2012.

The expectation of rising rates and less Fed purchases and widening spreads, that is a fall phenomenon that we have seen time and time again.

Yet it hasn't really quite happened.

So again, the thing I can't help but take away from this slide, much to Joel's point, is that it sounds like you are saying, the prudent course of action is to sit on our hands for a little while, and wait for some of that to play out, and keep more than a normal amount of dry powder.

Because everybody has wanted to keep some dry powder for a long time, but it certainly sounds like you are saying more than the usual amount of dry powder.

You have already answered a lot, but what I am hearing is, what you are saying is look, look for lower ROEs than we have delivered in the past going forward, because we still think, or we now think that it is much more likely that we are going to see that rise in rates than really you had, because again, this is a slide you could have put in any of the last three years or four years really?

No, look, I think I get your point, and I think it is a valid one, which is there is a reasonable possibility, and I want to be clear on this, that this turns out to be a huge head fake, so to speak, rates go back to 175 on 10s, and the economy falters, and we are back to where we were two years ago.

That is a possibility.

We can't completely ignore that.

That is one of the things that we have done that would help, is that we have a decent duration gap at this point.

We are maintaining some balance in our assets, we still have a lot of pre-payment protected assets,just a lot less than we did before.

But there are some differences this time.

And to your point, we felt comfortable before that the weighting of the risks coupled with the relative value of mortgages and how they were priced, really argued against obsessing about two to five years from now, okay?

On the other hand, the landscape is somewhat different.

The Fed is talking about, they are clearly spending a lot of time talking about tapering than not doing it, but it is, there are some differences.

The housing market is stronger now.

The energy boom in the United States is going to have some impact over time.

Europe is stronger.

So I am not trying to make the argument for why the economy is going to surprise to the upside, because honestly I think in the near term it is going to take time to get that momentum back, and I would probably argue for a somewhat later taper than that midpoint estimate.

But it is not the right kind of big picture position for us to put on.

We can't completely expose ourselves to the other side of that.

In other words, we can't just have all low coupon 30-years assuming we are going to sell them six months from now.

But on the other hand, some balance with a weighting to the long-term scenario so you don't get that wrong seems to us to be the right position for this environment.

And just to conclude and go back to your point, yes, we are willing to accept lower returns in that process.

Well, I appreciate the further commentary there.

I guess one somewhat related question is that you guys are still very heavy users of swaptions, all things considered $20 billion, out of a $70 billion overall hedge book.

I mean, it is a great convexity hedge, but one of the downsides, like with any option is that the value declines to zero fairly quickly as you approach the strike date at the end of the option period.

You also have the problem that as underlying VAL falls, you also get the K. The cost basis I think you guys indicated was about $425 million on those, less than one year to strike, if I am reading the numbers right, I mean, that is a pretty expensive position to hold if you think that we are, again, if I go to what you laid out on slide seven, it says that we are probably not going to see that 100 basis point rate spike in the next six months.

So I guess I am just wondering again, you began the call by talking about all of the things that changed over the quarter despite the lack of movement in interest rates, mediocre job reports, Janet Yellen, the clown show in DC continuing, does that not call for less expensive hedges where you don't need to be just right, but you need to be right, right now which is the case with swaptions?

Yes, this is Peter, let me take that question.

In my prepared remarks I mentioned that we had done some rebalancing to the portfolio.

All other things being equal I think that you have made some good points.

You are right, over timewe will continue to evolve the swaption portfolio to fit both the environment that we are in, and the assets that we have.

I didn't mean to imply in my prepared remarks that process was concluded.

We will still continue to do that as the environment evolves.

A couple of other important points though, you are absolutely right, that the options will decay fairly rapidly.

Our current portfolio option term is about 1.3 years on an average underlying of 7 years.

We have shifted that to be a little bit more appropriate for our 15-year portfolio.

It is also important to point out that there was extreme volatility in the third quarter.

If you go back and look at the market as recently as September 5th, our swaption portfolio had a market value of $850 million, so it was actually unchanged as of September 5th.

Just a few weeks obviously can change to whole outlook, but that portfolio still could continue to provide significant protection for us if the environment does change.

And we obviously will continue to evolve the portfolio over time.

One other thing to add it is very consistent to, I mean we have reduced the size of the portfolio, but we have also reduced, in a sense, the option period.

That is consistent to some degree with slide seven, which is that we see the uncertainty kind of working itself out.

So much of the uncertainty is Fed-dependent, and therefore is it somewhat near term dependent.

Really what I think some people tend to miss with options is it is very easy to see the cost of an option.

But if the option wasn't there, then you would have a different hedge, which would have a different cost.

And one of the reasons that we are willing to run a larger duration gap, which makes us a fair amount of money is because we have got kind of the worst case downside protected.

There is a real kind of interconnection of all those things.

So what I would say is to some degree the highest earning position is an asset portfolio with out of the money protection, because you take, you are getting all the carry up front with the exception of the option premium.

Your biggest exposure is a small increase in rates, because your options aren't going to be worth much, and your assets will lose value.

So keep that in mind.

Keep the big picture in mind, which is to your point, three months ago we were in a mindset where we were not going to take the duration gap and have the options, because we were doing that to hedge the spread component as well.

And because, look, we were 25 to 50 basis points away from another shoe dropping in terms of dominoes and positions.

So that is really the bigger picture.

And then in just to put a finer point on that duration gap.

If you think about our duration gap today at 0.9, without any options up 100 basis points our duration gap would be about 2.5 years.

Think about the environment we would be in, the strength of the economy if ten-year rates are up 100 basis rates.

People will expect them to go up 150 or 200 basis points, and we likely would not be comfortable running a duration gap of 2.5 years at that point.

I think that is the essence of what Gary was mentioning.

Thanks guys.

I do appreciate of all those comments.

Again, I will just echo something Gary you said at the outset, I think that if you plotted the book value across the quarter, that is where the true value in what you guys are doing shows up.

The lack of volatility, unfortunately as you also mentioned, everyone sees snapshots in time point to point, so a lot of the underlying stability gets lost by the market, at least as the stocks are trading right now under appreciating in the market.

I think congratulations on I what I believe is a very stable book value over the course of a very turbulent quarter, but maybe with the continued share buy backs, the market might come to appreciate a little more, or at least reward you a little bit more for it.

Thanks for the comments.

Our next question comes from Arren Cyganovich with Evercore.

Thanks, on the near term outlook slide on slide seven, I just wanted to clarify, you are saying that you are kind of in the base case right now.

If the near term changes, as you have laid out, such as economic activities slows towards the end of the year, would you actually take the actions of the short-term position increased leverage, et cetera in that environment?

Look, we will continue to react to new information, so absolutely.

Look, we don't dig our heels in with a position, and say this is the opinion we had, and we are sticking to it as new information comes about.

But I will say that what we will need in order to kind of start, if you want to call it going back the other way in a major way, would be that we would want to have, we want to feel that the shorter term picture was not only kind of leaning in a direction, but that there was stability around that because again, what we feel is not that the long-term is always more important than the short term, okay, or the intermediate term is always more important than the short term.

Honestly the short term very often is more important than the intermediate term.

The difference here is I think we have a lot more conviction around the intermediate term than the short term.

That is a key component of this.

And then the importance of one being wrong on one versus the other is also an important thing.

Again, just to reiterate your point I would say that we are in the sort of middle camp.

If you told me it wasn't the March April taper, I would probably tell you that it is more likely to be the right side of the page with a later taper not an earlier one.

But on the other hand, that could change very quickly with a couple of employment reports.

We don't want to be in that position.

We don't think the upside, again, if that scenario comes out, investors shouldn't see us as being offsides in that scenario.

We have a decent positive duration gap.

We still have 7 times leverage on both 30 and 15-year mortgages.

We will do fine in that scenario, and you should see book value kind of improvements in that type of scenario.

They just won't be as big as they otherwise would have.

That is a tradeoff we are willing to make.

Okay.

That make sense.

Moving on to a broader picture, the FT had an article a couple of nights ago about the Fed potentially reviewing banks exposure to mortgage REITs, and that fills in another theme that we are seeing from Fed Governor comments, FSOC report, IMS comments about the risks of mortgage REITs in the marketplace more broadly.

What are your thoughts about potential for regulation of the mortgage REITs over the intermediate to longer term?

First what I would say is, look, I did see the FT article, and it is just similar to what we have heard.

We do know that the Fed was asking banks about their policies and procedures around who they lend to and so forth.

And REITs are clearly on that list.

On the other hand I think, we are comfortable that the Fed is in an information gathering mode, and they want to understand things, and we have spoken to the Fed around how we manage risk, and so forth.

And I think the disclosure in the industry continues to improve.

I think to continue to get people comfortable, that the REITs don't operate the way people thought they did in the past, with just taking, buying five- to ten-year assets, and just putting them on a short-term repo with very few hedges.

The process is very different now.

Look, while this has been a trying scenario for the mortgage REITs, and no one should down play that.

On the other hand, going back to the slide, the second to last slide that we went over, I mean, through the whole QE 3 period we have generated positive economic returns.

Those are positive mark to market returns.

So big picture I think we are comfortable that the environment that we have gone through has been a test, and I think that people haven't gone out of business.

Did REITs sell?

Did they re-balance?

Yes.

Did money managers sell, did servicers sell and rebalance?

Absolutely.

And REITs are not the biggest component in this whole process.

So our sense of this test is one where what we have seen this year is that I think it should give people a lot more comfort than they probably had going in.

Thanks a lot.

Our next question is from Chris Donat with Sandler O'Neill.

Hi, good morning, thanks for taking my question.

I just had some, I guess I am trying to understand the trading environment here and the volatility, and looking at some of the big picture stuff, like from the New York Fed and looking at the primary dealer data, it looks like the trading volume of MBS was as low in the third quarter as it has been in the last seven years, and there has been other data out there showing that the dealer positions, not just in MBS, but in corporate bonds and other asset classes have really dropped off.

I wonder if that has had any impact on the volatility that we have seen?

Certainly there have been a lot of event driven volatility, butI am wondering if some of the natural shock absorbers you saw, or had seen in the past from a deeper market aren't quite there?

I know it is still a deep market.

I just wonder what your thoughts are on that broader market?

What I would say is that when you look at the MBS market first yes, volumes especially recently are down.

Volumes in the second quarter were pretty high.

I think what you have to understand in the case of the MBS market, origination volumes are down.

The Fed is such a big player in the market, that tends to kind of concentrate the volume there, and then there is less activity around that.

But there is tremendous liquidity in the mortgage market.

You are right about dealer positions.

Where you do have to be careful in any kind of more extreme movement is in less liquid securities that can't be shorted.

And so I think the problem sometimes is that when you go outside of the agency space, and you go to corporates, when you go to in some cases non-agencies.

When you certainly go to emerging market debt, when something bad happens, or when everyone wants to go in the same direction, there is really, it is very hard to get the other side done.

But what I would say, and this is important about the agency fixed rate market because it is a shortable mortgage, it reacts very, very quickly, but then retains its liquidity over time.

And so we are not worried about kind of a decrease in liquidity in the agency space.

I think all of the issues that we went through kind of demonstrated that market can function even in a time of pretty significant stress.

I do think that there were periods in other asset classes in emerging markets, debt is a great example, where things sort of lock up.

That is one of the risks that you always have when you participate in less liquid non-shortable markets.

Okay.

Thank you very much.

We have time for just one more question, and that question comes from Dan Furtado with Jefferies.

Thanks for the opportunity everybody, good morning, I must be missing something, but I for one think that the strategy is logical and appropriate and correct, given the price risk the Fed represents the asset values in this space.

That said, I do have a couple of questions.

The first is a big picture.

Looking more broadly at the residential mortgage market and not at AGNC's core assets, can you help us think about where you think the most attractive returns in the resi mortgage market are likely to lie in the next two- to five-year interim period before ROEs in the agency space become more attractive again?

I think what we have to be more cognizant of if that assets, different assets, that there is a crowding out effect from one asset type to another.

So sometimes when you just bounce from one type of asset to another, there is excess demand there because of QE 3. This is what the Fed is trying to do, is crowd people out of certain products, and that tends to work.

They move somewhere less liquid.

Our perspective is again depending on where you look, whether it is non-agency mortgages, whether it is agencies, whether it is CMBS, this is a lower return environment.

Now again, when go to slide eight, and you look at kind of a bigger picture of a wider spectrum of markets, the same is true for mortgage credit.

The same is going to be, you could say for MSR, is that as private capital has to absorb a much bigger part of the mortgage market across all of these spectrums, then ROEs are going to be more attractive down the road.

One of the things that is important to us is liquidity.

Because if you have a liquid instrument that has a manageable amount of spread risk, than if something better comes along you have the option to do something with it.

If you focus your portfolio, and this sort of ties in with the prior question with less liquid instruments, then you don't have the flexibility to react to the next opportunity.

And so I think big picture, this statement and these two slides which relate to the agency space, are true kind of over a much broader range of assets.

Excellent.

Thanks for that.

The other question, two more quick ones.

First, have you ever given any more thought or any more effort on potentially figuring out how to bring MSRs onto the balance sheet, or is that kind of not real feasible?

No, we continue to look at the MSR opportunity, which is the term I think way too many people have used, and what I would say is that opportunity has turned out to be A, harder to execute, and B, much less of a short-term kind of an opportunity, as a lot less, at least in the newer kind of MSR space is really traded, than people would certainly have anticipated, and prices in the near term have gone up.

But our perspective on that has not changed.

It is something that requires evaluation over time, and something that we would to still like to be able to be in a position to participate in.

It is just realistically harder to execute, and the opportunities haven't shown up as quickly as some of the literature would have implied a year ago.

Got you, and finally if I may, are you willing to give a stab as to where you think book value is today Gary?

What I would say, and this is true of the positioning, I was asked earlier about the positioning, what I would say is that really our positioning hasn't really changed a lot, and book value is not, there is no kind of material move one way or the other at this point.

I think that is relatively straightforward information.

Understood.

Thank you for the time.

Thank you.

I think that concludes our call at this point.

For those of you who weren't able to ask a question, please reach out to our Investor Relations group, and we will try to get you answers as soon as possible.

Thanks to everyone who participated.

Thank you.

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 November 12th by dialing (877)344-7529, using the conference ID 10035742.

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