American Capital Agency's CEO Presents at Bank of America Merrill Lynch Banking and Financial Services Conference (Transcript)

| About: AGNC Investment (AGNC)

American Capital Agency Corporation (NASDAQ:AGNC)

Bank of America Merrill Lynch Banking and Financial Services Conference

November 14, 2012 3:25 PM ET


Gary Kain – Chief Investment Officer

Kenneth Bruce – Bank of America Merrill Lynch

Kenneth Bruce

Thank you for joining us this afternoon. We have our next presentation from American Capital Agency Corp. As many of you may be aware, this has been a great success story within the agency mortgage REIT space over the last few years. There have been tremendous growth trend and profitability from the team at AGNC. And so it’s been a really, a great stock in many respects; I guess, if anybody has been paying attention to their Blackberry or the headlines of the last few days, you may recognize that things have gotten a bit more interesting post the election and that’s led to a lot of volatility in the sector and certainly in the stocks. So there maybe some questions that come about from just recent, recent market activity. But here to talk about American Capital to give us his view of the world is Gary Kain, the Chief Investment Officer for American Capital Agency Corp. So let me turn over to Gary.

Gary Kain

Thank, Ken. And thanks to all of you for your attendance and your interest in AGNC. Look, given what’s going on in the REIT space, clearly the stocks have been volatile and volatile in kind of the direction for them not to be volatile in. I had been planning on going through kind of the key themes from our Q3 earnings presentation, but given kind of what’s going on, I thought it was more appropriate for me to take a somewhat different approach today.

And over the last month or so, investors have been pummeled with a host of reasons to panic around the agency REIT space. And these things include things like the record-low mortgage rates due to QE3 prepayments, the election, tax changes, the fiscal cliff, and now rumors about the head of FHFA, DeMarco, potentially getting replaced. So what I want to do is directly address some of these concerns and use a few of the slides from our earnings presentation where appropriate. And since I’m just going to be jumping around, I’m not going to be going through obviously the presentation in any order. But if you are interested in the earnings presentation, clearly it’s recorded; the presentation is on our website and there’s a recording of the earnings call that will go through everything in detail.

But with that, let’s start with kind of QE3 and the first concern that we hear, what are the implications of QE3. And so, if we actually go to slide 9, we look at some of the -- we have a slide that really talks through that. But the real key ramifications of large scale mortgage purchases by the fed are that the yields on mortgages are going to be lower than where they would have otherwise been and prices are higher, these lower yields means the returns on new purchases are going to clearly be less attractive than if the fed hadn’t involved over time

But the other issue that concerns people and probably the bigger issue is that these lower mortgage yields also mean lower mortgage which means prepayments on our existing portfolio will be faster and that will hurt the yields of the current portfolio, plus you will have to then reinvest those pay downs into a lower-yielding instrument. And so, realistically, so what are the implications of QE3? And we’ll talk more about prepayments in a little bit, but the reality is there is some reason for concern here. This is not a benign prepayment environment. Prepayments are going to be faster given QE3, but there are also some places to hide. And so irrespective of changes to policy or whatever, prepayments are a factor and we’re going to talk a little more about that in a second.

But another thing that comes up periodically in these discussions really relate to, look, all right, so QE3 was a reasonable possibility, the stocks were fine for a little while after QE3. So was there something that really stands out that surprised us with respect to kind of how the market is reacting, the mortgage market or the prepayment landscape? And on that front, the answer is absolutely no.

And if we go to slide 11 for a second, this is a slide that we had originally included in our Q1 earnings presentation back in early May. And what it shows, it was the center scenario -- we talked about three scenario -- and the center scenario was one, a hypothetical QE3. And what you see is what we said under prepayment rate impact materially accelerate. We talk about what would happen in the mortgage market; the prices of lower coupon and prepayment protected mortgages would increase materially; that has happened. They’ve given back some of those gains but they’re still up.

And then prices of generic or higher coupons would perform -- their gains would be considerably less and the driver there is because there was no fed bid and the prepayment issues were going to be factor. When you go down to kind of the impacts on AGNC, prepayment protection is critical to the returns on the existing portfolio, returns on new purchases less attractive, and book value would increase in response to QE3. So when you put those together, what we’ve -- seeing the environment we’re looking at is absolutely what should have been predicted in kind of how we described this hypothetical scenario back in the first quarter or in the first quarter call.

So the next thing really comes up to, okay, well, QE3 increases prepayments and reduces yields; okay, everything about QE3 was predictable, so you were able to predict that this freight train was coming and you were able to look at the freight train but it still ran all you guys over collectively in the space, so is that the way I’m supposed to take this. And the answer is absolutely not; yes, it’s a more difficult environment. It is anything other than a goldilocks scenario but is absolutely a very manageable scenario as well if you have the right positions.

And so let’s start with slide 12. And on this slide, what we look at here are prepayments for Fannie Mae 2011 origination, 4% coupon mortgages. So newer, good credit mortgages, this is similar to what 3.5% of this year will look like soon. This is a good surrogate for the market on newer, cleaner mortgages with kind of relatively lower coupons but certainly not low enough.

And if you look at the top line for a second. These are jumbo conforming loans or loans from $420,000 [ph] to $625,000 [ph], so these are the largest loans securitized in the agency market. And look how fast they are; 50-ish CPRs and those are likely to actually increase from here. The next line, the blue line are what’s called generic or TBA 4% coupons; and they’re more like the mid-30s and probably likely to go up 40-ish. But the two lines on the bottom are two examples where you can have some confidence in the prepayment protection and the prepayment performance. And those are lower loan balance mortgages, sort of the opposite of the higher loan balance mortgages.

The higher balance mortgages are fast because originators and loan officers make the most money if they refinance big loans, so they go after them. Second of all, the fixed cost associated with refinancing are small relative to the size of the loan. If $1,500, it doesn’t matter that much if you have a $500,000 loan. But the inverse is it matters a lot if you have an $85,000 or $100,000 loan, those fixed cost on a relative basis are five times as much. In addition, the loan officer, if they can handle 100 loans, they don’t want to waste their time with you because they get paid maybe two points on a loan or one point on a loan or the company gets paid as a percent of the loan amount; they make five times as much on a $500,000 loan as to [ph] a $100,000 loan. So smaller loans are slower and they will continue or should continue to perform well even in a more challenging environment and we’ve seen that consistently over the last two or three years when prepayments have picked up.

Lastly, the green line are backed by loans that have already gone through the HARP program, either HARP 1.0 or HARP 2.0. These are higher LTV loans that where the borrower was able to refinance if Freddie and Fannie had their loan even though their LTV was such that they wouldn’t have generally qualified. And once you go through that program, you can’t go through it again. And for that reason, prepayments have tended to be very benign on those loans. So those are two very good examples of where you could potentially hide.

And now let’s go to page 15 for a second. And what you can see here is the composition of AGNC’s portfolio at the end of September. And what I want you to focus on is not so much how much was 30-year versus 15-year in the top pie chart, but on the bottom in the two tables what you can see, and let’s focus on the table on the right which is the larger piece, the 30-year mortgages. If you notice, 34% of our portfolio of the 30-year fixed rate portfolio was backed by lower loan balance. And if you look on the second to last column on the right, the one month speed was 7% CPR, so very contained. Our actual forecast for that which is what’s used for our yields is even more conservative at 10%. And that’s what’s already kind of accounted for in our amortization at the end of the quarter.

The HARP securities make up 45% of the 30-year fixed; so between them you’re looking at almost 80%, those are currently prepaying at 6% CPR or whereas in the release in October. And they’re projected at 11%, almost double where they’re currently coming in. So what’s important here is that you can find areas that are going to continue to perform well despite a very challenging environment.

And when we laid out what we thought would happen in QE3, we felt there were two places that were safe in the mortgage market. One was these prepayment protected securities, and there are a couple of other things besides HARP and loan balance but those are by far the two best. And the other is very low coupons. And those are the coupons that the fed would be buying; because even if they perform, if you are worried about the prepayments such as generic 3.5%, you could sell them to the fed.

And we talked about that on the earnings call, we had some generic 30-year 3.5%; some generic 15-year 2.5%. In the case of the 30-year 3.5%, we’ve actually moved down to lower coupons because we are worried about the performance of those and we’re able to do that in a very cost-effective manner. But what’s important here is you can design a portfolio that will continue to perform well despite the challenges presented by QE3.

And I’m going to stop here and also add that there are concerns around policy risk, around Washington and Obama and the second term of the administration. Is he going to fire the head of FHFA, Ed DeMarco, and replace him and then if that happens, are there going to be all these new streamline programs put in place and what would happen to AGNC or what would happen in response to the Boxer-Menendez Bill if that were to pass.

We start with the Boxer-Menendez Bill, if it were passed tomorrow, something like 3% of our portfolio is even exposed to that bill in any way, shape or form as written currently, 3%. And the reason is is that in order to be applicable for that bill, the loan had to be originated before June of 2009 and that is the same universe that’s exposed to HARP 2.0. We’ve made an effort over the last few years to make sure we’re not exposed to HARP 2.0 and that’s why we have so little exposure to it kind of if it were taken to the next level and if Boxer-Menendez Bill were passed.

The next thing is just DeMarco himself. When the HARP program was designed and when the kind of whole revamp of the kind of GSE refinancing model back in 2011 when the HARP 2.0 was rolled out, it was not only DeMarco and the GSEs. It was HUD. It was Treasury and they were all involved in designing that program. And so that was not just the work of Mr. DeMarco and he has done a great job. That is an incredibly difficult job and I think HARP 2.0 is a big success and he deserves some credit. But at the table where HUD, which is basically part of the administration and Treasury. And so, the proof that things like the cutoff date for a loan having had to have been originated by June of 2009 that there was kind of a general agreement on that is six months later when FHA or Ginnie Mae, what, that goes into Ginnie Mae’s securities, when they came up with their HARP program and DeMarco is not even related, involved in FHA, when they came up with that program, they used the same June 2009 date.

So FHA on their own, without DeMarco used [ph] that date, it’s kind of a very good indication that that’s not something that’s likely to change. So we feel pretty confident that, look, the administration, Treasury, others have looked at these streamline mass refinancing programs and they came up with as a group the HARP 2.0 program which is working very well. So we are very confident that there is a fair amount of prepayment risk.

QE3, the potential to go over the fiscal cliff and interest rates going lower, the fed increasing or continuing their program for a long time will present prepayment risks, but they are the risks that we know. This idiosyncratic policy risk is considerably lower in our opinion than where it’s been in a long time for the reasons that we outline. And again, if that Boxer-Menendez Bill that’s floating around pass, it would literally affect 3% or less of the portfolio.

So with that, the other concern is, okay, now let’s look at the earnings on the portfolio. And so I’m going to slide 14. And, okay, book value generally in the space hasn’t been the biggest concern. It’s more about what are the earnings look like. And this is where it comes down to it’s so important what you own. So if we look at the top line here or the top table, what you can see is a generic 30-year 3.5% at the price from October 23rd I believe and it’s not that different today.

In our opinion, the generic 30-year 3.5% originated over the last couple of years on average are likely to pay the 2011 vintage of these prepaid last month around 33% to 35% CPR. We think they probably go up to 40% over let’s say the next couple of months, but they’re likely to stay above 30% or average 30% or above for the next year.

So the problem is for those of you who are already looking at this chart, you’re thinking, why is he saying that, that looks pretty bad; the yield is 1%, well, 1.03%; funding cost of 75 basis points, that leaves a net margin of 28 basis points. And the next line shows the gross ROE if we apply seven times leverage so it looks like a hypothetical REIT, that gives me a gross ROE of 3% or a net ROE of 1%, 1.5% depending on your cost structure; and you said it might be faster than that. Well, that looks terrible. And the answer is, it is, okay. That’s why we don’t want to own generic higher coupon mortgages that can prepay quickly in this environment. You can’t or you’re going to have very, very poor returns.

And it is this slide that I think is the driver behind the performance in the REIT space. There are agency mortgage securities and a lot of them that are going to produce subpar returns right now. And the key though on the part of a management team is not to own those. And we feel like we don’t. And we’ve continued to kind of work on that to make sure that we have a portfolio that can produce reasonable returns.

Let’s look at (inaudible) another security at its market price and where it was trading on the bottom. This is a slower prepaying mortgage -- let’s say it’s a lower loan balance or a HARP-type security where a 10% CPR maybe -- is probably appropriate. Even in this kind of environment and go back to the graph that we went over before. If you own a security like that at a price of 1.5 points above the generic security where they were trading a few weeks, maybe they’re a little higher now, if you made that 10% assumption, you’re looking at a 2.26% yield, 75 basis points of assumed funding cost just to be equivalent. In theory, it might be a little higher. And then you get a net spread of 151; when you apply the same seven times leverage to this, you get a gross ROE of 12.8%.

Let’s say it came in at 25%, that’s still a double digit 12.5% or 15%, you’re still in the neighborhood of a 10% or higher return. So what’s really different is this is a tale of two types of investments. A generic faster investment is going to produce a very poor return in the absence of some major change. A slow prepaying mortgage, even if you pay a premium for it can still provide very reasonable levered returns in this kind of environment. And so what I think you should take away from this slide, and again, this is by far and away the most important slide in this presentation is that you’re going to see very, very different performance from different agency mortgage portfolios over the next three, six months, maybe a year. And there are reasons again why this is a challenging or not a goldilocks scenario, but there are places to hide. And so I just want to reiterate that once again.

Now, we also want to touch on a kind of an interesting subject, taxes and dividend kind of -- I think there were concerns floating around in the space, well, okay, the tax dividend taxes are going to go up but they no longer are going to get preferential treatment. Well, REIT dividends are already taxed as ordinary income. They’re not qualifying dividends. And so, for that reason, they’re already taxed at income rates. So there isn’t a change in the mortgage REIT space for how dividends would be treated if they change kind of the tax rate for qualified dividends. And that’s an important thing to keep in mind, and I think should be relatively straightforward but there seems to be some confusion in the market around that and you’re seeing obviously pressure on dividend-paying stocks in general over the past week or so. So I want to make sure people understand those differences.

So to sum up kind of these key points, QE3 has created and the environment we’re in is not a benign prepayment environment. Prepayments are important for the space. But there are places where you can hide and we feel very confident of the portfolio we’ve constructed. We therefore still believe we can produce reasonable returns in this environment. And there is risk at the prepayment landscape, gets worse. And I would tell you that I think that the risk of the prepayment landscape getting worse is 10 times greater or something like that. If we go over the fiscal cliff, the 10-year Treasury goes to 120 and the fed increases their mortgage purchase program, that’s a bigger risk or even keeps it in place for a very long time, that’s the bigger risk on the prepayment front than the policy-oriented risks. We’ve gone through that. For a portfolio that’s kind of not exposed to HARP 2.0, then you’re not exposed to the Boxer-Menendez Bill and you’re really not likely to see any big surprises from there.

So with that, I’d like to open up the presentation of questions.

Question-and-Answer Session

Kenneth Bruce

Let me get the first one in.

Gary Kain


Kenneth Bruce

You obviously addressed a lot of different topics that relate specifically to AGNC’s performance and then more generally how investors in this asset class are subject to certain types of risks. But in your review of the issues whether to be economic or just in the market and you kind of laid out at the end what you saw is the real kind of problematic scenario. Do you think that there is a high likelihood that you see 120 on the 10-year Treasury and we’re forced to be reinvesting into that type of a market?

Gary Kain

What I would say is it’s not that I see a high probability of us heading to 120 on 10s and the prepayment landscape getting considerably more challenging. But if we were to end up in a much more challenging environment, it’s more likely to come via that route than via a change on the policy front. Look, I think we have to be practical and we’ve said this often in terms of managing AGNC or MTGE’s position which is our job as a management team, you shouldn’t invest in AGNC because you think we know which way interest rates are going to go.

We try to be as agnostic around interest rates as we can be most of the time. And what we really try to use our expertise is around positioning ourselves for a range of possible scenarios. So to your question, I could definitely see that. I mean, the global economy is weakening. We are looking at the fiscal cliff. There are things that could easily drive us to lower rates and the fed has been pretty aggressive. It’s our job to design a portfolio like we have that can still hold up in this even more challenging environment if it happens. But I can’t count on that scenario. I shouldn’t. It’s not that high of a probability. And that’s where all of our hedges come in, because we also, and probably more importantly have to protect the portfolio for kind of the opposite scenario where the tenure goes 2.5% or 3%, and the price of mortgages drops while the prepay environment gets more benign, we need to protect our book value in that kind of scenario. And we lay out an earnings presentation everything we do on that front.

But again, what we’d like to tell investors is, look, it’s our job to try to prepare the portfolio and we can’t be prepared for every possible scenario, but it’s our job to be prepared over a range of scenarios and that is absolutely included in the spectrum of possible outcomes.


Unidentified Analyst

Two questions. First, given the recent market volatility in the mortgage market, have you seen any changes in the repo market particularly as it pertains to you? And then my second question is, can you talk a little bit about your share repurchase plan or policy?

Gary Kain

Sure. So the two questions were, have we seen any changes in the mortgage, well, given the volatility in the mortgage market and the REIT space, have we seen any changes on the repo front; and can we talk about share repurchases.

So, no, we have not seen changes on the repo side outside of year end or anything normal that we would typically see at this time. So one thing that’s important is repo agreements generally and our don’t have a tie [ph] to market capitalization; because our stock price has been a little weaker or whatever, that doesn’t impact kind of repo arrangements. Mortgage collateral has weakened in the last few days or over the last month relative to its highs. But generally speaking, in the space and certainly with us, book value has been very strong and no -- I don’t think anyone in this space is operating at anywhere near kind of peak leverage levels.

And so realistically, repo has not really been a question that’s come up much in this environment. We haven’t seen changes in terms or we have no concerns around the repo market at this point. And I think that’s general throughout the industry. Again, the important thing to keep in mind in the repo front and one of the things that we think we have termed out, we have taken over the last year, the initiative to reduce the term of our borrowings. We make sure we have a component of our portfolio that’s TBA eligible with most liquid mortgages. So that if we for some reason in the future ever had to delever, we would be able to do so in kind of the most user-friendly way. Again, this is not kind of a liquidity oriented environment. We would expect no issues there.

On the second part of the question, stock buybacks, what I’d like to reiterate is what we had talked about on the earnings call. And we’re talking specifically about AGNC but for MTGE investors, the same would apply. The bottom line is that it is important for us as a management team and for AGNC as a company, we have been able to raise [ph] accretive equity which has helped our economic returns over the past three to four years. And we should use the same lens in looking at stock buybacks as we use when we look at issuing stock. And that’s the way we think about it.

Now, what’s important to keep in mind is that there are costs associated with issuing stock and repurchasing stock, and you can’t think of that as, you just go back and forth and you’re trading your stock all day. I mean, there are restrictions around that. But there are also real costs, especially on the issuance side that have to be captured. So what we try to stress is, look, very small deviations from book value are inside kind of the cost area noise from our perspective, not that they’re not important and we wouldn’t want to see them, but that’s something that you have to get well outside the cost, the kind of issuance cost area which generally is somewhere like 5% before you even would start to think about stock buybacks.

And the other thing is we don’t look at our end of quarter book value when we think about it. We have real time daily kind of views into book value that would be the other thing that we’re going to look at with respect discounts. But I also want to be clear, we’re not looking for 20% and 30% discounts before we feel it makes sense to buy back the stock. I mean, this is something that we feel is in the best interest of the company. It’s a way to build book value and it’s something that we have to be focused on. And I know I didn’t give you very much specific information about what exact discount we would execute stock buybacks but there are a couple of reasons. The bottom line is that it’s a function of market conditions.

Unidentified Analyst

Do you view the current environment for purchasing MBS after the recent cheapening as an attractive one? Do you think there might be a better opportunity so you kind of keep some dry powder [ph]? And the cheapening is really common in kind of higher coupons and more generic things. Have you seen the same cheapening in some of the prepayment protected product that you normally would buy?

Gary Kain

That’s a very good question. So the question relates to what have we seen, I mean, mortgages especially higher coupons have cheapened up over the last few weeks or month. Is that something that’s attractive to us or have we seen cheapening in the prepayment-protected securities.

And so what I would say is, higher coupons have cheapened up but we do not find higher or even the middle coupons that relate to the slide 14 that we just went over. The bottom line is that at these types of prepayment rates, kind of the yields and carry anything higher coupon or not prepayment protected are still very unattractive and you have to have a very optimistic view of where they’re going to be six months from now to find those as good investment despite the change in prices. And that’s sort of kind of what we thought about going in to this. I think with respect to the prepayment protected securities, they really, I mean, they haven’t really cheapened up much of late. As a matter of fact, they’re still kind of noticeably higher in terms of the pay-ups versus where they were at the end of the third quarter. So you haven’t seen the cheapening there. I mean, you have seen some cheapening in the TBA price and you haven’t seen all of that made up for or in the pay-up component of it. So they look okay but I wouldn’t say there’s been a ton of cheapening there.

But the other area that we’re willing to look at are lower coupon fixed rates which are actually what the fed is buying and in those coupons such as 30-year 3% or 15-year 2.5%, you’re looking at kind of prices adjusted for interest rates which are not that different from where they were pre-QE3 despite the size of the fed’s bid, and there is another area where you don’t have to worry about prepayments and where the recent cheapening has definitely changed that equation.

So what I would say at this point is the mortgage, the agency mortgage market has gotten to a point, especially with the kind of movement over the last few days where there are parts of the market that are attractive at this point. And to your point about like will they likely be more attractive two weeks from now or four weeks from now, that’s obviously something where we have to use our judgment in terms of how we pursue those opportunities. But I would say kind of just at a high level, the current environment for lower coupon fixed is relatively attractive. And if I look out three to six months from now over most scenarios, they’re probably going to be a lot richer than where they are now.

Unidentified Analyst

Is it your view that maybe six months from now the current coupon that the fed would target would become 50 basis points cheaper on both the 30- and 15-year? So in other words, the fed could eventually start targeting 2.5% for 30 and 2% for 15. And if so, what are your thoughts on pre-buying those?

Gary Kain

Good, very good question. So the question relates to, could the fed instead of kind of having their main targeted coupon now be 30-year 3%, could it be 2.5%; and in 15-year, could it be 15-year 2% instead of 2.5%. And the answer is, yes, that’s actually a likely scenario if interest rates stay where we are. On the other hand, we feel that for a very long time that the 3% and the 15-year 2.5% are going to have enough fed support that if we change our view on the prepayment on those coupons that the bid for those coupons will be strong enough that we can rotate. And we do feel that the performance of those coupons, the higher coupons 30-year 3% and 15-year 2.5% would be considerably better if interest rates were to go up.

So at this point, we don’t see the need. We’ll look at it opportunistically to migrate positions below those levels but it’s something that all depends on price and that we’ll evaluate over time. I think it’s important -- the fed is a non-economic buyer of mortgages. And if you have an actively managed kind of mindset, you really should be able to generate a number of opportunities in this environment reacting to market dislocations or market opportunities. And so, what I would stress is, we’re talking about the market at one brief instant in time where you can already see how different the market is today versus where it was two months ago before QE3 or where it was at the end of the third quarter two weeks after or three weeks after QE3. So the way we look at this is absolutely on ongoing process that can change on a daily basis.

Unidentified Analyst

I have one more question for you. So with all the discussion around QE3, QE3 plus 4, acidity [ph], however you want to describe and no matter what the rate view is, just more broadly, there is the question of how does the fed reverse QE3 and what the implications of that will be for you, not from a timing perspective. I [ph] realize that nobody has great visibility into that, but just what do you think the milestones are that you’re going to have to look at to gauge your adjustments for a reversal of the QE3?

Gary Kain

Now, look, that is a very good question and I think it’s the question that’s kind of out there generally. I don’t think it’s really specific to the mortgage market, even though the fed obviously has a large mortgage position. But the question is if and when the fed has to change to a hawkish [ph] stance and either raises rates or at some point looks to sell their mortgage portfolio, what does that look like. And it looks like higher mortgage yields when both of those things happen. And at some point, we should assume as a management team they will happen. But what I would stress is that I think the fed is absolutely focused on kind of doing things in a transparent fashion and in a -- kind of in a fashion that is, one, that promotes kind of some market liquidity.

And so, I think we’ll have to react as time goes along. But what I do want to stress is with respect to higher rates, I just want to reiterate what I said during the presentation which is we have to be prepared for higher rates today as we sit here talking; not because rates are going to go up tomorrow. I certainly don’t think they will, but we cannot have a low coupon fixed rate portfolio or any mortgage portfolio and be in a position where we’re just hoping or assuming rates are going to stay here.

As a levered investor, there is a lot of risk associated with that. And then you’re going to end up doing your hedging when rates have gone a lot and after having lost a fair amount of economic value. And for that reason, you investors should look at our earnings presentation and look at what we do on the hedging side because it is substantial and it is designed to protect against the scenario where the market assumes the fed is going to start changing their policies and where interest rates starting with the backend mostly start to go up. And so we have to be prepared for that scenario and we won’t know unfortunately, I mean, we wish we were that good, but we won’t know two weeks beforehand when that’s going to occur. So we just have to keep that in mind. It’s a combination of leverage and probably more importantly hedging.

Unidentified Analyst

Just from a practical standpoint. Do you have a view or do you have thoughts around how the fed might exit? So, just to put that in some context, our economist which spoke at lunch basically indicated, okay, QE3 and 4 goes on, and then as the fed begins to see a real economic turn, it becomes more comfortable that its job is done, they would begin to possibly stop buying than maybe even so before they start to introduce absolute rate increases. Do you think that one comes before the other, how should we be -- how would you look at that?

Gary Kain

I mean, again, I wouldn’t view us as the expert on fed policy. My kind of thinking and understanding would be that the fed would stop their purchases first. They would then probably go to their more traditional tool of raising interest rates before they start to shrink the balance sheet. But, I mean, look, this is unchartered territory and there isn’t a blue print and I don’t believe they’ve stated specifically what they would do.

But I think one thing people should be very cognizant of is that a mortgage portfolio, even in a rising rate environment pays down. So I do think that it’s highly likely that the fed’s desire to “get out of their position” so to speak or to sell it will be tempered by the fact that it is a self-liquidating portfolio in a gradual pace. And so, I think that there is a more likely scenario across the board where it’s a long time before they sell their mortgage portfolio. And that it’s more likely that they’re going to let it run off.

Kenneth Bruce

Great. Well, thank you very much for your comments and joining us this afternoon. And please join me in thanking Gary.

Gary Kain

Thanks, Ken.

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