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American Capital Agency Corp. (NASDAQ:AGNC)

Q4 2012 Earnings Call

February 8, 2013 9:00 am ET

Executives

Katie Wisecarver – Investor Relations

Gary Kain – President and Chief Investment Officer

Christopher J. Kuehl – Senior Vice President-Agency Portfolio Investments

Peter J. Federico – Senior Vice President and Chief Risk Officer

Malon Wilkus – Chairman and Chief Executive Officer

John R. Erickson – Executive Vice President, Chief Financial Officer and Treasurer

Analysts

Joel J. Houck – Wells Fargo Securities, LLC

Bill Carcache – Nomura Securities International, Inc.

Douglas Harter – Credit Suisse

Steven C. DeLaney – JMP Securities

Mark DeVries – Barclays Capital

Bose George – Keefe, Bruyette & Woods, Inc.

Daniel Furtado – Jefferies & Co.

Arren Cyganovich – Evercore Partners

Kenneth Bruce – Bank of America Merrill Lynch

Stephen A. Laws – Deutsche Bank Securities, Inc.

Christopher R. Donat – Sandler O'Neill & Partners LP

Operator

Good morning and welcome to the American Capital Agency Fourth Quarter 2012 Shareholder Call. All participants will be in listen-only mode. (Operator Instructions) after today’s presentation there will be an opportunity to ask questions (Operator Instructions). Please note, this event is being recorded.

I would now like to turn the conference over to Katie Wisecarver in Investor Relations. Please go ahead.

Katie Wisecarver

Thank you, Denise. Thank you for joining American Capital Agency's fourth quarter 2012 earnings call. Before we begin, I'd like to review the Safe Harbor statement. This conference call and corresponding slide presentation contains statements that to the extent they are not recitations of historical fact, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act. Actual outcomes and results could differ materially from those forecast due to the impact of many factors beyond the control of AGNC. All forward-looking statements included in this presentation are made only as of the date of this presentation and are subject to change without notice.

Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the risk factors section of AGNC's periodic reports filed with the Securities and Exchange Commission. Copies are available on the SEC's website at www.sec.gov. We disclaim any obligation to update our forward-looking statements unless required by law. An archive of this presentation will be available on our website and the telephone recording can be accessed through February 22 by dialing 877-344-7529 or 412-317-0088 and the conference ID is 10024358.

To view the slide presentation, turn to our website agnc.com and click on the Q4 2012 Earnings Presentation link in the upper right corner. Select the webcast option for both slides and audio or click on the link in the Conference Call section to view the streaming slide presentation during the call.

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

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

Gary Kain

Thank you, Katie. Good morning everyone and thanks again for your interest in AGNC. I just wanted to discuss on this call, our portfolio continues to perform well despite the challenges post by QE3. We also believe our near-term earnings outlook is actually stronger now than it was at the end of the third quarter.

During the fourth quarter, mortgages did cheapen and favorable financing opportunities presented themselves in the TBA market. Moreover, since these financing dynamics are a function of QE3, they likely to remain very attractive for most of 2013 and possibly beyond as the stock effect of the Fed’s purchases dominates the market.

With introduction, let's turn to page 4 and quickly review AGNC’s 2012 full year performance. Most importantly, we generated economic or mark to market returns of 32% for the year. This was comprised of the combination of $5 per share in dividends and $3.93 of book value growth. A 32% return is a worthy accomplishment in any environment, we are especially pleased with AGNC's performance against the backdrop of Q3 and even more so because this is the fourth year in a row where AGNC has been able to produce economic returns in excess of 30%.

Against the backdrop of strong multi-year economic returns, a very sizable amount of undistributed taxable income and our confidence in our investment strategies, we continue to believe AGNC’s current dividend remains appropriate at this point. However, investors should remember that future dividends are by definition uncertain and will be a function of market conditions in our actual performance.

Now turning to slides five and six, I want to highlight the most important takeaways from AGNC’s Q4 performance. I also want to apologize upfront as I’ll be bouncing back and forth between these two sides. So first and foremost, when thinking about our true earnings power and/or risk, it is now important to focus on both our on balance sheet leverage and our net forward purchases of TBA mortgages.

As you can see on the top of page 6, our average on balance sheet leverage for the quarter was only 6.8 times. However, that number was 7.8 times when you include our net TBA position. At the end of the quarter, our on balance sheet leverage was seven times what we call at risk or true effective leverage was 8.2 times inclusive of our $13 billion in forward TBAs.

I started with the discussion of the TBA position, because it is imperative now to the understanding of our results both for this quarter and probably for most of 2013, assuming we continue to roll a sizable amount of MBS.

So now turning back to Slide 5, we had $0.89 per share of net spread income during the quarter of which approximately $0.11 related to catchup there. However, our estimate of the implying carry related to rolling TBAs were purchasing them for forward settlement dates totaled an incremental $0.29 per share. If you add that to the $0.89 per share of net spread income, you get a total of $1.18 per share, or $1.07 excluding the catch-up of their component.

So if you are wondering about the relative contributions of the TBAs versus the on balance sheet assets given the sizes of the positions, you do have to remember that currently the entire swap cost is essentially allocated to the regular net interest spread on the on balance sheet portion, which therefore understates the true economics there.

If we look at the bottom of Page 6, the snapshot of our net interest spread as of December 31, was 140 basis points without including TBA positions. However, this estimate increases to a 161 basis points when we include the economics implied by year-end dollar roll levels. This gives a more balanced perspective of the relative contribution to earnings power.

We have always stressed that our investment strategies must evolve with market conditions and the dollar rules are really an excellent example of this. Additionally, AGNC will always prioritize true economics of a earnings geography.

Now before moving on, I want to point out a few other highlights related to the quarter. First, book value did decline 2.6% as agency mortgages gave back some of their large games achieved during the third quarter after QE3 was announced. If we look at the two quarters together, AGNC grew book value by 7.5% in addition to paying $2.50 per share in dividends, and we feel really good about that performance both in relative and absolute terms.

Secondly, taxable income remains very strong at $1.93 per share, driving undistributed taxable income to $2.18 per share, our highest level ever. Lastly, we did repurchase some stock during the brief period in November, when our shares traded at a significant discount to book and we remain committed to repurchasing shares again in the future when conditions warrant.

With that, let me quickly turn to slide 7 and discuss what happened in the markets during Q4. As you can see on the top left, the five year and ten year treasury and swap rates increased between 9 basis points and 14 basis points. Prices of mortgage-backed securities clearly weakened during the fourth quarter as well. Interestingly, the highest coupons where AGNC has almost no exposure were the worst performers despite the fact that they should have been the least impacted by higher interest rates. The weakness in these coupons was widely attributed to faster prepayments driven by the continued success of HARP 2.0. The prices of lower coupons also dropped more than what would have been implied by the changes in treasury or swap rates. And this was the key contributor to the modest decline in book value during the quarter.

With that, I’d like to turn the call over to Chris to discuss our asset selection in the portfolio.

Christopher J. Kuehl

Thank you, Gary. QE3 has driven outperformance and lower coupon MBS. But as Gary just mentioned, it’s also responsible for extremely attractive implied financing rates through the dollar roll market. Dollar roll is simply a transaction where you simultaneously sell and agree to repurchase a TBA mortgage with the same term, coupon and issuer, but for a later settlement date.

And the price difference between the current month settlement date and next month settlement date is referred to as the price drop which is the economic equivalents of the net interest income earned for holding a mortgage security on balance sheet and financing that with repo.

At the bottom of this slide, we have a table that illustrates the financing advantage of rolling our position versus funding a mortgage security with repo. In this case, as of December 31, the price drop from January to February on a 30-year 3% TBA was a little less than a quarter of a point. In other words, the market was willing to pay, $0.24 more for January settlement versus February settlement.

Embedded in this price drop is an implied financing rate and you can solve for this rate given a dollar price and a prepayment speed. In this case, the implied financing rate is negative 20 basis points at two CPR, which is approximately 60 basis points lower than where the full could have been financed on balance sheet via repo.

Clearly, these financing difference are worthy of significant consideration if they are likely to persist and given that the Fed’s mortgage purchase program is a key driver of these dynamics, we believe that these financing opportunities should remain in place for most of 2013, which makes them very difficult to ignore. To this point, the implied financing rate on dollar rolls since year end has actually improved significantly and is now even more compelling today than it was during the fourth quarter. For instance, the implied financing rate on 30-year 3s is now around negative 50 basis points, which again is approximately 90 basis points through one-month repo.

So to summarize QE3 has led to tighter spreads on lower coupon MBS versus interest rate swaps. But when you overlay the extremely attractive financing rates available through the roll market, current margins are actually wider.

Let’s now turn to the next slide to discuss our portfolio composition. On Slide 9, you will notice that we’ve added another portfolio composition chart in the middle of the page, which includes our net forward TBA position, as of quarter-end it’s approximately $13 billion.

Now, moving down to the tables at the bottom of the page, you can see that the portfolio remains well positioned against prepayment risk with the vast majority of these positions backed by loans with lower loan balances or loans that were originated through the HARP program. And while the aggregate percentages within each category haven’t changed that much over the past few quarters, we have been upgrading some of these positions to subsectors of the market with better attributes.

For example, within the HARP category, which includes loans with LTVs over 80%, we sold a significant amount of the holdings with LTVs between 80 and 95 versus adding some higher LTV pools. This is important, because the higher LTV loans will remain very difficult to refinance even against the backdrop of an improving housing market.

I would also like to highlight that our prepayment speeds remain well contained post QE3 coming in at 11 CPR as of January and slowing to 10 CPR for the most recent release this past Wednesday evening. It’s also important to recognize that these speeds would be even lower if our TVA position was on balance sheet, since it’s largely comprised of low coupon, 30-year 3% and 15 year 2.5%.

Turning to slide 10, we have the familiar graph of turning prepayment performance of several types of 30-year 4% versus more generic MBS. We did further breakout the 80 to 90 LTV HARP subset to show how the lower LTV picking up. As I mentioned earlier, we have been reducing our exposure to some of the lower LTV HARP categories in both 3.5% and 4%.

I am not going to spend much time on this slide, but you can clearly see that prepayment speeds remain contained on the lower loan balance and higher LTV HARP securities and we expect that this will continue.

Now I will turn the call over to Peter to discuss our funding and hedging activities.

Peter J. Federico

Thanks, Chris. Today, I will briefly review our financing and hedging activities during the fourth quarter. I will start with our financing summary on slide 11. Our repo funding cost totaled 51 basis points at quarter-end, a slight increase from 46 basis points the previous quarter. The higher funding cost was due to both normal year end balance sheet pressure as well as our continuing effort to extend the maturity profile of our repo funding.

The average original maturity of our repo funding increased to 181 days, up from 141 days the previous quarter. Importantly, we continue to have good access to longer term repo funding. By quarter end, about 7% of our funding extended beyond a year, up from 2% the previous quarter.

Looking ahead, we see encouraging signs in the mortgage repo market that we believe will lead to slightly lower funding rates in 2013. These factors include a general easing of balance sheet constraints following year end, the end of operation twist which pressured dealer balance sheet and finally the Fed’s ongoing purchases of mortgage-backed securities.

Turning to slide 12 and 13, I’ll review our hedging activity. On slide 12, we provide a break-down of our swap and swaptions portfolio. Our pay fixed swap portfolio totaled $46.9 billion at quarter-end, a decline of $2 billion from the previous quarter-end. During the quarter, we terminated $3.7 billion of short maturity swaps that will have a little value in terms of their ability to offset fluctuations in the market value of our assets.

We’ve replaced these swaps with $1.7 billion of new pay fixed swaps, which had an average maturity of 8.7 years, considerably longer than the one and two year maturity swaps that we terminated. We also significantly increased the size of our swaption portfolio during the quarter. At quarter-end, our swaption portfolio totaled $14.5 billion, an increase of 70% or $6 billion since September 30.

The swaptions we purchased had an average option term of 1.7 years at an average underlying swap term of almost 8 years, largely as a result of QE3; the price of these options was extremely low by historical standards, making it an attractive time to add to our portfolio, and to purchase the protection for a longer period of time. Since year-end, prices have remained low and we have grown our swaption portfolio to its current size of just over $21 billion.

On slide 13, we’ve summarized our treasury and TBA positions. At quarter-end, our treasury position totaled $11.8 billion, up from $7.3 billion, the previous quarter. Finally, as Chris mentioned, our TBA position was long $12.9 billion at quarter-end. Taking together our hedge position including the effect of our long TBAs, covered 80% of our liabilities, up from 76% the previous quarter.

Lastly, I will review our duration gap on slide 14. Our duration gap at year-end was negative 0.2 years. During the quarter the duration of our assets increased to three years from 2.3 years the previous quarter, as prices fell and mortgage yields rose. Mitigating some of these expansions, the aggregate duration of our liabilities and hedges increased to 3.2 years from 2.9 years the previous quarter. Given the generally low level of interest rates and proving economic fundamentals and the extension risk inherit mortgage assets, we believe our current hedging activities are prudent from an interest-rate risk management perspective. Looking ahead, we will continue to actively manage our hedge portfolio adjusting both the size and composition as market conditions want.

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

Gary Kain

Thanks Peter. Before I turn the call over to questions, let me just quickly say a few things about the business economics slide on page 15. First and most importantly, given the earlier discussion about our off-balance-sheet TBA positions, this slide is considerably less constructive than it has been in the past. The effective asset yield, the cost of funds, and our leverage which drive those calculations, ignore any impacts from the TBAs. Additionally, as we have mentioned consistently in the past, the cost of funds number excludes the effect of our swaption and treasury positions, as well.

So with market conditions and our current investment strategies remain in place for an extended period of time, we will look at revamping this page to make it more wholesome. But for now, we thought it was preferable to remain consistent with the prior quarters.

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

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question will come from Joel Houck of Wells Fargo. Please go ahead.

Joel J. Houck – Wells Fargo Securities, LLC

Thank you. Good morning. I guess the first question is related to the spread differential from the TBA positions at the end of the quarter, it’s 22 basis points. How should we for modeling purposes think about that in 2013? I think you also made comment you believe the strategy is sustainable. However the relative advantage has also improved. So is it one of those things where 20, 22 basis points will have a starting point and we build from there. How should we think about it?

Gary Kain

No, well, Joel, it’s a good question and obviously relevant. I think what you’re refereeing to, are you referring to the difference in the kind of net interest, quarter end net interest spread.

Joel J. Houck – Wells Fargo Securities, LLC

Yeah, the 139 versus the 161 including the TBA.

Gary Kain

Right. So look, what’s going to happen there is, it’s going to depend on a number of variables, right. And you obviously alluded to one which is how attractive is the dollar roll financing assuming the dollar roll position remains the same size, right.

Joel J. Houck – Wells Fargo Securities, LLC

Right.

Gary Kain

The other thing, the other key variable is going to be just how big is the TBA position, let’s say, relative to the on balance sheet position and let’s be practical, both of those are going to be – could vary meaningfully during the course of the year.

So what we would say and I just want to reiterate what Chris mentioned is that, we do believe when it comes to the dollar roll situation, dollar rolls have been special in the past and plenty of times you look that as you ignore them, but what’s fundamentally different here is the driver is very straight forward, its QE3 and the Fed is having a very material impact.

Even the dollar roll levels could remain special even after that program is done given the amounts that the Fed is purchasing, and it’s going to be absorbing in the lowest coupons. And so we feel that these favorable financing levels are really likely to be in place. Now, they are going to bounce around to be negative 20, could they be zero, could they be negative 50, where they are right now or if they go to negative 70, they could be in all of those places, but I think we are pretty confident that if you look at over the course of this year, they are going to be very special using the term that people use in the market and financing is going to be attractive.

So I would say, look you always have more ways when you model anything, we don’t know where our repo rates are going to be and there is variability there. It is clearly more variability in the case of where the dollar roll levels are going to be, in spite we do believe they are likely to be again well through repo rates for the entire year.

Joel J. Houck – Wells Fargo Securities, LLC

Okay, that’s helpful. And if I could just one more and I’ll jump off. I kind of noticed the substantial increase in the swaptions portfolio, almost triple currently from where it was 9.30. I mean, that’s you guys have always been obviously used swaptions where it’s having, but is this, how should we look at this, is it a huge signaling effect, did you think there’s a substantial risk that rates could move materially higher over the course of the year and how should we think about that?

Peter J. Federico

Hey, Joel. This is Peter, I wouldn’t look at it as any sort signal. It’s consistent with the way we’ve approached our portfolio in the past. It’s just the combination of what hedges do we like in what environment, and in this particular environment, we’re particularly attractive to swaptions given the cost profile of the option. I mean a real benefit from the Fed is that they reduced interest rate volatility to the point where options that we’re buying today are at historically low prices.

So we just think it’s a really good time to buy options and I’m confident that we continue to point out that there is a lot of extension risk in mortgages and we will see some improving fundamentals in the economy. So rates have backed up some, but we certainly want to be prudent about hedging for higher interest rates, and we think options would be a valuable tool if rates backup anything meaningfully.

Joel J. Houck – Wells Fargo Securities, LLC

Okay, that’s helpful. Thank you very much.

Gary Kain

Sure.

Operator

Our next question will come from Bill Carcache of Nomura. Please go ahead.

Bill Carcache – Nomura Securities International, Inc.

Thanks very much. Good morning guys, so it sounds like the opportunity that’s a dollar rolls are providing certainly very attractive, just trying to understand Gary, whether it’s reasonable to expect a scenario where dollar rolls and kind of help you carry through this kind of period of where spreads are being kept efficiently tight, up until the point where the Fed exits, let’s say at that point, maybe the 10-year gets back up to kind of just a bigger range call it 225, 250 level, and now does that get us back into potentially kind of a Goldilocks environment that you’ve talked about that in the past, where could potentially there is a reasonable scenario, where you kind of get through all of this, without having to actually cut the dividend, could you talk about that top assets and I guess, can you talk about the reasonable and something like that being possible?

Gary Kain

Look our future performance is obviously going to be a function of the market conditions and how they are formed. We would say to your first point is and really just to reiterate what Chris said in his comments mortgages have tightened 10 to 20 basis points depending on where you look, and how you want to form, how you evaluate it, but the financing opportunities have improved if you go to the TBA markets more than 50 basis points, and across some of the coupons. So when you look at that to your point about kind of navigating through QE3, if QE3 lasts a long time mortgage spend will tighten, it will elevate prepayments. It would generally keep your returns, but on the other hand the financing opportunities should remain in placed longer-term, in which case you’ve lost, if they were to last for 10 years, you would have lost 10 or 20 basis points, but made 50 in financing, that’s unlikely, but to your point during the period of QE3, there is a very good offset, and you could argue even kind of an improvement if these dynamics stay in place.

What we have to navigate and what we have to keep in mind is when it goes back to the question about hedging, we are cognizant that there are two possible scenarios over the course of 2013 or over the next six to nine months, let’s say one is that the economy doesn't really pick up, this is another kind of false start, and the Fed stays with QE3 well into 2014, that's a very, very realistic possibility, we do need to be cognizant about there is a potential for that, and then the other one it goes to the hedging side of it which is – there is also possibility that the economy does continue to pick up momentum, it picks up significant enough momentum that towards the end of 2013, QE3 is a thing in the past and we've got to be positioned to able to navigate both of those positions, and those outcomes, and I think that's what you're seeing us doing.

Bill Carcache – Nomura Securities International, Inc.

Okay thank you that’s really helpful, and I now switching gears, can you share your thoughts on the Mortgage Refinance Legislation that Boxer and Menendez introduced yesterday, it seems like some of the controversial provisions were dropped last year and they remain out of this version, but – I just hope you could share any thoughts there?

Gary Kain

Really nothing new, I think we've talked a lot about it, we really just don't view policy risk as being a material issue at this point, I mean there is always risk on that front, but we would say again, that when you sit there and think about the risk, either on the pre-payment front or kind of an aggregate policy risk at this point is pretty low down on our kind of radar screen.

Bill Carcache – Nomura Securities International, Inc.

Okay, thanks very much.

Operator

The next question will come from Douglas Harter of Credit Suisse. Please go ahead.

Douglas Harter – Credit Suisse

Thanks, just one thing you could talk about sort of how you get comfortable with the TBA position, should we go down the scenario, where the economy doesn’t improve rates falling and pre-pays pick back up?

Gary Kain

Hi, great question. What I would say there is that is something that’s always led us in the past to launch best buy the collateral to make sure we’re protecting in that environment. But in the environment where rates stay very low, we’ll go lower from here. I mean we are highly confident that QE3 will stay in place for a longer period of time, which will mean these financing differences will stay on place and those coupons will be extremely well supported and perform better than they theoretically should given their prepayment protection.

And so this is exactly what in a sense our investors are paying us for, which is to figure out the differences between this environment and last years environment and the year before that. And so in our minds when we think it through the equation and the trade offs are different this time and they are different because the QE3 and the communication we’ve had from the Fed about how long it will stay in place. And so we see in those lowest coupons, we see very, very huge scenarios where in 3% coupons, we’ve specified prepayment protection will outperform generic mortgages.

Douglas Harter – Credit Suisse

Great. And then I guess just staying on the TBA’s, so I mean how you think about sort of the sizing of that position relative to – on balance sheet if this is more attractive one, bigger, how do you think about the size constraints?

Gary Kain

That’s a good question. And the short answer is there is plenty of room for it to increase our offer where it was at the – we’ll say at the end of the year. We also have to keep in mind, while going back to your first question, there are scenarios where we might want to go back to specified pools. Again we’re not sure on those coupons, but maybe in other coupons. And so you want to have a balance between taking advantage of these opportunities, but also being able to have other positions and not be in a situation where you have to do really big kind of allocations.

So there definitely is much more capacity in the dollar roll market, our positions are a tiny fraction of what’s going on there. So there is considerably more capacity, but I don’t think you should sit there and expect us to have more than half of our position dollar roll even if the numbers were attractive.

Douglas Harter – Credit Suisse

Okay, thanks Gary.

Operator

Our next question will come from Steve Delaney of JMP Securities. Please go ahead.

Steven C. DeLaney – JMP Securities

Thanks, good morning Gary.

Gary Kain

Good morning. How are you doing Steve?

Steven C. DeLaney – JMP Securities

Fine, thanks. The two things I noted in the press release, I just like you to probably comment on, first I noticed you did use your buyback plan and spend about $80 million and acquired the stock, it looks like about 92% at year-end book value which I think is certainly proper use of capital in an uncertain mortgage market. The other thing, I noticed in clocking back to last year’s fourth quarter press release when you were in a position to give some guidance as to the 2012 dividend rate, this year that was – you did not do that so, we were somewhat expecting some possible comment there.

Then noting that, you certainly have an ample reserve in UTI, but tying those two points together, it seems to me this year has the potential to be fairly volatile regarding the uncertainty around QE3 and the sort of backing off, the fall out or any back off as I said, are in the agency mortgage market and directly then impacting the agency mortgage REITs.

As the Board considers dividend policy, is the idea of having a work shaft of excess capital or let’s say excess capital or let’s say excess distributable income. To have that available for opportunistic stock purchases if we were to get the stocks trading down below 90% of book or something like that. Is that something that is in the discussion as you weigh whether to pay out a cash yield that’s already well above average or whether you hold on to a [work shaft] and reward your shareholders with very accretive buybacks. Thank you.

Malon Wilkus

Sure. Look, I think when – and just first on your first point on its own, we announced a buyback we were serious about it and we put a plan in place that was executed on and we would do the same thing in the future if the conditions were renewed. And we look at that as we’ve issued accretive equity in the past and we should buyback our stock if that’s a significant discount to book in most scenarios and I think the investors should be counting us doing that.

With respect to the dividend and undistributed taxable income, what I would say is there is no one factor with respect to the dividend that management and the board will look at. The reality is the undistributed taxable income, we feel does give us quite a bit of flexibility, but we also have to consider what’s going on in the market, what our earnings potential looks like, what our leverage is, and what’s happening to book value in particular. So we look at all of those factors and when we put all that together what I would say is, what I said in my prepared remarks which is we didn’t feel like any other announcement was necessary at this point and that’s something that we have to continuously revalue it.

Steven C. DeLaney – JMP Securities

Got it. Okay, so we will find out about the first quarter dividend when you normally would announce that in the middle part of March? I think it’s what you’re suggesting, Okay. Just one if you could, one follow-up, could you give us a little color on market pricing changes since year end, I mean we sort of see the generic 3.5, 4 down a point or better or more, and it seems especially recently these payups, a lot of people are – the markets kind of think maybe prepay protection isn’t worth as much, or it’s not as necessary as it was a couple of months back, so any color you could give on the market would be helpful?

John R. Erickson

Yes, payups have come off a little bit since the beginning of the year. But generally speaking, prepayment risk is still very much a material risk in this rate environment. And so specified pools for us as you can see in our portfolio composition are going to continue to serve an important purpose in the context of both risk management and returns, but there has been, mortgages have weakened somewhat to Gary’s point earlier and payups have come off a little bit as well.

Steven C. DeLaney – JMP Securities

And just going back to what I said earlier, right, it’s very dependent on the coupons right, where you see that value and I think that…

John R. Erickson

Yeah. Our mindset on specified is somewhat different than it has been. And there are places where we feel it’s very, very important, you can’t be in higher coupons where there is substantial prepayment risks even irrespective of 25 basis points one way or the other rate, but on the lower coupons, its actually hard to pay for that protection. And so I think what you have is, these markets change and we have always stressed to investors that we need to be flexible on whatever we did a year ago, or did two years ago or three years ago, it’s not necessarily what is appropriate for the new market, and what I would just – I think there are parts of the specified market we’re not very interested in and there are other parts we are extremely interested in. So hopefully that answers.

Steven C. DeLaney – JMP Securities

Yeah, that’s helpful and I appreciate the comments. Thanks, guys.

Operator

The next question will come from Mark DeVries of Barclays. Please go ahead.

Mark DeVries – Barclays Capital

Yes, thanks. I have a follow-up on those questions, the interest against your perspective on the near and intermediate term outlook for rates and mortgage spreads and how you think your portfolio may perform in that?

John R. Erickson

I think the short answer is that, we’ve given QE3 and given kind of the overall economic environment. We actually – our base expectation is we’re not going to see a huge amount of movement in rates at this point. But as Peter talked about and as we’ve always said in the past, we’re not going to know before, there is going to – two weeks before, there’s a big movement, so we are going out of our way to make sure, we feel like our portfolio is positioned to be a handled sizable moves in either direction.

So that’s the starting point. do we really think something is going to happen? Probably, not, but again, it’s our job to position the portfolio to manage either of those scenarios. On the mortgage front, the base assumption is unless something changes, which is the economy really heating up, the Fed is likely to – the absorption from the Fed’s QE3 program is very likely to be driving mortgage fronts tighter from here.

And so there’s obviously a chance if the economy really heats up critically that they will exit earlier and mortgage spreads will be under pressure in that environment. But the more likely scenario is that the Fed’s absorption right now is so high that mortgage spreads could be materially tighter three to six months from now. And we are as worried about being, or maybe more worried about kind of being positioned for that environment right now.

Mark DeVries – Barclays Capital

Okay, that’s helpful. Let’s have a follow-up on your comments around your report settling TBA position. Is it reasonable for us to assume if dollar rolls spread even more successful than they are right now that you would look to size that up?

Malon Wilkus

Yeah, I think that that’s reasonable. We have plenty of capacity on that front and what I would just reiterate more Chris and they are materially more special today or they have been over the last month, let’s say that they were at year end.

Mark DeVries – Barclays Capital

Okay, got it. And then just one thing, are there any complications into the REIT roll we will be need to be aware of for participating in dollar roll market?

Malon Wilkus

No, I mean basically you do that’s obviously keep track of your whole full percentages and TBAs forward positions really don’t contribute to the whole full percentage. But from the perspective it’s a good REIT income and we are – so there are things you have to keep in mind, but the short answer is there is plenty of capacity to be involved in the dollar roll market.

Mark DeVries – Barclays Capital

Okay, got it, thanks.

Operator

The next question will come from Bose George of KBW. Please go ahead.

Bose George – Keefe, Bruyette & Woods, Inc.

Hey, good morning. Just a couple of follow-ups on the dollar roll market. I guess first sits on the accounting. When you recognize the gain, is that a marked gain and then it’s trued up when you settle the purchase, I was just curious how that works?

Malon Wilkus

I’m sorry, can you repeat that.

Bose George – Keefe, Bruyette & Woods, Inc.

Just the – when you enter into the transaction, the gain that you are recognizing in any given quarter, is that a mark-to-market gain that’s trued up later, I’m just curious like what’s falling through the income statement?

Malon Wilkus

Sure, so the TBAs are just treated as derivatives and mark-to-market. So the TBA position is basically mark-to-market on a monthly or daily basis and quarterly. And so, you’ll get a price change and that’s what flows through the other income line is that, these are basically just fully mark-to-market.

On the other hand, what we cut out in this dollar roll estimation is just really the price difference between the current settlement and the future settlement, so it's only what we singled out in that 29 basis points – or $0.29 is just the difference between the current month and the future settlement and it's not a full mark-to-market. Does that make sense?

Bose George – Keefe, Bruyette & Woods, Inc.

Yeah, that makes sense. Thanks. And then actually I’m switching to the capital side of doing this, I mean should we think of it from a capital perspective that you're holding on balance sheet capital for this, so we should now look at your whatever pro forma leverage?

Gary Kain

I mean look, it's interesting because not only we're getting better financing, but higher costs were margin requirements for TVAs are actually lower than putting something on repo, plus you don't have the drag in terms of prepayment timing differences. So it's actually much being involved in – from a TVA perspective actually has lower counterparty risk and in a sense lower capital requirement, but absolutely the reason we discussed and I want to be very clear about this, the reason we highlighted what we call our average leverage or leverage including the TVA positions and we don't want people to understate kind of the aggregate exposure.

John R. Erickson

The only thing I would add to that is just with the exception of the one month rolled cash flow, which you've reduced that risk, but you have all the same risk exposure that you would ordinarily have to be underline MBS with non-balance sheet finance position, spread risk, duration convexity. So you should think about it as the effective leverage.

Bose George – Keefe, Bruyette & Woods, Inc.

Okay, great. Thanks a lot.

Operator

The next question will come from Daniel Furtado of Jefferies. Please go ahead.

Daniel Furtado – Jefferies & Co.

Good morning, Gary. Congratulations on another good or perhaps I should say more special quarter by you and your team. The first question I had is, in regard to the potential issuance of GSC credit securities, I know there are a lot of unknowns at this point, but would only need securities be within your charter, and if so would you imagine – or do you imagine you would participate in this program in the AGNC vehicle?

Gary Kain

The short answer is, we don’t believe that we would participate in purchasing at this stage of the game in AGNC, purchasing credit, tranches from the – or kind of a security that has kind of the embedded credit exposure from the GSC. This vehicle AGNC it’s not kind of – it’s not in its real house.

Daniel Furtado – Jefferies & Co.

Understood, thank you. And my second question is another hypothetical, in looking further out to the Fed exit from the MBS purchase programs, what are my concerns is that most mortgage REITs are predominantly hedged by interest rate derivatives. However, the technical selling pressure from a Fed exit of MBS purchase activities could potentially result in a situation where asset prices sell off meaningfully where rates take longer to move commensurately higher leaving portfolios unhedged for a period of time. Do you think this is a material concern and if so what strategies do you envision hedging against that risk?

Gary Kain

I will start now and see if Peter wants to add anything, but what I would say is look, mortgages are going to outperform hedges at some point of time, so underperform hedges in some point of time. I think there are two things to consider with respect to your scenario where interest rates or the expectation is the Fed is going to stop QE. One is that the Fed is buying both treasuries and mortgages and they are buying a lot of duration. So when it’s clear, the Fed is going to exit the mortgage market. You are likely to see a pretty sizable move in the [rates] market as well.

So I don’t think they are likely to be uncoupled. That being said, mortgages still could fall a lot quicker than the treasuries and swaps, and the way we are trying to deal with that potential is by at least being as we think much closer to fully hedged. And so you are always exposed to spread widening and that’s a nature of our business and we’ve really recognize we can’t lay that off, right but we can lay off the component that’s correlated with rates and we can manager our leverage such that we can handle very large spread under performance by mortgages and that’s really the position that we are in.

But I do want to overlay one thing and what we have learnt in the mortgage market from actual experience is that, when the Fed exits, when they exited QE1, it’s a lot of the impact is not their flow, okay, it’s not what they are buying today, it’s how much they have absorbed and the Fed has absorbed a extremely large percentage of the lowest coupon longest mortgages. So I think there is another world or another reality which is after a period of a few weeks of kind of dislocations, you actually could see mortgages perform very well as the Fed has absorbed so much of kind of the incremental duration that’s in the mortgage market.

Peter J. Federico

And I will just add to it, I think your question is a good one and you are right, rates may or may not keep pace in the environment that you described, but what we feel pretty confident about is that the interest rate volatility in the marketplace or the market expectation for future interest rate volatility in that environment will certainly increase. And that’s one of the reasons why we like option based derivatives because those derivatives will gain value as the market starts to anticipate a lot of interest rate volatility and I think that is going to be the case when the market starts to pricing and exiting of the Fed. So we think this option portfolio will gain incremental value in that environment relative to swaps.

Daniel Furtado – Jefferies & Co.

Great. Thank you for the insight. I really appreciate and good luck again this quarter.

Malon Wilkus

Thanks.

Operator

Our next question will come from Arren Cyganovich of Evercore. Please go ahead.

Arren Cyganovich – Evercore Partners

Thanks. Just thinking of really basic view of the TBA positions given that they are forward settling transactions, will these 3%, $13 billion of 3% eventually make their way through the balance sheet, or there is some sort of hedge position that actually treat them more like an arbitrage?

John R. Erickson

They could, they are certainly – we can choose to take delivery on how to mentor our balance sheet and we have plenty of repo capacity to then turn them to on balance sheet assets. We could also swap them for other coupons. And so the reality is they could end up on the balance sheet. They certainly don’t have to in their current form, or in just TBA or generic form. But that’s sort of the – I think you have a lot of flexibility within the mortgage market to adjust them over time, you can again change coupon, you can change, you can upgrade it to a specified that we wanted to in the future. And so it’s hard to say exactly what will happen.

Arren Cyganovich – Evercore Partners

So is it more so then more of a kind of arbitrage on taking a long and a short position at the same time, and you just getting that spread there over a specific period, I mean what’s the risk in that trade, I guess this is kind of what I’m thinking about?

Malon Wilkus

I want to be clear is that, we are net long, okay. It is that we purchase these assets, that’s why you should look at the TBA position as increasing our effective or leverage okay, as we mentioned earlier. But the financing piece is what you should think about, you should think this as, we could choose to take in those 3% coupon mortgages and put them on repo at 40 basis points and earn a spread life of one in the example. More alternatively, we could delay taking delivery by rolling them out continuously or for certain period of time and get the equivalent of financing them at minus 20 basis points to 50 basis points kind of over the last few months.

And what we are saying is that clearly makes sense to go that route, if you believe that those roll levels kind of will persist for any period of time. And so that’s the way you really should think about the dollar roll piece of it is. You have exposure to the mortgage market, we would have the exposure to the mortgage market anyway and you really should at it as deciding, which way you finance it and because of the Fed’s outsized involvement in the market and their targeted purchases and specific coupons, there are technical factors that should persist.

Arren Cyganovich – Evercore Partners

That’s helpful. And I guess in terms of the Fed’s activity, once they decide to stop purchases, how long of it kind of a delayed impact, it sounded like there will be some sort of a lag effect in the TBA market. How long would that last?

Gary Kain

It’s hard to say. It actually could last a while, it could be a month or two, but look, I think the important thing that’s around the financing piece, the bigger question in that environment will be what’s happening to the price of the underlying and that goes back to the discussion on hedging and spread risk and so forth. So the financing has a decent chance to hanging around for a little while after that, but again the bigger issue in our mind is how we manage the price risk of the underlying in that environment.

Arren Cyganovich – Evercore Partners

Okay. And then just kind of back on may be accounting of this in the tax, is this drop income considered taxable income for dividend…

Gary Kain

Yes. Yes. So it is considered taxable income, as good REIT income and essentially it’s recognized at the time when you settle the transaction. So if you would originally purchase something for February, you get to February and if you hold that to March, then you are recognizing it in the month that it would have, the original transaction would have settled. And so actually I mean it ends up within a month or so or a couple of months being all realized taxable income.

Arren Cyganovich – Evercore Partners

Okay. And then lastly, the example that you use in slide 8, has a CPR for the assumed life of 7%, for this 3% 30-year. That seems pretty low I guess that just prices in the assumption of extension risk, given where rates are today?

Christopher J. Kuehl

Yeah. You have to remember that these are 30-year 3% exactly these are 30-year 3% pass throughs with an average coupon or null rate of around 360. And so the seven CPR is just based off of our model to a forward curve. So there is not a lot of, to your point in today’s rate environment, there is not a lot of incentive for these borrowers to refinance.

Arren Cyganovich – Evercore Partners

Great, thank you.

Operator

Our next question will come from Ken Bruce of Bank of America. Please go ahead.

Kenneth Bruce – Bank of America Merrill Lynch

Thank you. Good morning. First thank you for the discussion around the TBA activities, it has been very helpful. And your disclosure is always excellent so I look forward to the enhancements there, I guess one follow-on question, just as we hear a lot of discussion around some of the changing collateral requirements, does that impact the dollar roll market or is that impacted by the dollar roll market, could you discuss those assets please.

Christopher J. Kuehl

We don't anticipate any changes to kind of collateralization, any material changes to collateralization of the forward TBA positions, again their margins as it is right now and those margins in it's on, basically equivalent of an exchange, and so what ends up happening is that could those margin requirements go up by a 1% from 3% to 4% something like that; yes, but realistically they are still noticeably below, where repo haircuts are for – mostly and for a couple of months repo, and again you don't have that pre-payments delay, which essentially increases your effective repo haircuts, so there's plenty of room, if they were to go up, and we don't envision any kind of material changes there.

Kenneth Bruce – Bank of America Merrill Lynch

Okay and just, maybe you said it earlier, and I just missed it, that as you look at what the changing hedge requirements would be because of a larger TBA, a larger forward purchase part of your portfolio, how would you envision that? Would that be more through swaptions or how would you just manage the different risk of a TBA, an ultimate TBA investment versus your traditional spec pool investments?

John R. Erickson

Well it's like Chris said and Gary said earlier we view the TBA position as having the same risk profile from an interest rate risk position, whether it be on the balance sheet or off balance sheet, so we treat the two similarly from a hedge perspective and we will continuously and dynamically change the way we hedge a portfolio in terms of the to the hedge composition, really just based on market conditions and the price of different options and hedge vehicle. So we look at them similarly and we look at it comprehensively from an interest rate risk management perspective.

Kenneth Bruce – Bank of America Merrill Lynch

Okay. And lastly there’s been some recent chatter about trying to have DeMarco replaced yet again. Any thoughts around that notwithstanding your earlier comments about just the general redress that you see?

Malon Wilkus

I think – look, it’s certainly a possibility I think the hard of him being replaced or probably come down versus they where were a few months ago. But I don’t think we have any great insight as to the odds. What I would just say is, we think that it’s really not something that we view is being a big of a risk to the prepayment landscape and certainly to our portfolio.

Again the main things that are kind of being discussed wouldn’t have that material impact, really wouldn’t have a material impact on the performance of agency, securities things like the principal write-downs or more for delinquent loans that have already been pulled out of pools for the most part. So there is really not a lot of risk on that front.

And again, we really don’t have the HARP 2.0 exposure, so things like the Menendez Bill and they came through when really wouldn’t impact our portfolio. So the bottom line is irrespective of we’d like to see him remain in office because I think he is doing a really good job in a very difficult position. But from the perspective of managing the business, we really don’t see it as being a huge picture issue.

Kenneth Bruce – Bank of America Merrill Lynch

Okay. That is it. And for what it’s worth I thought your discussion around the impact of the TBAs on your traditional metrics was very helpful. So thank you.

Malon Wilkus

Thank you. I appreciate that.

Operator

Our next question will come from Steven Laws of Deutsche Bank. Please go ahead.

Stephen A. Laws – Deutsche Bank Securities, Inc.

Hi, congratulations on the 30% plus economic return last year. I appreciate the color on the dividend outlook as well as the TBAs. I guess I just want to make sure I get a grasp of the different comments on the TBAs and have these correct as most of my other questions have already been addressed. But so recap it doesn’t qualify against the whole loan pool, it is good REIT income, lower haircuts and margin requirements. It does qualify its taxable when it’s settled to go forward and otherwise if you take delivery on the balance sheet as it been simply an unrealized positive market and not consider taxable distributable income until that gain is realized?

Malon Wilkus

Yeah, that’s correct. If you end up taking delivery, then you are going to have it on balance sheet asset with a basis.

Stephen A. Laws – Deutsche Bank Securities, Inc.

Right, so until you realize that gain, it would not effect the taxable income?

Malon Wilkus

Correct.

Stephen A. Laws – Deutsche Bank Securities, Inc.

Outside of those things, is there anything else you need to consider from the income or asset or REIT requirements that might be of note?

Malon Wilkus

Not that I can think, sorry.

Stephen A. Laws – Deutsche Bank Securities, Inc.

Okay, great, thanks for letting me on the call. I appreciate it.

Malon Wilkus

Thanks.

Operator

And we have time for one more question and it will come from Chris Donat of Sandler O'Neill. Please go ahead.

Christopher R. Donat – Sandler O'Neill & Partners LP

Hi, thanks for taking my question. Just one last one on the roll market here; can you talk a little bit about the competitive landscape, the barriers to entry of others getting in, because I would think that our hedge funds or other mortgage REITs or other players in the market see the kind of returns and at the risk, you are doing it, that might sort of takeaway some other profit opportunity, but could you just give us some color there, especially given the size of the market?

Malon Wilkus

The size of the market is really huge and the coupons that we are participating and especially like the main 30-year 3%. Look, no one knows the specific open interest in the coupons that get rolled, but hundreds of billions of dollars is, it’s clearly in that zip code. So realistically, when you look at the size of the Fed’s activities, this is the market that it’s huge. You’re looking at, monthly issuance in those coupons across Freddie, Fannie and Ginnie like 70-ish type billion or more.

So, realistically, we think those markets are extremely deep. And just to give you a couple examples, I mean, you can do $5 billion to $10 billion in a day at these, where we’ve done a $10 billion roll trade where you’ve got, where we’ve gotten favorable financing in one particular transaction, there are a plenty of times you can do $5 billion or more billion in the day without moving the market.

So I think the reality is, this market is much deeper than we are, and I think a lot of people are already participating in it. And we’re not – we’re focused on making the right decisions and communicating correctly, appropriately with shareholders and we’re not really concerned about the competitive dynamics.

Christopher R. Donat – Sandler O'Neill & Partners LP

Okay. Thanks very much.

Operator

We have completed the question-and-answer session. I would now like to turn the conference over Gary Kain for concluding remarks.

Gary Kain

I just want to thank everyone for participating on the call, and we look forward to talking to you our next quarter. Thank you.

Operator

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 February 22, by dialing 877-344-7529, using the conference ID 10024358. Thank for joining today’s call. You may now disconnect.

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