American Capital Agency Corp. (NASDAQ:AGNC)
Citi US Financial Services Conference
March 06, 2013 02:10 PM ET
Gary Kain - President and CIO
Thanks for coming to the presentation and for your interest in AGNC.
So, first if we look at just a quick overview on page five of AGNC, what you’ll notice is that agency IPO in May of 2008 which was a great time for an IPO, great year forward 2008. At a price of $20 per share, since then we’ve paid total dividends of $23.86 per share in just under five years that we’ve been public. And as importantly and this is really the key issue is in addition to paying those cash dividends we’ve grown book value over that same period and so book value per share our last disclosed book value is $31.64 per share at the end of 2012.
And so really it is and what we’ve stress with investors it is the combination of dividends, yes we’re high dividends stock or read and people focused on dividends for what space it is the combination of dividends and book value overtime that lead to total returns and we are focused on both components and investor should as well.
And the market capitalizations today is also grown from 300 million at IPO to over 12 billion as we speak and so, the stock is considerably more liquid and what we’re proud of is been the growth is great but the growth in it of itself has helped to not inhibit our actual performance. And, I think, this slide really goes to kind of the way we would, we ask investors to think about performance both with AGNC and kind of throughout the space and if you look at 2012, AGNC was able to produce 32% economic returns. And what we call economic returns is the combination of dividends and growth in book value or change in book value.
And importantly if you go back over the last four years, AGNC has been able to produce above that a 30% total economic return for each of those years and as importantly, if you compare, and again, these are mark-to-market numbers are in our portfolio is Agency Mortgage Securities, when you look at the comparisons versus our peers we’ve been able to significantly outperform our peers really over all four years again and so look a good quarter ends quarterly and performance matters but what’s really important is continued performance over the long run and I think we are proud of this history and we continue to focus and trying to optimize our ability to extract value from the mortgage market. And one key driver is really your ability to navigate the prepayment landscape and if you look at the graph on the bottom of this page in the bottom you can see that the line green line on top is the prepayments of the mortgage universe and way below that the bars represents AGNG’s monthly prepayments fees and for anyone who is newer to this space controlling prepayments fee the key to yield and key to return and you know by selecting the appropriate mortgage you can absolutely produce very different prepayment outcomes which can product very different total returns.
I am not going to go – I would at this point I’m going to turn to a slide eight and just quickly review a couple of things about the portfolio at the end of 2012. First of the portfolio was up to 85 billion in assets of which we also had forward purchase commitments in net TBAs of 13 billion, so all in you can think of our risk exposure as being 98 billion or kind of total portfolio size.
If you look at that total including the forward purchase commitments leverage was 8.2 times on balance sheet leverage was only seven times at the end of the quarter but again the at risk with leverage was 8.2. Our CPRs for the quarter averaged 10 and in the last month in the month of January they were 11% and then in the most recent month the February release they were backed down to 10%, so prepayments remain contained.
Importantly when you look at net spreads at the end of the quarter if you only looked beyond balance sheet portfolio you will be looking at the second bullet from the bottom 139 basis points when you include the income off of the TBA positions you would be estimating that at a 161 basis points. So, realistically when we think about the market going forward, we see an environment where obviously the FED has been a very active player in the mortgage market and the prepayments in the universe as a whole have picked up substantially but again our portfolio remains largely resistant to those forces and because of that we feel like we can continue to generate attractive returns.
If you turn to page ten, this shows you what’s happen to mortgage prices, kind of between from QE3’s announcement on September ’12 through the end of this month 2/28. And what’s interesting and this is one of the reasons why we were very comfortable with agency mortgage securities right now is kind of contrary to public opinion so to speak the prices of agency mortgage securities have not done that well, I mean they have improved in the lower coupons their lower in some of high or mid coupons. So, if you look at, the 73% coupon mortgages they have gone from 103 in the quarter to a little over 103.5 for 33 basis point improvement. The 3.5 are close to unchanged, they are up a little bit; the 4% coupons are actually down a quarter of point in price and the 4.5 so down the little less than that.
You will get the similar picture on the 15 year on the right side at the top right with the give or take a little bit largely unchanged. Now, interest rates have gone up a little bit so you would expect prices to be down not up. So, there clearly has been some positive performance but this is not dramatic outperformance and that’s on the back, you know and think about the environment that is creating this. That’s an environment where the FED is buying about 70 billion in agency mortgages a month and again the price improvement has not been that dramatic. So, why is that, we would attribute it to a few different factors. First, the origination volumes, as prepayments have picked up, origination volumes has also picked up and that’s to be expected whereas the FED’s purchases are largely fixed in terms of the amount.
Also, we've seen larger money managers reduce their waiting to agency mortgages after QE3 and so you’ve seen money managers in a sense sell mortgages into the FED and at the same time banks have been slower to re-invest than we would have expected and partly I think due to this overhang of well, if the FED buying so many they must be really expensive. But in the end when you look at the price performance and you think about how big the technical of the FED’s activity is. Over time we are still very convinced that mortgages have a lot, could be a lot more expensive than where they are today and so we feel like there is a fair amount of upside of in owning agency mortgages.
If you look at the middle of the page we show what’s happened to the price of specified mortgage falls and in particular a 110K average loan size mortgages and at different coupons, and as you can see in the lower coupons the payoffs or the premiums for those that dropped a little bit from Pre-QE3, but in the higher coupons were in 4s, they are actually up a little bit from then. So it’s kind of a mix picture there as well. So, when you look at the opportunity side in the mortgage market again, I think the key thing to take away from this is you are probably expecting to see mortgages so much more expensive than they were before that FED got involved and yes they are tighter. But it is not dramatic at all. Again our opinion is that they could easily improve from here.
When you look at page nine, I just want to kind of highlight one other thing that we are thinking about, that has impacted our portfolio, and that's why I mentioned TBAs and as having a material position in forward purchases of TBAs and it relates to the unique dynamics that we are seeing in the market created by the FED. And so as we just talked about on the prior slide, the agency mortgages are a little more expensive than they were before QE3, but there is a way to kind of leverage to get some of that value back with respect to improved financing on some of those purchases and so because the way the mortgage market works is originator such as Wells Fargo or JPMorgan Chase are locking, they are making new loans to borrowers, they are locking new mortgages two and three months forward.
And so they have a pipeline of new mortgage originations. They are hedging those pipelines so that they are not exposed to changes in interest rates or the mortgage market between now and two or three months from now when those loans lock and actually get delivered to Fannie Mae or Freddie Mac. So they hedge those by selling mortgages a few months forward.
Well at the same time, the at other FED and other banks and people that are buying or buying mortgages for today or in the current month and that sometimes creates an imbalance between the, where they supply two or three months from now and there is demand today. And because of that, I mean and this is not new in the mortgage market, what’s new is the magnitude of those differences and the fact that because of QE3 those differences are more likely to last for a longer period of time than they used to. They used to last for a couple of months here or there than they sort of be arbitraged away but given the size of QE3 coupled with the magnitude of the originations, we've already seen this stay in place for more than six months.
And so what ends up happening is that you are getting paid more to delay your purchases of mortgages and to help facilitate this short that’s in the mortgage market which is if you; people or dealers are having a problem delivering mortgages today. They would love to have you postpone your purchases and they will pay you to essentially wait to take your mortgages in. In theory what the FED would do that except that the FED is not an economic buyer and their goal is to put money into the system and so they want to take the securities in. If they get really-really crazy, they will roll their positions but they are going to wait, they have a very high hurdle.
And so what that’s allowed is that an opportunity for us to get implicit financing advantages by instead of taking pools in and putting them on repo, we can get paid to wait to take those pools in and the financing costs are implicitly negative. In other words, we get paid in this example in the bottom of page nine; we can get paid 24 basis points in price. The only way you could make, if you wanted to put that on your balance sheet and make the same amount of money, even assuming a 2% CPR with this slow speed, you would have to be able to get a repo rate of negative 20 basis points in order to make the same amount of money as delaying the purchase we're rolling it out into the future.
Clearly we are not going to get a repo rate of negative 20 basis points and it gets to be implied financing advantages in the dollar over market. Now I want to really caution investors that you shouldn’t go and sit there and say negative 20 for the next two years and assume that these financing rates will remain in place. So matter of fact they tend to be very volatile in the dollar role market.
A month ago, at our earnings call, they were probably negative 40 or maybe even a little better than that, going back a couple of months before that they were negative 10 negative 20, they're probably if we sit here today closer to negative 10 and I don't know where they'll be tomorrow but what I think is important to keep in mind, is that if they were to, we don't need them to be minus 20 for this to be compelling and positive 10, that's still a 30 basis point funding advantage versus funding on repo at 35 or 40 basis points.
So again expect some volatility in the dollar role levels but realistically we also at least had the option to put these securities on our balance sheet so even if the dollar role became so unattractive that it was worse than repo you wouldn't go and do the dollar role at a worse spread, you would just take the securities onto your balance sheet and finance them the generically.
So, it's something to keep in mind and it's a way where we can essentially extract some value from the FED to try to offset some of the negative effects of tighter spreads.
And then I just want to highlight on page 12, just to reiterate why it is that we've been able to kind of maintain the prepayment performance that we have and it really relates to the fact that we have a fair amount of our portfolio that's in both in 15 year and 30 year in lower loan balance and HARP securities and while we spent some time today and we spent time on our earnings call talking about TBAs and dollar roles, that's a relatively small component of our portfolio.
Our core portfolio is in somewhat higher coupons but also in prepayment protected assets and while we don't feel we need that prepayment protection in the lowest coupon, newest securities, you absolutely do need that protection in the higher coupons, and that protection is what's allowing us to maintain very slow prepayments speeds and to continue to produce the carry that we’ve been producing in the yields.
So, you'll know this kind of the composition of the portfolio is very heavily skewed. If you look at the 30 years, 40% of the 30 year position is lower loan balance, 48% is HARP and one thing to keep in mind is there's a lot of question about your bigger, can you continue to maintain a good well constricted portfolio and the short answer is, we still having a vast majority of our portfolio and value added securities despite our size. If you look at page 11 then I’ll stop and take question. But if you look at page 11 which you can see is how different the prepayments fees are depending on loan characteristics. So, if you look at the largest loans jumbo mortgages which are loan balances of in the 500 kind of average of over 500,000, that’s the orange line on top and if you look over the last three months that’s going averaging 50 plus CPR.
So, loan balance really matters. If you go to the TBA or generic 4% from 2011, you are in the mid-30s in terms of prepayments and those are average loan size that’s close to 275 to 300 and that’s zip code. Then you go to, let’s go down red solid line or the grayish, the other gray line at the bottom and what you’ll see from those two is those all are the average of HARP securities or lower loan balance securities and you can see despite the fact that these are all 4% of 2011, those prepayments are right around 10%. So, you can see that despite QE3 and really low mortgage rates the same strategies continue to be critical and continue to support the prepayment performance that we talked about earlier.
One thing I want to highlight is we’ve talked generally about prepayments on lower loan balance or HARP securities being favorable and they are but if you look at the dotted red line, I want to point out something specific to HARP securities. And again, what HARP securities are? They are the securities, when loans go through HARP 2.0 or the new HARP program, if the HARP program allows someone with a higher LTV above 80% to be able to refinance into a new Fannie or Freddie mortgage even though their LTV would generally make it difficult or impossible for them to do so. And so they can go through a completely streamlined underwriting process and they can qualify for that refinance whereas their LTV loan would probably make it difficult for them to. But it’s really important that loans can go through HARP program if they have an LTV or if they have 162 LTV but they pulled separately and their characteristics are very different, so the red line is the average of all the HARP securities going from 80 up to again the highest one which are around 170.
The red dotted lines are just the 80 to 90 LTVs and noticed that they’re already prepaying it 20 CPR, so double kind of where the rest of HARP securities are and so what you should take away from that is we’ve generally focused on these broader categories but within those categories there can be still substantial differences and prepayments and that’s what our team is focused on a daily basis not only looking at categories but within categories trying to position the portfolio effectively.
One of the thing, you should keep in mind with respect to the LTV of HARP loans is that it is important to keep in mind if the housing market continues to improve on 85 LTV can be a 75 LTV and even though the HARP program is a onetime program and you can’t go through it again that loan will go to being re-financeable kind of in the regular way with continued house price appreciation and it’s one of the reasons why Chris Kuehl who runs our agency portfolio talked about on our earnings calls how we were transitioning away from some of the lowest LTV HARP securities because given the strength in the housing market we’re concerned the increases in those prepayments on those LTV mortgages could pick up even from here.
So with that let me stop and open up to questions.
Gary, it’s interesting to see (inaudible) threshold highlighting mortgage REITs as I talk about sort of excess risk taking around the low rate environment from the FED’s action. When you read type of activity hereabout, how do you think about it and is there something that about mortgage REITS buying these assets and putting leverage?
That’s a great question and I mean clearly I think there it’s funny because what the government and you go back to the treasury’s white paper you know the government has wanted to bring private capital to the mortgage market and needs to bring private capital to replace the GSEs and to pick up some of the slack as too much of the mortgage market is sort of being taken down by government agencies or entities and when you look at the REITs, they have been the kind of cleanest source of capital to bring private capital to the mortgage market but look every time you look at, then people ask themselves okay good we are bringing capital here but this isn’t like the depository, they are not regulated the same way a bank is, is this the shadow banking system increasing the risk, one thing that’s really important to think about with respect to kind of REIT send systemic or systemic risk to the system, is it agency REITs operates at less than 10 times leverage.
The GSC portfolios operated at 40 to 50 times leverage and so what I think is really important to keep in mind is that the leverage employed by REITs in the private sector is about 15% to 20% of what was employed by the GSCs pre-crises and so you are accomplishing everything that policymakers wanted to accomplish. You are bringing capital to the mortgage market, private capital, you are doing it in a way with significantly less systematic risk and less leverage in the system and you are doing it in a way where the markets, the private markets are regulating the amount of risk of REIT or a private entity can take.
In order before people lend us money via repo they decide what our haircut should be which is essentially our capital requirement, they decide how much they are willing to lend us. They look over our portfolio to make sure they are comfortable with our hedging strategies and so in a sense, we are completely regulated by the capital markets which is the strongest regulator out there in our minds.
As a follow up to that, AGNC is exclusively agency securities but you also run a company that will invest in non-agency mortgage backed securities. I was wondering if you could sort of compare and contrast the return profiles you see of those different asset classes, short term and long-term?
Importantly, in the short term, let’s face it, returns on all fixed income assets have come in over the past few years and even over the past six to twelve months. And that’s true of both classes. I think the generic levered agency positions can still produce growth RVs, well north of 10%, if you are picking the right assets and even better than that if you are taking advantage of some of the financing opportunities we talked about. In the non-agency space you can still find value added investments that can get your returns like that. But those are not like generically available. You are going to have to be very picky selective and you are going to have to add those kind of assets at a very slow pace.
If you buy relatively generic non-agencies you are looking at returns south 10% at this point as prices have increased quite a bit. And look, you know, yes, we are more bullish like everyone on the housing market but a lot of that is priced in and so what we would say is that non-agency space remains attractive for the right assets but it’s much harder to kind of make just weight in the product at this point, in significant size. But I think more importantly around that question is what does the future look like? I think the future of the agency space is going to be a function of the FED’s activity. If the FED doesn’t stop really quickly, agencies are going to be pretty expensive three to six months from now.
And on the other hand the non-agency market is transitioning as well. And I think maybe one of the biggest misconception out there is that the non-agency space is immune to QE3 or it’s going to be the better place for returns over the next couple of years. First of the legacy non-agency space, the old subprime old day securities from pre-crisis are shrinking every month. They are either de-faulting their some prepayments, and that’s the shrinking universe that in a couple of years, it’s going to be very small and not going to be kind of a key driver of returns for a hybrid REITs. I think the area that’s more interesting on the hybrid side or in the non-agency side would be new credit risk opportunities either on jumbo loans and also via the GSCs and credit sales.
Now you can't kid yourself the opportunities in that space are pretty small today, the GSCs haven’t started selling credit. But I would say a year to two from now I think that’s going to be the key driver of the opportunity set for hybrid REIT. And so just keep in mind there is going to be a transition from what was subprime all day, the legacy products to kind of the new non agency products overtime.
Interesting, you mentioned housing improving. At some point the discussion will move into well if the FED rates, short term rates granted I think we almost will agree, it’s premature to talk about that and you have a nice window before they will raise but as you get closer to that point; what are some of the things you will think about and tactically what will you do to position for that and then how will that look for your company in terms of protecting book value and things of that nature?
The first thing I want to stress is we will get a fair amount of warning as to when the FED will actually tighten and to your point, I think that’s still ways off, I mean if you listen to the FED it’s at least two years off, or in maximum zip code and could be a lot longer. But I think what’s really important here is interest rate risk is the biggest risk we have face. And we can't take it lightly and investors should understand that, we won't know one month or two months before interest rates will go up all right and they could move quickly and they will start, they probably will start with the backend of the treasury curve, the interest rate curve of selling off; so five and ten year treasuries could spike higher in rates.
And again we are pretty good at happily managing our portfolio but people shouldn't confuse that with not only which way interest rates are going to go and for that reason we spent a lot of time on our last earnings call and have kind of consistently talking about the hedges that we employ. We have interest rates swaps that cover roughly 60% of our short term borrowings that essentially turned those borrowings into 4.5 year or weighted average maturity on the swaps. We also had 15 billion in swaptions which give us the right to enter into more swaps. If interest rates rise and those options are into swaps with an eight year average maturity, or almost eight year average maturity so that gives us quite a bit of protection on the back end of the curve which short over $10 billion in treasuries.
So what I want to stress is we have to protect ourselves now with respect to the backend of the curve, given the types of assets that we own and it's not something that you can just plan on timing perfectly, and so with those hedges, if we transition to a new environment where interest rates are quite a bit higher, we feel that we can continue to run our business the way we've run it before, we won't be de-levering and we think that there will be good opportunities in that environment because there probably will be some investors who will be caught offsides by a sizeable move in interest rates and we view it as the number one job of a management team is to kind of handle transitions in the marketplace. There we've had a couple of transitions on the prepayment side. We've had a transition to lower interest rates and we've had a couple pretty big pops in interest rates over the last few years and the number one thing for us is to make sure we remain on sites and we feel like we're well positioned for that.
The last quick question I had, we're almost out of time, we touched upon this earlier when we very talking Gary, HARP 2.0, do you think that could get extended or anything of that nature into sort of 2014, what are your views there?
I think it probably does get extended, there's really no reason for it to stop at the end of 2013, but again and there are other proposals about expanding it and the Boxer Menendis bill, what I would stress is look, the prepayment environment could get worse if interest rates fall again if fed continues QE 3 and a lower rate on the ten years at 150, but I think on the policy side we view policy oriented prepayment risk right now is at the lowest level that it's been since the crisis. You know our exposure in both of AGNC or MTGE to the HARP program and loans that are eligible are less than 2% or thereabouts of agency and none in MTGE, so the reality is, we're not exposed to those areas and again we're not seeing that prepayment risk is a thing of the past because it isn't and there could be environments where prepayments will become a big issue. We just think that, it's kind of the devil that you already know versus the devil that you don't know at this point.
Okay, great. With that we'll wrap things up. Gary, thank you. Appreciate our room talk.
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