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American Capital Agency Corp. (NASDAQ:AGNC)

Q1 2013 Earnings Conference Call

May 3, 2013 11:00 AM ET

Executives

Malon Wilkus - Chairman and CEO

Sam Flax - Director, EVP and Secretary

John R. Erickson - Director, EVP and CFO

Gary Kain - President and Chief Investment Officer

Christopher J. Kuehl - SVP, Mortgage Investments

Peter J. Federico - SVP and Chief Risk Officer

Bernie Bell - VP and Controller.

Hannah Rutman - Investor Relations

Analysts

Joel Houck - Wells Fargo Securities, LLC

Bose George - KBW

Jason Arnold - RBC Capital Markets

Henry Coffey - Sterne Agee

Merrill Ross - Wunderlich Securities

Arren Cyganovich - Evercore Partners

Daniel Furtado - Jefferies & Co.

Bill Carcache - Nomura

Douglas Harter - Credit Suisse

Operator

Good morning and welcome to the American Capital Agency First Quarter 2013 Shareholder Call. All participants will be in listen-only mode. (Operator Instructions) After today’s presentation there will be an opportunity to ask questions (Operator Instructions). Please note this event is being recorded.

I’d now like to turn the conference over to Hannah Rutman, Investor Relations. Please go ahead.

Hannah Rutman

Thank you, [Mora], and thank you all for joining American Capital Agency's first quarter 2013 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 May 16, by dialing 877-344-7529 or 412-317-0088 and the conference ID number is 10027585.

To view the slide presentation, turn to our website agnc.com and click on the Q1 2013 Earnings Presentation link in the upper right corner. Select the webcast option for both slides and audio or click on the link in the Conference Call section to view the streaming slide presentation during the call.

Participants on the call 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

Thanks, Hannah, and good morning and thanks for your interest in AGNC. As we will discuss in this call mortgage price performance was surprisingly weaker in the first quarter and this underperformance was even more pronounced in specified or prepayment protected MBS as fears of an early Fed exit led to extension risk becoming the main focus of mortgage investors. This weakness in both TBAs and specified strove that declined in our book value. Importantly, these conditions appear to be reversing in Q2 and recent Fed statements have been considerably more balanced.

On our last earnings call we said that we believe the prepayments on our portfolio would continue to be well behaved. Dollar roll financing would remain favorable. TBAs were preferable to specified mortgages and MBS prices would hold up well as the stock effect of the Feds purchases began to outlay other technical factors. It was on this last point were things turned out differently than we expected at least during Q1.

In addition, the price performances of specified mortgages while directionally consistent was considerably worse than we anticipated. On the positive side, dollar rolled financing continues to be extremely favorable and prepayments on our portfolio continue to be benign.

Looking ahead, we see little reason to believe this prepayment or dollar roll trends will change over the near-term and we’re also seeing repo rates beginning to drop as well, which should further benefit our aggregate cost of funds. It was the combination of these positive factors along with the more attractive MBS valuations that led to our decision to raise additional equity in February.

During the first quarter, economic data was surprisingly strong which prompted hawkish Fed statements about ending QE3 earlier than anticipated. These concerns put some upward pressure on interest rates and [spot] telling of MBS from money managers and foreign investors while keeping banks largely on the sidelines. However, over the past month or two, optimism related to the U.S. economy had been tampered. The global growth picture has weakened again and inflation expectations have declined.

At such a midyear tapering or a QE3 exit now looks unlikely. Against this backdrop, interest rates have come back down and mortgage valuations have strengthened. As such, as of month end, our book value had recovered a portion of the Q1 declines. We also believe the significant weakness in the prices of specified mortgages has created an excellent opportunity to add value-added product at attractive levels.

With that introduction, let's turn to pages 4 and 5 and quickly review some key metrics. First, comprehensive income was a loss of $1.57 per share. Total net spread income was $1.18 per share when you add the $0.40 of dollar roll income to the $0.78 of on-balance sheet spread income. Taxable income declined to $0.50 per share in Q1. We would caution investors against projecting this number into the future, as a large portion of this was driven by mark-to-market declines in the prices of PDAs that were treated as realized losses for tax purposes.

Since prices were dropping in Q1 and rolling TBAs requires positions to be paired off on a monthly basis, TBA price declines negatively impacted taxable income by approximately $0.55 per share. This impact is likely to reverse in Q2 given the recent recovery in TBA prices providing some tailwind to taxable earnings. Undistributed taxable income dropped as a function of the difference between taxable income and the dividend. It was also impacted by the mid-quarter equity raise, but that being said, UTI remains high by historical standards at $1.08 per share.

As I alluded to earlier, book value dropped to $28.93 per share which combined with our dividends drove our first negative economic earnings results of negative 5% for the quarter. The weakness in generic mortgage crisis and in the pay-ups for specified MBS were each significant contributors to this decline.

On page 5, you can see that leverage, inclusive of TBAs, remained essentially unchanged during the quarter and prepayment speeds continued to be well behaved. Our net interest spread, inclusive of dollar rolls but excluding the impacts of treasuries and swaptions, increased to about 187 basis points during Q1 and 171 basis points at quarter end [fluid] by dollar rolls and savored prepayment performance.

Now moving to slide 6, we can quickly review the market environment during Q1. As you can see on the top left, treasury rates didn't move very much during the quarter. The two-year treasury actually rallied 1 basis point while the five-year sold off 5 basis points. Even the 10-year moved less than 10 basis points. Swap rates moved somewhat more as swap spreads widened between 4 and 8 basis points. However, against this backdrop of these relatively benign moves in interest rates, lower coupon MBS prices dropped materially with the 30-year 3% coupon dropping one-and-three-quarter points.

To put this in perspective, the price decline of the five-year treasury was only about a quarter of a point. Even 15-year two-and-a-halves dropped 86 basis points in price or multiples of the move in the five-year.

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

The table on the top shows the performance of newer $85,000 to $110,000 loan balance close since the announcement of QE3. As you can see pay-ups over the difference in price between a lower loan balance pools and a comparable coupon TBA increased during the fourth quarter but then dropped significantly during Q1. For example this category of lower loan balance pools dropped an additional 73 basis points in price more than TBAs. Thus the aggregate price decline on these pools was actually 181 basis points in price, 73 basis points for the pay-up and 108 basis points for the TBA price decline. As you can see on the bottom chart, the performance of HARP security is actually slightly worse than the 3.5% and 4% coupons. Again this almost two point price decline in HARP and loan balance 3.5% needs to be put in the context of the five year treasury and swap hedges increasing in value by less than a quarter of a point and a half a point respectively.

Unfortunately and this is important, given the small move in treasury and swap rates, hedges that were spread out across the yield curve could not offset the weakness in mortgage valuations. Therefore as we have stressed in the past, our hedges including swaptions are designed to protect us against mortgage price changes that result from large interest rate moves while our equity is our main cushion against basis risk that is not correlated with rates.

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

Christopher J. Kuehl

Thanks, Gary. The most significant change in the composition of our investment portfolio during the quarter is the increase in lower coupon TBA MBS from around $13 million at yearend to approximately $27 billion as of March 31st. The increase was driven in part by a reduction in specified pools that were effectively converted to dollar roll positions given very attractive implied financing rates relative to on balance sheet repo. Our review were roll implied financing rates on in a few minutes, but before we turn the page I want to highlight the fact that within our higher coupon positions the vast majority of our holdings are backed by loans with lower loan balances or loans that were originated through the HARP program. While these securities underperformed from a price perspective this quarter, the prepayment performance continues to be strong allowing these positions to generate significant carry income.

To this point I’d like to draw your attention to the prepayment graph in the top right. As you can see our prepayment speeds remain well contained, also keep in mind that because our lowest coupon positions are TBA forward commitments they don’t factor into our reported CPRs therefore these speeds are higher than what they otherwise would be if our lower coupon TBA positions were on balance sheet and included in the reported numbers.

Let’s turn to slide 9. As Gary mentioned in his opening remarks, the roll market continues to be an attractive alternative source of financing for certain types of securities. Here we have two examples to highlight how significant the monthly roll advantage is and lower coupon 30 year and 15 year MBS. I am not going to walk through the examples in detail, but I’ll quickly summarize the takeaway which is, as of April 25th the monthly implied financing advantage from rolling 30-year 3% and 15-year 2.5% was approximately 94 basis points and 55 basis points respectively.

Now keep in mind that the carry comparisons shown in this example exclude all hedging costs that are not intended to detect long-term margins for either position but rather to better highlight the relative advantage of roll financing versus one month repo over the near term. Further more while we do expect that major differences in roll financing versus repo will persist for some time probably at least for 2013. Investors should expect volatility in month to month dollar roll levels. That said the monthly carry differences add up quickly and can significantly impact total returns.

The only other point I’d like to make around this example is that for purposes of comparability for calculating the annualized yields and margin in both examples using a short-term prepayment estimate of two CPR. If we were to use a faster lifetime CPR the advantage from rolling would be even larger. The reason for this is that, at a faster CPR the asset yield will drop in the on balance sheet example while the repo funding cost remains unchanged, therefore reducing the estimated net income. In the case of the dollar roll example, monthly income is fixed by the market price drop from the front month to the back month and therefore they're completely indifferent to the [imputed] asset yield.

So, on the roll example, while the asset yield will drop at a faster prepayment speed, the implied financing rate will also drop. Lastly, on the bottom of this slide, I thought it would be helpful to give you some historical perspective on how these two rolls have traded over the last couple of quarters.

The implied financing rates on the bottom chart are quarterly simple averages of the daily close to the front month's dollar roll during each respective period. [That bottoms] a fair amount of volatility around intra-quarter levels. The funding advantage has been material since the onset of QE3.

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

Peter J. Federico

Thanks, Chris. Today, I'll briefly review our financing and hedging activities during the first quarter. Let's turn to the financing summary on slide 10. As Chris discussed, the composition of our asset portfolio shifted during the quarter, with our share of on-balance sheet asset declining and our share of off-balance sheet TBA assets increasing. A favorable consequence of this shift is less reliance on repo funding. As a result, our repo balance dropped to 66 billion from 74 billion in the prior quarter.

Our repo cost also fell during the quarter to 47 basis point, down from 51 basis points the prior quarter. Looking ahead, we expect this positive trend in funding cost to continue perhaps resulting in another 5 to 10 basis points of improvement over the remainder of the year.

On slides 11 and 12, we provide a breakdown of our hedge portfolio. The key take away from these slides is that we materially increased our hedged positions during the quarter. In total, our hedge position at quarter end covered 94% of our liabilities, up from 83% last quarter.

On slide 11, we provide a breakdown of our swap and swaption portfolios. Our pay fixed swap portfolio totaled 51 billion at quarter end, up from 47 billion the previous quarter. Our swaption portfolio grew at an even more – even a faster pace over the quarter. At quarter end, our swaps reported for the year totaled 23 billion or roughly a 60% increase from the prior quarter.

On slide 13, we provide our duration gap information. Rather than reviewing this slide in detail, I want to turn to a new slide we added on the next page which is intended to provide greater insight to our interest rate risk sensitivity. On slide 14, we show you how our duration gap changes when interest rates increase significantly and instantaneously.

At the current low interest rate environment, all mortgage assets have significant extension risks. That is the risk that mortgage durations increase materially as interest rates rise. On the first three lines of the table, we provided an estimate of the extension risk inherent in our mortgage portfolio. And as you can see, the duration of our 30-year mortgage position will increase to about 7.5 years ending up 200 basis point rate scenario.

At the same time, our somewhat seasoned 15-year assets will increase to about 4.8 years. Taken together, the aggregate duration of our assets will increase from 3.6 years today to about 6.6 years and up 200 basis point rate scenario. Our challenge from an interest rate risk management perspective is to mitigate this risk.

We had the significant portion of our extension risk upfront with interest rate derivatives. On the fourth line of the table, we show the offsetting duration benefit of our liabilities, swaps and treasury hedges. The duration of these instruments is aggregated together and expressed in asset units. We calculate the duration in this way to make it comparable to the asset duration shown above. As you can see, in the up 200 basis points scenario, the duration of our liabilities, swaps and treasury hedges at 3.5 years offsets about half of our asset duration.

On the second to last line of the table, we show the duration of our swaption portfolio again expressed in asset units. Swaptions are nothing more than options on swaps and as rates rise, these options begin to take on the interest rate characteristics of the swaps that underlie them. As such, the duration of our swaption portfolio will naturally expand from 0.3 years today to about 1.3 years and up 200 basis point rate scenario. Then in other way, our asset durations will likely extend about three years and up 200 basis point rate scenario. Our swaption portfolio will hedge a full-year of that extension.

An estimate of our net duration gap which includes the impact of all of our hedges is showing on the last line of the table. As you can see in the unlikely scenario, were rate immediately increased 200 basis points, our net duration gap will increase from negative 0.2 years today to a positive duration gap of 1.8 years.

When interpreting these numbers, it is important to consider two critical assumptions. First, the numbers in the table are model estimates and as such may differ materially from actual results. Second, we assume that the interest rate moves in this analysis occur instantaneously. As a consequence, we did not include any benefit from ongoing portfolio rebalancing action. In reality, rate moves typically occur over time and given our active approach to risk management, we expect to take actions on a continuous basis to rebalance the portfolio.

There are two important takeaways from the table. First, we’ve hedged a significant portion of our mortgage extension risk up front with swaps, treasuries and swaption. And second, by doing so we have minimized our ongoing rebalancing needs which is important for us and important for the market as a whole. But again, even without any rebalancing actions, our duration gap in the immediate up 200 basis point rate scenario will be less than two years and below were many financial institutions operate on a day to day basis.

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

Gary Kain

Thanks, Peter. And before I open up the call for questions, I thought it was important to touch on economic earnings again, given the almost 5% decline this quarter. We’ve stressed in the past that economic return is the most important performance metric over the long run and we’re not going to change our tune about this, despite a weak quarter by this metric.

If you’re interested, slide 25 puts in context this quarter versus the value we’ve been able to create over the past four years. With the Feds massive involvement in the mortgage market, it’s clearly creating significant volatility in our economic earnings. And again economic earnings are the combination of book value changes and the dividend that we payout. And you can see that volatility very plainly in our last three quarters of economic earnings which totaled positive 15% in 3Q 2012, positive 1% last quarter and then this quarters negative 5% result.

With that said, I just want to reiterate our confidence in the earnings potential of the current portfolio. We believe that we’ve the right mix of assets and the right amount of hedges for the current environment, our financing position through both repo and TBAs is as good as its ever been. Lastly, both TBA and specified MBS have performed well in April and the combination of these factors gives me confidence in our ability to generate attractive risk adjusted returns for our shareholders in the quarters ahead.

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

Question-and-Answer Session

Operator

At this time we will begin the question-and-answer session. (Operator Instructions) And our first question is from Joel Houck of Wells Fargo.

Joel Houck - Wells Fargo Securities, LLC

Thanks. Good morning. I guess, my question has to do around the – its not the viability or strategy, but just the confidence in the strategy given – it seems like a lot more volatility that’s induced by the notion whether QEs going to strengthen or weaken as we saw in the first quarter when settlement changes, there is some pretty volatile moves in these specified pools relative to the underlying hedges which is something that obviously you can't control unless you're going to just sellout position in a major way. So, I guess the question is what are your thoughts with respect to maybe running leverages at current levels? Do you think Q1 was more of an anomaly and that really the sentiments going to be QE3 is going to continue indefinitely and therefore the recovery seen in April is kind of a durable recovery with respect to the assets that you own? Thanks.

Gary Kain

Sure. Very good question, Joel. Look, when we think about the ability to manage or hedge the portfolio, I just want to reiterate what I said in the prepared remarks. When interest rates as a whole don't change very much, then by definition specific hedging strategies aren't going to matter that much. On the other hand, if you really had kind of bigger moves in interest rates or game-changing type of scenario such as a true exit of QE3 and a true strengthening of the economy, then you'd absolutely expect all kind of fixed income instruments or certainly treasuries, interest rate, swaps and mortgages to move in the same direction if those moves are big. And so we – this does not in any way change our belief that we can effectively hedge our portfolio for larger moves in rates and even for the current, we'll call it day-to-day. But we do have to recognize and investors have to recognize that there is basis risk. And basis risk which is the risk of the specific mortgages you own versus your hedges, in this case interest rate products will show up. And what you've seen in the past is that's always or almost always presented decent positives in terms of returns. We actually believe that we'll over time, we should be able to continue to create alpha, so to speak, with respect to that basis risk. Now let's go to the specified mortgages and in a sense the fact that they underperformed in Q1 and one of our thoughts going forward is this temporary, is it permanent? Are these riskier products? And what I want to be very clear about is the reason we generally own specified products is because prepayments are much slower and they produce very attractive carry returns or net interest income, if you want to use that term, month-over-month and quarter-over-quarter. Whereas if you – we've used these slides in the past where if you have faster prepaying pools, they may be a little more stable on price but they're not earning you much at all, if anything, in many environments. And so realistically, our main driver for owning specifieds is the fact that they produce attractive risk-adjusted returns and they produce attractive returns in a base case scenario, even without tightening. Over time when you have the right entry point into those securities, then you should be able to benefit from environments where they become more or less attractive. And we feel that there was an overreaction in Q1. So, we do feel that they are still desirable products. We do think that they got to cheap in Q1, but we do recognize that if interest rates went up 100 basis points, then pay-ups would drop materially even from where they were. On the other hand, in that scenario, our hedges would kick in and be able to offset that. But in a more stable rate environment, we feel very comfortable with evaluations at this point.

Joel J. Houck – Wells Fargo Securities, LLC

Okay, great. Thanks for the answer. And maybe talk about the equity raise in concert with what you saw going on in Q1 and where you put the capital at work?

Gary Kain

Sure. I mean, look, let's – with respect to the equity raise, I mean if you look at what we've just said in terms of the environment in Q1, mortgages cheapened up materially. They got in a sense over the quarter back to levels which were unchanged despite QE3. So if you compared mortgages to where they were trading prior to QE3, they got back to the levels where they were essentially unchanged, which we viewed given the magnitude of the Fed's purchases as an opportunity and the valuations had gotten back to levels that were very attractive. So, if you would have asked us before QE3, if we thought equity raises were going to be likely in a QE3 environment; our answer would have been, no. On the other hand if you would have asked us six months into or five months into QE3, would prices be unchanged relative to where they were, we would have also said, no. And so, it was really the fact that mortgages are cheapened up, specifieds are cheapen up as well, and we felt good about we’ll call it the entry point.

Now, I do want to get back to where we deployed capital, and the reality is we actually still put more of our capital into TBAs at that point and not into specifieds; we did buy specifieds. Really we viewed specifieds as having cheapened up more kind of later in the game, and so we have been moving I’d say -- we’ve been more interested in specifieds really over the last month and a half. And as they’ve continued to kind of stay depressed despite the fact that the market had rallied back. And we feel good about the decision. If you go back to the discussion on TBAs, we did feel that the TBAs offered more value earlier in Q1 and certainly in Q4 than specifieds and well -- and clearly that’s played out and beyond what we had expected.

Joel Houck - Wells Fargo Securities, LLC

All right. Thank you.

Operator

And the next question will come from Bose George of KBW.

Bose George - KBW

Yes, good morning. Just wondering if you could be a little more specific about the improvement in book value since quarter end? Is it – have specified pools stayed roughly flat in the recoveries from that this were the generic assets?

Gary Kain

I can’t be much more specific with respect to intra-quarter numbers. We never really tried to -- we never give them out. What I would say is that both specifieds and TBAs have improved, let’s say through April, and even over the last couple of days specifieds appear to be and those volatility appear to be trading reasonably well. So, the short answer is there’s been improvement in both, but let’s face it. We're early in the quarter and we’ve seen volatility and so, we have to be careful with respect to kind of throwing numbers out there.

Bose George - KBW

Okay, sure. And then, maybe just in terms of the timing for the weakness last quarter. From your commentary it sounds like the specified pool market was the weakness really seen in March, and then was that kind of big when it happened?

Gary Kain

No, I mean look, I don’t want to tell you that all the weakness occurred in March, it clearly didn’t. We saw weakness kind of throughout the quarter. What I would say is, specifieds relative to interest rates and the way we think about them really started to become more compelling late – we’ll say very late in the quarter and even more so as we at the very early part of Q2. But the mortgages performed poorly throughout the quarter and it was not just the March effect.

Bose George - KBW

Okay, great. And then just one more quarter on HARP; just any thoughts on the potential or for the cutout date for harping extended and if that does happen, just curious about your exposure.

Gary Kain

Thanks for the question and it's a very good one and timely. Look, we continue to believe that we’ll call it policy risk is relatively low for our portfolio. And we say that against the backdrop of understanding that the president has nominated someone to be the new head of FHFA and while, I mean, I don’t think we're the best positioned to give political predictions with respect to whether or not this gets approved. Our main reason for comfort is even if they were to, even if he gets confirmed, even if he was able to convince the GSEs and convince others at FHFA and that the, at the inspector general that oversees at FHFA even if he were able to convince everyone over there to change their mind which we think is a high hurdle. Some of the numbers that I’ve seen is that, like for instance with a one year extension of the HARP cutoff date. We still have less than 5% of our portfolio that would be basically in that window. And so the reality is as you've seen for months – I mean we've been concerned that we were obviously very concerned about the HARP 2.0, we got out of the way of that really early and we've kind of continuously on and off as there's been this noise to look for opportunities to reduce our exposure to the one-year extension. And so it's not – it's not a big deal for us. Yes, the thing that would be, we'll say a major change from a prepayment perspective, would be on unlimited extension of HARP that allows for re-harping of all securities. But I haven't seen that even thrown out from anyone of late.

Bose George - KBW

Okay. Thanks for the detail.

Operator

The next question is from Jason Arnold of RBC Capital Markets.

Jason Arnold - RBC Capital Markets

Good morning, guys. Just a follow-up on the last one. I mean understandable that you don't want to give a book value number, but just curious if you could comment maybe more generically perhaps on the magnitude of improvement in some of the specified pool prices and TBA prices, kind of like maybe with respect to slide seven and eight?

Gary Kain

The information is readily available. Obviously, we had an unemployment number today and things are moving around. So I really don't want to just start throwing out prices, but I think that information's available. Mortgages have definitely improved relative to hedges, let's say since quarter end. And specifieds continue to trade well even into this morning. But I think we want to be practical about the fact that we're a little over a month into a three-month quarter, and the reality is book value moves around. I mean I can repeat what I said which is as of the end of April, we felt that we had recovered a portion of what we have lost in book value and will watch things from here, obviously.

Jason Arnold - RBC Capital Markets

Okay, thanks. And then just one follow-up. You had great color on the hedging side of things and you guys are certainly much more rate protective than I'd say a lot of people tend to believe. But just a question on some of the other mortgage REITs recently talking about utilizing Eurodollar futures as an increasingly effective way of hedging rates, so just curious if that's something you'd consider as well, maybe pluses and minuses are using that? Thank you.

Peter J. Federico

Sure. This is Peter. We obviously would consider really any hedging instrument, but our goal is to find the instrument that we think will best replicate the market value sensitivity of our assets. So that's kind of our first hurdle that we look at is trying to find hedges out there that will move in a way that's consistent with our mortgage assets. And to the extent that there are some exposures to short-term interest rates that Eurodollars will allow us to hedge, we would certainly do that. Eurodollar contract or short swaps really would have the same sort of interest rate profile. So our goal really is to find hedges that will best replicate the market value sensitivity of our assets, and we try to do that and then find the most cost effective hedge for that.

Jason Arnold - RBC Capital Markets

Okay. Thank you very much for the color.

Peter J. Federico

Sure.

Gary Kain

Just one other thing just to add around the hedging piece and is that just to reiterate, the choice of using a combination of swaps, treasuries and swaptions really goes back to our concern and what we recognize that we need to be doing on the hedging front is protecting against the really big moves, the game changers, the transitions from one environment to another. And again, it it's not about optimizing performance over 10 and 25 basis point moves. It's really about having the protection against the big moves. And swaptions are a great example and Peter went over how they work in that environment. For a move like what we saw this quarter, swaptions aren't going to do anything especially if volatility doesn't go up. But that doesn't mean they're a bad hedge, that means they are perfect for exactly what we need them to do which is help us and if there was a big move in rates.

Jason Arnold - RBC Capital Markets

That's all. Thanks.

Operator

Our next question is from Henry Coffey of Sterne Agee.

Henry Coffey - Sterne Agee

Hi, everyone. Thank you for taking my call. If we were to look at the decline in book value and break it down into respective buckets, you have the TBA pool, we have the disconnect on obviously on hedges and then we have what happened in the HARP market. I was wondering if you could give us a sense of how you would allocate the depreciation in equity value between those three or may be there is a fourth bucket that we should be focused on?

Gary Kain

Yeah, look I’m not – we don’t have specific numbers or we don’t put out specific allocations, but I think what you can takeaway from what we said is hedges net, just to reiterate, were positive, okay. They weren’t positive anywhere near or not so to speak, but they were net positive what – when you look at the pay-ups and the decline in pay-ups on specified collateral and you look at kind of underperformance of the mortgage basis or generic mortgages, they’re in the same neighborhood of each other, okay. And those are the biggest factors, then there is kind of delta hedging and other kind of intra-quarter activity in those kind of things which, don’t tend to be big numbers, but it’s the lion share of this is broken out and they’re reasonably close to each other, the performance of specified in the performance of TBAs.

Henry Coffey - Sterne Agee

And if we get right and put, I mean, maybe you cant do this is, -- is it possible to look at certain more specified pools and put the name HARP next to some of those pools and see how the relative performance of those pools was versus sort of the whole generic holdings?

Gary Kain

Yeah, what I would point you to and our intent was to give you that information …

Henry Coffey - Sterne Agee

Right. I’ve seen it, I was just trying to figure out the relative contribution to the drop and book value of HARP. Because that’s what the – that’s what everyone is asking us about today.

Gary Kain

Right. And look Henry we’re definitely trying to get you the ability to try to think through those and so if you take page seven, okay …

Henry Coffey - Sterne Agee

Right.

Gary Kain

… which and now these are not the specific marks in our portfolio, but they’re kind of generic marks for these buckets and so they’re useful in that regard. We show you the price difference in terms of the change in pay-ups, so take as an example, we will do the HARP 95 to a 100 LTV, which went from 152 basis – the pay-up went from 1.5 points or 152 basis points to 70 basis points during the quarter or a decline of 82 basis points. And if you go to page, I think its 23, hold on a second, in the appendix and you don’t have to do this now, we show you a breakdown of -- the holdings of our portfolio and we show you what percentage are specified within each coupon bucket and so you can kind of back into what we held in those areas and I think – and that’s an exercise that you might want to consider. We don’t give you and I want to be clear we have a range of in the case of HARP securities, we have a range of LTVs from better – from above 80 to basically the group, that’s above a 125 LTV and we don’t give you an actual breakout there, we do give you kind of weighted average characteristics. The same is true on the loan balance side. We give you kind of this we call it an average category. But there is some distribution around this and so you’re not going to be at backend to it exactly, but you’re going to get in the ballpark if you think about it that way.

Henry Coffey - Sterne Agee

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

Gary Kain

In April and May and again when you’re using the term HARP, I mean, the securities, the higher LTV securities that have gone through the HARP program, what we label as HARP securities have definitely improved and improved noticeably as have lower loan balance and the – the other, some of the other main buckets in the specified mortgage group. So, we’re seeing a strengthening of those categories of mortgages to-date or in the quarter and we do feel that they got to very attractive levels at their lows.

Henry Coffey - Sterne Agee

Looking at the other side of the equation, the dividend, you made some comments that there was a lot of expected recovery going on in the second quarter. Will that be enough to rebuild undistributed taxable earnings and core earnings to the point where you can sustain this dividend at $1.25, or should we begin to look more carefully at that issue?

Gary Kain

Look, what I can say with respect – let me clarify the comments I've made earlier about taxable income. We don't want you to project the $0.50 number because there were significant influences from declines in TBA prices where the hedges were not all included. So, that part I think should be pretty clear and we do expect taxable income to be noticeably stronger in Q2. In addition, many of the TBAs that create the realized gains and losses actually have already been rolled to the next quarter. So it's not completely variable with respect to what happens in the market. Again, a good chunk of those levels have been locked in for the quarter, so to speak. But there is still uncertainty with respect to kind of what happens in the market as a whole. And just more specifically with respect to your question around the dividend, really what I can say is there are few things that we've stressed over and over again that go into our mindset with respect to the dividend. They're book value performance and economic earnings, they are taxable income and are UTI. That's certainly an important factor. And then our confidence in our investment strategies and earnings potential going forward are all things that management and the Board are going to have to think about when we make a decision next month on the dividend.

Henry Coffey - Sterne Agee

Thank you. I appreciate it.

Operator

Our next question is from Merrill Ross of Wunderlich Securities.

Merrill Ross - Wunderlich Securities

Good morning. As you discussed this strategy, Gary, you said you had some confidence in how you've allocated your equity. Can you talk about what you might expect? Can the dollar roll still trade special after the Fed exit, because if that isn't trading special at that point obviously trade could evaporate?

Gary Kain

Look, that's a great question. And we talked a lot about this last quarter on the call. And Chris reviewed kind of how dollar rolls have been special for – since QE came into play. And so the obvious conclusion is that the second QE3 goes away, dollar rolls won't be special anymore. I do want to just reiterate that if the dollar roll specialness goes away, then you can just take those positions and put them on repo, so to speak, and fund them the other way. And in that environment, rates will be higher and the lack of prepayment protection probably won't hurt you. So it's not necessarily like a knockout blow if the roll specialness isn't there, as long as you make the assumption that the coupon isn't way over priced because of the roll specialness. And we feel that after the first quarter, you can probably get comfortable that that's not the case. Look, with respect to what will happen with the rolls when the Fed is done with QE3? Roles are a short-term financing vehicle and we – as Chris mentioned and as we mentioned last quarter, we expect that there's a very good chance that they'll remain special, more meaningfully special through the end of this year and it could be beyond that, but it won't be forever. But I do want to stress that the price of the underlying doesn't necessarily again as long as it's not way overpriced for that financing advantage, doesn't necessarily fall apart after that. You just back to a kind of more normalized funding mechanism. So to your point what I would say is people should not assume that roll specialness lasts three years. But practically speaking, even when the Fed is gone it is very possible because the new originations of mortgages will probably be another coupon, that those coupons could stay special well after a Fed exit and we actually saw that with respect to some of the higher coupons when the Fed exited from QE1 that the specialness did not disappear right, for a long time after the Fed’s exit.

Merrill Ross - Wunderlich Securities

Yeah, thanks. That’s very useful, and the idea that you could (indiscernible) on to your balance sheet and its steeper curved environment is also quite attractive. Thanks for your comment.

Operator

And the next question is from Arren Cyganovich of Evercore.

Arren Cyganovich - Evercore Partners

Thanks. It's actually along the same lines of the last question. You generally have pretty high leverage of 8.1 times when including the TBA. I would think you’d want to have lower leverage once the Fed does start to taper in QE3, what's your strategy for dealing with that, and essentially being able to take advantage of the cheaper pricing at that time?

Gary Kain

Look, I think that’s – I think that you bring up a great point, what's your leverage strategy in a QE3 environment? And again if you went back and you drew it on the board kind of going into QE3 you would expect that over six months as the Fed’s, the stock effect of the Fed’s purchases as they absorb more and more of the mortgage market that mortgages will get richer and richer to the point where you’ll want to take leverage down because the risk adjusted returns aren’t there, and it's better to wait and leave some earnings on the table to be able to buy at a later date. Again given the weakness that we’ve seen locally where in a sense QE3 got to the point what really wasn’t priced in at all to or negligibly to mortgage prices, we don’t feel that this is the right time so to speak. And again we feel at this point, these decisions are not always simple. But our view right now is that, there is probably a bigger risk to being under invested if the Fed keeps buying and the fact is that you’re going to go a long period where you’re going to be under invested and I think that realistically our mindset will be when we don’t feel that holding the securities produces a reasonable return than we will de-lever or we will consider de-levering, but we don’t feel that we’re anywhere there near that point given where prices are. And I think you can see that we feel that we can continue to generate reasonable risk adjusted returns, and so we’ll look at that again as things evolve.

Arren Cyganovich - Evercore Partners

Thanks. And are the TBA forward positions included in slide 14 in the extension risk?

Gary Kain

Yes, they are. So that absolutely we treat those like any other position, and they absolutely are included in that. And so that is an aggregate position out of our model.

Arren Cyganovich - Evercore Partners

Great. And then finally on the repo market, you mentioned that there could be a 5 to 10 basis point improvement. Could you -- I missed what was driving that, and also what's the general liquidity in the market and would they be able to usually take on the full amount of your forward TBA position if needed?

Peter J. Federico

Yeah. This is Peter, I’ll take that question and it's a great question, and we’ve talked about that before. From a TBA perspective what we have to do from a funding perspective is always be prepared to take that back on to balance sheet. And as Gary mentioned the environment right now from a funding perspective is really good. Our capacity is as good as it's ever been. So, we don’t have any concerns that we couldn’t take that position on in kind in traditional balance sheet form. And really what we’re seeing now is, I think part of the effect of the Fed which is they’re taking more and more mortgages out of supply which means that there is fewer mortgages that have to be financed in repo. And we’re seeing new counterparties coming into the space and in effort to find yield in the short-term market. So, the combination of those two things is starting to take effect. The termination of Operation Twist at the end of the year we thought would have a positive effect on dealer balance sheets and that started to show up late in the first quarter. So, the combination of the Fed taking mortgages out, increased demand from investors and the Fed’s Operation Twist all point to somewhat improving conditions for repo financing. And from a capacity perspective we’re in really strong position.

Arren Cyganovich - Evercore Partners

Great. Thank you.

Peter J. Federico

Sure.

Operator

And the next question is from Daniel Furtado of Jefferies.

Daniel Furtado - Jefferies & Co.

Good morning and thank you. I just had one question, higher level, and from looking at it from a high level perspective what's the risk of extrapolating this quarter as a case study for the potential impact to the mortgage REIT industry in general of the QE3 tapering event? Thank you.

Gary Kain

Dan, that's a great question and I'm glad you asked it. And I think again, what I think you really want to keep in mind with respect to looking at this quarter was that post – immediately after QE3, there were significant kind of book value gains where there was prices of mortgage-backed securities and specifieds got to pretty elevated levels. And we saw a run up in book values which I think have gone the other way but again, within a very narrow range of interest rates. And so what you're not seeing – you're only seeing basis risk bouncing around, which is limited in its magnitude, okay, generally speaking in terms of how far can one government-backed security move versus another. And when people extrapolate this to 100 and 150 or 200 basis point moves in interest rates, which, as we've always told you, they are possible and we're not going to know when it's going to come. The difference is that the hedging strategies at least I can speak for us that we employ are specifically designed for those kind of scenarios. And again, you can choose different hedging strategies, you can have a hedging strategy that uses less options that's more tailored around trying to pick up 10 and 15, 20 basis point moves or you can design a strategy that's more around the bigger moves. And we feel that this is the right strategy to use. So we feel very confident that we would perform reasonably well in that kind of, the real deal scenarios, so to speak. The other thing I would highlight is that some of the stress that was created in Q1 really resulted from the combination of economic numbers really, really picking up very quickly beyond where most people expected coupled with Fed shatter that very quickly I mean into the minutes of the December meeting which was when they kicked off the treasury portion of QE3 was already talking about tapering. And so the discussion was basically a really, really, really early exit to QE3 as essentially they were beginning it. And so even if they exit after they have absorbed a large amount of the mortgage market, I think you can expect more logical performance from mortgages. I think the issue here was that the discussion came way earlier when people weren't set up for it and I think now, as I mentioned earlier, money managers have largely "sold into the Fed." And so you have a very different landscape with respect to people being able to absorb things. We've also seen people like [foreign] investors, take the Bank of Japan's actions and you can kind of figure out the impact that would have. But we've had foreign investors go from pretty large net sellers in Q1 to buyers now. So we feel that the landscapes very different and you shouldn't be projecting – you should think about that when you're projecting performance to both us and maybe to the space.

Daniel Furtado - Jefferies & Co.

Thanks, Gary. I appreciate the insight there.

Operator

The next question will come from Bill Carcache of Nomura.

Bill Carcache - Nomura

Thank you. Good morning. Gary, I was hoping to follow-up on that last question from a slightly different angle. So it seems like this quarter at least gives some perspective on what happens when the market becomes more focused on extension risks and less focused on prepayment risk and the negative impact that that had on the pay-ups that had associated with the low balance flows and the high flows that had been so positive for you previously. If we fast-forward a couple of quarters, a few quarters whatever the timeframe is and at some point when the market becomes again concerned about the Fed pulling away and extension risk again becomes more focused. Would you be confident that we don’t find ourselves here all over again and maybe perhaps you could talk specifically about the basis risk? And maybe, I don’t know if there’s a way for you to potentially be able to bifurcate for us how much the unrealized gain that is in here in your book currently is associated with pay-ups and potentially at risk because it’s not really hedgeable, as the Fed transitions away from QE?

Gary Kain

Sure. What I want to actually you had a couple of questions in there, let me try to make sure I hit them. But I want to start with the last comments you made about, it’s not necessarily hedgeable. I wouldn’t take that – I don’t really feel that, that’s accurate, I think it is hedgeable to the extend that those, that changes in pay-ups occur across a wider move in interest rates, okay. And so let’s take as an example if you go to page seven of our presentation and you look at the pay-up as of March 31st of 70 basis points. If interest rates go up, now that security can’t drop below TBA level, so the most that security can drop from that mark was 70 basis points. Now if that occurred over a 50 basis point move or a 100 basis point move in rates, you can see okay, I’ve got a hedge I got to consider the fact that that can drop 70 basis points over, let’s say 50 to 75 basis point move. And so you can actually choose – you can have a reasonable hedge ratio for that and so from levels of where we’re to the extend to those pay-up declines are concentrated or consistent with interest rate moves you can hedge them to the extend that they occur like they did in Q1 within a 10 or 20 basis point move in rates, then you’re hedges are not going to pick up much of that. And so, that I think is the first thing that you really want to keep in mind. So you shouldn’t takeaway from the fact that these pay-ups are not hedgeable. They’re hedgeable, but with larger moves in interest rates. The other thing you should takeaway from them is that, I mean, if you just look at this page as an example half of the entire pay-up, declined over the course of the quarter, if you look at – at least the lower coupon buckets, the 3.5 buckets. And again, the amount of that decline is somewhat limited in terms of how much more can go and so you have to – you also should keep that in mind with respect to many of these buckets. So, big – so hopefully that answers most of your questions, but if I miss something let me know.

Bill Carcache - Nomura

Yeah. That’s helpful, Gary. Thank you. May be I just shift to over to my last question on the UTI, last quarter dollar roll income help contribute to an increase in the UTI, this quarter it seem like dollar roll income was still very, very favorable, but the UTI went down and then looking at the contributors to that it seemed like there were some realized loses that were at least partially contributing to that. Could you give some color on what drove those realized loses, and then in maybe tying that to the UTI is that – is the decrease or the drawing down on the UTI this quarter consistent with a scenario where that’s exactly what it's there for and the type of situation that in which you’d expect to draw on it or was it a bit unexpected. Just trying to get a sense for, in future quarters when the extent to which – when you would expect to draw on that UTI?

Gary Kain

Sure. Let’s first just go back through Q1 and why the UTI or why – I am sorry, taxable income was impacted by the dollar rolls. And, so what ends up happening is, when you dollar roll a security and in those case lets use an example, TBA Fannie Mae 3% and if the price of that security is dropping every month then you’re basically going to be locking in those price declines as if you sold an instrument that was on your balance sheet. And so, in a period where TBA prices are dropping irrespective of whatever you’re doing on the hedge side unless all of those are realized then you’re just kind of realizing price declines and that’s going to – from a taxable income perspective and that’s going to impact your taxable income and that’s what you saw in Q1, you had an environment where just the price of the underlying irrespective of the dollar roll level was declining and you were locking in these lower prices from the perspective of realized losses. Now to the extend the price is, don’t change you’re in an unchanged environment, then that’s not going to obviously have much of an impact and how much income you pick up from a taxable perspective will really relate to the drop or the attractiveness of the drop – dollar roll income. In the case where mortgage prices are going up, then you will be in a situation where you will actually end up with more taxable income than you probably should in that environment to or then what’s actually implied by the drop and so you will have the reverse of that scenario. And one other thing I want to just reiterate that I mentioned earlier with respect to that is that we don’t just wait when it comes to dollar rolls for two days before the kind of the time when you have to roll it in a particular month, many times we’re rolling these positions three months in advance or its certainly two months in advance and often three months and we tried to very much spread out our exposure to rolling things and it’s the best – it’s the way to get the best execution. And so as I mentioned earlier, in a lot of the cases we’ve already rolled a good chunk of our position into the next quarter in which case then that reduces the sensitivity from there.

Bill Carcache - Nomura

Thanks very much for your insights, Gary, I appreciate it.

Operator

We have time for one final question and that will be from Douglas Harter of Credit Suisse.

Douglas Harter - Credit Suisse

Thanks. Gary, you've talked a bunch about trying to hedge the basis risk. Can you talk about the attractiveness of MSRs or IOs to try to sort of minimize some of that basis risk?

Gary Kain

Now that's an excellent question and IO and MSR really are good ways to maybe offset some basis risks. They obviously would perform well in a rising rate scenario and a scenario where extension risk is getting priced into the market. But importantly you've got to buy IO off of the right types of instruments. And a lot of the IO that is available in the market, so to speak, the majority of it tends to be of either specialized collateral which is already priced – in particular priced to very low speeds, so you won't get much appreciation in a rising rate environment. And then another big chunk of it is off of the older mortgages that are kind of susceptible to HARP and those have been two areas where we haven't been that interested in IO. When you go to MSR, newer MSRs and not the historical or legacy MSR, is something that could be attractive and it's something that we have to think about. Now there are real barriers to entry in terms of being able to participate in that space. But that doesn't mean it should be off the table. It means that it is something that makes sense relative to an agency mortgage portfolio and it's something that we absolutely have to think about as we go forward.

Douglas Harter - Credit Suisse

Great. Thank you for that color, Gary.

Operator

This will conclude our question-and-answer session. I'd like to turn the call back over to Gary Kain for concluding remarks.

Gary Kain

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

Operator

The conference is now concluded. An archive of this presentation will be available on AGNC's website, and a telephone recording of this call can be accessed through May 16 by dialing 877-344-7529, using the conference ID 10027585. Thank for joining today's call. You may now disconnect.

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