American Capital Mortgage Investment's Management Discusses Q2 2013 Results - Earnings Call Transcript

Jul.31.13 | About: American Capital (MTGE)

American Capital Mortgage Investment (NASDAQ:MTGE)

Q2 2013 Earnings Conference Call

July 31, 2013 8:30 AM ET

Executives

Hannah Rutman – Investor Relations

Gary Kain – President and Chief Investment Officer

Jeff Winkler – Senior Vice President and Co-Chief Investment Officer

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

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

Analysts

Trevor Cranston – JMP Securities LLC

Michael R. Widner – Keene, Bruyette & Woods

Douglas Harter – Credit Suisse

Joel Houck – Wells Fargo Securities

Operator

Good morning, and welcome to the American Capital Mortgage Second 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 would now like to turn the conference over to Hannah Rutman in Investor Relations. Please go ahead.

Hannah Rutman

Thank you, Amy and thank you all for joining American Capital Mortgage Investment Corp’s second 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 may differ materially from those forecast due to the impact of many factors beyond the control of MTGE. 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 our periodic reports filed with the SEC. Copies of these reports are available on the SEC’s website. We disclaim any obligation to update our forward-looking statements unless required by law.

To view webcast of this presentation, access our website mtge.com and click on the earnings presentation link in the upper right corner. An archive of this presentation will be available on our website and a telephone recording of this call can be accessed through August 14, by dialing 877-344-7529 using the conference ID 10031373.

Participating on today’s call are 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; Jeff Winkler, Senior Vice President and Co-Chief Investment Officer; Peter Federico, Senior Vice President and Chief Risk Officer; Chris Kuehl, Senior Vice President of Agency Mortgage Investments; and Don Holley, Vice President and Controller.

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

Gary Kain

Thanks Hannah. Good morning everyone and thank you for joining us on the MTGE Q2 earnings call. The second quarter was characterized by significant volatility in fixed income markets. Interest rates rose materially during the quarter and almost all types of bonds suffered price declines.

The agency MBS market traded very poorly in May and June as changing market perceptions around the future of monitory policy combined with stronger economic data to drive interest rates significantly higher. Agency mortgages had to contend with considerably higher volatility, convexity hedging needs, money manager redemptions and concerns around changes to bank capital requirements, all of which contributed to the underperformance of MBS versus swaps and treasuries.

Non-agency mortgages performed very well and were generally higher in price in April and May, believed by the continued positive momentum in housing. However, that ended in June as they [choose] to come to the pressures on other credit related sectors, as liquidity across the capital markets deteriorated.

A key question for the non-agency space which probably will not be answered for at least three to six months, is how the housing market will react to close to 100 basis point we have seen in mortgage rates. This question, irrespective of your view of the answer, has ramifications for a portfolio that has a mix of both agency and non-agency assets. For the first time in the few years, price performance of agency MBS and a non-agency securities are likely to be correlated with each other, at least in the near term. As lower agency prices raise mortgage rates and up the stakes for the housing market.

In addition, stronger economic data that leads to expectations of less combination from the Fed is likely to continue to put technical pressure on both sectors as many investors were pushed to higher yielding assets to avoid the effects of the QE3. Given this view around the changing correlation between agency and non-agency MBS, the current volatility is a significant negative and the prudent course of action is clearly to prioritize risk management over earnings maximization.

To this point, as Jeff, Chris and Peter will discuss, we have reduced the size of our portfolio, increased our heads ratios and made meaningful changes to the comp position of our portfolio.

Despite the challenges posed by the current environment in the negative economic returns over the last few quarters, there are some positives, both agency and non-agency mortgages are cheaper today, the yield curve is cheaper, prepayments are continuing to slow, the future supply of MBS will be materially lower and the housing market still has considerable positive momentum. As such when we get more comfortable increasing our risk posture, the earnings environment could be quite attractive.

Now before I turn the call over to the team, I want to quickly give some additional insight into a few of the results on Slides 2 and 3. As a second bullet point on Slide 2 shows our net spread income inclusive of dollar roll income, totaled $1.5 per share. It was comprised of $0.65 of net spread income from on balance sheet assets and $0.40 from dollar rolls. It also includes a $0.05 per share benefit due to the catchup amortization associated with lower prepayment estimates.

Now taxable income came in at $0.76 per share during the quarter, which was slightly lower than $0.80 dividend. Our undistributed taxable income declined $0.02 per share to $0.43 per share. It is however, important to point out that our taxable income in Q3 is bias materially lower given some of the actions we took in Q2 and Q3, which will be realized for tax purposes in the third quarter of this year.

Book value declined 6.7% to $22.63 per share as the price declines on both agency and non-agency MBS exceeded the gains on our hedges. Economic return, which is comprised of a combination of our dividend and changes in our book value was negative 3.4% for the quarter.

Turning to Slide 3, our portfolio inclusive of TBAs was $8.8 billion down from where it was at the end of March 30th. The entire decline came from the agency side, as non-agency assets actually increased during the quarter. Our leverage ended Q2 at 6.4 times versus 7.4 times at the end of Q1.

Lastly, I want to highlight that we bought back $2.9 million shares or just shy of 5% of our outstanding common stock. In addition, our Board authorized an additional $100 million in share repurchases through the end of 2013. This is incremental to the $50 million that was authorized back in Q4, 2012. Management remains committed to repurchasing shares when our share price is at a material discount book, subject to constraint such as window periods that are applicable to all public companies.

With that let’s turn to Slide 4, and look at what happened in the markets during the second quarter. As you can see from the tables on the middle of the page, five and ten year treasury and swap rates moved over 60 basis points during the quarter. As big as this move is, it actually understates the inter-quarter volatility as rates actually moved around a 100 basis points from low to high during the quarter.

As I mentioned earlier, the prices of generic agency MBS performed poorly during the quarter and underperformed both treasury and swap rates. To this point 30 year 3s and 3.5s dropped 5.4 and 4.1 points respectively. Even 15 year mortgages dropped materially with 15 year 2.5s falling over 3.25 points. As I mentioned earlier, non-agencies finished lower as of June 30, based on the overall weakness in fixed income.

Now if we turn to Slide 5, we can quickly review the high level changes in our capital allocation. Our percentage of non-agency assets increased during the quarter as we continue to look for value added securities, in a disciplined and patience manner. On the agency side our leverage to decline somewhat as a function of the increased market volatility and the changing dynamics regarding correlation between the agency and non agency sectors.

Going forward you can count on us remaining opportunistic in our portfolios and positioning in response to changing market conditions. Moreover, we do continue to remain focused on evaluation more strategic endeavors such as MSR and non-agency originations and GSE credit sales.

And with that let me turn the call over to Jeff, to discuss the non-agency portfolio.

Jeff Winkler

Great. Thank you, Gary. Turning Slide 7, the non-agency market had volatile second quarter. First half continuations of themes from the prior 12 months with relatively light supply, strong housing and a general search for yield across capital market, prices increased 5% to 10% on the back of these trends in May.

For the end of May, a few forces combined to reverse this move with a dominant one thing, the potential lying down of the Federal Reverses active purchase program. This led to significant outflows from fixed income leaving risk free rates up about 60 basis as Gary just mentioned. When you combine this with the supply we saw from negative sellers risk appetite in the marketplace was significantly reduced.

As liquidity deteriorated and bid has spreads widened through the second half of the quarter, price is just lower giving back the gains and ending down roughly 1% to 3%. We’ve seen multiple instances of this kind of price action in non-agencies over the past few years and it’s definitely one reason to we keep our leverage moderate at around 1.5 times.

On the funding side our access to in terms of non-agency repo did not change. We attribute this to the conservative level of haircuts and rates to begin with as this part of the market has not moved much over the past couple of years despite the better tone in the market up until this quarter. However, we are watching it closely especially in light of any capital requirement changes for counterparties.

While the markets are driven mostly by technical factors over the quarter, the rate raise could have a fundamental impact. To the question Gary post earlier regarding housing and rate, housing still looks attractive in terms of supply demand, affordability and momentum, with payments up 10% to 15% due to the increase in mortgages rates we could see some deceleration.

Further as refinance activities slows and bank portfolios becomes more competitive for purchase mortgages slowdown in the pace of new issues on [low] securitizations is possible.

In terms of where the market currently is, turning to Slide 8 shows that while prices were down only slightly over the quarter, loss adjusted yields were up about 100 basis points from a mix of spread widening, higher rates and better than expected home price depreciation which led to reduced estimate of defaults. We see loss adjusted return on equity to be 9% to 11% across sectors.

Our focus remains on a sector that has the most sensitivity to the housing market and the highest unleveled yields allowing us employee conservative financial leverage as mentioned before.

Over 80% of the portfolio is an all state sub-prime or options ARMs. In terms of hedging we increased our use of interest rate hedges against the non-agency portfolio; while higher rates could be a good time for non-agencies if combined with faster economic growth. In the current environment, we felt that our rate selloff would be more technically driven in a possible negative for the asset, which is somewhat of a departure of how prices had moved versus rate over the past two years as Gary mentioned in this opening remarks.

Given how much non-agency prices have increased since 2011, we are now trading as a spread product, rather than on an absolute yield basis. And this will be even more so for cleaner, higher dollar priced sectors. So while at time, non-agencies will be a good offset, the agency movement in periods like we just witnessed in the second quarter, the overall correlation of spread product will dominate. We will continually reevaluate the appropriateness of these rate hedges in light of non-agency and housing market movements.

So with that, I’ll turn the call over to Chris to discuss the agency portfolio.

Christopher J. Kuehl

Thanks, Jeff. On Slide 10, you’ll notice that our agency MBS portfolio was $7.9 billion as of June 30. During the quarter, we took some meaningful steps to better position the portfolio for the current environment. We materially reduced our exposure to our lowest coupon, longer spread duration 30 year MBS position. More specifically, we have sold approximately $1 billion in 30 year 3s and $600 million 30 year 3.5s during the quarter.

We also increased the percentage of 15 year MBS to around 29% and as of today this percentage is noticeably higher. Given today’s higher rate and a higher spread volatility environment, 15 year MBS are attractively priced from the risk adjusted return perspective. They’re easier to hedge and have a favorable technical backdrop. Additionally, unlike other shorter duration alternatives 15 year MBS trade on a liquid TBA market.

On the next Slide, I’ll quickly review quarter-over-quarter price bills on specified pools. As Gary reviewed with you, we experienced a significant selloff in both treasury and swap rates during the quarter. Given the large price declines in generic MBS specified pool pay-ups were also sharply lower across the Board.

However, the movement pay-ups on lower coupon 3s and 3.5s were much more consistent with the move in rate this quarter versus the first quarter. For example the pay-up on lower loan balances 30 year 3.5s declined 69 basis points in price during the second quarter, against the 10-year treasury yield increasing 64 basis points, compared with the first quarter of pay-up decline of 73 basis points, while 10-year treasury yields were higher by only 9 basis points.

This correlation between rates and pay-ups implies their hedges for more effective this quarter at offsetting the decline in pay-ups. It’s also worth noting that given current market pay-ups and our asset composition as of the end of the quarter, our aggregate pay-up exposure is now less than a quarter points when measured across to our TBA deliverable agency portfolio. And therefore NAV exposure to pay-ups volume further into higher rates is less than 2.5%.

With that, let me turn the call over to Peter, to discuss funding and risk management.

Peter J. Federico

Thanks, Chris. Today, I’ll briefly review our financing and hedging activity during the quarter. I’ll begin with our financing summary on Slide 12. Despite very volatile market conditions, our access to attractive funding remains uninterrupted throughout the quarter. Moreover, the weighted average haircut on our agency repo at quarter end was unchanged at about 5%, while the average haircut on a non-agency repo decreased to 28% from 32% last quarter.

Our repo balance increased to $7.6 billion at quarter end and carried with it an average cost of 52 basis points, unchanged from the prior quarter. The average original maturity of our funding increased to 139 days, a meaningful increase from the 108 we reported last quarter.

Turning to Slide 13, I’ll briefly review our hedging activity. In aggregate, our hedge portfolio covered a 106% of our repo and TBA positions. With our hedge ratio was an all time high of 106% of our liabilities, we are obviously operating with a very defensive position from an interest rate risk perspective. This very high hedge ratio is also indicative of the shifting correlation we observed between agency and non-agency securities that both Gary and Jeff mentioned.

Our hedge portfolio is designed to protect our book value against larger moves in interest rates. During the second quarter, our hedge portfolio performed as intended. As you can see from the table our hedge portfolio offset a significant amount of the price decline of our assets. In total our hedge gains were $275 million in the second quarter or $4.75 per share.

With that, I would like to review our duration gap on Slide 14. As of June 30, our net duration gap was only 0.2 years; our asset portfolio had a net duration of 5.7 years at quarter end, a material increase from the prior quarter given the sharp rise in interest rates. In the middle of the table, we show the offsetting duration benefit of our hedges which for purposes of this table are expressed in years based on our asset market value. By computing our hedge durations in this way, each column can be easily summed.

At quarter end, our liabilities, swaps and treasury positions hedge 4.6 years of our asset duration. At the bottom of the table, we show the duration benefit of our [swations] which at quarter end hedged 0.9 years of our asset duration. Summing these three components together gives you our net duration gap of 0.2 years at quarter end.

The table also provides valuable insight into how our duration gap changes as interest rates change. For example, if interest rates were to increase 200 basis points, our asset durations will likely extend from 5.7 years to 6.5 years. In that same scenario our swaption portfolio will naturally extend from the 0.9 years to 1.4 years, thereby offsetting about two thirds of the asset duration extension. As a result, our net duration gap in that scenario will increase to only 0.5 years, assuming no rebalancing actions are taken.

The stability of our duration gap in a rising rate scenario, shows that the current size and the composition of our hedge portfolio is sufficient to offset most of the remaining asset extension we may face should rates increase further. It also allows us to safely operate with a larger duration gap at sometime in the future.

The benefit of a low and stable duration gap can be seen on Slide 15 through our net asset value sensitivities. Table at the top shows the estimated change in our net asset value for 50 and 100 basis points changing rates. For example, if interest rates increase 100 basis points and assuming no rebalancing actions are taken, our models indicate that we’d likely suffer only 2.5% loss to our book value, assuming no change in mortgage spreads.

Finally, given the volatility of mortgage spread in the current environment, we thought it was important to provide you additional information regarding the sensitivity of our net asset value to changes in the spreads between our mortgage assets and our hedges.

To that end, in the bottom table, we show you the estimated change and our net asset value for 10 and 25 basis points move in mortgage spreads. It is important to note that our sensitivity to mortgage spread changes does vary with interest rates, increasing as interest rates rise and decreasing as interest rates fall. That said, the change in spread duration is gradual. So you can use these numbers to estimate the impact of larger or smaller spread moves. From the all of these sensitivities, our model estimates and could differ materially from actual results.

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

Gary Kain

Thanks Peter. Before I open up the lines to questions, I want to quickly review MTGE’s performance over the past 12 months and since its IPO. On Slide 16, we show our economic return or the combination of dividends plus the change in our book value overall range of time periods, what maybe more surprising to investors is that our returns over the last 12 months have actually been positive 18%, despite the very difficult market conditions we have witnessed in 2013.

Since its IPO, just two years ago in August 2011, MTGE has generated in almost 45% total economic return. Economic return is essentially equivalent to a complete mark-to-market return on our portfolio and is analogous to the way I hedge fund or mutual fund would report its portfolio performance.

With that, let me open the call up to questions.

Question-and-Answers Session

(Operator Instructions) Our first question comes from Trevor Cranston at JMP Securities.

Trevor Cranston – JMP Securities LLC

Hi, thanks. I was wondering if you can maybe share your thoughts on the recent Freddie Mac stackers’ credit transaction, and talk a little bit about if given the way that the deal structure if you think that’s an asset class that has the potential to become a significant asset for MTGE. Thanks.

Gary Kain

Sure. Thanks for the question. Look I mean I think that we were very excited to see the product launch. And we did participate a little bit in the program and look I think we are looking forward to see how programmatic it will be. As far as whether it’s going to become a large portion of our portfolio, I think its just going to be a function of what we see the return equities be on asset overtime and how does that profile compared to other assets that we can buy.

And so I think that would be in the determinant these, I think, the prices that they sold were relatively attractive, however, given the widening in some of the legacy space and the profiles there and frankly the sort of more leverage to housing upside on some of legacy assets. I think it’s not as clear right now, but overtime that could change especially if some of the program changes as well.

Trevor Cranston – JMP Securities LLC

Okay are there any other issues with the way those are structured with being a good REIT asset?

Gary Kain

Yeah I mean, the way it is right now, it is a debt of Freddie Mac and so it definitely is not – I think it fits in the 75 to 95 income bucket for us, so that would be a limiting factor as well. But at least right now give the size of the program itself it’s not a big issue for us at the time.

Trevor Cranston – JMP Securities LLC

Okay, and then just one other thing on the, comments about expecting kind of agencies and non-agencies to be in more correlated assets going forward, when you show the potential returns on new investments in non-agencies on Slide 8, did those contemplate the additional interest rate hedging you’re doing and does that change? How you think about levering the non-agency portfolio at all?

Gary Kain

Those do include some of the interest rate hedges and I think that the overall correlation of spread product definitely changes how we think about our book on a macro level. But I think given the fact that as I was saying before, higher rates could be good for non-agencies. It was coupled with faster economic growth and a continuation of the housing recovery. In this particular environment, we felt that higher rates was not really a function of that, but more due to some of the actions out of the Federal Reserve. And so I think we’re just sort of reevaluated at each point in time in terms of our view of how those two assets will perform.

One thing to keep in mind is that we’ve always believed and it will be the case that in general, most credit tranches or credit investments have the interest rate characteristics as well. And so this is not I mean it’s kind of being unique with the legacy non-agency product that’s really had very little interest rate risks associated with it in a very low kind of high stress scale performance environment on the credit side.

The norm going forward will be that you have to manage interest rate risks and credit risks together. So if you look at new securitizations of Jumbo Securities. The subordinate tranches have quite a bit of interest rate risk. And so we see this is kind of just being an awakening to the realities of how we’re going to run that business going forward, and somewhat of a turning point to just the legacy piece of this, legacy non-agency assets generally made and there maybe some more periods where they don’t have a ton of interest rate risk. Again we think they do now. But going forward, credit and interest rate risks are going to have to be managed together and that’s one of the things that we’re going to remain very focused on.

Trevor Cranston – JMP Securities LLC

Okay. That’s helpful. Thank you.

Operator

Our next question comes from Mike Widner of KBW.

Michael R. Widner – Keefe, Bruyette & Woods

Good morning, guys. I was wondering if you could talk a little bit more about you TBA positions and I know you’re net don’t have much or at least at June 30 didn’t have much. But I guess number one, there’s a big change from where you were prior quarter? And then number two, hard to tease out, but it looks like you might – well I guess I’m curious about the magnitude of both the long and short, even though you’re net pretty close to zero?

Gary Kain

Sure. Thanks Mike. So there were a couple of drivers behind reducing our long roll position. And you have to remember these positions were some of our longest spread duration MBS, so with a greatest exposure to Q3. And so on the process of managing leverage and spread duration, the position declined. Role implied financing rates are the advantage versus repo also wasn’t as compelling towards the end of the quarter as it was in sort of first five months of the year.

And the other thing to keep in mind is that, MTGE’s size is also a consideration with respect to how large of a roll position it’s willing to take. And so there are times when and certain coupons where the risk of adverse selection in taking delivery of a role is much greater on a small position versus a larger position and MTGE’s size is a factor in that decision process.

Michael R. Widner – Keefe, Bruyette & Woods

So I guess the other part of the question was, as I look through your disclosures, I mean it looks like it’s not simply that you have a small long position right now. I mean it would appear that there is both the long and short position right now. And so I was just wondering if you can talk a little bit about what that is, how we should think about that and just that sort of letting stuff in that out as it kind of reaches the delivery date or is there a strategy behind kind of what’s going on there?

Gary Kain

First off, I mean we’re not getting into the specific sort of high level. There is a strategy in terms of there are longs and shorts and different coupons. The one think I would want to stress at this point is that those positions are extremely liquid and they’re designed to change relatively quickly.

So what I would say I wouldn’t be as focused on these specific quarter and number on longs and shorts within TBAs because those are things that will move around. So they’re going to be often times and we’re going to want to be long one coupon and short one coupon in a typical risk management strategy would be to sell over coupons and go up in coupon and be long higher coupons. You may do 30 year to 15 year TBA trades and then later take deliver or something. So what I would tell you is those are generally relatively temporary positions. And so we really don’t want to go in ton of detail about the specifics.

Michael R. Widner – Keefe, Bruyette & Woods

Yes, I understand that there is some secrets that you don’t want to reveal that, which it makes sense. I guess Gary, I mean maybe here is no other question that somewhat rely, one of your competitors, they reported yesterday also seems to like 15 year agency MBS and moved up to that 45% allocation there.

You guys are still somewhat less than that or even moving in that direction. So I guess maybe if you could just comment further on your expectations or maybe just were you see relative value now and what that implies for the portfolio? And within 15 year, I guess because obviously like if you could comment on sort of the economics of actually buying and holding positions versus the dollar roll in that where – looks to me like there is still pretty attractive roll income?

Gary Kain

Sure. I mean I think that MTGE absolutely believes that there are benefits to 15-year versus 30-year and has been increasing its position with respect to 15-years as well as another REIT. However what I would say is that MTGE has a different perspective it has a different business model. And so in its agency position it has to keep in mind that the agency position as its complete liquidity buffer given non-agencies, the non-agency position has different interest rate characteristics.

And so, its focused on its unique circumstances and generally speaking we’ll tend to have a higher percentage of 30-year mortgage than it otherwise would because of the tremendous advantage of liquidity and importance of liquidity to the mixed position in that there are times when if we want to add non-agencies where you want to sell something on the agency side if you want to move leverage around you are going to do that. So there are number of reasons why its business model dictates some differences in positions.

And so I would keep that in mind I would say big picture 15s are something that make more sense in this environment to MTGE and you’re seeing those trends reflected. Now with respect to the dollar rolls again there are trade-off, some 15 years one of the big advantages they roll down the curve and having a seasoned 15 year and a rising rate environment is worth a lot. And that if you believe the role benefits are only one or two months then, 15 years there’s a real benefit to getting the right collateral when you needed and so it’s very dependent on market conditions, and our view of the – kind of role opportunities over time.

And so, what I would say there is no simple formula we look at both, we view both as being big value added to 15-year either that you can get a season security that shorter in duration if you needed. And on the other hand, if you feel like rates are stabilizing and you not as worried about the win then you can take advantage of the role and that flexibility is a huge benefit of ours to 15s right now.

Michael R. Widner – Keefe, Bruyette & Woods

Okay, thanks. I appreciate the comments on the color.

Gary Kain

Thank you.

Operator

(Operator Instructions) our next question comes from Douglas Harter at Credit Suisse.

Douglas Harter – Credit Suisse

Thanks. Can you guys talk about how do you see the relative value between agency, non-agency today and any senses to where that equity allocation should be going in the coming quarters?

Gary Kain

What I would stress right now is that this is a period, set at the highest level and then we’ll take it on notch down. At the highest level this is the period of where you priorities risk management over short-term return and that kind of has plusses and minuses from both sectors. I think that liquidity is important in a potentially transitional environment that’s a positive on the agency side.

On the other hand, you do have more interest rate exposer, on the agency sides. So from a risk perspective, balance is important, liquidity is important. From a pure return perspective, I think that it agencies are right now we’re not trying to maximize return and if you are completely fully hedged on an agency position. The returns are nothing to ride home about.

On the other hand given a steep yield curve to the extents of willing to take a more normal or moderate amount of risk on those positions than they’re quite attractive. So I think the trade off really relates to kind of I think the trade-offs will evolve very quickly over time and it’s about kind of patience and risk management first right now.

Douglas Harter – Credit Suisse

And then obviously hearing your comments about the importance of liquidity right now, but just from the interest to sort of get your thoughts on how you’re going to view hybrid ARMs in the current environment given there, so recent weakness?

Gary Kain

It’s interesting because in general we believe that when it comes to managing interest rate risk, longer instruments that are hedged can give you a short duration, a manageable duration and convexity gap with much better liquidity. And so our starting point is before we look it let’s say less liquid mortgage securities whether they’re hybrid ARMs or CMO tranches or things of that nature.

There is a higher bar because you are giving liquidity and again while inferior shorter duration instruments sounds good. You can get to that point with hedges and but you can’t manufacture or kind of tweak things to get liquidity.

So, we start with a higher bar and ARMs that being said they have cheapened up sum and they are getting to the point where we are starting to think about them, I would say they are not quite bearish so to speak but what I would say is they have gotten back on the radar screen, but we would be – what I want to stress is we would not be comfortable with it being that big of a percentage of the portfolio.

And again especially for MTGE, where the reality is liquidity on the Agency side of the book is really important and so, that bar is reasonably high.

Douglas Harter – Credit Suisse

Great, thank you, Gary.

Operator

Our next question comes from Joel Houck at Wells Fargo.

Joel Houck – Wells Fargo Securities

Good morning. I guess maybe in more of a question on the non-Agency philosophy, there’s no question on housing sector has been very strong, but lot of that is being driven by institutional capital coming into that sector. And so, what we have today is, higher home prices, higher rates, which is serving to block out kind of the marginal first time home buyers, so, kind of with that backdrop and strength when you’re thinking about the non-Agency market differently than you did when you did the IPO or is it hey we think there is enough fuel here to keep things moving in the right direction and therefore our risk appetite is still greater, even greater than it was at the IPO?

Gary Kain

Yeah I would say in terms of the housing market itself, I mean obviously we have come in decent ways since the IPO, I do think there though that, some of the fundamental dynamics they are still pretty favorable, both in terms of the momentum you’ve seen, the supply coming down, are considerably in a lot of areas. And also, mortgage rates are 100 bips higher than their loss but it’s still very affordable. And if we get return in some of the credit box, which I think is slowly – we’re slowly starting to see that could be real tailwinds for the housing market as well.

Actually the bigger issue in terms of, how we are thinking about the non-agency market is also just how much prices have come, and I think that relates to some of the comment we had before where, at a certain point sort of fixed income nature of these products takes over as the housing assumptions change in the prices, keep on going up. And I think that’s the piece that we’re thinking about a lot more now, in terms of how we want to think about that risk.

I still like having assets that have that exposure to housing. I mean even if housing doesn’t rise as quickly as it had to the last 12 months, I think there is still a big benefit to those assets and I do think it will have that offset versus the agency book.

So I still want to have some basically optionality to a further recovery and that’s kind of how we’re thinking about this assets. And that’s why you see this sort of mix, still heavily filtered towards some of their credit sensitive sectors.

Joel Houck – Wells Fargo Securities

All right, and this is a follow-up, is it relates to kind of portfolio management with respective agency and non-Agency I mean near-term, we saw higher correlation particularly, at the end of the quarter with MBS spreads and non-agency performance, but it sounds like longer term you still hold the view that rising rates and stronger economies, good for non-agency pricing and therefore that correlation is more of that temporary transitory event?

Gary Kain

I mean longer-term, right a stronger economy is good for credit and mortgage credit as well, okay. And so that should hold over the intermediate term. But with the transitory short-term, where higher mortgage rates kind of changes in kind of perceptive on the Fed in a combination in the near-term, which the near-term could be a year. That correlation is now in our minds positive under many scenarios.

And then to Jeff’s point, which I think is really important and this is probably the most true for the best credit non-agency paper and it trades on a spread or you have to think of it on a spread to other fixed income rate. So if it’s not likely to a loss then it starts look like a typical fixed income bond in which case its prices going to go down if interest rates go up enough, okay.

So I think you got to put those things together and rates have gone up enough on where the highest quality non-agencies are going to show positive duration even without sort of a QE3 effect and clearly when you sit there and say that there could an exodus from sort of higher yielding assets that people have bought to kind of escape QE3 then that’s an added issue to deal with in.

And I think that’s why I think Jeff stressed and has stressed in kind of asset selection within the non-agency portfolio that’s kind of staying away from the quote clean as non-agencies is probably the right way to go right now because the interest rate risk component of that is growing pretty quickly.

Joel Houck – Wells Fargo Securities

Yeah, I guess that just increases the correlation which…

Jeff Winkler

Right.

Gary Kain

The whole purpose is to have since lower correlation between these two asset classes.

Joel Houck – Wells Fargo Securities

All right. Thank you very much.

Operator

We just have one more question which is from Mike Widner of KBW.

Michael R. Widner – Keefe, Bruyette & Woods

Hey, guys. I guess just one follow-up and you really haven’t talked about it much but Gary something you alluded to I think your words were prioritizing risk management over near-term return and obviously with the addition of a lot of hedging instruments in the quarter that has implications for near-term return or more specifically earnings power of the dividend.

So without – well I will let you comment however you want but I guess the question is what kind of drag might we expect or should we expect I guess maybe that you’re willing to sacrifice a little bit of dividend in the medium-term or in the near-term for the sake of a more hedged risk profile if you will?

Gary Kain

Sure. Look and that it’s a good question and look there is a cost running a higher hedge ratio and to being defensive and that’s clear. So the short answer is that we are comfortable in the near-term sacrificing incremental carry for risk management purposes until we get a little bit more clarity on the market and we feel strongly about that and so big picture we did add swaps remember some of the swaps that were added also were added in conjunction in the first quarter with the equity rate.

So they’re not just all rebalancing oriented swaps and I’ll let Peter comment a little bit on this on specific impacts there but again the thing to keep in mind is are kind of I wouldn’t project out this fully hedged on a duration or almost fully hedged on a duration of [capacity] position too far out in the future, this is not the way we expect to run the business over the long-term. It’s a temporary position and again we feel it’s prudent, but we are certainly looking for an opportunity to run the position differently.

Jeff Winkler

Bill and on Gary’s point obviously at 106% hedge ratio we’re very well hedged and we wouldn’t expect to operate at that hedge ratio over the long run, but certainly in the short run, given the volatility of interest rates in the potential moves and a correlation between interest rates and spread widening, we think it’s prudent to have a higher hedge ratio and part of those hedges are forwards starting swaps, which aren’t yet fully reflected in our cost of funds. And as Gary mentioned, we often use forward started swaps around the time we do equity raises to sort of align the facet purchases with the hedges that we put in place.

So over the next quarter or so if those hedges were to become effective, obviously our cost of funds would probably increase by 25 to 30 basis points, but it’s not yet clear that those swaps will still be on our books at the time, obviously it will depend on the environment.

Michael R. Widner – Keefe, Bruyette & Woods

Got you well, certainly appreciate the thoughts.

Operator

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

Gary Kain

I want to thank everyone for their participation on the call and we look forward to speaking to you next quarter.

Operator

The conference is now concluded, an archive of this presentation will be available on MTGE’s website and a telephone recording of this call can be accessed though August 14 by dialing 877-344-7529, using the conference ID 10031373. Thank you for joining today’s call. You may now disconnect.

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