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American Capital Agency Corp. (NASDAQ:AGNC)

Q3 2013 Earnings Conference Call

October 29, 2013 11:00 AM ET

Executives

Katie Wisecarver – Investor Relations

Gary Kain – President and Chief Investment Officer

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

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

Analysts

Douglas M. Harter – Credit Suisse Securities LLC

Steve C. DeLaney – JMP Securities LLC

Joel J. Houck – Wells Fargo Securities LLC

Michael R. Widner – Keefe, Bruyette & Woods, Inc.

Arren Cyganovich – Evercore Partners

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

Dan L. Furtado – Jefferies LLC

Operator

Good morning and welcome to the American Capital Agency’s Third 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 Katie Wisecarver in Investor Relations. Please go ahead.

Katie Wisecarver

Thank you, Chad and thank you all for joining American Capital Agency's third 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 forecasts 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 November 12 by dialing 877-344-7529 or 412-317-0088, and the conference ID number is 10035742.

To view the slide presentation turn to our website agnc.com and click on the Q3, 2013 Earnings Presentation link in the upper right corner. Select the webcast option for both slides and audio, and click on the link in the conference call section to view the streaming slide presentation during the call.

Participants on today’s call include Malon Wilkus, Chair 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 and Mortgage Investments; Peter Federico, Senior Vice President and Chief Risk Officer; and Bernie Bell, Vice President and Controller.

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

Gary Kain

Thanks, Katie, and good morning everyone. This is a very volatile quarter with substantial moves in both interest rates and mortgage spreads. However, if you just looked at the quarter-over-quarter changes and ignore what happened intra quarter things look relatively benign with small moves in rates and modest increases in most MBS prices. However, that approach to analyzing the quarter is somewhat short sighted as any prudent portfolio manager should not have simply just hoped that the Fed was not going to taper Janet Yellen would get the nod, the last two employment reports would miss the mark, money manager redemptions would slow and rates would recover.

As we stressed on the Q2 earnings call at the end of July, we would not employ this approach. We highlighted that our focus in this environment which is characterized by significant idiosyncratic and digital risk is to take actions to protect book value and to prioritize risk management over short-term returns. We also highlighted that leverage was declining. Our asset composition was evolving and that we were maintaining a conservative approach to hedging, despite the negative short-term’s earnings impact.

The good news is that these actions worked as intended and the variability in our book value was relatively limited intra quarter, despite the significant volatility. To this point when the market was at its weakest point during the quarter and 10-year rates were near 3%. Our daily estimates indicated that book value was only about 5% worse than where it ended the quarter. Thus even if we had closed the quarter at the lows on September 5, our economic returns would likely have been down only modestly.

In the current environment risk management is still the priority, but we are willing to increase our duration gap, as we believe the risk return trade off of disposition is considerably better now given that overall market positions are no longer off sides. And because of the new information we have around the direction of the Fed both in terms of leadership and policy.

I want to be clear that a key determinant of our willingness to increase our duration gap is related to the shorter spread sensitivity of our portfolio, and the fact that our asset portfolio becomes considerably less risky over time. While we remain relatively positive on the near term spread outlook for mortgages, we are unlikely to proactively take up leverage significantly as we remain more concerned about the intermediate term landscape and the idiosyncratic nature of the risk inherent in today’s market.

Now let’s turn to Slide 4, so I can provide additional color around some of the third quarter results, before handing the call over to the team. First, comprehensive income which includes both realized and unrealized gains and losses on assets and hedges was positive $0.45 for the quarter. Net spread income was $0.58 inclusive of a $0.03 loss due to dollar roll expense and a $0.03 hit due to catch-up amortization associated with slightly faster prepayment estimates this quarter. Net spread income declined due to lower leverage and the continued high cost of funds associated with the large hedge positions that we discussed last quarter.

Additionally dollar roll income swung to a net loss this quarter, as we opportunistically choose to maintain TBA short positions again certain specified goals that had negligible pay outs. As we indicated was likely on our Q2 call, our taxable income declined significantly in Q3 to $0.29. This figure also excludes about $2.20 of estimated net capital losses that are not deductible from our current taxable income. These capital losses will be carried forward for up to 5 years and applied against future net capital gains.

However taxable income also excludes around $222 million or $0.58 per share in net gains related to pairing of swaptions during the third quarter. These gains will actually be amortized through ordinary taxable income over the life of the underlying swaps. That was also important to point out that our taxable income in the fourth quarter is likely to remain under some pressure as we continue to divest some lower coupon 30 year securities which are probably not going to fit our investment objectives over the intermediate term.

To this point, we proactively choose to sell a large number of securities and replace them with other MBS that we believe are better suited to the evolving landscape. I want to stress that we will continue to priorities long run economic value over a short-term tax and accounting results and earnings geography.

This is the same approach that we have used over the past five years and it is critical to our ability to generate industry leading results over the long-term. Book value was down slightly at $25.27 in Q3, book value benefited from the strong performance of the MBS in the latter part of September, but was hurt by the significant volatility we witnessed during the quarter which required active rebalancing in order to be true to our approach of prioritizing book value protection over short-term income.

Our economic return for the quarter which includes both our dividends and our change in book value was positive 2%. Economic returns also benefited some from accretion associated with our $260 million of share repurchases. I want to stress that we remain committed to buying back our stock to the extent that our price to book ratio remains depressed.

The liquidity of our assets gives us the ability to easily sell assets and reduce repo borrowings with minimal transaction cost to generate capacity for share repurchases without the need to raise leverage. Therefore when our price to book ratio is at a significant discount, stock buybacks can generate meaningful shareholder value without increasing risk. This is a key benefit of the agency business model and we will continue to take advantage of these opportunities as they present themselves in the future.

Now if we turn to Slide 6, we can see the quarter-over-quarter changes in rates and MBS prices. Now as I mentioned in my earlier remarks this snapshot is a very misleading picture of the quarter given the substantial volatility we saw in both rates and spreads. For example while the 10 year treasury close the quarter at $261 on September 5, it touched 3%.

Likewise, 30-year 3.5s ended the quarter up 33 basis points in price at 101.83, but traded in the high $97’s on September 5. Essentially 4 points lower than where they were just three weeks later. These examples highlight the shortcomings of just looking at the quarter-over-quarter numbers. That said MBS prices ended the quarter generally up with mid-to-higher coupons performing the best.

In 30-years, the 4.5 coupon was the strongest performer, up almost a full percentage point. In 15-year, 3.5s were the best performer up a 140 basis points in price, which more than made up for their relatively poor performance the prior quarter.

Now before I turn the call over to the team, I wanted to turn to Slide 7, which we hope will give you greater transparency into how we are evaluating the trade-offs inherent in today’s environment. Here we depict two scenarios regarding the near-term economic picture and the timing of any such tapering.

On the left, we described the scenario where the employment picture and the economy as a whole quickly regained momentum allowing the Fed to taper relatively soon, let’s say by January. While the probability of this scenario seems to be dropping with most economists calling for a March taper at earliest, it is still a possibility.

On the right, we depict another very possible scenario, which many would argue is somewhat higher probability. In this scenario, the combination of unimpressive employment growth, lackluster economic activity and the low target inflation expectations make the Federal locked into cut-back on their MBS purchases before June of next year at the earliest.

It should be noted that there is a gap in between these two scenarios which entails the Fed tapering in March or April, which most economist would describe as sort of a base case scenario. In this scenario, it is much less clear exactly what the market reaction would be. Now that said, if we look at the early tapering scenario on the left, it would be logical to assume that intermediate to longer-term interest rates would increase with the 10-year treasury, potentially rising to 2.75%, maybe 3%.

Mortgage spreads would likely also come under some pressure but we believe the combination of remaining Fed purchases, low origination volumes and the substantial rebalancing actions that have already been taken by market participants will likely limit the damage to MBS in this scenario.

Lower coupon 30 or fixed rate mortgages, our likelihood and to were the greatest pain as few participants will want to own these securities in gradually rising rate environment with diminishing Fed support.

Now if we felt this was the likely scenario, we would want to lower our leverage, sell more or low coupon 30-year MBS and increase our hedge ratios despite the significant headwinds these action would create with respect to our earnings.

Now looking at the scenario to the right, were economic activity is not strong enough for the Fed to taper MBS purchases meaningfully in the first half of 2014. The outcome would be expected to be very different. In this scenario, interest rates are likely to be somewhat lower than where they are today. The yield curve flatter, and MBS spreads materially tighter.

Lower-coupon 30-years are likely to be the best performers in the short-run and longer-term hedges will be pretty expensive. If we felt this were the likely scenario, we would have relatively high leverage, a portfolio concentrated in lower to mid coupon 30-year fixed rate and would decrease our hedge ratios.

The key takeaway from this slide is probably really not that surprising and that is that the short-run picture for MBS is very Fed and data-dependent. Additionally, the continuing dysfunction in D.C. is another idiosyncratic risk that can clearly impact the economy and the Fed.

Now since the strategies one would employ are diametrically opposed and depend on which shorter run scenario you pick, we would air on the side excluding the difference because being wrong on either extreme would be very costly. Now that said, the intermediate to longer term picture is considerably clear to us and really is a key driver of how we are structuring our portfolio today.

Slide 8 summarizes our view on what we believe the landscape is likely [indiscernible] the next two to five years. In contrast to the short run, I think most people will agree that the Fed will not be purchasing a significant amount of agency MBS a couple of years from now. In their place the private sector will have to absorb a growing share of the mortgage market and as a result ROE expectations will likely be higher than where they are today.

In addition, higher bank capital requirements are likely to create a headwind, which should limit the ability of banks to materially increase their MBS holdings. Non-agency originations will likely be a growing percentage of the market. Now, since most investors cannot use the same amount of leverage on these investments as they can on agencies more capital will be required per loan than was required in the past, which will further amplify the need to attract additional capital.

Lastly, there will also be a larger amount of mortgage credit risk that will need to be underwritten by the private sector as the GSCs continue to lay off credit exposure and shrink market share. So what does all this tell us? It yells us that the ROE on agency MBS will likely be considerably more attractive two to five years from now.

Well, MBS prices of spreads are hard to pinpoint over the next year or so. We want to make sure we are in a position to be able to commit significant amounts of capital and more opportune times over the intermediate term. This is a conclusion we feel pretty strongly about. Overlaying this outlook with a moderately constructive buyers related to MBS in the short-term forms the foundation of our portfolio construction, which Chris will now talk about.

Christopher J. Kuehl

Thanks, Gary. On the next two slides I’ll walk through a few examples that demonstrate how we can remain invested over the near-term while creating significant flexibility to deploy capital over the intermediate-term even if rates at higher and prepayment speed slow further.

On Slide 9, we show the cumulative paydown over time for both a 15-year and a 30-year mortgage. The obvious point here is that 15-year mortgage returns principal at a much faster rate, which is mostly a function of the shorter amortization schedule, but also higher minimum prepayment speeds in a rising rate environment, which is the function of what the mortgage market terms borrower turnover.

Borrower turnover is a term that describes prepayments driven by life events such as a borrower’s decision to move or simply a decision to curtail their mortgage. Well, a number of factors can affect turnover. The primary reason a 15-year borrower is more have to move relative to a 30-year borrower in a rising rate scenario is that affordability is less likely to be a constraint since the 15-year borrower always has the option to switch to a lower payment 30-year mortgage.

Additionally, 15-year borrowers tend to curtail their mortgages or make extra principal payments at a much higher rate than borrowers with 30-year mortgages. What’s important to recognize is that both amortization and turnover are not highly correlated with interest rates, which means that 15-year MBS provides significantly more principal earlier for reinvestment, especially in higher rate environments like what is depicted in the bar graph.

Here you can see that by year five, the 15-year mortgage has returned 57% of the original balance whereas the 30-year has returned 34%. To put this into perspective, just in terms of principal that has already been returned, a $10 billion initial investments in 15-year MBS would be down to $4.3 billion five years from now versus $6.6 billion for a 30-year MBS. While this difference is dramatic it’s only a part of the equation.

Turning to Slide 10, we’ve taken a few steps further and you have the risk profile of a 15-year and a 30-year MBS evolve over time. If you recall last quarter, we compared the spread duration or basis risk of a 15-year versus a 30-year. On Slide 10, we’ve added the dimension of time to show how the risk profiles evolve. In the table at the top of the slide we have two hypothetical portfolios. One comprised of 30-year 4s and the other comprised of 15-year 3.5s and we’re showing the equity exposure of each to spreads widening 25 basis points assuming seven times leverage.

You can see on the table that the 30-year position continues to have considerable exposure to wider spreads. If spreads were to widen 25 basis points today, the 30-year position is estimated to close 15.6% of its equity. And if we look five years ahead, this exposure drops slightly to 14.1%, roughly a 10% reduction in equity spread risk. Now in the case of the 15-year position, its exposure drops by more than 30% by year five, from 9.3% today to 6.5% five years from now. So on a relative basis, the 6.5% spread risk estimate for five years from now for the 15-year position is roughly 45% of the spread risk estimate for the 30-year position.

It’s also important to recognize that future options cost or in other words future cash flow variability across various prepayment speeds of a 15-year MBS declined substantially relative to a 30-year MBS. In the table on the bottom of the slide, we have seasoned both positions five years and you can see that there is still considerable average life variability in the case of the 30-year pass-through whereas in the case of the 15-year pass-through its average life moves in a narrow range of 3.5 years at five CPR to 1.9 years at 30 CPR.

Clearly across a number of different metrics, you can see that 15-year pass- throughs delever or de-risk at a much faster rate and given today is relatively tight mortgage valuations than the inevitability of a future mortgage market without Fed support, it’s extremely important to have positions that naturally delever quickly and still provide reasonable returns today.

And let’s turn to Slide 11 to discuss how the composition of the investment portfolio changed during the quarter. As Gary mentioned earlier, the third quarter was volatile with idiosyncratic risk on multiple fronts that had the potential to move the market materially in either direction. Recognizing this we proactively reduced leverage in a measured way and continued migrating the composition of the portfolio to what we believe is balanced and appropriate for today’s transitional environment.

As of 9/30, the investment portfolio was $78 billion, which is down from $92 billion at the end of the second quarter. The majority of the decrease in our asset portfolio was explained by our at-risk leverage, which he brought down by a little over one turn and the balance can be attributed to sales associated with share buybacks.

The vast majority of reduction in leverage came from our TBA position, which was net short, approximately $7 billion as of quarter end. With dollar roll financing levels cheapening during the quarter on lower coupon MBS, it was cost effective to temporarily short [ph] certain TBA coupons rather than sell specified pools with attributes that have considerable option value and very little pay-up risk.

In hindsight, this was a good decision as the market has since rallied materially and we’ll likely chose to reevaluate which pools we end up keeping. At a high level, the most notable shift in the portfolio composition is that we continue to increase our waiting on 15-year MBS at the expense of positions with the most exposure to the Fed’s QE programs such as lower coupon 30-year MBS. With 15-year MBS now representing approximately 50% of the investment portfolio combined with somewhat lower leverage, we have considerably greater reinvestment flexibility over the next two to five years.

With that, I’ll turn the call over to Peter to discuss our financing and hedging activities.

Peter J. Federico

Thanks, Chris. Today I’ll briefly review our financing and hedging activity during the quarter. I’ll start with our financing summary on Slide 12. Our access to attractive repo funding remained uninterrupted throughout the quarter, despite very volatile market conditions. Our repo balance increased to $78 billion at quarter end, up from $70 billion the previous quarter. This increase in repo funding follows the shift in our asset composition toward a greater share of on balance sheet MBS versus off balance sheet TBAs. Other key repo terms like rate maturity and haircut were all largely unchanged in the quarter.

Turning to Slide 13, I’ll review our hedge portfolio. In response to changes in our asset portfolio we reduced the size of our hedge portfolio to about $70 billion at quarter end, down from $89 billion the previous quarter. Overall, our hedge position relative to our debt balance inclusive of our net TBA position fell to 91% at quarter end, down from 101% in the second quarter.

Given the shift in our asset composition toward a greater share of 15-year MBS, we felt like the third quarter offered a good opportunity to realize some gains on our swaption portfolio as well as shift the composition of our portfolio toward options that better fit our evolving asset portfolio. Although the size of our swaption portfolio decreased slightly during the quarter, it continues to provide a significant protection against materially higher interest rates.

Finally, I’ll review our duration gap sensitivity on Slide 14. Toward the end of the third quarter we took steps to increase our duration gap. At quarter end our duration gap was close to one year, up from about half a year last quarter. We are comfortable with this slightly larger duration gap because of the lower risk profile of our assets: the minimal extension risk left in our portfolio, the lower interest rate volatility in the market today and the lower leverage we are currently operating with. Collectively, these factors allow us to begin to move our interest rate risk positions toward more normal operating levels.

As can be seen from the table on this slide, given the composition of our assets and the natural extension benefits of our swaption portfolio, our duration gap will remain relatively flat at about one year even if interest rates increase materially.

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

Gary Kain

Thanks, Peter. Now, before I open up the call to questions, I just wanted to reiterate something on Slide 15 that we said on the last call. It is clear that an open ended QE3 introduced substantial volatility in our returns and the 2013 has been a difficult year. But it is important to highlight that our economic returns, which include both our dividends and our book value changes have been noticeably positive for the duration of QE3, which began in Q3 2012 and going through the end of this third quarter of this year. This is the case despite the significant rebalancing and de-risking activities we have undertaken to transition the portfolio for a somewhat different set of challenges and opportunities.

And lastly, while absolute returns are very important to investors any investment manager has to care about its performance versus a relevant index and its peers. As Slide 16 shows, AGNC’s active approach to portfolio management continues to provide industry-leading performance over the long-term and even since the onset of QE3.

So with that, let me open up the call at this point.

Question-and-Answer Session

Operator

Certainly. We will now begin the question-and-answer session. (Operator Instructions) Our first question comes from Douglas Harter with Credit Suisse.

Douglas M. Harter – Credit Suisse Securities LLC

Just took up your duration a little bit this quarter, can you talk about where you think that might settle out as you kind of normalize your hedges?

Gary Kain

Sure. We took it up, as Peter mentioned, to around a year from kind of around a half a year and a key component of being willing to increase duration gap is kind of holding down some of the other risks that we deal with, which are obviously our spread risk and it’s also as we kind of highlighted on this call, the evolution of the assets over time as well. And given those factors we don’t believe we’re at a limit in terms of how much duration risk we are willing to take. I mean it’s going to be dependent on evolving market condition. So I don’t really – it’s not that we have a target in mind that we’re trying to hit.

We will be responsive to market conditions, but in the end it’s really a combination of the types of assets and it’s also a function of the convexity of the position. And so in some ways when we think of the duration gap we think of it a little as the number today and we really think about our exposure to, let’s say, the up a 100 case scenario. And since we have so little extension in the portfolio from the base case to the up a 100, it gives us a lot more flexibility with respect to the duration gap.

So practically speaking, we could see that noticeably higher and wouldn’t concern me.

Douglas M. Harter – Credit Suisse Securities LLC

And you had said also that you did some further repositioning of the portfolio again in the fourth quarter. How do you think that impacts the net spread compared to kind of where you were at September 30?

Gary Kain

No, in the fourth quarter actually I mean, what I said was in the fourth quarter we will likely have some kind of taxable income headwinds as we deliver securities into some of the short TBAs. But those really aren’t kind of big picture rebalancing actions and the net of the dollar roll levels and the securities that will be delivered at this point probably aren’t going to be that meaningful.

So at this point our rebalancing, our activity in Q4 is not that substantial from an economic perspective.

In other words, our duration gap hasn’t come in, our leverage hasn’t really come down and really haven’t on anything at a high level, we haven’t done that much to the portfolio. That could change. Sorry, I just wanted to inject. That’s where we are today and obviously that could change if we see market conditions changes.

Douglas M. Harter – Credit Suisse Securities LLC

So as of today, the returns you were seeing at September 30 would be comparable today?

Gary Kain

Yes. And I would say the main difference between the portfolio as it might look would be that overtime, we would likely deliver some pools into some of the TBA shorts that you should see kind of, you should see the TBA shorts likely again something could change that likely kind of disappear by the end of the quarter.

Douglas M. Harter – Credit Suisse Securities LLC

Great. Thank you.

Operator

Our next question comes from Steve DeLaney with JMP Securities.

Steve C. DeLaney – JMP Securities LLC

Good morning, thank you. Gary, just a quick overview of your earnings components, third quarter versus second quarter, the thing that jumps off the page is the decline in contribution from drop income from a positive $0.49 to a negative $0.03 and I just wanted to – if you could talk a little bit about that, so that I and maybe others can understand all the moving pieces of the economic return there. Is it for starters, I guess my question would be, is this simple, is being the fact that you were net short TBAs at September 30 versus long TBAs and dollar rolls as of June 30?

Gary Kain

I mean, that is a key component, but let me take a step back and just walk through some of the changes there. So in terms of the position as we kind of talked about at the end of the Q2 call, our portfolio at the end of Q3 is smaller than it was – it will be aggregate TBAs plus on balance sheet assets is smaller than it was, and our hedge ratios although they are not higher at the end of Q3, they were very high, they were high at the end of Q2, and that clearly does have a short-term impact to the extend you maintain that. So those are the two kind of pieces which investors should be clear on.

The other is, the change in character so to speak of the $14 billion or so in long TBA positions that we had at the end of Q2. A lot of what happened there was, we actually took delivery of those securities. So they transferred from off balance sheet positions with dollar roll income to on balance sheet held positions and so the geography of that income merely changes.

Now, why did we do that? They were good dollar roll opportunities in a higher coupon, 15-years as an example. Well, we did that because there was a unique opportunity in the case of 15-years to take in those rolls and essentially force the delivery of seasoned calls. So we got a lot of two to three years old 15-year 3s and 3.5s in that process, which to us are much, much more valuable than our brand new 15-year 3 or 3.5 and you can kind of see that in the seasoning of the positions that Chris went over.

They are shorter duration, they are lower risk and so what we decided to do was sort of pass on short-term incremental income to prioritize kind of having the right assets on balance sheet at the end of the quarter. And then on the other side of that, the other side of that, the other piece of the TBA, short position really relates to as we were kind of shrinking the 30-year part of the portfolio, we chose to wait, so to speak in terms of deciding which pools to actually sell out to the market, and so we maintained the TBA short just against the pools, so we’d more time to make that decision. And when you think about why you do that, why is that important, even if there is a short-term cost?

Well, it’s important because if interest rates move a lot you may want to hold a very different pool. So if interest rates were 3.25 now, we would want to hold the most seasoned pools we certainly wouldn't care at all about prepayment protection and vice versa, if we were at 2.25, you make a very different decision and in between there is sort of the spectrum. So that was the reason and again, I just want to stress that we are in an environment where we're thinking big picture, we are thinking longer run returns that were not just try to optimize our quarter's numbers.

Steve C. DeLaney – JMP Securities LLC

Okay, that's helpful. And when dollar rolls obviously a function of QE3, when they became attractive and the term you guys used is when they become special, generally speaking do you still see dollar rolls as special and if you were to sort of re-risk a little bit, would long TBAs the dollar rolls be one of the tools that you might use.

Peter J. Federico

So, they are special in some coupons. So in a sense if you went back to the beginning of this year, what was the most special were the lowest coupons generally in 15 years and in 30 years.

Steve C. DeLaney – JMP Securities LLC

Right.

Peter J. Federico

Those are really not special now. Okay and so it’s cheaper if you wanted to maintain a short position, it is not that attractive to maintain a long position they are rolling, but in the higher coupons and 30 year even to some degree now in 3.5s but 4s and 4.5s there are opportunities to roll. In 15 years there are very good opportunities to roll, but then you’ve got to make trade-offs about whether or not it is worth it to roll that position and risk getting back on newer kind of war security.

So I think you’ve got a little more decision-making to do on the dollar roll side in 15 years, than you do in 30 years, but we expect to make use of dollar rolls in particular the 4% coupon going forward market conditions could change that, but we’re certainly positioned to do so.

Steve C. DeLaney – JMP Securities LLC

Okay, thanks for the color Gary. That's helpful.

Gary Kain

No problem.

Operator

Our next question comes from Joel Houck with Wells Fargo.

Joel J. Houck – Wells Fargo Securities LLC

Thanks. I guess looking at Slide 8, this sends a very articulate adjective cautious, expensive posture, but it seems to me that if REITs are selling, reducing their exposure to 30-year MBS, banks don’t want to [indiscernible]. I mean, how is the Fed actually going to be able to taper, into this environment without 30-year mortgage rates going substantially higher. I guess, the first question is – is this really, is this more a positioning out of the lack of understanding, what the Fed is going to do as opposed to the underlying fundamental because it would seem that if you just look out over the next year or so.

You didn’t seem to be any really head room for the Fed to taper in a meaningful way and to kind of step back and play defense at this point. I don’t know if investors are necessarily paying manager in the space to I guess to pay a decree often this kind of Slide 8 kind of seem to send the message that we’re not sure what’s going to happen in the next year or two, is that we are just going to kind of move the side line and clip coupon. I wonder if you could kind of comment on that.

Gary Kain

I think that is your perspective is interesting. That is not really the way we are thinking about it. What we do want to stress is and I think where we are consistent is if the short-term is idiosyncratic in nature, right. And it’s somewhat digital, I mean it’s depended on kind of what the Fed decides to do and yes, that is data dependent. But we do take pause in a sense in kind of getting too far in either direction. So we said that we are kind of marginally or we are somewhat bullish in the near-term on mortgage spreads. And for some of the reasons that you talked about, we don’t see the Fed exiting that quickly.

We think the odds are they are going to probably be a little around longer than maybe other people are where then let’s say the base case scenario. But that may not be the case and I think that it’s prudent from our perspective, when we don’t have any better information about how the economy is going to have adjusted or reacted to the government shut down on the debt ceiling issues.

To be cautious, because to your point it’s going to be – it could be reasonably expensive if you are holding tons of low coupon 30 years, when no one really wants to own them. And that is something that we view a risk that we have to avoid at this point, because we could walk in December and that employment number could be pretty strong and retail sales could have been strong and housing could hold up. And the Fed I think does want to taper at some point.

So when you put all that together that’s kind of the short-term picture. Now to your point about whether our longer intermediate term picture is cautious or defensive. I think it’s actually optimistic, okay, which is we are highly confident that we can make a fair amount of money in a couple of years, running our business. But there is one kind of key element to making that money is that we have to have capital to deploy at that point. And so one thing we don’t want to do okay, is mess that up, because we try to perfectly time kind of the Fed’s exit. And so look this is a different environment than other environments turns out that that’s been the case for the last 25 years, I have been in the business that every environment is a little different. But that is how we are piecing all that together.

And to go back to circle to complete that whole picture, it’s a key driver of why we are not obsessed about whether 15 years or five basis point cheaper or richer or 10 basis points here or there on option adjusted spread. Big picture they are a really good fit for investors that don’t want to be stuck with lower to mid-coupon 30 years as a huge percentage of their portfolio going forward. And we don’t want to get that big picture issue long.

Joel J. Houck – Wells Fargo Securities LLC

There is another way to think about this Gary there is a fast payout risk out there that you don’t want to be exposed during the mean time, unless you just return all the capital to shareholders you have to own something. So you can get these in return about exposing shareholder at risk, because it has never happened yeah, you give up some return, but you live to find another day whether it’s next year, four years from now.

Gary Kain

Yes. But going to your point we think we can generate short-term returns and very reasonable returns given the current environment, but let’s be also clear that across all asset classes, this is a generally low return environment, right and that’s one of the objectives of QE3.

So what we don’t want to do and so we feel we can generate reasonable returns, but what I want to be clear about is, look if the Fed stays in longer, okay, we will have very good total returns. We are maintaining 50% of our portfolio or have it at this point, it’s likely to drop overtime. But we are not all out, okay of 30 years, we will do fine in that environment, but what it maybe is, we would have picked up 10% in book value and we will pickup 7% or something like that, I mean I am not trying to vague those numbers exactly, but that’s fine for us right now.

That is a worthwhile trade off versus the scenario where we are sitting here with nine or 10 year bonds and returns two to three years from now are really attractive and we are not in a position to commit capital, that’s a bigger miss.

Joel J. Houck – Wells Fargo Securities LLC

All right, thanks. I will let other to ask, and I will jump back in queue. Thanks Gary.

Gary Kain

Thank you, Joe.

Operator

Our next question is from Mike Widner with KBW.

Michael R. Widner – Keefe, Bruyette & Woods, Inc.

Thanks. Good morning guys. And I am going to apologize, but I am going to take over drill the same question here. So again going back to that Slide 8, I guess my first reaction to reading it is, if you stuck this in the 3Q presentation from 2010, it did kind of would have fit right in and 2011 and 2012. The expectation of rising rates in less fit purchases and widening spreads is kind of I mean that's a fall phenomenon and we’ve seen time and time again and yet it hasn't really quite happen.

So again the thing I can't help but takeaway from this slide much to Joel's point is it sounds like you are saying the prudent course of action is to sit on our hands for a little while and wait for some of that to play out and keep more than a normal amount of dry powder because everybody just want to keep some dry powder for a long time but in there it certainly sounds like you're saying more than the usual amount of dry powder.

So, you’ve already answered a lot, but I guess what I am hearing is what you're saying look for lower ROEs than we delivered in the past, going forward because we still think or we now think that it's much more likely that we’re going to see that rise in rates than really than you had and – because again this is a slide you could have put in any of the last three years or four years really?

Gary Kain

No, and look, I think I get your point and I think it's a valid one which is, there is a reasonable possibility and I want to be clear on this that this turns out to be a huge head fake so to speak. Rates go back to 175 on 10’s and the economy falters and we're back to where we were two years ago and that is a possibility and we are not we can't completely ignore that and that's why that's one of the things we have done that would help – we have a decent duration gap at this point and we’re maintaining some balance in our assets.

We still have a lot of prepayment protected assets just a lot less than we did before. But there are some differences this time and to your point we felt comfortable before that the weighting of the risks coupled with the relative value of mortgages and how they were priced, it really argued against obsessing about 2 years to 5 years from now, okay.

On the other hand the landscape is somewhat different. The Fed is talking about – they are clearly spending a lot of time talking about tapering. They’re not doing it, but it is – there are some differences. The housing market is stronger now. The energy boom in the United States is going to have some impact over time. Europe is stronger.

So I’m not trying to make the argument for why the economy is going to surprise to the outside because honestly I think in the near-term it’s going to take time to get that momentum back and I would probably argue for somewhat later taper than that midpoint estimate, but it’s not the right kind of big picture position for us to put on. We can’t completely expose ourselves to the other side of that. In other words we can’t just have all low coupon 30 years assuming we’re going to sell them six months from now.

But on the other hand some balance with awaiting to the long-term scenario, so you don’t get wrong seems to us to be the right position for this environment and just to conclude and go back to your point, yes, we’re willing to accept lower returns in that process.

Michael R. Widner – Keefe, Bruyette & Woods, Inc.

Well, I appreciate the further comment there. One, I guess somewhat related question is that you guys are still very heavy users of swaptions, all things considered, 20 billion out of an 70 billion overall hedge book. I mean, it’s a great convexity hedged, but one of the downsides like with any option is that the value declines to zero fairly quickly as you approach the strike date at the end of the option period and you also have the problem that has evolved underlying Wall falls you also get the K.

So the cost basis, I think you guys indicated was about 425 million on those, less than one year to strike if I’m reading the numbers right. I mean that’s a pretty expensive position to hold if you think that we’re – again if I go to what you’ve laid out on Slide 7 because we’re probably not going to see that 100 basis point rate spike in the next six months. So I guess, I’m just wondering about, again you began the call by talking about all the things that changed over the quarter despite the lack of movement in interest rates, mediocre job reports Janet Yellen, the clown show in DC continuing. Did that not call for sort of less expensive hedges where you don’t need to just be right, but you need to be right, right now as is the case with swaptions.

Peter J. Federico

Yes, this is Peter. Let me take that question. In my prepared remarks, I mentioned that we had done some rebalancing to the portfolio and all other things equalize, I think you make good points and you’re right. Over time we will continue to evolve the swaption portfolio to fit both the environment that we’re in and the assets that we have and I didn’t mean to imply in my prepared remarks that that process was concluded. So we will still continue to do that as the environment evolves.

A couple other important points though, you’re absolutely right that obviously the options will decay fairly rapidly. Our current portfolio option term is about 1.3 years on an average underlying of seven years. So we’ve shifted that to be a little bit more appropriate for a 15-year portfolio, but it’s also important to point out that there was extreme volatility in the third quarter, and if you go back and look at the market as recently as September 5, our swaption portfolio had a market value of $850 million, so it was actually unchanged as of September 5.

So just a few weeks obviously can change the whole outlook but that portfolio still could continue to provide significant protection for us if the environment does change, and we obviously will continue to evolve the portfolio over time.

Gary Kain

Yes. And just one other thing to add is that, it’s actually very consistent to, I mean we have reduced the size of the portfolio, but we’ve also reduced in a sense the option period and that’s consistent to some degree with Slide 7, right which is that we see the uncertainty kind of working itself out. So much of the uncertainty is kind of Fed depended and therefore it’s somewhat near-term dependent.

And while – and really what I think some people tend to miss with options is it’s very easy to see the cost of an option, but if the option wasn’t there then you’d have a different hedge which would have a different cost, and one of the reasons that we’re willing to run a larger duration gap which makes us a fair amount of money is because we’ve got kind of the worse case downside protective. And so there is a real kind of interconnection of all those things and so what I would say is to some degree the highest earning position is an asset portfolio without of the money protection.

Right, because you’re getting all the carry upfront with the exception of the option premium. Your biggest exposure is a small increase in rates because your options aren’t going to be worth much and your assets will lose value. But so keep that in mind, keep the big picture involved in mind, which is to your point, three months ago we were in a mindset where we were going to not take the duration gap and to have the options because we were doing that to hedge the spread component as well. And because look we were 25 basis points to 50 basis points away from another shoe dropping in terms of dominos in position. So that’s really the bigger picture.

Peter J. Federico

And just to sort of put a finer point on that duration gap. If you think about our duration gap today at 0.9 without any options up 100 basis points, our duration gap would be about two and half years. So think about the environment where we would be in, the strength of the economy if 10-year rates are up 100 basis points people will be expecting them to go up 150 basis points or 200 basis points and we likely would not be comfortable running at a duration gap of two and a half years at that point. So I think that's the essence of what Gary was mentioning.

Michael R. Widner – Keefe, Bruyette & Woods, Inc.

Well, thanks guys. I do appreciate all those comments. And again, I’ll just echo something Gary you said in the outset. I mean, I think if you plotted the book value across the quarter that’s where the true value in what you guys are doing, shows up the lack of volatility. Unfortunately as you also mentioned everyone sees snapshots in time to point to point, so a lot of the underlying stability gets lost by the market and the stocks trading right now under appreciated in the market.

So, I think congrats on what I believe is a very stable book value over the course of a very turbulent quarter, but maybe with the continued share buybacks, the market might come to appreciate a little more at least reward you a little more for it.

Gary Kain

Well, thanks for the comments.

Operator

Our next question comes from Arren Cyganovich with Evercore.

Arren Cyganovich – Evercore Partners

Thanks. On the near-term outlook slide on Slide 7, I just wanted to clarify you’re saying that you are kind of in the base case right now. If the near-term changes as you’ve laid out, such as economic activity slows towards the end of the year, would you actually take the actions of the short-term position in increased leverage et cetera in that environment?

Gary Kain

Look we will continue to react to new information and so absolutely look, we don't dig our heels and with the position and say this is the opinion we had and we're sticking to it as new information comes about but I will say that what we will need in order to kind of, start kind of, if you wanted to call it going back the other way in a major way would be that we want to have – we want to feel that the shorter term picture was not only kind of leaning in a direction but that there was kind of stability around that, because again what we feel is not that the long-term is always more important than the short-term.

Okay, where the intermediate terms are always more important than the short-term. Honestly, the short-term, very often is more important than the intermediate term. The difference here is I think we have a lot more conviction around the intermediate term and the short term and that's a key component of this. And then the importance of being wrong on one versus the other is also an important thing.

So again, just to reiterate your point, I would say we are in the sort of middle camp and if you told me it wasn't the March April taper, I'd probably tell you it's more likely to be the right side of the page with a later taper not an earlier one. But on the other hand, that could change very quickly with a couple of employment reports. And we don't want to be in that position, we don't think the upside, again if that scenario comes out, investors shouldn't see us as being offside in that scenario.

We have a decent positive duration gap where long we still have seven times leverage on both 30-year and 15-year mortgages. We'll do fine in that scenario and you should see book value kind of improvements in that type of scenario. They just won't be as big as they otherwise would have, and again that's a trade off we’re willing to make.

Arren Cyganovich – Evercore Partners

Okay, that makes sense. And then, kind of moving on to broader picture, the FT has an article, a couple of months ago about the Fed potentially reviewing banks exposure to mortgage REITs and that kind of fills in another seem that we’re seeing from Fed government comments [indiscernible] report, IMS comments about the risks of mortgage REITs in the marketplace more broadly. What are your thoughts about potential for regulation of the mortgage REITs, I guess over the intermediate to longer term.

Gary Kain

First, what I would say is look, I did see the FT article and it is sort of just similar to kind of what we’ve heard. And we do know that the Fed was asking banks about their policies and procedures around who they lend to and so forth, and REIT’s are clearly on that list. On the other hand, I think we are comfortable that the Fed is in an information gathering mode and they want to understand things and we’ve spoken to the Fed around how we manage risk and so forth. And I think the disclosure in the industry continues to improve. I think to continue to get people comfortable that the REITs don’t operate kind of the way people thought they always did in the past with just taking – buying 5 years to 10 year assets and just putting them on short-term repo with very few hedges. The process is very different now and looking while this has been a trying scenario for the mortgage REITs and no one should down play that.

On the other hand, going back to the slide, the second to last slide that we went over, I mean through the whole QE3 period we’ve generated positive economic returns. So those are positive mark-to-market returns.

So big picture, I think we are comfortable that the environment that we’ve gone through has been a test and I think that people haven’t gone out of business. There is – did they resell? Did they rebalance? Yes. Did money manager sell? Did servicers sell and rebalance? Absolutely. And REITs are not the biggest component in this whole process and so our sense of this test is one where what we have seen this year is that I think you should give people a lot more comfort than they probably had going in.

Arren Cyganovich – Evercore Partners

Thanks a lot.

Operator

Our next question is from Chris Donat with Sandler O'Neill.

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

Hi, good morning, thanks for taking my question. I just had some I guess I am trying to understand the trading environment here and the volatility and looking at some of the big picture stuff like from the New York Fed and looking at the primary dealer data, it looks like the trading volume of MBS was as low as, it’s low in the third quarter, it has been in seven years and there has been other data out there showing that dealer positions not just in MBS, but in corporate bonds and other asset classes have really dropped off.

I am just wondering if you think that that’s had any impact on the volatility that we have seen, certainly there have been a lot of event driven volatility, but I am wondering if some of the natural shock absorbers, you saw from or had seen in the past from a deeper market aren’t quite there. And I know it’s still a deep market, but just wondering what your thoughts are on that broader market?

Gary Kain

What I would say is that when you look at the MBS market, first, yes, volumes, especially recently are down. Volumes in the second quarter were pretty high. I think what you have to understand is in the case of the MBS market origination volumes are down, the Fed is such a big player in the market that that tends to kind of concentrate the volume there and then there is less activity around that, but there is tremendous liquidity in the mortgage market.

You are right about dealer positions and I think where you do have to be careful in any kind of more extreme movement is in less liquid securities that can’t be shorted. And so I think the problem sometimes is that when you go outside the agencies facing, you go to corporates, when you go to some cases non-agencies, when you certainly go to emerging market debt, when something bad happens or when everyone wants to go in the same direction, there is really, it is very hard to get the other side done. But what I would say and this is important about the agency fixed rate market is, because of the shortable market it reacts very, very quickly, but then retains its liquidity overtime.

So we are not worried about kind of decrease in liquidity and the agency space and I think all of the issues we went through kind of demonstrated that that market can function even in a time of kind of pretty significant stress. I do think there were periods in other asset classes in emerging markets, that’s a great example, where thinks sort of lock up and that’s one of the risks you always have when you participate in less liquid, non-shortable markets.

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

Okay. Thanks very much.

Operator

Thank you. We have time for just one more question and that question comes from Dan Furtado with Jeffries.

Dan L. Furtado – Jefferies LLC

Thanks for the opportunity everybody, and good morning. I must be missing something, but I don’t want to think the strategy is logical, appropriate and correct given the price risk that Fed represents asset values in this space. That said, I do have a couple of questions, and the first is big picture, looking more broadly at the residential mortgage market and not at AGNC’s core assets. Can you help us think about what do you think the most attractive returns in the resi mortgage market are likely to lie on the next in that two to five year interim period before ROE’s and the Agency space become more attractive again?

Gary Kain

I think what we have to be cognizant of is that asset, different assets kind of that there is a crowding out effect from one asset type to another, and so sometimes when you just bounce from one type of asset to another there is still kind of excess demand their because of QE3. I mean, this is what the Fed is trying to do, is crowd people out of certain products and that tends to work. And they move somewhere less liquid.

So our perspective is again depending on where you look, whether it’s non-agency mortgages, whether it’s agencies, whether it’s CMBS. This is a lower return environment. Now again when you go to Slide 8 and you look at kind of a bigger picture kind of a wider spectrum of markets, the same is true for mortgage credit.

The same is going to be, you could safer MSR, is that as private capital has to absorb a much bigger part of the mortgage market across all of these spectrums, then ROEs are going to be more attractive down the road and so one of the things that is important to us is liquidity and because if you have a liquid instrument that has a manageable amount of spread risk then, if something better comes along you have the option to do something with it, if you focus your portfolio and this sort of ties in with the prior question with less liquid instruments then you don’t have the flexibility to react to the next opportunity.

And so I think big picture this statement at least two slides which relates to the agency space are true kind of over a much broader range of assets.

Dan L. Furtado – Jefferies LLC

Excellent, thanks for that. The other question, two more quick ones, first is, have you given any more thought or any more effort on potentially figuring how to bring MSR’s onto the balance sheet or is that kind of not real feasible?

Gary Kain

No, we continue to look at the MSR opportunity which is the term I think, way too many people have used. And what I would say is that opportunity has turned out to be: a, harder to execute and b, much less of a short-term kind of opportunity as a lot less at least in the newer kind of MSR space is really traded then people would certainly have anticipated and prices in the near-term have gone up.

But our perspective on that hasn't changed, which if something that requires evaluation overtime, and it is something that we would like to still be able to in a position to participate in. It’s just realistically harder to execute and the opportunities haven’t shown up as quickly as kind of that’s some of the literature would have implied a year ago.

Dan L. Furtado – Jefferies LLC

Got you. And finally if I may, are you willing to give a stab at where you think book value is today, Gary?

Gary Kain

What I would say is, and this is true of kind of the positioning. I was asked earlier about the positioning and what I would say is that our positioning hasn’t really changed a lot and book value is not – there is no kind of material move really one way or the other at this point. I think that’s relatively straightforward information.

Dan L. Furtado – Jefferies LLC

Understood. Thank you for the time.

Gary Kain

Thank you. And I think that concludes our call at this point. For those of you who weren’t able to ask a question please reach out to our Investor Relations group and we’ll try to get your answers as soon as possible. Thanks to everyone who have participated.

Operator

Thank you. The conference has now concluded. An archive of this presentation will be available on AGNC’s website, and a telephone recording of this call can be accessed through November 12 by dialing 877-344-7529, using the conference ID 10035742. Thank for joining today’s call. You may now disconnect.

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