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American Capital Mortgage Investment Corporation (NASDAQ:MTGE)

Q4 2013 Earnings Conference Call

February 6, 2014 11:00 AM ET

Executives

Hannah Rutman – Investor Relations

Gary Kain – President and Chief Investment Officer

Aaron Pas - Vice President, Portfolio Management

Jeff Winkler – SVP and Co-Chief Investment Officer

Chris Kuehl – SVP of Agency Mortgage Investments

Peter Federico – SVP and Chief Risk Officer

Analysts

Douglas Harter – Credit Suisse

Trevor Cranston – JMP Securities

Mike Widner – KBW

Joel Houck – Wells Fargo

Jason Stewart – Compass Point

Operator

Good morning and welcome to the American Capital Mortgage Q4 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 of Investor Relations. Please go ahead.

Hannah Rutman

Thank you, Denise and thank you for joining American Capital Mortgage Investment Corp’s fourth 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 facts 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 forecasts 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 the 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 February 21, by dialing 877-344-7529 using the conference ID 10039556.

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; Aaron Pas, Senior Vice President, Portfolio Management; 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 and thanks to all of you for joining us on our fourth quarter earnings call. 2013 created a unique set of challenges for all fixed income investors and as such, MTGE’s returns did not live up to our expectations. The unprecedented open-ended nature of QE3 created an added level of uncertainty that bond market participants were clearly unprepared for.

As the economy began to strengthen, and as communication out the Fed surrounding tapering started to escalate all fixed income assets suffered. The possibility of an earlier than expected tapering of QE3 led to widespread selling of agency MBS from a range of investors.

This significantly magnified the convexity related rebalancing activities that typically occur in periods when interest rates rise rapidly. Now despite peaking during the summer, interest rate in MBS spread volatility remained elevated through 2013 with the 10 year treasury touching 3% in July and again on the last day of December.

The interest rate volatility was most acute in the latter half of the second quarter and early in the third quarter as huge bond redemptions and a general risk-off mentality swept through the financial markets. In this challenging environment, liquidity was compromised for all credit-sensitive assets non-agency mortgages included.

The weakness in non-agency mortgages is somewhat counterintuitive as most of these instruments have relatively little interest rate sensitivity and should benefit from strengthening economic and housing fundamentals. Fortunately, the weakness in non-agencies was limited in scope and duration.

Although short-lived, the weakness also serves as historic reminder as to why it is important to be conservative with respect to leverage when managing a portfolio of less liquid assets.

As we enter 2014, there is reason to be more optimistic. Risk positions are materially lower today. Liquidity is solid and the changes to the FED’s monitory accommodation are now better understood. As a result, the fixed income markets are decidedly more stable than they were just a quarter or two ago.

In response to these improved market conditions, we increased our duration gap further in Q4 and marginally increased our allocation to non-agencies as we gradually shifted the portfolio back to the more normal balance between risk and return.

With this as the introduction, let’s turn to slide 3 and review some highlights for the quarter. GAAP income was a loss of $0.33 per share. Net spread income totaled $0.69 per share during Q4 after accounting for a net loss of $0.17 per share from rolling short TBA positions.

It also includes $0.08 per share in catch-up amortization. Taxable income came in at $0.84 per share which exceeded our $0.65 dividend for the quarter. As such, undistributed taxable income increased to $0.77 per share as of December 31.

Our economic return was negative 1.1% for the fourth quarter, based on the combination of our 65% dividend and a $0.90 decline in book value.

So far in 2014, however, interest rates have fallen and agency MBS prices have improved significantly. Non-agency prices are generally flat to a little firmer as well. The combination of which has given our book value a meaningful tailwind year-to-date.

As I will discuss at the end of the presentation, we also completed the purchase of Residential Credit Solutions or RCS.

On slide 4, I just want to highlight a couple of things. First, as of December 31, we made equity investments in agency-focused REITs totaling $39 million. As of January 31, this position increased to approximately $54 million. Our actions here are indicative of our desire to generate value for our shareholders by extracting value from the MBS market both directly and in this instance indirectly.

Given the sizable price to book discounts in the mortgage REIT space, we believed it made sense to sell some agency MBS and buy similar MBS assets in REIT equity form at around 80% of book value. At that discount, it is equivalent to buying agency MBS 2.5 points lower in price than where you can sell them.

To us, the choice was pretty straight-forward as the almost 20% discount more than compensated us for the incremental fees and the reduced transparency into this subset of the portfolio.

Now one thing we chose to execute the strategy in the agency REIT space, given the availability of REIT stocks with ample liquidity at sufficient discounts. Another factor is the straight-forward pricing of the underlying agency collateral. In contrast, there is considerably less transparency with respect non-agency valuations.

Our net interest rate spread improved in the fourth quarter. As of December 31 our net interest margin was 225 basis points, up substantially from 177 basis points at the end of the third quarter. This increase in spread was a function of our larger duration gap, a smaller on-balance sheet agency MBS portfolio and a substantial increase in the use of forward-starting swaps.

Lastly, as I mentioned earlier, we repurchased around 1.5 million or approximately 3% of our outstanding shares in the fourth quarter. For the year, we repurchased a total of 13% of our shares.

Turning to slide 5, I will review some summary information for 2013 as a whole. Economic return for the year totaled negative 4.7% during 2013 and was comprised of $3.05 in dividends and a decline in book value of $4.27 per share.

The bar chart shows that MTGE’s lifetime return is still very attractive averaging 17% despite the weak performance last year. This result is even more surprising given that the post-QE3 period comprises more than half of our existence as a public company.

The key driver of our performance last year was a diversified nature of our portfolio. While agency and non-agency prices were positively correlated at the depths of the market around mid-year, the two components of the portfolio performed very different over the whole of 2013 with non-agencies mitigating some of the pressure on agency returns.

If we turn to Slide 6, we can see how our capital was deployed at year-end. The biggest change is a decline in the percentage of our capital allocated to agency MBS from 70% at the end of Q3 to 65% on December 31.

Our capital dedicated to legacy non-agencies increased slightly to 32%. We also added the other category this quarter to capture the capital we have assigned to RCS and as you can see, we applied about $38 million to this investment. I do want to be clear that this was not the purchase price.

Now in the future, investments in MSR will also be included in this category. In fact, along these lines, we do have a forward commitment to purchase approximately $50 million in market value of MSR which is likely to settle over the next two months.

At this point, I will turn the call over to Aaron Pas to discuss our non-agency portfolio. Aaron is the Senior Vice President dedicated to non-agencies for MTGE and has ten years of experience in the mortgage market. He has been with MTGE since its inception in 2011 and worked with Freddie Mac for eight years prior to joining us.

Aaron Pas

Thank you, Gary. The non-agency market continued to see good support in the fourth quarter after the resolution of the government shutdown. Spreads continued to grind tighter led by option arm and sub-prime backed securities. This tightening generated a total return of around 2.5% the legacy securities market.

While the longer-term outlook is good, we had prime jumbo securitization volume to be very limited in 2014. This is in part driven by lower origination volume as refinancing activity has dropped coupled with stabilizing guarantee increases, limited adjustment to the current confirming loan limit and the qualified mortgage rules which became effective in January.

There are also several factors that we believe will continue to make the prime securitization platform uncompetitive. These factors includes strong bank demand for loans and poor price execution on a senior tranches.

The securitization of non-performing loans on the other hand has picked up recently due to increased loan sale volume and strong investor demand for yield in short duration assets. The strength of this demand makes the securitization market an attractive financing solution for buyers of non-performing loans.

As such, we expect securitization volume of these assets to remain high this year. As we think about our current investments in the legacy non-agency space, our forward view is largely driven by our expectation around house price performance, the rate of new defaults and loss severity.

The next few slides should help you understand how we think about these variables at a macro level.

Turning to slide 7, we provide a high level view of the housing market. House price growth was very strong at a national level coming in at 12% and broad based with roughly 90% of the growth increasing.

At this point, we have recovered almost half of the price decreases lost into the peak. Over the next three years, we expect 10% to 15% cumulative house price growth which will put affordability at a fair level considering our expectation for somewhat higher mortgage rates and relatively low wage inflations.

Additionally, with lending standards and credit availability is still relatively tight, we believe it will be tough for housing to meaningfully increase through historical affordability metrics in the short-term.

It is important to note that the recovery to-date has not been even across regions and we don’t expect growth will be either. For example, geographies where institutional investors and cash buyers are focused for the last few years have outperformed and are likely to see less support in the near term given this outperformance.

With respect to the thoughts, we are optimistic that we will see continued improvement in default rates. Looking to the chart on the bottom right of slide 7, we show the rate at which current loans specifically, loans that have never missed the payment are turning delinquent as a function of their updated LTV.

From looking at the chart, the blue bars represent the annualized transition rate for delinquent in December 2011 and the grey bars represent December 2013, as you can see the trend across all LTVs is positive but fewer loans going delinquent.

On the right-hand side of this chart, for the universe, the drop in LTV due to house price change and amortization, coupled with credit improvements has led to a 50% decline from roughly 11% to 5% on an annualized basis. We do not expect this pace of improvement to persist. However, we do believe these default rates will continue to improve.

Turning to slide 8, we provide some insight into our views on severity. While we are somewhat bullish on default rates, we are less optimistic with respect to loss severity. As you can see on the bottom left chart, loss severity has shown a very muted response in the phase of the 20% house price depreciation over the past two years.

There were some regulations, settlement agreements and new laws have caused for closer timelines to deteriorate – very low transition rates of loans moving into and through the foreclosure process. As some of these properties said they can and others are not properly maintained, there is significant value destruction.

As an example, in December of 2013, loans liquidated in less than four years had an average loss severity of 53% while loans that took more than four years to exit the foreclosure process had an average severity of 90%.

Looking to the chart on the bottom right, given the significant growth in the percentage of loans that are more than four years delinquent and the previous comments about loss severity on those loans, we expect limited improvements in severity at least in the near-term.

With that, I will turn the call over to Chris Kuehl who will discuss the agency portfolio.

Chris Kuehl

Thanks, Aaron. On slide 9 we have an overview of the agency portion of our investment portfolio. The overall size of our agency holdings decreased from $6.8 billion to $4.9 billion during the fourth quarter. The decrease was a function of MBS sales related to share repurchases investments in other REITs, our investments in RCS and a modest reduction in at risk leverage.

Our net TBA short position decreased during the quarter from negative $1.6 billion as of September 30. The negative $800 million as of yearend. It’s important to note that TBA short positions are netted in our at risk leverage calculation.

The other point I would like to make is that, we are very focused on generating returns across a range of different interest rate environments and our overall asset composition is consistent with the subjective.

As you can see in the pie chart on the top left, 15 year and ARMs combined represent nearly 50% of our holdings. This portion of the portfolio with its minimal extension risk and shorter spread duration is a critical component of our overall risk position and our willingness to increase our base duration gap.

It’s also important to note that the vast majority of our positions have some form of call protection and in many cases, such as lower loan balance pools have characteristics that in addition to prepayment protection also exhibits faster borrower turnover in higher lower rates lower prepayment environments leading to an overall asset risk position with relatively little negative convexity.

With that, I will turn the call over to Peter to discuss funding and risk management.

Peter Federico

Thanks, Chris. I will start with our funding activity on slide 10 with the decrease in our assets, our REPO balance fell to $6.5 billion at the end of the fourth quarter. Our weighted average cost of funds increased five basis points during the quarter to 56 basis points due to a slight shift in our funding composition for the higher share of funding backed by non-agency collateral.

On slide 11, we provide an overview of our hedge portfolio. As we mentioned in our third quarter call, we began to gradually reduce our hedge ratio as general market conditions stabilized and given the changes we made to our asset portfolio.

The trend continued in the fourth quarter as we reduced our basic swap position by just over $1 billion. As a result, our hedge ratio dropped 84% at year end from 88% in the third quarter and from 106% in the second quarter.

On slide 12, we show our duration gap and duration gap sensitivity. Consistent with the decline in our hedge ratio our duration gap at year end increased to 1.6 years up from 1.1 years at the end of the third quarter and up from 0.2 two years at the end of the second quarter.

A key consideration in our decision to operate with larger duration gap is the extension risk we face in a rising rate scenario. You could think about our exposure to higher rate as the combination of our beginning duration gap, plus the extension risk we experience as rates rise.

In an environment where extension risk is high we will tend to operate with a smaller duration gap. Conversely in an environment where extension risk is low, we’ll tend to operate with a larger duration gap. The key point here is that when measuring interest rate risk it’s important to think about the combination of the two risks.

Today we face very little of any extension risk in our asset portfolio and therefore are comfortable operating with the larger duration gap. Our limited extension risk is a function of our asset composition, the current level of rates and the significant benefit we derive from our swaptions portfolio in a rising rate scenario.

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

Gary Kain

Thanks, Peter. Let’s turn to slide 13, so I can tell you about Residential Credit Solutions or RCS and describe the rationale for purchasing this mortgage servicing platform. RCS was founded in 2007 and it’s currently servicing about $10 billion in mortgages. RCS has a very experienced and impressive management team.

They are a fully licensed servicer with approvals from Freddie, Fannie and Ginnie. Their infrastructure is both scalable and it’s compliance focused. RCS provides us considerably greater flexibility to expand our capabilities in a number of areas.

First, it gives us the licenses and the platform that are required to purchase mortgage servicing rights. MSRs currently provide reasonable ROEs and also service a natural hedge against the interest rate and spread risk inherent in a fixed rate mortgage portfolio. Over time, we anticipate that these ROEs will become even more attractive as a result of the following trends.

First, the traditional holders of MSRs such as banks are likely to reduce their footprint in the space as a result of capital constraints. Second, more originators will be forced to sell servicing given considerably tighter origination margins and the need to generate cash to fund their operations.

And lastly, the new PE and hedge fund money that has been earmarked for the space while soon it will be fully invested or redeployed to other investment opportunities. So from our perspective, the investment in RCS and in MSR in general – this is not a short-term trade, and we are very optimistic about the long run opportunities in this space.

And while it is possible to purchase MSR with a virtual servicing platform for all the actual servicing duties are outsourced, we chose to go a different path for a number of reasons.

Over time, the lower cost to service and dedicated focus on MTGE’s MSR portfolio should be a competitive advantage and then also by having boots on the ground in the servicing field. We believe we will be more successful over time in scaling our MSR holdings with the GSEs as they are very focused on diversifying their exposure to a relatively small number of service providers.

Now outside of just purchasing MSRs, RCS can also provide us with the ability to manage our credit exposures on either whole loans or on retained interest from future securitizations. But before opening up the call to questions, I thought it was important to reconcile two measures of performance that are important to both shareholders and management.

On slide 14, we compare our economic returns in the portfolio, since our IPO in August of 2011 to the total stock return over the same period. The blue bars on the chart on the top left depicts our economic returns over three distinct time periods.

Economic returns includes the dividends that we paid, plus changes in book value during the period. The aggregate economic return has been very attractive totaling 45.6%. Surprisingly, the returns are relatively evenly distributed between the pre and post-QE3 periods.

Moreover, the aggregate return of 45% is pretty impressive given that the post-QE3 period comprises such a high proportion of our existence as a public company. When we compare these results to our total stock return a very different picture emerges. Again, total stock return is the combination of dividends plus the change in stock price over the period.

As you could see from the middle panel on the graph, the two measures closely track each other pre-QE3. In the post- QE3 period however, there is a major divergence between the two. But the total stock return dropping 6.5% our economic return was positive 19%.

You can clearly see this divergence from the table on the top right which shows that our book value dropped only $0.61, while our stock price declined $6.39 per share.

As a result, our price-to-book ratio fell from 108% at the end of Q2 2012 to 81% at the end of 2013. And while some of this price-to-book shift is understandable given the changing sentiments surrounding the FED and the poor performance of the space in 2013 we believe the current valuations in the mortgage REIT space are inconsistent with today’s fundamentals.

Additionally, agency MBS completely repriced during 2013 and then they thus already incorporate the same concerns and greater risk premiums that the REIT equity markets seems to be demanding. On the non-agency side of the business, stronger housing market and an improving economy are significant positives for the performance of these assets.

So our price-to-book ratio at 81% essentially says the equity market is applying an additional 20% discount on top of what’s already priced into the bond market. This in our minds creates a unique opportunity for investors.

So with that, let me open up the call to questions.

Question-and-Answer Session

Operator

Ladies and gentlemen we will now begin the question-and-answer session. (Operator Instructions) The first question will come from Douglas Harter of Credit Suisse. Please go ahead.

Douglas Harter – Credit Suisse

Thanks. Gary, you talk – in talking about RCS, you highlighted some of the other opportunities that are out there. Can you talk about what the likelihood of making investments into sort of whole loans or securitizations in the near term might be?

Gary Kain

Sure, that is more of a – we’ll say intermediate term opportunity. As Aaron said in his prepared remarks, we are not really kidding ourselves about the short-term opportunities in non-prime or in non-agency prime originations at this point. The volumes are pretty small.

The bank debt is extremely active, so to speak. And if you just think about where non-agency originations are like the rate to borrowers being on top or through agency mortgage rates, the economics just aren’t there. I mean, you are going to – when you think about Triple As trading three points back of an agency and you are starting basically at the same rate, there is really no way to make those economics work currently. And to be perfectly frank, we don’t really see that as changing that much over the near term and the near term being 2014 and so, we stress it as an important action and something that we need to be positioned for over time.

But I do want to stress that we don’t feel like we are in a sprint year to get in position to do a ton of that business where we want to do it and position ourselves to do it right over the long run and what RCS is one component that will help position us.

And as we are accumulating whole loans and aggregating them even holding them for some period of time potentially and if we do securitizations down the road, the ability to service them ourselves could be a comparative advantage.

It allows you to manage your credit risk, let’s face it, servicing, being able to modify delinquent loans, being able to control your own destiny is – can clearly be a positive and that’s something we have learnt from the crisis. So, that's kind of how we are thinking about it and it’s a good question. It’s not a short-term opportunity per se but it is something that will be critical to our future.

Douglas Harter – Credit Suisse

And then, sticking with RCS, when you look at the cost to service through owning RCS today versus the cost to sub-service, is that sort of equal today, or is that something that as you get scale would become equal to/an advantage for you?

Gary Kain

So, very good question. It’s probably close to equal today not right there, but I think it’s more over time as we get scale, then you will see a cost advantage there. But I think importantly you control your own destiny with respect to cost.

So, we don’t know what the sub-servicing landscape will be three years from now and where those costs are, but if you have the capability yourself and especially if you are building the scale, then you are pretty much assured that you are going to have an advantage.

You are not going to have a disadvantage because the reality is you could outsource that servicing and we would be very willing to do that on some limited basis if the economics were better.

Douglas Harter – Credit Suisse

Great, thank you, Gary.

Gary Kain

Thank you.

Operator

Our next question will come from Trevor Cranston of JMP Securities. Please go ahead.

Trevor Cranston – JMP Securities

Hi, thanks. A couple of more things on RCS. In terms of the MSR investment you are looking at now, can you talk a little bit about kind of the type of MSRs you are focused on, if it’s newly originated loans or legacy stuff and what the pipeline of opportunity looks like for you there?

Gary Kain

Sure, this is Gary. I’ll start and I’ll let Chris talk a little about the pipeline. But, just at a very high level it’s new issued MSR that we are interested in. We have the capability through RCS. They certainly have tremendous capability in non-performing loan servicing. So that is a definite consideration and I wouldn’t be surprised for us to take to take advantage of some opportunities there. But our main objective and our main focus is on the newer MSR and I’ll let Chris talk a little more.

Chris Kuehl

Sure, as Gary mentioned as of year-end we had a commitment to purchase 5 billion of notional MSR with an investment amount of around $50 million. The transaction was subject to closing due diligence and about half of the portfolio will close and transferred to RCS in the first quarter. And the other half in the second quarter this year. But we see packages regularly from – on a weekly basis, several packages from the brokers, and there are also relationships that we are pursuing as well to source MSR.

Trevor Cranston – JMP Securities

Okay, and would the intention be as you find new investment opportunities and close on them, would the intention be to sell down some of the agency portfolio or maybe increase the leverage on that a little bit?

Gary Kain

I think, right now, we have capacity to go multiple routes. We absolutely can increase the leverage on the agency portfolio. We’ll be comfortable with that. We also could absolutely sell agencies if there was a larger need and then lastly, our investments in other REIT equity or something that we could sell as well to fund MSR purchases.

Trevor Cranston – JMP Securities

Got it. And then I guess lastly on the RCS, you mentioned the special servicing capability in and there are some comments in the prepared remarks about the strength in the securitization market for non-performing loans. Do you guys feel like this has enhanced your capabilities to just buy non-performing loan pools and potentially securitize them and do the servicing for yourselves and do you see any kind of near-term opportunities in that space?

Gary Kain

It is definitely something that we are looking at. Again, we feel we do have the capability to control our own destiny in servicing and I think to your point in the legacy space, that ability is worth more.

So, it is definitely something we are looking at and the reality is that we settled on the RCS little over, I guess, two months ago. So, we are more at the beginning of looking at those opportunities, but it’s something that we are in a position to take advantage of.

Trevor Cranston – JMP Securities

Fair enough. Appreciate all the comments. Thank you.

Gary Kain

Thank you.

Operator

The next question will come from Mike Widner of KBW. Please go ahead.

Mike Widner – KBW

Thanks guys and good morning. I guess, just one more – well a couple of questions I guess on RCS. How do you think about and how should we think about kind of the ROE – I guess both the ROE component of investments in the MSR assets, expectations what range would you expect that to be and should we think of that as or do you think of it as both the hedge and I guess [inaudible] ROE business – does it also help offset some of the hedging requirements on the agency portfolio side?

Gary Kain

So, it is both and I think you bring up excellent points. The yield on the MSR, the IO component of the MSR is, we’ll call it in the 5% to 10% area, higher single-digits. But the return opportunity goes beyond that because you are not just adding an instrument at that yield. To your point, as you add that instrument, you are going to take off other hedges that are costing you money.

You are going to take off some ten year swaps as an example which are creating – which are increasing your cost of funds. And so that also increases your ROE on your agency portfolio. And then over time, it is also very possible and very reasonable to lever MSR investments. So, the bottom line is that the return potential comes – it’s significantly greater than just the yield on the asset.

But it also will depend on how you use that and again, it’s also dependent on one of the reasons why we are convinced, we are going to be competitive in this space over time, is because we are going to have the fixed rate portfolio and then we are going to be able to achieve the benefits of that offset.

Mike Widner – KBW

Yes, no, I mean, that certainly makes sense to me and one of the reasons that I think MSR assets are attractive in a structure like yours where you have agencies already. So with all that said, and given you’ve already started buying some MSRs what do you see the – again rough range of sort of ROEs on the business going, in incremental dollars, capital invested today as you guys look at the opportunities, again sort of encompassing both the agency and MSR kind of the overall blended opportunity there?

Gary Kain

Yes, it’s Gary. The incremental value, the hedge benefits are significant. It’s too early at this point to quantify that. It’s something as the position grows, we will absolutely start to quantify that for you. But at this point, it’s a little bit early.

Mike Widner – KBW

Okay, so that part notwithstanding then let’s say, even exclude the MSRs I mean, where did you see the opportunity, again from an ROE perspective roughly speaking or net spread however you want to phrase it, just ROE is a sure the easy way to think about the incremental dollar invested in agencies or the overall business mix today.

Gary Kain

Sure, so, first off, on the non-agency side, new investments are going to come in and we will call it the 5% to 10% area would be a range depending on where you get optimistic or kind of downside credit performance. When you are talking, we’ll call it high single-digits on new investments at this point on the non-agency side.

On the agency side, I think what’s really critical to keep in mind and why – I think we are a little hesitant to quote ROEs is it’s very dependent on your – how you end up hedging them, what kind of duration gap you are willing to take and what kind of – and how that’s likely to be maintained over time.

That being said, as we commented earlier, we are much more comfortable currently running a reasonable duration gap which improves the ROEs on the agency side to lower double-digits easily in that with that kind of hedging structure. And so, we feel comfortable that.

Going back to your question when you then start to add the incremental hedging benefits and something like MSR, which are going to incrementally increase those returns from there? That business is attractive.

And then second of all, when you get to the next level of this, as we talked about we think MSR cheapens up as we talked about – a year, two years or three years from now, agencies are probably wider and then once the prime non-agency securitization picks up, then you are going to have another complete business line that will kick in. So current returns are attractive and future opportunities look very good.

Mike Widner – KBW

Definitely good to hear that perspective. Let me ask one final one and sort of more just counting on the RCS. There is two new line items in the financials this quarter obviously the other income and other expense.

I assume RCS was mostly in there and so, if you could sort of comment on that, or if that was mostly what those were, and then related to that, were there any – maybe order of magnitude, sort of one-timers there. I’m just trying to get a sense for how to model them going forward would help to know there was $5 million acquisition one-time charge in there, smaller or bigger, how to ballpark it?

Peter Federico

Yes, this is Peter. You are absolutely right. On our income statement we had other operating expenses this quarter of $7.5 million and that did reflect the RCS acquisition. About $3 million of that you can think about as the one-time charge in there. And the remaining portion is sort of operating expenses that obviously will change over time as we grow that business and bring it up to scale.

Mike Widner – KBW

Okay, and then the corresponding line, the other operating income which I think was that $3.4 million, I mean, is that mostly RCS as well?

Peter Federico

Yes, it is.

Mike Widner – KBW

Okay and you indicated, I think, Gary that, for the real RCS operations if you will that you would probably continue to report them in that category. Is that what I heard?

Gary Kain

Yes, that’s correct.

Mike Widner – KBW

Okay, so I guess, this will really be my final, final question. When you guys calculated your version of core it would appear that you have excluded those two line items. How should we think about that going forward since it sounds like RCS is pretty core to the business at this point?

Gary Kain

Well, I think what’s important is, what you are seeing here is that those – whole of the operating expenses within RCS will stay there. On the other hand, to the extent we are making incremental MSR purchases will take the non-servicing related income and to bring it up to the REIT and then start to include that in core.

Mike Widner – KBW

Okay, I guess, just it would seem to me that – well, it seem to me peculiar to exclude any, other than one-time items to exclude any of the cost of what’s core to the business from what you call core income?

Gary Kain

Yes, look, I mean, I guess, remember it’s again, we term it to be net spread income. What we will do is, we will make sure that, I think the key thing when you are talking about these kind of measures is you’ll get all the information and we’ll break that out such that you can kind of make your own adjustments.

But I think we understand your point and we will be very clear about breaking out kind of the income that comes from the actual – we’ll call it servicing profitability in ROE versus the – we’ll call it IO or excess servicing type income. So, I think you will be comfortable that you will be able to get at that information.

Mike Widner – KBW

Yes, well your voice then – great in your disclosures so I expect that to continue and appreciate it saying you will. Thanks.

Gary Kain

Thanks.

Operator

Our next question will come from Joel Houck of Wells Fargo. Please go ahead.

Joel Houck – Wells Fargo

Hi, good morning. Apologize if you’ve already passed on this, but, can you maybe remind us or talk about the potential capital you could allocate to the MSR strategy. I know it’s a part of the overall RCS platform you are approaching it differently than your peers that I am just wondering from a balance sheet catching standpoint, how big you see that business getting?

Gary Kain

I think realistically, it could be in the area of 25% of our overall capital is probably a reasonable place to think of it in a fully mature environment.

Joel Houck – Wells Fargo

And – again, just the MSR let’s say the capital as a whole RCS…

Gary Kain

Yes, I mean, you could add a little bit there, but again, the RCS capital won’t grow that much in terms of the – it will mostly be incorporated in the MSR valuation. So, I think maybe you could up that to 30% in a sense as a way to think about it of the current capital base. If the capital base changes, then that kind of we’ll call it core investment piece will vary. But I think that gives you a pretty good idea.

Joel Houck – Wells Fargo

Okay, and then lastly, can you affirm that the MSR is a REIT eligible asset?

Gary Kain

We certainly are treating it as a REIT eligible asset.

Joel Houck – Wells Fargo

Okay, great. Thanks.

Gary Kain

That is the excess MSR.

Joel Houck – Wells Fargo

Right, right. Okay.

Operator

Our next question will come from Jason Stewart of Compass Point. Please go ahead.

Jason Stewart – Compass Point

Okay, thank you for the opportunity. One follow-up on the way that you are looking at bidding on MSRs today, are you incorporating or expecting any returns to be able to put leverage on that MSR?

Gary Kain

As we are bidding on it now, we are not planning on levering the MSR today, but we do have the capability to do so. So, I mean, we think of it much more and kind of a portfolio context and so, we have plenty of room to increase the leverage and to finance more agencies with much higher leverage to finance non-agencies.

And so, we are looking at it much more in terms of an aggregate picture, but again, even in standalone form, given the hedging benefits, MSR can make sense. So, I think there is a little bit of a combination that we know we have the option down the road to either finance some MSR or to kind of use other vehicles of getting to the same place.

Jason Stewart – Compass Point

Okay, that makes sense. In terms of share repurchase activity it looks like a little bit lower quarter-over-quarter are you including the way when you are looking at repurchasing your own equity or purchasing other mortgage REIT equity? Is that the same bucket to you and part the driver of the lower activity quarter-over-quarter?

Gary Kain

No, absolutely not and I think what you should think about with respect to the share repurchases is that, they are going to be very dependent on the price-to-book ratio and some other factors over the course of a quarter and I would restrict that into over the course of open window periods where we can transact in our stock.

That being a key driver, I would say if there was one extenuating circumstance that impacted our share repurchases, it was a little more of the RCS purchase and sort of bidding on MSRs around the same time as a settlement where we are probably being a little more defensive with respect to keeping that in mind.

But, that would be more of a one-time impact. I want to just reiterate, say with respect to the other REIT purchases, they do not detract from share repurchases. They, in our minds are a way to incrementally improve the returns on our existing or remaining agency portfolio and that’s the driver and you should not expect if we were to do more of that. But that’s going to continue to hold down the repurchase levels.

Jason Stewart – Compass Point

Okay, and then in terms of the equity bucket that you are looking at there for the other mortgage REITs, does it differ at all at MTGE versus AGNC given the focus and this vehicle is more credit-sensitive?

Gary Kain

Well, as we said in the prepared remarks, the answer is, it could very well differ. So we considered purchasing hybrid REITs for MTGE and we would have if we felt it was compelling.

But I want to stress that when you think about the hybrid REIT purchase versus an agency REIT purchase, there is so much more transparency around pricing in the agency space that it’s much easier to think of that as more of an arbitrage and less of– and there is not a ton of noise around valuations.

When you start to move to purchasing a hybrid REIT, then you are picking up a lot more uncertainty. You are also picking up a lot more risk around managements both in terms of valuation, but also in terms of switching from one sector to another which is harder to both manage.

And so, in our minds, it’s not that those returns and that those opportunities couldn’t be compelling, but they are much less of a substitute for an asset and much more of a purchase of another entity. And so that was one thing that – one reason for not going that route.

One thing I do want to mention very specifically with respect to MTGE because it might be implied otherwise is that, MTGE would not be or did not purchase AGNC stock. And the key point there is that, one of the advantages of – one advantage of another third-party managed entity is you are not restricted with respect to trading that stock.

And obviously, a large percentage of our purchases were actually in December and January and we would not have been able to transact in AGNC if we had wanted to. And second of all, then there are lots of restrictions with respect to trading it down the road. So, you should not expect – none of the agency REIT stock purchases within MTGE include AGNC.

Jason Stewart – Compass Point

Okay, that’s helpful. Thank you for the color.

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

Well, I’d like to thank everyone for joining us on the call and we look forward to speaking with you next quarter. Thanks again.

Operator

The conference has now concluded. An archive of this presentation will be available on MTGE’s website and a telephone recording of this call can be accessed through February 21, by dialing 877-344-7529 and using conference ID 10039556. The conference has now concluded. You may now disconnect your lines.

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