Gary Kain – President & CIO
American Capital Agency Corporation (AGNC) 2014 Credit Suisse Financial Services Forum Conference Call February 12, 2014 10:15 AM ET
Good morning, my name is Defoma [ph] and I'm one of the Credit Suisse Analyst, working alongside Douglas Harder. And it's my pleasure today to introduce AGNC, American Capital Agency. And today joining us is Gary Kain, President and CIO. With that, I'll hand it over to Gary.
Thanks a lot. And I appreciate the invitation to be here in Florida where it's nice and warm versus on the East Coast where it is anything but warm. And with that let's jump into the presentation.
So if we turn to page two, this is just some highlights of AGNC since it went public in May of 2008, and AGNC went public at dollar price of $20 a share. I think the most interesting thing, maybe on any of these pages is that since our IPO, we have paid $27.61 per share in dividends and cash dividends. And at the same time, over that whole period we've still grown book value upto $23.93 a share at the end of December. So, paid a lot of dividends and grown book value, additionally the company has gone from – around $300 million at the IPO to having a market cap today of around $8.5 billion. So we feel – we certainly feel good about that history but we also recognize that the important thing is – for investors at this point is the future.
So if you go to page three, we can look at the 2013 year which – as we said on the earnings call was clearly a disappointing year for us, and for agency mortgages in particular. There are going to years where certain asset classes underperform, 2013 was clearly a year like that for fixed income. And agency mortgages again were shorted at the center as a storm. Now that said, I think what is really important here is looking at the – at the bar chart on the bottom, and putting last year’s performance in the right context. So AGNC produced a total economic return of negative 12.5% in 2013, and that's the combination of the dividends we paid and then the loss in book value.
When you put that in perspective, any two year period in AGNC's history, returns have been very attractive, and if you look at it on an annualized basis since our IPO, the returns have still been around 18% – a little over 18% over that whole period, and again, that's inclusive of the poor performance in 2013. So big picture, there are going to be years where fixed income is going to underperform, we feel pretty good that 2013 was that year and for reasons that we talked about on the earnings call, and we'll touch on them throughout this presentation, we don't see a repeat of that in 2014.
You turn to page four, I think what's important here is, there are two return measures, the two – which we think are the two most important. There are tons of return measures but we talk a lot about economic return, and economic return is essentially the mark-to-market return on the portfolio itself. Said in other way, it's a combination of dividends that we pay plus the change in our book value. And, so in the book value calculation you're marking to market all your assets and this is sort of – if it was a hedged fund, if it were a mutual fund that would be the way your total return would be thought about is the economic return.
And then on this – on the chart here what we've done is that we've broken this out into three periods. Since our IPO to the end of last year, but then we've – in its entirety and that we've broken it out into the pre-QE3 period which was through the second half or the middle of 2012, and then the post-QE3 period which is Q3 2012 through the end of this year. And what's interesting is that that obviously the economic return, the blue bars, almost all of the returns essentially came from the pre-QE3 period, and our economic return, our mark-to-market return of the portfolio has basically been up a couple of percent over the last year and a half.
But what's unfortunate though is that when you look at the other really important measure for shareholders and for management, total stock return, which is dividends again, plus the change in the stock price, they tracked each other really well over the whole period or in the pre-QE3 period, but in the post-QE3 period we have seen a real divergence between the actual return on the portfolio, and the return on the stock. And so what you see in the post-QE3 period, the last year and a half, is you see that economic returns again positive by couple of percent, and the stock return, negative 25%.
And if you go over to the table on the right, you can see this all boils down to one relatively straight forward thing because, again, both measures incorporate dividends, and the same amount of dividends, so you can just drop that out. And it comes down to the performance of book value versus the performance of the stock. So, it was not a good year for book value, book value was down 5.5%. On the other hand, the stock price dropped 14.3% – or I'm sorry, $4, so $14.32 versus $5.48.
So when you put those together, that's the explanation of why these two measures are so different and if we say that in other way, what that is – you can look at it in terms of the price to book ratio, the price to book ratio went from 114% to 81%. And we'll talk a little more about what that means but the divergence or that between these two measures in our minds create a really good opportunity for shareholders looking forward.
If we go to the next slide, slide five, we can touch on AGNC's portfolio from a very high level. I think the main – there are two main points I want to make here. One is that, the portfolio hasn't really changed that much or didn't change that much in terms of the big picture composition between September 30 and December 30. So I get the question a lot, which is, is the rebalancing or repositioning of the portfolio that you've described in 2013, where is that? Is it half the way there, three quarters of the way there, 25% of the way there? The bottom line is it's almost entirely there. And where you can kind of see that is that the portfolio hasn't changed much in the last quarter in terms of roughly 50%, 15-year and 30-year, coupons have moved a little bit inter-quarter, or between the two quarters. But at a high level, we feel very comfortable with the portfolio, where it sits right now, we feel comfortable with our leverage and the – as well as composition. And so, that's not to say that we won't change things if market conditions change, but for now I think what you should think about is, there aren't wholesale changes that we need to make to the portfolio.
If you turn to the next slide, this is probably a much better picture into the actual portfolio itself, and really the easiest way I think for investors to understand AGNC's exposure to the market – the mortgage market, let's say versus if we had just brought or held an average or commensurate amount of the outstanding. And so if you were thinking about this as what areas of the market are you overweight or underweight, the number one thing to keep in mind is, the difference is 15-year versus 30-year mortgages, and we're clearly overweight 15-year mortgages versus 30-year mortgages. The mortgage market is 80% 30-year, while the fixed rate mortgage market is 80% 30-year; agencies 50-50, slightly higher on 15-years.
And the one question again a lot is, do you think that 15-year mortgages are so much cheaper than 30-year mortgages, is that the reason for this overweight? And that's not the reason for the overweight. I want to be clear. The reason is because we have to manage risk and we have to manage that risk importantly overtime. And so I can – we can hedge the duration of a 30-year mortgage versus a 15-year mortgage and make sure that we have the same duration gap for both, that's very straight forward. But the difference is the time profile of those assets, and how long is your capital committed, that I can't hedge.
On a 15-year mortgage as we went over on our Q3 earnings presentation, you get cash flows back relatively quickly, and much much quicker, almost twice the rate, and especially on a seasoned 15-year mortgage than you do on a 30-year mortgage. Which means if mortgage spreads happened to be wider two years from now, which is a very real possibility given the current trajectory of the Fed, then we have a lot of cash to reinvest, whereas the problem on the 30-year mortgage side is, I'm exposed to that spread risk, the risk that spreads are wider for a much much longer period of time and that doesn't decay the way it does on 15-year.
So the point that I want to stress to people about this position is, it's not – our mindset here is one of the evolution of these risks overtime, and not just the risk at any one point in time. So the advantages are shorter spread duration today but even more so, the evolution of that risk with time, because unfortunately I can't take the exact time when spreads are going to widen or when the Fed's going to be done or how the markets going to react to each of those. And by having that kind of a portfolio that's broken out along these lines, we are much better positioned overtime to react to those situations.
One other thing I want to stress about the 15-year proportion of the portfolio is the average maturity, at 12.5 years. And what that means is, the 15-years are shorter even if they were brand new, but these are two and a half years old, and they're going to season every quarter. But what's important here is that makes a big difference in terms of both, the extension risk, the spread risk, and how much cash flow you're getting back. A brand new mortgage, a brand new 15-year mortgage is not going to prepay, it's getting amortization that you're going to get but it's going to be prepaying one or two CPR for the first year or two. We're well passed that kind of trajectory on this portfolio. So while 15-year is valuable no matter what in terms of reducing the risk we talked about, seasoned 15-year is that much more valuable, it makes a big difference.
So with that let me move onto our kind of overall extension risk or kind of – a good summary slide around risk management. And I think investors in this space have heard a lot about duration gap, where duration gap is a measure of the difference in price sensitivity of your assets and your liabilities. But it's at one point in time, that one rate level where we stand today or in this case, at the end of the year. I think what is more important for investors to think about and what we've been talking about with people for over a year now, is it's much more about what does your exposure look like in a move that's going against you, and in this example, the upper 100 rate scenario.
And so what's important here is that, AGNC's duration gap has increased to one and a half years. It's profitable for us to run a longer duration gap but importantly, when we think about our risk, we think about our duration exposure, let's say in the upper 100 scenario. And in that case, this is actually the 1.8 years which you see in the – under the upper 100 rate column, and net duration gap was one options is actually very consistent with where it's been over the last year or two when we were running much lower duration gaps.
So from an aggregate pure interest rate risk perspective, even running a larger duration gap or aggregate risk position with respect to an upper 100 rate scenario has not increased. It has increased a little from September 30 but the 1.2 years was sort of off the chart low number, and if you went back another couple of quarters, what you'll see is that this is a much more normal position. So again, think about extension risk as it being the combination of duration gap plus the convexity of factor, what happens in a rising rate scenario. That exposure is lower than it's ever been which allows us the flexibility to run the larger duration gap. But I want to stress again, that the asset composition that we have is a key component for the lack of extension risk. And as you can see, the 15-year portfolio extends only 0.4 years, whereas if the 30-year portfolio which is lower coupon has already extended still has a full year of extension. So you can see some of that advantage that we talked about in 15-years. Again, this isn't the time variable part but it shows some of the flexibility that you're afforded by having a diverse portfolio.
Now if you move to the next slide, what you can see is, and this is kind of interesting, what I want to focus on here, this is a graph that shows what happened since the beginning of 2013 to both, the 10-year and to the mortgage rate. And obviously, what jumps off the page is May of 2013 where interest rate shot up, and you can see the impact of both – on both, the 10-year and on the mortgage rate. And mortgages clearly underperformed, it's not that obvious from the graph but mortgage rates underperformed, even the 10-year treasury which sold off about 140 basis points from high to low during that period.
What I want to focus on here is the very – the far right hand portion of this graph which, the dotted line shows you when the Fed made it's tapering decision in December. And there was tons of fear throughout 2013 with respect to changes at the Fed, the different stands, what are they going to do from the perspective of a combination. And clearly, the bond market spend second half of 2013 or from May on, adjusting to those assumptions. But since the actual tapering announcement, what you've seen is rates have been – have declined, mortgages have done well, and generally, a much less volatile period.
Now there has been some volatility obviously, partially due to the equity market volatility, and we're not saying volatility is gone but what we're saying is it's important to keep in mind that the bond market has had a long time now to adjust to a changing economy and a changing view of the Fed, and from our perspective most of that is priced in, and that's why even post-tapering you've seen very good performance of fixed income and much more stable performance, and we expect that actually to continue.
And if you go the next slide, I think this is interesting to look at with respect to what's happened in the market actually from January or from the end of December through today. And clearly, in the fourth quarter interest rates went up, mortgages – prices went down, mortgages generally underperformed. And so if we take, let's say a 30-year 4% which is if you go to the bottom left table, and you go three rows down, you can see that in Q4, they – the 30-year 4% dropped 1.75 points. In 2014 just to the right of that, they've recovered 1.87 points, so they are up about 430 seconds [ph] but net from September.
And so when you think about in the – if you're thinking about book value for AGNC, if you're thinking of just about the space, you were back to essentially the levels that we were at, in the case of this coupon back in September. And then if you go to the 15-year side, we look at 15-year 3%, that they haven't – they've dropped 1.48 points, and they've made back a 140 basis points, so almost all of it on that side. One thing that's interesting is that the mindset – just if you compare the performance, 15-years of performed fine but they are basically where they were at the end of September. And 30-years are not that dissimilar to where they were at the end of September as well.
And so just bigger picture, the takeaway from this is that what you've seen so far in 2014 is basically a reversal of everything you saw in Q4. And the other thing to keep in mind is that that's true of the mortgage pricing side, but actually swap rates have not rallied as much as – or in other words that, swap rates are still higher than they were as of the end of September. So mortgages have actually performed better than other interest rates for treasury and swaps.
So moving on to the last slide, if we look at this, I think what – this is sort of a summary of why we think going back to the slide where we talked about the economic return versus the total stock return, why we feel like this is such a good opportunity in the space which is one, mortgage rates and treasury rates have adjusted, the bond markets had its chance to price in the different environment, and that's already happened. A lot of the other risks that people had discussed with respect to mortgages have really dissipated. One is that the duration risk or the extension risk, mortgages rates have gone up and mortgages have extended already. Second of all, a large percentage of the mortgage universe is now an epithet, it's not hedged. Other players such as indexed funds that don't hedge and rebalance, some banks, foreign institutions also own big percentages of portfolio. And so the amount of rebalancing or repositioning needs in the mortgage market are at multi-decade lows from our perspective, and so that's going to make mortgages perform a lot better going forward, and if we do get a rising rate scenario, so that helps.
Policy risk is something we've downplayed for the last three or so years. And we always get questions about it. It's not something that we've been that worried about but there have been concerns with Mel Watt going to FHFA that that might change. I think most importantly with respect the HARP program and the effective date, and – or the date at which if you – if the loan was originated prior to May of 2009, it's eligible, there were a lot of fears that that might get extended, treasury has come out saying that they are not in favor of that. The market has taken that to me and it's not likely to happen, which I agree with. So big picture, it doesn't seem to be much in a way a policy risk, also just given this interest rate environment, that's not a big factor either.
And then lastly, in this category there has been a lot of concern about repo and the discussion has been – well, leverage ratios of the banks are going up. They are not going to be willing to do the same amount of repo that they have been willing to do before. There were concerns about netting which could really make that situation a lot worse. And what we've seen is that, the leverage ratio calculation has been softened which takes kind of the biggest exposure out from – that people were concerned about. But also we've been adding counter parties. From our perspective, we have more availability of excess capacity than we've had at any point in our history. The reality is we've added counter parties, and what people seem to forget here is that our portfolios and the REIT industry as a whole, and other users of repo, portfolios have dropped pretty significantly. So while there is a concern that the supply of repo may drop for these reasons, people seem to be have been ignoring the fact that the demand for repo has already dropped pretty significantly. So realistically we feel the supply and demand equation is actually more favorable for us now than it's been in a long time. And so we really think there are lot of reasons to – there are lot of moving part to the space, repo shouldn't be very high on anyone's concerns at this point.
So when you put all this together, we feel pretty good about the risk return trade-off, and that's even – and that's just for mortgages in general, but when you're starting at 80% a book or 85% a book, you're essentially getting an opportunity to buy mortgages somewhere around two points below the market price for the securities, and that's a unique environment. And when you think about stock buybacks, and the generation of the accretion you can generate from those type of activities, you're going to get even better opportunities, incremental ROE from those things.
And then the last thing I want to say, again about the price to book issue is, what I've heard sometimes over the last three to six months from people is, well, look get used to it. A lot of industry's have – we've seen a lot of institutions that can trade at a price to book discount, you guys just maybe entering that group. And people point to things like closed-end Unifunds or banks that have been at discounts to book, regional banks or other banks. And what I would stress here is, there is a huge difference between some of these other examples and the agency REITs. First is and most important is, the collateral. The liquidity transparency of the underlying collateral agency MBS is the second most liquid bond market in the world. Pricing and – it offers spreads or negligible. And so, there is an uncertainty with respect to the book value. The book value is sort of a known commodity, that's not the case with one-off loans to small businesses, or working market exposures. The other thing is there isn't one other big drivers of discounts in the banking industry were regulatory exposures, legal liability, capital requirement changes, and so forth, none of those things apply to the REIT space.
And then lastly, just the size and liquidity of a stock like AGNC versus the size and liquidity of Unibonds [ph], closed-end mutual fund. So I think big picture, the other thing I would leave people with at the end is that, this – in our minds it is a unique situation that's been created by the fact that we had a major repricing during 2013 in the bond market, that's definitely scared investors in REIT stocks and they've applied their own discount to an already discounted bond price. And really I think that's the unique kind of source of value that investors should be looking at.
So with that let me stop here and open it up to questions.
Gary, so with the stock price trading at a pretty significant discount to book here, and the relatively faster pay downs from the 15's. How did you guys balance out, redeployment of that incremental capital between – as a reinvestment, share buybacks or any other stuff that you're doing?
That's a very good question. So the question relates to, when – as we're looking to deploy capital, how do we decide between stock buybacks, buying assets, which assets and so forth. The first thing is, as we've stressed on the stock buybacks and we bought back 7% of our shares last quarter which I think by any measure was a very very big number, again that's 7% in a quarter of our outstanding shares. We're committed to doing that at the right price to book levels and going back to our discussion that if you're able to buy your shares back at let’s say 80% to book, then that's – you're supposed to do that, and if you don't want to increase leverage which naturally would occur from buying your shares back, you can sell mortgages, given how liquid they are. And we did a fair amount of that.
So if you just really looked at last quarter, our leverage actually ticked up. We sold about $10 billion in mortgages but that was offset by the share buybacks, and our purchases of other REIT equity. And when you put – and, so going forward, at these kind of price to book discounts it's really hard to justify not buying back a reasonable percentage of your shares. And then looking at other ways – one thing that we discussed on our call at length was that we were buying other REIT, stocks which was clearly a new move for us, it's something that got a lot of discussion on the earnings call. But the reality is it's – for all the reasons we talked about, it's hard for us to pass on opportunities to buy agency mortgages multiple points below. We have a lot of confidence in our ability to manage our assets, and we would put a premium on that but there are times when you've really – and I said this on the call, you have to check your ego at door because 0.5 point of outflow [ph] or something like that over a quarter really a great value added. It's hard to make up for a two point disadvantage.
Still very correlated with rates, right, I mean we say rates went up in May, the NAV went down, it's now trading a big significant discount to book value but the book value has gone down. I mean, in the end is the rate component is such a big part of the move, I mean how do – how would you convince investors or what would you tell investors, let’s say if a 10-year wants to go to 3.75 to 3.50 by let’s say four to six months, I mean how do you think AGNC will do and how would you positioning yourself or – in the end, is it – yes, I mean it's a levered bet on levered mortgages with – you have massive duration and it will be what it will be. So –
Look, we do have – we have the ability to hedge our duration gap and as we talked about earlier in the presentation, we've chosen over recently to increase our duration gap, not reduce it because we feel that the risk return of that position is positive. Last year, for the most part, the bigger cause of pain for us was not our duration gap, it was the mortgage spread performance and the widening of mortgages that we saw in Q2 and Q3. And so, realistically that's more of the exogenous risk that we can't hedge.
To your point, we disclosed our duration gap, we disclosed our models view of the impact of 50, 100, 200 basis points moves in interest rates, in our earnings presentation. And there is real exposure, so it's roughly for our 50 basis points – for our 100 basis points move we're – you're looking at 13% decline in book value, an immediate 100 basis points shift, so call that 6.5%, it's not linear but for the 50 basis point move. And – but on the other hand you got to remember that you've got pretty significant earnings from a dividend, and then that's assuming we take no rebalancing actions. So we do – we have decided to not limit the – to not take that down further because we feel that that's the right kind of place in terms of risk return.
One thing for investors too, and I think this January really points out one of the advantages for a typical equity investor to look at the mortgage REIT space which is really the inverse correlation versus the rest of the equity market. So interest rates tend to drop when the economy seems weaker, you typically look at – what we saw last year, we saw a great year for stocks, poor year for bonds. And, so one of the other benefits that I think people don't realize is the fact that you can – this is an equity like return, but it's inverse correlation to a typical equity position. And so I think that to your point about exposure to interest rates, I think someone has to look at that in terms of their aggregate portfolio and decide whether how they feel about that exposure. But what we try to do is make sure we disclose a lot of different looks at the portfolio to kind of make sure that people understand those exposures.
Hey, Gary. [Indiscernible] and also, obviously agency stock, you consider to just keep indefinitely or a time that eventually you presume where you sell that was taken. What are you thinking around when you do that?
So the question was why did we buy Hatter [ph] stock and what we plan to do with it. And – so first off, I want to stress with respect to the purchase of other REIT stocks, and there is a couple of things to keep in mind.
First, irrespective of how much – there is not – this is not an either/or decision. If we hadn't brought other REIT stocks, we wouldn't have bought back more of our shares. And if you want to evaluate the question on our share buybacks, the 7% number really speaks for itself relative to any other activity in this space in any context. I think people will conclude the 7% buyback was a huge number and it was in response to a very compelling environment as we talked about. So, but even if we had done 10% or whatever number you want to think about, we now have – we still have a portfolio of $60 billion plus of agency mortgages. And when you look at what that 80% of book means, or they are about, it's incredibly compelling versus holding mortgages. And so, I found the question a couple of times today, are you just doubling down, don't you have any enough exposure to agency mortgages, to interest rates, why are you doubling down? We're not doubling down. We're selling an equal amount – a levered amount of agency mortgages themselves and buying REIT stocks at a massive discount. And really just – our exposure is that maybe six months from now the price to book ratio will have gone from 80% to 60%, we want to take that risk. We don't think that's going to happen, we're getting paid to take it, you're getting more carry at 80%.
With respect to the one name that I can talk about Hatter [ph] because it's public, is, we actually were considering we don't buy in hybrid ARMS, we wouldn't have minded increasing our exposure to them. They are not that easy to buy in size, they are – if we had try to buy them in size, we would have moved that market half a point or more and made them more expensive. It would have been unclear we would have gotten a couple billion of them. Whereas in the case of buying Hatter [ph] as a stock, we can get access to 15-year in hybrid ARMs which we're both comfortable – we're comfortable with those assets. At 2.5 points below the market or 2 points when you're net out approximately management fees, it's just clearly the right economics for our shareholders and again, that's the way we looked at it. And so from our perspective, look, we don't – the last thing we want to do is grown and tell investors, look, it's all about price, it doesn't matter about the management team. The management team is very very important but investors should also understand that, look, we have a lot of confidence in our ability, we cannot make up for a 2.5 to book difference on an agency mortgage in this environment. And so, there is this check your ego at the door and you have to be practical about what you can do and what you can't do.
Lastly, I asked about what are we going to do with them or other REIT stocks. And what I would stress is, this is in our mind and that's a component of our asset portfolio, it's a surrogate for mortgages. The big driver is obviously price to book, if it gets to one – if gets our 100%, there is probably no reason for us to keep it, okay. On the other hand, we're totally comfortable holding these and we're not thinking of these as short-term trades. So the reality is, don't expect us to be long short and do anything fancy, these are one-only positions, and our mindset is they are surrogates for mortgages and we talked about the economics, and we'll sell them when we feel that they no longer add that compelling advantage versus the agency mortgage space.
You don't added – MSRs to their book, the thing this is a natural hedge to their agency and BS [ph] positions. Would that be a mandate or that could be like a strategy for AGNC going ahead?
It definitely is on the table for AGNC in terms of let's say, new origination MSR. Because that does have hedging benefits, it is a good compliment to a fixed rate portfolio. From AGNC's perspective, being an agency-only REIT, and just given its size, it's looked at opportunities there but hasn't found anything that's scalable. One thing I should say is, MTGE or other, our hybrid REIT has recently purchased a servicing platform, RCS. It has invested in MSR, and – so it is a market that we're extremely familiar with, and it's a market that we're spending a lot of time with. What we're trying from agencies perspective is we want to make sure that anything we do there is relatively clean and straight forward but also that it's scalable. We just have to be practical about what moves the needle. With that I think we are out of time at this point.
Alright. Join me in thanking Gary. Break up session is in Salon II [ph] just right outside.
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