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American Capital Agency Corporation (NASDAQ:AGNC)

Q1 2014 Earnings Conference Call

April 29, 2014 11:00 AM ET

Executives

Katie Wisecarver – IR

Gary Kain – President and Chief Investment Officer

Chris Kuehl – SVP, Agency Portfolio Investments

Peter Federico – SVP and Chief Risk Officer

Analysts

Joel Houck – Wells Fargo Securities

Mark DeVries – Barclays Capital

Douglas Harter – Credit Suisse Securities

Aaron Saganovich – Evercore Partners

Steve DeLaney – JMP Securities LLC

Mike Widner – KBW

Eric Beardsley – Goldman Sachs

Dan Furtado – Jefferies

Operator

Good morning and welcome to the American Capital Agency First Quarter 2014 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. And I would now like to turn the conference over to Ms. Katie Wisecarver in Investor Relations. Please go ahead.

Katie Wisecarver

Thank you, Maureen. And thank you all for joining American Capital Agency’s First Quarter 2014 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 sec.gov. We disclaim any obligation to update our forward-looking statements unless required by law.

An archive of this presentation will be available on our website, and the telephone recording can be accessed through May 12 by dialing 877-344-7529 or 412-317-0088, and the conference ID number is 10044220.

To view the slide presentation turn to our website, agnc.com and click on the Q1 2014 Earnings Presentation link in the upper right corner. Select the webcast option for both slides and audio, or click on the link in the Conference Call section to view the streaming slide presentation during the call.

Participants on the call today 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, Mortgage Investments, Peter Federico, Senior Vice President and Chief Risk Officer; and Bernie Bell, Vice President and Controller.

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

Gary Kain

Thanks, Katie, and I want to thank all of you for your interest in AGNC. It was certainly nice to see some stability return to the fixed income markets in 2014 and we are pleased with our first quarter results.

A sizable portion of this performance was attributable to some of the actions we took with respect to the portfolio toward the end of 2013 and rather than just an overall tailwind for MBS.

Our economic return in the first quarter was positive 5.1% comprised of a $0.56 increase in our book value coupled with a $0.65 dividend. Our economic return was driven by a number of factors. First, as we discussed last year, we shifted a significant portion of our assets to 15-year mortgage securities. Fifteen-year MBS generally outperformed 30-year production coupons in the first quarter, and we attribute this to the realization on the part of many investors of the need to position portfolios into assets with shorter average lives and with less exposure to mortgage credit risk both today and in the future.

The second important driver of our book value performance during the quarter was our decision to operate with a larger duration gap and the positioning of our hedges across the yield curve.

Given the rally in longer-term rates, our decision to begin the quarter with a duration gap of one-and-a-half years, our largest reported duration gap since 2010, was obviously beneficial to overall performance.

Additionally, as we discussed on our last few calls, we felt it was prudent to reduce the size of our swaption portfolio. Option prices or in market terms the level of implied volatility, declined meaningfully during the quarter. And so losses on our swaption portfolio while still material were considerably smaller than they otherwise would have been.

Lastly, our purchases of other agency-focused REITs in December and January also turned out to be a very good move. These purchases generated about $50 million in both realized and unrealized gains during the quarter.

Looking ahead we expect a certain amount of yield curve volatility to persist as the market continuously reprises the timing and the magnitude of future Fed tightenings. As such, we believe active portfolio rebalancing will remain critical to our performance over the coming quarters.

With respect to the mortgage market, we remained constructive on MBS spreads given many of the same factors we discussed on our last call. Extension risk remains muted. Implied volatility should remain low. The prepayment landscape continues to be benign. And as we will discuss at the end of this presentation, the supply and demand equation and the overall positioning in the mortgage market remain very favorable. And this is despite our view that the Fed will continue to taper their purchases along the current trajectory.

Now before reviewing our financial results, I wanted to spend a few minutes discussing the increase in our dollar roll position and the implications on our taxable earnings outlook.

During the quarter, we increased our dollar roll position to around $14 billion based on the combination of very favorable financing and the reduction in the benefits of holding specified collateral.

First we’ll review the economics of these tradeoffs in greater detail, but I wanted to highlight an additional benefit of using dollar rolls given the fact that we have a large capital loss carry forward for taxable earnings.

In short, dollar roll income is treated as realized gain on sale each time the TBA is rolled. As such, the income is treated as capital gains or losses for tax purposes rather than as ordinary income as would be the case if we held the same position in pool form and funded it with repo.

Dollar roll income therefore nets against the accumulated tax loss carry forward which allows us to utilize that benefit more rapidly and reduces taxable income in our current period earnings.

Assuming we continue to make significant use of dollar rolls, this difference in tax treatment between dollar rolls and MBS pool positions will have significant implications for our taxable earnings outlook versus both our GAAP earnings and versus our true economic earnings as well.

To this point, taxable earnings as well as UTI will become less relevant in understanding our financial performance and our capacity to pay dividends. For this reason, we will likely deemphasize taxable earnings as a supplement non-GAAP measure in the quarters ahead.

Now it’s important to understand that the tax versus GAAP differences created by dollar roll income will not impact our decision with regard to where we set our dividends. As we have said many times in the past, we determine our dividend based on our view of the all in economics earnings power of our portfolio and not based on earnings geography.

If we can utilize our capital loss carry forward by generating capital gains via dollar rolls, we can in essence pass along that tax benefit to our shareholders by continuing the base of the dividend amount on the economic earnings power of the portfolio and changing the tax characterization of our dividend from ordinary to return of principal.

Dividends characterized as return of principal reduce an investor’s bases in their stock which only impacts the capital gain or loss they have upon sale of the stock. Again, if this occurs, it would generally be beneficial to shareholders in that return of principal dividends represented deferred tax liability for shareholders and are typically taxed at the lower capital gains tax rate rather than being taxed in the current year at the ordinary income tax rate. So this is the introduction.

Let me quickly touch on a few highlights from the first quarter on Slide 4. First, net spread income inclusive of dollar roll income but excluding catch-up am was $0.71 per share versus $0.67 in Q4. Dollar roll income comprised $0.14 of that figure for the quarter.

As I discussed in my opening remarks, dollar roll income nets against our capital loss carry forward, so taxable income was $0.47 per share. And UTI declined to $0.42 at the end of Q1. Again, the decline in taxable income in UTI based on the geography of dollar roll income will not impact our decision regarding future dividends.

With respect to the stability of the $0.65 dividend, management views it as an important objective to maintain the current $0.65 dividend and believes that should be achievable assuming market conditions remain favorable.

Book value per share increased 2.3% during the quarter to $24.49 per share in Q1. Moreover, our current estimates indicate that so far in Q2, book value is up at least as much as it was during the first quarter.

Now turning to Slide 5, our portfolio increased to just over $70 billion. The larger portfolio was essentially offset by the increase in book value, so at risk leverage was little change that quarter end at 7.6 times.

Our holdings of other REIT equity increased during the quarter to $352 million. As I mentioned earlier, total returns on this position totaled $49 million with approximately $10 million coming in the form of dividends. The remaining $40 million of realized and unrealized gains on our REIT equity holdings accounted for 20% of our total book value gains for quarter.

Now at this point, I’d like to hand the call over to Chris to review market developments and changes to our asset portfolio during the quarter.

Chris Kuehl

Thank you, Gary. Turning to Slide 6, I’ll quickly review what happened to the markets during the first quarter. As you can clearly see in the top two panels, both treasury and swap rate curves significantly both flattened during the quarter as the market began to price and Fed tightening.

Three-year treasury rate increased 12 basis points, while 10-year treasury rates were out at 31 basis points. And 5-year rates were roughly unchanged.

Mortgage performance during the quarter was mixed. And one’s view of performance was largely a function of hedge positioning on the curve, versus the 10-year mortgages significantly underperformed, but versus the 5-year, they did quite well.

Generally speaking, 30-year option adjusted spreads widened during the quarter 5 to 10 basis points. And 15-year options [ph] were unchanged to a few basis points tighter.

Let’s now turn to Slide 7 to review our investment portfolio composition. Our investment portfolio increased by approximately $2 billion during the quarter to $70.5 billion with the growth coming from our holdings of 30-year MBS. Our 15-year position was down slightly in both absolute and percentage terms declining from 51% to 48%.

The increase in our 30-year position was driven by our view that 30-year MBS performance would improve based on strong technical factors, lower volatility, a flatter yield curve and attractive roll financing.

As I mentioned on the previous slide, 15-year MBS outperformed 30s during the first quarter and we expect that 15s will remain well-supported as investors continue to look for ways to remain invested while reducing the interest rate spread in reinvestment risk.

To this point, despite the small increase in our 30-year position this quarter, 15s and other shorter spread duration assets will remain a core position that we will add to if opportunities present themselves.

The other notable change during the quarter is the increase in our TBA roll position which was approximately $14 billion as of the end of the first quarter.

Turning to Slide 8, we have an updated version of the dollar roll economic slide that we introduced this time last year. Given the increase of our TBA roll position, we wanted to provide you with a snapshot of current market conditions.

On Slide 8, we have two examples to highlight the financing advantage of rolling versus repo as of quarter end. You can see that as of March 31st, the advantage of rolling 30-year fours and 15-year threes was 74 basis points and 123 basis points respectively.

While there are tradeoffs in rolling versus carrying specified pools, the risk are lower now for several reasons. With each additional month that Fed purchases, the TBA deliverable improves as the Fed absorbs more and more of the cheapest-to-deliver flood [ph].

Secondly, refinancing activity is extremely low and is expected to remain muted, and therefore prepayment differences on different types of MBS are not a major factor. For perspective, this time last year, the refi index was north of 4,500. Mostly recently, it came in around 13.60. That’s been a third of where it was in the spring of last year.

And lastly, with the rally in rates and the flatter yield curve, seasoning is less important than it was a couple of quarters ago.

Now keep in mind that the margin shown in this table exclude hedging cost that are not intended to detect long-term returns, but rather to highlight a relative advantage of roll financing versus one-month repo over the near term.

Furthermore, while we do expect that differences in roll financing versus repo will persist for most of this year, you can expect volatility in month-to-month dollar roll levels. That said, the current monthly carry advantage from rolling versus repo adds up quickly and can significantly impact returns. With that, I’ll turn the call over to Peter to discuss hedging and risk management.

Peter Federico

Thanks, Chris. I’ll begin with a review of our financing activity on Slide 9. Our access to very attractive funding continue through the first quarter. Consistent with the shift in our asset composition toward a greater share of off balance sheet TBA securities, our repo balance fell to just under $50 billion at quarter end down from $61 billion the prior quarter.

With the repo regulatory landscape now clear, capacity appears to be improving further and slight downward pressure on rates is emerging. At quarter end, our average repo cost was 43 basis points down 2 basis points over the quarter.

More importantly, the reduction in our funding cost was realized despite a significant increase in the average term of our funding which increased to 162 days up almost 40 days from the prior quarter.

Strengthening our liquidity position is always a priority and as such, we will continue to opportunistically extend the maturity of our funding, thereby further reducing roll over risk.

On Slide 10, we provide a summary of our hedge portfolio. Overall, the total notional balance of our hedge portfolio increased to about $61 billion up from $58 billion last quarter. The increase in our hedge portfolio is consistent with the shift in our asset composition toward a slightly larger share of 30-year MBS and our decision to modestly reduce our duration gap.

In addition, we also altered the composition of our hedge portfolio during the quarter with swaption hedges decreasing and swap and treasury hedges increasing. Specifically, our payer swaption portfolio fell to $8 billion last quarter from $14 billion the prior quarter.

This decline is reflective of our view that interest rate volatility will likely remain low and that extension risk in our portfolio and in fact in the entire MBS market is relatively limited at this time.

During the quarter, we terminated $4.3 billion of payer swaptions at a market value of $72 million. Importantly, had we not terminated these positions, the market value would be significantly lower today given the rally in rates in the 10-year decline and implied volatility.

The reduction in our swaption portfolio last quarter is a continuation of a strategy that we initiated last year following the increase in interest rates. Over the last three quarters, we have terminated close to $21 billion of swaptions at a realized gain of approximately $270 million.

Lastly, on Slide 11, we summarized our duration gap and duration gap sensitivity. Given the significant rally in longer-term rates during the quarter, we reduced our duration gap to 1.2 years at quarter end down from 1.5 years the previous quarter. With that, I’ll turn the call back over to Gary.

Gary Kain

Thanks, Peter. And before opening up the call to questions, I’d like to revisit something I mentioned in my earlier remarks that the supply and demand outlook for the mortgage market is likely to remain very favorable despite the Fed tapering.

Slide 12 helps illustrate why we believe this is the case. The graph on the left compares total agency originations versus Fed and GSE purchases since 2000. The blue bar show the gross supply. And as you can see, origination volumes in 2014 are expected to be considerably lower than what we witnessed over the prior five years.

The red bar show that Fed purchases while declining because of tapering are still expected to be very material relative to production.

The purple bars on the graph on the right more clearly demonstrate this point by directly showing the actual difference between gross origination and the Fed and GSE purchases. As a matter of fact, 2014 is projected to have the lowest amount of mortgage supply net of the Fed for any year with the exception of 2009.

Moreover, the supply available to the private sector in 2014 is projected to be roughly half of what it was between 2010 and 2013. As such, it is really difficult to panic about the implications of lower Fed purchases against the backdrop of plummeting originations.

As an additional point, the blue dot show the annual average of the daily observations of the option-adjusted spread on new production MBS over the same time period. Option-adjusted spread is a measure that attempts to isolate the residual spread on agency securities after accounting for all the embedded options related to borrower prepayments.

While this is only one of the many ways to assess relative value in the mortgage market and the average annual numbers clearly smooth out significant intra-period volatility, it is very hard to conclude from this graph that agency MBS are mispriced given the current supply-demand factors.

Also, keep in mind that the current coupon mortgage OAS as of March 31st, which is shown on the graph as the red dot on the far right, was actually wider than the 2014 average as a result of heavy money manager selling during the second half of the quarter.

Some market participants argue that the focus should be on net mortgage supply which excludes refinancing volumes and only looks at the net growth of mortgage debt outstanding when trying to assess the technical backdrop for the market.

We agree this makes sense over the longer-term, but think that approach is very short-sided in the near-term because it completely ignores the stock effect of the Fed’s purchases.

To this point, let’s turn to the next slide and we can look at how the investor base for agency mortgages has changed over the last years and a half since the onset of QE3. First and foremost, as you can see on the far left of the bar chart, the Fed’s holdings of agency MBS skyrocketed to around 30% since September 2012, and will continue to grow by another 2% even assuming they end QE3 later this year.

Additionally, and this is often overlooked by market participants, the Fed is widely expected to continue to replace the runoff in their mortgage portfolio, and so they will continue to buy a very significant amount of agency MBS well after QE3 is over. As such, the Fed would maintain its share of the mortgage market around its peak which should be in the low 30% area until such time as it decides to stop replacing runoff.

So what have other investors done over the same period? As you can see, they have universally reduced their holdings as a percentage of the overall market and on an absolute basis as well.

The GSE and Federal home loan bank holdings have declined and will likely continue to drop, but at a somewhat slower rate growing forward.

And as most of you on this call know, mortgage REIT holdings of agency MBS have declined as REITs adjusted their portfolios to reflect lower book values, reduced leverage, and in some cases stock buybacks.

However, this trend has likely run its course as leverage levels across the space are at historical lows. If we look at domestic banks, they have also not grown their holdings of MBS despite significant increases in their deposit base and relatively anemic loan demand. As such, it is likely that banks will begin to increase their mortgage portfolios over the remainder of 2014 especially if rates were to rise or spreads were to widen.

Foreign investors also saw a decrease in their holdings of MBS. But there are some reasons why they couldn’t reverse. Yields on European and Japanese sovereign debt have declined significantly relative to the yields on treasuries and agency mortgages. And so it is very possible that overseas investors may become buyers of US debt during the remainder of 2014.

If you were an overseas investor and you have a choice between an agency MBS or an Italian 10-year bond, and both yields around 3.25%, which would you choose? At the beginning of 2013, you could have picked over 250 basis points or more than doubled your yield if you opted for Spanish or Italian debt. As of today, that entire yield advantage has disappeared.

Last, but certainly not least, domestic money managers have been the largest source of bonds for the Fed. Domestic money managers are meaningfully underweight agency MBS versus their indices.

Remember, some money managers are pure index players and have mandates to replicate the indices and thus, don’t have the option to underweight MBS.

Actively managed fixed income funds will likely need greater and greater incentive to decrease already underweight positions. Moreover, spreads on competing product including high-yield corporate debt and other sovereign debt have generally tightened at least as much if not more than mortgages over the past several years. And they don’t enjoy the same financing advantages.

Lastly, if bond fund redemptions were to reverse, then even without a change in weighting versus an index, money manager holdings of MBS would increase.

So in conclusion, all the categories of investors have reduced their holdings of agency MBS as the Fed ownership of the market has increased. There are numerous reasons why many of these investors may begin to reverse this trend. Therefore, when you combine the impact the Fed has already had on the investor base of agency MBS with the favorable supply and demand equation that we looked at on the previous slide, it seems like a very risky debt to assume that agency mortgage are going to widen significantly in the near term.

So with that, let me stop and ask the operator to open up the lines for question.

Question-and-Answer Session

Operator

(Operator instructions). Our first question comes from Joel Houck from Wells Fargo. Please go ahead.

Joel Houck – Wells Fargo Securities

Thank you. The question on the increase in 30-year exposure, I mean most of the industry REITs [ph] I think you guys included going back last year kind of caused it. So it sounds like that’s eating a bit – I don’t want to put words in your mouth. I guess I’m more interested in how you think about the opportunity set in the 30-year MBS as the taper kind of ends into the second half of this year.

Gary Kain

Sure. What I would say on the 30-year MBS is we’ve obviously always been comfortable with them. But we do care about pricing implications between 15 years and 30 years, and that’s something we’re always going to think about. And yes, if we – theoretically, I would rather have 70% of the portfolio be in 15-years or arms or shorter duration assets. And there’s no reason on our part to try to replicate the mortgage index or anything like that, so we’ll call it a 20% to the 15-years comprised in the mortgage index are – that’s kind of off the table completely.

But big picture, we also have to be cognizant of what’s going on in the mortgage market and in the overall REITs environment completely which is implied volatility has plummeted, the yield curve has flattened, and financing advantages of 30-year have improved.

And so we’re comfortable with 30-year mortgages in the portfolio and we’re comfortable with the spread environment at this point for a lot of the reasons we talked about. So yes, there’s still a preference on our part of 15-years, but we are going to be opportunistic with respect to both portions of the market, and are totally comfortable playing on cases.

Joel Houck – Wells Fargo Securities

And Gary, would it be a fair statement to say that even though perhaps you’re still cautious into the end of the taper, you’re less concerned about the balance softening [ph] and spread widening in perhaps six to nine months ago?

Gary Kain

Well clearly, six to nine months ago, there were a lot of other factors going on and yes, we were considerably more concerned about market positioning, about a number of different factors.

I think at this point, it’s pretty clear that the market has adjusted to Fed tapering. Okay, the bottom market has adjusted to Fed tapering. And in particular, the mortgage market has adjusted to expectations around Fed tapering. And I think that you can see that in the positioning of investors kind of across the board.

And so yes, that kind of positioning gives us greater comfort that spread volatility will be more contained at this point.

Joel Houck – Wells Fargo Securities

All right, great. Thanks for the comments.

Operator

Our next question comes from Mark DeVries at Barclays. Please go ahead.

Mark DeVries – Barclays Capital

Thank you. Gary, you made a long convincing case as to why you don’t see spreads widening much near. Could you talk a little bit more, though, about why you don’t see the dollar roll cheapening much over the next year relative to repo?

Chris Kuehl

Thanks for the question. This is Chris. Well, I mean it’s in part because the float continues to improve each month with the Fed taking delivery of the large portion of the cheapest delivered bonds.

It’s also simply the demand technicals versus gross issuance and the fact that the would-be sellers of the bases are already underway for the most part or at least very much on size and not overweight.

I mean the rolls also benefit from accounts that had set short positions expecting the bases to widen. The short base has to either cover their position or buy the roll each month. And the reality is given low levels of gross issuance, a lot of the short positions were bought by going away types of accounts, the Fed, small to mid-size banks. And so we expect the technicals to remains very favorable for this year.

Ultimately, the imbalances will work themselves through, but it will take time.

Mark DeVries – Barclays Capital

Okay, great. Next question, you guys mentioned the material reduction, the swaption position reflect income lower applied volatility. I’m just wondering, though, with kind of the big move in sort of the long end of the curve during the quarter, and presumably, I guess would imply volatility lowered, swaptions are now cheaper protection. Does that make you – given rates are – back it’s still relatively low at absolute levels, does it not make it more attractive to think about adding swaptions here?

Peter Federico

Yes, and this Peter. The short answer is it could. And you’re absolutely right, that the drop in swaption prices has been really significant over the quarter, call it 15% to 20% drop in prices.

But when you look at the prices relative to rates, they are at the lower end of the range, so that would imply that they’re fairly cheap. The flipside, though, is that we just don’t see a lot of extension risk in the mortgage market, and that’s I think the unique difference about today’s environment versus environments in the past.

If we get 100 basis points moving rates, for example, mortgages might extend a year or something in that neighborhood.

The other significant point about rate volatility is that the Fed not only earns a huge amount of the outstanding supplies – Gary mentioned about 30% – they also own an even larger percent of the outstanding negative convexity probably 40% or more. So the extension risk that will occur is going to be in the hands of the Fed as opposed to in the hands of private investors who have to rebalance it.

So we think there could be opportunities to add swaptions in the future, but right now we likely don’t need them for our portfolio.

Mark DeVries – Barclays Capital

Okay, thanks. And then just one last question. I think if we back out the changing value in your investments and REIT holdings, it looks like you put about as much capital to work again in buying other REITs this quarter than you did buying back your own stock.

Can you just talk about how you’re thinking about allocating capital between those two opportunities?

Gary Kain

Yes, this is Gary. We don’t allocate capital in the sense between those. The stock buybacks are something that we are committed to. We have demonstrated our willingness to do this.

But I want to point you back to what we said on the Q1 on the call in February related to Q4 2013 which is at that point in December and January was when we did the vast majority of these purchases. So most of, if not all, of the increase in the other REIT equity positions were in the month of January.

And that’s what we had given you the $400 million number on that call, which was the position essentially at that time. So while we’ve been in window periods this quarter, the conclusion that you came to that we bought more of other stocks than we did of our own just does not apply.

Mark DeVries – Barclays Capital

Okay, got it. Thanks.

Gary Kain

No problem.

Operator

Our next question comes from Douglas Harter at Credit Suisse. Please go ahead.

Douglas Harter – Credit Suisse Securities

Thanks. Gary, I was hoping you could sort of expand on sort of the gross supply for 2014 and how you’re thinking about that sort of today versus kind of the end of the year because obviously, it’s a different picture as the Fed tapers.

Gary Kain

It absolutely is, and you can think of as the Fed purchases drop. And over the summer originations will pick up some clearly because of seasonals and housing activity. But toward the end of the year, it’s very possible that mortgage production and again, is kind of back at its lows.

And then remember that the Fed will still be replacing runoff which is something they didn’t do after QE1. So big picture, even in that environment, with production of maybe $60-ish billion maybe $70 billion in the winter in the fourth quarter let’s say versus Fed purchase of something like $10 billion to $15 billion.

That’s still an incredibly small number of securities kind of available for the overall market. And then when you put that against the positioning of other investors, I mean in no way, and take a look at that, versus a larger time – over a larger history in the mortgage market. Those are still pretty close to record low amounts of bonds available for other investors. So that’s the driver for kind of lack of concerns so to speak that there’s an accident waiting to happen.

Douglas Harter – Credit Suisse Securities

And I mean, how do you think about it within sort of the specific coupons that the Fed is buying today? I mean do you have a sort of similar mindset there?

Gary Kain

Look, obviously we have different opinions of different coupons both on the 30-year side of things and on the 15-year side of things. And so I think the coupon performance one big factor is going to be what happens with the shape of yield curve and what happens with the overall level of rates as well as things like implied volatility.

But the one thing you have to understand in this overall equation to your point, there are some coupons that are more dependent on the Fed than other coupons. And that’s something we’ll certainly keep in mind. But again, most of those conclusions are going to be dependent on the evolution of interest rates and some of those other factors. And so those decisions are things we can deal with over the course of the year.

Douglas Harter – Credit Suisse Securities

Great. Thanks for that color, Gary.

Gary Kain

Thank you.

Operator

Our next question comes from Aaron Saganovich at Evercore. Please go ahead.

Aaron Saganovich – Evercore Partners

Thanks. With your larger TBA position, I’m just curious what you think about taking those on balance sheet and what the net impact would be if you were to actually delivery of all of the TBA and how that would impact your yield in the cluster funds?

Gary Kain

Sure. I mean we talked about, and Chris showed you the kind of the difference between on balance sheet returns versus the dollar roll returns. And so yes, dollar rolls present a good opportunity.

But I want to be very clear, and Peter highlighted this in his discussion, we are at record amounts of unused repo capacity. And so we have multiples of repo capacity to handle this dollar roll position and even a much larger dollar roll position if that were to come around.

So we have absolutely no concern whatsoever about taking on dollar roll positions. And we have experience settling securities and so forth. And actually one of the advantages of AGNCs size is that if we were to take positions in, given the size of those positions, it’s almost impossible for dealers to adversely select you, if you’re going to take in $5 billion or $10 billion of a particular coupon, it’s hard enough for people to find those securities let alone to find the absolute worse securities for you.

And as Chris mentioned, given the absorption that the Fed has had, given the other conditions that we talked about, the difference in what you’re going to get delivered in most coupons is just not significant right now.

So, not an area of concern. We absolutely want to be clear before we put on a dollar roll position, we’re always assuming there may be a circumstance where we’ll take it in and we’re completely comfortable doing that.

Aaron Saganovich – Evercore Partners

I guess I was just thinking more or less how that would impact your profitability. So if you were to add those all on balance sheet, your core – your earnings in $0.71 on a dollar rolling included basis, how would that be negatively impacted if you add those on balance sheet.

Gary Kain

Yeah, I’m sorry, I forgot the more specific piece of that. But basically, if you think about it, the $0.14 that we talked to you about in dollar roll income for Q1 would be – on balance income would be lower than that. I don’t exactly what the number would be but maybe it’s $0.10 or something in that zip code. So that’s as of Q1’s number. That’s the kind of exposure $0.05 that you’re looking, you’re looking at if we were to do that.

Aaron Saganovich – Evercore Partners

Okay, thanks. And then, I guess, getting back to the OES spread illustration you had being wider today. I guess, my question would be why would money managing be underweight the sector with OES spreads? What are they waiting for in terms of – does that need to widen out further for them actually increase demand or you believe that we’re just waiting for the Fed to exit their full taper?

Gary Kain

Sure, look, what I want to be clear is, look, there are logical reasons why – and especially larger investors may want to reduce their exposure to the mortgage market. I mean, it’s a popular concern to be worried about the Fed tapering and the implications.

The other thing I’d like to be clear in a way, that the money managers selling didn’t just occur at the very end of March at the wides [ph]. The money manager selling was significant enough to push mortgages to the wides [ph]. And a lot of that was done at much – much tighter levels.

So I think, big picture though, what you have to think about and what we’re trying to explain to investors is there are a number of ways to think about these technical factors and if you focus on the fact that the Feds bid is going to be smaller, then it would be logical to sell prior to that. If you focus on the overall picture and if you think about kind of how the landscape of investors has changed, then from our perspective, it just becomes a real concern if you reduce – and we’ll just talk for ourselves, if we were to let’s say reduce leverage significantly, you forgo significant income opportunities especially with dollar rolls and then you’re hoping that all of these investors that have reduced their positions all win and that spreads are much wide and that they all can get back in at wider levels within a relatively short period of time. And again, from our perspective, that seems like a pretty big risk.

Aaron Saganovich – Evercore Partners

Okay. Thank you.

Operator

The next question comes from Steve DeLaney at JMP Securities LLC. Please ask your question.

Steve DeLaney – JMP Securities LLC

Good morning. Thank you. Gary, thanks for the clarity on the dividend policy with respect to the tax efficiency of dollar rolls; that was definitely my first question. So I appreciate those comments.

The thing that struck me looking at the presentation in terms of the financing benefits of dollar rolls was the advantage or the benefit if you will – the greater benefit that 15-year rolls have over the 30 years. It looks like the – it’s about a 50 basis point greater benefit. And when I look back at the portfolio on page seven, overall you’re about 50-50 15s and 30s but specifically the TBA position, the 15-year TBAs are only about half of the 30-year TBAs despite that financing. Could you explain why we’re seeing it that way.

Gary Kain

Yeah, look, one thing is there’s two sides of that coin, right. And what we want to stress is, look, the financing advantages as to your point are excellent on the 15-year side. But there is a little bit of a higher cost to not owning a particular seasoning buckets within 15s. And so that’s a key tradeoff and that’s very different in, let’s say, 15-year 3.5 and 3s and 2.5 and so forth. And so, there are implications on both sides of that, but, again, 15s when you factor in the financing advantages on incremental positions there are very attractive, even with lower yields.

I don’t know, Chris, if you want to take that [indiscernible].

Chris Kuehl

The one thing I’d add, Steve, is just if you recall last quarter we had a net short 4 billion TBA position in 15s versus seasons polls [ph] that basically served s an option on rates. And given the rally combined with a flatter curve, really strong roll valuations and actually reasonably strong season spec pull bids [ph], we chose to – we shifted that position, basically 8 billion over the course of the quarter. So we didn’t – it was a material shift from a short position of four to a long position of four.

Steve DeLaney – JMP Securities LLC

Okay. Now, that’s helpful and it sounds like as you’re saying they may be cheaper on financing but I think, Gary, what I heard you say is the characteristics of some of those bonds if you were to be – take delivery on the bonds. It may be paper you wouldn’t necessarily want to have. Is that what –?

Gary Kain

Or it’s less desirable if that has something –

Steve DeLaney – JMP Securities LLC

Less desirable.

Gary Kain

That’s three –

Steve DeLaney – JMP Securities LLC

Okay.

Gary Kain

– or four years old in 15 years, you don’t necessarily want to give that up. So there are tradeoffs that I think we spend a lot of time thinking about, but I do want to reiterate this as another example where the bigger positions, some people worry that bigger positions are harder to manage or you give up opportunities. In some cases with respect to rolls, if you were to choose to take in bigger positions, you sometimes get much, much better securities in the end because of the issues around the outstanding float. And so, we actually feel very comfortable in the case of 15s that in certain areas we’ll get very good securities if we were to take these rolls on.

Steve DeLaney – JMP Securities LLC

Okay. Thanks. And just one final thing just kind of thinking big picture, not too far from your office, the Senate Banking Committee is kicking around Johnson-Crapo GSE reform. And one specific question and then just a general open-ended; would it be your understanding as the way things are drafted that if this were to proceed and that we’re talking about years down the road before it would be in place, but would it be your view that Fannies and Freddie’s would become full fate [ph] credit bonds, that would be the specific question, and therefore possibly close to Ginnies.

And then lastly is just anything about this proposal about this whole concept the GSE reform that we should think, be thinking about with respect to the pure agency mortgage REIT model. Thanks.

Gary Kain

Now, look, Steve, and appreciate the question. It’s a good one and timely as you pointed out. Big picture, we’re not worried about the legislation. We don’t see it as drafted or even most of the other drafts that have been out there as being, let’s say, a threat to our business model. To your point about Freddies and Fannies or the new version of Freddies and Fannies being full faith in credit of the government and looking like Ginnies, we agree that that’s the likely outcome. But we think that the pricing of that combined universe will actually be much closer to Freddies and Fannies than it is to Ginnies. Ginnies get a beneficial pricing that they get because there aren’t enough of them to fill that specific Ginnie-only bid so to speak.

But when you combine the three agencies, if the three agencies were all full faith in credit, you’d fill that bid and you’d still be requiring to get the incremental bid from people that are buying Freddies and Fannies today.

Steve DeLaney – JMP Securities LLC

Oh, okay.

Gary Kain

So big picture, we’re not really – we don’t see the legislation as something that concerns us and again we remain just very, very comfortable with the agency REIT business model. We think that it really does provide investors with a very liquid alternative that they can’t duplicate in, in other strategies.

Steve DeLaney – JMP Securities LLC

Well, appreciate the comments and great quarter. Thanks.

Gary Kain

Thank you.

Operator

(Operator instructions) And our next question comes from Mike Widner at KBW. Please go ahead. Please go ahead.

Mike Widner – KBW

Good morning, guys. So, I guess the first one, I just detailed here, you indicated you sold 2.8 billion in swaps during the quarter. Where were they on the curve, kind of part of the duration spectrum were they at?

Peter Federico

Hi, Mike, this is Peter. They were more on the front part of the curve. And you see we also added about 5.9 billion of swaps. In fact, we added most of our swaps by all of our swap [ph] [indiscernible] that we had over forward starting swaps which we show specifically because they give us the ability to sort of tailor our exposure to the intermediate to longer term part of the curve. So call it the three-year to five-year part of the curve but in forward space by a couple of year. So we unwound some of our shorter spot starting swaps and replaced them with forward starting swaps.

Mike Widner – KBW

Yeah, because I was just trying to figure out what exactly the interest rate bet was if you were and basically – I mean, it sounds like you’re taking advantage of – and into a large degree the curve flattened in that kind of 3 to 10-year range. And it sounds like you sold them high and bought low basically.

Peter Federico

Yeah, I mean, we still have a significant portion and obviously, as Chris mentioned in the beginning, if you – depending on where you’ve had your hedges, obviously, it was a huge drive of the performance of the mortgage portfolio. We still need and want a lot of our hedges in intermediate to longer-term part of the curve. It’s close to about 60% today. And obviously, if we had them while shorter, this last quarter, our book value would have been up much more but that wouldn’t have been the right position to have in the long run.

Mike Widner – KBW

Yeah, that makes sense. Let me just ask you a quick follow up on the mortgage REIT holdings. You indicated I think on the last call that somewhere around end of January that the position was 400 million, 352 now, so suggest that you did some selling because the stuff, generally, is up in pricing across the sector. So, I mean, how do we think about that balance and can we read any kind of trajectory into that. I mean, are you winding the position down or how should we think about that?

Gary Kain

Sure. This is Gary, and I appreciate you asking the question along those lines where it looks like we did some selling versus we tried to find a way to lose money on a sector that went up during that period. But, now, we did take a targeted approach to selling out some of the REIT equity that we bought. We’re in no hurry on that, from that perspective. They weren’t kind of blanket across the board sales.

But, look, we understand the mortgage market. We remain comfortable with the market. We can analyze other REITs portfolios reasonably well and so the bottom line is we don’t feel like in any way, shape or form that we’re in a hurry to divest of these positions. We, again, are comfortable holding them for an extended period.

On the other hand, if they appreciate enough, then we’re totally comfortable selling off more. So kind of similar to last quarter, we don’t give a ton of the information about the kind of – our quote, “strategy there” but to your point I think it should be pretty straight forward.

Mike Widner – KBW

Yeah, thanks. I mean, is there – I’m sure you’re not going to answer this, but I mean, is there a price-to-book level at which you kind of feel like you’ve gotten what you’re going to get at? So, I mean, when you were buying them, a lot of them were trading 80s of book and now we’re kind of low 90s probably on a lot of the group. High 90s on or even over 90 – over 100 on some but – I mean, is there a level at which you feel like it just doesn’t make a whole lot of sense in your portfolio anymore?

Gary Kain

Yes, there are levels. I’m not really going to go into the specifics of it, but – and it also depends on the underlying portfolio and whether or not we feel that the underlying portfolio is complementary or not complementary and so forth. So there aren’t set thresholds, but look, if they were above book, all of the reasons why we gave you for owning them would not apply. And so, I mean, that’s really the most I’ll say about that.

Mike Widner – KBW

Yeah. No, that certainly makes a lot of sense. And the final one, you added $1 billion of receiver swap options, and I guess, what I’m just sort of wrestling with there, trying to figure out is, I mean, what’s the rate scenario that that position is a benefit to you, and I guess I’m just trying to think about the value of those in a mortgage REIT.

Peter Federico

Yeah, this is Peter. I would think about that more in the context of the type of assets that we’re owning. And obviously, we talked a lot about our TBA position, and in fact we have more 30 years and some of those are in TBA form, so you don’t have the same prepayment protection that we would normally have on our assets. So, I would think about it just in the context of giving us some prepayment protection on some of our TBA position.

Mike Widner – KBW

Okay, that’s an interesting way to think about it, but I wouldn’t have come up with that on my own. So thanks and appreciate the comments as always, guys, and good quarter.

Peter Federico

Thank you.

Gary Kain

Thanks a lot, Mike.

Operator

Our next question comes from Eric Beardsley at Goldman Sachs. Please go ahead.

Eric Beardsley – Goldman Sachs

Hi, thank you. I was just curious what the original dates in maturity was on your REIT though. It looks you extended the term quite a bit there; just curious where that started out.

Peter Federico

Well, last quarter our average was 124 days versus 162.

Eric Beardsley – Goldman Sachs

Yeah, so I guess, the disclosure you used to give, I think –

Peter Federico

Yeah.

Eric Beardsley – Goldman Sachs

– that reconnects your two Q13 presentation, had the original days versus the remaining days.

Peter Federico

We don’t disclose that just for simplicity. But I can tell you that just ballpark, the number is give or take 10 days of the 162.

Eric Beardsley – Goldman Sachs

Okay, great.

Peter Federico

It’s still – it’s be very close, the original days of maturity.

Gary Kain

One thing to keep in mind is given that we have so much more – a, we have so much excess capacity, I’m glad you asked the question, as we also do dollar rolls which is sort of like replace some of the shortest term financing, we found it both cost effective and relatively easy to extend the maturity of our repo borrowings, which is actually very significant for investors in terms of reducing risk either around rollover risk around repo and also just any kind of risk around haircuts changing because they’re locked in for the term.

Peter Federico

Yeah, so just to build on that point, at the end of the first quarter, about 10% of our repo funding was longer than a year; that’s up about 3% from 7% last quarter. And importantly, we’re seeing liquidity and really attractive financing, to Gary’s point from one all the way up to five years. So we will continue to opportunistically take advantage of those funding opportunities as they present themselves.

Eric Beardsley – Goldman Sachs

Great. And just what are the conversation has been from the dealer side in terms of capacity and pricing. I think you’d mentioned that you felt that the market had priced in new rolls whether it’d be SOR, NSFR, are you thinking that that’s solely there now and that there isn’t more tightening to come?

Peter Federico

From what we hear from our counterparties, I think the answer to that is yes. Our counter party seem to have gotten ahead of that and made the adjustments that they need to make, and if anything, we’re seeing our existing counterparties looking for more business. So I think that they fully captured the regulatory obligations that they will face. I don’t expect a lot of change from them.

And then, in addition we’re seeing increased number o counterparties coming in to the market that we hadn’t seen before. I suspect, for example, on the second quarter of this year we might add two more counterparties and we’re talking about significant size repo positions. So we think the environment really is really attractive for financing right now.

Eric Beardsley – Goldman Sachs

Okay, great. Thank you.

Peter Federico

Sure.

Gary Kain

Thanks [indiscernible].

Operator

And our last question comes from Dan Furtado at Jefferies. Please ago ahead.

Dan Furtado – Jefferies

Thanks for taking my question everybody. Hi, can you hear me now?

Gary Kain

Yeah.

Dan Furtado – Jefferies

Yeah, most rumor at [ph] – I just kind of wanted to look at this slide 12, the gross supply versus the GSE gross purchases. And we rolled that out a year in the 2015. I think the consensus would be that the blue bar stays about the same. That red bar comes in pretty substantially. It opens up some supply. I mean, when you think about outing [ph] the 15, I mean, there’s not a right way to think about it and I guess the response from where you sit would be – you’d readjust the portfolio going into that or how should we think about that, the turn of the year, that rolling in to 15?

Gary Kain

I think there are two things to keep in mind. And by most estimates, you got to keep in mind that the Fed is still reinvesting pay downs at that point. So the red bar is not zero –

Dan Furtado – Jefferies

Right.

Gary Kain

– which people I think make a mistake off him [ph]. And if you just netted, we’ll call it the – those two bars, okay, with a pretty small [indiscernible] bar and you compare that going back in history. That’s just still a relatively small amount of kind of supply that needs to be absorbed by the private sector.

And so, the idea that there again, this massive imbalance about to hit the market I think is misplaced where that becomes an issue and I want to be clear is if we were to have a significant rally in rates and if the Fed were not replacing runoff, oaky, which was the scenario that occurred in 2010, right. So the Fed exited QE3, the market performed great following the Fed’s exit until we had a pretty significant rally in rates, production picked up pretty dramatically. The Fed was not reinvesting pay downs. And so very quickly, all of the Feds holdings were in a sense or a good chunk of the Fed’s holdings were being thrown out to the overall market at the same time we had lower yield levels and so there were some, in particular, oversees selling of mortgages. And then you had a pretty healthy widening in mortgage spreads.

But if you think about the scenario you are describing, none of those things apply unless we were to rally significantly to lower rates where you’d get a pretty significant pick up in refinancing activity. And that’s going to again require more than a 50 basis point rally from here and I’m not going to try to say that’s not possible. It obviously is possible, but there are other benefits to that scenario as well.

So I think that’s kind of the key is in thinking about it the supply numbers that the market is looking at either at the end of 2014 or even at the – in 2015 are manageable, are very manageable, especially, again, given that the market is completely positioned for it. And I think one of the things that happened was given the stress on the market in 2013, basically, it forced investors to make the adjustments they would be making let’s say in the middle of this year. It forced them all to make them last year, including the REITs and including us.

And so, I think that you’ve seen those adjustments and now, I think, too many people are sitting there waiting for mortgages to [indiscernible].

Dan Furtado – Jefferies

Great point. I appreciate the commentary, Gary.

Gary Kain

Well, thanks a lot, Dan. I appreciate the question. And I want to thank everyone for participating on the call and we’ll turn it over to the operator.

Operator

We would now like to complete the question-and-answer session. I’d now like to turn the call back over to Mr. Gary Kain.

Gary Kain

Well, thank you. And again, I want to thank everyone for participating on the call and we look forward to talking to you next quarter.

Operator

The conference has now concluded. An archive of this presentation will be available on a AGNC’s website. And a telephone recording of this call can be accessed through May 12th by dialing 1-877-3447529 using the conference ID number 10044220. Thank you for joining today’s call. You may now disconnect.

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