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American Capital Agency Corp. (NASDAQ:AGNC)

Q2 2014 Earnings Conference Call

July 29, 2014 11:00 AM ET

Executives

Katie Wisecarver – Investor Relations

Malon Wilkus – Chair and Chief Executive Officer-American Capital Agency Corp.

Chief Executive Officer-American Capital AGNC Management, LLC

Gary Kain – President and Chief Investment Officer-American Capital Agency Corp.

President-American Capital AGNC Management, LLC

Samuel A. Flax – Executive Vice President and Secretary-American Capital Agency Corp., Executive Vice President, Chief Compliance Officer and Secretary-American Capital AGNC Management, LLC

Peter J. Federico – Senior Vice President and Chief Risk Officer-American Capital Agency Corp., Senior Vice President and Chief Risk Officer-American Capital AGNC Management, LLC

Christopher J. Kuehl – Senior Vice President, Agency Portfolio Investments-American Capital Agency Corp., Senior Vice President-American Capital AGNC Management, LLC

John R. Erickson – Chief Financial Officer and Executive Vice President-American Capital Agency Corp., Executive Vice President and Treasurer-American Capital AGNC Management, LLC

Bernie Bell – Vice President and Controller.

Analysts

Mark C. DeVries – Barclays Capital, Inc.

Douglas M. Harter – Credit Suisse Securities LLC

Arren Cyganovich – Evercore Partners

Matt P. Howlett – UBS Securities LLC

Joel J. Houck – Wells Fargo Securities LLC

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

Eric Beardsley – Goldman Sachs & Co.

Operator

Good morning and welcome to the American Capital Agency Second 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.

I would now like to turn the conference over to Katie Wisecarver in Investor Relations. Please go ahead.

Katie Wisecarver

Thank you, Andrew, and thank you all for joining the American Capital Agency’s second 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 www.sec.gov. We disclaim any obligation to update our forward-looking statements unless required by law.

An archive of this presentation will be available on our website, and the telephone recording can be accessed through August 12 by dialing 877-344-7529 or 412-317-0088, and the conference ID number is 10049322.

To view the slide presentation turn to our website, agnc.com and click on the Q2 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 thank you all for your interest in AGNC. I am pleased with the very strong performance of our portfolio during the second quarter. In Q2, our economic return total 10%, making it one of our best quarters since the end of 2009.

Through the first half of 2014, our economic return totaled 15%, and was bolstered by our decision late last year to shift away from a risk of mentality and back toward a more normal balance between risk and return. Our performance in the second quarter was driven primarily by the significant tightening of AGNC MBS spreads, which is now widely attributed to the supply and demand equation that we laid out in detail on our Q1 earnings call.

These favorable dynamics gave us the confidence to maintain our leverage of 7.6x, as we entered the quarter and to significantly increase our holdings of 30 year MBS early in Q2, both of which enhanced our returns. We also benefited from actively managing our hedge positions.

to this point, late last year, we made the strategic decision to run a larger duration gap versus where we had operated over the past several years. The driver of this change was a combination of our comfort with the U.S. interest rate outlook and the relatively limited extension risk, inherent in our portfolio.

We also made significance adjustments to the size of our swaption portfolio. again, this was the result of an explicit strategy that Peter discussed on our last two earnings calls.

Following the increase in rates and changes to our portfolio in 2013, option-based hedges became less important to us, as the negative convexity in our portfolio declined. This was also true for the entire MBS market, and when combined with low realized interest rate volatility, the reduced demand for options led to a significant decline in most swaption prices. As such, had we maintained the same swaption portfolio as we carried for most of 2013, it would have resulted in a significant drag on our financial performance.

So with that as the introduction, let me quickly touch on a few highlights on Slide 4. Comprehensive income totaled $2.43 per share, comprised of $0.08 of net income and $2.35 of other comprehensive income. Net spread income inclusive of dollar roll income totaled $0.87 per share; it was comprised of $0.48 from our repo funded on balance sheet portfolio and $0.39 per share from dollar roll, or drop income associated with our forward TBA positions. Our TBA position averaged around $14 billion in size during the quarter.

Given the relatively large contribution of dollar roll income to our aggregate NIM, we added a couple of new slides to the presentation this quarter to provide investors with a more detailed analysis of how our net spread income is impacted by our forward TBA position.

We will also specifically address the sensitivity of these results to changes in the amount of specialness inherent in dollar roll levels. As I’ve discussed on our Q1 earnings call, dollar roll income nets against our capital loss carryforward, and is therefore not included in our current period taxable earnings.

This is an additional positive of the dollar roll strategy and that it allows us to cap – to utilize the capital loss carryforward and in essence, has that benefit on to our taxable shareholders. We will continue to base our dividends on the true earnings of the portfolio and this position will not be impacted by the use of the capital loss carryforward. This will result in a portion of the dividend being treated as a return of capital versus ordinary income.

Our shareholders that hold AGNC’s stock and taxable accounts, this will likely result in an improvement in their aftertax returns. Book value per share increased over 7% to $26.26 per share. This coupled with our $0.65 dividend, drove economic earnings for the quarter to approximately 10% or almost 40% on an annualized basis.

Turning to slide 5, our portfolio increased slightly to just under $72 billion during the quarter. Our at risk leverage declined to 6.9x at the end of the second quarter versus 7.6x as of Q1. If you turn to Slide 6, I want to quickly point out something that may be surprising to many of you. Our strong 2014 economic returns have offset almost all of the economic losses incurred during 2013.

Additionally, as you can see on the circled porion of the bar chart, the aggregate economic return on our portfolio is now positive 15% for the two years, since the beginning of Q3. Our performance over this period, while excluding changes in our price-to-book ratio fully reflects the mark-to-market of AGNC’s portfolio and it’s quite respectable given roughly 100 basis point increase in rates and the tremendous spread volatility we experienced over the past couple of years. It also provides further evidence that our business model is durable across a wide range of economic environments, including one our interest rates drive significantly.

Turning to slide 7, I want to follow up on my earlier comment on how dollar roll income impacts our aggregate net spread income. If you remember on slide 4, we discussed that our total net spread income was $0.87, consisting of $0.48 for the on-balance sheet, or repo funded portfolio, and $0.39 from the dollar roll funded position.

It is important to understand that this dollar roll contribution is a gross number and does not include any allocation of swap hedge cost, operating expenses or preferred stock dividends. The coral area of this is that all of those costs are allocated solely to the repo funded portfolio, which unfairly depresses its contribution to the aggregate net spread income.

If you look at the table on the top of the slide, you can see how this picture changes when we allocate the various costs to each portfolio on a duration-weighted basis. The second line from the bottom shows the adjusted breakdown of our net spread income after this expense allocation.

As you can see, the revised net interest margin for each portfolio is materially different from where we started. The contribution from the repo funded assets increases from $0.48 to $0.61 per share. While the dollar roll component drops to $0.26 from $0.39. The last row on the table shows what this translates to in terms of NIM. Importantly the repo funded assets show a 152 basis point margin and despite the added cost NIM on the dollar roll portfolio remains extremely attractive at 259 basis points. In its entirety the net interest margin on the portfolio averaged to 173 basis points in Q2.

Now it’s important to understand that the difference in the margins between the two sub-portfolios is a result of both TBA specialness and portfolio composition. More specifically the repo funded portfolio contains the bulk of our season 15-year positions, which are lower risk, but also generate lower margins. On the other hand our TBA position is concentrated in newer 30-year MBS which generate higher yields and margins.

Now, if we turn to the next slide, I want to address the earning sensitivity of our TBA position with respect to changes in dollar roll financing levels. As you can see on the second line, if TBA financing rates improve, that is to get more special, our dollar roll income will obviously benefit. Conversely to the right of the table, if TBA financing rates increase, our dollar roll income will deteriorate. Let’s look at the extreme scenario where dollar roll financing rates increased by a 100 basis point. In this scenario, our dollar roll income will decrease by $0.10 per share, assuming we have the same $14 billion TBA position.

This is a very unlikely scenario. A 100 basis point increase in the dollar roll funding would essentially wipe out all specialness in the TBA market. Said another way, if financing rates converged on rolls and repo and we went back to repo financing our entire portfolio. I would expect or adjust its spread income to drop by about $0.10 per share.

A more likely scenario is one where dollar roll specialness deteriorates by 50 basis points. In this case, our net spread income would drop by about $0.05 again assuming a TBA position identical in size and scope to the average Q2 portfolio. I should reiterate something that we have stressed many times in the past. Net spread income for what many analysts refer to is core income has shortcomings and is not a complete measure of the true earnings power of our portfolio. It is based on the historical cost basis of assets and swaps and not their current yields. It also does not capture the cost associated with treasury swaptions or forward starting swaps as such we continued to be more focused on economic earnings.

With that, let me turn the call over to Chris.

Christopher J. Kuehl

Thanks, Gary. Turning to slide nine, I’ll briefly review what happened to the markets during the second quarter. As you can see in the top two panels both treasury and swap rate curves continue to rally and flatten. 10-year treasury notes rallied 19 basis points while 5-year notes fell only 9 basis points.

Mortgages performed extremely well versus rates during the quarter and while hedge positioning on the curve was again a factor. Mortgages meaningfully outperformed both the long-end and the front-end of the curve. For perspective 15-year 2.5 were up nearly 1 3/4 points where as the 5-year treasury note which has a similar duration increased in price by less than half of a point.

30-year MBS also did well during the quarter with 3.5 and 4 up over 2 points despite having a duration in between that of 5-year and 10-year treasuries, which on average were up just a little over 1 point. So far into the third quarter mortgages have given up some ground against the backdrop of heightened geopolitical concerns and the curve is continued to flatten with 10-year rates rallying 6 to 7 basis points, and 5-year rates selling off 6 basis points.

Let’s now turn to slide 10 to review our investment portfolio composition. As Grey mentioned our risk leverage was down from 7.6 at the start of the quarter to 6.9 as of June 30, despite the slight increase in our investment portfolio to $71.9 billion. The decrease in leverage is due to a combination of net asset value appreciation, sales of other REIT equity positions and a preferred stock issuance in May.

As we discussed on our last call, it was our expectation that MBS and in particular 30-year MBS would benefit from strong technical factors, lower levels of implied volatility, flattening yield curve, and attractive roll financing. Given the continued bull flattening moving rate during the month of April, we added 30-year MBS both out right as well as versus doing 15-year MBS. Quarter-over-quarter, our 15-year position was down from 48% at the start of the quarter to 38% as of June 30 with the majority of the repositioning done in the first half of the quarter.

While 15-year MBS will remain a core position for the reasons we have discussed at length on prior calls. Valuations on higher coupon 15 became stretched, at the same time that the benefits of those positions became much meaningful in today’s lower rate, lower volatility, and flatter yield curve environment. Our net TBA roll position as of June 30 was $18.4 billion, up from $14.1 billion at the start of the quarter. Roll implied financing rates were very attractive throughout the second quarter and while rolls have weakened since the start of the third quarter implied financing rates on 30-year 3 to 4 as well as 15-year 2.5 are significantly lower than on balance sheet repo rates in the financing advantages still materially exceed the need for holding certain specified pool.

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

Peter J. Federico

Thanks, Chris. I’ll begin with a brief review of our financing activity on slide 11. At quarter end, our weighted average repo cost was 41 basis point down 2 basis points from the previous quarter. Our liquidity position continues to be strong marked by significant excess capacity and good access to attractive longer term funding opportunities.

On slide 12, we provide a summary of our hedge portfolio. Given the stability of interest rates during the quarter, our total hedge portfolio remained relatively unchanged.

Turning to slide 13, we show our duration gap and duration gap sensitivity. At quarter end our duration gap fell slightly to 1 year, down from 1.2 years the prior quarter. As we have discussed before, when measuring interest rate risk, it is important to consider both the starting duration gap as well as how the duration gap will change as interest rates change. This incremental change in duration gap is due to the negative convexity in mortgage asset. We refer to the increase in duration as rates rise, as extension risk.

On slide 14, we show our reported duration gap as well as what our duration gap would be if interest rates increased by 200 basis point and no rebalancing actions are taken. The distance between the two lines is the extension risk we face due to negative convexity. By estimating our duration gap in this up 200 basis point scenario, we fully capture the dual effects of our starting duration gap, plus the change in our duration gap due to the negative convexity in our mortgage asset.

As you can see, when extension risk is high, we operated with a low or negative duration gap. During the middle part of 2013, when the fixed income markets were unstable and idiosyncratic risks were high, we carefully managed our overall interest rate risk position to a combination of managing our starting duration gap, the greater use of option-based hedges, and through asset selection.

More recently, with both extension risk and mortgage spread risk diminished we proactively increased our spot duration gap. This larger duration gap however does not mean that we are operating at a higher level of aggregate interest rate risk. In fact, as you can see from the graph, over the last two quarter, despite having a larger duration gap our aggregate interest rate risk position in the up 200 basis point scenario has been relatively constant at about 1.8 years and below where it has been for most of the last 2 years.

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

Gary Kain

Thanks Peter. Before I open up the call to questions, I want to close with some thoughts on the MBS market as we look ahead. The bottom line is that we remain reasonably constructive on agency mortgages especially in light of the recent weakness early this quarter that Chris referred to. We also continue to believe interest rate volatility will remain relatively low. While agency MBS tightened materially in the second quarter, their performance over the last few years as still lagged other fixed income alternatives, such as investment grade bonds, high yield, European and Japanese sovereign debt, and even most emerging market debt.

Moreover, agency MBS have some significant advantages that are not enjoyed by these competing products. These include tremendous liquidity, which is only surpassed by that of the U.S. treasuries and they also benefit from favorable financing rates and this relates to both repo rates and obviously be a dollar rolls. Lastly, reduced interest rate volatility is also a much bigger positive for MBS given the embedded prepayment option.

Now, when it comes to the supply and demand equation and this doesn’t get enough attention even after the end of the QE3 program, the Fed will still almost certainly be the largest buyer of MBS in the market as they continue to reinvest sizeable pay downs on their $1.8 trillion portfolio. To this point, the Fed is likely to continue to buy around 20% of the gross issuance of mortgages well into 2015.

Lastly, as we’ve mentioned last quarter, Fed ownership of almost one-third of the agency market has forced investors to significantly reduce their own footprint in the market and most remain underway or under invested in the product.

As such short-term periods of wider spreads are likely to be met with significant buying, a technical that other products are less likely to enjoy. Lastly, as we discussed last quarter, the supply picture for agency mortgages remains extremely favorable with gross and net supply continuing to be anemic.

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

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. (Operator Instructions) The first question comes from Mark DeVries of Barclays. Please go ahead.

Mark C. DeVries – Barclays Capital, Inc.

Thank you. Let me be the first to thank you for the new slides and presentation is very helpful. First question is on the interest rate risk management slide is for peers. I think as you mentioned, you took down your duration gap a little bit on the sequential quarter basis, but with rate volatility, it’s kind of very low levels here, and swap rate is quite low. Could you just talk about how you think about the appeal how do you assess the appeal of potentially taking your duration gap even lower here?

Malon Wilkus

Yes. Sure, Mark. Certainly, there’s a lot of factors that go into where we position our duration gap. and obviously, we’ve positioned a large duration gap at the beginning of the year, when the rates were higher. so as we continue to drop to lower levels, you could expect our duration gap also to shrink, but we also depend on the composition of our portfolio, the mix between 30 years and 15 years, the coupon concentration in our portfolio.

And also as rates stabilize and interest rate volatility also continues to stabilize and drop, we’ll likely to continue to shift the composition of our portfolio from swaps to potentially more option-based hedges, if the interest rate environment, more than step sort of protection. so we will continue to move our position around dynamically, and looking importantly, at our extension risk and contraction risk, because as rates move around, we’ll actually have a little bit more contraction risk in our portfolio than we do have extension risk, which is why we’ve added some receiver swaptions to our portfolio over the last quarter.

Gary Kain

The one thing Mark I’d like to add quickly is that we’ve always in – and I think everyone in the industry tends to talk about duration gap. the other thing is that when you look at what’s going on with the yield curve right now, a bigger source of kind of interest rate risk really is curve risk, and that’s something that we’re watching very carefully and that we’ve moved hedges around. you can run a curve short duration gap, if you – with a lot of three-year hedges, or you can run a short duration gap with all 20-year hedges, obviously less of them and get to the same duration gap. and I think at this point, for us, it’s much more about factoring in kind of protection throughout the curve, and making sure, that’s consistent as our portfolio evolves. And that’s really a kind of another key factor that I think everyone in the industry has got to be focused on.

Malon Wilkus

And just to add to Gary’s point there, although our overall pay fixed swap portfolio didn’t change very much. We did add about $3 billion worth of new pay fixed swaps, terminated some other shortest swaps. so we did move some of our hedges during the quarter to more in the call for 10-year to 15-year part of the curve to give us a little bit more protections against longer-term rates, particularly against our increased 30-year portfolio.

Mark C. DeVries – Barclays Capital, Inc.

Okay, great. That’s helpful. Next question just trying to better understand the allocation to 30-years, it sounds like you’re generally a little bit more constructive on that, benefitting as even leaving aside that the specialness, which they’re trading. If that specialness disappears, or at least drops 50 basis points as you felt those being the more realistic scenario, but would you see yourself reallocating back towards 15 years here?

Malon Wilkus

Yes, it’s possible. If you remember last quarter, I talked a little bit about just higher coupon season 15 has been a relatively inexpensive option on rates, and had the markets sold off, the position would have performed extremely well versus newer production 15s or 30-year MBS. Instead we rallied and flattened, and the position still performed very well, and in fact better than we would have expected. And so that’s why described valuations have been so much stretched in my prepared remarks, and we took the opportunity to take advantage of that to reduce our 15-year position by around $7 billion, and a little of 30s just given the movement in rates.

Mark C. DeVries – Barclays Capital, Inc.

Okay, got it. And then finally, it looks like you took up your TBA position even more since the end of the quarter, I guess really $10 billion today. Is that an indication that it’s creating even more special and you’re integrating more spread today, or you’re just feeling more comfortable with that trading, just picking up a little more leverage there?

Malon Wilkus

It’s not an – things are not more special today than they were kind of throughout the second quarter, or most of the second quarter. Look, the TBA allocation, but again, let me just, while they are not more special, they are still special on the returns on dollar roll funded, TBAs are still better than specified. But I think an important piece of this, and this is really kind of something that’s just very different inherently than where we were two years ago is the need for a specified pool is very different today. First off, if interest rates go up from here, the specified pool we want is one that’s seasoned, maybe 50 months to 60 months old, because it will prepay a little faster and it will be a shorter that’s in 30-year and it’s even more important in 15 years.

On the other hands, we’ve rallied down to almost 240 on hands, and if we would rally another 25 basis points the overwriting concern in some coupons, so the mortgage markets going to be prepayments and you’re going to want a low loan balance pool, or some other prepaid protective pools again, in a few different coupons.

So right now, when you think about the equation, prepayments are generally benign, still expected to be relatively benign. but yes, that could change. on the other hand, if rates went up, the type of pool you would want is the more season, less prepayment pool up, protective pool.

So, again there is even on certainty as to what type of pool you would like. the other thing is just given the fact that the price is between different coupons and mortgages what we call coupon swaps are such that if you really want to protect yourself from prepayments, the most cost-effective way is probably to go into a lower coupon and not – and not to grow the specified coupon route at this point. Obviously, these things can change, but, so again, I just want to fill back to the kind of the crocks of your equation.

Dollar roll TBAs versus specified pools are a combination of the funding advantages for TBAs and what you expect for them going forward weighed against, the need or benefit from having a particular pool and both of those things are telling us to go in one particular way. Hopefully, that helps.

Mark C. DeVries – Barclays Capital, Inc.

Yeah, it does and just one last question. I think you mentioned that you don’t see the specialness completely disappearing as a realistic pair, could you just give us some context for what’s kind of a normalize level when the Fed is not an active participant in the market?

Malon Wilkus

It varies and I think you have to be cognizant that there isn’t like. It slightly depends on coupons; it depends on a lot of different factors. What I think is absolutely safe to say is that the Fed’s stock effect, the fact that they own a third of the market and those coupons are not – those positions are not going to come back into the market, probably impacts the dynamics of dollar rolls for – for a pretty extended period of time. And so, look, in the end, we expect dollar rolls to remain special, certainly through this year and well into next year.

and when I say special, it doesn’t mean that they necessarily get back to the levels where they were last quarter, and we don’t need them too. I mean let’s face it in this market; in any market of 50 basis points funding advantage is tremendous. Again, especially against the backdrop of not having a huge need for our specific tool.

Mark C. DeVries – Barclays Capital, Inc.

Okay, thank you.

Operator

The next question comes from Douglas Harter of Credit Suisse. Please go ahead.

Douglas M. Harter – Credit Suisse Securities LLC

Thanks. Hoping you could talk about some of the factors that will move around the specialness of the roll market in the coming quarters as the Fed sort of eventually ends their purchases, exits the reinvestment?

Gary Kain

Sure. Look, I mean there are a lot of factors. and so look, we can’t isolate any one. but I think what’s important to keep in mind is that in general, what creates specialness, what creates specialness is, because of the tremendous liquidity of the mortgage market, people can have short positions in – and always have short positions in TBA coupons, originators, while Wells Fargo or JPMorgan Chase are taking locks from borrowers, two and three months into the future. In order to hedge their exposure, they’re selling TBAs into the market for future settlement dates and those pools will be delivered again, over the course of a couple months, and then the whole process will be repeated.

Against the backdrop of that, you have an outstanding float of mortgage securities that have already been created that kind of can be delivered against other, against other trades. and to the extent again, that the Fed’s holdings of those other securities are so large, and then it’s not only the Fed, I mean as the Feds have been buying over this period, also other buy and hold investors, banks, insurance companies, REITs have also bought pools that aren’t likely to come out to the market as well.

And so against that backdrop, while short positions may have some temporary factors like short positions may have dropped as people have gotten a little more comfortable with the mortgage market. These other factors are likely to stay in place.

So it’s a difficult question to answer, but what I would reiterate is, there’s always core shorts in the market, the thing that really allows for rolls to kind of be on the low end of specialness is an outstanding amount of flow, the larger outstanding amount of flow of pools that people don’t want to keep and we don’t think we’re fundamentally in that kind of environment.

Douglas M. Harter – Credit Suisse Securities LLC

Got it. Thank you. And then when you are thinking about sizing it – sizing that the position of the TBAs or the rolls, how are you thinking about that from here, given the clear financial advantage that those are offering you today?

Gary Kain

Look, we obviously agree that their advantages, that there are substantial advantages I think there are practical considerations and what I would say is that it’s in the area of 25% to 30% of your portfolio, they are probably comfortable rolling. let’s be practical that you don’t want to be in a situation where I mean again, we operate with the assumption we could take these in at any point of time. And so we want to make sure whether it’s whole pool coverage, or kind of a variety of different coupons and different types of assets in our portfolio. You do want to manage concentration risk.

Douglas M. Harter – Credit Suisse Securities LLC

Great, thanks.

Malon Wilkus

Yes, just to add to Gary’s point and making sure that we carry enough excess capacity from a repo perspective to take on the entire position is really critical from a risk management perspective. that’s why in the beginning of my remarks, I’ve mentioned a fact that we currently have about as large as an excess capacity position as we’ve ever carried. So we have lots of capacity to bring all the position on balance sheet if we needed to and still have excess room.

Gary Kain

Yes, it’s interesting, actually I think as people ask about the repo availability sometimes, I mean one other hindrance is that our repo positioned with, has contracted obviously, over the last year, or so and especially as we’ve built up the TBA position. And we’ve increased the amount of lenders pretty substantially and just keeping enough securities to kind of maintain that relationship with people as another factor that we have to think about it, somewhat of the opposite of what people might think.

Douglas M. Harter – Credit Suisse Securities LLC

Great, thank you.

Gary Kain

Thanks, Doug.

Operator

The next question comes from Arren Cyganovich of Evercore. Please go ahead.

Arren Cyganovich – Evercore Partners

Thanks. Just a question about the increase of the 30-year MBS from the 15-year, maybe what specifically was in those assets that you purchased that, where they’re able to keep the duration of the assets roughly the same as the prior quarter. Just normally I would think increasing the 30-year relative to 15-year should increase your asset duration risk?

Gary Kain

Yes, and it would, so I mean we didn’t have any magical dust to sprinkle on them. They are longer duration assets. but remember, we had a pretty healthy rally in the mortgage market, which sort of brought down the durations of everything. And so what you’re seeing is and this is where it all makes sense, right is that as the market was rallying and dollar prices were going up, and your durations are shortening. And at the same time, we actually, maybe a little before that, we were allocating more towards 30-year. But what you’re seeing is kind of a confluence of a few different factors and that’s why I didn’t see the durations change.

Arren Cyganovich – Evercore Partners

Got it. Okay, thanks that’s helpful. And then in terms of the – I guess slide eight, when you talked about the sensitivity of the dollar roll. Could you talk about that well as to your historical dollar roll income that has bounced around a little bit more I think in the second half of 2013, you actually had negative dollar roll income as opposed that you actually had short positions in TBA, because it’s a pretty big delta from $138 million to zero, what are the mitigating factors of that and maybe taking some of that on balance sheet, or something in that nature?

Gary Kain

Sure. Look, that’s really all related to just the size and kind of the position. So to your point, in the second half or around the middle of 2013, we were actually net short TBAs. And so given the symmetry of how we report, we were reporting a negative drag in income due to those short TBA positions. So we feel – so I think to your point and something we tried to stress and going through this table is obviously one key variable for aggregate dollar roll income is the amount of specialness, which is what we’ve outlined here. And the other is the size and composition of the portfolio.

So to the extent that the portfolio gets larger, obviously that’s going to help the aggregate amount of dollar roll income, to the extent that the – that it moves to 30-year coupons or coupons with more specialness that not going to help as well. So to your point, that really are three factors there, I mean there are more, but the three biggest are going to be size of the position, the composition of the portfolio, and then the specialness that we’ve outlined here.

Arren Cyganovich – Evercore Partners

Okay, thank you.

Peter J. Federico

Thanks.

Operator

The next question comes from Matt Howlett of UBS. Please go ahead.

Matt P. Howlett – UBS Securities LLC

Thanks, guys. Thanks for taking my questions. Just on the comments on our volatility that you said you expect volatility to be rather low going forward. Just getting back to our laps, what happened last May, I think that surprised a lot of people looking, and today I think you still see consensus in terms of economist out there having some of the 10-year over 3% by year end, which would imply us a pretty big move from now until then. And I guess just what you see around volatility? Why do you expect it to remain fairly benign going forward?

Gary Kain

I’ll start now I’ll let Peter chime in as well. I think the most important thing to keep in mind on the volatility piece is really within the mortgage market, what happen is durations have extended, there isn’t the same aggregate negative convexity in the market especially when you think about the fact that the Fed has absorbed a third of the market. So the aggregate negative convexity in the mortgage market as a whole is already lower than it normally is before our Fed tightening cycle.

Second of all, a third of that is held by the Fed and some people might think well in the past that was held or a lot of that was held by the GSEs, the difference is the GSEs would hedge that and they were actually the most active hedger in the market, so there is a massive difference there. So I think one thing you really have to keep in mind is just the fact that the mortgage market impact on volatility and for that matter we’ve been spread volatility last year was just completely different than it is today. And so even if we had quick increase in interest rates, it won’t feed on itself the way it did and it won’t create the same stress within mortgages. Originators have already sold originations tiny at this point, just across the board none of those factors are really in place.

Peter J. Federico

And I would just add two other points to that I think are really important in – that will show the difference between the environment we face today versus the environment win. The first one is the correlation between rates and mortgage spread, last summer what we saw is a positive correlation between rates and mortgage spreads. So rates were going up, mortgage spreads were widening that was compounding the sort of rebalance the needs and pressure on the MBS market. So you really couldn’t afford to have any duration exposure because you had the incremental exposure of spreads widening as rates were moving.

And then the final point that I think makes in today’s environment different is how fragile the economy is, now it is growing and the economy seems to be doing well, but we saw a 100 basis point move in rates last year what that did to mortgage rates and what ultimately that did to the housing market and housing market even today even though the economy is showing signs of strength, the housing market itself is sort of neutral and perhaps even slowing. So those are some other factors that I think will mute the rate increase.

Matt P. Howlett – UBS Securities LLC

Yes. I think that they should pointing that out. There are clear differences. And then just on that note, when you look at the potential to raise capital, you did the preferred deal this quarter, it looks like that markets open for you guys, there’s room to go on that end. But when you look at, I think your kind of thoughts that you said earlier that AGNC market was sort of fairly valued and I don’t put words in your mouth that rates not really cheap. You think about mainly buying more MBS, and then you hear on our end and sort of the real money investors aren’t buying for a while. What would make you decide in terms of adding more MBS at this level, could you obviously, where could you take leverage in order to question you all the time. Would you look to issue more preferred and if you do get above book, would you look potentially to raise additional equity?

Gary Kain

Look, I think there are so many different factors that go into the equity equation. We certainly to your point we’ll consider all options are around raising capital and we’ll evaluate them the way that we have in the past. And so obviously, going back a few years, we issued a lot of comments, we demonstrated the symmetry of that equation by being willing to buyback a lot of our shares, thought that made sense. And we’ll continue to be opportunistic around the aggregate landscape, again, with respect to the mortgage market and our view on spreads, that is a factor, and we understand, there will always be different opinions around which way spreads are headed or what the market looks like. But we’ll continue to – we’ll continue to focus on what we really feel makes the best most sense for our shareholders.

Matt P. Howlett – UBS Securities LLC

Great. Thanks, Gary.

Operator

The next question comes from Joel Houck of Wells Fargo. Please go ahead.

Joel J. Houck – Wells Fargo Securities LLC

Thanks and good morning. The question is on the mortgage REIT holdings that you had at the end of June, obviously you took some exposure down. Do you have the kind of the total IRR, the overall investment in mortgage REIT and then how do you – how comfortable are you looking forward with what you still hold?

Gary Kain

Look, we in terms of the IRR, I’m not going to go into like specific numbers, I mean if you look at the returns we reported, I mean they made about $50 million in Q1 kind of on an all-in basis, and…

Joel J. Houck – Wells Fargo Securities LLC

$24 million.

Gary Kain

$24 million of this quarter. So you’re looking at $75 million in profits as of the end of the quarter, how you would judge the specific size of that portfolio, different times we’ll determine the end result. But what I would say is with respect to kind of go-forward, I’m really not going to comment at this point, it’s not a huge portfolio and big picture. I think we’ve given people enough direction over the last couple of calls as to how we’re thinking about it. We’ll continue to be opportunistic with respect to the holdings and make decisions as markets change.

Joel J. Houck – Wells Fargo Securities LLC

Okay. A conceptual question, if in fact, the financing the dollar roll market is more expensive. Is it necessarily there a tight correlation with overall spread widening in a sense that if you have less contribution from that portfolio, you would find more attractive opportunities in a regular market where you’re finding with repo or is there not really a correlation at all and we shouldn’t – as we think about modeling spread earnings growth where we shouldn’t necessarily make that connection?

Gary Kain

I guess what I would say is, if you’re trying to think about the overall earnings power of the portfolio, I almost don’t think it matters that much for you to try to model the aggregate, or the size of one portfolio versus the other, it’s more a matter of, I mean so if we – it’s more a matter of making an assumption on dollar roll specialness. And then yes, you can make an assumption, you would have to make an assumption of size. But in a sense, whether it turned out, we moved stuff one way or the other. Again, I think what we’re kind of showing you is that you can allocate those the returns between the two portfolios, and you can kind of think about them in aggregate and then the key variables going to be what happens with specialness in terms of like the aggregate net spread income.

So I know that realistically, if rolls become less special, I think there is a likelihood that we will move some more to TBA, or to our specified pools, but I just want to be very clear that you have to be practical like even at 30 basis point funding advantage is extremely valuable over time. And so I think the mistakes some people make is they focus a little too much on the direction of the move that it get 40 basis points, or 25 basis points worth as opposed to – is the difference still compelling.

Joel J. Houck – Wells Fargo Securities LLC

And the final one I guess on the dividend, you clearly have, there’s a lot of run rate in terms of core earnings versus $0.55 dividend, and the reason that you’ve already pointed out that the taxable earnings are lower, but that’s a good thing for shareholder, how should for income oriented investors, should they focus more on the core earnings in terms of dividend direction and ignore taxable earnings at moment, maybe how should we think about that?

Gary Kain

Sure. I mean first off, what we’ve told you is, yes, to ignore or not to focus on the taxable earnings numbers. the dollar roll income is essentially left out; we’re able to use that against the tax loss carryforward, which is a big advantage. So yes, you should basically ignore the taxable income number and we will be essentially ignoring it as we set the dividend.

Joel J. Houck – Wells Fargo Securities LLC

Okay, great. Thanks, Gary.

Operator

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

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

Hey, good morning guys. Just I had a couple follow-on questions; let me start by beating this horse of specialness. But just a real simple the chart you showed on page 8 that 0% column represents where the specialness was in 2Q on average. If you were to characterize that as of today, four weeks after quarter end, would you say we’re kind of around the 50% column or is it a little more or less than that again, point in time?

Gary Kain

Look, it’s hard to kind of get the exact, let’s say, this was our quarterly number across multiple coupons, and where we are now is we have different coupons, but dollar roll funding levels have worsened over where they averaged. I would say that you’re not that far off, it may be in between the plus 25% and the plus 50%, maybe it’s a little closer to the plus 50%, but I don’t – I think it would be really hard for me to try to point an exact picture at it.

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

Okay, that makes the follow-up harder. So I was going to ask you to forecast the rest of the quarter, but I guess I’ll just skip that.

Gary Kain

Yes. Maybe hold that one for after the quarter we might be better out at them.

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

Okay. that sounds good. So a different follow-up question, I had I think it was Matthew that asked a question about sort of a volatility and sort of rates. I think you answered that with I think very good and elaborate answers on why this year and the current situation probably has been set up as badly as it was a year ago or maybe a little over a year ago. But as far as absolute rates, I mean we’re sitting here with the 10-year back below 2.5, and as I was getting too precise with that, I mean in the last four out of last five years, we’ve seen a pretty strong rally in yields and rates have risen pretty sharply, somewhere around year-end, as we get that kind of seasonal enthusiasm cycle, this spring is going to be the year that the economy really breaks out. And one of the setups, it’s a little worse this year, is actually the Fed has been tapering and the Fed has been talking about moving forward in terms of when it actually raise its rates.

The reality of whether it happens or not is pretty clearly secondary to the market, emotion around that expectation of springtime, economic all is good. Does that concern you at all; you’ve set up the portfolio and again, against the backdrop that mortgage spreads have actually tightened up quite a bit. It doesn’t matter about the fundamentals, as long as the markets going to trade on sentiment and expectation. So I guess I’m just wondering, you did a lot of repositioning kind at this time last year, doesn’t sound like you’re really thinking about in the same way right now and I’m just curious.

Gary Kain

I think what’s important is that we react to the change in the environment and it’s not just like the absolute level of rates. Let’s go back to, you are absolutely right. if you look back a year ago in the second quarter, we shrunk our portfolio, we’ve repositioned from 30s to 15 years. We’ve reduced our duration gap and to Peter’s earlier point, we reduced our exposure to kind of negative convexity as well because we were very worried about kind of idiosyncratic spread risk.

If you would then described, over the next year to your point, at that point, there was quite a bit of concern that or technical reasons, fundamental reasons everything that people weren’t able to distinguish between a tapering, or the potential of the tapering and a rate increase everything will sort of lump together. We felt that really defensive position made sense. But if you think like look at 15 for an example, which is a difference, if you look at what happened over the last year, we’ve seen a tremendous flattening of the yield curve, a massive decline in interest rate volatility.

these aren’t things that you necessarily would have expected at that point. I mean yes, they were kind of the best case scenario in the end for the mortgage market, but they are not the things, the reasons why you are buying 15 years last year. All right, you weren’t buying them to be the best performer in a massive flattener and where rates came back down and where – and we’re evolved volatility drop. And so we have to be practical, the other thing I would say is, your point about we’ve rallied back in the 10 years back to 250, it’s still 75 to 100 basis points higher than where it was.

But more importantly, I think what you are describing is the dynamics of the yield curve, which I mentioned earlier in response to another question. The five-year treasury has actually sold off this quarter. The three and five-year have, it’s significantly affected already by changing expectations around where the funds rate will be. And so I do think that the – I want to just stress what we mentioned earlier, active management is just really important all the time, but it’s more important when all of these kind of factors are moving around. And so I would say our focus right now is at least, is probably more on the yield curve and what might happen there as much as just the absolute level of 10-year rates.

Malon Wilkus

And just to build on that point, even though our overall hedge portfolio hasn’t moved a lot. We have done a lot of rebalancing within the hedge portfolio take our payer swaption portfolio for example, while that looks relatively small at about $8 billion. We’ve actually shifted that composition to Gary’s point to be much more concentrated on the intermediate part of the yield curve for example the four to seven-year part of the yield curve where we think interest rates really could become volatile and its scenario whereas the Fed backs up, and not maybe so much on the back end of the yield curve where the position had been last year. So there has been pretty significant changes in the – in where our hedges are located are along the yield curve.

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

Yes. Well, that makes sense. I mean what I’m really taking away from it. I guess in summary, as you’re not feeling nearly a defensive and yes, probably appropriately so as you were at this point a year ago. But you are going to still maintain the AGNC philosophy of active rebalancing anytime the wind suggests that that’s the thing to do.

Malon Wilkus

Well. The other point that I want to go back to is that I made at the beginning, which is we’re looking at our exposure for both interest rates up and interest rates down. Now we have much more two sided risk today than we had a year-ago. A year-ago, we had a lot of extension risk; everybody had a lot of extension risk.

Today, we have to also look at our duration gap and what will happen to our interest rate risk, if rates rally by 100 basis points. So that’s not out of the question, although not likely, not out of the question. So we have to be cognizant about our position in both directions.

Gary Kain

And Mike, first, I want to thank you for the question, because I think this is obviously a really important topic and the other piece – the other thing to keep in mind is the other side of this is everyone wants to look at what’s happened in the past when the Fed has tightened, okay. And I think you got to be a little careful with looking at those as examples, because in the past when the Fed has tightened it has never just gone through a tapering process. And the tapering process still created a more than 100 basis point increase in rates. It’s already done things like, across the supply of mortgages and have people kind of go through a complete hedging process.

And all of that occurred like a year ago and maybe potentially year and a half before kind of an actual tightening process occurred. So I think that there are a lot of dynamics here that we feel that have to be taken into account and just clear, just looking back to 2004 and 1994 is very shortsighted, given what we’ve already gone through and the fact that we’ve never had a situation where the Fed had already tapered. And so that’s another key thing to keep in mind.

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

Yes, well. Certainly, appreciate it and nice quarter.

Gary Kain

Thanks.

Operator

We have time for one more question. And our last question comes from the line of Eric Beardsley with Goldman Sachs. Please go ahead.

Eric Beardsley – Goldman Sachs & Co.

Hi, thank you. Just perhaps, the follow-up to that in terms of what is your current outlook for rates, are you positioned for how you expect the yield curve to develop as is today, are you more bullish on where rates go and where spreads go on MBS? And then if we were to progress along the yield curve as it is today, how would you change your positioning?

Gary Kain

Look, I think big picture where we don’t have a strong view right now on interest rates. And you can see that by our duration gap coming down to sort of a more normal kind of position at a year, again a year with very – with still even though it’s increased a little, still very little extension risk. In an environment where we don’t think extension risk, and so if interest rates go up, we actually think that’s the better environment for mortgage spreads right now, not a worse environment. So we – a key factor for us is the comfort level that and I think others share this.

The comfort level that if interest rates went up and we were 2.75% to 3% that would bring in a lot of buyers for both treasuries and rates, and likely hold mortgage spreads in very well. In that kind of environment, this is a pretty neutral duration gap given the amount of extension risk. And so we’re not making well, say – we don’t have a big internal call on interest rates and on around the curve, I think that the one thing to – curves flattened a lot involve that’s the logical outcome and assuming the Fed remains on their kind of, we’ll call it current course.

Then it’s logical to assume the curve is even flatter six months to a year from now. But we have to be cognizant that something could change that. and to Peter’s point, the housing market has been kind of a weak link recently. And so what I would say is, if there is room for one really big move in the market, it’s probably if the market were to start a price out of Fed tightening, or push that back that you could again, not counting on it, but a scenario we have to watch for is one we have the five-year rally significantly, because that’s a place where there are very, very deep shorts to the marketplace.

Eric Beardsley – Goldman Sachs & Co.

Great, thank you.

Gary Kain

Thanks.

Operator

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

Gary Kain

I’d like to thank everyone for their interest in AGNC and we look forward to joining you next quarter.

Operator

The conference has now concluded. An archive of this presentation will be available on AGNC’s website and a telephone recording of this call can be accessed through August 12 by dialing 1-877-3447529 using the conference ID, 10049322, again 10049322. Thank you for joining today’s call. You may now disconnect.

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