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Executives

Katie Wisecarver – Director IR

Malon Wilkus – President & CEO

John Erickson – EVP & CFO

Gary Kain – President & CIO

Chris Kuehl, SVP of Mortgage Investments

Peter Federico – SVP & CRO

Bernie Bell – VP & Controller.

Analysts

Bose George – KBW

Mike Taiano – Sandler O’Neill

Douglas Harter – Credit Suisse

Joel Houck – Wells Fargo

Mike Widner – Stifel Nicolaus

Jim Ballan – Lazard Capital Markets

Edward Friedman – MacLean & Partners

Daniel Furtado – Jefferies

American Capital Agency Corp (AGNC) F2Q11 Earnings Call July 27, 2011 8:00 AM ET

Operator

Good morning. My name Ellis and I will be your conference operator today. At this time I would like to welcome everyone to the Q2 2011 AGNC Shareholders Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks, there will be a question-and-answer session (Operator instructions). Thank you.

I would now like to turn the call over to Ms. Katie Wisecarver, in Investor Relations, you may begin your conference.

Katie Wisecarver

Thanks Ellis. Thank you for joining American Capital Agency’s Second Quarter 2011 Earnings Call. Before we begin, I would 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 forecast, 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 Risks Factors section of AGNC’s 10-K, dated February 25th, 2011 and 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 10th, by dialing 855-859-2056 and the conference ID number is 84890133.

To view the Q2 slide presentation, turn to our website agnc.com and click on the Q2 2011 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. If you have any trouble with the webcast during this presentation please hit F5 to refresh.

Participants on the call today include Malon Wilkus, Chairman and Chief Executive Officer; John Erickson, Chief Financial Officer and Executive Vice President; Gary Kain, President and Chief Investment Officer; Chris Kuehl, Senior Vice President of Mortgage Investments; Peter Federico, Senior Vice President and Chief Risk Officer; and Bernie Bell, Vice President and Controller.

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

Gary Kain

Thanks Katie. Good morning, everyone, and thanks for joining us. Deja vu is probably the best way to describe this quarter. The similarities to the second quarter of 2010 are striking and this only reinforces what we stressed last quarter. Our portfolio must be able to perform if rates move in the either direction. Therefore, we really do feel good about continuing to produce strong results this quarter, despite the unexpected rally in the bond market.

Now, before we discuss the quarter, we realized that many of you have questions around the debt ceiling, the risk of a downgrade of US government debt and the implications on agency MBS.

And, now while political wrangling clearly seems to dominate the thinking or lack thereof in Washington, we strongly believe that the debt ceiling will be raised at the last minute.

That being said, there is a risk of a downgrade of US debt below its historical AAA rating. However, we believe the impact on government and agency debt of a downgrade will be limited.

The markets are clearly aware of this risk and US Treasuries actually rallied with prices higher and yields dropping yesterday. Additionally, agency mortgages are also holding up reasonably well given the headlines and prices of all generic mortgages were higher yesterday.

Lastly, I want to address some misconceptions that seems to be floating around with respect to agency repo. First of all, the agency repo market is functioning normally and we have not seen pressure on haircuts. Agency repo is readily available and rates remain extremely attractive.

Furthermore, even in the unlikely event that at same point in the future we saw a 1% or 2% increase in haircuts to something like 5% to 6% on agency MBS from the current levels of near 4%, this would not impact our comfort level with our leverage.

To demonstrate why we are not concerned, remember in early 2009 when the equity market was at its lows, agency repo haircuts averaged around 7% to 8%. Why is that significant.? Because at that time the average leverage in the REIT space was very close to where our leverage currently is.

In other words, we would be comfortable running our current business and could fully fund our positions with ample cushions, even if haircuts increased two or more percent.

To further provide comfort here, at the depths of the market in the second half of 2008, agency REITs with eight or more times leverage were able to make it through the worst liquidity period we have witnessed.

In conclusion, we continue to repo at terms consistent with or better than where we were earlier in the year and our business model can handle any reasonable increase in haircuts.

So with that out of the way, let’s move on to a more pleasant subject a review of AGNC’s performance for the quarter. First, GAAP net income totaled $1.36 per share and if we exclude the net loss of $0.05 a share in other investment income that leaves a $1.41 per share of what some like to describe as core income versus the $1.30 per share of last quarter.

Taxable net income was a $1.56 per average share. Our undistributed taxable income increased again this quarter by $23 million as our taxable earnings continue to exceed our dividend. So, as of June 30th, UTI totaled $78 million or $0.44 per share off of our ending share count of nearly a 179 million shares.

Book value rose $0.80 per share to $26.76 during the quarter. Importantly, our economic return which is the combination of dividends plus the increase in book value totaled 8% for the quarter or 34% on an annualized basis.

So, as you can see on the next slide, our mortgage portfolio totaled $40 billion as we deployed a large percentage of the almost $1.4 billion in accretive equity we raised towards the end of the quarter. But really what’s most important is that this growth did not come at the expense of the asset quality, and Chris will address this in some detail in a few minutes.

But now let’s turn to slide five, and look at what happened in the markets during Q2. As you can see in the top two panels on the left, interest rates dropped materially during the quarter with the five-year part of the curve outperforming. If you look at the changes in swap rates, two-year and 10 years swaps drop around 30 basis points. While five-years swaps dropped by 43 basis points. Notice that the two-year and five-year swap spreads widened significantly during the quarter as well.

But now, let’s look at generic mortgage performance. Overall, we were impressed with the performance of agency mortgages during the quarter. When rates rally significantly, we assume prepayment fears will escalate, providing resistance to mortgage price increases. This did end up happening, but only late in the quarter when the rally appeared to be more powerful and more sustainable.

That being said, while mortgages weakened later in the quarter, their overall performance was quite respectable with 30-year, 4.5 coupons increasing by almost 2 points. Also as you can see on the bottom left, 30-year 6% coupon mortgages rose by a 1.25 during the quarter. Interestingly, the price of that 6% coupon mortgage reached a high of over 110.5 in early June as the market became somewhat complacent about prepayment exposure and risk premiums.

In 15-years, shown on the top right, performance was also reasonable as the price of 15-year, 3.5 and 4s increased by 1.75 and 1.6 points respectively. Now importantly, the prices of prepayment protected mortgages, such as low loan balance and HARP loans increased by more than generic mortgage products. As a result, the aggregate performance of our assets outpaced the losses on our total hedge book, which drove a large portion of the increase in our NAV during the quarter.

So now, I’m going to turn the call over to Chris, who will discuss why we believe our portfolio is even better positioned going forward.

Chris Kuehl

Thank you, Gary. As you can see on slide six, we maintained significant diversification on growing our asset base to approximately 40 billion given the increase and our equity base.

During the quarter, we increased our holdings of select types of 15-year and 30-year mortgage backed securities with an emphasis on securities with prepayment protection on maintaining our discipline with respect to extension risk.

As you can see on the bottom left chart, prepayment speeds on our portfolio remained very well behaved. Our portfolio CPR averaged just 9% during the second quarter. Additionally, despite the decrease in interest rates, our portfolio prepaid at only 8% in the most recent release in early July.

The CPR performance is a function of specific attributes of our holdings and as slide seven shows, the percentage of securities backed by loans that provide significant prepayment protection increased materially during the quarter.

As you can see on the chart on the top right, prepayment protected 15-year pools represent largest holding. And while 15-year pass-through have the obvious benefit of shorter durations, given a shorter amortization schedule, they’re also generally backed by borrowers with very high FICO and low LTVs. And unfortunately, everything else being equal, very strong credit translates the considerably greater prepayment risk.

To mitigate this risk, more than 85% of our 15-year holdings, up from 76% last quarter are backed by loans with either low loan balances or were originated through the HARP program. While these pools do trade at a premium to TBA, the premium paid is a small fraction of the value of having the more stable cash flows. We’ll show you an example of just how important this is on the next slide.

Now, within the 30-year sector, we have reduced our holdings of our highest coupons securities as the valuation of these instruments got to levels where the risk return equation no longer made sense. As an example, we sold the significant amount of 30-year 6% pass-throughs and we replace these assets with newer lower coupons pools, the result as you can see in the chart, more than 65% of our 30-year holdings now have some form of explicit prepayment protection. This category is comprised primarily of pools backed by HARP originations, and to a lesser extent backed by lower loan balances.

As we discussed on prior calls, we continue to maintain our disciplined approach with respect to evolving the composition of holdings in response to the ever-changing market environment while maintaining responsible diversification.

As Gary mentioned, the substantial decline in interest rates and the increase in mortgage prices looks very similar to what happened during Q2 and Q3 of 2010. And our strong performance during that period was driven by our asset quality, but we didn’t have this information back then, slide eight shows just how important it is to own the right assets when rates fall significantly.

The graphs at the top of the page show the prepayment performance of low loan balance versus more generic 15-year securities during 2010. Even more striking is the difference relative to the higher loan balance 15-year securities. It’s important to recognize that if you have purchased TBA or generic 15-year 4’s or 4.5’s you have to assume that the dealer will always give you the cheapest to deliver or fastest prepaying security available.

The graphs at the bottom are even more striking, highlighting the difference in performance between the high LTV, 100% REIT buyback pools versus more generic 30-year cohort and cheapest to deliverables. As a levered investor in mortgage securities, were only as good as our assets and so we’ll continue to optimize our holdings to ensure we are properly positioned as market change.

And with that, I’ll turn the call over to Peter to discuss our hedging activity on slide 10.

Peter Federico

Thanks, Chris. Let me start by reviewing our interest rate risk management objective. As we have stressed before, the primary goal of our hedging activities is to maintain our book value within reasonable bands under a wide range of interest rate scenarios.

Our goal is not to eliminate risk or to lock-in particular net interest margin, but rather preserve book value over a wide range of interest rate scenarios. Book value and net interest margin are not mutually exclusive measures.

By definition book value is the present value of all future cash flows. So, by focusing our hedging strategies and protecting book value, we also protect the portfolio’s long run cash flows and net interest margin.

The foundation of our interest rate risk management framework is careful asset selection. As Chris just discussed in some detail, our current portfolio is comprised mostly of assets to give us significant down rate protection. As such, we have structured our hedge portfolio to give us protection against a rise in interest rates. To do that, we use combination of instruments such as interest rate swaps, swaptions, treasuries, total returned interest-only swaps and TBA mortgages.

As you can see on slide 10, our swap portfolio totaled $22.2 billion at the end of the quarter. Given the growth in our asset portfolio and a decline in interest rates experienced during the quarter, we increased our swap portfolio by $7.1 billion or 47% during the quarter.

Our swap portfolio had an average maturity of 3.6 years and an average pay fixed rate of 1.68%. At the end of the quarter, our swap portfolio hedged 62% of our repo balance when accounting for unsettled positions.

During the quarter, we entered into $7.3 billion worth of new pay fixed swaps, which had an average maturity of 3.9 years and an average pay rate of 1.44%.

Our swaption portfolio also increased materially over the quarter. At quarter end, our portfolio of put swaptions, which give us the rate to enter into a pay fixed swap at a predetermined rate totaled $4.1 billion.

During the quarter, we added $2.7 billion of swaptions at a cost of $36.3 million. The cost of the outstanding swaption portfolio totaled $53 million at the time of purchase, and at quarter end, had a market value of $36.4 million.

While, the combination of our swaps, swaptions, TBA securities, and other hedges provide considerable protection against a significant rise in interest rates, this is not our expectation. However, as the levered leveraged investor and a steward of your capital, we must we must endeavor to protect net asset value against this risk, even if it is not our base case expectations, given the current state of the global economy.

To illustrate this point further, let’s turn to slide 11, where we show the market value profile of our swaption portfolio over a wide range of interest rates. As this the case with any long option position, the maximum one can lose is the amount paid for the option. In the declining rate scenarios on the graph, you could see that the maximum loss of the swaption portfolio is $36 million, corresponding to its current market value.

Conversely, if the interest rates increase significantly our put swaptions will gain considerable value. If interest rates were to increase by 200 basis points for example, the market value of our put swaptions would increase by about $240 million, or in per share terms, the value would increase by about a $1.35 per share.

Now, let’s turn to slide 12 for a brief review of our duration gap. The net duration gap of our assets and our hedges provides an estimate of the sensitivity of our portfolio to changes in interest rates.

As you can see from the slide, we ended the quarter with a duration gap of 0.6 years, unchanged from the prior quarter. For 100 basis point increase in rates, a positive duration gap of 0.6 years implies a loss of approximately $250 million. As a percentage of our net asset value, the $250 million loss would equate to a loss of approximately 5%. Of course, as we say in the slide, and in our Q, and as Gary has said in the past, this excludes the effects of convexity and is only a model based estimate.

Actual results could obviously differ materially from these estimates. That being said these numbers should give investors some broad insight into changes in our interest rate exposure overtime.

And with that I will turn the call back over to Gary.

Gary Kain

Thanks, Peter. And I can’t stress enough how important it is to have someone like Peter with over 20 years of market experience joining our team and leading our risk management activities.

Now, on slide 13, let’s focus on the left-most column, which depicts the economics of our business as of June 30th. As you can see, our portfolio yields remain essentially unchanged, declining only 2 basis points to 3.45%.

Our cost of funds at quarter-end increased from the prior quarter end by 4 basis points to 1.09% as a function of the larger swap Peter discussed earlier.

Again, this cost of funds number includes our repo cost, our settled interest rate swaps and the detrimental effect of any forward starting swaps that begin in any point during the third quarter. It does not included any of the other supplemental hedge instruments outlined on the page 10.

Leverage as of June 30th was 7.5 times when incorporating unsettled trades, which is somewhat below where we would expect to operate and is a function of the timing of our Q2 capital raise and market conditions. After subtracting our total expenses, you get a net ROE of just over 19%.

So, now let’s turn to slide 14 because I want to give a quick illustration of how sensitive the ROE of a levered mortgage investment is to prepayments. I think this example in conjunction with the prepayment speed history that Chris reviewed with you earlier, should provide more insight into why we obsess about asset quality and why different companies in the same space can produce noticeably different returns.

The table shows the yields under various prepayments or CPR assumptions for a hypothetical levered position in generic 15-year 4% coupon securities. The table also shows net margin and ROE estimates assuming 1% all in financing and eight times leverage.

As you can see the ROE numbers drop off significantly as prepayment speeds increase. For example, on one end of the spectrum, at an 8% CPR, the projected ROE on the levered portfolio is just over 19%. However, when prepayment speeds increase, the expected returns drop off significantly as you can see in the table.

So, the take-away is actually pretty obvious, the returns on a levered portfolio of mortgage securities will be a function of how those assets perform in the future coupled with how effectively the portfolio was hedged. As such, given the combination of what you heard from Chris and Peter today, we remain very optimistic about our ability to continue to produce strong returns for our shareholders in the current environment.

So, with that I will ask the operator to open the lines for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Bose George with KBW.

Bose George – KBW

Questions – the first is just really on sort of the growth that you guys have had lately. Historically, I was going to characterize your business model as being kind of opportunistic, where you would position your portfolio based on opportunities in the market. And, given the size of your portfolio now, with over $40 billion in assets, I mean, do you think it changes in any way how your business model runs going forward?

Gary Kain

Well Bose, I mean it’s a good question but I think one other things to look at is I think what the way we would describe our business is be independent on asset selection and being about holding the best assets we can in a given environment. And as Chris went over today on the call, our asset portfolio despite the size has really never been stronger in terms of protection against extension risk with the high percentage of 15-year, in terms of protection against prepayment speeds, with the highest percentage of prepayment protected attributes. So when you put that together, we’re actually extremely comfortable of that. As the portfolio was growing we can maintain a portfolio that is – that has asset qualities that we are extremely comfortable with. And so again, I would look at the composition of the portfolio as evidenced that it’s not an issue.

Bose George – KBW

Okay. Great, makes sense. Thanks. And then just switching to the spreads on new investments, I was wondering if the spreads you guys had this quarter, the 245-ish, is that roughly sustainable?

Gary Kain

Well, look us as we’ve always said around spreads, it’s very depended on what assets you’d deploy, and so, I mean, the yield on 15-year and 30-year mortgages are very different. They’re different on ARMs. So it’s obviously a function of what composition, what assets you find attractive. But I mean, big picture, spreads, in that zip code that are not, you can certainly can get them on the higher ends of, you know, let’s say the 30-year part of the market. They’re little below on 15-year, and clearly lower on ARMs. So again it depends on what part of the market you focus on.

Bose George – KBW

Okay, great. Thanks a lot.

Operator

Your next question comes from the line of Mike Taiano with Sandler O’Neill.

Mike Taiano – Sandler O’Neill

Good morning. I guess just the first question on the whole macro issue with the debt ceiling, and I hear what you’re saying in terms of what happened in ‘08, but just curious -- is there any change in how you are operating the business in terms of leverage or type of securities you own as we kind of get into sort of the last leg of this, it looks like, and hopefully in the next week or so, or is there anything you’re doing specifically?

Gary Kain

Look, we obviously factor in the volatility into every decision we make, but practically speaking, we are very comfortable with our leverage levels and first off around liquidity by having fixed rate mortgages. We have extremely liquid assets that are easy to mark and that could be sold if they needed to be sold. So we really feel very comfortable with our positions, but remember everything that Peter went over today and everything we’ve gone over with you in the past, we set our portfolio up to be in a position to handle big moves in either direction.

And that’s our daily operating philosophy. So we really don’t feel like we have to do something different in an environment like this, because again, whether it is our government and the debt ceiling or whether it is the European debt crisis or whether it was the big backup in rates in the fourth quarter. We run our business to be in a position to handle those kind of moves and I think we’ve demonstrated that in the past. So I would say big picture we think – we don’t know what the next risk will be, but we’re always running our portfolio to be prepared for it.

Mike Taiano – Sandler O’Neill

Okay, that’s fair. And then, just had a question on page 10, where you kind of go through your hedge positions and I’m probably way oversimplifying this, but just on the payer swaptions, the $3 billion in notional with the pay rate of 3.68%, so how -- I guess, given that that’s fact that your yields right now are like at 3.35%, 3.45%, how does that sort of work from a spread perspective, if rates were to go up?

Gary Kain

So a good question actually. When you think about – this really gets to the core of what we have stated as our objective around risk management. Yes, you could look at that and say well that’s not a very attractive pay rate, so does that really provide me a ton of value so to speak. But remember, if interest rates go up, those options increase in market value quite a bit and provide significant protection of book value. And so, they also actually provide significant interest rate protection in that environment, they add duration essentially to our hedges.

So yes, while that part of the portfolio you can almost think as a ceiling or a cap on our funding cost and not like a benefit to the funding costs in the rising rate environment. The material positive impact on book value is critical to us being able to manage our portfolio in that environment. So, it really does get to why we try to stress the objective of maintaining book value under a wide range of scenarios.

I think we’re comfortable having that percentage of our hedges that’s a ceiling on funding cost if you think of it from that perspective and getting the benefit in terms of book value.

Mike Taiano – Sandler O’Neill

Okay, so it basically goes back to the book value protection pieces that you guys talked about earlier?

Gary Kain

Absolutely. And in that up rate scenario, the larger operate scenario protecting book value is job one and we’ll prioritize that over NIM any day of the week and we’ve been clear on that.

Mike Taiano – Sandler O’Neill

Okay. Now, just last question, if I can, just in terms of the HARP and low loan balance securities that you have, can you give us a sense of what sort of the split is between the two. Is the majority now low loan balance, or is HARP large enough where it actually is a significant piece of those respective portfolios?

Chris Kuehl

Sure. This is Chris. Within the 15-year sector the majority of our holdings are actually low loan balance loans. And within the 30-year sector, the HARP program is a little more significant as a percentage of issuance and the HARP loans that we’re originated through the HARP process represent a larger portion of those holdings relative to low loan balance loans.

Gary Kain

So, I think in 30 years, it’s roughly what like two-thirds probably of…

Chris Kuehl

Right.

Gary Kain

That category is actually HARP versus loan balance, but in 15-years it’s – the vast majority are loan balance.

Mike Taiano – Sandler O’Neill

Great. Helpful. Thanks a lot, guys.

Operator

Your next question comes from the line of Douglas Harter with Credit Suisse.

Douglas Harter – Credit Suisse

Thanks. I was wondering if you could talk about any political risks that could increase your prepayment speeds.

Gary Kain

So, I think you’re probably referring to the Boxer bill and some of the discussion around sort of streamlined refinance programs were fees at the GOCs are waived and so forth. And if you remember, this was like a huge topic a year ago in the mortgage market, and higher coupon mortgages underperformed because of this. Our mindset, I want to be very clear, our mindset on this is that the government gave us a lot of consideration a year ago and decided it was a non-starter. If you think about what’s changed since then, the political climate has moved so much further away from kind of doing more with the GOCs to help homeowners and help the economy, it’s gone in the other direction with the white paper saying, reduce the GOC presence, increase fees, reduce the footprint. So, we feel pretty strongly that this risk is as low as it’s been at any point kind of over the past few years.

Now that being said, how do you deal with a very low risk that could be significant? You deal with from the perspective of diversifying your portfolio and managing the amount of your portfolio that’s exposed to some, call it very far out-of-the-money risk.

And actually, our portfolio right now has probably the lowest exposure to something like this than it’s had in ages. And as an example, the entire 15-year part of the portfolio is already very, very good credit mortgages. They are new, they are higher FICOs, they are lower LTVs, they can refinance now. The reason they don’t is because there are low loan balances and the fees are -- cost of outside of the GOCs, closing cost, appraisals and so forth, are a big hurdle on small loans, plus it’s economical for the servicer or the brokers to deal with these borrowers.

So, that area would actually be basically unaffected. As would a lot of our 30-year mortgages. The ones that would be affected as a higher coupon mortgages and obviously things like IO strips and so forth. But we’ve actually reduced our positions because prepayment in those areas pretty materially over the quarter, not because we’re worried about this, but because earlier people had really kind of been complacent about generic prepayment risk and the prices of both IOs and higher coupon mortgages have gotten out of control. So, big picture, we’re not worried about the issue. We view a cheapening of higher coupons as more of an opportunity, but we’ll balance and diversify our portfolio, so that our exposure is manageable.

Douglas Harter – Credit Suisse

Great, thank you.

Operator

Your next question comes from the line of Joel Houck with Wells Fargo.

Joel Houck – Wells Fargo

Thanks and good morning. Gary, I’m wondering if you want to kind of handicap the probability of actual downgrade occurring, and then along with that your best guess of what would happen to MBS pricing. And then, kind of wrapped into that question is another one, which is, leading into this, have you guys kind of delevered your balance sheet in the last week or so in anticipation of dislocation? I heard your earlier comments about haircuts and you are fine, but this is more of an opportunistic question or in that sense that now you would have excess capital to deploy if we got a 2, 3 point sell-off in MBS.

Gary Kain

All right. So, with respect to – if we got a downgrade, in terms of the probability of the downgrade, I don’t really feel like we have greater insight into this than the market as whole let’s say. But clearly, the market as whole is saying that the probability of the downgrade is not insignificant is probably the best way to describe it. And importantly, once that’s the case then that probability is priced into the market.

And so, when you see mortgages and you see treasuries performing as they have, you have to assume that the impact would be relatively muted, because people are considering that there is some – there is risk on this front of a downgrade. So, big picture, we expect maybe a modest widening, but it would be modest and relatively brief and so we don’t tend to operate our portfolio based on, like trying to time leverage decisions to two weeks here or there.

That being said, again, we do look at long-term risk management and factor those kind of things in to our positioning decisions. Generally speaking, we try not to give into inter-quarter updates on our leverage and so forth. So, I’m kind of avoid giving specific – a specific answer to your question on our current position, but I would kind of point you to those themes in terms of thinking about how we would response. And I’m sorry, I think you had a last piece to that question.

Joel Houck – Wells Fargo

Yeah. Well, it was more geared toward, I hear what you’re saying with regards to it, it’s not going to blindside anybody. However, the very act of a ratings downgrade could force, however a brief period of time, could force some severe selling by pension funds, insurance companies. Where these entities deploy that capital is anybody’s guess. Just there is no other AAA market to replace it with. So, while your comments about it being kind of temporary, I think, resonate with investors is still could be quite a huge shock if it actually happened.

Peter Federico

Yeah, this is Peter, let me add a little bit to Gary’s and I’ll pass it back to him in a moment. Yeah, I think you’re right, I think the risk of volatility is significant in the marketplace. But I think what’s happening right now is I think investors are preparing for that scenario and I wouldn’t be surprised if people were reviewing their investment guidelines as we speak, because you are right there are really is no other substitute. So, I think everything is going to have to shift kind of relatively speaking. And to build on the point about the risk of downgrade and the credit of the mortgage-backed securities, I think the market will quickly conclude it with superior credit, fixed income credit product available. If you think about it, the mortgage-backed security is first backed by GSE which is essentially capital neutral, it’s backed by the U.S. government and now it’s also backed by performing, largely performing mortgages. So, it is a collateralized security and I think people quickly view it from the credit perspective as being superior even to a treasury.

And one other point though to kind of build on your question on being opportunistic. I just want to talk real quickly on our repo capacity. As we have mentioned in the presentation, we have 26 repo counterparties. We have excess, some amount of excess capacity with every one of those counterparties. So, we have a reasonable amount of excess rebuild capacity and we also carry a cushion to absorb in a form of cash or mortgages to absorb the incremental margin that Gary mentioned earlier. You want

Gary Kain

No, I think that’s a great explanation and I just want to reiterate the point Peter made about agency mortgages. If you worry – if at some point down the road, there is a real like worry about U.S. sovereign credit, but agency mortgage-backed security is the safest instrument. It’s collateralized by real loans and houses that are – and the delinquent loans are already been pulled out. So, when you put that together that makes it a much safer instrument than a U.S. treasury and since – we had a down, like, Japan had a downgrade of its debt, interest rates are at the lowest level there, close to – the lows in interest rate there. The yen has performed fine. I think you just have to be practical that the rating agency is cloud at this point and is not what it used to be.

Joel Houck – Wells Fargo

All right, thanks guys. Appreciate it.

Operator

Your next question comes from the line of Mike Widner with Stifel Nicolaus.

Mike Widner – Stifel Nicolaus

Hey. Good morning, guys.

Gary Kain

Good morning.

Mike Widner – Stifel Nicolaus

So, I got a couple questions for you. First, I want to just follow-up on Bose’s question and probably get the same answer, but I’m going to ask it again anyway. As I look at you guys’ strategy and execution over the past, well, in relation since the IPO. This is the first quarter since inception that core earnings, as you referred to it, actually has covered the dividends. And actually, if we look back over the past six quarters, the percentage of the dividend being covered by trading gains or however you want to phrase, non-core, has been a steadily declining percentage. There has been 25% of your dividend was covered by that stuff last year versus effectively zero this quarter.

Obviously, the portfolio is getting larger. And then another point, as I’ve listened to you guys talk, the tone of the language certainly seems to be different. You know what I mean by that, that you are talking a lot more defensively today. And I don’t mean that in a bad way, but things about protecting book value and generating stable or predictable pass-forward and protection from repurchase spikes and what not, which is a bit different from the tone that was, I would say, a little more offensive and little more trading-oriented in terms of seizing opportunities from this pricing. That language seems to be gone from your discussion right now. So with all of that said, is there sort of a gradual, but strategic shift in the way you guys think about managing the business at this point that is more about longer term focused and so on and so forth as opposed to just opportunistically taking advantage of whatever the market gives you today?

Gary Kain

Actually I would say that our approach to the market is not very different from where it was a year ago or a year before that. If you went back to our earnings calls in 2010 we talked about swaptions, we talked about protecting book value and managing book value for bigger moves in interest rates and we are proud of the fact that we’ve been able to do that over those periods. I think we may be getting to your point a little better at may be kind of communicating it, but go back to – we have used swaptions and they have produced material gains for us in the second quarter of 2010 we talked about them when the big increase in the interest rates in the fourth quarter, a lot of our performance of that up rate scenario was due to the swaptions portfolio in the TBA shorts.

So look, we view it as a key – we view in a sense generating returns for our shareholders as being a combination of price gains or appreciation and net interest income. And I think we still have that exact same mindset, which is we don’t – we want to make money for our shareholders. We are not obsessed about which pocket it comes in through and that is the same mindset that we used in the past. I think practically speaking, we are in a little bit different of an environment right now where the – we are not in the midst of things like GSE buyouts and where the theme has been a little more consistent, but let’s go to a couple of things that happened at this quarter.

We sold entire coupon 30-year 6’s. We basically took off the vast majority of our IO position during the quarter because prepayments risk premiums kind of disappeared from the market and we no longer felt those were good hedges anymore. So, you will see on the margin that we are adding – we are continuing to add value through those means. It’s just, there is clearly a difference in terms of the market environment versus other periods of times.

Mike Widner – Stifel Nicolaus

Well, that’s certainly fair. And yeah, I guess what I would take away from that is, again, your attitude hasn’t changed, but the opportunities that it’s giving you today appear to be more on the net interest income side, is kind of what I distill from all that. And that’s why it looks like core earnings are getting a bigger share. But it’s not a mind shift so much as that’s the environment that looks like it’s out there today.

Gary Kain

And I would point you, and I’d point you to the last slide that we went over today. Right, I mean look we don’t mind outperforming by holding really good securities, right. I mean, its not about that we have to sell something to add incremental value. If you look at the last slide, slide 14 that we went over in the presentation, I think that sums up our mindset and our positioning right now. If we own the best assets and we hedge them appropriately we will provide extremely attractive returns for our shareholders. If the market changes and we should hold different assets, we will continue to evolve our portfolio and we feel that even at the current size that’s not going to be a problem.

Mike Widner – Stifel Nicolaus

Great, that makes sense. So just the second question then, in -- so the core income was very solid. But if I look at that other income line, it’s really decomposed into the realized gains on MBS sales and then a combination of unrealized and realized gains on the derivative instruments. Those two individual components ended up balancing out to about $6 million, which is pretty small for you guys, all things considered. But the individual line items were actually the largest that we’ve ever seen from you guys. So you’re $94 million in gains or about $0.70 something a share in realized gains, and then offset more than entirely by the liability side. So just wondering if you could talk a little bit about those components and sort of particularly the realized gains and the realized losses on the derivative side and the asset side.

Gary Kain

Sure. Good point. Look, the bottom line is that as we’ve said in the past we -- a chunk of our hedges are mark-to-market through income, right. So the market rallied and so it’s very logical that since some of our only the swaps are essentially in hedge relationships. The other hedge instruments are mark-to-market and in a rally they will produce negative marks and that’s absolutely expected.

The gains, on the other hand, relate to sales of things like 6’s and other not-so-well prepayment protected securities that given the rally in interest rates we no longer wanted to hold. But big picture, this is those exactly that to why what we tell you guys to look at on a consistent basis is dividend plus NAV, right? Because it marks everything, all right. It’s independent of whether we take a realized gain or we see it as an unrealized gain. It’s independent of whether the swap is, mark-to-market to income or OCI or the hedge.

So when you look at NAV, our asset outperformed our hedges in their entirety and when you look at the dividend, we paid the dividend and grew book value. So, that’s we continue to kind of fall back and say that is the best measure to look at on a consistent basis because it really drops off kind of the specific accounting anomalies associated with what gets marked through income and what gets mark through OCI.

Mike Widner – Stifel Nicolaus

Yes, well, certainly can’t complain about the performance on that standpoint. I would agree that the consistency and the high returns have been – yeah, certainly one of the best in this sector. Let me – just one quick follow-up there, the realized loss or the realized gain from derivative instruments and trading securities and if I understand that correctly, that is only – yeah, that’s the majority of the loss there, the $80 million. Is that reflecting terminations, or is there things that actually are considered realized even if you don’t unwind or roll off or terminate the hedges?

Peter Federico

This is Peter. The majority of the loss, a $100 million associated with our short TBA position. So that’s why it syncs up so well with the realized gains because the $95 million realized gain was on mortgages that we sold. At the same time we unwind a TBA hedge and so that’s the associated loss associating with it. The other component in the realized gains or losses were – gains and losses predominantly associated with a treasury hedge position that we had.

Gary Kain

But one other thing on the TBAs is because of they are monthly contracts, they almost automatically are realized because they move out to another month in the future. So, even if you still had a position on, it would generally be realized as long as it’s terminated within the quarter. So it doesn’t necessarily mean you quote, took off the trade or whatever. So just keep that in mind.

Mike Widner – Stifel Nicolaus

Yes, well, that’s crystal clear actually, just highlighting that it was mostly TBAs explains what I was wondering about. And thanks for the comments and questions, and congrats on another solid quarter, guys.

Gary Kain

Thanks a lot, appreciate it.

Operator

Your next question comes from the line of Jim Ballan with Lazard Capital Markets.

Jim Ballan – Lazard Capital Markets

Okay. Thanks a lot. Gary, as you mentioned already on the call, like a recurring theme for you guys has been protection of the book value. But if you look over the last year plus, I mean, you’ve actually had pretty nice book value growth. Can you – and you’ve talked about some of this already today, but can you talk a little bit about just the components of the book value growth that you’ve had and maybe what the opportunity for further growth going forward is?

Gary Kain

Look, I mean, when it comes to all-in returns, the book value growth essentially is you pay a dividend and if the remaining net asset value is higher than it started then your book value grows. Obviously that’s the “simple math.” I mean, it’s obviously book value is a function of market conditions. We’ve also benefited from a accretive capital raises and that’s a factor. But big picture, our mindset is one of, again just to reiterate total performance, right? And so, if – we are not thinking of, okay, how do we grow book value next? We think about it from the perspective of, if we own the best assets we can own. If we use logical and prudent leverage and then if we hedge the portfolio appropriately, we can generate very strong returns for our shareholders.

And, you know, then there is a dividend that you are paying, and then hopefully, you’ve got book value growth from there. We absolutely believe that further book value growth from this point forward is very doable. When we look at managing our portfolio though, we look at it from the perspective of, we want to protect our shareholders money. And so, you know, book value growth is actually a very good thing and we want to see it. But whereas, we are also as focused on trying to maintain book value within a reasonable band if we get some challenging scenarios.

Jim Ballan – Lazard Capital Markets

Okay. I also wanted to ask about, you mentioned those haircuts back up a couple of percentage points here, for whatever reason that there really wouldn’t need to be any change in your strategy. Have you thought about what a break point would be where haircuts would have to go before it does have an impact on your strategy and maybe you would need to unwind some positions?

Gary Kain

Look, it’s a function of a number of things. It’s a function of not only just haircuts, but market volatility, where our interest rates and other factors, where our prepayments speeds, because they also effect your ability to lever. So actually, let me give you the comparison again. The early 2009 scenario was haircuts in the 7% to 8% area with expectations around prepayments being much faster than where they currently are, which in a sense added the equivalent of another 1% to 2% haircuts, versus the prepayment speeds today.

So realistically, at that time this kind of leverage level was the norm in the REIT space, so I would – and that was a volatile period as well. So, my mindset is that we’ve got quite a bit of cushion with respect to changing haircuts and market conditions before kind of leverage policy so to speak changes. And so we feel very well positioned to take advantage of opportunities if they present themselves. And again, our prepayment protected assets really help us as well with respect to kind of reducing our aggregate effective haircut, so to speak.

Jim Ballan – Lazard Capital Markets

Got it, got it. Got it, and just one last question, if I may, you’ve talked a lot about how even with the growth in the book that you had over the last year, you’ve kind of maintained the strategy. Is there anything that you’ve gone through over, say, the last year, with all the growth that surprised you in terms of any differences in the way you’ve had to run your business, whether it’s managing the book or just running the business in general?

Gary Kain

Actually, the one thing that would surprised me or that may have surprised us a little bit is how little in a sense things have changed, in that, our outperformance or our mindset was about owning really good assets in the past and it’s still about owning really good assets. And look, having come from managing a $700 billion portfolio, I’ve seen even the other side of this. So there is comfort on our side in managing a portfolio from kind of the smallest that AGNC was up to a portfolio that AGNC will never get near.

So we’ve had experience on both sides of the spectrum, and I would say, what we’ve been continuously impressed with so of speak is the ability to find value-added assets when we need them. And I think part of that relates to the fact that we view this as a continuous process. So we’re not starting with, okay, we need to go turnover our $40 billion portfolio and buy the low loan balance now because we haven’t thought about it in the past. In that case it would be kind of much, much harder.

But when you kind of incrementally, day in and day out, come in with a focus of keeping your portfolio optimized. It’s amazing how much you can move your portfolio in a relatively short period of time and you can do that in a way without moving market prices and you can do it where you’re adding incremental value to your shareholders.

Jim Ballan – Lazard Capital Markets

All right. Terrific. Thanks a lot.

Operator

Your next question comes from the line of Edward Friedman with MacLean & Partners

Edward Friedman – MacLean & Partners

Hello. People have already asked this, but I was wondering if you could elaborate a little bit more on how will the book value be impacted if the U.S. does get downgraded. Let’s say, and the investment fully declines by, let’s say, 5%, 10%, if there any precedent in the past and what was the impact in previous crises?

Gary Kain

We don’t really have a precedent in the U.S. for a downgrade from the AAA level. We do our precedence in other countries. And generally speaking and you can even look at with respect to other securities that have been downgraded. The rating agencies especially over the last three or four years have not been perceived to be kind of the market leaders around kind of evaluating credit, whether it’s the sovereign credit issues in Europe, whether it’s – whether it was downgrade in Japan.

I mean, the reality is that rating agency actions tend to come well after the market has digested any of the information. And so, big picture, I just to want to reiterate that we feel the market is thinking about all these things and it’s clearly pricing in the risks. So, we don’t expect any massive moves. Remember, if all yields go up, then our hedges also perform very well. If all yields go down, then what we are worried about is the performance of our assets versus other yields.

So our main exposure realistically is the prices of mortgages versus interest rate swaps for the most part, treasuries to a very small extent. And going back just to reiterate Peter’s point, we do feel that if the market were to –at some point, we don’t see this happening anytime soon, price in through U.S. sovereign credit, sovereign credit risk. Agency mortgages being collateralized by performing loans and the GOC helping out as well, put them in a much, much stronger position than even treasury. So, we are optimistic actually about the price performance of mortgages overtime.

Edward Friedman – MacLean & Partners

Thank you.

Operator

Your final question comes from the line of Daniel Furtado with Jefferies.

Daniel Furtado – Jefferies

Hi Gary. Thanks for taking the question. I just had a real quick mechanical question and that’s back to the swaptions. How should I think about those in an up-rate scenario, if we had a shock upwards in rates, do you then hold these to maturity? Or do you pair the gains on the swaptions with losses you would have on the portfolio in order to get out of underwater MBS positions at no impact on book value or theoretically no impact to book?

Gary Kain

My answer would be, yes. So, I know you asked an either/or. The answer is that’s one of the beauties of having an option, right?

Daniel Furtado – Jefferies

Yes.

Gary Kain

So, you have the option if you feel that MBS at that point in time in that scenario are cheap and that the valuations and that you’re not really that interested in selling than you would actually exercise that option and you would be able to put on a swap below where swaps rate are at that point in time and you can realize the value that way. Or if you fee like, you don’t need that protection or if you want to sell some mortgage assets because they’re performing very well in that environment, then you could do that and pair off the swaption at a gain. So, in a sense, it’s going to be very dependent on the yield curve, volatility levels, mortgage performance as to how we operate. But, big picture, the number one thing that we’re looking for is that the price performance of those options, those will be extremely valuable options if a scenario like that were to unfold and that market value can be achieved one way or another.

Daniel Furtado – Jefferies

Understood. Perfect. Thank you so much, Gary.

Gary Kain

No, problem. Thank you, Dan.

Katie Wisecarver – Director IR

I think that’s it. So if you could just close the call, that would be great.

Operator

Thank you. This concludes today’s conference. You may now disconnect.

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