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American Capital Agency Corporation (NASDAQ:AGNC)

Q3 2011 Earnings Call

October 26, 2011 11:00 AM ET

Executives

Katie Wisecarver – IR

Gary Kain – President and Chief Investment Officer

Christopher Kuehl – SVP, Mortgage Investments

Peter Federico – SVP and Chief Risk Officer

Analysts

Bose George – KBW

Michael Taiano – Sandler O’Neill

Jason Weaver – Sterne Agee

Michael Widner – Stifel Nicolaus

Steven DeLaney – JMP Securities

Joel Houck – Wells Fargo

Dean Choksi – UBS

Operator

Good morning. My name is Terence and I will be your conference operator today. At this time, I will like to welcome everyone to the AGNC Shareholders Q3 2011 Conference 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 Katie Wisecarver of Investor Relations. You may begin your conference.

Katie Wisecarver

Thanks, Terence. Thank you for joining American Capital Agency’s third quarter 2011 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 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 November 9th by dialing 855-859-2056 the conference ID number is 16828279.

To view the Q3 slide presentation turn to our website agnc.com and click on the Q3 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 Calls section to view the streaming slide presentation during the call. If you have any trouble with the webcast during the presentation, please hit F5 to refresh.

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

Gary Kain

Thanks, Katie and thanks to all of you for joining us on the call and for your interest in AGNC. What an interesting quarter between the debt ceiling fiasco where our politicians did everything they could to create a crisis and to the U.S. debt downgrade the worsening of the European debt crisis, two surprises from the Fed and growing prepayment risk. Growing the SEC concept release and Monday’s HARP announcement and it is no wonder the risk factor has been a touch all over. But with all this we feel really good about AGNC’s performance and perhaps more importantly how it is positioned looking ahead.

Recall for a moment the prevailing view on interest rates at the end of the last quarter, the concern was that the growing U.S. debt burden and the potential for a rating downgrade would lead to a significant rise in interest rates many very well respected investor place large bets on that outcome instead we experienced the opposite a significant decline in interest rates.

AGNC on the other hand bet on neither outcome and was positioned to protect shareholder value under either scenario. The specific attributes of our portfolio that we highlighted last quarter proved to be critical in positioning the company to continue to generate very attractive risk adjusted returns despite the flatter yield curve, record low grades and even the recently announced changes to the HARP program which we will discuss in detail in a few minutes.

With that as introduction I want to quickly review the highlights of the quarter on slides 3 and 4 as we have a lot to cover today. As you will see we have also made a concerted effort to further enhance our disclosures related to our funding and counter party exposures and Peter will review them with you shortly.

First GAAP net income totaled $1.39 per share. Now if we exclude the $0.24 of other investment income that technically leaves $1.15 per share however that number includes approximately $0.08 of non-recurring catch up to amortization which relates to a one-time adjustment to our historical amortization due to the increase in our prepayment estimates.

As such the $1.23 per share is probably the best surrogate for what analyst like to call core income. The 13% CPR projection which drives our amortization an asset yields is approximately 50% faster than our actual Q3 CPR of 8. As such it’s like other players in the industry we did not make forward projections to our prepayments and just used our 8% actually CPR our decline in net interest income would have been considerably smaller. Alternatively you may want to think of this as us having taken the margin compression we would expect to see over the next few quarters upfront versus waiting for actual speed increases to show up. Now taxable net income increased significantly to $1.86 per average share as unrealized mark-to-market losses on derivatives don’t impact taxable earnings and taxable amortization was considerably lower than GAAP numbers. To this point taxable amortization was $34 million or $0.19 per share lower than GAAP amortization the cost prepayment projections do not impact taxable yields.

This is a key point to understand and you can see these numbers on slide 25. Given the strong taxable earnings our undistributed tax income essentially doubled this quarter to $156 million or $0.85 per share. Book value rose slightly to $26.90 per share from $26.76 our economic return which is the combination of dividends plus the increase in book value totaled 5.8% for the quarter or 22.9% on an annualized basis. As you can see on the next slide our mortgage portfolio totaled $42 billion leverage during the quarter was 7.9 times and was down slightly at quarter end to 7.7.

Now turn to slide 5 and we can quickly look at what happened in the markets during Q3. The tables on the upper left show the significant rally and curve flattened we witnessed in both treasury and swap rates over the past several months.

On the bottom left table, you can see what happens to mortgage prices. Lower coupons rally considerably more than higher coupons which makes sense in the longer durations and greater exposure to the back end of the curve. This result was also impacted by the uncertainties surrounding the prepayment landscape which obviously included the concerns regarding the changes to GSE policy and the HARP program which obviously impacted higher coupons the most. 15 years on the top right showed a similar pattern to what we saw in low the middle coupons over the years while August generally underperformed on organic prepayment fears.

Now let’s turn to the next slide, slide six where we’ll summarize the new prepayment landscape. A number of market participants have argued that prepayments will remain benign despite record loan rates. They have generally sided into relatively low Refi index, title underwriting practices, capacity constraints, high percentage of borrowers who may have trouble taking advantage of low rates. You know all of these arguments are actually valid. But in our opinion they don’t argue for benign prepayments. They argue for very large prepayment differences between various types of mortgages. And as we stressed in the past borrowers who took out mortgages between 2009 and 2011 are very good grips. They are ready to qualify under title underwriting practices generally have equity and can refinance with few if any barriers. This is what happened in 2010 and guess what that is exactly what they are doing now.

Now Monday’s announcement from the FHFA did elevate prepayment risk on more seasoned mortgages as well and this adds a new element of risk to this segment of the market but before we get to this, let’s turn to page 7 and look at the organic prepayment situations.

Now focus your attention on the far right portion of the two graphs because these show the most recent prepayments from Fannie Mae which were released just around two weeks ago this is current data at it clearly demonstrates the point around differentiation between loan attributes.

On the graph on the left we show 2010, 15-year 4% mortgages look at the speeds on both the universe of 15-year 4s and the TBAs which again is what you get delivered if you don’t buy lower loan balance pools. They’ve already hit 30 CPR which exceeds where they were last year. On the other hand prepayments on the securities backed by lower loan balances between 85 and a 110,000 have increased but are still around 12% CPR.

The exact trends can be seen on the right side of the page where we show the 30-year coupons. The TBA are high loan balance 2010, 30-year 4.5 spiked to 24 CPR while both the lower loan balance pools and the HARP loans remain very slow and well below 10% CPR. The differences are pretty striking. And what we take away from this data is that owning the right stuff is more critical than ever.

So now let’s move to page 8 and we’ll discuss the incremental risk arising from the recently announced HARP changes. First I want to be clear that we strongly believe that these changes will have a negligible impact on AGNC because as we discuss on our Q2 call we were proactively selling our higher coupon season paper and reducing IO exposure beginning in earnest during Q2. As importantly our core positions newer low loan balance and existing HARP securities remain definitively outside of the scope of these changes, so we are even more confident after this announcement that our portfolio speeds will remain well ahead.

Now with that said we do believe the changes announced by the FHFA could materially impact prepayments speeds on seasoned fixed rate and adjustable rate mortgages. While the elimination of the 125 LTV cap and the reduction in the fees charged by the GSEs should have a small impact the significantly reduced reps and warrant exposure for originators and the reduction in the need for appraisals could be very important. These changes could be material because appraisals slowdown the processing of the refinanced and significantly increase the exposure to the lender if the valuation of the house is later deemed to be wrong. And additionally the apparent relaxation of the reps and warrants around a borrower’s ability to pay also reduces originators underwriting exposure.

So given these issues and also just a significant air time that the program changes on receiving in the press which should raise borrower awareness, speeds of some of the most exposed seasoned cohorts could be above 40 CPR for some period of time, but we know realistically the full story here until the first quarter of 2012 when actual speeds come in. As such we hope our investors agree that not having this exposure hanging over the portfolio is a meaningful positive.

Before I turn the call over to Chris I want to quickly highlight on slide nine why prepayments are just so critical right now.

On the conclusion from the tables the bottom of the page is really obvious faster prepayments speaks materially affect yields and ROEs. The key point here is the magnitude of these differences based on core prices. Now keep in mind that pools with favorable characteristics do trade at meaningful premiums to generic mortgages, but this table is based on TBA prices for its simplicity and convey ability.

Look at third year four and a half at speeds ranging from 10% to 40% CPR. The yield is 3.48% at a 10 CPR only 2.06% at a 30 or 1.19% at 40 CPR. Now as we saw on slide seven, this entire range of speeds is possible depending on what types of pools you own. Now look at the impact for an investor like AGNC with assumed leverage of 8 times. Most ROE on a third year 4.5 can be as high as 24.5 at a 10% CPR and as well as low percent at 40% CPR.

This is really why we obsess about asset selection from and this slide is relevant for both our existing portfolio and for new purchases. And the bottom line is that new purchases can still produce very attractive returns if you can control for prepayments and this is even after accounting for the payoffs that you have to pay.

So at this point I am going to ask Chris to review how AGNC’s portfolio is positioned against this backdrop.

Christopher Kuehl

Thank you, Gary. Let’s turn to slide 10 to review the composition of our investment portfolio. At a high level the portfolio is similar to where we ended the second quarter with 15-year representing approximately 53% and 30-year representing 38%. Recall on our second quarter discussion that the vast majority of these positions were backed by loans with favorable prepayment characteristics. And so we were extremely well positioned for the rally that occurred during the third quarter that being said we did make some meaningful adjustments during the quarter in light of renewed focus at all levels within the government on making improvements to the HARP program.

What’s particularly relevant on this slide is that average prepayments speeds continue to be very well contained despite the rally in rates and subsequent material increase in prepayments on more generic MBS. For example the entire cohort of 2010 originated Fannie Mae’s 15-year 3.5s over 27 CPR for the October fact release again its 15-year 3.5s at 27 CPR that’s 125% increase versus the prior month. The actually prepayments speed on our portfolio came in at just 9% CPR for the most recent October fact release and average just 8% CPR during the quarter.

Let’s turn to the next slide for more detail on why we experienced such favorable performance relative to more generic MBS. As Gary mentioned earlier prepayments are going to drive performance and we were worried about two forms of prepayment risks. Organic prepayment risk and policy risk given today’s record low interest rate environment organic prepayment risk or in other words traditional refinancing risk driven by record low mortgage rates is very high on loans originated over the past two years at the same time we had all levels of government evaluating enhancements to improve the effectiveness of the HARP program and hence introducing significant policy risk on the HARP eligible cohorts.

On slide 11, we’ve given you more detail on the breakdown of the composition of holdings with in the 15-year sector which represents 53% of our portfolio the vast majority more than 90% are backed by loans with favorable repayment characteristics. Over 88% of these pools are backed by loans with lower loan balances. The lower loan balance category is comprised to pools backed by loans with original loan balances less than or equal to 150,000 and have weighted average original loan size of 104,000.

I also want to point out that within the $1.6 billion other category approximately $640 million are pools backed by loans with original loan balances less than or equal to 175,000. Now within the 30-year sector, more than 86% of holdings are backed by pools with loans that were either originated through the HARP program or have loan balances less than or equal to 150,000, this component of the position increase during the quarter as we continue to sell seasoned higher coupons and other generic MBS as we had done during the second quarter.

With respect to policy risk it was our opinion during the quarter that the most exposed category to the HARP program enhancements, higher coupons pools issued prior to 2009 up which less than 5% of our portfolio was comprised of single family fixed rate or ARM pools issued prior to 2009. Both these entire coupon pools have provided reasonable performance over the past couple years given an efficient HARP program, our opinion was under risk and return profile was no longer compelling in light of the renewed government focus on improving the program effectiveness and relatively full valuations.

The next slide summarizes the positioning of the portfolio versus segments of the overall mortgage universe. It also overlays the heat map that outlines our views on prepayment risk levels for these categories while I’m not going to review the slide in detail by comparing last two columns on the right side of the page, investors can get a very good feel for how different AGNC’s portfolio is relative to the mortgage universe. The table demonstrates which should be pretty obvious at this point AGNC is extremely over weight, lower loan balance and HARP securities and AGNC has very little exposure to new generic securities or the seasoned universe.

With that I’ll turn the call over to our Chief Risk Officer, Peter Federico.

Peter Federico

Thanks, Chris. Protecting your capital over a wide range of interest rate scenarios is our primary objective. Careful asset selection and prudent hedging is the foundation of that framework. As Gary mentioned in his opening remarks this means that we do not make significant bet on particular interest rate outcomes. Today I would like to discuss three important topics that have been the subject of increased focus this past quarter. These topics include liquidity management, counter party credit risk management and lastly changes to our swap portfolio. With that introduction please turn to the financing summary provided on slide 13.

During the quarter, we undertook several important actions that significantly enhanced our liquidity position. First, our repo balance increased to $38.8 billion at quarter end from $33.5 billion the prior quarter. More importantly, we significantly reduced rollover risk by lengthening the contractual term of our repo funding. In percentage terms, the share of our repo funding with maturities greater than three months increased to approximately 20% from about 12% the last quarter. Given the longer-term of our repo funding and slightly higher repo rate in general our average funding cost increased slightly to 28 basis points from 23 basis points last quarter.

Our ability to extend the maturity of our repo funding was a direct result of another important decision we took during the quarter which related to hedge accounting. At the beginning of quarter, we decided to not designate new pay fixed swaps as cash flow hedges for accounting purposes additionally at the end of quarter we decided to discontinue hedge account for the remainder of our swap – of our pay fix swap positions. Without the funding restrictions associating with hedge accounting which required us to precisely align the term of our repo funding with the swap reset date we were able to begin to move a greater share of our funding into three, six, nine and 12 months maturities.

Going forward we will continue to enhance our liquidity profile by opportunistically accessing funding across the full scope of the funding of the repo funding spectrum. As of quarter end the contractual original days to maturity of our repo book was 57 days. As of October 21st the original days to maturity had extended to about 70 days.

Our decision to discontinue hedge accounting will also have significant impact on our financial statements. Most notably going forward fair value changes associated with our swap contract will be recorded in the income statement through other income as a result we expect our GAAP earnings to be more volatile and more sensitive to interest rate changes. It is very important to understand that this increase in earnings volatility is not reflected of any change to our true economic risk profile and that book value remains the best measure of our aggregate mark-to-market performance.

I would now like to turn to slide 14 and discuss counterparty credit risk management. Slide 14 provides new information regarding our counterparty exposure that we felt was important to share given the heightened sensitivity to this area in recent months. First the table on the bottom left of the page shows the dispersion of our repo counterparties by geographic region and by percent of funding.

During the quarter we took actions to ensure prudent counterparty and geographic diversification. We also increased the number of our repo counterparties to 29 from 26 last quarter. We continued to diligently manage and monitor access funding capacity both in aggregate and by counterparty. The table on the right shows the economic exposure we have to each counterparty.

The middle column of the table shows our exposure expressed as a percent of our equity. We compute these exposures daily taking into account the actual repo haircut as well as daily market value fluctuations. Our largest single counterparty as of quarter end was less than 4% of our equity. Top five exposures together totaled less than 15% of our equity and were well diversified geographically.

A final thought on funding and counterparty risk management. Despite increased concerns regarding the European debt crisis at no time during the quarter did we experience a disruption to our repo funding. At times during the quarter repo levels did increase, but these episodes were short lived and the increases were measured in single-digit basis points. At no time during the quarter, did we experience a reduction in liquidity or an increase in margin requirements.

I would now like to turn to slide 15 and discuss our derivative portfolio. As shown in the table, our pay fix swap balance increased 22% to approximately $27 billion at the end of the quarter, up from $22 billion last quarter. Given the increase in our swap book about 70% of our repo funding was economically hedged with pay fix swaps at quarter end.

In addition, given the historically low level of swap rates observed during the quarter, we concentrated our swap activity on intermediate and long-term swaps. Despite our focus on longer maturities, the average pay rate on our swap book decreased to 1.58% in the quarter from 1.69% last quarter. Our swaps and balance decreased to $3.3 billion during the quarter from about $4 billion last quarter given the rate decline during the quarter, the market value of the portfolio dropped to around $5 million from about $36 million last quarter.

Looking ahead, with interest rates at such low absolute levels, we view the risk of maintaining a relatively longer duration hedge portfolio has been significantly diminished. Today, the risk of over hedging mortgage assets is intermediate term swaps is significantly lower given the fact that swap rates are bounded by a zero floor.

Now let’s turn to slide 16 and 17, which cover our duration gap and interest rate sensitivity.

On slide 16, you can see we had a very small duration gap of negative 0.03 years or about half of them were on at quarter end. Our duration gaps declined during the quarter from a positive duration gap of about seven months last quarter. This decline was due to the rare rate and the intra quarter activity. Duration gap can be a useful measure of comparing relative risk levels from one time period to another. But as highlighted on this slide, duration gap does not take into account the negative convexity of mortgage assets.

For that reason on slide 17 we provided you the same interest rate sensitivity that we typically provide in our 10-Q. The table on slide 17 shows the estimated change in value of our portfolio for 50 and 100 basis point rate shocks. The change in value is expressed both as a percent of market value of our assets in the middle column and as a percent of our equity in the right hand column. Our interest rate sensitivity at quarter end provides a good subway into the last area I will cover which is our goal of protecting book value, a topic I briefly mentioned at the beginning of my remarks.

Slide 18 shows the quarterly change in our book value over the last 11 quarters plotted against a graph of the 10 year treasury yields. As you can see in 10 or the last 11 quarters our book value increased. This consistent performance is particularly meaningful given the extreme interest rate and prepayment episodes experienced during this time period.

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

Gary Kain

Thanks Peter. So, let’s turn to page 19 and quickly review the quarter end numbers. First our asset yield declined from 3.45% to 3.18%. This was driven again predominantly by the increase in our projected CPRs and the changes to the composition of our portfolio. Our cost of funds also increased 15 basis points to 1.24% as of September 30th as repo rates increased and we increased the percentage of swaps to go to 70% of our repo balance. This throughout turned net interest spread as of quarter end to 194 basis points and after adjusting for leverage and adding back the asset yields, this provides gross ROE of just over 18% or net ROE of around 16.5% and again this is without regard to any potential benefit from other income.

So now let’s turn to page 20, so I can conclude by giving you a little more transparency into what we think the future could hold. So first we remain really optimistic that we can continue to produce strong returns for our shareholders despite lower rates, a flatter curve and a more challenging prepayment environment. In fact in the absence of negative surprises to prepayments, significant changes to interest rates or material changes to the portfolio we expect asset yields to be relatively stable and remember we’re already projecting faster prepayments speeds and we would need prepayment picture to worsen beyond these assumptions to negatively impact our yields.

With the HARP changes already announced, this risk is considerably lower given the composition of our holdings. Alternatively, we would have upside in the event that actual speeds are below our forecast. Now with respect to our cost of funds we have significantly increased our percentage of hedges and materially reduced our duration gap. We have also accounted for higher repo rates that we’re currently seeing. So lastly, new purchases are still attractive as orgies have cheapened versus swaps as risk premiums related to prepayments have increased.

So in conclusion, we remained optimistic that AGNC’s portfolio will continue to perform very well in this new interest rate environment. So with that let me ask the operator to open up the call for questions.

Question-and-Answer Session

Operator

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

Bose George – KBW

Hi, good morning. I had a couple of questions first I just wanted to see or check what kind of premiums do you need to pay for the prepayment protective bonds that you guys have, relative to TBAs?

Gary Kain

It very dependent on the coupon and whether it’s 15-year or 30-year. So in the last we’ll say month or two those premiums in particular very recently after the prepayment release showed some, the risk in the newer coupons the premiums have gone up. But let say, something typical they’re close to a point may a little more on some less on some. So that point in yield terms is something like 25 basis points. But if you go back to that ROE slide on page 9, 25 basis points is still a very small kind of increase or difference in CPR. So I mean what you can see is if you layer that in to those charts is that the break-even prepayment speed is for something with a one point payout is maybe 4 CPR depending on the coupon.

Bose George – KBW

Okay great. And then just switching to HARP funds I mean given that the change could create a new flow of HARP funds is that something where we could see that continues to be a big part of your portfolio?

Gary Kain

Yeah great question we are extremely happy with the performance of the HARP funds and given the recent release the HARP securities are still not refinanceable and – probably won’t be now for the future. And we’ll see given what FHFA said as such I mean when you look at the prepayment speeds when you look at the fact there are no options for most of these borrowers and they already have pretty low rates. This is a great security to own. Now the one thing you have to keep in mind there is that new coupons are going to be produced are lower. Okay so that, that doesn’t mean they’re not attractive but the advantage of having them in 4.5 and 5% coupons is much greater than the advantage would be in a 3.5% or 4% coupon. So the short answer is it’s our favorite position, we feel better about it now we’re going to continue to take advantage of it, but the change in coupons is material to the equation.

Bose George – KBW

Okay great thanks a lot.

Gary Kain

Thank you Bose.

Operator

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

Michael Taiano – Sandler O’Neill

Thanks for taking the question. So it seem as if this quarter you took a number of actions to I don’t know if you want to use the term de-risk, but it looks like in terms of your hedging strategy and extending out repos that you floored the risk profile during the quarter? Is it fair to say at this point how you kind of structure the portfolio that you feel like you can take on more leverage particularly with the hedges that you put on in the quarter?

Gary Kain

The short answer would be yes that the portfolio is on a lower risk both in terms of prepayments, hedges and so forth. So in a sense running an equal risk position today could afford materially higher leverage. I think the thing you have to keep in mind is the some of the uncertainty that we’re seeing overseas and so forth. So I mean that’s a consideration, but if you got to have that now that we’re passed the uncertainty around the changes to the HARP program, higher leverage is a realistic future outcome and not from the perspective of pushing in around returns just from a perspective of the risk equation if you appropriately hedged and if you have prepayment protected assets is a, something you’re supposed to think about.

Michael Taiano – Sandler O’Neill

Okay. And then just a follow-up to the previous question, so is it fair to say that you guys always talk about relative value, the relative value equation here on the HARPs and the lower balance assets? I mean do you still feel similar to you – as you did going into the quarter on a relative value basis on those relative to say hybrid arms given the price differential at this point?

Gary Kain

Honestly, you know in terms of the relative value even though the premiums for loan balance and mark loans have gone up and they’ve gone up again in the last couple of days as they’ve essentially gotten scoped out of the HARP program. You know there is still value for a long term investment in those products although even with the higher prices. Honestly in a vast prepayment environment like today, private ARMs are not high on our list of considerations. We do feel comfortable and would feel comfortable by more generic lower coupons 15 year or 30 year where coupons may be low enough this time around where some of that protection is necessary. But I would just say at this point hybrid ARMs were in a pretty you know this is a prepayment environment. We’ve talked about that. Hybrid ARMs really don’t given you a place to hide on that front. So they are really not on the kind of radar screen at this point.

Michael Taiano – Sandler O’Neill

Great that’s helpful thanks guys.

Operator

The next question comes from the line of Jason Weaver with Sterne, Agee.

Jason Weaver – Sterne Agee

Good morning. Congratulations on another solid quarter. Just a couple of questions, where would you estimate the drag was on net interest income from the repositioning out of the high coupon paper and what are you expecting from your run rate spread going forward?

Gary Kain

So two thing, I don’t have the number for you on the first one, what the drag was, but if you look at the aggregate moves right, in terms of three things affected our net interest spread kind of materially. One would be higher cost of funds, another would be the faster again projected prepayments fees that are actual prepayments fees slow down and the last would be repositioning of the portfolio. I don’t have to breakdown all those, but the reality is that between the two relating to asset yields we think the prepayment one was the bigger impact. And again, the prepayment one being faster projected speeds. The one thing I will say around your second question which is where you asked me to project out our margins going forward. And I’ll just reiterate what I said on the last slide. I mean you know the components of margin, their funding costs and asset yields. We’re already projecting our asset yields for you know a material increase in prepayments despite the fact that we have very good collateral and that’s just out of models given the significant drop in interest rates switching. So, given the fact that that’s projected, it’s not we’re not waiting for actual speed to show up and remember that higher CPR is a lifetime CPR. It doesn’t mean you can’t have a few prints and it actually incorporates some initial prints well above the 13 number. So, keep all that stuff in mind as you think about that going forward, but again we don’t tend to give guidance.

Jason Weaver – Sterne Agee

Fair enough. And just a little bit further clarification on that. You spoke about it and you touched on it. The 250 assumed duration on the fixed rate assets that you show on slide 16, does that take into account the higher model durations of the lower loan balance and HARP funds?

Gary Kain

It does. On the other hand we’re very careful of not to and this is a really important question. We don’t use what we would call theoretical model durations for HARP funds and low loan balance and the reason is, it’s because they are too long and they don’t kind of, or they are not informed by the way the securities are priced and the way they trade. In a sense the model assumes that they trade at their full theoretical valuations. They don’t the model also assumed that they can trade below the price of a TBA or generic mortgage if interest rates go up well they can because they deliverable and you would just sell it into the TBA. So for that reason while we use longer durations versus TBAs for the low loan balance, and the HARP loans we are very, very careful to manage those to kind of realistic market pricing assumptions and we absolutely do not blindly follow our model.

Jason Weaver – Sterne Agee

Okay. And then just finally it seems like positioning has been particularly well suited for the speed bumps that we’ve encountered in the market this year. Now that we’re at this point what is your attention turn to on the risk side now that you are less exposed to HARP 2.0?

Gary Kain

You know, it’s I think it’s, it’s way too early to say that, prepayments are kind of behind this. Look the bottom line is we’re in a low interest rate environment where prepayments are going to dominate ROEs unless something changes. There are two things can change, right. We can have further decline in interest rates in which case prepayments become more important or we can get on – obviously we can say here or we can go up in rates. If we go up in rates, prepayments will obviously be lesser the issue, but because we have the confidence, in our portfolio, and how it can perform, if interest rates fall, it allows us to be a little more aggressive so to speak or hedging at this point, which is what Peter went over, which is why you’re seeing higher hedge ratios. So when you put those two pieces together we feel the treat so to speak, a faster prepayments we contained, another risk is higher interest rate. So we’ve taken steps to contain that. And our mindset again is we don’t know which way interest rates are going to go, we don’t know how the Europe is going to resolve itself and everything the fed’s going to do and so forth, we’re not kidding ourselves. We’re trying to be able to make money and protect our book value in either of those outcomes.

Jason Weaver – Sterne Agee

All right, thank you very much.

Operator

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

Michael Widner – Stifel Nicolaus

Good morning guys, we’re just wondering if you could maybe elaborate a little more on, you saw as far as leveraging in the portfolio size go and specifically I guess so you finished the quarter at 7.7 times, you averaged 7.9 during the quarter, both of those were a little lower than where you were on average last year, and you also talked about with the increase in the swaps book, you potentially got the chance to add assets and you sort of already have the hedges in position, in some regard. So I mean putting all that together I don’t know just tell me reconcile kind of the lower leverage versus the quarter average, against the other things you see out there?

Gary Kain

Honestly I think that the lower leverage versus the quarter average I mean the difference is not significant it’s not that significant. But the picture look, there was a lot of uncertainty as I kind of started discussion with this quarter. Just everything that was going on and look, we’re not, we feel like we do a reasonable job of hedging the portfolio for different outcomes, but we recognize the volatility and I think that was a key factor in decisioning with respect to leverage.

Let me follow up on leverage which was I think the first part of your question and I want to stress something that people don’t focus on enough which is there is another massive benefit for having a slow prepaying portfolio and that is that it significantly improves your liquidity. I’m going to use an extreme example if you run the risk of having prepayments in the 40% or 50% area on a monthly basis that means 4% or 5% of your portfolio it’s factoring down and given the delay between when those factors are released and when you get the money from the GSEs that 4% or 5% is essentially an incremental haircut.

So – if you have to allot for 4% prepayments and you had above 4% haircut to begin with, you essentially get double the haircut with half coming from the posting of margin on the initial haircut and half coming from the prepayment issue. And so another key advantage for AGNC is significantly improved liquidity position as a function of not having to allocate a lot of room in a sense for prepayments. When you think about the HARP program, when you think about low loan balance we can expect kind of unit changes going forward and that helps us a lot on that equation.

Michael Widner – Stifel Nicolaus

So I mean just following up on that, again another sure reason between having the heavy swaps position and having slower prepays which basically afford you a greater liquidity, both suggest that there is greater comfort or cushion at least for sure higher portfolio size, higher leverage and that’s really just what I’m trying to get a feel for is that directionally speaking you head it down at the end of the quarter versus where you had been and where you were during the quarter and is that kind of a trend line we should extrapolate it, is this a current level we should extrapolate from or should we assume you’re going back to something close to eight times or may be north of eight items which is certainly territory you’ve been in quite a bit before.

Gary Kain

What I’d say is it’s going to depend on market conditions but I wanted just to reiterate what I said in the absence of kind of real volatility and uncertainty the more kind of benign hedging environment or things Peter mentioned kind of 0.04 and the risk of not being, the lower risk of being over-hedged coupled with confidence on the prepayment size given our portfolio. All those issues lend themselves to us being comfortable with noticeably greater leverage than where we are today. On the other side, you’ve got the EU meeting this afternoon and a fair amount of volatility. Again, we’re not worried about counterparty risk, we’re not worried about availability of repo or any those are not the concerns. The concerns are just big picture. There is the volatility. So, if we get more visibility around kind of volatility than higher leverage is definitely something we’ll consider. The other factor is how cheap mortgages are and whether what we think about the risk adjusted returns, we’re not going to layer on more mortgages if we feel that they don’t offer us significant value and if they’re not going to produce kind of very good risk adjusted returns. Right now, that isn’t a constraint.

Michael Widner – Stifel Nicolaus

Right, okay. So, let me ask you one another question on the swaps, at 70% swap more or less and that’s quite a bit higher than where you’ve traditionally been higher than where most of the group has been and so, from a more normal level let’s say 55% just kind of picking that arbitrarily where you guys are today at 70% by my math presents roughly at $0.10 to $0.12 drag on earnings all else being equal just from having that that sort of excess level of swaps and I kind of just to pose that against your comments early on that some of, some peers and some other smart investors out there made big bets on interest rates going up a quarter ago and that didn’t work out real well for them.

And so, given that the additional level of swaps is inherently a drag on earnings, I mean are you effectively making a bet at this point, that yeah, that rates go up and again you also I think talked to appropriately proudly about the ability you guys to raise book value consistently over the past couple years. And as we look around the world I mean, one way to sort of increase your likelihood of that happening is effectively making a between on interest rates one way or another. So how should I think about all those issues with regard to the hedges?

Gary Kain

Turn to page 17, which Peter reviewed and what that shows is and again models or anything but perfect we’ve talked about it. But this just kind of gives you and again we use BlackRock Solutions as our based risk management systems that we’ve come out of that system. Basically what this shows you is, in a sense where it’s both flat as we could have been at the end of the quarter. So you shouldn’t read into that in any way so you performed that, we were that we are making a bet so to speak. We just feel that the, given but how low swap rates are and were, it was a prudent move and there are we take risks, when we feel that we’re getting paying a lot for them and to be perfectly honest 10 basis points in spread right now is irrelevant compared to the prepayment equation right. Look at that, look at slide 9 again I mean, having the right securities as we’re 50, 75 or 100 basis points, the 10 basis points and feeling better about the hedge environment just not high on our priorities.

Christopher Kuehl

And just Peter I would just add one thing to that which and remember I didn’t share in my prepared remarks, but in marginal costs that the swaps that we entered into was just a little bit north of 1%. So you know that compares pretty favorably to the 1.6% of the existing swap. The marginal cost of hedging right now is really low.

Michael Widner – Stifel Nicolaus

Yeah I get that, you know I mean a quick comment on page 17, I mean does that really seriously entertain and there is you know we’re going to have parallel upward shift in the yield curve and you know it’s kind of impossible to have a downward parallel shift in the yield curve. So I’m not sure how useful, I understand it’s the boiler plate template that everyone uses but I’m not sure that’s a very good indication of real interest rate sensitivity, but you know I certainly appreciate the comments there?

Peter Federico

No, and I appreciate your comment and that’s one of the reasons why we talked about the fact that in the, for our spot book we essentially had kind of a zero bond on rate effect. You know spot rates could go to zero, but more practically and I think to your point if we have a significant rally, the rally 50 basis points to have 100 basis points. So there is certainly asymmetry in our interest rate risk profile. It is just generically right now and I appreciate you comment about the fact that yeah, it’s not likely that we’re going to get a pair of our ship, but the down rate scenario will be significantly less than the up rate scenario right now.

Michael Widner – Stifel Nicolaus

Great and one final one if I may, just looking at the income statement, I was wondering if you could, you know in particular the 263 million gain on sales. That was a surprisingly large number to me just given the, as I look at the templates that you provide on what’s in the portfolio. I mean it looks like that was a lot more MBS sales in the quarter than I can sort of derive from looking at what changed. I just wondered if you could maybe comment on the dollar value of where the fair value of principle amount or whatever of MBS that you sold in the quarter, just I’m trying to reconcile how to get to a number that large?

Gary Kain

Yeah, I mean sales volume was a little with a little over 10 billion, but there are couple drivers of that. So obviously a big, a chunk of it was what we would call the seasoned hired coupons and particularly 5% coupons you’ll notice that we have a lot of them on our prior chart on page in the appendix and there are a lot less of them in the edge of the 5% is considerably newer that was a component of it. Another component just as NFYI was we did view there to be some risk on the, in terms of the HARP program changing and borrowers being allowed to re-HARP.

We didn’t think it was a smart decision and but we would have we had to consider that so one of the ways as an example we managed our exposure to that program risk which luckily now gone is that we sold our highest pay ups we sold as an example some of the part loans that were trading with pay ups close to 2 points at different points during the quarter and replace those with other HARP loans that had lower coupons and lower payments got payouts that were well less than a point. And so in doing that we could own more of them with actually less pay up risk if the program had changes. So there are other kind of transactions like that that you won’t see in the numbers that derive that have big impact on those numbers. I think at this point we probably need to flip over to the next question because I know we have a number of people in the queue.

Michael Widner – Stifel Nicolaus

No I thought I was the most important, but thanks I appreciate all the comments.

Gary Kain

Thank you.

Operator

The next question comes from the line of Steve DeLaney with JMP Securities.

Steven DeLaney – JMP Securities

Hey thank you Gary great job in a tough quarter man and especially on growing the book value there, good work.

Gary Kain

Thanks.

Steven DeLaney – JMP Securities

I’ll try to be quick on these because I know you’re dragging on here for about almost an hour. First on the undistributed taxable I mean obviously we’re in a world with flatter curve and faster speed, so spreads our tighter you’ve told, you’ve disclosed that and given it’s your 194 sort of spot spread. So it kind of, it forces I think the kind of look at the cushion I call it cookie jar when we think about the dividend going forward.

So 156 million or $0.85 I just want to ask you so how you think we should think about these GAAP tax differences and I guess it’s 80 million or $0.40 or so of annualized derivative losses and the difference in premium amortization. When we look at the cookie jar should we look at it as $0.85 less $0.40 of taxable expense coming in the next couple of quarters as those items come through the system and you certainly, it seems you have a cushion but I’m not sure we should value the cushion at $0.85. I mean any comment on where I’m looking at that?

Gary Kain

Well, I think what I comment on is kind of the GAAP tax differences, which is probably the best way to think about on distributed taxable income. So a key point and this is the amortization difference right, there is a pretty big amortization difference between GAAP which again and this gets to the point where we’re trying to stress earlier on which was the GAAP we’re using a, we’re using a projected number that’s well above where things are now and where purchased assumptions where and for that reason GAAP in amortization including this catch up component, which is a one-time thing was above materially above the tax number.

First off, if you thought about a tax of a run rate, it’s going to be higher than the GAAP run rate and that $0.19 difference between the two should give you some insight into the difference of the two different amortization schedule. So, that’s the first key point. Then, with respect to the timing differences in unrealized gains and losses that make up the other component of $0.45 of GAAP versus tax, there are two sides of that. The first is there were timing differences in the previous quarter, going into the quarter, which actually I believe that number was around $0.15 where in a sense the first $0.15 of your $0.45 actually was from Q2 differences. And so, there is really $0.30 for the most part out there so to speak that those in the other direction, is that right, Bernie.

Steven DeLaney – JMP Securities

Yes, it was 4 to 5 million?

Gary Kain

I’m sorry, yeah, I got I’m doing that in cents and not in dollars. So, that’s a good point. But so, what is 30 million going out there and actually where you could almost see the bulk of that. Steve is in the swaption numbers.

Steven DeLaney – JMP Securities

Right.

Gary Kain

Actually, so essentially what happens is we mark-to-market the swaptions which as Peter told you the mark-to-market of the swaption was not exactly a large number at this point in time. On the other hand, for taxable purposes, you’re going to recognize the difference between what you paid for the swaptions and if you exercise it, then you’ll get that value. We don’t exercise it and it expires then you will take that loss and we’ve got swaptions going out a couple years. All right so that really gives you kind of a good feel for the bulk of the recognition of those differences, but first off it’s just not nearly as big a number as you might think, given the component of the amortization number, and also given the fact that it’s both forward looking and backward looking in terms of timing differences.

Steven DeLaney – JMP Securities

Yeah, that’s helpful Gary. Now – especially the fact that the premium amortization difference is actually going to be an ongoing thing until such time that the actual might catch up with the projected. So we’ll spin all that through in terms of trying to make your modeling assumptions and then one final thing just the, obviously the company is grown a lot of hires and obviously the management fees is going to be just a function of equity? But we do note that the G&A expenses basically doubled from like first quarter to third quarter from 2.6 to 5.8, what’s really driving that is that comp reimbursements stock comp, what’s going on there?

Gary Kain

It’s actually more in terms of things like prime brokerage, its varying settlement patterns, it isn’t. There is no compensation component that it’s kind of disallowed, there’s no way there could be a compensation component.

Steven DeLaney – JMP Securities

Got it.

Gary Kain

To that number so it’s literally paid fees around settlements and so forth, and BlackRock Solutions different services that we use data that we paid for its things like that, maybe consulting services and those kind of issues.

Steven DeLaney – JMP Securities

Okay, so transaction on obviously in a quarter where you had a lot of activity in and out that that number might trend higher than in a quarter where the portfolio saw less turnover.

Gary Kain

Absolutely, that’s a very good way to think of it. It’s probably most affected by in a sense transactional volume as opposed to other aspects.

Steven DeLaney – JMP Securities

Very helpful. All right, thanks for the time.

Gary Kain

Thank you, Steve. Appreciate it.

Operator

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

Joel Houck – Wells Fargo

Okay, thanks. I’m looking at page 18, it’s obviously clearly a relationship between benign prepayments in an environment versus high refinanced risk in terms of impact on book value. But given that you guys tend, book value tends to better in a higher rate environment, how does that square with the disclosure on page 17. I understand that 17 is just a model but if you’re really going to lose 7% of NAV for 100 basis point increase in rates that would seem at odds with past experience and that’s not the case. If perhaps more realistic disclosures you can put out in terms of interest rate, forward interest rate sensitivity?

Gary Kain

Look, what we have to do here is use kind of a consistent model method. If you go – I mean look the reality is mortgages are negatively impact some big moves in interest rates that we show. We lose money on either side. You’re absolutely right in saying that actual results in a sense are going to vary definitively from the model and so that is the core. What’s interesting and I think what you, the point that you’re in a sense trying to tease out is generally when interest rates go up especially from a period where prepayment risk premiums are large. Then mortgages in a sense tend to perform better than a model would think because those risk premiums would have come out of the market as overall prepayments come down and that’s a lot of what we saw in Q4 and Q1 2010, early 2011.

And what you certainly could see if rates were to go up quickly over the next year or so, conversely when interest rates fall, you have the opposite risk premiums around prepayments go up and so mortgages tend to do worse than a model would actually project. And this is again in and above just the absolute projections of prepayments even assuming your model was perfect on those projections. It’s really that the markets tolerance for risk and big rallies goes down and vice versa in big sell off tends to get easier for people to handle prepayment risk. That’s a key component of the equation.

Joel Houck – Wells Fargo

Okay, that’s makes a lot of sense, and it helps. Now do you, have you guys looked at Ginnie Mae had pools? Is it making sense given the lack of sensitivity your rate changes with respect to prepayments or is that not fit into kind of your overall investment portfolio thesis?

Gary Kain

Well, you know we will then periodically. I think yeah, we’ve focused our attention in other areas generally speaking. I mean those are interesting and I definitely can see why people see value there. From our perspective, the other side of the Ginnie Mae equation is, there is a generally speaking a pretty big premium for just having we’ll call it the absolute full faith in credit of the government which is really the key reason why Ginnie Mae’s are generally off the radar screen.

Joel Houck – Wells Fargo

Okay, I guess in other way looking at the premiums may diminish some of the IRR over time. The last thing I have Gary on the mark on the swaptions book does that run through OCI or net income?

Peter Federico

It runs through net income in GAAP terms so that’s already essentially been taken by the, the swaptions book is marked at this point at $5 million. And look, going to your question about big increase in interest rates while clearly those are way out of the money at this point. This is exactly what we like about the swaptions rate. They could have provided us hundreds of millions of dollars of value if some, the prognostications of higher rates came through. And the worst phase was we could lose 30 million or, whatever $0.15 per share. And so big picture the swaptions are essential marked, close to zero and if we have some disasters senior they would actually kick in and they still have some value.

Joel Houck – Wells Fargo

All right thanks very much. Thank you.

Operator

We have time for one last question. Your last question comes from the line e last question. Your last question comes from the line Dean Choksi with UBS

Dean Choksi – UBS

Thanks for keeping the call this long and letting me in the queue. I have a couple of questions on prepayments. Looking at slide seven I guess the chart on the left the prepayment speeds for 2010, you have forced...

Peter Federico

Yeah.

Dean Choksi – UBS

I mean you’ve really seen that prepays for the kind of the more generic collateral really accelerated over the last couple of months particularly in October, the first is and do you think the October prepayments for generics were an nominally or the new trend? And second if it’s the new trend, I mean what kind of mortgage rate do you think low loan balance, what mortgage rate would it take for a low loan balance CPRs to really increase? And then I guess the second question would be, on the 13% CPR assumption, you’re using in your model and that’s a lifetime assumptions? So can you provide a little more color around how you think estimated prepays will trend around that lifetime assumption?

Gary Kain

Yeah sure so, let me that’s a couple questions. So let me start with the first one which were related to was October a one-time issue or where do we think things go from here. So for that one the short answer is no, and we don’t think it was there will be no ways in that there is a lot of factors that affect each individual months prepayment things like day count is really important one, right. In some months there are X number but there’re two or three business days more or less than other months that can be a big factor when they’re holidays. There can be rate moves from a month or two earlier, all of those affect that anyone particular month’s trend so to speak.

On the other hand we don’t, we believe that you’re still going to see higher credit, newer mortgages, pay fast until the interest rate for months or until the interest rate environment changes. And so we don’t believe that’s an aberration we actually think the trend is most likely higher. Now let’s take that to the next part of your question, which is a very important one, which is what happens with low loan balance? And the short answer is we think there are two affects with respect to low loan balance. The first one is that there are our transactional costs that because these are smaller loans that make it that they need a much bigger incentive usually 50 or 75 it depends on the size of the loan or more than that in terms of the rate incentive before they kick in. So you have a pretty good cushion there.

The other effect is that there are just different types of borrowers and they don’t just they don’t tend to get nearly as fast. And then lastly there is a key component that helps to say in the low loan balance which is a little different and we’ve mentioned this in the past but it becomes most important in environments like this where prepayments pick up. And that is the issue of the capacity constraints and when an originator, a Wells Fargo or a CHASE or a mortgage broker, the guy calling people or a third party originator.

When these guys are out there trying to get business, when they have more business than they can handle they are just not going to spend any time on a small loan right, they are not going to even like that the guys with a $100,000 loan gets put on hold for six hours while the $400,000 loans get processed and it’s not, it’s just simple math and simple economics, people get paid in that process based on the percentage of the loan amount and people that are busy are not going to process multiple loans to make less money. And so that’s sort of a kind of one thing that really helps with respect to this – but in that almost the worst things get on prepayments the more important that factor becomes. So keep that one in mind as well.

Dean Choksi – UBS

Thank you. And then I guess the, how you expect the prepays to trend around that 13% lifetime CPR?

Gary Kain

Oh thank you. I’m sorry, so lifetime CPR and you know this is going to depend on the product and how old the mortgage is and what time it is and so you know I can go on with all why it will prove of all the caveats. Basically, it allows for noticeably higher CPRs upfront than the 15 okay? It expects spikes that are we’re seeing materially above that. And then assumes things gone out and start to come down from there and again that’s for most products and so forth. The other thing to keep in mind is it is informed by sort of the forward curve. So there is also a built in assumption on the back end that rates are higher and then prepayments were slowing for that reason. So you can thing about and this is an important point is that assumption has already built into it. You know speeds we’ll say over the next couple quarters well in excess of 13. So I think that’s the best I can do in terms of giving you kind of a tight profile laid into that, but I think that should help.

Dean Choksi – UBS

I appreciate that, thank you. I guess enjoy your lunch.

Gary Kain

Well, thank you and I appreciate the questions.

Katie Wisecarver

Thanks Terence, if you can close the call that will be great.

Operator

This concludes today’s AGNC shareholders Q3, 2011 conference call. You may now disconnect.

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