Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

American Capital Agency Corporation (NASDAQ:AGNC)

Q1 2012 Earnings Call

May 3, 2012 11:00 AM ET

Executives

Pete Deoudes – Director, Equity Capital Markets

Gary Kain – President and Chief Investment Officer; President, American Capital AGNC Management, LLC

Chris Kuehl – SVP, Mortgage Investments

Peter Federico – SVP and Chief Risk Officer

Analysts

Jason Arnold – RBC Capital Markets

Dean Choksi – UBS

Mark DeVries – Barclays

Arren Cyganovich – Evercore

Scott Smith – Private Investor

Joel Houck – Wells Fargo

Chris Donat – Sandler O’Neill

Ryan O’Steen – KBW

Operator

Good day and welcome to the American Capital Agency Shareholders Call. All participants will be in listen-only mode. (Operator Instructions) After today’s presentation, there will be an opportunity ask questions. (Operator Instructions) Please note that this event is being recorded. I would now like to turn the conference over to Pete Deoudes, Director, Equity Capital Markets. Please go ahead.

Pete Deoudes

Thank you, Amy, and thank you, everyone for joining American Capital Agency’s First Quarter 2012 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 that they are not recitations of historical facts, 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 Risk Factors section of AGNC’s periodic reports filed with the Securities and Exchange Commission. Copies are available on the SEC’s website at www.sec.gov. We disclaim any obligation to update our forward-looking statements unless required to by law.

An archive of this presentation will be available on our website and the telephone recording can be accessed through May 17 by dialing 877-344-7529. And the conference ID number is 10013452.

To view the Q1 slide presentation, turn to our website at agnc.com and click on the Q1 2012 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 the presentation, please hit F5 to refresh.

Participants on today’s call include Malon Wilkus, Chairman and Chief Executive Officer; Sam Flax, Director, Executive Vice President and Secretary; John Erickson, Chief Financial Officer and Executive Vice President; Gary Kain, President and Chief Investment Officer; Chris Kuehl, Senior Vice President, Mortgage Investments; Peter Federico, Senior Vice President and Chief Risk Officer; Ernie Bell, Vice President and Controller; and Jason Campbell, Senior Vice President and Head of Asset & Liability Management.

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

Gary Kain

Thanks, Pete. And thanks to all of you for joining us today. Let me start by saying we are extremely pleased with AGNC’s performance starting Q1 and as we’ll discuss on today’ call, our asset selection strategies continue to create substantial value for our shareholders. Furthermore, we remain confident about the future and we’re going to conclude this presentation with a detailed summary of how we are positioning the company in relation to a variety of scenarios that could unfold as 2012 progresses.

Now the big story for the quarter was the continued strong performance of lower loan balance and ARM securities. In addition to providing stable prepayments, the market valuations of these assets continue to improve as other investors recognize the necessity of having slow and predictable prepayments in the current market environment.

With that, let’s review the highlights for the first quarter on slide three. Our net comprehensive income was $2.44 per share, which was comprised of GAAP net income of $2.66 per share and a loss of $0.22 in other comprehensive income. Now net spread income, which what many of you refer to as core income, was up materially to $1.42 per share during the quarter. Now this number does include a one-time premium amortization catch-up of $0.12 related to lower prepayment projections. Now excluding this Catch-up M, our net spread income was still very strong at $1.30 per share. Now the significant improvement in this measure versus prior quarter was driven by the combination of higher average leverage of reduced cost of funds and lower prepayment projections.

Now with respect to that last point, our lifetime prepayment estimate dropped to 9% CPR due to the combination of higher interest rates during the quarter, changes in the composition of the portfolio, which included a 24-basis point drop in the average coupon and enhancements to our prepayment model provided by Blackrock Solutions. These changes in lifetime prepayment estimates now bring our projected speeds much closer to our actual Q1 CPR of 10%. And as I mentioned before, Blackrock does update their model periodically as new information becomes available. That was the case in the first quarter, and we reflected the model change in our results. Now taxable net income, which was not impacted by the changes in prepayment projections or in the unrealized gains and losses on derivatives was also very strong at $2.03 per share. Our undistributed taxable income more than doubled from $180 million to $384 million.

As such despite the increase in our share count, undistributed taxable income on a per share basis increased substantially to $1.28 per share at the end of Q1, our highest level ever. A key driver of the strength in taxable income and thus UTI were sales of some higher coupon HARP and lower loan balance securities.

The book value rose by $1.35 or almost 5% to $29.06 per share from $27.71 and while still early in the current quarter, we have seen this trend continue, which has given the book value a nice tailwind so far for Q2. The combination of book value growth coupled with our dividend of $1.25 per share led to total shareholder value creation or economic returns during Q1 of $2.60 per share or 38% on an annualized basis.

Now turning to slide four, our mortgage portfolio increased to around $81 billion by the end of the quarter. Leverage during the quarter averaged 8.2 times while quarter-end leverage came in at 8.4 times. Our net interest spread increased 13 basis points to 207 basis points as of March 31st from 194 basis points at the end of December. And lastly, while we raised a significant amount of equity during the quarter, we remain disciplined with respect to the timing and deployment of accretive equity raises. To this end, the performance of AGNC over the last few quarters and over the last several years should demonstrate to investors that equity can be raised in a manner that is supportive of shareholder value creation.

Now I will turn the call over to Chris so he can discuss what happened in the markets during Q1 and the changes to the portfolio.

Chris Kuehl

Thank you, Gary. Let me start by reviewing the market data on slide five. In the top left panels, you can see the curves steepened as rates sold off during the quarter with five years swap rates up 5 basis points and 10-year swap rates of 26 basis points. 30-year passthroughs were largely unchanged in price and 15s outperformed 30s on both the price and a spread basis by about a quarter point.

Let’s turn to slide six to review the composition of the investment portfolio. The portfolio grew to just under $81 billion during the quarter as we raised significant amount of equity and increased leverage given attractive asset valuations. Our purchases were concentrated in the lower coupon generic mortgages as well as lower coupon passthroughs backed by lower loan balance and HARP loans. Our average prepayment speeds continue to be slow despite record low mortgage rates.

I do want to address the four CPR increase and actual prepayment speeds over the February-March time period. The increase is largely attributable to a couple new positions that were purchased fully anticipating having higher speeds. The more significant contributor to the CPR increase is a position in generic 15-year passthroughs that we believed offered attractive risk adjusted returns relative to other very short duration assets despite the faster speeds.

Now let’s focus on slide seven for more detail on how our markets performed during the quarter and how we’re currently positioned. As Gary mentioned in his opening remarks, the real story during the first quarter was the tremendous out performance of higher coupon, loan balance and HARP securities.

In the chart on the right, you can see that pay-ups or in other words the market price premium for some of these strategies outperformed generic passthroughs on a price basis by another half of a point. It’s important to point out that this occurred during a period when interest rates increased. Given that these cash flows do have longer durations than generic passthroughs, this is exceptional performance and a realization of just how cheap these loan attributes were a couple of quarters ago.

As you know from our disclosure in prior quarters, the agency with heavily overweight pools backed by both loans with lower loan balances and loans originated for the HARP program. We still strongly believe that these types of securities should form the foundation of a well constructed portfolio but are also cognizant that the risk adjusted return advantages of these products has by definition diminished somewhat relative to other MBS as valuations have improved.

As such, we sold a material amount of higher coupon HARP and lower loan balance pools during the quarter, approximately $6 billion, in an effort to reduce the magnitude of our still overweight position. Some of the sales were executed at over 3 points above TBA levels, many of which were replaced with lower coupons at lower pay-ups and prices. So in conclusion, we remain confident that despite reducing some exposure to the highest coupon, highest pay-up pools, the portfolio is still very well positioned with respect to prepayment risk.

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

Peter Federico

Thanks, Chris. Today, I will review our financing and hedging activities. I will start with our financing summary on slide eight. Our repo cost decreased slightly to 37 basis points at the end of the quarter from 40 basis points the previous quarter. As we discussed on our last call, we expected repo rates to fall during the first quarter as year-end balance sheet pressure subsided. Repo rates did in fact fall slightly. Offsetting the benefit of somewhat lower rate was our continued focus on lengthening the term of our liabilities. During the quarter, we increased the weighted average original maturity of our repo funding to 104 days from 90 days the previous quarter. This maturity extension increased our funding cost by about a basis point.

Turning to slide nine, I will review our hedging activity. Consistent with the asset growth we experienced during the quarter, our pay fixed swap portfolio increased to $38 billion at quarter end from $30 billion last quarter. During the quarter, we entered into approximately $8 billion of new pay fixed swaps. These swaps had a weighted average pay fixed rate of 1.47% and a weighted average term of 6.3 years.

As I have mentioned before, our swaption portfolio plays an important role in our goal of protecting book value. We enter into swaptions opportunistically as market conditions and portfolio composition dictate. During the first quarter, we significantly increased the size of our swaption portfolio. In total, we purchased $8 billion of put swaptions at a cost of $65 million. With these purchases, our swaption portfolio totaled $10.5 billion at quarter end.

Given the significant increase in our swaption portfolio, we thought it would be helpful to review the benefit we see in these hedges. On slide 10, we show the expected performance of our swaption portfolio over a wide range of interest rate changes. The benefit of our swaption portfolio can be viewed both in terms of its market value as well as its duration profile. The graph on the top right shows the estimated market value of our swaption portfolio. As of March 31st, the portfolio had a market value of approximately $78 million. If interest rates remain relatively constant or fall, the swaption portfolio will expire with little or no value. To put this in perspective, losing the entire $78 million would equate to a loss of around $0.26 per share.

Conversely, given the significant positive convexity of these instruments, the market value of the swaption portfolio will increase in a very non-linear way as the interest rates increase. At the extreme, if interest rates were to immediately increase 300 basis points, the market value of the swaption portfolio will increase to approximately $1.5 billion or about $5 per share. As such, our swaption portfolio is a critical component of our overall book value hedging strategy and it’s specifically designed to provide some insurance against the large and rapid increase in rates.

The graph on the bottom of the page shows the duration profile of the swaption portfolio. As you can see from the dark blue line, the duration of the swaption portfolio varies considerably as interest rates change. From the latest duration today of around 1.5 years to a peak duration of about five years. And in rising rate scenario, the duration increase associated with our swaption portfolio can be viewed as a partial hedge of the asset duration extension we will experience.

To better illustrate this point, the gray line on the graph shows the duration profile of the swaption portfolio expressed in the terms of the amount of asset duration hedged. At its peak, the swaption portfolio will hedge about 0.8 years of our asset duration. Said in another way, if interest rates increase significantly and our asset duration extends from about 3.5 years to about 6 years, a third of that extension would be offset by our swaption portfolio. This makes the remaining extension considerably more manageable.

Turning to slide 11. Our duration gap was positive 0.4 years. The increase in our duration gap from about flat last quarter was due to portfolio activity, interest rate changes and the implementation of the enhanced prepayment model provided by Blackrock Solutions that Gary mentioned earlier. This model update had the effect of lengthening our estimated asset durations by about a half-year.

Before tuning the call back to Gary, I would like to review slide 12, which is intended to help investors better understand the interaction between prepayment speeds on our assets and our ability to prudently deploy leverage. Prepayment speeds are an important driver of leverage capacity because of the GSE payment delay. During this period from factor release to principal remittance, we as repo borrowers are required to post additional collateral to cover the principal paydown. As a result, slow prepayment securities require less incremental collateral each month and fast prepaid securities require more incremental collateral.

Leverage capacity is impacted by many factors. The three important factors highlighted on slide 12 are the repo haircut, asset prepayment speeds and a cushion to absorb adverse price movements on assets relative to hedges. For illustrative purposes the graph shows how NAV or equity would be allocated to these three variables across different leverage and prepayment speed scenarios. To explain in greater detail, I’ll focus on the circled bar in the middle of the graph. That bar shows the amount of NAV needed to support the repo haircut monthly prepayment and adverse price shocks. The calculations assume 8 times leverage in an asset that prepay at 12% CPR. Starting at the bottom, the blue section represents the amount of NAV required to support the repo haircut, which as an example is assumed to be 5%. The next section in green shows the NAV required to support monthly prepayments, which is 1% a month given the 12% CPR assumption. Finally, the gray section on the top shows the NAV required to support an adverse price move on assets relative to hedges of 2.5 points. Taken together, these three variables consume about 70% of this hypothetical portfolio’s NAV.

In comparison, the stack bar to the immediate right shows the NAV allocation at asset prepayment speeds increase to 36% holding the other variables constant. In this scenario, the total NAV allocation increases to about 90%.

The graph shows similar calculations assuming 6 times leverage and 10 times leverage. For example, a hypothetical portfolio with 10 times leverage and assets that prepay at 12% CPR has a total NAV allocation of just under 90%. Such an allocation is very similar to a portfolio leveraged 8 times but with assets that prepay at 36% CPR. This comparison highlights the importance of asset prepayment speeds with respect to leverage capacity.

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

Gary Kain

Thanks, Peter. And before taking your questions, I want to highlight three scenarios that we are focused on as we strategize on how to position the portfolio for the current environment.

So turning to slide 14, the first scenario is the one that the market currently assesses the highest probability to. It is one where moderate economic growth continues and inflation remains more or less consistent with the Fed’s forecast. In this scenario, we would not anticipate a QE3 from the Fed and would generally expect a somewhat steeper curve with the 10-year rate increasing somewhat to maybe 2.5%. Prepayments on most types of mortgages would likely slow from current levels.

Now with respect to the impacts of the market, we would anticipate that the combination of the somewhat lower mortgage prices, a steeper yield curve, slower organic refinancing activity and manageable interest rate volatility would be very supportive of mortgage spreads and thus returns. Some might even describe this as today’s version of a Goldilocks scenario. And in this scenario, we would likely expect book value changes to be relatively modest.

The next scenario seems somewhat less likely but is clearly a very real possibility and something that deserves reasonable consideration from a positioning perspective. Under this scenario, the improvement in economic numbers that we saw during the first quarter turned out to be another head weight with economic growth or the employment picture weakening and/or the inflation outlook dropping below the Fed’s target. This scenario could be in fact priced in very quickly in response to a number of catalysts including further problems in Europe or just weaker U.S. economic data. If this occurred, we would likely see the Fed implement a QE3, which would likely include significant purchases of Agency MBS.

The outcome of this scenario would be more challenging as the Fed then would be expected to drive the prices of the lowest coupon fixed rate MBS to very rich levels. This in turn would cost prepayments to accelerate materially on many types of mortgages, adversely impacting returns on existing holdings. It would also likely force investors to pay even higher prices for securities such as lower loan balance or HARP mortgages where prepayments would still be relatively stable.

As such, especially given the flatter yield curve, returns on future purchases would be considerably less attractive. So clearly this would not qualify as a Goldilocks scenario and not being appropriately positioned in advance will be critical to performance. But with the right assets and with adequate leverage, book value gains could be significant.

As such, we could actually produce very strong total returns in this scenario. Again it will all be about positioning. The last scenario is one where economic growth or inflation expectations pick up dramatically. Here we could see intermediate or longer-term treasuries increase over 100 basis points in a very short period of time. We view the optimistic curve is very low, give both the global and domestic economic picture.

The likelihood of this scenario is further limited by a Fed that has been very transparent about its intentions with respect to interest rates and its view of the headwind status in the economy. That being said, we cannot just dismiss this out of hand because it does present the greatest risk to a levered portfolio as mortgage prices will drop significantly. Having appropriate hedges in place will be absolutely critical to attempting to mitigate potentially large book value declines in the unlikely event that this actually happened.

Now, slide 15 is intended to summarize some of the things that we discussed earlier related how we positioned AGNC against this backdrop and to provide some insight into our thought process in getting there. So in short, prepayment potential and lower coupons are critical to returns in the current environment and to reasonable performance in a QE3 scenario. However, as Chris mentioned, we have taken material steps to attempt to lock in some of the book value of our performance that we’ve achieved over the last few quarters.

All right, I want to reiterate an earlier point. It would be irresponsible for us not to maintain a core position of prepayment protective mortgages as predictable prepayment behavior is just playing fundamental to managing a mortgage portfolio. As Peter said, we also increased the duration of our hedges to improve our performance in the moderate growth scenario and took advantage of lower option prices to buy a material amount of protection against the risk of a large spike in interest rates like in scenario three.

And lastly, with respect to leverage, our bias in Q1 was toward increasing leverage as mortgage valuations were attractive and we didn’t want to be under-invested. However, as the prices in mortgages have appreciated significantly over the last few months, we now believe a more moderate stance toward leverage is warranted. But we are still currently biased against running at leverage levels below, say, 7 times as the risk of having to compete with the Fed in a QE3 scenario for overpriced mortgages is just too great. Moreover, we do not expect to be able to buy mortgages cheaper net of hedges, of course, in the base case moderate growth scenario.

So in conclusion, we feel our portfolio was well positioned to produce attractive returns over a range of market outcomes. We also hope that by summarizing our thought process in this manner, it helps give investors some transparency into management’s approach to the current environment. But remember as our performance over the past few years has demonstrated against the backdrop of a QE1, QE2 operation twist, the GSE buyouts of delinquent loans, multiple HARP program enhancements and several European debt flare ups, just to mention a few of the things that have gone on, it is going to be the ability to change direction based on evolving marketing conditions and then to implement appropriate strategies around asset selection and hedging that’s going to be the real driver of market leading performance.

So with that, let me stop and turn the call over to the operator for questions.

Question-and-Answer Session

Operator

(Operator Instructions) And the first question comes from Jason Arnold at RBC Capital Markets.

Jason Arnold – RBC Capital Markets

Hi, guys, great results this quarter. You did very well with the low balance of HARP specified pools trade but it did sound like you took some profits here. So I was just curious if you could share with us your thoughts on, broader thoughts on value right here between the two segments and then perhaps comment on the incremental spreads on new investments you’re seeing right here?

Chris Kuehl

Pools, the HARP and lower loan balance pools have performed very well and by definition they’re not as attractive as they were a couple of quarters ago. But overall, we still very much like the risk adjusted returns of these strategies or at least most of them and they’re going to continue to be a core position for us for a number of reasons. Peter reviewed with you on slide 12 the importance of slower prepayments with respect to repo and margin calls. And it’s critical to have a portion of your position like you can count on to not drive increases in repo margin calls due to prepayments on a stressed scenario. And these positions are also extremely important from a convexity risk management perspective.

Again knowing that you can count on these positions to perform and it really allows you to hedge more effectively. And so we’re not managing for just today’s prepay and interest rate environment, we’re – it’s important that we perform across a range of different environments and these positions will help us do that and so they continue to be a quarter position for us and we still find the risk adjusted returns as being attractive. The positions that we sold during the quarter were largely very high coupons backed by lower loan balance and HARP loans.

Gary Kain

Just one other thing, I mean as slide seven, points out, I mean we are, however, cutting our kind of aggregate exposure to those back counts what we would say are more kind of normal levels. So our bias over the last few months has been, not that – we’ve still been buying some, we’ve even been selling some but are depending on coupon and strategy. But our bias has been to be more balanced given today’s pricing.

Jason Arnold – RBC Capital Markets

Okay, so for like the dollar-for-dollar you are putting probably more into the lower coupon side and then perhaps kind of balancing that out with other areas of interest, is that fair, (inaudible)?

Gary Kain

Yeah, it is, but I do want to stress that it’s not all or nothing, I mean we still look at – we don’t buy except in, kind of, one-off cases what we would call TBA. So even if we’re not buying something like a HARP or a loan balance for, we’re certainly thinking about the amount of third party originations. We’re looking at plenty of other factors. So I don’t want you to – but to be frank those things don’t matter, I mean they are important but they don’t matter nearly as much as some of the stories we’ve talked to you about. But there is, I just don’t want to give you the impression that it’s kind of all or nothing, I mean even if you’re not involved in something that has kind of really strong prepayment protection, you certainly in everything you do, you absolutely have to overweight the worst and we feel like we can do that across the board.

Jason Arnold – RBC Capital Markets

Okay. And then just one quick follow up, thanks for the color on the rate hedges. I know the planned renewal swaps aren’t ideal given in that convexity and prepayment optionality. But I was curious if you could comment on what really led to the uptick in the use of swaptions from a macro view or rate view standpoint? And then perhaps you could also comment on the use of the short TBAs in treasuries and specifically what component of the rate risk kind of spectrum you’re hedging out with those?

Peter Federico

Yeah, this is Peter. On our last call, I mentioned the fact that we’re opportunistic in our purchases and that we were seeing the cost of these options decline as once we got through year-end. So in December and early in the first quarter, we saw implied volatility in the marketplace come down, the combination of the lower cost from an option perspective as well as the strike of the options with rates coming down, the combination of those two things really led us to view these much more attractive in the first quarter than they have been in the past. Subsequently, later in the quarter, the prices went up a little bit and now they’ve come back down to close to 12-month (inaudible) again. So they continue to look attractive to us.

With regard to the treasury hedges, I’m glad to point it out, we do use a combination of hedges and in this quarter we used treasuries more extensively than we have in the past with about $5.5 billion at quarter end. And again it’s just opportunistic hedging. We use treasuries, we use swaps, we use swaptions. So we just look at them on a relative value perspective. What do we think is going to happen to swap spreads and try to just position the portfolios as best we can from a hedging perspective. Chris, you may want to add a comment on the TBAs.

Chris Kuehl

I mean again the TBAs gave us again exposure to different parts of the curve and partial durations and at times are very effective hedges and allow us to source call protection through some of these specified pull strategies at times where we don’t necessarily find the mortgage swap basis attractive.

Jason Arnold – RBC Capital Markets

Okay, terrific. Thanks for the color, guys.

Chris Kuehl

Thank you.

Operator

The next question comes from Dean Choksi at UBS.

Dean Choksi – UBS

Hi, good morning, gentlemen. Can you talk about your expectations for HARP 2 prepayments?

Gary Kain

Sure. This is Gary. On HARP 2, we absolutely think HARP 2 is relevant. You can take comments from any of the large originators or FHFA. You can look at the flow of kind of the over 125% LTV new mortgage securities into the marketplace. We’re definitely seeing the impacts that – HARP 2.0 will have impacts and we’ve seen faster, somewhat faster speeds on the higher coupons.

We think this is still very early and interestingly as you can tell from our portfolio we are still avoiding HARP 2.0 risk. And let me give you the main reason, it’s kind of interesting. Again as we’ve talked to you about, we can’t just manage for one scenario. We’ve got to manage over a range of interest rate scenarios and for that matter prepayment scenarios. And the thing that usually people like about higher coupon fees in mortgages and they were a very sizable part of our portfolio back in 2010, when interest rates go up 100 basis points, 50 or 100 basis points, they tend to outperform other mortgages and so they are short of duration and they add a lot of value in that scenario.

Right now, even in HARP 2.0, we actually think they would perform very poorly in that scenario. And the reason is, is that right now originators seem to be dedicating maybe 30% of their capacity to HARP 2.0. If rates went up 75 basis points, all the other refinancing activity that they are doing that’s using 70% of their capacity would go away. Which would leave them to dedicating all of their capacity in our minds with a mass majority to HARP 2.0, plus the coupons are high enough that they would still be very much re-financeable. So it’s really – that’s probably the biggest concern we have with the universe that’s exposed to HARP 2.0. So I hope that helps.

Dean Choksi – UBS

Yeah, it did, thanks, I appreciate the color as well as the incremental disclosure in the slides. Can you also talk about; how you deployed the capital around that capital raise couple of months ago.

Gary Kain

Sure. I mean, I think you can kind of see it from the portfolio and what you can infer is, we put less of that into – just into lower loan balance and HARP securities, but we still bought some. We put into 30-year than 15-year mortgages. But on that front, we also were well positioned for the capital raise and we had acquired some of what we did buy in the specified mortgages earlier.

And that’s one of the reasons we use TBA hedges is to kind of stockpile good assets at good prices. So when you put all that together we were able to deploy the capital raise much quicker this time, right, versus the quarter before where the capital raise was very much opportunistic with respect to a very specific opportunity and to be appropriately honest we weren’t able to forecast it as well. So the deployment time while I think it was a great time back in October, it took a little longer.

Dean Choksi – UBS

Great, thank you.

Gary Kain

Hope it helps.

Operator

Our next question comes from Mark DeVries at Barclays.

Mark DeVries – Barclays

Yeah, thanks. My question is revolving around the outlook for mortgage spreads. First, it seems like Freddie and to a lesser extent Fannie have been accelerating the run off in their routine portfolios. What if any implications has this had for agency spreads?

Gary Kain

Very little. I mean, you’re absolutely right, we’ve seen that same trend as well. But remember that the treasury basically just stopped their mortgage sales program, which was around $10 billion a month and so the incremental slowdown in purchases or net sales from the GSEs right now is not a market moving event and we don’t think that’s likely to impact spreads much at all.

It’s just not that big picture of a factor in the market, especially against the backdrop of Fed purchases and reinvestment of cash from pay downs and a lack of net supply into the mortgage market. So we are pretty constructive still on mortgage spreads across kind of two of the – most of the environments that we see unfolding. That being said, they’ve had a very good run over the last few months and so we’re very glad that we had reasonable leverage and had purchased value-added securities before because they’ve had a good run but we honestly don’t expect any material cheapening unless you get a real outlier type scenario.

Mark DeVries – Barclays

Okay. And what are your thoughts on bank demand for mortgages with these kinds of low absolute yields, are you seeing that drive at all or are they still pretty big buyers?

Gary Kain

No they are still being pretty big buyers. I mean, could it dry out in some scenarios or slow down? Yes. But I mean the short answer is banks have a ton of cash to put to work. I mean their liquidity levels are higher than they have been in ages. And so it’s hard to forecast but the short answer is we don’t expect bank demands really can drop off that much.

Mark DeVries – Barclays

Okay, thanks.

Operator

The next question comes from Arren Cyganovich at Evercore.

Arren Cyganovich – Evercore

Thanks. With your purchases of more, I guess, you would call them straight generic 15, 30-year mortgages after you recycled out of your HARP and lower loan balances, I would think that that would increase your prepayment risk associated with the portfolio, yet the model had it going down pretty substantially quarter-over-quarter. Can you talk about the dynamics of that with your portfolio?

Gary Kain

Sure, I mean first of, again just if you look at the numbers and the chart on page seven, as an example. We haven’t really gotten out of the specified or the HARP and lower loan balance securities. We’ve reduced our weighting to them. That’s probably the best way to describe it. But very importantly the average coupon on our portfolio dropped 25 basis points, right. So again a lot of that repositioning may have been selling a 5% coupon or 4.5% HARP security at $11 price than buying a HARP security backed by 30 or 3.5s at a much lower dollar price and a much lower payout where the prepayment speeds would be expected to be slower, so that’s one component that don’t ignore the drop in the coupon.

The other thing to be cognizant of it, when anyone projects prepayment is interest rates, right. So the 10-year swap rate was up almost 25 basis points during the quarter and so that’s material as well and then realistically and I think this has come up on other calls, you know there were some parts of the market in a sense in particular HARP loans or whatever but our estimates were good and they were very reasonable. However, there was an argument as you got more data that may be we’re a little fast and so I think that factored into Blackrock’s – their general process for taking in new data and then making logical revisions on an ongoing basis to their model.

So you have all of those factors, so we feel we’re very comfortable with our assumptions against that backdrop. But I do want to just complete that by saying, as Chris mentioned in the prepared remarks, there are some targeted positions where we’re comfortable with faster prepayments. The bulk of what we’ve added to the portfolio was in low enough coupons where in the absence of a major change in interest rates or mortgage prices, we don’t expect to see faster prepayments there.

Arren Cyganovich – Evercore

Okay, that’s helpful. And then looking at your scenarios between scenario one and three in terms of the 10-year assumption of an increase, we can see some pretty rapid moves in the 10-year, I think it’s down over 100 basis points from where it was only a year ago. What kind of an increase are you talking about in scenario one versus scenario three?

Gary Kain

In scenario one we are talking about a modest increase. I mean I think I would say, I think what I said in the prepared remarks was maybe the 10-year goes to around 2.5%. So we’re not talking about a major shock. I mean, it’s kind of where we – we were near that back in March, okay. So that’s more a gradual kind of relatively small increase.

When you get to scenario three, we’re talking about more than 100 basis points. So, obviously, there’s some room in connecting the dots between all these scenarios and in no way share reform is just designed to give you every possible outcome and, obviously, we can’t do that and there are infinite possibilities there. But I think the intent of one is one where interest rates gradually increase some but it’s not a big move, all right. The intent of the illustration in three is one where interest rates shoot up and the move is large, okay, and large being more than 100 basis points. And that’s kind of the intent of those scenarios from an illustrative point of view.

Arren Cyganovich – Evercore

All right, thanks.

Operator

And the next question comes from Scott Smith, Private Investor.

Scott Smith – Private Investor

Hi. Thanks for taking my call. Just a quick question maybe it’s more educational. On slide four you talk about a 9% average projected portfolio CPR life. And as I look at some of the other slides, I see March and April have been running more around 12%, how does one really think about that? I guess to a lame and you would think that maybe you would view is a higher CPR rate given March and April, but how do I think about the 9% and how is that used, that projected rate used in your financials?

Gary Kain

No, look, that’s a great question and what you should think about is there is a couple of things that are important to keep in mind. So if you compare that, first off we are not trying to with our lifetime projection benign, okay, it’s again a lifetime projection for the portfolio and it’s going to be – and the reality is it’s going to be subject to change on a quarterly basis based on market conditions, interest rates being the most important and composition of the portfolio. But it’s again a lifetime speed. It’s not intended to project the next month or two in terms of prepayment speeds.

So you should expect that those aren’t going to line up actually more often than not in terms of the one month speeds versus kind of a lifetime projection. The lifetime projection also considers things, importantly the forward curve, you know the forward interest rates. So there is a lot of factors that go into sort of the time pattern of prepayments without getting too technical but that’s a key thing to keep in mind. The important piece of the projection is that all we can do is give you the aggregate numbers. We give you somewhat of a breakdown based on page six based on some of the larger product types within the portfolio but those are really the key differences between why a 9% and 12% don’t necessarily aren’t supposed to equal each other all the time.

Scott Smith – Private Investor

Okay, great. Thanks for that. And just a follow on question, albeit small, I guess I was scratching my head as to why you issued preferred stock, I think given the cost and I thought I read about a conversion feature versus the availability of common stock issuances to you?

Gary Kain

Sure, no, look, a very reasonable question. Our reason for tapping the preferred market was one of being at the highest level it’s one of flexibility and you want to know any issue or wants to know what their options are and wants to develop liquidity in as many vehicles as possible for accessing funding or equity. And so from our perspective having access and developing kind of price points and the market is an important issue in and of itself. Now that being said, we feel that the execution also is very reasonable in that, yes, we’re paying an 8% coupon that’s callable in five years or it’s taxable other than that, otherwise callable at our option.

But our ROEs are well above 8% and so on those investments, common shareholders are getting incremental returns from that issuance and it makes sense. I mean, another way you could look at this is you’re paying common shareholders a dividend much higher than that, you’re getting equity at a much lower cost of equity than common. I mean, big picture, that isn’t – there are fundamental differences in the two profiles. So it’s not as simple as the latter example. But I think big picture, this is not a wave of the future for AGNC at this point. It’s more a matter of keeping our options open, understanding the layout and what you can do in different markets.

Scott Smith – Private Investor

Okay, great. Thanks. And if I may, one final question. Could you just comment on your exposure in the repo market let’s say Europe and how one should think about the news we’ve read about Europe and the potential outlook there and how that relates to your repo portfolio and then I’ll take it offline?

Chris Kuehl

Yeah. We gave that breakdown at least by geography on slide 27 that shows that about 29% of our repo funding is coming from Europe with nine counter parties. But the point is that we’re very cautious about all of our counter parties. We try to diversify our exposure and we also gave you on that page a measure, not by name of counter-party but by measure of the equities that we have at risk with each of our counterparties and so you can get a sense on how small on a per counter-party basis our actual equity at risk is.

Scott Smith – Private Investor

Perfect. And so at this point, you’re fairly comfortable with the outlook for the European banks that are participating in your repo program?

Chris Kuehl

Yes, yes, and particularly the type of counterparties that we have, we’re very comfortable with.

Scott Smith – Private Investor

Okay. Thanks so much, guys. Great quarter and...

Gary Kain

Thank you, really appreciate it.

Operator

(Operator Instructions). Our next question comes from Joel Houck at Wells Fargo.

Joel Houck – Wells Fargo

Thanks, and good morning. Gary, I’m wondering if you could maybe, I guess more of a philosophical question talking about the relative size of AGNC now in terms of looking forward that the value add with the kind of specified pool strategy as opposed to TBAs, obviously, as you pointed out has come down here in the last couple of quarters. In scenario one, the moderately rising rate environment, what are your thoughts about how TBAs would perform versus spec pool and how, if any, would you reposition agency to perhaps get ready for that environment?

Gary Kain

Well, look obviously, as you know from the fact that we put out the scenarios as well in it, I’m sorry, your question was more specific to scenario one.

Joel Houck – Wells Fargo

It’s more specific scenario one but also dovetails in just kind of as you get bigger, $80 billion portfolio, how much more ability do you have to kind of even play in the spec pool market as opposed to more generic.

Gary Kain

Let me address that one first, look those are both very big questions and look with respect to the size issue, we could have easily maintained the higher percentage of spec pools that we had had before. Okay, if that was our desire, I mean we went out of our way so to speak to sell, and Chris gave you the number $6 billion in HARP and loan balance securities in Q1. If we didn’t do that, then we would have had irrespective of even purchasing any more, which we could have done that would have had a pretty decent impact on the weightings first off. So what I would say is that’s a pretty big market and there is something on the order of 20%, 25% of total production and that will increase with HARP 2.0 that comes in through those products.

So there’s a decent amount out there and will be sizable not in our minds inhibit or it’s not likely to inhibit our involvement in those sectors right now. But to your point about scenario one, right, that is exactly what we’ve talked about and why we’ve chosen to sort of both reduce and reposition the coupons because the reality is and that if interest rates go up 50 basis points and prepayments slow across the board then the price premiums for the specified pools will come down and at some point, they could over react like they did before, in other words they could become too cheap in which case that will be a good time to add them.

So we’re absolutely focused on trying to balance between being able to handle the current environment, having a core position that is predictable and that could be hedged, coupled with the fact that we don’t want to give back all the book value gains and out performance that we’ve had versus more generic mortgages in the scenario, which is probably which could end up being the one that unfolds. So I think that’s the balancing act and what I want to stress is that we think about it. And we don’t only think about it, we view it as our responsibility to take action.

Joel Houck – Wells Fargo

Okay, good. And I don’t know, Peter, can you give us or is it in the Q the strikes for the swaptions, strike levels that you put on?

Peter Federico

On the ones we’ve – well I gave you the total for our swaption portfolio, 2.7%. So that is down a little bit, so I don’t have the exact number of the strike on the $8 billion that we purchased during the quarter, it was lower than that.

Joel Houck – Wells Fargo

Okay.

Peter Federico

But it’s in that neighborhood.

Joel Houck – Wells Fargo

Okay, thanks.

Peter Federico

Because the underlying on most of the swaptions were all, mostly 7 and 10 year underlying.

Joel Houck – Wells Fargo

Okay, thanks, Peter.

Peter Federico

Sure.

Gary Kain

Thanks, Joel. Appreciate it.

Operator

Our next question comes from Chris Donat at Sandler O’Neill.

Chris Donat – Sandler O’Neill

Hi, good morning, everyone.

Gary Kain

Good morning, how you’re doing?

Chris Donat – Sandler O’Neill

Doing fine. Just one question on the, with the increase in the size of the portfolio I’m wondering a little bit about the seasoning and how that might affect CPRs. I would just guess as you add relatively new MBS there’d be some pressure a few quarters out as far as CPR goes for higher prepayments, but I’m not sure I’m understanding it correctly and I certainly know that you’ve got your prediction for a 9% average portfolio CPR that factors in a bunch of different attributes, but I know I’d just like to understand, how seasoning might affect CPR?

Gary Kain

Look, that’s a great question and we’ve talked about this on other calls. It is one of the reasons we don’t like to use actual CPRs, right. Because if we were buying relatively generic or the reason we have some of those that are one month old or three months old then clearly, they’re going to prepay very slow today, but they’re going to pick up a year from now, unless interest rates go up or whatever.

So our models, obviously, completely capture that and that’s another reason why lifetime CPRs are very different from monthly CPRs. But keep in mind what we don’t have except in a couple of positions are lower coupon, I mean are middle or higher coupon generic mortgages that are new. So in the case of our generic mortgages, they are very low coupons and they are new.

So, yes, they will speed up, but that increase will be moderate, whereas if you had higher coupon generic mortgages that were a few months old that you had purchased maybe before interest rates fell, then they may have been slow over the last few months but they’re going to be very fast or could be in the 30s a few months later. We really don’t have much of that, so I think if you looked at page six you can kind of see the breakouts across strategies but those are some things to keep in mind on that front.

Chris Donat – Sandler O’Neill

Okay. Thanks so much on that one. And then just more of a policy question. As Peter went through the leverage discussion at different CPRs, the underlying mechanics of the MBS market with the prepayment release date early in the month and then the principal and interest payments received later in the month, is there any talk among all the potential reform of Washington about just changing the mechanics of the MBS cash flows world?

Gary Kain

I mean, there are, I mean there are discussions FHFA has been public about discussions about designing new securities and there are discussions about combining Freddie and Fannie securities and seeing what the right solution is. I mean, look we don’t expect “relief “on this issue in the next year for sure and so we’re certainly operating from the perspective that this is the landscape, but we’ll certainly work with all those entities to try to find longer run solutions.

But, again, one thing to really keep in mind is that and I think what you should take away from the slide is, there is a lot of excess capacity if you can manage prepayments to reasonable levels given today’s leverage levels in the industry. So it’s really something that if it’s addressed, it doesn’t need to be addressed that quickly. I mean, it’s not inhibiting an investment with a reasonable portfolio to lever where it’s appropriate.

Chris Donat – Sandler O’Neill

Okay, thanks for that context.

Gary Kain

Thank you.

Operator

We have time for one more question and that comes from Bose George at KBW.

Ryan O’Steen – KBW

Hi, thank you, actually this is Ryan O’Steen on for Bose. Just a follow up on the leverage comments, I mean, so you’ve mentioned on one hand a well hedged portfolio and slow prepayments can support greater leverage. Presumably you’re pretty comfortable with your hedging and your prepayments have certainly been slow. On the other hand you mentioned a more moderate stand seems reasonable, could you just kind of help reconcile that?

Gary Kain

Sure. I mean I was really trying to get to, and it’s a good question. We disclosed that as of March 31st our leverage was 8.4 times. Again, mortgages, one, we would feel comfortable levering a good – a strong mortgage portfolio to the point, a well hedged portfolio and one with predictable prepayments and we feel our portfolio qualifies in both of those comments at higher leverage than 8.4. That doesn’t mean that we’re going to go there so to speak. And the reason why we have sort of dampened our excitement or our view on leverage is just completely related to the price discussions. I mean, mortgages have done very well again in April.

Book value probably in this space are up, we feel that and that’s true both of generic mortgages and as we’ve discussed extensively on the pay-ups and the value attributed to specified mortgages. So when you put those two together, the risk return equation is less compelling than it was three months ago. And so, yes, our portfolio can handle higher leverage and we’ll be very comfortable operating that way and did in the Q1.

But right now given the pretty significant book value gains that we’ve achieved over the past several months. We feel that a more moderate stance is warranted but we are not comfortable, as I said earlier, at low leverage right now. I mean, there is too much risk that then later you’re going to be taking leverage up at a much worst time and so we’re not comfortable there either and so I’d say, that’s why we’re trying to give you guys reasonable amount of insight into our thought process today but recognizing that things could change.

Ryan O’Steen – KBW

Good, thank you.

Gary Kain

Thanks guys. Look, I really appreciate everyone’s interest in AGNC and look forward to speaking to you again.

Operator

The conference is now concluded. Thank you for attending today’s event. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: American Capital Agency Management Discusses Q1 2012 Results - Earnings Call Transcript
This Transcript
All Transcripts