Dean Choksi – UBS
Gary Kain – President and Chief Investment Officer
American Capital Agency Corporation (AGNC) 2012 UBS Global Financial Services Conference Call May 9, 2012 10:40 AM ET
Good morning. Thanks for joining us for our next presentation the American Capital Agency. I’m Dean Choksi, UBS’s Consumer and Specialty Finance Analyst. Pleased to be joined by Gary Kain, President and Chief Investment Officer of American Capital Agency.
American Capital Agency is a buyer rated stock. One of my favorite mortgage REITs in the sector – my favorite mortgage REIT in the sector, because they really distinguish their self among their peers by generating the highest level of book value growth, by repositioning their portfolio for different prepayment risks and the changing interest rate environment. Thank you.
Thanks, Dean. And it’s a real pleasure to be here at the UBS conference and to talk to you guys about AGNC. So, if we turn to a couple of slides to slide three, we have a quick overview on AGNC. And I think what’s probably most important is AGNC IPO’ed in May of 2008. We IPO’ed at a price of $20 a share. Since then, in less than four years, we’ve paid $20.11 in dividends over that period, so actually slightly more than the purchase price. But in addition to paying dividends, we’ve also grown our book value from the original $20 to $29.06 as of March 31, 2012. The market cap of AGNC is actually a little over $9 billion at this point. So, it’s gone from a $300 million original IPO to a much larger, a more liquid company as well, with a lower expense ratio.
So, AGNC invests in agency mortgages, which are mortgage securities that are backed by Freddie, Fannie and Ginnie Mae. So, as such, we take very little interest rate or credit risk, and the bulk of our risks are prepayment risk and interest rate risk. Our objective is to provide attractive long run returns, which can either come through dividends, the main kind of source of returns or book value growth. And we’ll talk a little more about things – those going forward, it’s – realistically, it’s the combination of those two that is critical to all end returns.
And one thing that’s important, as Dean mentioned, one of the things that’s been key to our success has been the fact that we’re actively managed. One thing that we feel very strongly about is the opportunities and the risks in the mortgage market evolve over time as interest rates change, as different mortgage programs change. And it’s imperative that we change our portfolio and that we evolve with the times that we react quickly to new developments in the market. So, I think a key thing that distinguishes AGNC from our peers is our willingness to invest throughout the agency mortgage spectrum and our willingness to rebalance the portfolio as conditions change.
So, with that, let’s turn to slide four. And I think this really gives a snapshot of AGNC’s returns over the past three years versus our peer group. And what I’d like you to focus on is the graph on the top right. And what you can see there is, what we call, economic returns or mark-to-market returns for AGNC, which are the two blue lines for the three years, 2010, 2011 and 2012 versus our peers. And if you look, you’ll see consistent outperformance, both in terms of book value and in terms of dividends paid. And when you think about other professionally managed vehicles, such as a hedge fund, or a mutual fund, you think of your returns over a period of a quarter as any cash you get, plus the change in the value of your assets or your NAV.
Well, that’s exactly what this analysis is. It’s just dividend which are cash, plus change in NAV or book value for us versus our peers. So, it’s kind of a mark-to-market analysis by the bond market of the performance of the various REITs. And you could see, AGNC has just consistently outperformed its peers. And we – that may surprise people and that they think, okay, you’re investing in agency mortgages. It’s a big liquid market. I wouldn’t expect to see such big differences amongst different players.
And I think part of that relates to active management and the willingness to move the portfolio around. But another chunk is that realistically all agency mortgages are not created equal and there are some very big differences between the prepayment characteristics and the interest rate characteristics of different types of mortgages. And that allows for – especially in a relatively volatile market that allows for a pretty different return profile between different players in the space. And that’s what we see as the key driver there. And obviously, on the graph, on the bottom right, what you can see is that the stock return has tracked in a sense the total economic return for AGNC versus the peer group.
So, with that, let’s turn to page – slide five. And this is from our recent earnings presentation, which we did a week ago. So, for those that are interested in kind of learning more specifics about the company in recent reporting. But going to the point about the differences in different types of assets and how they can impact performance. If you look at the graph on the top right, what you’ll see is we show in the blue and gray bars the price differential of two specific types of mortgages, mortgages backed by smaller loans or lower loan balance mortgages, and mortgages backed by – or mortgage securities backed by loans that have been through the HARP.
This is the program that was set up in 2009 and then recently revised. These two types of mortgages, the smaller loans and the HARP loans tend to prepay much slower. So, they now trade at a substantial premium to more generic securities. And at the end of September, that premium for HARP securities was about a point – one percentage point over a regular security. For lower loan balance, it was a point and a half.
While interest rates have been relatively constant and the price of regular mortgages didn’t change that much over that period, the price differential or the price of these particular types of mortgages, the lower loan balance and the HARP securities have appreciated quite a bit. And what you can see in the graph is that they’ve gone to around two and a half points above more generic mortgages from again a point and a point and a half just six months ago. And that kind of outperformance of more generic mortgages has driven our book value, on the bottom right, to really grow quite a bit over the last six months, almost 10%, in an environment where book value for many of our peers was relatively flat.
So, that’s an – this is kind of a more current example of how those differences can materialize. On the line – on the graph, on the top right, we show that as the prices of the securities have gone up, we have reduced the percentage of our portfolio that is being dedicated to the securities, because price matters. And while we believe the securities still need to form the basis of a well-constructed portfolio, the tremendous overweight we had to these securities, we feel like we’re supposed to bring it down some, given the outperformance of the asset class.
So, with that, let me turn to the next slide and quickly just go over the business economics, or kind of a look at the earnings power of the portfolio as of the end of Q1. And what you can see is the yield on our portfolio was around 3.06%. That’s a yield at our cost bases, or amortized costs, using a projected prepayment speeds on the portfolio of 9% CPR. To that point, our actual prepayments on our portfolio in Q1 were around 10% CPR. The cost of funds is – includes both our repo borrowing costs, as well as our interest rates swap expense. It does not include any of our supplemental hedges, such as interest rate swaptions, short treasury positions or short TBA positions.
The net interest spread is 2.07%. When you multiply that by our leverage, which was, at the end of the quarter, 8.4 times, you add the asset yield to get a gross ROE of just over 20%. When you subtract our operating expenses, you get a net ROE in the upper 18% area.
Now, look, actual returns are going to be a function of how our securities and how our entire portfolio performs over time. It will be a function of actual prepayments of actual funding costs. This is just a snapshot in time. But investors should keep in mind that these – that AGNC, as you can see in the past, has also been able to generate a fair amount of return from actively managing the portfolio, other income, either trading or realized gains that have contributed quite a bit to AGNC’s returns over the past couple of years.
Additionally, AGNC has undistributed taxable income of $1.28 per share as of the end of March 31. And where that’s important is that is taxable income that has been earned, but not yet paid out in the form of dividends. And so that undistributed taxable income gives us quite a cushion that makes it unlikely that anytime in the near future taxable income will be a constraint with respect to paying the dividend.
If you turn to slide seven, what we can look at is something we covered on our earnings call. And these are probably the most important slides in the presentation. And here, we look at kind of three scenarios that we are really thinking about as we try to figure out what – how to position the portfolio in the current environment. And the three scenarios are pretty straightforward. We didn’t – there’s nothing magical here.
The base scenario is one where the moderate economic growth that we’ve seen continues. Inflation remains ballpark around where the Fed’s target is. In this scenario, maybe rates increase a bit from where they are, but stay pretty well anchored, so to speak. We don’t get a QE3 in this example and maybe the 10-year goes to 2.5%. So, this is sort of the unemployment continues to drop. It’s the scenario where – and again, the Fed stays on-hold.
In the scenario, which some people in the REIT space would call it a Goldilocks scenario, because the higher – the steeper yield curve from the 10-year backing up would drive slower prepayments. Again, better spread between funding and asset yields. And so, combined, that will improve the returns both on the existing portfolio and you’ll have wider spreads on new purchases.
Book value would remain pretty well anchored. It wouldn’t be that big of a change in rates. Volatility would likely be manageable. So, you should see – you should see this being kind of a very straightforward and good environment for the entire agency or mortgage REIT space. And again, some would call it a Goldilocks-type scenario.
The next scenario is one that has pluses and minuses, but, on the surface, could be very challenging from a returns perspective. And that’s the scenario that certainly, looking at the markets over the couple of days, is clearly moving further and further kind of into consideration, so to speak. And that’s one where the economy weakens, either because of Europe or for other reasons, and where interest rates probably end up a little lower or drop like they have, maybe the 10-year is – it’s up 2%, where it currently is.
And you end up with a flatter yield curve. The Fed does come in and execute our QE3, which involves purchases of a substantial amount of agency mortgage securities. That will drive mortgage rates lower and significantly impact or increase prepayment risk or refinancing risk, raising prepayment speeds. That in turn will – in that process of the Fed, buying a lot of mortgage securities will drive prices of lower coupon fixed-rate mortgages to very expensive levels, which will hurt the returns of any of our new purchases in that environment. So, again, weak returns on new – much weaker returns on new purchases, tougher – faster prepayments speeds and a flatter yield curve, all kind of hurt cash flow returns.
However, if you have the right mortgage securities, you’re going to see a tremendous increase in book value because you’re a levered holder of agency mortgage securities and the Fed is going to be buying a large amount of the securities, driving the values of them up. So, the benefits are very strong book value performance. The weaknesses are the fact that go-forward, actual cash flow returns are going to be weaker.
So, in this environment, what we would say is it’s absolutely all about positioning. You have to have reasonable leverage going in, or you’re going to be competing for your new purchases with the Fed. The other thing is you have to have a good chunk of your portfolio that’s prepayment-protected or that’s going to be perform well from a prepayment perspective. Low loan balance and HARP securities are the two kind of main areas that I think provide that kind of protection. Because in an environment, where prepayment speeds are going up, people are going to even further flock to those types of assets in that kind of environment.
And then, where you have more generic securities, you probably should be in the lowest coupon fixed rates because that’s what the Fed’s going to buy, in which case, the prices of those are going to be driven to very high levels and you’re going to get a fair amount of book value appreciation. And even if those securities prepay quickly, you’ll be able to sell them at substantial premiums to the Fed’s bid, so to speak.
And then, now, let’s move to the last scenario, which is the one that’s a pretty low probability, but it’s not something we can just dismiss out of hand because it would have a pretty material impact on the space and for any levered mortgage portfolio, it’s kind of the scenario that you have to worry about.
And that’s the one where the – and again, looks even less likely this week. But interest rates shoot up and quickly and maybe the 10-year goes up by 150 basis points or more. I guess that would – some drivers for that would be absolutely the economy heating up, inflation fears picking up dramatically. And in that scenario, our book value would likely be negatively impacted by – I mean, significant drops in the prices of our assets, hedges would help, but they mostly likely wouldn’t be enough. And what’s – so – but they will be the key determinant of how you – how one entity fairs versus another and how well you can manage through a tough scenario.
Now, what – then, we’ll go to the next page and I’ll talk a little about when we look at these three very different scenarios, but we can’t – we’re not trying to pick which one is going to happen and that’s not the intent of this presentation. What we’re trying to do is, say, this is the landscape we’re looking at. Given this landscape, what should we do and what can we do to be able to perform reasonably well across the range of scenarios?
And if you go to slide eight, we kind of lay that out and give you a feel for what we’re thinking. So first thing in terms of the positioning, while QE3, up until maybe the last couple of days was not the most likely scenario, it is so important to be well-positioned for it. We still felt that we needed to have a lot of prepay protected mortgages and we needed to have lower coupon fixed rate. In that scenario to perform well, again, you need to have the assets that you’re going to get book value or appreciation from the slower prepaying, ones you can hold to the TBAs, or a little generic ones you can sell to the Fed. And that way you can get the book value appreciation and maybe take advantage of that to have attractive total returns.
We’re avoiding the types of mortgages that are exposed to HARP 2.0, so the more seasoned, higher coupon mortgages. Why? Because HARP 2.0 is continuing to kick in. These are the adjustments to the HARP program that we announced in October and November. And we’re seeing speeds pick up there. But more importantly, there are number of different scenarios including the QE3 scenario where those prepayments could pick up more. So when we look over a kind of a range of scenarios, we don’t like that asset class.
Hedging, and this is kind of critical, in order the deal with scenario three, we’ve greatly increased our swaption position, and swaptions are put options essentially on interest rates. They’re the option to enter into, in our case, a longer term swap, if interest rates rise. And so, we’ve bought out of the money optional protection that will kick in essentially if rates go over 50 to 100 basis points. And that’s a tool that we’ve used to help kind of in a very specific way, protect against that low probability, but very unpleasant scenario option, with a scenario three that we just spoke about.
Now, lastly, I wanted to kind of just mention leverage levels. So, in thinking about the two most likely scenarios one and two, the moderate growth or the QE3 scenario, in both of those scenarios, most mortgage prices should do very well. In that, in the first scenario, it’s sort of – it’s a great scenario for mortgages, prepayment slow down, the yield curve steeper versus your hedges, mortgages will not likely be cheaper later – six months from now than where they would be in that scenario. And clearly, in the QE3 scenario, you don’t want to have waited until you’re competing with the Fed to have – to be purchasing mortgages.
So, against that backdrop, the one kind of position we would be uncomfortable with is very low leverage because 90% of the scenarios or 85%, everything except scenario three, you don’t want to wait for your purchases, you actually need to have – or should have the positions both to earning interest and earning carry now, but also those positions will be most likely much more expensive relative to your hedges in either of those two scenarios.
And then, second of all, given how well mortgages have done though both in the first quarter of the year and actually so far this quarter, both generic mortgages and some of the better kind of – the mortgages with better attributes have both done extremely well. And that’s helped drive our book value growth. But because of that, we do have a little bit more of a moderate stance toward leverage, let’s say, today than we did a month or two ago when the – toward the end of the first quarter or when we close the quarter.
And so, I think, again – I think there’s a better argument though if mortgages cheapen up for taking leverage up than there is for running at very low leverage, especially if the risk of QE3 is still pretty real. I mean, obviously, over the last week, it’s only increased.
So, with that, I’d like to conclude by saying we remain very optimistic about when we think about this – the range of scenarios that we may face, we’ve continue to believe AGNC’s portfolio can produce attractive returns over our range of different scenarios. And with that, I’ll open up the floor to questions.
In your presentation on slide five, I just wanted to make sure when you talk about low loan balance, is it low loan balance or is it medium?
In that graph, those are – they are mod loan balance, which are loan balances between $85,000 and $110,000.
Okay. So, by and large, you are in that sort of bucket versus less than $85,000?
What we have is a range. Well, if you look at the footnotes from our earnings presentation, the average loan size on our portfolio, at the end of the quarter, was in the low hundreds, which would be slightly above the moderate loan balance. So, in that category of lower loan balance, we include the less than $85,000, which people refer to as low LLBs, up to maximum loans of $150,000.
So, we have the combination of every – of pools that have loan sizes up to $150,000 in what we’ll call lower loan balance, but the average of that is probably just above MLB because the average is about $105,000 to $110,000.
Okay, thanks. You guys have done a fantastic job of managing the prepays. Your CPR is arguably the best for the last few quarters. I noticed though that in this past quarter, even though you came in again at a very low CPR, you increased your model CPR a little bit. Any sort of thoughts on that why the increase this quarter versus the past two (inaudible)?
The decrease this quarter versus the prior quarters?
Right. And your projection had gone up, right?
Well, no, the projections went down in Q1.
13% to 12%, okay.
So, our projection in Q4 for the portfolio was 14-ish CPR and it dropped to 9%. And so, what we talked about on the call is we would attribute that to three different factors. The first factor is that interest rates during the quarter, obviously, that’s changed now, but during the quarter, went up. So, the 10-year swap rate was up maybe 25 basis points during Q1. So, a little of that is just generally higher interest rates.
Another factor was that the average coupon on our portfolio dropped. So, we sold some higher coupons. We bought lower coupons. The average coupon dropped about 25 or so basis points from where it was the prior quarter. That also leads you to run slower prepayments speeds.
And then lastly, we used models created by and maintained by BlackRock Solutions. And they go through a rigorous process where they are consistently evaluating how their models have done in the past for different types of securities, and they frequently provide updates – not frequently, but they periodically provide updates to those models.
There was a model update, which also had the effect of slowing prepayments down, especially for securities like HARP securities, where their projections had been faster than where things were coming out. So, all three of those contributed to the lower projected prepayments speed going forward.
But what I want to make sure people understand is this is one of the key reasons why, in the end, our performance is going to be around continuing to maintain slow prepayment speeds. Whether you use the actual speeds like many people in the space do or whether you project, A, you don’t know what the interest rate scenario will be and there’s always going to be noise in those projections. But in the end, your returns are going to be based on how well you control prepayments speeds and how well you hedge the portfolio going forward. And it’s something that why we are so obsessed, so to speak, with asset selection because, in the end, prepayment speeds do make a big difference in terms of total returns. And I think you can see that in the results.
Gary, you mentioned that the price premium on the prepay protective securities has increased. And while you do hedge book value against interest rates, is there anything you can do to hedge some of the premium that’s built up there?
Now, that’s a great question. And what we talked about on the earnings call was that we have the – we’ve actually sold quite a few of the highest coupon, highest pay-up securities. We did in Q1 and we’ve sold a few since then as well.
And so, one way, we don’t want to give back all these book value gains that we have achieved from pay-ups going up. And so, we’ve rotated out of the highest coupon, HARP, and lower loan balance securities, into some more generic mortgages and into lower coupon, HARP securities that have lower loan balance that have lower pay-ups. And so, one way to minimize kind of the risk of giving back those gains is to move your position into lower pay-ups or some stuff that doesn’t have pay-ups.
Another is you increase your hedge ratios and that – now that the markets are signing so much more value to them, you know in a rising rate environment, prepayments across different asset types will come together and some of that pay-up will disappear. So, another way you try to insulate yourself against giving that value back is through a little longer hedge ratio.
So, we’ve certainly kind of considered both of those, because to your point, we still are very confident that we need to maintain a core position of securities with predictable prepays. So, we want to be in these sectors. But we had a very, very heavy overweight to the securities back in September. Again, we’re made up over 80% of our portfolio. We’ve brought that down, because price matters. And the reality is they’re no longer ridiculously undervalued, they are much more – much closer to fair value, and so a more moderate weight is advisable at this point.
Who you are thinking behind issuing preferred stock? And how should we as investors think about future for the capital raises coming out of either common equity or more preferred offerings?
So, first, with respect to the preferred stock, just simply from a math perspective, one way to think about the math on the preferred stock, you assume you’re paying a – we’ll call it 8% on the preferred stock. And if you look at AGNC’s ROEs being kind of high-double digits then – and you’re levering that equity – you’re paying 8%, you can lever that and produce something well north of that. And that increment – those incremental profits and dollars get distributed to common shareholders. So, common shareholders benefit from the fact that you can generate considerably better than 8% returns and then that’s distributed to common shareholders. That’s the economics.
But there’s a key point on the preferred – the one thing that was very important to us and looking at it, is it’s important to – for a company to understand its options with respect to raising capital, borrowing, whatever the activity is in the financial markets, knowing your options and having price points out there and spots is important to your decision-making over time.
And so, what you should think about is a lot of the driver for the preferred issuance was to have a preferred stock deal out there and to know where it’s trading. So, at some other point in time, if you’re thinking about doing more in that area, then you have a – it’s much easier to come with the next deal, the market used to you, and you know where things are going to clear. And so, there’s a lot of kind of value to that.
Now, with respect, generally, to common equity and equity raises, I mean, the things that we focus the most on in terms of timing – I want to make this very clear, we’re very focused on our current book value, okay. People, I think, make the mistake very often of calculating our price to book off of an old book value that was disclosed. In that process, they don’t factor in the accumulated dividend, you know, if it’s later in the quarter.
But, as importantly, a lot of times they don’t factor in what’s happened in the mortgage market, such as – I mean, over the last of couple quarters, I think people have generally expected AGNC to do equity offering sooner than maybe we did, because I think they weren’t paying attention to – in some cases, to how much book value might be up at a particular time. So, I think when you think about the book value component that – or a price-to-book component that can be a factor in equity raises, it’s very important to think about that in terms of the current environment.
The other big piece is thinking about the investment opportunities and how good do they look at any particular time. And in an environment where mortgages are appreciating in price and trading very well, as our kind of mortgages with favorable loan characteristics, then that’s less opportunistic or less advantageous to issue equity in an environment like that.
And so, those are the kinds of things people should be thinking about and that we are thinking about. We also recognize, though, that the growth that we have achieved over the past few years – the growth rate has to decline, were much bigger at this point. And people should expect – they should expect equity raises, but they should expect them to be less frequent, just given size and given the market conditions. But other than that, the real – those are the – the drivers are still the same as they’ve been for over the past couple of years.
Great. Thank you.
Well, the management will be available for a breakout. I guess, we can just stay in this room, because lunch is coming up next. Thanks.
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