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American Capital Agency Corp. (NASDAQ:AGNC)

Q2 2012 Earnings Call

August 3, 2012 10:00 am ET

Executives

Katie Wisecarver – Investor Relations

Malon Wilkus – Chairman and Chief Executive Officer

Gary D. Kain – President and Chief Investment Officer

Christopher J. Kuehl – Senior Vice President

Peter J. Federico – Senior Vice President and Chief Risk Officer

Analysts

Joel J. Houck – Wells Fargo Securities, LLC

Jason Weaver – Sterne, Agee & Leach, Inc.

Bill Carcache – Nomura Securities International, Inc.

Daniel Furtado – Jefferies & Co.

Bose George – Keefe, Bruyette & Woods

Arren Cyganovich – Evercore Partners

Jasper Burch – Macquarie Research

Douglas Harter – Credit Suisse

Christopher R. Donat – Sandler O'Neill & Partners LP

Operator

Good morning and welcome to the American Capital Agency Q2 2012 Shareholder Call. All participants will be in listen-only mode. (Operator Instructions) After today’s presentation, there will be an opportunity to ask questions. (Operator Instructions) Please note this event is being recorded. I would now like to turn the conference over to Katie Wisecarver, Investor Relations. Please go ahead.

Katie Wisecarver

Thank you, Amy, and thank you for joining American Capital Agency’s Second 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 August 20 by dialing 877-344-7529. And the conference ID number is 10015859.

To view the Q2 slide presentation, turn to our website at agnc.com and click on the Q2 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; Gary Kain, President and Chief Investment Officer; Chris Kuehl, Senior Vice President of 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 Kain.

Gary Kain

Thanks, Katie. And thanks to all of you for joining us today. As we’ll discuss on today’s call, our portfolio remains very well positioned for the current market environment. Now the current landscape is one where interest rates are at record lows, the yield curve is considerably flatter and prepayments on most parts of the mortgage market are poised to exceed the highest seen over the last few years.

Mortgage spreads relative to swaps and treasuries are tighter than where they have been in the recent past. But valuations are generally warranted given the interest rate and prepayment outlook. Furthermore, the art of additional quantitative easing from the Fed have increased since last quarter when we reviewed the three scenarios that we were focused on. If we do get a QE3 that incorporates substantial purchases of Agency MBS, we would expect lower fund mortgage valuations to richen substantially and we would also anticipate the prepayment picture becoming even more challenging with only a few places to hide.

As Chris will go over when he reviews the portfolio, we believe we have positioned our portfolio in the areas that we performed well even if we do end up in this kind of environment. But as we discussed on our last call, I really want to be clear. We are not betting on our QE3. This is evidenced by our hedge ratios and our somewhat lower leverage. But we just cannot afford to be caught off-sized if economic activity doesn’t pick up and the Fed does decide to act. It would be irresponsible for us to be unprepared for this scenario.

With respect to the second quarter financial results, we feel good about AGNC’s performance. We continue to create significant value for our shareholders by producing total economic or mark to market returns of around 22%, while at the same time reducing our risk factor via improved asset selection, increased hedge ratios, lower leverage and by continuing to increase the average term of our repo funding.

With that, let’s review the highlights for the quarter on slide four. Our net comprehensive income which incorporates unrealized gains and losses on both assets and hedges was $1.58 per share, which was comprised of a GAAP net income loss of $0.88 per share and a gain of $2.46 per share in other comprehensive income.

Net spread income, which is what many refer to as core income, came in at $0.94 per share, essentially reversing the increase we saw last quarter. When we exclude in $0.11 per share estimate for premium amortization catch up costs, we get an adjusted net spread income of $1.50 per share. The decline from last quarter’s $1.30 in adjusted net spread income was largely a function of faster prepayment projections, reduced leverage, increased hedge ratios, higher repo costs and changes in asset composition.

Now with respect to the higher prepayment estimates, which were a big factor, it is important to note that our actual prepayments were unchanged quarter-over-quarter, and actually declined on a monthly basis during the quarter. As such, if we had used our actual prepayment speeds, our net spread income would have been higher.

Taxable net income, which is not impacted by the changes in the projected prepayment speeds or by unrealized gains and losses on derivatives continue to be solid at a $1.62 per share. Our undistributed taxable income increased considerably again to almost $0.5 billion or $1.61 per share as of June 30. Even after adjusting this number for the share issuance in July, our undistributed taxable income equates to $1.44 per share post equity risk.

Book value increased modestly to $29.41 per share and additionally the performance of lower coupon, HARP and lower loan balance mortgages has been very strong so far during Q3. So we are seeing a material tailwind for book value at this point in the quarter.

Now, before I turn to slide 5, I want to briefly discuss our current thinking with respect to the undistributed taxable income in light of our continued book value growth. When we made the decision to lower the dividend to a $1.25 earlier this year, we said that we believe the dividend should be sustainable for a reasonable period of time given current market conditions and our best estimate of future financial performance.

Given the strong book value performance and the large amount of UTI, we continue to believe our dividend is sustainable at its current level over at least a near-term despite the recent spread compression. Now ultimately however, future dividends will be a function of actual financial performance and are therefore uncertain.

Now, turning to slide 5, our mortgage portfolio decreased to $78 billion from $81 billion by quarter end, as we reduced leverage from 8.4 times where it was at the end of Q1. Leverage during the quarter averaged 7.5 times while quarter-end leverage came in at 7.6 times.

Our average CPR remained unchanged at 10% during the quarter, but was only 8% in the most recent prepayment release in July. Our quarter end net interest spread decreased to 162 basis points driven in large part by the combination of faster prepayment projections, increased hedge ratios and higher repo cost.

Lastly, we raised a small amount of accretive common equity via our ATM program and did our first preferred stock offering during the second quarter. We also raised around $1.2 billion during July in a follow-on offering.

Now let’s turn to slide 6 and look at what happened in the bond market during the second quarter. As you can see we had a significant rally in longer term rates during the quarter with the 10 year dropping 56 basis points. The yield curve also flattened materially at the two year treasury rallied only three basis points.

Now in price terms, the five year treasury rallied around 0.5 while the 10 Year Treasury increased in price close to five points. Now as shown on the bottom left the prices of lower coupon mortgages also increased materially, but in response to the declines in interest rates. While the price changes were more limited as you move to higher coupons. The same trend can be seen on the top right with respect to 15-year mortgages.

Now if we turn to Slide 7, we can see how AGNC’s book value has performed over the past three and a half years in some different interest rate environments. The first thing that’s important to point out is that 10-year rates have been pretty volatile over this period and despite that AGNC’s book value has increased in 13 of the past 14 quarters. In aggregate, book value has increased 71% since the beginning of 2009 with book value growing from $17.20 to $29.41 per share. This is of course in addition to the $18.85 of dividends we have paid during the same period.

Interestingly, as you can see in the bar chart on the bottom, our two weakest book value quarters were Q3 2010 and Q3 2011, both of which were characterized by substantial declines in interest rates. Why? There are a number of factors including the timing of equity risk and accretion, but a key driver is that AGNC hedges a significant portion of its interest rate risk and mortgages often underperform when interest rates fall quickly. In particular, the premiums or pay-offs of slower prepaying mortgages tend to lag behind changes in interest rates as the market generally requires some time to adjust to a changing prepayment landscape.

So what are the key takeaways from this slide? I think our multi-year track record demonstrates that it is possible for an actively managed portfolio with the right assets coupled with appropriate hedges to not only produce industry leading returns over time, but to do so with greater consistency and less volatility.

So now, I’ll turn the call over to Chris to discuss the changes to AGNC’s portfolio during the quarter.

Christopher J. Kuehl

Thank you, Gary. On slide 8, we’ve updated a familiar graph highlighting the prepayment differences between various types of 2011 30-year 4% pass-throughs. You can see that pools backed by loans with lower loan balances as well as loans refinanced through the HARP program continue to perform extremely well, relative to more generic TBA pass-through’s which have meaningfully spread out despite being a relatively new production cohort.

As Gary reviewed with you on the market updates, interest rates are again at all time lows and therefore asset selection is more critical than ever. Given today’s low interest rate environment, we expect to see prepayment speeds on more generic TBA pass throughs continue to diverge from HARP and lower loan balance securities. Many Wall Street investment firms expect speeds on TBA 30 year 4% to be well into the high 30s to low 40s over the next several months. On the other hand, lower loan balance and HARP securities will likely increase by only a few CPR.

As we turn to the next slide, keep these speeds in mind. Now on slide 9, we have two hypothetical yield tables that illustrate the importance of prepayment speeds and their impact on returns. In the table on the top half of the page, we have generic 30 year 4% which are currently prepaying in the mid 20s and as we discussed on the prior slide, these securities will likely be paying closer to 40 CPR over the next few months.

Now look what happens to ROE as prepayment speeds increase. At a 20 CPR, we have an asset yield of 2.25% in this example. If we assume a cost of funds of 70 basis points, at least the net spread of 1.55% and if we apply 7.5 times leverage, that generates a gross ROE of 13.88%.

Now look what happens at 30.0 CPR. The asset yield drops to 1.46%, which leaves us with a net spread of just 76 basis points and with 7.5 times leverage, your ROE drops to 7.16%. Now on the table, on the lower half of the page, we again have 30 Year 4.0%. However, here we’re calculating the yield at a price 2 points above the TBA price. This is roughly where some higher LTV HARP securities were trading as of June 30. You can clearly see that despite the strong price performance of these strategies over the last few months, there is still a lot of value even on today’s HARP apps.

At 7.5% CPR, which is roughly where these securities have been tamed, we have a gross ROE at nearly 19%. Even if speeds increased by 5 CPR, which is beyond what we would expect in the current environment, the returns are still above 15% in very compelling relative to more generic TBA 30 Year 4.0%. Given today’s low interest rates and high dollar prices, prepayments fees are going to be a primary driver of performance with or without a third round of QE from the Fed.

Let’s turn to slide 10 to review the composition of the investment portfolio. During the quarter, we increased our holdings of lower coupon HARP and lower loan balance pass throughs to nearly 70% of the total portfolio. But equally as important is that more than two-thirds of the portfolio is other non-HARP loan balance positions are in low coupons. In the case of 15 year, these positions are mostly 2.5 than in the case of 30 year mostly 3.5. You can see more detailed break-down of these positions by coupon in the appendix on slide 25, what we give you the percentage of HARP and lower loan balance by coupon.

Then lastly I’d like to highlight the fact that the portfolios prepayments fees remained well contained and actually well fell during the quarter despite fees on more generic security is increasing.

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

Peter J. Federico

Thanks, Chris. Today, I’ll briefly review our funding and hedging activity. I’ll begin with our financing summary on slide 11. The cost of our repo funding increased 5 basis points during the quarter. At quarter end, our average repo cost was 42 basis points, up from 37 basis points the prior quarter. This increase was driven predominantly by a general increase in repo costs and to a lesser extent by the longer average maturity of our repo funding.

During the quarter, we further reduced roll over risk by extending the average maturity of our repo book. At quarter end, the average original days to maturity of our repo funding was 121 days, up from 104 days the prior quarter. As you can see from the table, a significant portion of our repo funding now includes maturities in the one, two, and three year sectors.

To put this maturity expansion in context, just 12 months ago, our repo funding had an average maturity of 20 days. Since that time and consistent with the growth of the portfolio, we have termed out a significant portion of our funding, thus reducing roll over risk and developing greater access to longer term repo funding.

A summary of our hedge positions is provided on slides 12 and 13. Slide 12, shows the detail associated with our swap and swaptions portfolios. Given the decline in interest rates experienced during the quarter and a change in composition of our asset portfolio, we increased the size and duration of our pay fixed swap portfolio. With swap rates reaching historical lows, we believe further rate declines, and hence the downside price risk for swaps is relatively limited.

In contrast, in a rising rate scenario swap rates have no such bound. As a result, we believe the price profile of swaps at these low rate levels is somewhat similar to the price profile of an option, with limited price declines in a falling rate scenario and unlimited price gains in a rising rate scenario.

Given this asymmetric profile, we preferred pay fixed swaps over other hedge instruments last quarter. As a result, we added $12 billion of new pay fixed swaps during the quarter, bringing the total swap portfolio to $48.6 billion at quarter end. These new swaps had an average term of 6.7 years. Given the addition of these swaps the average maturity of our swap portfolio increased to 4.3 years at quarter-end from 3.9 years the prior quarter.

On Slide 13, we break-out our other hedge positions, namely our treasury and mortgage hedges in greater detail. Taken together, our total edge portfolio covered 91% of our debt balance at quarter end. On an average during the quarter, our hedge portfolio covered 88% of our debt balance, up significantly from 78% in the first quarter. We chose to operate with a higher hedge ratio last quarter, because we believed it was appropriate given the confidence that we have in the performance of our assets in a falling rate environment, and given the market conditions we fixed.

As portfolio composition and market conditions change, we will adjust our hedge ratio accordingly.

Turning to Slide 14, I’ll review our duration gap information. Due to the combination of falling interest rates and portfolio positioning, our duration gap shifted to negative 0.44 years at quarter end from a positive duration gap of 0.41 years the prior quarter. This shift in our duration gap was driven by changes in both our asset portfolio as well as changes in our hedge portfolio.

The duration of our asset portfolio decreased to 2.27 years from 3.3 years, as interest rates fell during the quarter. The duration of our hedge portfolio increased to 3.1 years from 2.9 years as we added a significant amount of longer term swaps to the portfolio.

Given the low interest rate environment and the potential expansion risk in our assets, we believe maintaining a negative duration gap and a higher hedge ratio was prudent from a risk management perspective. At the current rate level, the duration of our asset portfolio is near its low point. In contrast, if ratified significantly, our asset duration could expand to about six years. By maintaining the negative duration gap, we essentially pre-hedged some of that potential extension risk.

Additionally, in the current environment, we believe our assets will likely exhibit longer duration than those implied by our model.

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

Gary D. Kain

Thanks Peter. Now, let’s turn to Slide 15 and take a quick look at the business economics. Focusing on the two left most columns, you can see that our net interest spread compressed to 162 basis points from 207 basis points at the end of Q1. A little more than half of the decline came from the lower asset yield and the biggest factor here is the impact of our faster prepayment projections and what they had on premium amortization. More specifically, the change in prepayment estimates accounted for at least half of the 25 basis points decline in asset yield.

Now our cost of funds also increased during the quarter by 20 basis points. And this was a function of two main drivers. first, repo rates were about 5 basis points higher. second, as Peter discussed, we’ve made the conscious decision to increase our use of swaps and the duration of our hedges in response to record low interest rates. The higher swap cost accounted for the remaining 15 basis points.

When you take our net interest spread multiplied by the leverage and add back the asset yield, you get a gross ROE of around 15% or a net ROE of 13.6%. Remember, this ROE excludes realized gains and losses on our assets and all the impacts of our supplemental hedges, which also flow through the other income line item. And yes, this ROE snapshot is lower than prior quarters, but it is still compelling especially against the backdrop of a materially lower risk position.

Now, if we turn to Slide 16, I want to conclude by quickly summarizing how the company was positioned at quarter-end. The bottom line is that we feel that our portfolio is tailor-made for the current environment. As Chris mentioned, almost 70% of our assets are backed by the lower loan balance or higher LTV loans originated under the HAPR program. Of the remainder, the majority are very low coupons that should remain relatively slow in the absence of a QE3. If we get a QE3, the Fed’s then should drive valuations on those assets to very rich levels and we would likely sell those positions to the Fed, if we had concerns around prepayments performance.

Lastly, as I said earlier, we’re not netting on low rates or QE3, but we can’t ignore the realities of the market. We have increased our hedges materially, which should help support the performance of the portfolio if interest rates rise for any reason. Yes, these hedges cost money, but they are critical to our objective of producing attractive returns across a range of interest rate environments.

Moreover, if rates decline further due to weakness in the U.S. economy, Europe or Asia, it is highly unlikely that we would be over hedged as mortgage performance should significantly outpace hedges.

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Joel Houck with Wells Fargo. Go ahead please.

Joel J. Houck – Wells Fargo Securities, LLC

Thank you. Good morning. I guess the first question is, Gary, the $1.2 billion capital raise in July, maybe talk about I think it’s implied that you guys continue to like the spec pool trade economics on page 9, I think suggest that. But question is, did you add anymore hedges or was the increase in swaps in the second quarter in anticipation of the equity rates?

Gary D. Kain

So to your last point first, Joel, we absolutely did add hedges with purchases that were made concurrent or around the same time as the equity rates. The hedges that we put on in the second quarter were not in contemplation of doing an equity rates and pre-hedging purchases, we’re very comfortable with that position given the assets that we had at the time. And with respect to kind of new purchases, we continue to maintain essentially the same type of view with respect to hedging on that we had at quarter end.

Joel Houck – Wells Fargo Securities, Llc

And in terms of the deployment of capital on the equity rates, is that similar types of things that you guys have liked on a relative value basis?

Gary D. Kain

Yes, in general, I mean, without going into the specifics, we absolutely have added some specified collateral I mean in the last week or two, the specified collateral has really taken another leg up in terms of price. And so our view is a little more subdued than it was, we’ll say at the end of the quarter given the example that we – in fact went over. But we continue to view lower coupons, the combination of lower coupons in specified collateral is being the right place to be and when you are buying those assets, you also want to have a reasonable hedge ratio and I think we are maintaining that same philosophy with respect to deploying capital.

Joel J. Houck – Wells Fargo Securities, LLC

Thank you very much. That’s great color.

Gary D. Kain

Thanks, Joel.

Operator

Our next question is from Jason Weaver with Sterne, Agee. Go ahead please.

Jason Weaver – Sterne, Agee & Leach, Inc.

Good morning, guys. Thanks for taking my questions. Gary, I was hoping you could give some more detail regarding the prepayment and duration assumptions on both the lower coupon and the HARP 30-year securities. May be you can correct me here, but it seems that aside from treasury starting to look more like the JGB curve, there are relatively few scenarios where you’d expect much real refinancing demand for borrowers underlying these bonds.

Gary D. Kain

I think you are right that – so if you are looking at the – let’s go with the HARP or lower loan balance securities that have kind of demonstrated pretty good prepayment behavior over the last two or three years. We don’t, as Chris said, we don’t expect them to pickup materially even in a kind of a further decline in interest rates or let’s go to kind of an extreme even in a QE3 type of scenario. So we think the cash flows are going to remain very solid on those assets, which is a key reason for being there. But one thing I do want to stress though is you have to be cognizant and one of the real challenges and something that we focus that are incredible and a lot of attention on is, how do you hedge those positions? And you don’t want to just sit there and say, okay, well, the prepayments are going to be slow, so I should hedge them in a sense really, really long, because their market prices and the way they trade will be and will not really track that. And so, I think you have to be more dynamic with respect to how you think about that hedging equation.

Now with respect to the lower coupon fixed rate, I think we need to be a little careful here, we do agree that if you are in the lowest coupons, the call risk or prepayment risk is relatively low. But when you start to get one coupon above that let’s say 30-year 3.5s or 30-year 4s where people have in the past said, those things can’t prepay, I don’t need to worry about prepayments and those types of assets, 15-year 3s. We are already seeing those pickup and there were many scenarios where those could be pretty fast.

So I think the reality is that mortgage rates are at record lows and a much higher percentage of borrowers now actually can execute on that refinancing options. There are two categories, the borrowers who have taken out a loan recently, let’s call it the last two or three years, they are generally good credit and generally have LTV. The borrowers before that generally qualify under HARP 2.0 and clearly HARP 2.0 is working. So I do agree with you that at least have tried to stress, we feel good about our prepayment positioning so to speak, and feel our assets will hold up, and that’s a key reason why we are hedging them longer. I do want to be clear that I think there is more prepayment risk in the mortgage market generally than people are expecting.

Jason Weaver – Sterne, Agee & Leach, Inc.

Thank you. That’s very helpful. And one further question, I think, we’ve seen about [six] preferred deals in this space since yours earlier this year. And it seems like they are getting pretty popular for obvious reasons, but putting the preferred markets liquidity aside for a moment, what would you say would be the optimal proposition of these within the capital structure, if you could raise as much as you need to do there?

Peter J. Federico

I think it’s very depended on, I mean the market conditions and so forth. And it’s depended on how you’re commensurating as well. And so we felt very good about accessing the preferred market and making sure we do where that acquisition was and generally speaking however preferred at this point is has been our kind of choice in terms of trying to access it in let’s say a deep passion. But again, I think it’s hard to say there is an optimal capital structure, I think it’s very depended on market conditions and the execution on common.

Jason Weaver – Sterne, Agee & Leach, Inc.

Okay, thanks very much guys.

Operator

Our next question is from Bill Carcache with Nomura. Go ahead please.

Bill Carcache – Nomura Securities International, Inc.

Good morning. Thank you for taking my questions. Gary, can you comment on your view of policy related prepayment risks from here particularly given the premiums being paid today. You mentioned that it seems like HARP 2.0 is working. Is that – does that extend a bit or do you – is there a risk do you think that there could be additional policy risk on the prepayment front.

Gary D. Kain

So, there is always policy risk and let’s face it – if the economy takes another leg down there will be more discussion, or whatever it looks. In picture we feel that policy risk is probably as low as it’s been over the last three years. And the reason is this is because to your point HARP 2.0 is working. There are things that can be done to make HARP 2.0 more effective you heard from Freddie Mac and FHSA two years ago that there is some changes in the works there. There is the Menendez-Boxer bill that’s being discussed, that would do even more to kind of reduce some of the frictions that make HARP 2.0 more effective. there is also some discussion in that deal of moving the HARP eligibility date one year longer. But let’s take a step back, so there’s still some policy risk out there. There’s so some discussion even though FHFA has given its opinion on things like principal write-downs, which could have a minor impact utmost on the prepayment picture. The big picture, these things are very modest and incremental on the margin and they would apply to a very tiny percentage of our portfolio kind of in aggregate.

So big picture, when you think about what’s even being discussed and a lot of it’s very unlikely that anything happens with it. It's very different from what was being discussed a year-ago when people were talking about mailing of the 4% mortgage rate to every homeowner who would pay their mortgage. I mean, so I think people may just take a step back and say, there is always risk on the policy front. but if you look at what’s being discussed at this point versus what was being discussed a year-ago or a year before that, the changes are very incremental in nature. and for most mortgage portfolios that would affect a very small percentage of holdings. and then in the case of AGNC, even the Boxer bill would affect a very small percentage of our holdings.

Bill Carcache – Nomura Securities International, Inc.

That makes a lot of sense, it’s really helpful perspective. Another question I have is you’ve crystallized for us how to think about what happens in different economic scenarios, and if we focus on the QE3 scenario, you’ve highlighted how it’s not a wholly locked scenario, the curve would flatten, and we'd see further spread compression, but there would be a book value benefit. if I could ask you to just look past a bit further out past that initial book value benefit, would the premium in the industries book relatively high. Do you worry about kind of the eventual loss of demand from the side and the extent to which there are no natural buyers out there for 30 year mortgages and ultimately what that means for prices? I guess, I’m just trying to get my hands around the risk that the big premiums being paid for agency yesterday will somehow come back [throughout] industry at some point down the road. If you could just help me kind of and how to think about that?

Gary D. Kain

Sure. I mean first off, I think there was a real misconception out there that the only reason mortgage prices are where they are is because of kind of government involvement in the mortgage market. I think one thing that people need to focus on is that it is much safer and easier to hedge mortgages in this environment. As Peter discussed with respect to – you could see it in kind of the way we're hedging.

Mortgage investors have to be very concerned at times on paying on swaps or paying short treasuries or some of the things that we all do to hedge our interest rate risk, because if interest rates fall mortgages prepay and don’t keep up. But as we’ve talked about, the risk of being over hedged and kind of the amount of prepayment risk in the new loan coupons is so much lower that it’s been in the past.

And because of that, the – kind of risk-adjusted returns on mortgages are still very reasonable even without QE3. And then if you go to the page, in our presentation, page 9 were Chris went over in a sense the returns on the specified mortgages, yes they’re trading at high dollar prices, but they're trading at high dollar prices, because prepayments are reliable and once you take that out of the equation, then the returns are actually pretty reasonable. So I think big picture, our view is that the mortgage market is supported by a number of different factors and yes, in a QE3 scenario there will be a time where certain coupons will be unattractive to most other people besides the Fed, but we actually don’t believe we’ve reached that point.

Bill Carcache – Nomura Securities International, Inc.

Great. Thank you very much. I will jump back in the queue. Thanks.

Operator

Our next question is from Daniel Furtado with Jefferies. Go ahead, please.

Daniel Furtado – Jefferies & Co.

Hello, everybody. Thank you for taking my question. The first question is on this change in the premium or the catch-up that happened in the quarter, can you help us understand is this due to portfolio composition changes or was this movement due to your change in view of the future?

Gary D. Kain

So the catch-up component is not due to the composition of the portfolio, it’s due to raising our projected prepayments fees. So if in the prior quarter, we ran the portfolio at 9 CPR and this quarter we are running the portfolio at 12 and let’s ignore kind of the changing composition for a second, catch up, Dan, really only applies to the existing portfolio, not the new part of the portfolio, but it’s really related there kind of two ways that that prepayment change affects your yields and your spread income.

And the two ways are, first off, just because you are running it at a faster speed, the yield is lower and you are going forward going to amortize premiums quicker. That’s the normal impact, but you also have to in a sense catch up for the fact that you had been running the security slower in the past. And so there is sort of a one time or non-recurring change due to that increase in the prepayment speed which is what we referred to as the catch up component. So and the go forward numbers is running the security at the 12 CPR. And so that’s kind of more of a lasting impact, but then there is usually one-time adjustment where you actually account for the fact that you have been running it slower before.

Daniel Furtado – Jefferies & Co.

Gotcha. I guess what I am trying to reconcile is that your assumptions for the future for CPRs move up modestly. But over the last couple of months we’ve seen CPRs move down pretty materially and I guess – are you just factoring this recent move in the 10 year or incorporating the potential QE3 in that forward outlook or I guess that’s really what I am trying to reconcile. We’ve seen things improve but yet your expectation is for things to worsen from where they were a quarter ago.

Gary D. Kain

One thing that we want to be very clear on with respect to the prepayment projections is that it is important when you do this to use a defined process. And so we’ve said in the past and it’s absolutely still true with respect to the prepayment forecast, is that we rely on an outside provider Blackrock Solutions and their model essentially reacts mostly to the change in interest rate. So the flatter yield curve and the considerably lower 10 year treasury and the higher mortgage prices are the key inputs to that model. And then that model generates faster prepayment estimates.

Now periodically, as new information comes in around the securities where may they don’t prepay as fast as the model had thought, then adjustments get made and then there is we will call it a true up process. But that’s a slow moving process realistically, I mean and key driver of that increase in prepayments fees is purely the change in the interest rate environment and it is essential very much a model driven type of result. And I want to be clear, it’s our responsibility to believe that the model is producing reasonable numbers and we do. But as we see the actual prepayments unfold then we certainly factor that information in, in terms of projections going forward.

Daniel Furtado – Jefferies & Co.

Great, and thanks for that clarity. And if I may just quickly, more philosophically, but I know that IOS are [a touch dangerous], should prepays pickup, but at what point do IO securities start to make more sense for you? And then you have a small amount on a notional basis now, but is there an environment where you could see becoming much more aggressive on using IOS as a hedge?

Gary D. Kain

Absolutely, there are environments where we think IOS make a lot of sense. I think one of the things that has let us to kind of use less of them over the last year let’s say because we had a relatively larger position, we had a decent sized position let’s say at the beginning of 2011. But most of the IO that’s available to trade in the marketplace is in the HARP 2.0 eligible cohorts. And we’ve had an opinion that that’s not an area that you want to dedicate, where you want to take prepayment risk. Now we feel that as most people are probably aware the higher coupons, 5s, 5.5s and 6s, which are eligible under HARP 2.0 or most of them are eligible, are now prepaying kind of near or above 40 CRP, and so HARP 2.0 has clearly worked. So we feel good about having avoided those cohorts. With respect to kind of IO of lower coupons, if it were available in reasonable size and if pricing made sense, it’s certainly something that we would look at. But in the HARP 2.0 universe where kind of most of IO that trades is available, we’ve been kind of embraced on it so to speak.

Daniel Furtado – Jefferies & Co.

Great. Thanks for the time, Gary. I appreciate it.

Gary D. Kain

No problem, thank you.

Operator

Your next question comes from Bose George with KBW. Go ahead.

Bose George – Keefe, Bruyette & Woods

Hey, good morning. I was just wondering your quarter end spread that 162 basis point number. I am just curious if you could give us maybe where that is right now?

Gary D. Kain

I think big picture, we’re not going to update any kind of financial numbers in for quarter. But our mortgages have certainly tightened and pay-offs in a sense have gone up. But for the existing portfolio, the biggest moving parts were things that occurred during the second quarter. In other words, if you look at the change in interest rates this quarter and change in prepayment fees, most of any impact there would have been felt in Q2. Most of our change in our hedging framework occurred in Q2. So I mean if we talk about the drivers of spread compression, they’re largely drivers that kicked-in in the second quarter versus drivers that are kicking-in in the third quarter.

Bose George – Keefe, Bruyette & Woods

Okay, great. That’s helpful. And then actually just on the duration, I am curious your negative duration at the end of second quarter, does that suggest that you’re less – that you’ll be less benefited from QE3 than you would have been back in the first quarter.

Gary D. Kain

It depends. It’s a short answer. It’s very possible that we will benefit less from a QE3. So if a QE3 occurs and drives treasury yields, and swap yields lower then clearly we will be hurt by having incremental hedges. Again, we feel like our assets would perform very well in that scenario.

However, if QE3 occurs and mortgages are the main beneficiary, but the equity market let’s say improves, you could very easily see like what you saw with QE2 a situation where treasury yields actually stay the same, but go up, in which case then we wouldn’t be impacted by the hedges. I mean, honestly I don’t think we’re not calling for treasury yields to back up in a QE3, I think our mindset on the positioning with respect to hedges is one of – let’s be able to perform in either scenario. But one thing we feel pretty strongly about is, we don’t want to have mortgages that are significantly exposed on the pre-payment front, because there is really no good way to hedge that exposure, we would rather have kind of better performing mortgages and then use interest rate hedges. We feel that that’s the right way to position the portfolio and that’s what you’re seeing from us.

Bose George – Keefe, Bruyette & Woods

Okay, great. Thanks a lot.

Operator

Our next question is from Arren Cyganovich with Evercore. Please go ahead.

Arren Cyganovich – Evercore Partners

Thanks. On the repo side, I’m just curious, if you could talk a little bit whether you are getting close to full capacity with your repo counterparties and how much additional upside do you have with your repo counterparties?

Gary D. Kain

With respect to repo, we’ve certainly grown into number of counterparties. We’ve grown our repo balance. I think what I would say is, we feel we have sufficient repo, if we have some push in our unused capacity. but I do want to be clear, the repo does not grow on trees, and it’s not like you can just push a button and have $20 billion of repo capacity, let's say just appear. So we feel very good about repo, we certainly feel that there are other counterparties out there that we can get repo from over time. We feel that we can probably get the additional capacity from some of our existing players, but we also want to be very clear that it is not a limitless resource, and that’s certainly factored into all of our decision-making.

Arren Cyganovich – Evercore Partners

Okay. on that same topic, what other options do you have if you intend to grow your balance sheet further as you have the past couple of years?

Gary D. Kain

I think the first thing is that we are cognizant of the fact that we’re not going to maintain the same growth trajectory given our current size. so, I mean, I think the first pieces is that people should just recognize that. but second of all, I think there are a number of different options, which I don’t really want to go through on this call to over time expanding the funding options for agency mortgage securities. there are a number of things that we’re currently working on that front that we feel will provide benefits over time. But again, I think it’s probably not appropriate for us to go into one more call.

Arren Cyganovich – Evercore Partners

Okay, thank you.

Operator

Our next question is from Jasper Burch with Macquarie. Go ahead.

Jasper Burch – Macquarie Research

Hey, good morning everyone. I guess just starting off with you spent a lot of time on the call talking about what risks you don’t have and what risks you’re hedged against. I just wondering, I mean, I guess on the current portfolio and then on the new assets that you are putting on, I mean what are the risks that you still see out there, that is sort of most material or meaningful or even the sort of less likely risk that’s really hard to hedging [in this environment]?

Gary D. Kain

The two main risks obviously when we buy mortgages and we hedge those mortgages with interest rate swaps and other financial instruments, if mortgage spreads or prices decline without an offsetting move in our hedges, we will lose a fair amount of money in terms of mark-to-market of the portfolio. So what some – what people call kind of mortgage basis risk is a key component.

Obviously there is prepayment risk, I think we've talked at length about why we feel good about our position there. There's liquidity risk and funding risk and I think we’ve talked about some of those things that we've done there. And then lastly there is always negative convexity, which is the hardest thing to deal with when it comes to hedging a mortgage portfolio, which is any big move in interest rates requires rebalancing and active management of the portfolio. And so, that’s something that we always keep track off. So I think that, I mean there is obviously other risk, you can read the Qs and Ks for additional risk factors, but those are some of the bigger ones.

Jasper Burch – Macquarie Research

And then, I guess just on the negative convexity, I mean putting on mortgages in this environment, lower yielding, higher basis price, it seems like that risk if anything is going up as you expand the portfolio. I was wondering, is this – are you – is it just based on bet that you know we’re going to continue in this lower interest rate environment for a long period and then when rates do eventually rise, it will be at a modest club.

Gary D. Kain

Well, let me start and then I am going to hand it over to Peter. What I want to actually I think that risk in terms of negative convexity and hedging is not going off. And because you can afford to hedge the extension risk, more so than you could in a normal environment, and that because rates are sort of float at zero or near zero depending on how you want to think about it, your downside when you put on hedges right now is very different from when if you put on a 10 year swap at 4%, you could loss 300 basis points putting on a 10 year swap at 160 basis points. What’s the Japan scenario maybe it’s 100 basis points or 110 basis points, something like that for 10 year swaps. So that’s a manageable kind of move. So I think bigger picture, it’s important to keep that dynamic in mind. And then to the other point, which I’m going to let Peter speak to it, we absolutely are not betting on the Japan scenario, there’d be plenty of other positions were we tag on.

Peter J. Federico

Yeah, we’re certainly not betting on the fact that if interest rates rise, they’re going to rise in a slow and measured way. They could rise very rapidly and that’s really why I try to point out that some of that extension risk in our portfolio has to be prehedged. We don’t want to rely 100% on our ability to rebalance the portfolio as interest rates are changing. So buying at swaptions for example are a great way to pre-hedge some of that extension risk and we will continue to focus on our swaption portfolio. And using our duration gap, like I mentioned positioning the portfolio at negative or about half a year again is a way to pre-hedge some of the extension risk, so that when rates rise you are not forced to rebalance into a volatile market and there can be a scenario where we would run even a larger negative duration gap than what we’ve reported this last quarter.

Jasper Burch – Macquarie Research

Okay, that’s all very helpful. And then if I could just ask one more, I mean in the opening remarks, you said that there is a tailwind to book value and I think we’ve all seen that booking at the mortgage market. I mean how much of that do you think is driven by an expectation for QE3, and so that how much more upside could there be in a QE3, if that occurs and then what’s the downside if it doesn’t, do you think the book value pulls back?

Gary D. Kain

I think that it’s a tough question, I mean, I obviously will be – I’ll try to give you an answer, but I just want to be clear to people that there’s no easy way to extract how much, what percentage of a QE3 is priced into the mortgage market or what market participants think the odds are and so forth. my personal opinion is that mortgages should be tighter than people otherwise expect in this environment for the reasons we’ve talked about, the lower rate environment, the ease in hedging them. the fact that 100 basis points spread over a treasury is a lot more valuable when the treasury is at 100 basis points than it is at 300 basis points. It’s a much higher percentage of the aggregate yield. so there is a number of reasons why mortgages should be pretty tight right now. And I think that some investors are kind of misreading that. And they’re assuming that this is all about QE3 is priced, it’s 90% priced in. Our mindset is if mortgages have done very well this quarter, but we still think that if you’ve got a large QE3 that involved mortgage purchase – large amounts of mortgage purchases from the Fed that mortgages would end up being significantly tighter than where they are today, call it 0.75 to a point tighter over time. And is there a downside if QE3 gets priced out? Definitely, there are certainly players in the marketplace that view that as kind of luxury so to speak. But we think it’s considerably less than we’ll call it the move that we would get if QE3 were to happen.

Jasper Burch – Macquarie Research

Okay. Thank you, Gary and team very much as always you’ve given us a lot to think about.

Gary D. Kain

Well, thank you. I appreciate it.

Operator

Our next question is from Douglas Harter with Credit Suisse. Go ahead please.

Douglas Harter – Credit Suisse

Thanks. You moved your repo maturities pretty noticeably. Do you have any plan to further extend those maturities?

Christopher J. Kuehl

Yeah, I’m glad you ask, I mean we have made a very conscious effort to try to continue to extend our repo maturities, reduce our rollover risk. We feel like it’s the right thing to do, to continue to focus on that, and we will do that. We were finding good liquidity out, call it into one, two and three year sector. So, we will continue to try to access that funding. We think there is availability there and we think it’s at a relatively attractive rate. So it won’t be limitless, but it is something that we’ll continue to focus on.

Douglas Harter – Credit Suisse

And could you just give us a sense as to how much more expensive, I’d say one year repo is right now versus 30 or 90 days?

Christopher J. Kuehl

Yeah, just round numbers, one to three month repo is probably in the 40 to 45 basis point range, six month, let’s call it 50, 12 month maybe at 16 and you could see from our table out and we call it 25 to 36 month range, our cost is around 75 basis points. So, it is higher certainly than our overall portfolio average, but at 25 basis points, it’s probably higher than the average, we think that that’s the money really well spent.

Douglas Harter – Credit Suisse

Great, thank you.

Operator

Our final question is from Chris Donat with Sandler O'Neill. Please go ahead.

Christopher R. Donat – Sandler O'Neill & Partners LP

Hi, just one quick one for you, Gary. You’ve talked about the sustainability of the dividend over the near-term. I’m just – see if I can pin you down on what you mean by near-term, was that quarters or years? And then as a related function, the undistributed taxable income, so I think of that as like a reserved account that will be there at some level in perpetuity or some – or is it an amount that you would be willing to drawdown to zero? Thanks.

Gary D. Kain

No, problem. Thanks for the question. Look, what I’ve said was at least over the near-term was the wording, and I really can’t see more specific than what I’ve said with respect to that. Now with respect to the undistributed taxable income, I think what’s really important here is that our taxable income overall let's just go back and talk about where it came from. It came from the fact that our taxable income over the last three years or so has exceeded our dividend. And so, we have basically accrued a lot of taxable income that has yet to be used to pay a dividend, but will be over time. And so I think the best way to think about that is something that materially reduces the risk that taxable income will be a constraint on our dividend. That doesn’t mean that at some point we’re just going to sit there and continue to pay this dividend or raise the dividend until that number goes to zero, that’s not the mindset, there were other factors that go into the dividend. But I think the way you should think about undistributed taxable income, is just the way I described it, and as something that really limits the risk over the near-term, that’s we're going to have a taxable income shortfall under a kind of a pretty wide range of scenarios. The real factor, and what I want to stress, and what I said in the statement was the reason, we feel very good about the dividend is not only as taxable income exceeded our dividend. But clearly our kind of true economic returns have exceeded our dividend as well and that’s why you’ve seen a consistent improvement in book value over time. And it is the combination of those two factors that give us the confidence to make the statement that we made.

Christopher R. Donat – Sandler O'Neill & Partners LP

Got it, thank you.

Operator

There are no further questions. the conference is now concluded.

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