American Capital Agency Corp. (NASDAQ:AGNC)
Barclays Global Financial Services Conference
September 12, 2012 10:30 am ET
Gary Kain - President and Chief Investment Officer, American Capital Agency Corp. President, American Capital AGNC Management, LLC
Good morning. I am pleased to introduce our next speaker, Gary Kain, American Capital Agency. Gary is the President and CIO of the company. I am sure many of you know him well. American Agency has evolved the mortgage REIT, has generated pretty dramatic alpha with average total returns in excess of 30% plus for the last several years.
With that I will hand it up to Gary. We look forward to your comments.
Well, thank you and really thanks for the opportunity to present at the conference and also for that kind introduction. First off, I really want to thank everyone for your interest in AGNC, both, here, in the auditorium and people that are listening via the webcast.
Now, probably what you are expecting from what we usually do at these conferences, which is in some way or another a rehash of our last earnings presentation and kind of highlight a few things from that, but I think you are in luck if I am not going to do that this time. I mean, the bottom line is the biggest story in the markets right now, and this is true of the equity markets or the bond market, is QE3 and whether it's going to happen, whether Fed is going to embark on more quantitative using, and one of the implications for the mortgage market since interestingly while other markets are talking so much about it, I think it's kind of widely expected that if the Fed executes QE3, it's going to involve a large amount of purchases of agency MBS, and that's our market, it's clearly a big picture issue for us and for the space, so I figure I would kind of focus today's discussion on that topic.
The other thing is, I want to be clear. I don't want to sit here and guess about whether are going to do it or not, or I am not going to sit here and talk about try to opine on whether or not they should do it. Honestly, I don't think Chairman Bernanke, really cares about my opinion nor should on whether he should go down that.
I think I think really what I'll leave it at is, I think clearly if you'll listen to the minutes or a few or look at the minutes, I think most people agree that it this point it's a very real possibility. Let's call it maybe likely they are not, but no other darn deal, so it's a real risk. It's a real possibility and how do we think about it, how would it affect our business.
Before we go right into that, let me start on slide three, and just quickly talk for a second for those of you who are new to AGNC about the company. Agency is an agency mortgage REIT, and as we only invest in securities backed by Freddie Mac, Fannie Mae or Ginnie Mae. Since all of those entities obviously received substantial backing from the federal government, we are really not taking a lot of credit risk.
We do or we are exposed to other risks such as prepayment risk, interest rate risk, liquidity risk and a host of other things which are outlined in our Qs and Ks, and in our earnings presentations that are available through the website, but just quickly I want to focus a little bit on the history of AGNC on the left side of the slide.
Agency went public went public in May of 2008 at a dollar price of $20. Probably the most shocking statistic is that and though it's not a misprint, since its inception less than five years ago, 4.5 years ago, it's paid $21.36 of dividends. Most importantly, while paying those dividends, we've also grown our book value from $20 per share to $29.41 as of June 30th. Again, in the end when you look at returns, dividends are great. You don't dividends to be coming out of book value, and I think what we feel really good about is the ability to produce both, to have produced significant book value gains, which I think has lead to share price performance in addition to producing great returns on the dividend front.
With that let's jump into the "meat of the presentation", which again relates to QE3. The first question that we are really going to like try to answer is, why do we care? We supposed to just say, well, look we can't control what the Fed does, we are a long-term investor. Should we even care about QE3? The bottom line is that, we have a responsibility to our shareholders to position the portfolio for a range of different scenarios.
The key risk that we are concerned about are prepayments and interest rate risk and QE3, certainly is designed to some degree to affect those, so realistically since QE3 could have a very significant impact on both, mortgage prices, valuations return, and can have a significant impact on our cash flow, right? How fast mortgage is prepay, it doesn't make any sense for us not to focus on this issue especially given that it's obviously a real possibility Agency mortgage purchases would be most likely a very large part of the picture, and those purchases have those ramifications. Again, both on pricing and valuation, but importantly also on our cash flows so from our perspective not an option not to pay attention here.
Let's just take another look at this a little more. All right, here the Fed may buy mortgages, what are they going to do? Do they buy a cross-section of the entire market? Do they impact all mortgage securities essentially the same way? Absolutely not. I mean, the Fed is currently active in the mortgage market. It is reinvesting its pay downs, where the prepayments on its existing holdings into lower coupon mortgage backed securities and these are fixed rate mortgages, specifically securities backed by or securities with 3% 3.5% coupons in 30-year in securities with 2.5% and 3% coupons in 15-year, so the lowest coupon fixed rate.
Now, it's not a coincidence that the Fed is buying the lowest coupon fixed rates. Why is the Fed buying mortgages, why would they buy mortgages in a QE3 scenario. They are hoping to help the economy. They are hoping to create incremental refinancing activity. They are hoping to lower mortgage rates and get people to buy homes. Well, if that's your objective then you have to buy the production coupons. The coupon that drive the mortgage rates that will hopefully flow through in some way shape or form to borrowers, and so we certainly and I think most mortgage people expect the Fed would continue down the same path which is focusing the vast amount of their resources on the lowest coupon fixed rate mortgages, because that's what achieves their purposes. And if rates stay kind of ballpark where they are, and the Fed is successful in driving prices up, you would actually expect the coupons of what the Fed's purchasing to continue to migrate to lower coupons over time, and so importantly, if the Fed shows up, expect them to be buying the lowest coupon fixed rates. They are not going to buy ARMs, they are not going to buy specified mortgages or low loan balance, they tend to buy generic mortgage products.
Moving onto the next slide, the next question that obviously comes up is, how is this activity likely to impact MBS prices? Well, the first thing is, we just talked about what the Fed is going to buy, and we are going to buy the lowest coupon fixed rate, so those securities are going to be directly impacted by the Fed's bid, and look the sizes of what the Fed could buy range, estimates range from $250 billion up to even $600 billion in mortgage-backed securities. Obviously, how much and what type of program it is could influence that, but we actually believe that we saw maybe a quarter point of this on Friday with the unemployment number is that raise the expectations around QE3, but we think a point in outperformance on lower coupons versus swaps or treasuries is certainly possible over time for lower coupons. It won't happen immediately, because what we've seen from other actions from the Fed is that the absorption of supply over time is probably the bigger driver than their day-to-day activity, so it takes a while for their program to kind of have absorbed a lot more mortgages, so maybe three, four, five, five months into their program, we wouldn't be surprised to see significant price moves, again, maybe upwards toward a point in outperformance of some of the mortgages.
Let's be practical. The lowest coupon mortgages don't make up a huge percentage of what's out there in the world, and actually if you looked at the REIT's space, it's probably a very small fraction. It's probably less than 20% of the holdings of mortgage REIT community and agencies are the coupons that the Fed will actually be buying, so what happens to the rest of the market?
One speculation is, well, look. You could start with, well, yes. The Fed's not buying the other coupons, but all agencies are going to go up a lot in price, because look I know what happens. The Fed buys the lowest coupons, the people that would have bought those, they get kind of crowded out and they move up to higher coupons and they would go somewhere else, so it gets spread out pretty much throughout the market. That's a reasonable expectation and that happens in a lot of other products, but there is another factor that you have to keep in mind and that is the fact that prepayments speeds on mortgages are tied to the lowest coupon mortgages. Again, they affect the mortgage rates to borrowers to a degree, not one-for-one, but to a degree and over time. As the Fed drives the prices up of lower coupons, it also increases prepayment risk on the other coupons, and because of that there are two offsetting factors. Yes.
The Fed is going to reduce the risk premiums or kind of yield bogies for people in the mortgage market as a whole and in throughout all asset classes and that's why one of the reasons they are doing this, and let's say they move things 15 basis points. Well, that's going to help push prices up a little on the rest of the mortgage universe, however these are all very high priced securities. 106, 107-type dollar prices, and they are very sensitive to prepayments speeds, so if the Fed increases the expectation around prepayments by let's say 5 CPR by buying the lower coupon securities, then actually that 5 CPR is worth more than the 15 basis points of lower yield bogies, and so you could literally make a very strong case for the prices of some of these securities going down in a QE3 environment.
I think it's really important to say that, look, you don't necessarily have to see and you are not likely to see the same pattern of price performance throughout the agency market, securities that are kind of protected from prepayments or security more protected from prepayments, and securities that are directly impacted by the Fed are going to appreciate quite a bit. The securities are sensitive to prepayments and aren't directly supported by the Fed are a much tougher kind of question to answer and I think it really relates to the amounts the market kind of prices in, or the actual changes in prepayment behavior, and that will be kind of the key driver of the ultimate performance of those securities.
With that as being a key driver, let's move onto the next slide and ask that question. Will prepayments really change? When you look at this, you start by saying, look, it's not automatic. I think, it's automatic that the Fed's program of driving lower coupon prices up will have some impact. The question is, how big is that impact? Look, let's start with the arguments that people would make saying it's not going to have that big of an impact. Look, people have been talking about low mortgage rates for a while. We have low mortgage rates, but a lot of ours don't qualify for those mortgage rates. Underwriting has been tightened, a lot of people don't have LTV, whatever, so look it's not that big of a deal this time around.
Other one is look, mortgage rates are already at record lows. Most borrowers already have incentive to refinance, and so we are already in that kind of situation. Probably the most important one, originators are operating kind of near full capacity. They are working for very wide profit, spreads, because, look, they've got all the business they can handle. They might as well not pass along the next [eight or] quarter for rate and work for a higher spread. That's probably the most material kind of factor.
Let's take a step back and let's look at those arguments and let's look at it from the other perspective. Most importantly, the universe of borrowers that really don't qualify for new mortgages right now is actually pretty small and it's much smaller than it was a couple of years ago.
There are really two groups of borrowers. There are the borrowers who took out loans over the last two or three years, since 2009, who have equity in their homes. They have qualified under the new tighter underwriting and they can refinance now without any special programs, they are going to generally qualify and we are seeing them do that, so they can qualify. Then the area that where people really were having trouble qualifying was the older mortgages kind of pre-2009, but the HARP 2.0 program put in place at the end of last year is absolutely working. Those borrowers, we were seeing prepayment speeds on some of those cohorts, so the 2007, 2008, 5s and 5.5, getting close to 50 CPR. That's almost double where they were a year ago before that program was put in place. It's working.
When you put that together, the reality is that the majority of agency borrowers can refinance right now. There is a perception that that's not the case, but that perception is wrong. To give you evidence of that, just the prepayment release that was put out by Fannie and Freddie on Friday night indicated that the 30-year fixed rate universe, average CPR for all outstanding was 31.5 CPR, okay? That's everything. That's not 5, I mean that's not 10, 15, 20 CPR. Just a few months ago that was the low 20s.
30 CPR is not the 60s and 70s, which we saw for a brief moment in 2003, but the prices of the mortgage market and there is no expectations of 60s and 70s, and a 30 CPR for this environment is actually a pretty fast speed, so importantly borrowers can qualify. You are already seeing it in refinancing levels. The real question is, does that change and how much does that change with the Fed if they get involved, and here is our concern.
We think that a big factor is what people a media effect. We are all talking about the Fed, but look we talk about the stuff. We are in the financial industry, but every new show in addition to the election is talking about QE3. If this is actually implemented, it's going beyond the U.S.A. Today, it's going to be on Good Morning America, it's going to be discussed at parties about how mortgage rates are 3.25 or 3.50%, The Fed is buying hundreds of billions of mortgages and you've got to take advantage of that, so awareness demand for mortgages will increase because of the high profile of the Fed activity, and originators will increase their capacity. I am not sure how much, but they will feel that the business is going to be there for a longer period of time and it's going to make sense for them to add employees capacity to get a handle more refinances, because they are probably going to be handling that business for a longer period of time.
Additionally, the amount of incentive to refinance is going to increase, because on the margin over a six-month period, rates are going to be lower, mortgage rates are going to be lower than they otherwise would be, so when you put that together, our mindset is it's on a 19-day change on the prepayment front, but it's not insignificant. Realistically, we feel that QE3 elevates prepayment risks, will over time elevate prepayments speeds and it is absolutely important to factor that in to how you position your portfolio or it's going to significantly impact your returns.
With that in mind, how is AGNC positioned against this backdrop? Look, if we feel we have the right assets, and what the right assets mean are assets that are going to remain relatively stable from a prepayment perspective and we feel that we can still generate reasonably attractive returns, so those assets of that 70% of our portfolio is backed by either lower loan balanced mortgages, smaller loans that have kind of demonstrated that they remain relatively stable in terms of prepayments even when rates fall.
Why is that? I mean, we've talked about it a lot. I think, others in the industry have, but two main reasons. First is that there are fixed costs in refinancing, and if you have a small loan, it's really hard to overcome. We need a much bigger rate differential, so it's not really worth that promotes borrowers with small loans to refinance.
Second of all, go back to that capacity issue, and it's even more true in a QE3 environment and this is what's really helpful about these types of securities. The more Wells Fargo or Chase has to ration their origination capability, the more they've got so much business they don't know what to do with it. Are they going to do $100,000 loans and make one fit as much as they do on a $500,000 loan? No. That's bad business and it's going to cost people. They are going to make a lot less money, so the short answer is they push lower loan balance and smaller loans to the backburner.
The other area that makes up the 70% is securities originated under the HARP program. HARP 2.0 was working, but the borrowers that go through that or went through HARP 1.0, have higher LTVs. They had a one-time option to refinance through the program, but once they have done that, it's really hard for them to refinance. Not impossible, but hard especially if they have a higher LTV to refinance outside of that program, so we've seen very good prepayment speeds on those types of assets, so by having 70% of our portfolio in those two categories and assets, we feel very confident that our prepayment speeds will remain in check.
Of the remainder, the majority of remainder are in the lower coupons, in the coupons that the Fed is likely to be buying, and so there are likely to be low enough coupons. We're not going to have to worry about prepayments, but we are also going to have kind of the backup plan that the prices will be supported by the Fed, and if we are unhappy with the performance of those mortgages from a prepayment perspective, we'll have them out and be able to sell them.
We are not in any way repositioning, betting on QE3. We are also not going to stick our again heads in the sand and hope it doesn't happen, so what if it doesn't happen and interest rates go up. I mean, actually interest rates could go up as it does happen, we don't view this as a time to take big interest rate positions and so we've increased our hedge ratios, we're using longer term hedges. We are taking a very balanced approach at this point to managing our portfolio and we are doing it because interest rates are low and you have a unique environment where if the five-year treasury is 65 or 70 basis points, if you short it, or if you are paying on swaps if we have a big rally maybe that goes to 40 basis points, 35 basis points, but the amount that you can lose on a short position or a hedge position is now limited. In that environment, you actually can reduce your risk posture with greater hedging.
200 basis points would go in rates. If you increased your hedges, you just change the direction of your risk from kind of having up way risk to down way risk or vice versa. You can move it around by moving your hedge ratio, but you couldn't really just outright reduce risk, but when you are at these kind of levels of rates where the amount that a hedge can cost you if things move against you is limited, you actually can just take risk down by adjusting your hedge ratios and by hedging more.
In conclusion, and this is really important. Look, we believe it is our responsibility as a management team to protect the portfolio and position the portfolio over a range of possible scenarios. That's interest rates, or interest rates lower, I mean, prepayments that are faster because of whether it's the GSE buyouts in 2010, or it's good credit, high loan balance mortgage prepaying faster or we felt it was our responsibility to get out of the way of HARP 2.0.
Well, if the Fed's QE3 is a threat to prepayment speeds, we have to react to it the same way we would react to something else, and we've got to position our portfolio understanding that this can change the landscape of the market. Again, I mean, the three biggest risks that we deal with are prepayments and interest rates. QE3 is designed to impact both, and so as a mortgage REIT, this has to be completely on our minds. When you just put in perspective to other risk factors, political risk seems very low right now in the prepayment arena.
If you look at the (Inaudible) bill as an example, which kind of an example policy risk it really only affects the newer version that was just filed on Friday, took out the extension, the one-year extension of the HARP eligibility date, which would have meant that the universe of loans is eligible for HARP 2.0 would have expanded some. That was even taken out, so now it really only is a souped up version of HARP 2.0, and honestly HARP 2.0 affects less than 3% of AGNC's portfolio that's even originated earlier enough to be impacted by, so it's just not a big picture issue for us, so it's kind of a unique environment, where political risk we believe is kind of on the low side or policy risk with respect to prepayments and then you've got this relatively high probability event, okay? QE3, which can have a very material impact on prepayment, it is absolutely the biggest issue on the horizon for the mortgage market. For that reason again it just is not an option for us not to be thinking about it.
With that let me open the floor to questions.
Thank, Gary. First question. How much would mortgage rates have to decline before you start to worry about the protection inherent income to low loan balance? In other words rates dropping enough that now even somebody with a $60,000 loan balance has an incentive to refinance?
Now look, it's a good question and you can get to that answer via number of ways. One thing is, I would say is, first it's a function of the actual loan balance. You used the example of a $60,000 loan. With what we classify as low loan balance, we include everything with. That range is from zero up to $150,000, in that category. The average is more like $105,000, I think, for our portfolio of lower loan balance, but big picture there are two pieces of the defense, right?
One is the point you alluded to, which is what is the amount of incentive where it typically make sense and it's very dependent on the amount you save relative to closing cost, and it's generally well over 100 basis points of incentive before it make sense for anyone in that category, but the other piece of the defense again is the fact that the originators will charge you a higher rate and often a significantly higher rate if you have a small loan. They really don't want your business, or they put you on a waiting list or they put you through a runaround or whatever, because you are not as profitable and that interestingly the more interest rates fall, the bigger that second impact tends to get, right? Because, rates are falling, mortgage rates are going down, Wells is getting busier, the worst the trade-off is from them, and so for that reason you really generally need something like 150 or more basis points of incentive and you need to be kind of further into the cycle where capacity is generally available in the space and then you start to see lower loan balance kind of and this is going back aways in history, then you start to see them pick up, but you have a decent cushion in most coupons, both in terms of that rate move. It would have to be pretty significant in mortgage rates, and you have another cushion in time before people get around to you so to speak, so it's a pretty good defense.
Other thing, one of the things we've done is, we moved the coupons down of our lower loan balance and HARP security, so even there the bulk of our portfolio has borrowers paying like 460 or below, so they are pretty far from being in that zip code.
Okay. Can you imagine though, if we got QE3 and it kind of remains in force for a long period of time would you start trading out of those low loan balances? You get close to the point where originators now actually have time and capacity would start focusing on those mortgages?
Absolutely. Look, our mindset, honestly I think we are probably fine given the coupons that we have where we think the low loan balance will survive the cycle so to speak, and it's probably a core holding, but look our philosophy is built on one of every day you have to rethink your positions and you have to look at the environment and the direction things are going, and if capacity is not a factor anymore in the system and if there is incentive, then you start to see warning signs, then we will absolutely reposition the portfolio accordingly and we have done that in the past. I mean the bottom line is the mortgage market is a dynamic market. The risk that we'll face a year from now or two years from are going to be different than the ones we are facing today. The risk we were facing 2 or 3 years ago, or 5 or 10 years ago were very different than those that we face today.
I think your point is just really good one. It is possible that the securities we have today are not going to be well positioned for something in the future, and it is absolutely again a lot of responsibility to be prepared for that and then to be in a position to take corrective actions.
Okay, just one last from me. I know you are conservatively hedged in terms here with potential QE3, how tempted are you to reduce your swap position a little bit here?
Not really. I mean, we are not tempted. I think, we always after the fact that if we knew which way rates were going, we would be very happy to position to it, but look the reality is it comes do it. It is not a view on interest rates. I want to be very clear. We haven't gotten defensive on interest rates. We actually feel like we are going to stay in a low rate environment. Our core competency is not to guess the direction of interest rates, and there are many cases you could get QE3 and have the 10-year back up to 2.25. It's a very real possibility saw it with QE2, okay? It's also very possible to see, we'll get a QE3 and have the 10-year be at 1.25. I mean, that's maybe a little less likely, but it's a very real possibility, but I think the bottom line is we hedge because it's by definition it is like the term says hedging. We are trying to offset risks inherent in our mortgage portfolio. And given how low interest rates are, the risk return of having a few more hedges is better and it's the right place to be positioned in this kind of environment.
The cost of having hedges and the downside if they move against you is limited right now, and let's face it, our mortgages are lower coupons, they are protected from prepayments, so they are kind of longer than they might otherwise be in this kind of environment, and so we have to be cognizant of what our position looks like. For that reason, I think at least for the time being and given these rate levels, we feel our hedging position is appropriate and it's not about kind of timing the market or waiting to see what happens with QE3, and then taking them off so to speak.
Great. Thank you very much. I appreciate everyone's interest in AGNC, and thanks for coming.