Good morning. And welcome to the American Capital Mortgage Q3 2012 Shareholder Call. All participants will be in a 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 Hannah Rutman in Investor Relations. Please go ahead.
Thank you, Emily, and thank you all for joining American Capital Mortgage Investment Corp. third quarter 2012 earnings call.
Before we begin, I’d like to review the Safe Harbor statement. This conference call and corresponding slide presentations contain statements that to the extent they are not recitations of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act.
Actual outcomes and results may differ materially from those forecast due to the impact of many factors beyond the control of MTGE. Our forward-looking statements included in this presentation are made only as of the date of the 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 our periodic reports filed with SEC. Copies of these reports are available on the SEC’s website. We disclaim any obligation to update our forward-looking statements unless required by law.
To view a webcast of this presentation, access our website, mtge.com and click on the Earnings Presentation link in the upper right corner. An archive of this presentation will be available on our website and a telephone recording of this call can be accessed through November 16th by dialing 877-344-7529 using the conference ID 10019155.
Participating on today’s call are Malon Wilkus, Chairman and Chief Executive Officer; Sam Flax, Executive Vice President and Secretary; Gary Kain, President and Chief Investment Officer; Jeff Winkler, Senior Vice President and Co-Chief Investment Officer; Peter Federico, Senior Vice President and Chief Risk Officer; Chris Kuehl, Senior Vice President, Agency Mortgage Investments; Jason Campbell, Senior Vice President and Head of Asset and Liability Management; Don Holley, Vice President and Controller.
With that, I’ll call the -- turn the call over to Gary Kain.
Thanks, Hannah, and thanks to all of you for your interest in MTGE. We feel really good about MTGE’s performance this quarter and as importantly since our IPO last August.
During the third quarter, MTGE was able to continue to pay an attractive dividend, significantly build its undistributed tax income and grow book value around 14%. Economic returns, which include both the $0.90 dividend and the $3.13 of book value growth equated to 72% annualized return for the quarter.
In our first full quarter since our IPO, MTGE has paid $3.50 per share in dividends and increased book value by $5.25 per share. This $8.75 per share of total shareholder value creation equates to a 44% annualized return over the past 12 months.
Importantly, we’ve been able to accomplish this with the conservative approach to managing credit, interest rate and liquidity risk.
Looking ahead, investors are clearly focused on QE3 means to our business. The bottom line is that we feel very good about how MTGE is positioned against the dual challenges of tighter spreads across both the agency and non-agency spectrums, and a more difficult prepayment landscape on the agency side.
Slow speeds are critical to minimizing the impact of the tighter spread environment. If our prepayments obtained we have minimal reinvestment needs, which in turn means that tighter spread environment should have a very limited impact on our total returns.
We may and probably will choose to sell a fair amount of agency MBS at some point during the duration of QE3. That would be a proactive decision, where we are confident the net of those sales and subsequent reinvestment into non-agency and agency securities will add incremental value to shareholders.
So the key to this environment is in a combination of having being correctly positioned prior to QE3 and then trusting management to position the portfolio going forward as relative value opportunities present themselves across the entire spectrum of mortgage assets.
With that, let’s review the highlights for the quarter on slide two. Net income which incorporates both realized and unrealized gains and losses on both assets and hedges was $4.03 per share.
Net spread income which excludes $3.32 of investment related gains came in at $0.71 per share. The decline in net spread income during the quarter was largely a function of faster prepayment projections.
Estimated taxable net income totaled $1.33, which significantly exceeded our $0.90 per share dividend. As a result, our estimated undistributed taxable income grew materially to $0.54 per share.
Book value increased $3.13 or just over 14% to $25.21 per share during the quarter, as the performance of both agency and non-agency MBS were very strong.
Our portfolio, turning to slide three, our portfolio increased to $6.9 billion as we grew the agency and non-agency components of the portfolio. Leverage declined slightly during the quarter to 6.6 times from 6.8 times as of June 30th.
Now MTGE’s average CPR remained very slow at just below 7% and that’s both last month and for the third quarter as a whole. In response to QE3 and lower mortgage rates, we did increase our projected CPR to 13%, which is now around 90% higher than our actual QE3 CPR.
This significant increase in our CPR projection was the primary driver of the contraction in our quarter end net interest margin from a 194 basis points to a 188 basis points, had we used our projection equal to our actual CPR, our quarter end margin would have actually increased.
Lastly, we announced that the Board authorized up to $50 million in share repurchases. Management and the Board are committed to using all tools at our disposal to generate long-term value to our shareholders, including stock buybacks when our shares are trading at a material discount to our book value. It is important to understand that they are costs associated with both issuing and repurchasing shares. So repurchases are not likely with very small price to book discounts.
Now let’s turn to slide four and look at what happened in the markets during the third quarter.
As you can see in the middle section of the table, treasury rates were largely unchanged during the quarter with the five-year treasury rallying 9 basis points and the 10-year drooping only 2 basis points.
Swap rates rallied on average of about 10 basis points more, as the risk on backdrop during the quarter led to tighter swap spreads.
As shown on the top left, the prices of lower coupon mortgage-backed securities increased substantially during the quarter, despite the relatively small changes in rates, 30-year 3% coupons increased over 3 points during the quarter.
The prices of higher coupons were also up but to a lesser extent with 4.5% coupons up less than 1 point. Clearly, QE3 was a key driver here and we will look at an updated picture of the relative performance of agency MBS since QE3 in a few minutes.
Now with respect to risk assets, Q3 was a very strong quarter across the Board. The S&P 500 was up around 6% and spreads on almost all risk products were noticeably tighter.
Home prices also showed improvement and the housing market feels like it has some positive momentum. Against this backdrop, as Jeff will discuss shortly, non-agency RMBS prices were up strongly during the quarter.
But before I turn the call over to Jeff, I want to directly address QE3 on slide five, because I know it is a big issue for investors right now and it has led to some significant volatility in mortgage REIT stock prices.
Prepared now our third round of quantitative easing and extended its low rate guidance to mid-2015 after September 13th meeting. The new program involves large scale agency mortgage loan purchases and it is open ended in nature.
The Fed is buying around $70 billion a month in agency MBS and that is comprised of $40 billion a month for QE3 itself and close to $30 billion related to reinvesting their paidouts on the existing portfolio.
The Fed is purchasing the lowest coupon fixed rate MBS because these securities have the greatest impact on the rates offered to borrowers. As such, in the absence of a material change in interest rates, the Fed’s future purchases are likely to be focused on mainly 30-year 2.5%s and 3s and 15-year 2% and 2.5% coupons.
Therefore, QE3 is likely to impact agency investors in several ways. First, QE3 has already impacted the prices of lower coupon mortgage securities, which has reduced the yields and ROEs on new purchases in this sector.
Secondly, prepayments on existing mortgages will be faster than they otherwise would have been in response to lower mortgage rates.
And third, we do believe that the risk of significant book value declines is lower today, as the Fed’s large purchases should reduce the risk that agency MBS significantly underperform our swap, swaption and treasury hedges.
Liquidity and funding risk should also be less of an issue right now as the Fed’s purchases not only directly improve market liquidity, but they also remove substantial amounts of securities from the hands of private holders that would otherwise have financed them in the repo market.
Now, the performance of non-agency MBS have and should continue to be impacted by QE3 as well. First of all, demand for the product has increased as investors seek out higher yielding assets, the spreads on agencies and other competing products tighten.
Secondly, the lower mortgage rates should help support the housing market and actually drive some prepayments on non-agencies both of which are net positives for this space.
So with this as the background, let’s turn to the next slide where we can see the direct impact of Fed has had on various types of agencies securities from the day before QE3 through last Tuesday, October 23rd.
The price performance of lower and higher coupon MBS have diverged significantly now that the market has had a chance to more fully price in the implications of QE3. For example, 30-year 3% coupons have rallied 1.36 points, while 30-year 4.5%s are essentially unchanged.
The contrast is even greater in 15 years with the 2.5% coupon up two-thirds of a point while the next level coupon 30-year 3s are unchanged and 15-year 3.5% and above are actually down in price.
Interestingly and contrary to conventional wisdom as of last week, the price of the majority of the outstanding MBS were relatively unchanged and some were actually lower.
However, 30-year MBS backed by lower loan balance in HARP securities have appreciated meaningfully relative to generic mortgages in most coupons, as prepayment fears have increased post QE3.
Let’s look at the table on the bottom left. Pools backed by $85 to $110,000 loan balance 4% coupon mortgages have appreciated almost a full point versus their generic counterparts, which were up less than $0.20 since the start of QE3. And as the performance of lower coupon and prepayment protected assets demonstrates, asset selection is more important now than ever.
With that said, let’s turn to slide seven. We can see how MTGE’s capital was deployed at the end of September. And the table at the top shows, our portfolio remained biased toward agencies at the end of the quarter but to a lesser extent than in prior quarters. We had about 23% of our equity dedicated to non-agencies at the end of Q3. Our non-agency portfolio continues to grow at a measured pace and we remain focused on the all day sector.
Additionally given our expectation that the Fed’s purchases will continue to drive lower coupon MBS spreads tighter from these level, we would expect the percentage of our capital dedicated to non-agencies to increase over the course of the next three to 12 months.
However, as we know all too well, things can change quickly and a key advantage of MTGE’s business model is its flexibility. As such, we will continue to actively manage our portfolio and will not hesitate to reposition the portfolio in any direction, as economic or market conditions evolve.
At this point, let me turn the call over to Jeff to discuss the non-agency landscape.
Thank you, Gary. So turning to slide nine, some of the key themes over the year in the non-agency market -- in the non-agency market remained firmly in place, contributing to a very strong quarter for this sector as a whole.
First, we had a continuation of the low interest rate environment, further reinforced by the recent Federal Reserve Actions that Gary just highlighted. This period of low rates has helped stabilized housing, both due to attractive rental yields and as an inflation hedge. Housing data has responded favorably with broad price indices up in the low single-digit year-over-year.
Further, investors in the capital markets are moving further out the risk spectrum in search of higher yielding assets. When you combine this with the decreasing universe of non-agencies, the result with strong performance across the board with the sectors that have more leverage to housing outperforming.
In terms of spread moves, the cleaner sectors like prime starting at about 100 basis points while the more credit sensitive sectors like subprime tightened about 200 to 250 basis points. As the table shows, at current market prices and with conservative leverage levels we see the return on equity in this space to be about 8% to 11%.
Now I wanted to spend a few minutes on the next slide, slide 10, discussing our thought process related to how we assess relative value within the non-agency space. Obviously, return on equity is a major driver both within non-agencies and relative to our agency investments.
In addition, exposure to a housing recovery, stability and cash flows, and market liquidity are also key factors when assessing the quality of returns in the non-agency sector. The following example demonstrates some of the differences among these sectors.
The table on the left has some static information including how many borrowers have never missed the payment, how may are re-performers and how many are still delinquent for the bonds we used to represent each sector. We also provide our estimate for the average current loan to value of the underlying home, the FICO at origination and the leverage we use for these bonds.
The graph on the right shows the estimated return on equity across a few simplified housing scenarios. The housing scenarios only differ in terms of what happens over the next two years. The base are flat scenario assumes a cumulative change in home prices over the next two years of up 3%. The lower corresponds to down 5% and the higher up 12%.
Based on the graph, Alt-A and subprime have the highest return on equity in a flat housing scenario. Equally important, both sectors outperform in a housing recovery as they will benefit the most from lower default and severities. This makes sense given the delinquency profile of these sectors.
As far as cash flow stability goes, we feel that Alt-A securities are more attractive, given the higher percentage of borrowers who have never missed payments, while it is true that borrowers who are re-performing have been exhibiting better payment behavior recently. The re-default rate is still around 40% and there can be a fair amount of choppiness in those cash flows, particularly due to service or behavior.
All of this contains though as the function of market pricing. If the differential return on equity across sectors change dramatically we would reevaluate and reposition the portfolio.
There is also a lot of sensitivity around this estimate especially at the individual security level. Against this backdrop, we’ve constructed a portfolio comprised 50% in Alt-A, 25% in subprime Option ARM and the remaining 25% in prime assets.
Now, I’ll turn the call over to Chris to discuss the agency portion of our portfolio.
Thanks, Jeff. On slide 12 we have a graph comparing the prepayment performance of 34% passthroughs with different loan characteristics. As you can clearly see in the graph, repayment performance continues to vary significantly across different types of mortgages, even of the same vintage and coupon.
Just look at the two extremes, on the slower side, we see that lower loan balances, in this case loans between 85 and 110,000, as well as higher LTV HARP securities continue to perform well prepaying around 10 CPR.
On the other hand, if you contrast that with the ARMs lines which represent pulls back by Jumbo confirming loans, which generally have loan balances averaging over 500,000 are still prepaying right around 50 CPR. The generic or TBA securities shown in blue on the graph are also quite fast with speeds in the mid-30s.
Now, something to keep in mind as you look at this graph is that these speeds are a result of the environment prior to QE3. The 30-year mortgage rate today is approximately 25 basis points lower than rates driving the October speeds in this graph.
We expect that today’s loan rates coupled with the media attention given to QE3 will continue to drive prepayments bit higher on more generic securities in the coming months.
On the other hand, we expect prepayments speeds on lower loan balance and higher LTV HARP securities to remain well behaved. And as we’ll see on the next slide, thoughtful asset selection is even more critical in today’s high prepayment risk, high dollar price environments than it has been in the past.
So turning to slide 13, we have two hypothetical yields tables. In the table on the top half of the page, we have yields on generic 30-year 3.5s but the TBA price as of October 23rd. To put this table into perspective, the 2011 Fannie Mae 30-year 3.5% universe, which is now on average only 12-month seasoned paid at 31.6 CPR last month.
So even at 25 CPR these passthroughs yield approximately 1.43%. If assume a funding cost of 75 basis points, that leaves just 68 basis points of net spread or a hypothetical gross ROE of 6.19% with 7 times leverage.
Now if we look at 30 CPR, which is more likely over the next year or so, the net margin falls to only 28 basis points and the ROE drops to just 3%. The picture clearly gets much worse on generic mortgages with speeds above 30 CPR.
Now on the table in the lower half of the page, we again have 30-year 3.5s. However, here we’re calculating yields at a price 1.5 points above the TBA price, which is approximately were MLB or 110K max loan balance pools were trading as of last week.
And as the table shows, despite the strong out-performance of lower loan balance and HARP securities during the last quarter, the returns are still very compiling even at today’s higher payups versus holding more generic TBA passthroughs.
And if speeds remain contained on these types of securities, as we expect they will, low double-digit returns are still achievable even with lower leverage than where we’re currently running.
Let’s turn to slide 14 now to review the composition of the agency investment portfolio. As we’ve discussed it once since the launch of our IPO, managing prepayment and interest rate risk is critical to performance.
During the quarter, we continued to maintain a large percentage of our holdings and positions with favorable prepayment characteristics. The majority of our more generic positions were in new production, lower coupons in the case of 15-year mostly 2.5s and in the case of 30-year pulls on our balance sheet mostly 3.5s as of quarter-end.
However given the yield table, that we just went over on the prior page, generic 30-year 3.5s now comprise a small percentage of our position as this exposure has largely shifted to 3s.
I’d also like to highlight the fact that the portfolio’s prepayment speeds, as Gary mentioned, remain well-contained coming in at approximately 7 CPR for the most recent October factor release, which was down from approximately 8 CPR in the prior month.
Again these speeds should be evaluated against the backdrop or the average of the Fannie Mae 30-year universe has been prepaying around 30 CPR over the past few months.
With that, I’d like to turn the call over to Peter to discuss our funding and hedging activities.
Thanks, Chris. Today, I’ll briefly review our finance and hedging activities for the quarter. I’ll begin with our financing summary on slide 15. As of the end of the third quarter, our overall repo funding costs was 51 basis points, up slightly from 47 basis points the previous quarter. The increase in funding costs was due to generally higher rates throughout the repo market, as well as the slightly longer term of our repo funding.
Turning to slide 16 and 17, I’ll review our hedging activities during the quarter. At quarter end the notional balance of our pay fixed swap portfolio was $2.9 billion, down slightly from the previous quarter.
Our swap portfolio has an average maturity of 5.6 years and covers 48% of our repo funding.
Our swaptions and treasury hedges totaled $500 million and $350 million respectively at quarter end. Taken together, our swap, swaption and treasury hedges covered 62% of our repo balance and will provide substantial market value protection in rising rate environment.
Turing to slide 18, I’ll review our duration gap information. As you can see from the table, given the drop in mortgage rates and the increase in mortgage security prices experienced during the quarter, the effective duration of our assets fell to 2.3 years from 2.9 years last quarter. In response to this move, we shortened the net duration of our liabilities and hedges to 2.8 years from 3.4 years the previous quarter.
As a result, at quarter-end our net duration gap was negative 0.5 years, unchanged from the previous quarter. At current rate levels, mortgage assets carry a significant amount of extension risk.
Additionally, we believe that our models somewhat understate asset durations in this unique market environment. For these reasons, we believe it is prudent from a risk management perspective to position the portfolio with the negative duration gap.
With that, I will turn the call back over to Gary.
Thanks, Peter. Let’s quickly turn to slide 19, so we can review the business economics as of September 30th. The asset yield on the agency side declined 25 basis points to 2.43%. During the quarter, we increased our projected pre-payment speed from 9.5 CPR to 13%. And this was the key driver of the decline in asset yield.
Again, our 13% CPR projection is now around 90% higher than our actual quarterly speed of 6.7 CPR. Our net funding cost declined by 9 basis points, largely as a function of the reduction in the percentage of our repo balance covered with interest rates swaps.
The combination of these changes led to a net interest rate spread of a 156 basis points and when you apply leverage of 8.2 times and add back the asset yield, you get a gross ROE snapshot of around 15%. Of course, this table is based on our cost basis for assets and the original cost of the swap portfolio. Footnote one, gives you the same figures on a mark-to-market basis.
On the non-agency side, our funding yield -- our asset yield decreased around 43 basis points from 7.39% to 6.96%. Funding cost also declined by around 24 basis points, as we continued to leverage the agency portfolio for greater percentage of our non-agency funding.
After applying leverage and adding back the asset yield, the gross ROE falls out just under 16% for the non-agency portfolio, in aggregate, the combination of the two sides of the business weigh to a gross ROE of near 15% and a net ROE of 13.3%.
In conclusion, we believe our portfolio is very well-positioned for the current environment. Given this, we continue to believe that we can produce attractive risk-adjusted returns across a range of economic and interest rate environments despite today’s tighter spreads.
We also view the current market as more of a total return environment, where asset selection and active management are really going to be critical to performance. And we’re going continue to manage our portfolio accordingly.
So, with that, let me open up the call to questions.
(Operator Instructions) And our first question will come from Joel Houck of Wells Fargo. Please go ahead.
Joel Houck - Wells Fargo
Okay. Thank you. Good morning. My question if we could maybe just stay on slide 19, footnote one, I’m just doing the math in my head here, but I see the 1.87% yield on the agency book at the end of the quarter that kind of points to your gross ROE of around 10% before expenses?
And so, how should we think about that relative to the higher returns in the non-agency side, you’ve already kind of indicated directionally where you’re going, but how quickly would you anticipate and kind of the magnitude of the change toward non-agency investments?
And then kind of related question, if you go back to your comments on slide five about the risk to managing a levered agency portfolio of lower, does that necessarily mean you could take leverage higher in the agency book to kind of compensate for the lower return and just kind of how do you think about increasing leverage and agency versus just allocating more capital to the non-agency book?
Sure. Thanks Joel for the question. So, first off, you’ve got to be careful not to use, you want to try to do an apples-to-apples comparison. I’ll start with your point on the mark-to-market ROE.
I mean we use that, we want to make sure investors have that to have a feel for if you, essentially if you’ve bought the whole portfolio today, what would that kind of spread look like if you bought the exact same portfolio.
You’d actually have to do the same analysis on the non-agency side to compare them appropriately, so you wouldn’t want to use the cost bases which include having bought eight non-agencies at kind of older prices as well.
And so, maybe we’ll think about in the future kind of giving putting those numbers out as well. But that’s the first point I’d want to make which is you’ve got to look at both sides kind of under the same lines.
The other point, going to your second half of your question, which is around the, kind of the reallocation of assets and how we look at that. You’re absolutely right that there is a period where you could, you would be comfortable from a risk perspective taking up leverage on the agency side, but it’s not necessarily kind of the approach we will take.
I think we have a lot of flexibility given this vehicle to allocate between the two sectors because we’re not -- we have -- as we increase the percentage of non-agencies your amount of (inaudible) risk or a kind of pure interest rate risk changes and it does allow you to go for some periods where you’re going to run higher leverage.
I think big picture though, we’re going to look at the risk-adjusted returns on both sides of the business and decide what makes sense and if I look out a year from now, my expectation is not that the agency portfolio has higher leverage than it currently does, my expectation would be lower.
But, again, I think the key to managing a mortgage portfolio is, not, is being open minded and seeing what happens in the market and responding appropriately to changes both in valuation and market conditions and that’s absolutely what we intend to do.
Joel Houck - Wells Fargo
Okay. That’s very helpful. Thanks, Gary.
Thank you, Joel.
And our next question comes from Bose George of KBW. Please go ahead.
Ryan O’Steen - KBW
Hi. Thank you. Actually this is Ryan O’Steen on for Bose. I was wondering if you could just talk a little bit about your decision to increase the projected lifetime CPR?
Sure. The process that we use, I want to be clear that it’s not really a decision. We don’t get together in a room and decide where we think prepayment should be for that, for the quarter. We use a defined process that’s based on a model from BlackRock Solutions who’s sort of an industry leader in terms of mortgage analytics.
And so, the key drivers into that process, into the model are mortgage rates and interest rates in general. And that’s the kind of the building block, the key input into where our CPR projection is.
And so if you look at what happened with mortgage prices higher and mortgage rates lower, it’s logical to see prepayment projections faster than where actual speeds are especially in light of QE3.
So what I want to be clear about is, that we, we feel the model is a reasonable estimate for future prepayments. But the way we get there is in a controlled manner and it’s not really, we try to minimize the amount of management judgment that comes into setting the quarter-over-quarter speeds.
Ryan O’Steen - KBW
And can you quantify the impact that that had on your $0.71 of net spread income?
I mean, I -- if you ran the portfolio at 7 -- if you ran the portfolio with a projection of 7 versus 13, the difference would be pretty material, in the neighborhood of 25 plus basis points, so it’s a big difference.
Ryan O’Steen - KBW
Okay. Thanks. And second, just curious in terms of what you like in terms of capital allocation on new purchases, agency versus non-agency and on the non-agency side, it sounds like per some of your comments earlier, Alt-A is most attractive currently. Is that accurate?
You want to, Jeff, you want to talk?
Yeah. I mean in terms of the non-agencies. I think, I mean, I think that the -- we’re still probably going to have the highest allocation to Alt-A, within each sector we definitely find bonds that we like and we’ll add.
So I think it’s just a function of what we see out there and again with the focus on the return equity profile, having some exposure to a housing recovery, as well as having reasonably stable cash flows and I think that’s what we’ll continue to focus on.
And in terms of the allocation between agency and non-agency, it’s very much a moving target and we’re kind of if you look out long way and if you think about being QE3 here a long time that we would expect clearly the non-agency percentage to increase, but we will be very reactive to market conditions and so, I would actually not expect that to be a straight line.
Ryan O’Steen - KBW
Great. Thank you for the detail.
(Operator Instructions) And the next question will come from Stephen Laws of Deutsche Bank. Please go ahead.
Stephen Laws - Deutsche Bank
Oh! Yes. Thanks for taking my questions. A couple of been addressed kind of I just wanted to follow-up on the prepay increase in your assumed prepayment speeds? And then tie that in together with your comments in the prepared remarks about potentially selling and taking some gains.
To the point that you do so a portion of your agency MBS assets and I guess, assuming that you sell those you think are miss priced with regards to prepay, so they’ll prepay faster maybe than how they’re valued in the market?
Could we see that adjustment reverse in some future period as the portfolio of agencies has been less prepayment since after the sales and you could take a benefit there at some point next year?
I mean, I think what you’ll find is as you get new information about realize prepayments that, that immediately kind of will adjust to kind of your all-in yields. But with respect to sales, if your sell something that will show up in other income and if you, so you’re going to -- you’ll see that as a realized gain, you see -- really wouldn’t see the we’ll call it a reversal of kind of other income from to net interest margin so to speak, due to executing sales.
Where you’d actually see that the quickest is if interest rate back up, what you’ll see is a much lower prepay, projection on prepayments across the board. And so if you kind of were looking for a reclassification, the number one catalyst for that would be an increase in interest rates. The other catalyst for kind of a reclassification between those two different geographies would be kind of further information about the realized prepayments on both the HARP securities and lower loan balance and where model projections kind of are adjusted overtime. And we’ve seen that happen infrequently in the past.
So those are the big things that would kind of drive income getting classified one way or another. When you think about those two, this is exactly why we don’t obsess about the geography of income, because neither of those are kind of real true economic issues.
They’re really a function of, something that’s important accounting, but they’re a function of accounting and so our mindset is one of we’re really concerned about generating income, provide it performing well over the long-term and much lower down on the list for us is the geography of which bucket it shows up in.
Stephen Laws - Deutsche Bank
Right. But you don’t think it’s very likely that due to a mix and a mix change in the agency portfolio as you sell some assets that, that model will push out a lower prepayment assumption say 11% instead of 13%, you don’t expect that to happen?
Well, it could happen in terms of if you just happen to sell the securities that you’re running faster then it will come down, but you won’t actually see that show up in terms of the asset yield because those will have been expected to do that.
So, I think, again, when you sell something, if you, if in your mind you’ve amortized it faster than you expected, you’re just going to have a bigger gain and that’s going to show up in realized gains.
Stephen Laws - Deutsche Bank
Okay. And then maybe a little more color if possible on the repo market. It seems like repo rates are increasing a little bit. I think you guys also referenced increase in duration of the repo book?
But can you maybe talk about what’s going on in the repo markets, do you think you’ll see repo rates continue to kind a gradually increase like we’ve seen the last couple of quarters? What are you guys seeing out there with your counterparties?
Well, we have seen repo rates being kind of sticky for the last several quarters at this kind of current level and part of that I think has been some amongst our counterparties some capital allocation going on with different businesses and moving capital around from one business to another. And in some cases, counterparties have reduced their overall capital allocated to mortgage repo, in other cases they’ve increased it. So, I think that’s one of the reasons why mortgage repo rates have been where they are.
Now, that said, we see good capacity in the marketplace and as Gary mentioned in his opening remarks, the Fed’s purchase program, we think could have a beneficial impact on mortgage repo rates going forward.
They’re obviously taking out $60 billion or $70 billion worth of mortgages every month, which in some cases would have gone to the repo market for financing. So that’s a positive from a supply perspective for the repo rates.
So, from our vantage point right now we see good things on the capacity side. We feel good about where we are. We have lots of counterparties who are willing to give us term repo, which is a good development, and then of course, we have the backdrop of the Fed. So we’re optimistic.
Stephen Laws - Deutsche Bank
Great. And then one last quick question, I think it’ll be a pretty straightforward answer. But are there any issues with your REIT structure that went that or things you need to watch specifically as you reposition the portfolio and generate maybe some gains as opposed to cash flow without the income reviewed?
Not really, I mean, there are always things you have to keep in mind around paying out certain amounts of taxable income, but you have a fair amount of flexibility to do what you think makes sense.
Stephen Laws - Deutsche Bank
Great. Again thanks for taking my questions.
Our next question is from Trevor Cranston of JMP Securities. Please go ahead.
Trevor Cranston - JMP Securities
Hi. Thanks. I had a question related to slide 10. We often see kind of catch-up amortization numbers on the agency side as prepay assumptions change. Can you guys maybe talk a little bit about what your current base case assumptions are in terms of home prices and how much data you’d need to see and what the process might be like for changing those assumptions in the future?
Yeah. Sure. I think, in terms of our housing view in general, look we think that particularly as, if you look at the rate environment I think that’s really stabilized home prices at this point, where at this time last year I thought there was the potential for some sort of an overshoot to the correction but at this point, I feel like there’s definitely a floor in place.
However going forward, I don’t think we’re going see sort of a V shape recovery in the housing market. I’d like to see a little bit more pick up in mortgage purchase applications and when we look at our liquidation data, I mean keep in mind in the non-agency market it’s only about 10% of the overall mortgage market.
So when we look at the liquidation data that we have, I look and we try and tease out what the actual home values are that are being cleared. We do see an uptick in that data. But it’s not materially enough for us to start to change our assumptions. So if we start to see some of those types of data change then we’ll start to make changes to our underlying model.
Trevor Cranston - JMP Securities
Okay. That’s helpful. Thank you.
Our next question comes from Jason Stewart of Compass Point. Please go ahead.
Jason Stewart - Compass Point
Guys, thanks. You talked a little bit about leverage on the agency portfolio, but given what it seems like is a little bit more constructive view on housing? Could you give us some updated thoughts on leverage on maybe increasing on the non-agency portfolio?
Yeah. Sure. I mean I think the leverage on the non-agency is a function of poking our view on housing, but also a function of market liquidity and [haircuts] that are provided by the market.
And that’s one area while it’s definitely improved over the course of the year. [Haircuts] have not come down materially in that space and I do think that it’s still a space that lends itself to illiquid times.
So, I think, until we start to see those things change, both the sort of [haircuts] in the market as well as some real stability in the pricing, I don’t think we’re going to change our overall leverage assumptions at a given sector level
And I would just add to Jeff’s comment that we are starting to see more counterparties willing to provide financing for the non-agency security. So overtime we’re hopeful that, that will -- that increased competition will lower the financing costs there.
Jason Stewart - Compass Point
And our last question comes from the line of Joel Houck with Wells Fargo. Please go ahead.
Joel Houck - Wells Fargo
Thanks. Just a quick follow-up. On the taxable income, is the accounting the same for GAAP income with respect to using life CPRs or is there a difference?
No. The -- it’s interesting. The difference for taxable income and for the amortization, you use your original projection at the time when you purchase the security and then you don’t update that projection the way we update projections on the accounting side.
So, amortization from a tax perspective is a combination of actual paydowns as they occur, and that’s the only thing that changes. But your go-forward projections are whatever you had at the beginning when you purchased the securities. They don’t get updated. So, there is a pretty big difference between taxable ARM so to speak, and GAAP ARM.
Joel Houck - Wells Fargo
Okay. Thanks for that clarification.
We have now completed the question-and-answer session. I’d like to turn the call back over to Gary Kain for concluding remarks.
Well, thank you, guys. I appreciate everyone’s interest in MTGE, and we and the team are available if there are any future questions please contact us. Thanks again and have a good day.
The conference has now concluded. An archive of this presentation will be available on MTGE’s website and a telephone recording of this call can be accessed through November 16th by dialing 877-344-7529 using the conference ID 10019155. Thank you for joining today’s call. You may now disconnect.
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