American Capital Agency Corporation (AGNC)
Bank of America Merrill Lynch Banking and Financial Services Conference
November 14, 2012 3:25 PM ET
Gary Kain – Chief Investment Officer
Kenneth Bruce – Bank of America Merrill Lynch
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Thank, Ken. And thanks to all of you for your attendance and your interest in AGNC. Look, given what’s going on in the REIT space, clearly the stocks have been volatile and volatile in kind of the direction for them not to be volatile in. I had been planning on going through kind of the key themes from our Q3 earnings presentation, but given kind of what’s going on, I thought it was more appropriate for me to take a somewhat different approach today.
And over the last month or so, investors have been pummeled with a host of reasons to panic around the agency REIT space. And these things include things like the record-low mortgage rates due to QE3 prepayments, the election, tax changes, the fiscal cliff, and now rumors about the head of FHFA, DeMarco, potentially getting replaced. So what I want to do is directly address some of these concerns and use a few of the slides from our earnings presentation where appropriate. And since I’m just going to be jumping around, I’m not going to be going through obviously the presentation in any order. But if you are interested in the earnings presentation, clearly it’s recorded; the presentation is on our website and there’s a recording of the earnings call that will go through everything in detail.
But with that, let’s start with kind of QE3 and the first concern that we hear, what are the implications of QE3. And so, if we actually go to slide 9, we look at some of the -- we have a slide that really talks through that. But the real key ramifications of large scale mortgage purchases by the fed are that the yields on mortgages are going to be lower than where they would have otherwise been and prices are higher, these lower yields means the returns on new purchases are going to clearly be less attractive than if the fed hadn’t involved over time
But the other issue that concerns people and probably the bigger issue is that these lower mortgage yields also mean lower mortgage which means prepayments on our existing portfolio will be faster and that will hurt the yields of the current portfolio, plus you will have to then reinvest those pay downs into a lower-yielding instrument. And so, realistically, so what are the implications of QE3? And we’ll talk more about prepayments in a little bit, but the reality is there is some reason for concern here. This is not a benign prepayment environment. Prepayments are going to be faster given QE3, but there are also some places to hide. And so irrespective of changes to policy or whatever, prepayments are a factor and we’re going to talk a little more about that in a second.
But another thing that comes up periodically in these discussions really relate to, look, all right, so QE3 was a reasonable possibility, the stocks were fine for a little while after QE3. So was there something that really stands out that surprised us with respect to kind of how the market is reacting, the mortgage market or the prepayment landscape? And on that front, the answer is absolutely no.
And if we go to slide 11 for a second, this is a slide that we had originally included in our Q1 earnings presentation back in early May. And what it shows, it was the center scenario -- we talked about three scenario -- and the center scenario was one, a hypothetical QE3. And what you see is what we said under prepayment rate impact materially accelerate. We talk about what would happen in the mortgage market; the prices of lower coupon and prepayment protected mortgages would increase materially; that has happened. They’ve given back some of those gains but they’re still up.
And then prices of generic or higher coupons would perform -- their gains would be considerably less and the driver there is because there was no fed bid and the prepayment issues were going to be factor. When you go down to kind of the impacts on AGNC, prepayment protection is critical to the returns on the existing portfolio, returns on new purchases less attractive, and book value would increase in response to QE3. So when you put those together, what we’ve -- seeing the environment we’re looking at is absolutely what should have been predicted in kind of how we described this hypothetical scenario back in the first quarter or in the first quarter call.