AGNC Investment Corp

NASDAQ:AGNC

Earnings Call Transcript 2020-Q1

[Operator]

Good morning and welcome to the AGNC Investment Corp. First Quarter 2020 Shareholder Call. [Operator Instructions] Please also note this event is being recorded.

I would now like to turn the conference over to Katie Wisecarver in Investor Relations. Please go ahead.

[Katie Wisecarver, Investor Relations]

Thank you for joining AGNC Investment Corp.'s first quarter 2019 earnings call. Before we begin I would like to review the Safe Harbor Statement. This conference call and corresponding slide presentation 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 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 sec.gov. We disclaim any obligation to update our Forward-Looking Statements unless required by law.

Participants on the call include; Gary Kain, Chief Executive Officer; Bernie Bell, Senior Vice President and Chief Financial Officer; Chris Kuehl, Executive Vice President; Aaron Pas, Senior Vice President and Peter Federico, President and Chief Operating Officer.

With that I will turn the call over to Gary Kain.

[Gary Kain, Chief Executive Officer]

Thanks, Katie, and thanks to all of you for your interest in AGNC. As you know, conditions were extremely challenging in March as the market reacted to the COVID-19 pandemic. The dislocations witnessed during in March were unprecedented in terms of both magnitude and speed, resulting in a significant decline in the valuation of Agency MBS and other fixed income products.

AGNC's financial performance, like almost all financial companies, was severely impacted by the market volatility, with AGNC posting an economic return for the quarter of negative 20%. While we were disappointed by this result, we are optimistic that the worst is behind us. And we believe that we are uniquely positioned to generate strong risk adjusted returns as we look ahead to the remainder of 2020.

In saying this, we fully recognize the significant uncertainty presented by the pandemic and its associated impact on the U.S. and global economies. To this point, I intend to dedicate the remainder of my prepared remarks to explaining the rationale behind our optimistic outlook.

Importantly, the bold and decisive actions of the Federal Reserve stabilized the entire fixed income complex in late March. As was the case in QE1 and QE3 Agency MBS were again a critical part of the Fed's actions, but this program has different significantly from prior episodes in that the fed purchased a larger amount of securities over a much more compressed timeframe than at any point in history. In just one and a half months the Fed has purchased approximately 575 billion Agency MBS.

This coupled with the expectation of ongoing Fed purchases should provide the necessary support and stability to the sector as the market contends with any future challenges associated with COVID-19.

Against this backdrop, we believe that the financial markets are in the process of transitioning from a focus on liquidity to the next phase where performance will be driven primarily by actual fundamental factors.

Fortunately, our portfolio is comprised almost entirely of the Agency MBSs which enjoy the guarantee of timely interest and principle from the GSCs. As a result, we have very little credit exposure in our portfolio, which is where the bulk of the future uncertainty lies.

In contrast, prepayments funding and interest rate risk are the fundamental factors that will determine AGENC's ultimate performance. So with this in mind, let's briefly examine how these factors will be impacted by the current landscape.

First, on the prepayment front, most models tell us that the record low levels of interest rates will increase pre-payments substantially. However, these models are not designed to incorporate the unique circumstances associated with the current crisis.

More specifically, some borrowers will opt to take forbearance on their existing mortgage while others will have difficulty refinancing due to a job loss, reduction in compensation, a decline in self employment income, or other adverse events.

Social distancing may also reduce origination capacity and extend closing timelines. Purchase activity or housing turnover as it is called in the mortgage industry will likely be impacted to a greater degree as social distancing limits open houses and other showings.

While every scenario is different. There are some similarities between the current environment and the one we witnessed between 2009 and 2012 where the impact of then record low interest rates on prepayments was also materially offset by credit considerations and changes to the mortgage origination landscape.

If we move on from prepayments to funding, the benefits from the current environment are even more straightforward. The Fed cuts the Fed funds target and the overnight Repo rate to around 10 basis points and they have offered virtually unlimited liquidity to keep Government Repo rates near the target.

As such, our MBS Repo rates, as Peter will discuss shortly, have generally ranged from single-digits on overnights through our in-house broker dealer to around 30 basis points on three month maturities in bilateral Repo. The last element of the fundamental cash flow picture for AGNC is the current asymmetry and our exposure to changes in interest rates.

Normally hedging a levered position in Agency MBS requires substantial tradeoffs as we seek to balance the risk of both significant declines and increases in interest rates on the duration of our assets.

However, if you believe that substantially negative interest rates in the U.S. are unlikely in the near-term which is our opinion, then there is considerably less call risk or downside to being more fully hedged, given today's record low swap Rates.

So to summarize, the fundamental landscape for Agency MBS is favorable. Prepayments should remain contained, despite low rates as a function of social distancing and credit concerns. The Agency Repo market is trading very well, with rates close to zero.

And with most relevant interest rates below 50 basis points, we believe there is considerably less downside risk inherent in our hedge portfolio. For these reasons, it is hard not to be optimistic about the prospects for our business despite the tremendous economic uncertainty that lies ahead.

At this point, I will ask Bernie to review our financial results for the first quarter.

[Bernie Bell]

Thank you, Gary. Turning to Slide 4. We had a total comprehensive loss of $3.61 per share for the first quarter, net spread and dollar roll income excluding catch-up am was $0.57 per share, which was unchanged from the fourth quarter. As the decline in our investment portfolio that occurred later in the quarter was offset by lower funding cost.

Tangible net book value decreased 22.9% for the quarter. At a high level, the decline and our book value was driven by the underperformance of our mortgage assets relative to our hedges, resulting in materially wider spreads during the quarter.

More specifically, about half of the decline was due to lower premiums or pay up values on our specified pool position. While the remainder of the decline was due to rebalancing costs incremental losses on our OAS swaps, and our non-Agency assets.

Including dividends, our economic return on tangible common equity was negative 20% for the quarter. This quarter end valuations of TBA MBS have improved modestly while pay up values on our specified pool position have recovered and meaningful portion of their Q1 under performance. As a result, as of yesterday, our net book value was up approximately 8%.

Turning to Slide 5, our investment portfolio decreased $15 billion during the quarter to $93 billion as of quarter end. Our ending leverage was unchanged at 9.4 times tangible equity, but has declined commensurate with our increase and book value in April to around 8.5 times.

Our liquidity position at quarter end was at pre-crisis levels with our cash and unencumbered Agency assets totaling $3.5 billion. Importantly, that figure does not include an additional $1.2 billion of capital on excess margin that we held at our broker dealer subsidiary, or 300 million of unencumbered credit assets. Our portfolio forecasted CRPs increased to 14.5% from 10.8% during the quarter as a function of lower rates. Actual pre-payments for the quarter averaged 12.2%.

During the first quarter we also completed one billion of a creative equity transactions including a 575 million, 6.125% fix to floating rate preferred equity offering, and approximately 440 million of common equity issued through after market equity offerings. Additionally, subsequent to quarter end, we have repurchased approximately a 100 million of common stock at substantial discounts to our estimated tangible net book value.

With that, I will turn the call over to Chris to discuss the Agency markets.

[Christopher Kuehl, Executive Vice President]

Thanks Bernie. Let's turn to Slide 6. As Gary mentioned, the market dislocations in March were unprecedented. Agency mortgages widened a 100 basis points inure month before TBA MBS recovered three quarters of the move as the fed launched QE4 and purchased 250 billion of Agency mortgages over the course of two weeks.

The underperformance of Agency MBS in March was even more dramatic and high quality specified pools were pay ups on HLB, 3.5 and fours declined by more than two points. To make matters worse. These pay ups would have been expected to increase given the 40 basis point decline in interest rates during the month of March.

Money manager redemptions, investor de-leveraging, balance sheet pressures and a flight to cash lead to extreme inter month moves for all risk assets. While TBA mortgages recovered a significant amount of the underperformance versus rates by the end of March specified pool valuations ended the quarter at extremely depressed levels.

When we released our Company update on April 8th, we thought it was important to inform shareholders that we were able to maintain our high quality specified pool holdings through the market turmoil in March as we believed valuations would normalize and that these positions would be a critical component of the performance going forward.

Since March 31st, specified pools have in fact recovered meaningfully, with pay-ups on HLB 3.5 and fours more than a point higher. But more importantly, as I will discuss in a few minutes, we believe the cash flow return expectations on these positions are very attractive.

Let's turn to Slide 7, as you can see, the investment portfolio declined to $93 billion as of March 31st. The $15 billion net decline was comprised of $4 billion in pay downs and net sales of approximately $25 billion and lower pay up relatively generic pools with about $14 billion of those sales replaced by TBAs.

As we discussed on priority calls, we had added relatively generic lower coupon MBS in lieu of specs and these positions were critical to our ability to build liquidity during the middle part of March without having to sell higher quality specs at fire sale levels.

Turning to Slide 8,we present several illustrative examples to highlight the compelling nature of Agency MBS returns despite unprecedented purchases by the Fed in the second half of March, the two top tables show the potential gross return on equity as of quarter end on 30 year HLB, 3.5 or fours using nine times leverage. As a reminder, HLB pools are those backed by loans with loan balances less than or equal to 150,000.

As you can see, potential gross returns, inclusive of hypothetical hedging and funding costs, but prior to convexity costs, were in the mid to high teens as of March 31st. Importantly, even if pre-payments are higher than the base speeds displayed in the table returns are still attractive.

In the lower two tables, we show TBA 30-year 2.5s with and without an assumed funding advantage from dollar roll specialness. 30-year 2.5s are the predominant production coupon and as such enjoy the greatest amount of support from Fed purchases.

Role implied financing on 2.5s is currently trading flat to slightly through Repo. However, we do expect that role specialness will improve in the coming months and may average 25 basis points through Repo given current origination and Fed purchase dynamics.

As you can see, even without a role implied financing advantage, based on our assumptions potential gross returns on 30-year 2.5s pre-convexity costs were solidly in the mid-teens as of March 31st.

Since quarter end, valuations have improved and so currently returns are roughly 2% lower than the example shown on the slide. As we look forward, we are excited about the return environment for Agency MBS, while spreads have tightened materially from the depths of March, they remain wide to historical norms despite QE4. And while we fully recognize the unprecedented economic challenges presented by the current crisis, our Agency MBS business is somewhat uniquely positioned on a go forward basis.

I will now turn the call over to Aaron to discuss the non-Agency sector.

[Aaron Pas, Senior Vice President]

Thanks, Chris. As Gary mentioned, the credit markets were also very challenging to navigate, as they ultimately had to grapple with complete illiquidity across all fixed income products, and the rapid emergence of serious credit uncertainty associated with pricing and the impacts of a recession.

I will quickly recap our activity in the quarter and then update you with our outlook on credit. Please turn to Slide 9. As we discussed on our last quarter's call, we anticipated reducing our CRT position given the further tightening of spreads in January. Accordingly, we sold close to 200 million of CRT in Q1 prior to the decline in prices in mid-March.

The other changes for the portfolio during the quarter were an increase in residential credit subordinate bonds backed by GSE eligible collateral and a small addition of CMBS versus a reduction in our PL subs.

With respect to portfolio composition, as you can see from the GSE CRT portfolio pie chart, more than half of our CRT portfolio was issued in 2016 and 2017. These CRT vintages have performed well since quarter end and have recovered materially from the lows given their solid credit support and built up HPA.

Additionally, we remain comfortable in large part with our current CMBS holdings. Almost all our exposure on the conduit side is double A rated or higher. And while we have some lower rated CMBS [FASB] (Ph) deals, we have no single asset or hotel exposure and minimal retail exposure. In the second half of March, non-Agency asset were hit with a perfect storm.

Adding to the illiquidity and credit concerns, there were material challenges on the financing side, increasing haircuts and borrowing rates along with difficulties in rolling Repo with some counterparties combined to produce a brutal couple of weeks.

The massive intervention from the Fed helped stabilize credit markets. And once for selling subsided, non-Agency valuations recovered a meaningful amount of their initial declines. Against that backdrop, financing has eased a bit, but still remains challenging. Importantly for us, given the relatively small size of our non-Agency portfolio, we have the option of taking the entire position on balance sheet if necessary.

Looking ahead these are some of the things we were thinking about. On the residential side, while it was impossible to discount a significant drawdown in-house prices, our view is that in the near-term only a shallow decline in-house prices is likely.

We came into 2020 with a strong housing market supported by limited housing inventory and pent up demand due to strong household formation. The quick implementation for Barron's programs should both by time for economic recovery and give servicers time to work on modification programs should they be needed.

With rapid increases in job losses over the past six weeks, it is likely that conventional mortgage forbearance rates will increase from around 5.5% where we stand today to the 10% to 15% range.

Given this increase extending the timing of defaults in REO dispositions far enough into the future should dampen the impact to house prices and is critical to limiting the downside scenarios.

As Gary and Chris addressed earlier, we expect prepayment speeds on Agency collaterals to be slower than many models would project at these rate levels. This negatively impacts discount price credit securities with slower return of principal and de-leveraging.

The GSCs use of CRT to hedge their guaranteed business is likely to reduce the refinance programs they would be willing to implement in the future. If the GSCs were to add new refinance programs that bypass normal underwriting constraints other than the existing Harp Lake program, they would lose the value of the credit protection they purchased by issuing CRT.

Turning to the commercial front, the credit curve has steepened out meaningfully as the top of the capital structure and conduit deals has been anchored by the inclusion in the Federal Reserve's [top] (Ph) program. Conversely, the bottom of the capital structure is trying to price into some assumptions around forbearance rates. Material increases in default expectations and the potential for downgrades.

Challenges in the hotel and retail sectors are top of mind, but New York and other big office buildings could face significant headwinds as some companies look to diversify the location of their workforce. These issues will take time to play out and in our view the commercial real estate market faces the greatest uncertainty and biggest range of possible outcomes.

This may lead to interesting opportunities in the coming quarters as we begin to get delinquency data and monitor credit performance. In light of the tightening in spreads for many structured products securities along with Repo challenges, we believe a patient approach on the credit side is warranted at this time.

With that, I will turn the call over to Peter to discuss funding and risk management.

[Peter Federico, President and Chief Operating Officer]

Thanks Aaron. I will start with the review our financing activity on Slide 10 despite considerable market turmoil, the Repo market for Agency MBS functioned remarkably well during the quarter.

Given the Repo issues last fall, the Fed had already taken significant steps to ensure that the Repo rate for Agency and treasury collateral remain closely tied to the Fed Funds target. On March 20th the Fed began providing an additional $1 trillion of liquidity to the Repo market each day.

This dramatic step coupled with the Feds ongoing open market operations ensured that the Repo market for high quality collateral like Agency MBS remain extremely liquid throughout the crisis.

The Fed also lowered the Federal Funds rate to the zero bound with the 50 basis point rate cut on March 3rd and a 100 basis point rate cut on March 15th. Our weighted average Repo funding costs for the first quarter was 1.8% down 32 basis points from the prior quarter. Our Repo costs at quarter end is still significantly more to 1.36%.

Today, the Repo market has largely are-priced to the new Fed Funds target. Overnight Repo has averaged about 10 basis points in April. Importantly, the term market has also are-priced with 30-day Repo now trading at about 12 basis points and 90-day Repo trading at about 22 basis points. Given these funding levels, I expect our average Repo cost in the second quarter to decline to approximately 80 basis points.

Our aggregate cost to funds which includes the cost of our Repo funding and swap Hedges also improved during the quarter, but to a lesser degree, as the improvement in our Repo costs was largely offset by a lower received rate on the floating leg of our swaps.

Importantly, with LIBOR swaps representing only a small part of our portfolio, our aggregate cost to funds will not be negatively impacted as LIBOR converges with other short-term rates. Looking ahead, I expect our average cost to funds in the second quarter to be about 110 basis points.

Turning to Slide 11, the notional balance of our hedge portfolio totaled $59 billion at quarter end down significantly from $99 billion in the prior quarter. In response to the rapidly changing interest rate environment, particularly in March, we repositioned our hedge portfolio by terminating a significant portion of shorter term swaps and treasury hedges. As a result, our hedge ratios declined to 70% from 102% the prior quarter.

With short-term rates being close to zero swap rates are-price dramatically during the quarter. With shorter term OAS swaps rallying about 135 basis points and longer term swaps rallying about 120 basis points.

The pay rate are new five and 10-year OAS swaps is now only about 20 and 40 basis points respectively. As such, these swaps provide a unique opportunity to lock in very attractive funding levels for an extended period of time, while also providing protection against the reversal in rates in the event of a sharp recovery.

On Slide 12, we show our duration gap and duration gap sensitivity. Given the changes that I mentioned to our hedge portfolio, our duration gap remained in a fairly tight band throughout the quarter and ended the quarter at about zero.

With interest rates being at such a low absolute level, there is now significantly more extension risk in our portfolio and in the mortgage market as a whole. You can see this asymmetric risk profile in the table with our duration extending about two times more in the up rate scenario than it contraction in the down rate scenario. Given this asymmetry and the low cost of longer term hedges, we will likely favor operating with a flat or even negative duration gap in the current environment.

Such a risk profile is further supported by interest rates being so close to the zero bound. While negative rates are certainly possible, we believe there will be significant resistance to that, as the Fed will likely utilize all of their tools including especially large scale purchases and forward guidance before resorting to lowering the Fed Funds rate significantly below zero.

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

[Gary Kain, Chief Executive Officer]

Thanks, Peter. And at this point, we would like to open up the call to questions.

[Operator]

Thank you. [Operator Instructions] And the first question will come from Rick Shane with JP Morgan. Please go ahead.

[Richard Shane, J.P. Morgan]

Good morning everybody. And I hope you are doing well through all of this. Two questions. First on the non-Agency side, look, it is a relatively small part of the portfolio. As we have seen over the last six weeks, it creates a very different risk profile that doesn't necessarily benefit from the same policy interventions in advantages. I'm curious if going forward you see the dislocation as an opportunity or as an exit.

[Gary Kain, Chief Executive Officer]

Rick, first off, thanks for the comments and I also want to wish everyone the best in this kind of unique environment to say the least. But let me get to your question. We don't view this as like an exit opportunity.

But, I mean, what we have said about the credit portion of our portfolio is that we do believe that it makes sense to be fluent in crack in the credit sectors of the mortgage market. Because we do think over the long run, it is naive and limiting to assume that at all points in time Agency MBS are just clearly going to be the best place to run a levered mortgage position.

So we are committed and as we have said for a few years now, we are committed to being involved in the credit sectors, but we will be very patient and very disciplined with respect to that involvement and we will only increase those positions significantly to the extent that the risk return tradeoffs are compelling.

And so you know let me take that to today's environment and so I can kind of put that - kind of make that a little more specific. Right now credit has obviously cheapened up significantly. But the environment is very uncertain and there are real credit headwinds to a range of sectors. Including CRT or conventional mortgage market.

The commercial space is probably kind of has the most uncertainty as Aaron mentioned and we certainly believe that. So at this point with the improvement that we have seen in credit from the lows, we don't see credit as being back up the truck cheap by any stretch of the imagination. But as the fundamental information comes in, as we start seeing delinquencies, as we start seeing some of the stress, then we think there are very easily could be some good opportunities there.

It is also very possible that on the agency side of our business, depending on the magnitude of the Fed’s programs, depending on things, how things evolve over the next three to six months, we could see a situation like what we saw in QE3, where Agency MBS get tightened significantly from here. While that is good for our book value, it will kind of reduce the risk adjusted returns on the Agency side.

And so there is a very real possibility that three to six months from now, it will make sense for us to rotate some of our capital away from agencies into credit. And having the fluency with credit, having the involvement but without having it be like handcuffs is a real positive.

And so we are not saying that that is definitely the way we are going to go. I would say it is probably less than 50% chance that those conditions will arise. But it is a much more likely scenario now than it certainly was six months ago.

So that is kind of what we are looking for. But now we are committed, we feel like we achieved a good balance of again being fluent, understanding the products without it ending up handcuffing us in terms of running our core business.

[Richard Shane, J.P. Morgan]

Look, that makes sense. I think what I'm hearing strategically it is important to keep it as an option and tactically, you are not seeing the opportunity quite yet. One follow-up question, giving your view on rates and the asymmetry issue sort of develop your hedging strategy going forward, do you think the [swaptions] (Ph) will become a larger part of the strategy?

[Gary Kain, Chief Executive Officer]

So it is interesting, the answer there is, it might, but at not at this point, it is interesting because the asymmetry allows you really to just pay fixed on let's say a seven-year swap, that is where the pay rate on an OIS swap is, let's say mid 30s. So that swap cost you, you are receiving, let's say, 10 basis points so that cost you 25 basis points in carry. But if you don't believe in negative rates, how much can you lose on that short position.

Let's say that swap rate goes to 15, okay, so you lose 20 basis points. In most cases you are going to pay that or more for a premium on an option. So it is kind of unique that again, unless you are of the mindset that swap rates can go to negative 50 then options really aren't necessary.

Look and I want to just mentioned on negative rates, we are not saying it is absolutely impossible, we are obviously aware of that is going on in Europe and they have substantially negative rates.

But we do think the Fed will do a host of other things before they go there, increasing their QE would be one thing they will definitively do, they will probably do something around yield curve control, and there will be lots of warning signs that will probably give us an exit point on our mortgage position at tighter levels as well. So we think in the short run again, this asymmetry really helps us manage a portfolio and it is a unique position to be in, where the zero bounds really helps.

Let me let Peter add something to that.

[Peter Federico, President and Chief Operating Officer]

Yes. Hi Rick. Let me just add, we sort of already started to implement the strategy that Gary just talked about. I know you have seen the drop in our swap portfolio, which was about 32 billion but what we ended up taking off a lot of the much shorter term swaps to one- year, two-year swaps, but we also added a significant amount of longer term swaps during the quarter.

In fact, we added about $10 billion worth of swaps between four and 10-years. So we have already begun that rotation that he was describing because those hedges are so much more cost effective and efficient versus option based hedges in an environment where interest rate volatility is so high.

[Richard Shane, J.P. Morgan]

Got it, okay great. Thank you guys very much.

[Gary Kain, Chief Executive Officer]

Thanks Rick.

[Peter Federico, President and Chief Operating Officer]

Take care.

[Operator]

Your next question comes from Bose George with KBW. Please go ahead.

[Unidentified Analyst]

Hey, thanks. Good morning. It is [Eric] (Ph) on for Bose. And I hope you guys are all well. How are you guys thinking about the amount of leverage you are taking right now, just given the fact that spreads are already relatively wide and returns could arguably be considered and still be considered very strong with less leverage. I mean, why do you guys feel the need to be as levered in this environment as you were at year-end just given the obvious risks that are still out there and that you also acknowledged in your opening remarks?

[Gary Kain, Chief Executive Officer]

Well look, that is a great question and I know, I will kind of take it at a higher level, which is - and I will answer your question plus, given what we went through in March, has that changed our perspective on leverage big picture.

But first off, one thing in Bernie's prepared remarks he mentioned that over the course of April, our leverage has come down, not via shrinking the portfolio. It was mainly due to just the increase in book value and not replacing the full amount of prepayments so to speak.

So in the end we are running, leverage now again, that is closer to 8.5, but I do want to stress that the aggregate leverage number is an important determinant of your liquidity. But it is in no way, shape or form the final answer.

And TBA positions are much, much more efficient for us from a liquidity perspective. Then on balance sheet pools and on balance sheet pools also differ kind of in terms of their impact on your liquidity. A pool that can pay 30 or 40 CPR is a substantial drain on your liquidity, given the payment delay issue where you have to wait for your PNI receivable till the 25th of the month.

So what I would say is that, we are willing to run leverage levels consistent with where we were before, 9.5 to 10, let's say. But, I would say we are putting a little - we are definitely putting a greater emphasis on liquidity in this environment because we think that is what shareholders would want from us.

So big picture I would ask you know analysts and investors to look a little below beyond just the quote at risk leverage and understand there are different components that affect both your liquidity and your ability to handle kind of adverse moves.

And just as a quick example of that, a TBA position through - as the securities dealer requires a margin that is around 1% to or maybe 1.5% in all-in whereas, the haircut on an on balance sheet position in bilateral Repo is 5% on average, and that pool has a pay down that if it is let's say in the 20s in CPR, that almost adds an effective 2% more to the haircut.

So that is a massive difference right between an effective 7% haircut on a bilateral Repo with a pool that's pre-paying versus a TBA position. So what I would say is investors should expect AGNC to be cautious on the liquidities side, but to do it in a smart way that optimizes our risk adjusted returns.

[Unidentified Analyst]

Got it. Thank you that was helpful. I think we did pretty well in the my next question on funding. I mean, it hasn't - lost on anyone that has bank earnings have come out. The loss reserves that they have been looking has been pretty meaningful, which at least on its face creates I think some risk that they manage their own balance sheets, somewhat differently going forward. So I'm just curious how you guys think about your funding exposure to the banks and their ability to supply funding in general, not just AGNC, but other businesses as well. And as a side to that, I mean, operationally how challenging would it be to move even more of your funding, we will just say kind of the bulk of your funding over the - securities if you needed to or wanted to?

[Peter Federico, President and Chief Operating Officer]

Hi, this is Peter. Hope you are doing well, thanks for the question. First off, I would say that as I mentioned in my prepared remarks, the Repo market for agency collateral really traded remarkably well throughout the crisis. And the Fed has done a terrific job of making sure that there is sufficient liquidity in the system and they are continuing to do so today. I don't expect that to change.

You know we have 47 other counterparties in addition to the Fed to securities. And those counterparties all performed very well for us during the quarter, we had no issues with any of the counterparties. But having 47 of them, we have our exposure, which as you point out is about 45% at the end of the quarter of our funding books spread out across those counterparties.

So there is really no significant concentration. And that allows us to move positions from counterparty-to-counterparty very quickly, because we don't have significant concentrations in any one counterparty.

And your other point about the Fed to security is a good one. From an operational perspective, it is very easy for us to move collateral. When our bilateral collateral matures for example, we can very quickly move it to the Fed to securities. We have additional capacity, and we could utilize it.

And we may utilize it to some degree, because as Gary mentioned, it is highly efficient from a margin perspective on the funding side, and it is incredibly efficient on the TBA side, and we would not be able to do that on TBAs if we didn't have Fed to securities.

But we also like the fact that our portfolio is highly diversified and so right now we think the best mix is to have a really large group of strong individual counterparties. And I believe that they are going to continue to participate in the market and provide support for us, as well as have the ability to move motive but best if we need to.

[Gary Kain, Chief Executive Officer]

And I just want to that, just keep in mind right that the agency - the government Repo complex didn't go through it shock in March, it went through it actually lasts September, right. And when there was a huge spike, unexpected spike in overnight Repo rates, and since then the Fed has been incredibly engaged and taken ownership of all Government Repo rates.

And to Peter's point, I think a lot of the success of the market in March and the Repo market in March was a function of the fact that Fed had been dealing with it in a large way. Okay. Buying bills, doing open market operations, well prior to March to address that and then they offered a trillion dollars in overnight Repo.

I mean the Fed is very, very focused on that issue and even before you get to purchasing of treasuries or Mortgage Backed Securities. So I think that is the last thing that the Fed's going to let have issues.

And you having our broker dealer on the FICC gives us - it is not direct access and want to be clear, but it is closer. And we have shrunk, we have definitely let our repo book, given the shrinkage in the portfolio and the move of more to the Fed stuff. We have lots of spare capacity, on the bilateral side. But thank you for the question.

[Unidentified Analyst]

Thank you guys for the answer. That was very helpful. Stay well, thank you.

[Gary Kain, Chief Executive Officer]

You too.

[Operator]

Your next question will be from Doug Harter with Credit Suisse. Please go ahead.

[Douglas Harter, Credit Suisse]

Thanks. As you mentioned, kind of specified pools have performed well in April. Can you just talk about whether there are price wise, pay up wise compared to January and February.

[Gary Kain, Chief Executive Officer]

Yes. Why don’t I let Chris take that one.

[Christopher Kuehl, Executive Vice President]

So thanks Doug. I think Relative to the start of the year pay-ups on HLB, 3.5 and fours for example, are slightly higher. But a thing to keep in mind is that you know valuations at the start at Q2 were still at very, very depressed levels and so while pay-ups have improved over a point or so since then, they are still extremely attractive given that coupon swaps are still very depressed.

They were starting at extremely cheap valuations, [OUS] (Ph) changes year-to-date are still, a good 30 to 40 basis points wider. When you think about just the 125 basis point move in rates, they have actually still underperformed quite a lot given despite the absolute changes in pay-ups.

So if you look back to the ROE slide that we presented, yields are currently on 3.5 and fours around 20 basis points or so lower than they were as of 331. And so I would say potential ROE is roughly 2% lower. And so but even there returns are still very, very attractive.

[Douglas Harter, Credit Suisse]

Great. And I guess again, thinking of that slide where you are looking at the returns, how do you think about balancing out, kind of what the returns are on the - pools versus kind of the more liquid two and a halves? And, how to use think about what is the right balance to gain the liquidity from kind of the more generic coupon versus the specified pool, which obviously proved to be less liquid in the periods of stress?

[Gary Kain, Chief Executive Officer]

It is a great question and, well, Chris, why don't I start and then you can add. But what I would say is, first off, look the lesson from the liquidity of March was something we were certainly fully aware of before which is you don't want your whole portfolio in high pay-ups specified pool.

And that reduces your liquidity and your options for moving things around to say the least. But that said, I think, look both offer competitive returns, even given the tightening that we have seen in April, and they are now relatively balanced.

In the higher coupons, you have got relatively stable cash flows, there is no origination, the technical factors are stable in today's environment. So, I don't think you are going to see that much price volatility there. Your exposure is going to be to kind of realize pre-payments speeds, and are there going to be surprises there.

In the short run, we think the surprises are more likely to be to the downside versus expectations, rather than to the upside. But on the other side of it, there is a lot to be said for lower coupon returns and the potential for role specialness to improve those.

You have the liquidity benefits where you can run those positions in pure TBA form, or in a new production pool, that is not going to have a pay down. So there are benefits there. And I think the short answer is, we want to achieve a balance of those.

The one other issue you have with low coupons is that there has been and there will be significant production. So the technicals are how fast is production coming in versus the Fed’s bid and any other bids. So we do expect more price volatility in lower coupons and we will look to use that as an entry point.

So that is it from a high level. I will let Chris add something to it.

[Christopher Kuehl, Executive Vice President]

Gary, I think you summed it up pretty well. I don't have a lot to add other than, I mean I would say that while specs have improved a fair amounts, I mean, the cash flow stability from a spec position is important diversification around our lower coupon position. We don't want to be overly expose to reliant the Fed there.

[Gary Kain, Chief Executive Officer]

No, that is a good point.

[Douglas Harter, Credit Suisse]

I appreciate that. Thank you guys.

[Operator]

The next question is from Trevor Cranston with JMP Securities. Please go ahead.

[Trevor Cranston, JMP Securities]

Hey, thanks. A question on the previous side. You talked a lot about the factors that are likely to limit how fast speeds get at least in the near-term. Can you comment on sort of what you guys bake into your base case prepay assumptions in terms of how much compression there could be between primary mortgage rates and secondary MBS yields and what you would consider the biggest risks to that spread potentially compressing kind of further than where you currently expect it to?

[Gary Kain, Chief Executive Officer]

Yes. Let me start on that. I mean, I want to say that the modeling, when you look at OAS models or Monte Carlo simulations, prepayment models right now, this is a stressful environment for them. Their results are all over the place.

And the thing you addressed, how you derived the mortgage rate, okay. This primary rate and how you evolve it overtime is one of the key variables that differ quite a bit from model to model.

But what I would say is, from our perspective in thinking about prepayments, we do expect the primary rate, or primary secondary spreads to compress. They do in these kinds of environments overtime. I think that it is not going to be immediate.

And given how much of the universe is refinance today and given the unique circumstances, we think that that compression will be slower than it was in let's say other kind of periods of big drops and interest rates.

So we think that will take time, but yes, that will kind of increase the incentive to refinance. But on the other hand, as we have said over the next, we will call it three to six months, you have the social distancing type headwinds as well as credit headwinds.

I mean, you know, we didn't talk a lot. We mentioned the forbearance issues in our prepared remarks, but forbearance is a very, very good option for GSE borrowers. And generally there are going to be a lot of people that aren't going to be able to qualify. Others that don't take forbearance but won't qualify easily for a new loan.

So, practically speaking, I think there are factors that, work. There are a lot of factors that will keep prepayments from surprising to the upside, certainly over the next three to six months. But that is predicated and those are prepayment thoughts.

And where we think things are going to go are predicated on the fact that the primary secondary spread will compress overtime as it as it normally does. Again, I think it will take a little longer this time.

[Trevor Cranston, JMP Securities]

Got it. Okay. That is helpful. And then one more question just on the credit side. I think Aaron mentioned in his remarks that the availability of funding remains somewhat constrained. I was wondering if you could provide any additional color there in terms of just kind of if you are seeing a significant number of counter parties completely pull away from that market and just generally how much change you have seen in terms of the haircuts and where rates are for credit securities. Thanks.

[Gary Kain, Chief Executive Officer]

Yes, sure. I mean we obviously do finance some non-agencies, as I think everyone knows, our positions are relatively small and it is a very small percentage of kind of our funding considerations, but I mean, higher haircuts are kind of across the board at this point, they are almost - you know they have been raised.

The rates are much less attractive than they were going into this. And we have seen some counterparties exit the business altogether. But to be clear there are people that are still willing to do the business and if anything from over the course of the month, things are a little better now than they were, but you are still looking at rates and whatever 2% kind of or more area, and haircuts are obviously dependent on the type of security.

And then there are some things that you just can't finance. And that, so, one of the things that absolutely affects our view on waiving in credit so to speak are these challenges. I mean, and if we were to have sort of a double dip in the economy or some of these fundamental factors were to start looking bad which is very possible, then we could see more stress again on the financing side. So we have to build that into our assumptions in ROE.

Look, it is one thing if you are looking at a position from an unlevered or cash position, long only position, things are more attractive than when you look at them on a levered position given the challenges on the funding side.

[Trevor Cranston, JMP Securities]

Okay. I appreciate the color on that. Thank you.

[Operator]

The next question will be from Kenneth Lee with RBC Capital Markets.

[Kenneth Lee, RBC Capital Markets]

Hi good morning. Thanks for taking my question. I'm wondering if you would be able to just give us a sense altogether, how much net interest spreads could potentially improve in the near-term, given the dynamics from the ongoing Fed supportive agencies as well as the much lower funding costs that you mentioned in prepared remarks? Thanks.

[Peter Federico, President and Chief Operating Officer]

Sure. Good morning, Ken. This Peter, hope you are doing well. As I mentioned, I expect our Repo costs to come down around 80 basis points in the second quarter. I will sort of give you the building blocks.

And I expect significant improvement from there into third and fourth quarters by the way. As some of our higher costs longer term Repos mature, it could easily drop to about 50 basis points in the third quarter and down around 40 basis points in the fourth quarter.

The variable for our cost of funds is going to be - our swap costs, which are expected to be net on total liabilities around 35 basis points. So that would give us a cost of funds of around 110 in the second quarter.

On the asset yield side, obviously, it is going to come down, but probably in the neighborhood of around 270, in terms of asset yield might be a reasonable starting spot. So I would expect our net interest margin in the second quarter to trend toward 150, 160 basis points.

And then from there, it will depend on obviously rotations in the asset portfolio in the third and fourth quarters. And then as well as some of the rebalancing or reposition that we are going to continue to do on the swap side, which would ultimately I think put some downward pressure on the cost of swaps as we move our swap hedges to the longer part of the curve or intermediate part of the curve which as we talked about doesn't cost very much right now. So directionally I think it is heading up into that range.

[Kenneth Lee, RBC Capital Markets]

Okay, great. Very helpful. And just one follow-up, if I may, in terms of the liquidity position $3.5 billion of cash in unencumbered assets, is there a way that you could provide us some context or just help us frame how strong this liquidity position is or what is the best way for us as outside observers to determine the relative adequacy of this liquidity position? Thanks.

[Peter Federico, President and Chief Operating Officer]

Yes, thank you very much for that question. And you are right, it obviously helps a lot to have some background to that. So you know where that stands historically. Let me just give you a starting point. At the end of the year, our cash unencumbered at AGMC was 3.6 billion and then between non-agency securities and Bethesda, it was another 1.8, so it is 5.5 billion, right.

And that represented 52% of our equity at the time, which is a really pretty strong position and if you look back historically, you would see that somewhere between 45% and 55% so it was at the upper end of where we typically operated. And that gives you a lot of obviously capacity to absorb huge stocks.

As Bernie mentioned, the total of the 3.5 billion that we had on March 31st plus the 1.2 billion at the Fed which is all cash in from Agency MBS and then the 300 million non-agencies totaled $5 billion and that was a 54% of our capital. So at the end of March, we ended the crisis period on a percentage basis with more cash in unencumbered equity.

Yesterday, our position at AGNC was even stronger. It was $4.2 billion of cash in unencumbered plus another 1.2 at the Fed and securities and yet 300. So we had 5.7 billion of unencumbered and against the capital that we sort of described it being up 8%, our percentage of unencumbered had increased close to 60%, which is close to as high as we have ever operated.

So that gives you a sense on how we have prioritized risk and liquidity in this environment. And we have put ourselves in a position where we have actually come through the most significant crisis in the history and actually now have a cash in unencumbered position that gives us - it is even stronger and gives us more flexibility going forward to take advantage of market opportunities.

[Gary Kain, Chief Executive Officer]

Let me give you another just quick way to think about it too, which is if we walked in tomorrow mortgages, we are across our entire position. We are down two points, which is obviously a massive move. I mean, we saw worse obviously, before, but that would generate kind of or that would be expected to generate margin calls of about 1.8 billion. Right Peter?

[Peter Federico, President and Chief Operating Officer]

That is right.

[Gary Kain, Chief Executive Officer]

So, 90 plus billion and more, so two points, we have margin calls around 1.8 billion. That would be less than half of our liquidity thought that we have on hand with the zero, without having to make any adjustments. So that is another way to think about that in terms of how substantial that cushion is.

[Kenneth Lee, RBC Capital Markets]

Really appreciate that. That is very, very helpful color. That is it from me. Thanks again and everyone stay safe. Great thanks.

[Peter Federico, President and Chief Operating Officer]

Yes, you too.

[Operator]

Our next question will come from George Bahamondes with Deutsche Bank. Please go ahead.

[George Bahamondes, Deutsche Bank]

Hi good morning. I believe my question has been answered on the on the prior question. I mean, was just to confirm Peter that you expect total average borrowing costs to be roughly 1.1% in the second quarter. I believe you may have just addressed that though?

[Peter Federico, President and Chief Operating Officer]

Yes, that is correct. I expect that total cost to funds to be in that range. And again, the two components of the total cost to funds is a Repo which I expect at around 80 basis points. Chris talked about TBA specialness, I expect that TBA cost to be down around 25 or 35 basis points.

So the combination of that plus the cost of our swap hedges which at the end of the quarter, if you sort of projected that out going forward expressed as a percent of our total liabilities would be about 35 basis points. So total cost to funds of around 1.1%.

[Gary Kain, Chief Executive Officer]

But just keep in mind, obviously, we are less than a month into the quarter and there are lots of moving parts in terms of what we end up doing with swap positions and assets and where dollar rolls go and so forth. So, keep that in mind to that there is lots of different things that could move those numbers around.

[George Bahamondes, Deutsche Bank]

Absolutely, great. Thank you all for confirming that.

[Gary Kain, Chief Executive Officer]

Thank you.

[Operator]

The next question will be from Matthew Howlett with Nomura. Please go ahead.

[Matthew Howlett, Nomura Instinet]

Hi everyone, thanks for taking my question and first of all, congrats on really protecting shareholder interest during the volatility. Gary, you are always sort of one step ahead of the Fed, last time to the QE program. So I want to really focus on just more some of those questions. First, did you address there has been talk of yield curve control? I don’t know if you would address that, but I want to first, when you talk about the policy, do you think there is any risk that they implement something of that nature?

[Gary Kain, Chief Executive Officer]

I think there is, I mean, in a sense, it is kind of like, they decide where they want the intermediate sector and the longer end. Obviously, they currently peg the very short end that is their job in setting Fed Funds and overnight Repo.

And, but others, such as the Bank of Japan have chosen to kind of pick a level, let's say, for the 10-year, I will just hypothetically say they decide they want the 10-year to be around 50 basis points. And if they were to go that route, they would execute whatever amount of trades they needed to do to keep it in that zip code, so to speak.

And so where I think this comes into play, I don't think they are ready to do that right now. I feel like, they have just unleashed a hosts of tools, and they are using them extensively. And obviously, financial markets have stabilized and are kind of performing much, much better than they were, I don't feel like the Fed feels they have a crisis on their hands at this point.

But let's say things start to unravel a little bit more than these are the kinds of things that the Fed is likely to do, they are probably likely to up their QE again on the mortgage side and on the treasury side, because they have brought their purchases down substantially from where they were a month ago.

So if they felt they were losing ground and the economy was weakening again and liquidity was getting worse, I think they would start to look at what else they could do. But the first thing they would probably do was increase QE again, okay.

And probably first in terms of the magnitude of what they are doing because they have backed down their two main levers treasuries and MBS. And then they might look to this yield curve control.

And all of these are things that we think they will do before they experiment with negative rates, which I think there is really no stomach for right now, either at the Fed or kind of even amongst most financial market participants. So, it is possible, I don't think it is in the offing in the short run. I think again, it would be one of the tools they might go to before they went to negative rates.

[Matthew Howlett, Nomura Instinet]

Thanks for that. When you think about your business model managing your duration, gap, but you feel that Fed has got more different backup the 4% that they are just going to come in and start buying. And then more would you think they want to bring rates below 3%. Do you think they have a target in mind that we are going to buy until consumer can see 3% below mortgage rates. I mean this also different in QE you mentioned that - you know what do you think your target is where they want mortgage rates to be?

[Gary Kain, Chief Executive Officer]

You know I think it is evolving. I think there is still and I would take this in some ways from a [Chair Powell’s] (Ph) press conference yesterday, but I think they are still in the mindset of their purchases are more designed around liquidity and proper function of the market. And a month or two from now they are going to start focusing on stimulating the markets.

Okay. And when they go to stimulating and you have heard this from the Fed over and over again, and from people like Simon Potter who left the Fed, one of the unique tools that they have that other central banks don't have is the ability to move the mortgage rate okay.

And right now it wouldn't matter because of the discussion to an earlier question related to the primary, secondary spread. So they could move mortgage prices higher and it wouldn't affect mortgage rates today, because the primary secondary spread would just offset it.

A couple months from now. That won't be the case and they will have more incentive to potentially want to push mortgage rates lower. So I think that is in a sense, the next phase of their mindset is how can they stimulate the economy, right now they are still in kind of preserve liquidity, strengthen the financial markets and they will go from there.

[Matthew Howlett, Nomura Instinet]

Thanks Gary. Thanks everyone.

[Gary Kain, Chief Executive Officer]

Thank you.

[Operator]

The next question will be Brock Vandervliet with UBS. Please go ahead.

[Brock Vandervliet, UBS]

Thank you. You made a passing reference to your expectation of the forbearance levels rolling from call it six to 10 to 15. Obviously this is kind of over the, the end of the horizon at this point, but how do you look at the risk of some of those credits, not recovering delinquency rates, pulling up, and therefore the risk of the GSEs having to buy these out of the pools and what effect that could have on pricing?

[Gary Kain, Chief Executive Officer]

Yes, look, that is a great question. And I think, over the past month, different researchers have written about this and kind of described it as we will call it a significant risk to prepayments. And that was a reasonable concern early on, because the GSEs used to have a policy with respect to delinquencies where after four months of delinquencies loans were pulled from pools.

So if they were to have stuck with this boilerplate practice, then if we got to 10% forbearance and if forbearance was treated like a regular delinquency, you could have very fast free payments coming relatively quickly from this forbearance equation.

But both the GSEs and FHFA have explicitly and it was probably about a week ago, put out guidance where they are not going to treat forbearance like a regular delinquency, and they will wait until the forbearance period, which could be up to a year is over before they start that four month clock, okay.

So there are there are situations if the loan turned out to be modified before that, and there are ways where it could come out of the pool before that, but I think that is a very low likelihood. So, realistically delinquencies getting pulled from these pools is a problem for let's say, a year and a half from now.

And then first off, we think and they are obviously very focused on it. We think that a good chunk of those delinquencies will be able to be put on a reasonable repayment plan. And obviously, the hope is that many of those people will have regained their jobs by then.

And so yes, a percentage of them will probably ultimately default and be pulled out of the pools. But let's say you sit there and if you tried to say, okay, maybe 3% or 4% of these borrowers are pulled out of the pool in 18-months, I mean, that is actually a very, very low CPR, so to speak, and it is not something that we think negatively impacts the performance of our pools.

On the contrary, I think net-net, that is a very good outcome in a way, I mean, again, I don't want people missing payments and so forth. But, from a prepayment perspective, the key change was the GSEs treating this the way they have treated Katrina and other hurricanes where they don't view these forbearances as delinquencies, and that they are going to wait a long time to pull these loans out of the pools.

That is critical to the performance of higher coupon securities and specks in particular, and we were very happy to see FHFA explicitly define that in a press release.

[Brock Vandervliet, UBS]

Got it. Okay, that is a key distinction. I guess an analogous question beyond CRT. Obviously, this is credit protection, if they forebear and modify that would threaten the value of CRT, but they would come out right out of the gate with very aggressive forbearance. How does that through to the value of the CRT market?

[Gary Kain, Chief Executive Officer]

So, I mean, you know look with CRT the forbearance is good in terms of the fact that we are giving borrowers who would have a short-term interruption to their income and their ability to pay, we are giving them significant time to work through that. And if they get their job back, then hopefully there is a plan to get them current and I think there will be lots of options.

And as Aaron mentioned in his prepared remarks, just buying a lot of time keeps any pressure off the housing market from REO disposition and it prevents or likely prevents a downward spiral for house prices. So that good for CRT ultimately.

The other thing that is interesting that Aaron alluded to just going back to kind of the prepayment question is one of the things, we have gotten the question at times about, well, you have this favorable view on prepayments, that they are not going to be that fast.

The other thing that CRT does is it really, really handcuffs the GSEs with respect to trying to implement some much faster streamlined Refi program where they look past income and job situations in terms of deciding whether someone can Refi.

But if they do that and they let people Refi that have credit issues, then that is a home run for us as a CRT holder, because they essentially have this in the money protection that they have bought for seven years. Okay. That protects them from the bulk of the losses, for these weaker credit borrowers.

And if they just go and Refi them and do that uneconomically, they are basically going to waste that protection. So we certainly do not see that happening. In a sense for our position, we sort of have a little bit of a built in hedge for that situation.

[Brock Vandervliet, UBS]

Got it. Great job. Thanks Gary. Stay safe.

[Gary Kain, Chief Executive Officer]

Okay. You know you too and thanks again.

[Operator]

And ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the conference call back over to Gary Kain for any closing remarks.

[Gary Kain, Chief Executive Officer]

Well, look, I would like to thank everyone for their interest in AGNC. I hope that everyone stays safe through these really difficult times and we look forward to speaking with you again next quarter.

[Operator]

Thank you, sir. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.