Q1 2020 Earnings Call

[music].

Good morning, welcome to the EG and we see investment Corp, first quarter 2020, Cheryl shareholder call all participants will be any listen only mode.

Would you need assistance, please football college specialists, but that's going to Starkey <unk> budget.

After todays presentation, there will be an opportunity to ask questions.

Yes. Good question you May Press Star then one on your telephone keypad.

Withdraw your question. Please press Star then too.

Please note this event is being recorded.

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

Thank you for joining.

The investment Corp, first quarter 2020 earnings call before we begin I'd 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.

Looking statements within the meaning of the private Securities Litigation Reform Act of 1995.

All such forward looking statements are intended to be subject.

So 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 and EG and see.

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 statement.

And the risk factor section of agencies periodic reports filed with the Securities and Exchange Commission.

Copies are available on the Fccs web site at FCC Dot Gov.

We disclaim any obligation to update our forward looking statements.

That's required by law.

Participants on the call include Gary Kain, Chief Executive Officer.

For any bell senior Vice President and Chief Financial Officer.

This kewill executive Vice President.

Aaron past senior Vice President and Peter Federico President and Chief operating officer with that I'll turn the call over to Gary Kain.

Thanks, Katy and thanks to all of you for your interest in agency.

As you know conditions were extremely challenging in March as the market reacted to the cold at 19 pandemic.

The dislocations witness starting mid 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.

Agencies financial performance like almost all financial companies.

What severely impacted by the market volatility with agency posting an economic return for the quarter of negative 20%.

While we were disappointed by this result, we're optimistic that the worst is behind us and we believe that we are uniquely positioned to generate strong risk adjusted returns as we look at.

I had 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.

[noise] importantly, the bold and decisive.

Action so the federal reserve stabilize the entire fixed income complex in late March.

As was the case in Q. We won in Q3 agency MBS were again, a critical part of the Feds actions.

But this program has deferred 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.

And just wanted a half months the fed has purchased approximately 575 billion and 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 Covance 19.

Against this backdrop, we believed 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 MBS, which enjoyed the guarantee of timely interest and principal from the G.S. sees.

As a result, we have very little credit exposure in our portfolio, which is where the bulk of the future uncertainty lives.

In contrast, prepayments funding an interest rate risk are the fundamental factors that will determine agncs 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 prepayments substantially.

However, these models are not designed to incorporate the unique circumstances.

She added 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 a 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.

Well every scenario is different there are some since similarities between the current environment and the one we witness between 2009 and 2012.

Where the impact of then record low interest rates on prepayments was also material is 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 cut 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 RMBS repo rates as Peter will discuss shortly have generally range 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 agency is the current asymmetry in our exposure to changes in interest rates.

Normally hedging a levered position and agency MBS requires substantial trade offs 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 art art unlikely in the near term, which is our opinion than 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.

Thank you Gary turning to slide four.

We had a total comprehensive loss of $3.61 per share for the first quarter net spread and dollar roll income excluding catch up and was 57 cents 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 costs.

Tangible net book value decreased 22.9% for the quarter.

At a high level the to the decline in our book value was driven by the underperformance of our mortgage assets relative to our hedges, resulting in materially.

The 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 cost incremental losses on our Oh, I asked swaps and our non agency assets.

Including dividends, our economic return on tangible common equity equity was negative 20% for the quarter.

Since quarter end valuations of TV, a and B S have improved modestly while pay up values on our on our specified pool position have recovered and meaningful portion of their Q1 underperformance.

As a result as of yesterday, our net book value was up approximately 8%.

Turning to slide five 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 on April two around eight half times.

Oh liquidity position at quarter end was that precrisis 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 in excess margin that we held at our broker dealer subsidiary or 300 million of unencumbered credit assets.

Our portfolio forecasted CP ours increased to 14.5% from 10.8% during the quarter as a function of lower rates actual prepayments for the quarter averaged 12.2%.

During the first quarter. We also completed 1 billion of accretive equity transactions, including a 575 million, 6.1% to 5% fixed to floating rate preferred equity offering.

And approximately 440 million common equity issued through aftermarket equity offerings.

Additionally, subsequent to quarter end, we have repurchased approximately 100 million a common stock at substantial discounts to our estimated tangible net book value.

With that I'll turn the call over to Chris to discuss the agency market.

Thanks, Bernie, let's turn to slide six as Gary mentioned the market dislocations in March were unprecedented agency mortgages widened 100 basis points intra month before TV, a MBS recovered three quarters of the move as the fed launched Q4 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, where pay ups on each ob three and a half and fours declined by more than two points.

It makes matters worse these pay ups would've 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 led to extreme intra month moves for all risk assets, while TV a mortgages recovered a significant amount of the underperformance versus rates by the end of March specified pool valuations ended the quarter at extremely depressed.

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When we released our company update on April eight 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 critical would be a critical component of the performance.

Going forward.

Since March 30, Onest specified pools have in fact recovered meaningfully.

With pay ups on HLB, three and a house 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 seven.

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 and 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 TV.

Yes.

As we discussed on prior earnings calls, we hit 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 eight we present several illustrative examples to highlight the compelling nature of agency MBS returns despite unprecedented purchases by the fed and the second half of March.

The two top table show the potential gross return on equity as of quarter end on 30 year, HLB, three and a half some fours using nine times leverage.

As a reminder, HLB pools are those backed by loans with loan balances less than or equal to ordered and 50000.

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 30, Onest importantly, even if prepayments are higher than the base speeds displayed in the table returns are still attractive.

In the lower two tables, we show TV, a 30 or two and a half's within without an assumed funding advantage from dollar roll Specialness 30, or two and a half are the predominant production coupon and as such enjoy the greatest amount of support from fed purchases.

Rolling implied financing on two and a house is currently trading flat to slightly through repo. However, we do expect that roll Specialness will improve in the coming months and May averaged 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 or two and a half spree convexity cost were solidly in the mid teens as of March 30 Onest.

Since quarter end valuations have improved and so currently returns are roughly 2% lower than the example shown on this slide.

As we look forward, we're excited about the return environment for agency MBS, while spreads have tightened materially from the depth of March they remain wide to historical norms. Despite Q4, and while we fully recognize the unprecedented economic challenges presented by the current crisis, Our agency MBS business is something.

Uniquely positioned on a go forward basis, I'll now turn the call over to errand to discuss the non agency sector.

Thanks, Chris as Gary mentioned, the credit markets were also very challenging to navigate as they ultimately you had to grapple with complete illiquidity across all fixed income products.

Any of the rapid emergence of serious credit uncertainty associated with pricing and the impacts of a recession.

I'll quickly recap or activity in the quarter, and then update you with our outlook on credit.

Please turn to slide nine.

As we discussed on our last quarter's call, we anticipated reducing their CRT position given the further tightening of spreads in January.

Accordingly, we sold close to 200 million of CRT Q1 prior to the decline in prices in mid March.

The other changes to the portfolio during the quarter or an increase in residential credit subordinate bonds backed by GST eligible collateral and a small addition of CMBS versus a reduction in RPL subs.

With respect to portfolio composition as you can see from the GRC CRT portfolio Pie chart.

More than half of our CRT portfolio was issued in 2016 and 2017.

Do you see or T vintages have performed well since quarter end and have recovered materially from the lows given the theres solid credit support and built up H.P.A.

Additionally, we remain comfortable in large part with our current CMBS holdings.

Almost all our exposure on the conduit side is doubly rated or higher and while we have some lower rated CMBS Salisbury deals, we have no single asset or hotel exposure and minimal retail exposure.

And this in the second half of March nine agency assets were hit with the 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 enrolling 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're thinking about.

On the residential side, well, it's impossible to discount to 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 markets supported by limited housing inventory.

And pent up demand due to strong household formation.

A quick implementation of forbearance 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 Oreo dispositions.

Far enough into the future should dampen impact a house prices.

And is critical to limiting the downside scenarios.

As Gary and Chris addressed earlier, we expect prepayment speeds on agency collateral to be slower than many models with projected these rate levels.

This negatively impacts discount price credit securities with slower return of principal and deleveraging.

The G fees use of C or T to hedge their guaranteed business is likely.

To reduce the refinance programs there would be willing to implement in the future.

If the GNC is where do you were to add new refinance programs that bypass normal underwriting constraints.

Other than the existing harp like program they would lose the value of the of the credit protection they purchased by by issuing CRT.

Turning to the commercial front the credit curve steepens out much meaningfully as the top of the capital structure and condo deals has been anchored by the inclusion in the federal reserves TALF 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 in retail sectors are top of mind, but New York and other Big office buildings could faced significant headwinds as some companies look to diversify the location of their workforce.

These issues will take time to play out and 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 began to get delinquency data and monitor credit performance.

In light of the to 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'll turn the call over to Peter discussed funding and risk management.

Thanks, Aaron I'll start with a review of our financing activity on slide 10, despite considerable market turmoil the repo market for agency MBS folks should 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 a treasury collateral remain closely tied to the fed funds target.

On March 20 is the fed began providing an additional one trillion dollars of liquidity to the repo market each day.

This dramatic step coupled with the feds ongoing open market operations. They showed 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 Threerd, and a 100 basis point rate cut on March 15.

Our weighted average repo funding cost for the first quarter was 1.8% down 32 basis points from the prior quarter.

Our repo cost at quarter end, it fell significantly more to 1.36%.

Today, the repo market has largely repriced to the new fed funds target.

Overnight repo has averaged about 10 basis points and April.

Importantly, the term market has also repriced 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 two declined to approximately 80 basis points.

Our aggregate cost of 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 cost was largely offset by a lower receive rate on the floating leg of our swaps.

Importantly, with LIBOR swaps, representing only a small part of our portfolio.

Our aggregate cost of funds will not be negatively impacted and slide were converges with other short term rates.

Looking ahead I expect our average cost of funds in the second quarter to be about a 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 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 ratio declined to 70% from 102% the prior quarter.

We're short term rates being close to zero swap rates reprice dramatically during the quarter were shorter term Elias swaps rallied about 135 basis points and longer term swaps really at about 120 basis points.

The pay rate on new five and 10 year old I ask swaps is now only about 20 and 40 basis points respectively.

As such these swaps provides a unique opportunity to lock in very attractive funding levels, where an extended period of time, well also providing protection against the reversal in rates in the event of a sharp recovery.

On slide 12, we show our duration gap in 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 it's such a low absolute level. There is now significantly more extension risk in our portfolio and in the mortgage market as a whole.

This profile in the table with our duration extent.

Given your view on rates and the asymmetry.

Is you sort of develop your hedging strategy going forward do you think that swaptions will become a lot.

Merger part of the strategy.

So it's interesting the answer there is it might but not at this point.

It's interesting because the asymmetry.

Allows you really to just pay fixed on let's say a seven year suite.

Bob.

Thats, where the pay rate on an alliance swap is.

Yes, let's say mid Thirtys.

So your that swap costs you.

You're receiving let's say 10 basis points to that that costs you 20.

Hi basis points and carry but if you don't believe a negative rates how much can you lose on that short position lets say, that's what cooperate goes to 15, okay. So you lose 20 basis points.

In most cases, you're going to pay that or more for.

Premium on an option. So it's kind of unique that again unless you are of the mindset that.

Swap rates can go to negative 50.

Then options real flea aren't.

Necessary look and I want to just mentioned on negative rates, we're not saying, it's absolutely impossible. We're obviously aware that it's going on in Europe.

[music].

Actually negative rates.

But we do think of fed will do.

Host of other things before they go there increasing their key way would be one single definitively do they'll probably do something around yield curve control and there'll be lots of warning signs that we'll probably give us an.

Exit point on needle on our mortgage.

I should add at tighter levels as well. So we just we think in the short run again this asymmetry.

Really help.

Okay.

I Hope you guys are allow.

How are you guys thinking about the amount of leverage you're taking right now just given the fact that spreads are already relatively wide and returns could arguably there will be considered and still be considered very strong with less leverage and how.

Why do you guys feel the need to be Levered in this environment.

As you were at year end, just given the obvious risks that are still out there and then you also acknowledged in your opening remarks.

Well look thats a great question I know.

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I'll kind of taken at a higher level, which is.

Ill answer your question plus.

Given what we went through in March has that changed our perspective on on leverage Big picture.

But first off one thing in Bernie's prepared remarks, you mentioned to that over the course of April our leverage has come down.

Not the shrinking the portfolio. It was mainly due to just the increase in book value.

And and not replacing the full amount of prepayments so to speak.

So in the end we are running leverage now again, that's closer to eight and a half what 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 PVA positions are much much more efficient for us from a liquidity perspective than 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.

He is a substantial drain on your liquidity.

Given the payment delay issue, where you have to wait for European I receivable till the end of the 25th as a month. So what I would say is that we are we are willing to run leverage levels consistent with where we were.

Before nine and a half to 10, let's say.

But we I would say, we're putting a little we're definitely putting a greater emphasis on liquidity in this environment, because we think thats whats shareholders would want from us.

So big picture I would ask.

Analysts and investors to to look a little below beyond just the quote at risk leverage.

And understands the.

That that there are different components.

That's the it will that affect your both your liquidity and your ability to handle kind of adverse moves and just as a quick.

Example.

Of that.

TV a position.

Acquired through our Bethesda Securities dealer requires a margin that's around one to maybe 1.5% in all end, whereas.

The haircut on an on balance sheet position in bilateral.

Repo is 5% on average and.

That pool has a paydowns that if it's a little if it's let's say Edna twentys and CPR that almost adds an effective 2% more to the haircut.

So that's a massive difference right between an effective 7% haircut.

On a bilateral repo with our pool, that's prepaying verse.

Two is TV a position so what I would say as investors should expect agency to be cautious on the line.

Liquidities side, but to do it in a smart way.

That optimizes our risk adjusted.

Good returns.

Got it thank you that that was helpful.

I think we've been pretty well into my next question on funding I mean it hasn't.

Net loss on anyone that has bank earnings and come out here the loss reserves.

Part of your funding, which is a kind the bulk of your funding over to Bethesda Securities.

If you do.

For one Hi, Hi, Eric This Peter Hope you hope you're doing well thanks for the question.

First off I would say that the as I mentioned in my prepared remarks, the repo market for ages like collateral really traded remarkably well throughout the crisis in the fed has done a terrific job of making sure that there's sufficient liquidity in the system and they're continuing to do so today I don't expect that to change.

You know we have 47 other Counterparties in addition to Bethesda Securities.

Those counterparties all performed very well for us during the 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 ended the quarter of our funding book spread out across those counterparties. So theres really no significant concentrate.

Question.

And that allows us to move positions from Counterparties counterparty very quickly.

Because we don't have significant concentrations in any anyone counterpart.

Pretty.

And your other point about buses the securities is a good one from an operational perspective, it is very easy for us to move collateral.

When when when our bilateral collateral matures for example, we can very quickly move it to assess the securities we have additional capacity and we could utilize it and we may utilize it to some degree because as Gary mentioned, it's highly efficient from a margin perspective on the funding side and it's incredibly efficient on the TV.

Side, and we would not be able to do that on Tvs, if we didnt have possess the security.

But we also like the fact that our portfolio is highly diverse.

The side and so right now we think the best mix is to have a really large group of strong individual counterparties and I and I believe.

Because they're going to continue to participate in the market and provide support for us.

As well as have the ability to move more to possess if we need to and I just wanted to add to that and just keep in mind right that the agency, where the government repo complex didn't go through its shock in March it went through it actually last September right.

The repo market in March.

Was a function of the fact, the 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 offer to 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 thats the last thing that the feds going up.

Let have issues.

And you, having our broker dealer on the FCC gives us it's not direct access I want to be clear, but its closer.

And we shrunk we've definitely let our our repo book at any given the shrinkage in the portfolio and the move of more to the faster.

We have lots of spare capacity.

On the bilateral side.

Thank you for the question.

Yes. Thank you guys would answer those very helpful say well. Thank you you too.

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

Thanks.

As you mentioned kind of.

Goals have performed well in April can you just talk about where those are.

Or was compared to January February.

Right.

Yeah, why don't I, let Chris.

Take that one.

Right.

Yes, so I mean relative thanks, Doug.

Relative to the started the year.

I'd pay ups on.

HLB.

Three and a half in force for example.

Our.

Slightly slightly higher but the thing to keep in mind is that valuations at the start of Q2, we're still at very very depressed levels and so well pay ups have improved over a pointer. So since then.

They are still extremely attractive given that coupon swaps are still very depressed they were starting at extremely cheap valuations Oh, yes.

Changes year to date are still.

Good 30 to 40 basis points wider but when you think about just the 125 basis point move in rates, they've actually still underperformed quite a lot given.

Despite the the absolute changes and payouts.

And so.

If you look back to the our lease slide that.

That we presented.

Yields are currently on three and absent for is around 20 basis.

Points are so lower than they were as of Threethirty won and so I'd say potential our OE is roughly 2% lower.

And so but even there returns are still still very very attractive.

Great and then even thinking about Oh, sorry go ahead.

No go ahead.

So then I guess is again thinking about slide where where you're looking at the returns how do you think about.

Balancing out.

What the returns are on the agility pools.

Versus.

The more liquid.

And a house and how do you think about what is the right balance to gain the liquidity from kind of in the more dinner.

Coupon versus.

Versus the specified pool, which obviously proved to be less liquid and the periods of stress.

Specified pools.

And that that is.

It reduces your liquidity and your options for.

Okay from moving things around to say the latest.

But that said I think look both both offer competitive returns even given the tightening that we've seen in April and they're now relatively balanced.

In the higher coupons, you've got relatively stable cash flows theres no origination the technical factors or are stable in today's environment. So I don't think your.

Going to see that much price volatility there.

Your your exposure is going to be to kind of realized prepayment 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's a lot to be said for lower coupon.

Turns and the potential for roll Specialness to improve those you have the liquidity benefits, where you can run those positions in pure TCPA form or in a new production pool that.

It's not going to have a paydown.

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 feds bid and any other bids so we do.

You expect more price volatility in lower coupons and ill and we'll look to use that as an entry point.

Yes, so that thats it from a high level I'll, let Chris.

Add something to.

Gary I think you you summed it up.

Pretty well I I don't have a lot to add other than.

I'd say that while specs have improved a fair amount 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 exposed to rely on to the said there.

No it's a good point.

Appreciate that thank you guys.

Okay. Thanks question is from club Trevor Cranston JMP Securities. Please go ahead.

Okay. Thanks.

A question on the previous side.

You talked a lot about the factors that are likely to limit how fast speed good.

At least in the near term.

Can you comment on sort of what you guys baked into your base case prepaid assumptions in terms of.

How much compression there could be between primary mortgage rates and and secondary MBS yields.

And you know what would you would consider the biggest risks to that spread potentially compressing kind of further than where you currently expected to.

Yes, let me, let me start on that I mean.

I want to say that the modeling.

When you look at.

Okay asked models or Monte Carlo simulations prepayment models right now.

Is this is a stressful environment for them their results are all over the place.

And the thing you addressed how you derive the mortgage market rate okay.

The primary raid and how you will evolve it over time as one of the key variables that differs quite a bit from model to model.

But what I would say is no from our perspective in thinking about prepayments. We do expect the primary rate or primary secondary spreads to compress they do in these kind of environments over time.

I think that it's not going to be immediately.

And given how much of the universes refund ansible today.

We would and given the unique circumstances, we think that that compression will be slower than it was.

In lets say other.

You know kind of periods of.

Big drops in 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've said over the next we'll call it three months.

Three to six months you have these that you have the social distancing type head wins as well as as credit headwinds I mean, less and we didn't talk a lot. We mentioned the forbearance issues in our prepared remarks, but forbearances are very very good option.

For.

See borrowers.

And generally they're going to be a lot of people that aren't going to be able to.

Qualify.

Others adult take forbearance foot mall qualify easily.

For our new.

A new loan so practically speaking I think there are factors that.

In a work.

Yes, 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.

Got it okay. That's helpful.

And then one more question just on the credit side.

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 interesting a significant number of counterparties completely pull away from that market and just generally going or how much change youre seeing in terms of haircuts and where rates are credit securities. Thanks.

Yes, sure I mean, we obviously.

Do finance some non agencies is as I think everyone knows our positions are relatively small and it's a very small percentage of kind of our founding considerations, but I mean higher haircuts or kind of across the board at this point are almost.

They have been raised the rates are much less attractive.

No.

Than they were going into this and we have seen some counterparties exit the exit of business altogether, but.

To be clear or there are there are people that are still willing to do 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're still looking at.

You know rates and.

Whatever 2% kind of more more area.

And haircuts are obviously dependent on the type of security and then there there are some things that you just can't finance.

And.

That.

So one of the things that affects our that absolutely affects our view on waving in credit so to speak.

Are these challenges I mean, there and if we work to have sort of a double dip.

In the economy or some of these fundamental factors where to start looking.

Yeah.

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 on our way.

And that look it's one thing it's one thing if you're looking at a position from an unlevered or cash position long only position.

Yeah.

Things make yet or are are more attractive than when you look at them on a levered position given the the challenges on the funding side.

Okay. Appreciate the color on that thank you.

Next question will be from Kenneth Lee with RBC capital markets.

Hi, good morning, Thanks for taking my question.

Wondering if you'd 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 said support of agencies as well as the much lower funding costs that you mentioned the prepared remarks. Thanks.

Sure. Good morning, Ken This is Peter hope you're doing well.

As I mentioned I expect our repo costs to come down around 80 basis points in the second quarter. So to 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 cost longer term repos mature it could easily drop you know to about 50 basis points into third quarter down around 40 basis points.

In the fourth quarter.

The variable for our cost of funds is going to be on ours, our swap costs, which I expect to be net on total liabilities around 35 basis points, so that would give us the cost of funds.

Around 110.

In the second quarter.

On the asset yield side, obviously, it's going to come down.

But but probably in the neighborhood of around 270 in terms of asset yield might be a reasonable starting spot. So I would expect armored our net interest margin in second quarter, two trend toward 150 160 basis points.

And then from there it will depend on obviously rotations in the asset portfolio and his third and fourth quarters.

And then as well as some of the rebalancing and reposition that we're going to continue to do on the swap side.

Which would ultimately I think puts 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's heading up into that range.

Okay, great very helpful.

And just one follow up if I may in terms of the liquidity position is $3.5 billion of caching unencumbered assets.

Is there way that you could provide us some context or just help us frame, how strongest liquidity position is or what's the best way for us as outside observers to determine the relative adequacy of this liquidity position. Thanks.

Yes. Thank you very much for that question and you're right. It obviously helps a lot to have some some some background to that so you know where that stands historically, let me just give you a starting point at the at the end of the year.

Our cash and unencumbered Ed.

GNC was 3.6 billion and then between non agency securities in Bethesda. It was another 1.8, so is 5.5 billion.

All right and that represented excuse me, 52% of our equity at the time, which is really pretty strong position and if you look back historically you'd 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 shocks as burning mentioned the total three and a half believe that we had on March 31st plus the $1.2 billion assess the which is all cash and.

Agency MBS and then the 300 million non agencies total $5 billion and that was represent I was at 54% of our capital. So we actually had at the end of March we ended the crisis period on a percentage basis with more cash and unencumbered equity.

Yesterday, our physician AD agency was even stronger it was $4.2 billion of cash and unencumbered plus another 1.2 episodes the securities and Usthree hundred. 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've ever operated so that gives you a sense on.

How we've prioritized risk in liquidity in this environment and we put ourselves in a position where we've actually comes through the most significant crisis in the history and actually now have a cash and unencumbered position that gives us it's even stronger and gives us more flexibility going forward to take advantage of market opportunities.

Let me give you another just quick way to think about it too.

Which is if we walked in tomorrow and mortgages.

Or across aren't tire position or down two points, which is obviously a massive.

Uhhuh.

I mean, we saw worse, obviously before but we.

We would that would generate kind of or that would be expected to generate margin calls of about 1.8 billion.

Peter So.

90 plus billion in mortgages. So two points, we would we have margin calls around 1.8 billion that would be less than half of our liquidity that we have on on hand with zero.

Without having to make any adjustments so thats another way to think about that.

In terms of how substantial that cushion as.

Really appreciate that that is very very helpful color.

Thats It for me, Thanks, again, everyone stay safe.

Yes. Thanks.

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

Hi, Good morning believe my question been answered on on the prior question was just to confirm Peter that you expect total average borrowing costs to be roughly.

1.1% and the second quarter believe you may have just address that though.

Yes, Thats correct I expect our total cost of funds to be in that range and again the to the two components of the total cost of funds is.

Our repo, which I expect that around 80 basis points.

Chris talked about PVA specialists, I expect that TV costs to be down around 25, or 35 basis points. So the combination of that plus the cost of our swap hedges, which.

At the ended 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 of funds of around 1.1%, but just keep in mind, obviously will lessen 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.

Thats.

That in mind to that.

Theres lots of different things that could move those numbers around.

Absolutely great between Calvert confirming that.

Thank you.

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

Hi, everyone. Thanks for taking my question and the first of all congrats on Lilly protecting shareholder interest during during the volatility.

Gary you are we sort of one step ahead of the said last time look through the cube program. So I want to really focus on on says most of those questions. First did you address there's been talk of Yieldco yield curve control.

If you could address that by workers.

We've talked a little policy do you think there's any risk that they implement something of that nature.

I think there is I mean in a sense, it's kind of like.

They decide where they want.

The longer end to the intermediate sector and the longer and obviously they currently peg the very short end thats there quote job.

In setting fed funds and 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 tenure I'll, just hypothetically say they decide they want the 10 year to be around 50 basis points and so then they execute whatever.

The in 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 we're I think this comes into play I don't think they're ready to do that right now I feel like they they've they've just.

On leash.

All host of tools and they're using them extensively and I think they obviously financial markets have stabilized.

And our 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 there probably likely to opt their key we again on the mortgage side and on the treasury side, because they've brought their purchases down substantially from where they were a month ago.

So if they if they felt they were losing ground on the economy was weakening again and liquidity was.

Was getting worse I think they would they would start to look at what else. They could do but the first thing. They probably do was increased key way again, okay, and probably first in terms of the magnitude of what they're doing because they've backed down there two main levers treasuries and and Mds and then they.

Might look to this yield curve control and all of these are things that we think they'll do before they experiment with negative rates, which I think theres really no stomach for right now either at the fed or kind of even amongst most financial market participants so.

It's possible I don't think it's in the offering in the short Ron I think it again it would be one of the tools they might go to it before they went to negative rates.

Thanks for that when you think about your business model managing your duration gap would you feel the feds got a good morning pick back up to four present that you're just going to commit Scott stop start buying and then where would you think they want to bring rates below 3% you need to have a targeted mine that we're going to buy.

Hill.

Consumer can see 3% low mortgage rates missiles. If thank you. We you mentioned that so what do you think your target is where they want mortgage rates.

I I think it's evolving I think they're still and I think I take this in some ways from share powles.

Press conference yesterday, but I think they're 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're going to start.

Focusing on.

Stimulating the markets, Okay and.

And when they go to stimulating and you've 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 on 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 of months from now that won't be the case and they'll have more incentive to potentially want to push mortgage rates lower.

So I think thats in a sense the next phase of of their mindset is.

How can they stimulate the economy right now they're still in.

You know kind of preserve liquidity strengthen the with the financial markets and they'll go from there.

Thanks, Gary Thanks, everyone.

Thank you.

Your next question will be from Brock Vandervliet with CBS. Please go ahead.

Thank you.

I was just you made a passing reference to your expectation of forbearance levels Rolling from call. It six to 10 to 15.

How do you. Obviously this is kind of over the end of the rise in 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 GRC is having to buy these out of.

Out of the pools and what effect that could have on on pricing.

Yes look thats, a great question and I think.

Over the past month.

Different researchers have written about this and kind of described it as well 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 four Bayer and well delinquencies were after four months of delinquencies.

Paul let loans were pulled from pools. So if they were to have stock with his boiler plate.

Practice than if we got to 10% forbearance and a forbearance was treated like a regular delinquency you could have very fast prepayments coming relatively quickly from this.

Forbearance equation.

But.

Both the Gses and FH, if they 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 then there are ways, where could come out of the pool before that but I think thats, a very low likelihood so realistic.

Equally delinquency is getting hold from these pools is a problem for let's say.

Here 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 let me.

If you have you tried to say, okay, maybe three or 4% of these borrowers or are pulled out of the pool.

In 18 months I mean, that's actually a very very low CPR, so to speak and it's not something that we think negatively impacts the performance of our pools.

On the contrary I think net net that that's 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.

Are they don't view these forbearances as and delinquencies and that they're going to wait a long time to pull these loans out of the pools that's critical to.

To the performance of of higher coupon Securities and specs in particular, and we were very happy to see FH, if say explicitly.

Define that.

In a press release.

Got it okay Thats, a key distinction I guess in it analogous question beyond CRT.

Actually this is credit protection.

Now if they for bear in modify that would threaten the value of CRT, but they've come out read out of the gate with very aggressive forbearance.

How does that.

The value of the CRT.

Market.

So I mean look.

With CRT.

The forbearance is is good in terms of.

The fact that we're giving borrowers who would have a short term interruption to their income and their ability to pay we're giving them significant time to work through that and if they get their job back then hopefully there's a plan to get them currently 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 Oreo disposition and out of it prevents or likely prevents a downward spiral for house prices. So that's good.

For for CRT ultimately the other thing Thats interesting in that area alluded to just going back to kind of the prepayment question is one of the things we've gotten.

The question at times about low.

You have this favorable view on on prepayments.

That they're not going to be that fast. The other thing that CRT does is it really really handcuffs. The GNC is with respect to trying to implement some much faster.

Streamline re Fi program, where they look past income and job situations in.

In terms of.

Deciding whether to someone can re fi, but if they if they do that and they let people re fi that have credit issues. Then that's a home run for us as a CRT holder because they essentially have this in the money protection that they've bought for seven years okay.

That protects them from the bulk of the losses.

These weaker credit borrowers and if they just go and re Fi them.

You know.

And do that on economically there, they're 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.

Got it great color, Thanks, Gary stay safe.

Okay, No you too and thanks again.

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

Well look I'd like to thank everyone for their interest in agency.

I hope everyone stay safe through these really difficult times and we look forward to speaking with you again next quarter.

Thank you Sir the conference has now concluded. Thank you Chris any today's presentation you may now disconnect.

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