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AGNC > SEC Filings for AGNC > Form 10-Q on 9-May-2013All Recent SEC Filings

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Quarterly Report

Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is designed to provide a reader of American Capital Agency Corp.'s consolidated financial statements with a narrative from the perspective of management. Our MD&A is presented in five sections:
Executive Overview

Financial Condition

Results of Operations

Liquidity and Capital Resources

Forward-Looking Statements

American Capital Agency Corp. ("AGNC", the "Company", "we", "us" and "our") was organized on January 7, 2008 and commenced operations on May 20, 2008 following the completion of our initial public offering. Our common stock is traded on The NASDAQ Global Select Market under the symbol "AGNC". We are externally managed by American Capital AGNC Management, LLC (our "Manager"), an affiliate of American Capital, Ltd. ("American Capital").
We operate so as to qualify to be taxed as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended (the "Internal Revenue Code"). As such, we are required to distribute annually 90% of our taxable net income. As long as we qualify as a REIT, we will generally not be subject to U.S. federal or state corporate taxes on our taxable net income to the extent that we distribute all of our annual taxable net income to our stockholders. It is our intention to distribute 100% of our taxable income, after application of available tax attributes, within the limits prescribed by the Internal Revenue Code, which may extend into the subsequent taxable year. We earn income primarily from investing on a leveraged basis in agency mortgage-backed securities. These investments consist of residential mortgage pass-through securities and collateralized mortgage obligations ("CMOs") for which the principal and interest payments are guaranteed by government-sponsored entities, such as the Federal National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac"), or by a U.S. Government agency, such as the Government National Mortgage Association ("Ginnie Mae") (collectively referred to as "GSEs"). We may also invest in agency debenture securities issued by Freddie Mac, Fannie Mae or the Federal Home Loan Bank ("FHLB"). We refer to agency mortgage-backed securities and agency debenture securities collectively as "agency securities" and we refer to the specific investment securities in which we invest as our "investment portfolio".

Our principal objective is to preserve our net book value (also referred to as "net asset value", "NAV" and "stockholders' equity") while generating attractive risk-adjusted returns for distribution to our stockholders through regular quarterly dividends from the combination of our net interest income and net realized gains and losses on our investments and hedging activities. We fund our investments primarily through borrowings structured as repurchase agreements. Our Investment Strategy
Our investment strategy is designed to:
manage an investment portfolio consisting of agency securities that seeks to generate attractive risk-adjusted returns;

capitalize on discrepancies in the relative valuations in the agency securities market;

manage financing, interest and prepayment rate risks;

preserve our net book value;

provide regular quarterly distributions to our stockholders;

qualify as a REIT; and

remain exempt from the requirements of the Investment Company Act of 1940, as amended (the "Investment Company Act").

The size and composition of our investment portfolio depends on investment strategies implemented by our Manager, the availability of investment capital and overall market conditions, including the availability of attractively priced investments and suitable financing to appropriately leverage our investment portfolio. Market conditions are influenced by, among other things, current levels of and expectations for future levels of interest rates, mortgage prepayments, market liquidity, housing prices, unemployment rates, general economic conditions, government participation in the mortgage market, evolving regulations or legal settlements that impact servicing practices or other mortgage related activities.

Our Risk Management Strategy
We use a variety of strategies to economically hedge a portion of our exposure to market risks, including interest rate, prepayment and extension risks, to the extent that our Manager believes is prudent, taking into account our investment strategy, the cost of the hedging transactions and our intention to qualify as a REIT. As a result, we may not hedge certain interest rate, prepayment, or extension risks if our Manager believes that bearing such risks enhances our return relative to our risk/return profile, or the hedging transaction would negatively impact our REIT status.

Interest Rate Risk. We hedge some of our exposure to potential interest rate mismatches between the interest we earn on our longer term investments and the costs on our shorter term borrowings. Because a majority of our leverage is in the form of repurchase agreements, our financing costs fluctuate based on short-term interest rate indices, such as LIBOR. Because our investments are assets that primarily have fixed rates of interest and could mature in up to 40 years, the interest we earn on those assets generally does not move in tandem with the interest rates that we pay on our repurchase agreements. We may experience reduced income or losses based on these rate movements. In order to attempt to mitigate a portion of such risk, we utilize certain hedging techniques to attempt to lock in a portion of the net interest spread between the interest we earn on our assets and the interest we pay on our financing costs.

Additionally, because prepayments on residential mortgages generally accelerate when interest rates decrease and slow when interest rates increase, mortgage securities typically have "negative convexity." In other words, certain mortgage securities in which we invest may increase in price more slowly than most bonds, or even fall in value, as interest rates decline. Conversely, certain mortgage securities in which we invest may decrease in value more quickly than similar duration bonds as interest rates increase. In order to manage this risk, we monitor, among other things, the "duration gap" between our mortgage assets and our hedge portfolio and our convexity exposure. Duration is the estimated percentage change in market value of our assets that would be caused by a parallel change in short and long-term interest rates. Convexity exposure relates to the way the duration of a mortgage security changes when the interest rate and prepayment environment changes.

The value of our mortgage assets may also be adversely impacted by fluctuations in the shape of the yield curve or by changes in the market's expectation about the volatility of future interest rates. We analyze our exposure to non-parallel changes in interest rates and to changes in the market's expectation of future interest rate volatility and take actions to attempt to mitigate these risks.

Prepayment Risk. Because residential borrowers have the option to prepay their mortgage loans at par at any time, we face the risk that we will experience a return of principal on our investments earlier than anticipated. Prepayment risk generally increases when interest rates decline. In this scenario, our financial results may be adversely affected as we may have to invest that principal at potentially lower yields.

Extension Risk. Because residential borrowers have the option to make only scheduled payments on their mortgage loans, rather than prepay their mortgage loan, we face the risk that a return of capital on our investment will occur slower than anticipated. Extension risk generally increases when interest rates rise. In this scenario, our financial results may be adversely affected as we may have to finance our investments at potentially higher costs without the ability to reinvest principal into higher yielding securities.

The principal instruments that we use to hedge a portion of our exposure to interest rate, prepayment and extension risks are interest rate swaps and options to enter into interest rate swaps ("interest rate swaptions"). We also purchase or sell TBAs, specified agency securities on a forward basis, U.S. Treasury securities and U.S. Treasury futures contracts; purchase or write put or call options on TBA securities; and invest in other types of mortgage derivatives, such as interest-only securities, and synthetic total return swaps, such as the Markit IOS Synthetic Total Return Swap Index ("Markit IOS Index"). Our hedging instruments are generally not designed to protect our net book value from the risk of an increase of the market spread between the yield on our agency securities and the yield on U.S. Treasury securities or interest rate swap rates, referred to as "spread risk" or "basis risk". The spread risk associated with our agency securities and the resulting fluctuations in fair value of these securities can occur independent of interest rates and may relate to other factors impacting the mortgage and fixed income markets, such as actual or anticipated monetary policy actions by the Federal Reserve, liquidity, or changes in required rates of return on different assets. Consequently, while we use interest rate swaps and other supplemental hedges to attempt to protect our net book value against moves in interest rates, such instruments typically will not protect our net book value against spread risk and, therefore, the value of our agency securities and our net book value could decline.

The risk management actions we take may lower our earnings and dividends in the short term to further our objective of maintaining attractive levels of earnings and dividends over the long term. In addition, some of our hedges are intended to provide protection against larger rate moves and as a result may be relatively ineffective for smaller changes in interest rates. There can be no certainty that our Manager's projections of our exposures to interest rates, prepayments or other risks will be accurate or that our hedging activities will be effective and, therefore, actual results could differ materially. Income from hedging transactions that we enter into to manage risk may not constitute qualifying gross income under one or both of the gross income tests applicable to REITs. Therefore, we may have to limit our use of certain advantageous hedging techniques, which could expose us to greater risks than we would otherwise want to bear, or implement those hedges through a taxable REIT subsidiary ("TRS"). Implementing our hedges through a TRS could increase the cost of our hedging activities because a TRS is subject to tax on income and gains.
Trends and Recent Market Impacts
On September 13, 2012, the Federal Reserve announced their third quantitative easing program, commonly known as QE3, and extended their guidance to keep the federal funds rate at exceptionally low levels through at least mid-2015. QE3 entails large-scale purchases of agency mortgage-backed securities ("MBS") at the pace of $40 billion per month in addition to the Federal Reserve's existing policy of reinvesting principal payments from its holdings of agency MBS into new agency MBS purchases. The program is open-ended in nature, and is intended to put downward pressure on longer-term interest rates, support mortgage markets, and help make the broader financial conditions more accommodative. The Federal Reserve plans to continue their purchases of agency MBS and employ other policy tools, as appropriate, until they foresee substantial improvement in the outlook for the U.S. labor market.
The Federal Reserve's purchases have been concentrated in newly-issued, fixed-rate agency MBS (i.e., the part of the mortgage market with the greatest impact on mortgage rates offered to borrowers). The Federal Reserve has purchased an average of approximately $78 billion in agency securities per month during the first quarter of 2013, representing approximately half of the average monthly gross issuance of fixed-rate agency MBS over this period. While prices across the agency MBS spectrum initially increased significantly following the Federal Reserve's QE3 announcement, they decreased during the fourth quarter of 2012 and again during the first quarter of 2013. As of March 31, 2013, agency MBS prices were only slightly higher than those seen prior to the announcement of QE3.

The table below summarizes interest rates and prices of generic fixed-rate agency mortgage-backed securities as of the end of each respective quarter since March 31, 2012:

                                                                                       Mar. 31, 2013         Mar. 31, 2013
                                                                                            vs.                   vs.
                                    Mar.      Dec.      Sept.     June      Mar.
                                     31,       31,       30,       30,       31,
Interest Rate/Security Price (1)    2013      2012      2012      2012      2012       Dec. 31, 2012         Mar. 31, 2012
1-Month                             0.20%     0.21%     0.21%     0.25%     0.24%       --0.01      bps      --0.04      bps
3-Month                             0.28%     0.31%     0.36%     0.46%     0.47%       --0.03      bps      --0.19      bps
6-Month                             0.44%     0.51%     0.64%     0.73%     0.73%       --0.07      bps      --0.29      bps
U.S. Treasury Security Rate:
2-Year U.S. Treasury                0.24%     0.25%     0.23%     0.30%     0.33%       --0.01      bps      --0.09      bps
5-Year U.S. Treasury                0.77%     0.72%     0.63%     0.72%     1.04%        +0.05      bps      --0.27      bps
10-Year U.S. Treasury               1.85%     1.76%     1.63%     1.65%     2.21%        +0.09      bps      --0.36      bps
Interest Rate Swap Rate:
2-Year Swap                         0.42%     0.39%     0.37%     0.55%     0.58%        +0.03      bps      --0.16      bps
5-Year Swap                         0.95%     0.86%     0.76%     0.97%     1.27%        +0.09      bps      --0.32      bps
10-Year Swap                        2.01%     1.84%     1.70%     1.78%     2.29%        +0.17      bps      --0.28      bps
30-Year Fixed Rate MBS Price:
3.0%                               $103.11   $104.84   $105.58   $102.55   $99.67          -$1.73               +$3.44
3.5%                               $105.58   $106.66   $107.25   $105.11   $102.72         -$1.08               +$2.86
4.0%                               $106.61   $107.22   $107.75   $106.44   $104.86         -$0.61               +$1.75
4.5%                               $107.73   $108.03   $108.25   $107.28   $106.38         -$0.30               +$1.35
5.0%                               $108.34   $108.33   $109.06   $108.23   $108.03         +$0.01               +$0.31
5.5%                               $109.08   $108.64   $109.63   $109.08   $108.97         +$0.44               +$0.11
6.0%                               $109.56   $109.22   $110.44   $109.91   $110.20         +$0.34               -$0.64
15-Year Fixed Rate MBS Price:
2.5%                               $103.75   $104.61   $105.13   $103.09   $101.42         -$0.86               +$2.33
3.0%                               $105.17   $105.61   $106.00   $104.77   $103.56         -$0.44               +$1.61
3.5%                               $106.03   $106.14   $106.41   $105.66   $104.92         -$0.11               +$1.11
4.0%                               $107.00   $107.00   $106.91   $106.34   $106.00           -                  +$1.00
4.5%                               $107.67   $107.55   $107.84   $107.17   $107.20         +$0.12               +$0.47


1. Price information is for generic instruments only and is not reflective of our specific portfolio holdings. Price information can vary by source. Prices in the table above obtained from a combination of Bloomberg and dealer indications. Interest rates obtained from Bloomberg.

In addition to generic fixed-rate agency MBS price declines during the first quarter of 2013, price premiums (or "pay-ups" over generic MBS prices) on specified pools of securities with favorable prepayment attributes also declined during quarter, as market participants shifted concerns over prepayment risk to extension risk amid favorable economic data released during the first quarter and increased expectations of a potential early slowing or discontinuation of the Federal Reserve from QE3.
The table below summarizes pay-ups on specified pools over the corresponding generic agency MBS as of the end of each respective quarter for a select sample of specified securities. Price information provided in the table below is for illustrative purposes only and is not meant to be reflective of our specific portfolio holdings. Actual pay-ups are dependent on specific securities held in our portfolio and prices can vary depending on the source:

                                                                             Mar. 31, 2013     Mar. 31, 2013
                                                                                  vs.               vs.
Pay-ups on Specified Mortgage       Mar.    Dec.    Sept.   June    Mar.
Pools over Generic TBA Price        31,      31,     30,     30,     31,
(1)(2)                              2013    2012    2012    2012    2012     Dec. 31, 2012     Mar. 31, 2012
30-Year Lower Loan Balance
Pay-ups ($85k - $110k): (3)
3.0%                               $0.13    $0.69   $0.09    N/A     N/A        -$0.56            +$0.13
3.5%                               $0.91    $1.64   $1.02   $0.75   $0.31       -$0.73            +$0.60
4.0%                               $3.28    $4.19   $3.45   $2.00   $1.25       -$0.91            +$2.03
30-Year HARP Pay-ups (95% - 100%
LTV): (4)
3.0%                               $0.07    $0.47   $0.06    N/A     N/A        -$0.40            +$0.07
3.5%                               $0.70    $1.52   $1.00   $0.63   $0.22       -$0.82            +$0.48
4.0%                               $2.85    $4.06   $3.25   $1.94   $1.31       -$1.21            +$1.54


1. Source: Bloomberg and dealer indications

2. "Pay-ups" represent the value of the price premium of specified securities over generic TBA pools. The table above includes pay-ups for newly originated specified pools. Price information is provided for information only and is not meant to be reflective of our specific portfolio holdings. Prices can vary materially depending on the source.

3. Lower loan balance securities in table above represent pools backed by an original loan balance of $85,000 to $110,000.

4. HARP securities in table above represent pools backed by 100% refinance loans with loan-to-values ("LTV") of 95% to 100%.

N/A = Not applicable, as TBA coupon was not actively traded as of the applicable date.
Our risk management strategy is designed to protect against larger moves in interest rates, and as a result provided little protection against agency MBS price declines as interest rates increased only modestly during the first quarter of 2013. The widening spread environment and associated underperformance of both generic and specified agency MBS relative to U.S. Treasury securities and interest rate swaps led to a decline in our net book value, whereas prepayments on our portfolio remained relatively low at near 10% during the first quarter of 2013 and the TBA dollar roll market continued to provide favorable financing well below repurchase agreement rates.
As the Federal Reserve continues to deliberate the timing of a potential slowing or discontinuation of QE3 and as agency MBS investors react to changing expectations of the Federal Reserve's actions, we expect the agency MBS market to continue to experience significant volatility. Although the timing of a potential slowing or discontinuation of QE3 is uncertain, we anticipate that the Federal Reserve will continue its large scale purchases of agency MBS through the remainder of fiscal year 2013.
We expect during periods in which the Federal Reserve purchases significant volumes of mortgages, yields on agency MBS securities will be lower than yields would have been absent QE3 and refinancing volumes will be higher than volumes would have been absent QE3. Since returns on agency MBS are highly sensitive to prepayment speeds, we have positioned our investment portfolio towards agency MBS that we believe have favorable prepayment attributes. As of March 31, 2013, 78% of our fixed-rate agency MBS portfolio was comprised of agency securities backed by lower loan balance mortgages (pools backed by original loan balances of up to $150,000) and loans originated under HARP (pools backed by 100% refinance loans with original loan-to-value ratios of greater than 80%), which we believe have a lower risk of prepayment relative to generic agency securities. The remainder of our agency MBS portfolio as of March 31, 2013 was primarily comprised of low coupon, new issuance fixed-rate agency securities. Further, as a result of the favorable TBA dollar roll financing levels resulting from QE3, during the first quarter of 2013, we increased our TBA dollar roll positions, while further reducing our on-balance sheet agency MBS investments financed through repurchase agreements. (See Financial Condition below for further details of our portfolio composition as of March 31, 2013).

The following table summarizes recent prepayment trends for our portfolio and, for comparison, Fannie Mae 2011 30-year fixed-rate generic mortgage-backed securities universe.

Annualized Monthly Constant Prepayment
Rates (1)                                   December 2012   January 2013   February 2013   March 2013
AGNC portfolio                                   10%            11%             10%           10%
Fannie Mae 2011 30-year fixed-rate MBS
universe (2)                                     35%            31%             30%           26%


1. Weighted average actual one-month annualized CPR released at the beginning of the month based on securities held/outstanding as of the preceding month-end.

2. Source: JP Morgan.

As of March 31, 2013 and December 31, 2012, our investment portfolio consisted of $76.3 billion and $85.2 billion, respectively, of agency MBS and $27.3 billion and $12.9 billion, respectively, of net TBA positions, at fair value. Our net TBA positions are recorded as derivative instruments in our accompanying consolidated financial statements, with the TBA dollar roll transactions representing a form of off-balance sheet financing. As of March 31, 2013 and December 31, 2012, our net TBA positions had a net carrying value of $(11) million and $95 million, respectively, reported in derivative assets/(liabilities) on our accompanying consolidated balance sheets. The net carrying value represents the difference between the fair value of the TBA contract (or of the underlying agency security) and the cost basis. The following tables summarize certain characteristics of our agency MBS investment portfolio and our net TBA position as of March 31, 2013 and December 31, 2012 (dollars in millions):

                                                                   March 31, 2013

                                                                                                Weighted Average            2013
Agency MBS Classified as                                                                                                  Projected
Available-for-Sale                           Amortized     Amortized                                                      Life CPR
("AFS")                      Par Value         Cost        Cost Basis     Fair Value     Coupon   Yield    Age (Months)      (1)
Investments By Issuer:
Fannie Mae                 $    50,510     $    53,181       105.3%     $     54,109     3.63%    2.71%         16           9%
Freddie Mac                     20,228          21,167       104.6%           21,437     3.59%    2.78%         15           9%
Ginnie Mae                         218             227       104.1%              233     3.76%    1.59%         27           18%
Total / Weighted Average   $    70,956     $    74,575       105.1%     $     75,779     3.62%    2.73%         16           9%

Investments By Security
 ? 15-Year
Lower Loan Balance (2)     $    14,153     $    14,705       103.9%     $     15,212     3.61%    2.61%         24           12%
HARP (3)                         1,351           1,405       103.9%            1,442     3.44%    2.46%         19           12%
Other (2009-2012
Vintages) (4)                    5,634           5,884       104.4%            5,890     2.86%    1.80%         11           11%
Other (Pre 2009
Vintages)                           29              30       104.7%               31     4.62%    2.76%         90           14%
Total ? 15-Year                 21,167          22,024       104.0%           22,575     3.40%    2.38%         20           12%
Total 20-Year:                     417             439       105.5%              451     3.98%    2.90%         20           10%
Lower Loan Balance (2)          16,631          17,683       106.3%           17,966     3.81%    2.89%         16           8%
HARP (3)                        21,814          23,190       106.3%           23,493     3.84%    2.92%         13           8%
Other (2009-2012
Vintages) (4)                    9,718           9,978       102.7%           10,001     3.14%    2.75%         6            6%
Other (Pre 2009
Vintages) (4)                      312             335       107.3%              342     5.61%    3.67%         91           19%
Total 30-Year                   48,475          51,186       105.6%           51,802     3.70%    2.88%         13           8%
Total Fixed-Rate                70,059          73,649       105.1%           74,828     3.61%    2.73%         15           9%
Adjustable-Rate                    749             773       103.3%              794     4.09%    2.37%         45           21%
CMO                                148             153       103.3%              157     3.56%    2.85%         69           15%
Total / Weighted Average   $    70,956     $    74,575       105.1%     $     75,779     3.62%    2.73%         16           9%

                                                                    March 31, 2013

                               Underlying                                              Weighted Average            2013
Agency MBS Remeasured at       Unamortized                                                                       Projected
. . .
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