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AGNC > SEC Filings for AGNC > Form 10-Q on 7-Nov-2013All Recent SEC Filings




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 net 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 a government-sponsored enterprise, 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 rate, prepayment rate and extension risks;

preserve our net book value;

provide regular quarterly distributions to our stockholders;

continue to 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 interest we pay 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 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 similar duration 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 as well as our convexity exposure. Duration is the estimated percentage change in market value of our mortgage assets or our hedge portfolio that would be caused by a parallel change in short and long-term interest rates. Convexity exposure relates to the way the duration of our mortgage assets or our hedge portfolio changes when the interest rate or 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 faster 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 loans, 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 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 "spread risk" (also referred to as "basis risk"), which is the risk of an increase of the market spread between the yield on our agency securities and the benchmark yield on U.S. Treasury securities or interest rate swap rates. The inherent 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, extension 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 ("Fed") 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 Fed'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 Fed 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 Fed'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 Fed purchased an average of approximately $70 billion in agency securities per month during the first three quarters of 2013, representing nearly half of the average monthly gross issuance of fixed-rate agency MBS over this period.
The Fed's participation in the MBS market has affected asset prices and put downward pressure on net interest margins. The unpredictability and size of QE3 has further injected volatility into the pricing and availability of certain MBS assets. Following the Fed's announcement of QE3, mortgage spreads relative to U.S. Treasury securities and interest rate swaps narrowed sharply and prices across the agency MBS spectrum rose to at or near historical highs, with specified pre-payment protected MBS significantly outperforming generic MBS as investors were focused on pre-payment protection. By early 2013, mortgage spreads had retracted some of their decline, but remained well below their historical average with both specified and generic MBS prices remaining at or near historical highs. However, during the first quarter of 2013, investor perceptions around the future of monetary policy began to shift as concerns grew around the timing and impact of the Fed's eventual withdrawal from the mortgage market. These concerns combined with generally stronger economic data, pushed interest rates higher and mortgage spreads returned to near pre-QE3 levels by the end of the second quarter. Price premiums (or "pay-ups" over generic MBS prices) on specified pools of securities with favorable prepayment attributes also declined during the period, as investor sentiment shifted from prepayment concerns to extension risk and "up rate" protection. The third quarter, although ending with prices and rates largely unchanged relative to the end of the second quarter, experienced significant intra-quarter volatility in both interest rates and spreads as employment reports fell short of expectations and the Fed decided not to commence tapering during its September 2013 Federal Open Market Committee meeting, contrary to earlier predictions. With tapering expectations shifting to sometime between December 2013 and the second half of 2014, the near term outlook for the agency MBS market was increasingly uncertain by the end of the third quarter.

Given ongoing uncertainties related to the U.S. economic outlook, the timing of changes to QE3 and the actions of U.S. government policy makers, we expect the agency MBS market will continue to experience significant volatility. Consequently, throughout the first three quarters of 2013, we took actions to rebalance the composition of our asset portfolio toward lower duration assets, such as 15-year fixed rate MBS, which are less sensitive to changes in interest rates and mortgage spreads and provide greater capacity to redeploy cash flows into higher yielding assets over the intermediate to longer term (two to five years) in a post QE3 higher rate environment. In addition, with the near term outlook uncertain, we continue to prioritize risk management over short-term returns. As of September 30, 2013, we lowered our "at risk" leverage ratio, inclusive of our net TBA position, to 7.2x our stockholders' equity and continued to maintain a large hedge portfolio relative to pre-QE3 levels. As of September 30, 2013, our hedges, consisting of interest rate swaps, swaptions and U.S. Treasury positions represented 91% of our repurchase agreements, other debt and net TBA position. This hedge ratio was moderately lower than our June 30, 2013 hedge ratio of 101%. We were comfortable operating with a slightly lower hedge ratio and slightly larger duration gap at the

end of the third quarter due to the lower risk profile of our assets, the significant extension risk protection provided by our swaption portfolio and the relatively lower level of operating leverage.
Collectively, we believe our actions will provide us with greater book value protection in a rising rate environment. However, in the event that interest rates decline, we continued to hold 65% of our fixed-rate mortgage assets (or 71% inclusive of our net short TBA position) in pre-payment protected securities (i.e., securities backed by original loan balances of up to $150,000, referred to as "lower loan balance securities", and securities backed by 100% refinance loans with original loan-to-value ratios of at least 80% originated under HARP, referred to as "HARP securities") as of September 30, 2013. Substantially all of our pre-payment protected securities as of September 30, 2013 were deliverable into TBA contracts and, therefore, had largely the same liquidity profile as generic agency securities. Further, fixed rate agency TBA deliverable securities had a weighted average pay-up of 0.16% as of September 30, 2013. Therefore, if pay-ups had declined to zero, it would have resulted in less than a 2% decline in our net asset value as of September 30, 2013. For further details of our portfolio composition as of September 30, 2013 refer to Financial Condition below.
Because our primary focus in the current market environment is to prioritize protecting our net asset value and longer term earnings potential over short term returns, we expect that the combination of portfolio rebalancing actions and maintaining a large hedge ratio will result in lower net spread income (net interest income, less periodic costs on interest rate swaps and operating expenses) over the short to intermediate-term. Additionally, as of September 30, 2013, $43.9 billion of our agency MBS had unrealized losses totaling $1.4 billion. Therefore, as we continue to actively manage our portfolio we may recognize additional realized losses on sales of our agency securities. 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 September 30, 2012:

                                    Sept      June      Mar.      Dec.      Sept.       Sept 30, 2013         Sept 30, 2013
                                     30,       30,       31,       31,       30,             vs.                   vs.
Interest Rate/Security Price (1)    2013      2013      2013      2012      2012        Dec. 31, 2012         Sept 30, 2012
1-Month                             0.18%     0.19%     0.20%     0.21%     0.21%       --0.03      bps       --0.03      bps
3-Month                             0.25%     0.27%     0.28%     0.31%     0.36%       --0.06      bps       --0.11      bps
6-Month                             0.37%     0.41%     0.44%     0.51%     0.64%       --0.14      bps       --0.27      bps
U.S. Treasury Security Rate:
2-Year U.S. Treasury                0.32%     0.36%     0.24%     0.25%     0.23%        +0.07      bps        +0.09      bps
5-Year U.S. Treasury                1.38%     1.39%     0.77%     0.72%     0.63%        +0.66      bps        +0.75      bps
10-Year U.S. Treasury               2.61%     2.49%     1.85%     1.76%     1.63%        +0.85      bps        +0.98      bps
Interest Rate Swap Rate:
2-Year Swap                         0.46%     0.51%     0.42%     0.39%     0.37%        +0.07      bps        +0.09      bps
5-Year Swap                         1.54%     1.57%     0.95%     0.86%     0.76%        +0.68      bps        +0.78      bps
10-Year Swap                        2.77%     2.70%     2.01%     1.84%     1.70%        +0.93      bps        +1.07      bps
30-Year Fixed Rate MBS Price:
3.0%                               $97.70    $97.72    $103.11   $104.84   $105.58         -$7.14                -$7.88
3.5%                               $101.83   $101.50   $105.58   $106.66   $107.25         -$4.83                -$5.42
4.0%                               $104.86   $104.16   $106.61   $107.22   $107.75         -$2.36                -$2.89
4.5%                               $106.80   $105.82   $107.73   $108.03   $108.25         -$1.23                -$1.45
5.0%                               $108.45   $107.65   $108.34   $108.33   $109.06         +$0.12                -$0.61
5.5%                               $109.03   $108.65   $109.08   $108.64   $109.63         +$0.39                -$0.60
6.0%                               $109.39   $108.78   $109.56   $109.22   $110.44         +$0.17                -$1.05
15-Year Fixed Rate MBS Price:
2.5%                               $100.61   $100.45   $103.75   $104.61   $105.13         -$4.00                -$4.52
3.0%                               $103.53   $102.82   $105.17   $105.61   $106.00         -$2.08                -$2.47
3.5%                               $105.58   $104.20   $106.03   $106.14   $106.41         -$0.56                -$0.83
4.0%                               $106.25   $105.32   $107.00   $107.00   $106.91         -$0.75                -$0.66
4.5%                               $106.25   $106.00   $107.67   $107.55   $107.84         -$1.30                -$1.59


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 were obtained from a combination of Bloomberg and dealer indications. Interest rates were obtained from Bloomberg.

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:

Pay-ups on Specified Mortgage       Sept    June    Mar.    Dec.    Sept.    Sept 30, 2013     Sept 30, 2013
Pools over Generic TBA Price        30,      30,     31,     31,     30,          vs.               vs.
(1)(2)                              2013    2013    2013    2012    2012     Dec. 31, 2012     Sept 30, 2012
30-Year Lower Loan Balance
Pay-ups ($85k - $110k): (3)
3.0%                               $0.03     $-     $0.13   $0.69   $0.09       -$0.66            -$0.06
3.5%                               $0.22    $0.22   $0.91   $1.64   $1.02       -$1.42            -$0.80
4.0%                               $0.70    $0.91   $3.28   $4.19   $3.45       -$3.49            -$2.75
30-Year HARP Pay-ups (95% - 100%
LTV): (4)
3.0%                                 $-      $-     $0.07   $0.47   $0.06       -$0.47            -$0.06
3.5%                               $0.03    $0.16   $0.70   $1.52   $1.00       -$1.49            -$0.97
4.0%                               $0.21    $0.59   $2.85   $4.06   $3.25       -$3.85            -$3.04


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%.

The following table summarizes recent prepayment trends for our portfolio

Annualized Monthly
Constant Prepayment                  Feb.    Mar.    April    May    June                            Sept.
Rates (1)                Jan. 2013   2013    2013     2013   2013    2013    July 2013   Aug. 2013   2013
AGNC portfolio              11%       10%     10%     11%     11%     12%       11%         11%       8%


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.

As of September 30, 2013 and December 31, 2012, our investment portfolio consisted of $85.0 billion and $85.2 billion of agency MBS, respectively, and $7.3 billion net short TBA position and $12.9 billion net long TBA position, at fair value, respectively.
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 September 30, 2013 and December 31, 2012, our net TBA positions had a net carrying value of $(196) 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 underlying agency security in the TBA contract and the cost basis or the forward price to be paid or received for the underlying agency security. The following tables summarize certain characteristics of our agency MBS investment portfolio and our net TBA position as of September 30, 2013 and December 31, 2012 (dollars in millions):

                                                                   September 30, 2013

                                                                                    % Lower
Agency MBS                                                                           Loan               Weighted Average
Classified as                                                                      Balance &
Available-for-Sale                     Amortized     Amortized                       HARP                                           Projected Life
("AFS")                Par Value         Cost        Cost Basis     Fair Value      (2)(3)     WAC (4)   Yield (5)   Age (Months)      CPR (5)
Investments By
Fannie Mae           $    63,884     $    66,722       104.4%     $     66,251        60%       3.91%      2.66%          20              8%
Freddie Mac               17,604          18,379       104.4%           18,069        75%       4.04%      2.86%          21              7%
Ginnie Mae                   237             245       103.4%              249        -%        3.08%      1.12%          24             19%
Total / Weighted
Average              $    81,725     $    85,346       104.4%     $     84,569        63%       3.93%      2.70%          20              8%

Investments By
Coupon: (1)
 ? 15-Year
 ? 2.5%              $    11,531     $    11,772       102.1%     $     11,613        33%       2.96%      2.07%          10              6%
3.0%                       6,123           6,306       103.0%            6,338        66%       3.43%      2.34%          17              8%
3.5%                      16,201          16,877       104.2%           17,123        42%       3.93%      2.50%          27              9%
4.0%                       6,002           6,297       104.9%            6,400        88%       4.40%      2.77%          34             10%
4.5%                         621             654       105.3%              661        98%       4.87%      3.14%          37             11%
? 5.0%                         9               9       104.5%               10        26%       6.44%      4.36%          69             14%
. . .
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