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AGNC > SEC Filings for AGNC > Form 10-K on 27-Feb-2014All Recent SEC Filings




Annual Report

Item 7. 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 seven sections:
Executive Overview

Financial Condition

Results of Operations

Liquidity and Capital Resources

Off-Balance Sheet Arrangements

Aggregate Contractual Obligations

Forward-Looking Statements

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.
Trends and Recent Market Impacts

Fiscal year 2013 was a challenging and difficult year for all fixed income markets and the agency MBS market was one of the hardest hit sectors. As a result, our net book value per common share fell.

Throughout much of 2013, MBS investors struggled with uncertainty surrounding when the Fed would alter its open-ended, third quantitative easing, asset purchase program, commonly known as QE3, as stronger than expected employment reports early in the year triggered a significant rise in interest rates. For the year, the 10 year U.S. Treasury rate increased 127 basis points and 30 year mortgage rates increased 138 basis points. Agency MBS prices came under pressure and underperformed other fixed income instruments as agency MBS investors significantly pared back their holdings in anticipation of a sooner-than-expected Fed tapering of QE3. As a result, agency MBS spreads widened relative to U.S. Treasury and swap rates. This spread widening was the primary driver of our 24% decline in net book value per common share over the course of 2013.

In December 2013, the Fed announced that it would begin reducing the pace of its asset purchases by $10 billion per month beginning in January 2014, split equally between agency MBS and U.S. Treasury securities. The Fed stated that additional reductions to its asset purchases are expected "in measured steps" at future meetings, but that it is not on a preset course and the level of future asset purchases will depend on the pace of economic activity. The Fed stated that it would maintain its policy of reinvestment of principal payments on its holdings of agency MBS into new agency MBS. The Fed also extended its guidance on short-term interest rates and stated that it will likely maintain the current exceptionally low target range of 0.0% to 0.25% for the federal funds rate well past the time that the unemployment rate declines below 6.5%, especially if projected inflation continues to run below its 2% longer-run goal.

Given the challenging market conditions and significant volatility throughout 2013, we prioritized risk management over near term earnings. To this end, our Manager took steps to reduce leverage, increase our hedge positions and alter the composition of our asset portfolio. Together, we believe these actions meaningfully reduced our exposure to rising rates and widening agency MBS spreads.

These portfolio rebalancing actions, however, drove a decline in our net spread income per common share. Our more defensive positioning, coupled with the reduction in our net book value and taxable income, caused us to reduce our dividend.

In 2013, we declared $3.75 per common share in dividends, down from $5.00 per common share in 2012. Combining the dividends we paid and the decline in our net book value per common share we experienced during 2013, our economic return for the year was a negative 12.5%. However, as a result of the Fed exiting its unprecedented participation in the mortgage market, we believe that the mortgage market is returning to a more normalized risk return environment. In light of the portfolio rebalancing actions we took during 2013, we are well positioned to respond to attractive investment opportunities as they arise in the current steeper yield curve, wider spread environment.

Additionally, given the significant volatility during 2013 in the agency MBS market and the broader fixed income market, our stock price came under significant pressure during the year, at times trading at a substantial discount to our estimated book value. In response, in September 2013, our Board of Directors expanded our common stock repurchase program by $500 million, authorizing us to repurchase up to $1 billion of our outstanding shares of common stock, and extended the program through December 31, 2014. During 2013, we made open market purchases of approximately 40.3 million shares of our common stock. The shares were purchased at an average price of $21.25 per share, totaling $856 million, including expenses. Since commencing our stock repurchase program in the fourth quarter of 2012, we have purchased approximately 43.0 million shares of our common stock, or approximately 10% of our outstanding common shares from their peak in March 2013, for total consideration of $934 million, including expenses. As of December 31, 2013, $66 million remained available for repurchases of our common stock and, during January 2014, our Board of Directors authorized additional repurchases of $1 billion of our common stock through December 31, 2014.
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 December 31, 2012:

                                     Dec.      Sept      June      Mar.      Dec.        Dec. 31, 2013
                                      31,       30,       30,       31,       31,             vs.
 Interest Rate/Security Price 1      2013      2013      2013      2013      2012        Dec. 31, 2012
1-Month                              0.17%     0.18%     0.19%     0.20%     0.21%       --0.04      bps
3-Month                              0.25%     0.25%     0.27%     0.28%     0.31%       --0.06      bps
6-Month                              0.35%     0.37%     0.41%     0.44%     0.51%       --0.16      bps
U.S. Treasury Security Rate:
2-Year U.S. Treasury                 0.38%     0.32%     0.36%     0.24%     0.25%        +0.13      bps
5-Year U.S. Treasury                 1.74%     1.38%     1.39%     0.77%     0.72%        +1.02      bps
10-Year U.S. Treasury                3.03%     2.61%     2.49%     1.85%     1.76%        +1.27      bps
Interest Rate Swap Rate:
2-Year Swap                          0.49%     0.46%     0.51%     0.42%     0.39%        +0.10      bps
5-Year Swap                          1.79%     1.54%     1.57%     0.95%     0.86%        +0.93      bps
10-Year Swap                         3.09%     2.77%     2.70%     2.01%     1.84%        +1.25      bps
30-Year Fixed Rate MBS Price:
3.0%                                $95.11    $97.70    $97.72    $103.11   $104.84         -$9.73
3.5%                                $99.48    $101.83   $101.50   $105.58   $106.66         -$7.18
4.0%                                $103.11   $104.86   $104.16   $106.61   $107.22         -$4.11
4.5%                                $106.06   $106.80   $105.82   $107.73   $108.03         -$1.97
5.0%                                $108.80   $108.45   $107.65   $108.34   $108.33         +$0.47
5.5%                                $110.05   $109.03   $108.65   $109.08   $108.64         +$1.41
6.0%                                $111.09   $109.39   $108.78   $109.56   $109.22         +$1.87
15-Year Fixed Rate MBS Price:
2.5%                                $99.00    $100.61   $100.45   $103.75   $104.61         -$5.61
3.0%                                $102.05   $103.53   $102.82   $105.17   $105.61         -$3.56
3.5%                                $104.58   $105.58   $104.20   $106.03   $106.14         -$1.56
4.0%                                $105.94   $106.25   $105.32   $107.00   $107.00         -$1.06
4.5%                                $106.44   $106.25   $106.00   $107.67   $107.55         -$1.11


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:

                                       Dec.     Sept     June     Mar.     Dec.     Dec. 31, 2013
Pay-ups on Specified Mortgage Pools    31,      30,      30,      31,      31,           vs.
over Generic TBA Price 1,2             2013     2013     2013     2013     2012     Dec. 31, 2012
30-Year Lower Loan Balance Pay-ups
($85k - $110k): 3
3.0%                                  $0.02    $0.03      $-     $0.13    $0.69        -$0.67
3.5%                                  $0.09    $0.22    $0.22    $0.91    $1.64        -$1.55
4.0%                                  $0.23    $0.70    $0.91    $3.28    $4.19        -$3.96
30-Year HARP Pay-ups (95% - 100%
LTV): 4
3.0%                                    $-       $-       $-     $0.07    $0.47        -$0.47
3.5%                                    $-     $0.03    $0.16    $0.70    $1.52        -$1.52
4.0%                                  $0.06    $0.21    $0.59    $2.85    $4.06        -$4.00


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%.

Summary of Critical Accounting Estimates Our critical accounting estimates relate to the recognition of interest income and the fair value of our investments and derivatives. Certain of these items involve estimates that require management to make judgments that are subjective in nature. We rely on our Manager's experience and analysis of historical and current market data in order to arrive at what we believe to be reasonable estimates. Under different conditions, we could report materially different amounts based on such estimates. The remainder of our significant accounting policies are described in Note 2 to the consolidated financial statements included under Item 8 of this Annual Report on Form 10-K. Interest Income
The effective yield on our agency securities is highly impacted by our estimate of future prepayments. We accrue interest income based on the outstanding principal amount of our investment securities and their contractual terms and we amortize or accrete premiums and discounts associated with the purchase of investment securities into interest income over the projected lives of our securities, including contractual payments and estimated prepayments, using the interest method. The weighted average cost basis of our securities as of December 31, 2013 was 104.6% of par value; therefore, faster actual or projected prepayments can have a meaningful negative impact, while slower actual or projected prepayments can have a meaningful positive impact, on our asset yields.
Future prepayment rates are difficult to predict and we rely on a third-party service provider and our Manager's experience and analysis of historical and current market data in order to arrive at what we believe to be reasonable estimates. Our third-party service provider estimates prepayment speeds using models that incorporate the forward yield curve, current mortgage rates and mortgage rates of the outstanding loans, age and size of the outstanding loans, loan-to-value ratios, volatility and other factors. We review the prepayment speeds estimated by the third-party service and compare the results to market consensus prepayment speeds, if available. We also consider historical prepayment speeds and current market conditions to validate the reasonableness of the prepayment speeds estimated by the third-party service and, based on our Manager's judgment, we may make adjustments to their estimates. We review our actual and anticipated prepayment experience on at least a quarterly basis and effective yields are recalculated when differences arise between (i) our previously estimated future prepayments and (ii) actual prepayments to date plus current estimated future prepayments. If the actual and estimated future prepayment experience differs from our prior estimate of prepayments, we are required to record an adjustment in the current period to the amortization or accretion of premiums and discounts for the cumulative difference in the effective yield through the reporting date.
The most significant factor impacting prepayment rates on our securities is changes to long-term interest rates. Prepayment rates generally increase when interest rates fall and decrease when interest rates rise. However, there are a variety of other factors that may impact the rate of prepayments on our securities. Prepayments can also occur when borrowers sell the property

and use the sale proceeds to prepay the mortgage as part of a physical relocation. In addition, changes to the GSE's underwriting standards, further modifications to existing U.S. Government sponsored programs such as HARP, or the implementation of new programs can have a significant impact on the rate of prepayments. Further, GSE buyouts of loans in imminent risk of default, loans that have been modified, or loans that have defaulted will generally be reflected as prepayments on agency securities and also increase the uncertainty around our estimates. Consequently, under different conditions, we could report materially different amounts. Item 7A. Quantitative and Qualitative Disclosures About Market Risk in this Annual Report on Form 10-K includes the estimated change in our net interest income should interest rates go up or down by 50 and 100 basis points, assuming the yield curves of the rate shocks will be parallel to each other and the current yield curve. Fair Value of Investment Securities
We estimate the fair value of our agency securities based on a market approach using "Level 2" inputs from third-party pricing services and non-binding dealer quotes derived from common market pricing methods. Such methods incorporate, but are not limited to, reported trades and executable bid and ask prices for similar securities, benchmark interest rate curves, such as the spread to the U.S. Treasury rate and interest rate swap curves, convexity, duration and the underlying characteristics of the particular security, including coupon, periodic and life caps, rate reset period, issuer, additional credit support and expected life of the security. We generally obtain 3 to 6 quotes or prices (referred to as "marks") per agency security. We attempt to validate marks obtained from pricing services and broker dealers by comparing them to our recent completed transactions involving the same or similar securities on or near the reporting date. Changes in the market environment and other events that may occur over the life of our investments may cause the gains or losses ultimately realized on these investments to be different than the valuations currently estimated.
We also evaluate our agency securities for other-than-temporary impairment ("OTTI") on at least a quarterly basis. The determination of whether a security is other-than-temporarily impaired may involve judgments and assumptions based on subjective and objective factors. When a security is impaired, an OTTI is considered to have occurred if any one of the following three conditions exist as of the financial reporting date: (i) we intend to sell the security (that is, a decision has been made to sell the security), (ii) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis or (iii) we do not expect to recover the security's amortized cost basis, even if we do not intend to sell the security and it is not more likely than not that we will be required to sell the security. A general allowance for unidentified impairments in a portfolio of securities is not permitted. If either of the first two conditions exists as of the financial reporting date, the entire amount of the impairment loss, if any, is recognized in earnings as a realized loss and the cost basis of the security is adjusted to its fair value. If the third condition exists, the OTTI is separated into (i) the amount relating to credit loss (the "credit component") and (ii) the amount relating to all other factors (the "non-credit components"). Only the credit component is recognized in earnings, with the non-credit components recognized in OCI. However, in evaluating if the third condition exists, our investments in agency securities typically would not have a credit component since the principal and interest are guaranteed by a GSE and, therefore, any unrealized loss is not the result of a credit loss. In addition, since we designate our agency securities as available-for-sale securities with unrealized gains and losses already recognized in OCI, any impairment loss for non-credit components is already recognized in OCI.
The liquidity of the agency securities market allows us to obtain competitive bids and execute on a sale transaction typically within a day of making the decision to sell a security and, therefore, we generally do not make decisions to sell specific agency securities until shortly prior to initiating a sell order. In some instances, we may sell specific agency securities by delivering such securities into existing short to-be-announced ("TBA") contracts. TBA market conventions require the identification of the specific securities to be delivered no later than 48 hours prior to settlement. If we settle a short TBA contract through the delivery of securities, we will generally identify the specific securities to be delivered within one to two days of the 48-hour deadline.
Derivative Financial Instruments/Hedging Activity

We maintain a risk management strategy, under which we may use a variety of derivative instruments to economically
hedge some of our exposure to market risks, including interest rate risk, prepayment risk and extension risk. Our risk management objective is to reduce fluctuations in net book value over a range of interest rate scenarios. The principal instruments that we use are interest rate swaps and options to enter into interest rate swaps ("interest rate swaptions"). We also utilize forward contracts for the purchase or sale of agency MBS securities on a generic pool, or a TBA contract, basis and on a non-generic, specified pool basis, and we utilize U.S. Treasury securities and U.S. Treasury futures contracts, primarily through short sales. We may also purchase or write put or call options on TBA securities and we may 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").

We recognize all derivatives as either assets or liabilities on the balance sheet, measured at fair value. During the third quarter of 2011, we elected to discontinue hedge accounting for our interest rate swaps. Accordingly, subsequent to the third quarter of 2011, all changes in the fair value of our derivative instruments are reported in earnings in our consolidated statement of comprehensive income in gain (loss) on derivatives and other securities, net during the period in which they occur.

The use of derivatives creates exposure to credit risk relating to potential losses that could be recognized in the event that the counterparties to these instruments fail to perform their obligations under the contracts. We attempt to minimize this risk by limiting our counterparties to major financial institutions with acceptable credit ratings, monitoring positions with individual counterparties and adjusting posted collateral as required. We estimate the fair value of interest rate swaps using a third-party pricing model. The third-party pricing model incorporates such factors as the LIBOR curve and the pay rate on our interest rate swaps. We also incorporate both our own and our counterparties' nonperformance risk in estimating the fair value of our interest rate swaps. In considering the effect of nonperformance risk, we consider the impact of netting and credit enhancements, such as collateral postings and guarantees, and have concluded that our own and our counterparty risk is not significant to the overall valuation of these agreements. We estimate the fair value of interest rate swaptions using a third-party pricing model based on the fair value of the future interest rate swap that we have the option to enter into as well as the remaining length of time that we have to exercise the option, adjusted for non-performance risk, if any.

As of December 31, 2013 and 2012, our investment portfolio consisted of $65.9 billion and $85.2 billion of agency MBS, respectively, and a $2.3 billion and $12.9 billion net long TBA position, at fair value, respectively. Our 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 December 31, 2013 and 2012, our net TBA position had a net carrying value of $(5) 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 December 31, 2013 and 2012 (dollars in millions):

                                                                  December 31, 2013
Agency MBS                                                                          % Lower
Classified as                                                                        Loan             Weighted Average
Available-for-Sale                     Amortized     Amortized                     Balance &                                     Projected Life
("AFS")                Par Value         Cost        Cost Basis     Fair Value     HARP 2,3    WAC 4    Yield 5   Age (Months)       CPR 5
Investments By
Fannie Mae           $    50,914     $    53,099       104.3%     $     52,289        62%      3.89%     2.64%         24              7%
Freddie Mac               12,640          13,264       104.9%           12,980        81%      4.08%     2.85%         27              7%
Ginnie Mae                   223             230       103.1%              235        -%       3.94%     1.66%         27             21%
Total / Weighted
Average              $    63,777     $    66,593       104.4%     $     65,504        66%      3.93%     2.68%         24              7%

Investments By
Coupon: 1
 ? 15-Year
 ? 2.5%              $    11,189     $    11,400       101.9%     $     11,109        31%      2.96%     2.11%         14              6%
3.0%                       6,037           6,220       103.0%            6,166        69%      3.48%     2.34%         21              7%
3.5%                      14,049          14,632       104.2%           14,716        51%      3.93%     2.52%         31              9%
4.0%                       5,700           5,981       104.9%            6,056        88%      4.40%     2.78%         37              9%
4.5%                         588             619       105.3%              631        99%      4.87%     3.15%         40             10%
? 5.0%                         8               9       104.5%                9        23%      6.49%     4.40%         73             14%
Total ? 15-Year           37,571          38,861       103.4%           38,687        55%      3.66%     2.42%         25              8%
 ? 3.0%                      350             347       99.2%               346        28%      3.55%     3.10%         7               5%
3.5%                         770             788       102.4%              785        63%      4.05%     3.11%         10              6%
4.0%                          93              97       105.0%               97        47%      4.53%     3.10%         28              7%
4.5%                         116             125       107.3%              124        97%      4.89%     3.20%         37              8%
? 5.0%                         6               7       106.7%                7        -%       5.89%     3.39%         67             16%
Total 20-Year:             1,335           1,364       102.2%            1,359        56%      4.05%     3.11%         13              6%
 ? 3.0%                      231             236       101.8%              220        69%      3.69%     2.78%         11              5%
3.5%                       8,530           9,051       106.1%            8,477        99%      4.02%     2.76%         19              5%
4.0%                       9,077           9,669       106.5%            9,359        92%      4.46%     3.14%         22              6%
4.5%                       4,075           4,355       106.9%            4,332        88%      4.95%     3.53%         33              7%
5.0%                         211             226       106.6%              229        65%      5.46%     3.84%         69             10%
? 5.5%                       271             295       108.8%              298        36%      6.25%     3.46%         84             19%
Total 30-Year             22,395          23,832       106.4%           22,915        93%      4.41%     3.08%         24              6%
Total Fixed-Rate          61,301          64,057       104.5%           62,961        69%      3.95%     2.68%         24              7%
Adjustable-Rate            1,196           1,223       102.2%            1,235        -%       2.58%     2.41%         26             17%
CMO                        1,280           1,313       102.6%            1,308        -%       4.30%     2.88%         21              7%
Total / Weighted
Average              $    63,777     $    66,593       104.4%     $     65,504        66%      3.93%     2.68%         24              7%

. . .

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