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AGNC > SEC Filings for AGNC > Form 10-Q on 9-May-2014All 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 ("agency MBS"). 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 and in other assets reasonably related to agency securities.
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 primarily of agency securities and assets reasonably related to 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 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 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 a portion 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 funding 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; therefore, we may experience reduced income or losses due to adverse 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 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 basis, or a TBA contract, 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 and principal-only securities.
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 ("Fed"), 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
The first quarter of 2014 saw some stability return to the fixed income markets. After being one of the hardest hit sectors in 2013, fixed rate agency MBS prices were generally higher over the first quarter largely due to lower long term rates and lower levels of implied volatility (lower option prices). The yield curve flattened during the quarter as the market began to anticipate a shift in Fed monetary policy toward a moderate pace of tightening potentially beginning mid-2015. During the quarter, the Fed continued to taper its asset purchase program at a pace of $10 billion per meeting, spread equally between agency MBS and U.S. Treasury instruments. A continued decline in new mortgage origination volumes more than offset the reduced Fed purchases and generally supported mortgage performance despite significant selling on the part of fixed-income money managers.
The favorable landscape for agency MBS led to our economic return for the quarter of 5.1%, or 20.5% on an annualized basis, comprised of a $0.56 increase in our net book value per common share and a $0.65 dividend per common share. A sizable portion of this positive performance related to how we positioned the portfolio toward the end of 2013. These actions included maintaining just over 50% of our portfolio in 15 year fixed rate agency MBS, operating with a larger than normal "duration gap" (the estimated difference between the interest rate sensitivity of our assets and our liabilities and hedges), concentrating our hedges in the three to seven year part of the yield curve, and reducing the size of our swaption portfolio both prior to and during the first quarter. Our decision to operate with a slightly larger duration gap during the first quarter was consistent with the higher share of 15 year MBS in our asset composition, our moderate leverage profile, and the minimal extension risk in our portfolio and in agency MBS more broadly. Our exposure to an increase in interest rates is the combination of our current duration plus the duration extension that occurs as interest rates increase. As such, when extension risk is very significant, we will tend to operate with a smaller duration gap and when extension risk is very low we will tend to operate with a larger duration gap. See also "Quantitative and Qualitative Disclosures about Market Risk" for a discussion of our exposure to interest rate sensitivity as of March 31, 2014.

Given very favorable implied financing terms available in the agency MBS to-be-announced market (or "TBA" market) during the first quarter, we held a greater share of our assets in the form of forward commitments to purchase agency MBS, or TBAs, rather than settling specific mortgage pools and funding them with repurchase agreements. Our TBA dollar roll position increased to approximately $14 billion at quarter end due to a combination of very favorable financing and a reduction in the benefits of holding specified collateral. An additional benefit to gaining exposure to agency MBS in TBA form and continuing to roll the purchases forward to later settlement dates is that dollar roll income associated with these positions is tax efficient given our large capital loss carryforward from 2013. Each dollar roll transaction is recognized as a realized event and dollar roll income/loss is treated as capital gains/losses for tax purposes, rather than as ordinary income as would be the case if the position was held in pool form and funded with repurchase agreement financing. Dollar roll income, therefore, nets against our accumulated tax capital loss carryforward for taxable earnings purposes. If we continue to utilize our capital loss carryforward by generating net capital gains through dollar roll transactions, the tax characterization of a portion of our dividend may change from "ordinary" to "return of capital." Dividends characterized as "return of capital" may reduce a shareholder's cost basis in their stock position and thus impact the capital gain or loss they may recognize upon sale of the stock. If this occurs, it may be beneficial to shareholders in that dividends recorded as "return of capital" may represent a deferred tax liability and are typically taxed at the lower capital gains tax rate rather than being taxed in the current year at the ordinary income tax rate. As of March 31, 2014, we had $1.7 billion (or $4.77 per common share) of remaining capital loss carryforwards available to be applied against future capital gains (see also "Dividends and Income Taxes" in our "Results of Operations"). The final tax characterization of our dividends will be determined on an annual basis and reported to shareholders on Form 1090-DIV after the end of the calendar year. The tax consequences of an investment in our common stock will depend upon each shareholder's particular circumstances and shareholders are advised to consult with their tax advisors concerning the tax consequences of an investment in our common stock.
The table below summarizes interest rates and prices of generic fixed rate agency mortgage-backed securities as of each date presented below:

                                     Mar.      Dec.      Sept      June      Mar.        Mar. 31, 2014
                                      31,       31,       30,       30,       31,             vs.
 Interest Rate/Security Price 1      2014      2013      2013      2013      2013        Dec. 31, 2013
1-Month                              0.15%     0.17%     0.18%     0.19%     0.20%       --0.02      bps
3-Month                              0.23%     0.25%     0.25%     0.27%     0.28%       --0.02      bps
6-Month                              0.33%     0.35%     0.37%     0.41%     0.44%       --0.02      bps
U.S. Treasury Security Rate:
2-Year U.S. Treasury                 0.42%     0.38%     0.32%     0.36%     0.24%        +0.04      bps
3-Year U.S. Treasury                 0.90%     0.78%     0.63%     0.66%     0.36%        +0.12      bps
5-Year U.S. Treasury                 1.72%     1.74%     1.38%     1.39%     0.77%       --0.02      bps
10-Year U.S. Treasury                2.72%     3.03%     2.61%     2.49%     1.85%       --0.31      bps
30-Year U.S. Treasury                3.56%     3.96%     3.69%     3.52%     3.10%       --0.40      bps
Interest Rate Swap Rate:
2-Year Swap                          0.55%     0.49%     0.46%     0.51%     0.42%        +0.06      bps
3-Year Swap                          0.99%     0.88%     0.76%     0.82%     0.54%        +0.11      bps
5-Year Swap                          1.80%     1.79%     1.54%     1.57%     0.95%        +0.01      bps
10-Year Swap                         2.84%     3.09%     2.77%     2.70%     2.01%       --0.25      bps
30-Year Swap                         3.54%     3.93%     3.66%     3.45%     2.99%       --0.39      bps
30-Year Fixed Rate MBS Price:
3.0%                                $96.53    $95.11    $97.70    $97.72    $103.11         +$1.42
3.5%                                $100.59   $99.48    $101.83   $101.50   $105.58         +$1.11
4.0%                                $103.94   $103.11   $104.86   $104.16   $106.61         +$0.83
4.5%                                $106.69   $106.06   $106.80   $105.82   $107.73         +$0.63
5.0%                                $109.05   $108.80   $108.45   $107.65   $108.34         +$0.25
15-Year Fixed Rate MBS Price:
2.5%                                $99.92    $99.00    $100.61   $100.45   $103.75         +$0.92
3.0%                                $102.72   $102.05   $103.53   $102.82   $105.17         +$0.67
3.5%                                $104.83   $104.58   $105.58   $104.20   $106.03         +$0.25
4.0%                                $105.78   $105.94   $106.25   $105.32   $107.00         -$0.16
4.5%                                $106.05   $106.44   $106.25   $106.00   $107.67         -$0.39


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 following table summarizes recent prepayment trends for our portfolio:
Annualized Monthly Constant Prepayment Rates 1 Dec. 2013 Jan. 2014 Feb. 2014 Mar. 2014 AGNC portfolio 8% 8 % 7 % 6 %

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 March 31, 2014 and December 31, 2013, our investment portfolio consisted of $56.4 billion and $65.9 billion of agency MBS, respectively, and a $14.1 billion and $2.3 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 March 31, 2014 and December 31, 2013, our TBA position had a net carrying value of $(25) million and $(5) 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 March 31, 2014 and December 31, 2013 (dollars in millions):

                                                                   March 31, 2014

                                                                                    % 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 (Mths)       CPR 5
Investments By
Coupon: 1
Fixed Rate
 ? 15-Year
 ? 2.5%               $     7,439     $     7,597       102.1%     $      7,451       36%      2.96%     2.04%        17             5%
3.0%                        4,655           4,797       103.1%            4,788       76%      3.49%     2.30%        25             7%
3.5%                       10,479          10,894       104.0%           11,004       59%      3.93%     2.53%        36            10%
4.0%                        5,436           5,699       104.8%            5,788       88%      4.40%     2.76%        40            12%
4.5%                          568             597       105.2%              608       97%      4.87%     3.11%        43            14%
? 5.0%                          8               8       104.3%                9       24%      6.48%     4.37%        76             2%
Total ? 15-Year            28,585          29,592       103.5%           29,648       63%      3.72%     2.43%        30             9%
 ? 3.0%                       345             342       99.2%               345       28%      3.55%     3.10%        10             2%
3.5%                          757             775       102.3%              779       63%      4.05%     3.09%        13             4%
4.0%                           89              94       104.9%               94       47%      4.53%     3.06%        31             8%
4.5%                          113             121       107.1%              122       97%      4.89%     3.15%        40            11%
? 5.0%                          6               6       106.5%                7        -%      5.90%     3.38%        70            21%
Total 20-Year:              1,310           1,338       102.1%            1,347       56%      4.04%     3.10%        16             5%
 ? 3.0%                       228             232       101.8%              220       69%      3.69%     2.77%        14             5%
3.5%                        8,651           9,160       105.9%            8,706       96%      4.02%     2.75%        22             6%
4.0%                        9,223           9,808       106.3%            9,592       94%      4.47%     3.10%        26             8%
4.5%                        3,215           3,433       106.8%            3,445       91%      4.95%     3.47%        36            10%
5.0%                          204             217       106.4%              223       65%      5.45%     3.79%        72            13%
? 5.5%                        254             276       108.5%              280       36%      6.24%     3.39%        87            17%
Total 30-Year              21,775          23,126       106.2%           22,466       93%      4.38%     3.02%        27             7%
Total Fixed Rate           51,670          54,056       104.6%           53,461       75%      4.01%     2.70%        28             8%
Adjustable Rate             1,152           1,176       102.1%            1,195        -%      2.58%     2.36%        28            18%
CMO                         1,249           1,281       102.6%            1,289        -%      4.29%     2.88%        24             7%
Total / Weighted
Average               $    54,071     $    56,513       104.5%     $     55,945       72%      3.99%     2.70%        28             8%

                                                                       March 31, 2014
Agency MBS Remeasured at       Unamortized                                             Weighted Average
Fair Value Through              Principal        Amortized                                                        Projected Life
Earnings                         Balance           Cost          Fair Value     Coupon 1   Yield 5   Age (Mths)       CPR 5
Interest-Only Strips         $       1,324     $       211     $        230      5.49%      7.83%        47            12%
Principal-Only Strips                  265             204              202        -%       4.13%        28             9%
Total / Weighted Average     $       1,589     $       415     $        432      4.57%      6.01%        38            10%


1. The weighted average coupon on our agency MBS classified as "AFS" was 3.53% and the weighted average coupon on our total agency MBS portfolio, including agency MBS remeasured at fair value through earnings, was 3.65% as of March 31, 2014.

2. Lower loan balance securities represent pools backed by an original loan balance of ? $150,000. Our lower loan balance securities had a weighted average original loan balance of $100,000 and $95,000 for 15-year and 30-year securities, respectively, as of March 31, 2014.

3. HARP securities are defined as pools backed by100% refinance loans with LTV ? 80%. Our HARP securities had a weighted average LTV of 107% and 106% for 15-year and 30-year securities, respectively, as of March 31, 2014. Includes $987 million and $2.1 billion of 15-year and 30-year securities with >105 LTV pools which are not deliverable into TBA securities.

4. WAC represents the weighted average coupon of the underlying collateral.

5. Portfolio yield incorporates a projected life CPR assumption based on forward rate assumptions as of March 31, 2014.

                                                                  March 31, 2014
                                      Amount - Long                         Market
TBA Securities                          (Short) 1        Cost Basis 2      Value 3       Net Carrying Value 4
15-Year TBA securities:
2.5%                                 $      1,774       $      1,773     $    1,769     $              (4 )
. . .
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