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AGNC > SEC Filings for AGNC > Form 10-Q on 7-Aug-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 ("repo").
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 fixed income markets saw improvement and a return to relative stability during the first half of 2014, after being one of the hardest hit sectors during 2013. Fixed rate agency MBS prices were generally higher during both the first and second quarters of 2014, driven by a combination of lower long term rates, tighter mortgage spreads and lower levels of implied interest rate volatility (lower option prices). During the first half of 2014, the Fed began to reduce purchases under its asset purchase program ("QE3"), in line with its "tapering" guidance issued during December 2013. Mixed economic data and the "measured" tapering actions taken by the Fed during the first half of 2014 led to a meaningful flattening of the yield curve, as the market began to realize that the pace of tightening in Fed monetary policy would likely be more gradual and have a more moderate impact than many had initially expected. Agency mortgage spreads also tightened significantly during the first half of 2014, leading to considerably more price appreciation on agency MBS than on comparable duration U.S. Treasury securities. The relative outperformance of agency MBS is widely attributed to a combination of historically low mortgage origination volume, conservative positioning by fixed income investors, with many agency MBS investors meaningfully underweight their benchmark, and a favorable "stock-effect" due to the Fed's significant ownership of approximately one third, or nearly $1.8 trillion, of the agency MBS market as of June 30, 2014. In addition to the general outperformance of the agency MBS market, our performance during the first half of 2014 was also bolstered by very favorable financing rates in the TBA dollar roll market, our moderate leverage profile and our decision to maintain a larger "duration gap" (the estimated difference between the interest rate sensitivity of our assets and our liabilities and hedges). The combination of these factors drove our aggregate economic return of 15.2% for the first half of 2014, comprised of $1.30 dividends per common share and a $2.33 increase in our net book value per common share.
By the start of 2014, we had increased our 15 year fixed rate mortgage position to just over 50% of our portfolio, which benefited our first quarter performance as 15 year mortgages, on a hedge adjusted basis, generally outperformed 30 year mortgages during the first quarter. Early in the second quarter, the price of higher coupon 15 year agency MBS increased significantly relative to other agency MBS instruments, particularly 30 year agency MBS. In response to this changing dynamic, we reduced our 15 year position to approximately 38% of our portfolio and increased our 30 year position to 57%. This shift further benefited our performance in the second quarter as 30 year mortgages generally outperformed 15 year mortgages.
In addition to operating with a larger duration gap during the first half of 2014, we also shifted the composition of our hedge portfolio toward a greater share of hedges in the three to seven year part of the yield curve and avoided the negative impact of lower option prices by reducing the size of our swaption portfolio beginning in the fourth quarter of 2013.
Our decision to operate with a slightly larger duration gap was consistent with 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 viewed as more significant, we will tend to operate with a smaller duration gap and when extension risk is deemed less significant, we will tend to operate with a larger duration gap. For further discussion of our interest rate sensitivity, refer to Quantitative and Qualitative Disclosures about Market Risk in this Form 10-Q. Given the very favorable implied financing terms available during the first half of 2014 in the TBA dollar roll market and lower relative benefits of holding specific mortgage pools, we increased our investment allocation in TBA securities, rather than settling specific mortgage pools and funding them with repurchase agreements. Our TBA dollar roll position increased from $2.3 billion as of December 31, 2013 to $18.4 billion as of June 30, 2014 (or from 3% to 26% of our portfolio). Gains and losses on TBA positions are treated as capital gains or losses for purposes of determining our taxable earnings. 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 may be offset against our prior year capital loss carryforward. Therefore, given our relative shift towards dollar roll income, we expect that a portion of our 2014 dividends declared on our common stock will represent a "return of capital" for income tax purposes when the final determination is made after the end of our calendar year. For shareholders that hold our common stock in taxable accounts, this may result in an improvement in their after-tax returns. The final tax characterization of our dividends will be reported to shareholders on Form 1099-DIV after the end of the calendar year. Please also refer to Dividends and Income Taxes in our Results of Operations for further information regarding our estimated taxable earnings.
Looking ahead, we believe agency MBS valuations will benefit from favorable supply and demand technical factors throughout the remainder of 2014 and likely into 2015. An important driver of our outlook for agency MBS is our belief that the Fed will remain a significant purchaser of agency MBS, as it continues to reinvest paydowns on its portfolio into new agency MBS holdings, for a considerable time following the conclusion of QE3. In addition, we expect new loan origination volumes to be depressed as refinance activity will be muted in the absence of a significant decline in interest rates and as first time homebuyers continue to face a myriad of challenges. We also believe agency MBS are more attractive to fixed income investors relative to other fixed income investments, as agency MBS yields have increased by more than 100 bps since the start of QE3 through June 30, 2014, while yields on comparable duration investments have generally fallen. Agency MBS also offer several advantages over many other fixed-income products, such as greater liquidity and financing opportunities and a favorable "stock-effect" due to the Fed's significant ownership of agency MBS.
Given these factors, we believe agency MBS will perform well relative to other fixed income products and that TBA dollar roll financing will remain very attractive for some period of time, even if funding rates were to rise above, or become less "special" than, levels experienced during the first half of 2014. However, if conditions change resulting in higher interest rates and/or wider mortgage spreads, and assuming we took no further portfolio rebalancing actions, it would likely have an adverse impact on our net book value. For the estimated impact of changes in interests rates and mortgage spreads on our net book value please refer to Quantitative and Qualitative Disclosures about Market Risk in this Form 10-Q. However, since we employ an active management strategy, the size and composition of our assets, liabilities and hedges will evolve based on our Manager's view of the current market environment and relative risks and rewards. As such, the actual impact of changes in interest rates and mortgage spreads could differ materially from our estimates.
The following table summarizes interest rates and prices of generic fixed rate agency mortgage-backed securities as of each date presented below:

                                  June      Sept      Dec.      Mar.      June        June 30, 2014         June 30, 2014
                                   30,       30,       31,       31,       30,             vs.                   vs.
Interest Rate/Security Price 1    2013      2013      2013      2014      2014        Mar. 31, 2014         Dec. 31, 2013
1-Month                           0.19%     0.18%     0.17%     0.15%     0.16%        +0.01      bps       --0.01      bps
3-Month                           0.27%     0.25%     0.25%     0.23%     0.23%            -      bps       --0.02      bps
6-Month                           0.41%     0.37%     0.35%     0.33%     0.33%            -      bps       --0.02      bps
U.S. Treasury Security Rate:
2-Year U.S. Treasury              0.36%     0.32%     0.38%     0.42%     0.46%        +0.04      bps        +0.08      bps
3-Year U.S. Treasury              0.66%     0.63%     0.78%     0.90%     0.87%       --0.03      bps        +0.09      bps
5-Year U.S. Treasury              1.39%     1.38%     1.74%     1.72%     1.63%       --0.09      bps       --0.11      bps
10-Year U.S. Treasury             2.49%     2.61%     3.03%     2.72%     2.53%       --0.19      bps       --0.50      bps
30-Year U.S. Treasury             3.52%     3.69%     3.96%     3.56%     3.36%       --0.20      bps       --0.60      bps
Interest Rate Swap Rate:
2-Year Swap                       0.51%     0.46%     0.49%     0.55%     0.58%        +0.03      bps        +0.09      bps
3-Year Swap                       0.82%     0.76%     0.88%     0.99%     1.00%        +0.01      bps        +0.12      bps
5-Year Swap                       1.57%     1.54%     1.79%     1.80%     1.70%       --0.10      bps       --0.09      bps
10-Year Swap                      2.70%     2.77%     3.09%     2.84%     2.63%       --0.21      bps       --0.46      bps
30-Year Swap                      3.45%     3.66%     3.93%     3.54%     3.33%       --0.21      bps       --0.60      bps
30-Year Fixed Rate MBS Price:
3.0%                             $97.72    $97.70    $95.11    $96.53    $98.77          +$2.24                +$3.66
3.5%                             $101.50   $101.83   $99.48    $100.59   $102.92         +$2.33                +$3.44
4.0%                             $104.16   $104.86   $103.11   $103.94   $106.11         +$2.17                +$3.00
4.5%                             $105.82   $106.80   $106.06   $106.69   $108.30         +$1.61                +$2.24
15-Year Fixed Rate MBS Price:
2.5%                             $100.45   $100.61   $99.00    $99.92    $101.59         +$1.67                +$2.59
3.0%                             $102.82   $103.53   $102.05   $102.72   $103.88         +$1.16                +$1.83
3.5%                             $104.20   $105.58   $104.58   $104.83   $105.98         +$1.15                +$1.40
4.0%                             $105.32   $106.25   $105.94   $105.78   $106.17         +$0.39                +$0.23


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   Apr. 2014   May 2014   June 2014
AGNC portfolio                           8%          8%          7%          6%          8%          9%         9%


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 June 30, 2014 and December 31, 2013, our investment portfolio consisted of $53.6 billion and $65.9 billion of agency MBS, respectively, and a $18.4 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 June 30, 2014 and December 31, 2013, our TBA position had a net carrying value of $200 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 June 30, 2014 and December 31, 2013 (dollars in millions):

                                                                   June 30, 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%               $     7,315     $     7,465       102.0%     $      7,445       37%      2.97%     2.05%        19             7%
3.0%                        4,942           5,096       103.1%            5,136       76%      3.50%     2.28%        26             8%
3.5%                        8,940           9,292       103.9%            9,485       56%      3.93%     2.50%        39            10%
4.0%                        5,156           5,400       104.7%            5,520       88%      4.40%     2.74%        43            11%
4.5%                          537             565       105.2%              579       97%      4.87%     3.09%        46            11%
? 5.0%                          7               7       104.4%                7       26%      6.46%     4.43%        78            14%
Total ? 15-Year            26,897          27,825       103.4%           28,172       62%      3.70%     2.40%        32             9%
 ? 3.0%                       339             336       99.2%               345       28%      3.55%     3.10%        13             6%
3.5%                          740             757       102.3%              774       63%      4.05%     3.07%        16             8%
4.0%                           87              91       104.7%               94       47%      4.53%     3.03%        34             9%
4.5%                          108             116       107.0%              118       99%      4.89%     3.08%        43            10%
? 5.0%                          6               6       106.2%                6        -%      5.90%     3.35%        73            19%
Total 20-Year:              1,280           1,306       102.1%            1,337       55%      4.04%     3.08%        19             8%
 ? 3.0%                       224             228       101.8%              221       69%      3.69%     2.77%        17             6%
3.5%                        8,476           8,972       105.9%            8,733       96%      4.02%     2.75%        25             6%
4.0%                        8,459           9,014       106.6%            8,983       96%      4.47%     3.11%        30             7%
4.5%                        2,695           2,878       106.8%            2,943       91%      4.95%     3.48%        38             8%
5.0%                          196             209       106.6%              217       65%      5.45%     3.82%        74            10%
? 5.5%                        237             259       109.3%              265       36%      6.23%     3.49%        90            17%
Total 30-Year              20,287          21,560       106.3%           21,362       94%      4.37%     3.02%        30             7%
Total Fixed Rate           48,464          50,691       104.6%           50,871       75%      3.99%     2.68%        31             8%
. . .
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