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On February 7, American Capital Agency (AGNC) reported its Q4 and FY 2012 results. AGNC reported comprehensive income of $126M during Q4 2012, or $0.36 per share, compared to comprehensive income of $1.33B, or $3.98 per share, in Q3 2012. During Q4 2012, AGNC reported $0.89 of net spread income per share and $0.29 per share of estimated net carry income (also known as "dollar roll income"). Net book value for AGNC saw a small 2.6% decline to $31.64 per share. The market reacted positively to the earnings reported, sending AGNC's stock higher by 3%. With this recent surge in share price, AGNC is now trading at a 1.5% premium to its book value.

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Total economic return, (dividends plus book value increases), for Q4 was $0.40 per share, or 5% on an annualized basis. For the full year 2012, AGNC reported a 32% economic return. Since 2009, AGNC has provided its shareholders with an average total economic return of over 40%.

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During Q4, AGNC was able to somewhat "turn lemons into lemonade" by generating income via net carry income (also known as "dollar roll income"). This income is associated with purchases of agency mortgage backed securities ("MBS") on a forward-settlement basis through the "to-be-announced" ("TBA") dollar roll market. The price differential between MBS purchased for a forward settlement date and the price of MBS for settlement in the current month is referred to as the "price drop". The price drop is the economic equivalent of the net interest carry (interest income less implied financing cost) on the MBS earned during the roll period.

AGNC stated that the FED's involvement in the mortgage market ("QE3") has made it more attractive to purchase MBS on a forward-settlement basis through the TBA dollar roll market. AGNC anticipates that this is likely to persist for most of 2013. Readers of my recent article on CYS Investments (CYS) may have noticed that this method of generating income is seems similar to the way CYS generates its "drop income".

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Due to the use of the innovative "dollar roll income", AGNC actually saw an increase in its net interest rate spread during Q4. The net spread for AGNC increased to 1.63% for Q4, compared with 1.42% for Q3. Excluding "dollar roll income", AGNC would have seen the net interest rate spread drop to 1.39% in Q4.

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During Q4, AGNC continued to position its portfolio against prepayments ("CPR"). AGNC saw a 10% portfolio CPR for the quarter. The low CPR was primarily due to the combination of increases in long-term interest rates, higher concentration of lower loan balance and HARP security holdings and a decline in the weighted average coupon rate on AGNC's portfolio during the quarter.

(click to enlarge)AGNC saw only a 2.6% book value decline during Q4. AGNC may have helped its book value by repurchasing shares. 2.7 million shares of stock were repurchased during the quarter at an average net repurchase price of $29.00 per share. I have previously written about these share repurchases and it is my opinion that they are accretive to book value.

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Conclusion

Considering how other mREITs performed during Q4, AGNC reported an excellent quarter. AGNC was able to report a less than expected decline in book value, while also increasing its net interest rate spread. AGNC's management continues to show why it is regarded as the best in the industry.

However, I do find it slightly odd that the market decided to reward AGNC for its use of "dollar roll income", while at the same time, punishing CYS Investments-- which has been using "drop income" for several quarters. At first glance, it seems that both methods are similar. However, both these methods of generating income are very complex. AGNC had to explain this process in quite some detail during its conference call. These analyst that were asking questions are considered experts in the industry. Yet, even they were having trouble grasping the concept.

Source: AGNC Shareholder Presentation [.pdf]

Source: American Capital Agency Reports An Excellent FY 2012, With A 32% Total Economic Return