Seeking Alpha
Long-term horizon, dividend investing, mREITs, BDCs
Profile| Send Message|
( followers)  

Focus of Article:

The focus of this article is to provide a detailed projection of American Capital Agency Corp.'s (NASDAQ:AGNC) second quarter of 2013 income statement including a net income per share estimate. Prior to results being provided to the public early next month (via its quarterly press release), I would like to analyze AGNC's second quarter of 2013 income statement and provide readers a general direction on how I feel this recent quarter has panned out.

Due to the length of the material covered in this article, I feel it is necessary to break AGNC's second quarter of 2013 income statement projection into two parts. This article will be broken-down by the following categories within the income statement:

A) Net Income (Including Per Share Calculation) (PART 1)

B) Other Comprehensive Income (Loss) (OCI / OCL) (PART 2)

C) Comprehensive Income (Loss) (A + B Combined) (PART 2)

PART 2 will also summarize the information from both parts of the article. In a future article, I will project AGNC's book value as of 6/30/2013 (end of the second quarter of 2013).

Side Note: Predicting any mortgage real estate investment trust's (mREIT) accounting figures is usually more difficult when compared to other sectors due to the various hedging and asset portfolio strategies that are implemented. There are several assumptions that are used when performing such an analysis. Actual values may differ materially from the following estimated values within this article due to unforeseen circumstances. This includes a deviation from the typical business strategies by management in a specific quarter from past quarters. Readers should be aware as such. These projections are my personal estimates and all figures detailed below should not solely be used for any investor's buying or selling decisions. All actual reported figures that are above my ranges within this article will be deemed a positive sign in my judgment. All actual reported figures that are below my ranges within this article will be deemed a negative sign in my judgment. Unless otherwise noted, all figures below are for the "three-months ended" (quarterly) time frame.

A) Net Income:

- Net Income Estimate of $1.39 Billion; Range $1.14 - $1.64 Billion

- Net Income (Excluding OCL) of $3.49 Per Share; Range $2.85 - $4.13 Per Share

- Confidence Within Range = Moderate to High

- See Table 1 Below Next to the June 30, 2013 Column for References

Let us first look at AGNC's past quarterly income statements (ACTUAL) for the trailing twelve-months going back to the second quarter of 2012 and my projection for the second quarter of 2013 (ESTIMATE). This information will be provided via Table 1. The income statement (ACTUAL) figures are derived from AGNC's quarterly SEC submissions via its 10-Q or 10-K where applicable.

Table 1 - AGNC Quarterly Income Statement and Net Income Per Share Projection


(Click to enlarge)

1) Interest Income:

- Estimate of $535 Million; Range $475 - $595 Million

- Confidence Within Range = Moderate to High

- See Boxed Blue Reference "1" in Table 1 Above and Table 2 Below Next to the June 30, 2013 Column

AGNC's interest income figure consists of two accounts: a) cash interest income subtracted by b) premium amortization. I based my estimation of these two figures via Table 2, which is shown below. Some past (ACTUAL) figures within Table 2 (excluding some recalculations + ratio figures) are derived from AGNC's investor presentation slides, AGNC's quarterly SEC submissions (10-Q or 10-K), or a combination of both. Therefore, there will not be an identical sheet AGNC provides that matches the data I have prepared in Table 2 below. I have gathered specific information derived from multiple tables/charts for a more clear analysis of the cash interest income and premium amortization accounts.

Table 2 - AGNC Quarterly Interest Income Projection


(Click to enlarge)

Two assumptions should be noted within Table 2 when projecting the second quarter of 2013 a) cash interest income figure. First, I am estimating the average agency securities within AGNC's MBS portfolio to decrease $3.5 billion from the first quarter of 2013. During this volatile second quarter of 2013, many researchers have predicted most mREITs will deleverage its portfolios to minimize the losses due to MBS price declines. However, AGNC had a somewhat unique MBS portfolio structure as of 3/31/2013. AGNC had a total (including its "off-balance sheet" TBA MBS) portfolio leverage ratio of 8.1 times equity. AGNC's regular MBS leverage (excluding its TBA MBS forward contracts) was only 5.7 times equity. It should be noted AGNC's TBA MBS positions are OPTIONAL in regards to taking delivery. Therefore, the total leverage ratio of 8.1 times equity is somewhat deceiving. The actual regular MBS leverage ratio of 5.7 times equity is quite low when compared to past AGNC quarters. The CIO of AGNC (Gary Kain) stated its company's total leverage ratio has not changed too much during the entire second quarter of 2013. This information was obtained via AGNC's June 9, 2013 Morgan Stanley Financials Conference Presentation. Since Mr. Kain stated total leverage remained relatively flat throughout the quarter, I am only decreasing the average agency securities for the second quarter of 2013 by $3.5 billion to $74.5 billion.

Second, I estimate a cash interest income yield increase of 12 basis points from the second quarter of 2013 vs. the first quarter of 2013 (3.80% vs. 3.68%). This is due to an overall sharp increase in mortgage interest rates since the beginning of May and continuing through the end of June 2013. This estimated increase in yield is also from the notion of Mr. Kain stating AGNC has already sold a modest portion of its lowest-coupon MBS during the second quarter of 2013 to minimize potential unrealized losses in future periods. Therefore, AGNC has already reinvested a modest portion of its sold lowest-coupon MBS into the currently higher-coupon MBS this quarter. These newly purchased MBS should help bolster a slight increase in the portfolio's overall cash interest income yield.

Since I am projecting a cash interest income yield increase of 12 basis points but a lower overall average agency security balance of $3.5 billion, I am projecting an overall cash interest income decrease of $41 million for the second quarter vs. the first quarter of 2013 ($640 million vs. $681 million).

As stated earlier, the second component of AGNC's interest income figure is its b) premium amortization. If one first looks at Table 2 above, AGNC's fourth quarter of 2012 premium amortization yield, it was -0.95%. If you compare this to AGNC's first quarter of 2013 premium amortization yield, it dropped to -0.88%. One reason for the drop was AGNC did not have a net increase in its average agency securities for the first quarter of 2013. When there's less agency securities on the balance sheet, there will be less of a premium amortization expense to consider (in most cases). This is due to the fact you have expensed a quarter's worth of premium amortization while the agency securities balance (net) has decreased a little. As you can see in Table 2 (dark blue highlighted figures), the cumulative net unamortized premium balance dropped from a cumulative balance of $4.4 billion at 12/31/2012 to $3.8 billion at 3/31/2013. This same trend should persist for the second quarter of 2013.

Furthermore, mortgage interest rates have dramatically increased during the second quarter of 2013. As such, the prepayment risk on most existing MBS has drastically decreased. Therefore, most existing MBS maturities have also increased. Prepayment risk has been replaced with extension risk. When this type of situation occurs, the quarterly premium amortization expense decreases (more time to expense over the estimated life of the MBS).

The premium amortization I am estimating for the second quarter of 2013 is $105 million (a -0.92% yield). One could argue this amount/yield percentage could be even lower. As briefly mentioned above, mortgage interest rates have dramatically increased during the second quarter of 2013. Therefore, the likelihood of most mortgages being refinanced decreases. This will produce a lower overall CPR on the existing MBS and extends its projected life (maturity). This will have a positive impact on the premium amortization expense for the quarter due to the fact the MBS life has been extended. If the weighted average life (maturity) of AGNC's MBS portfolio increases, the quarterly premium amortization expense will decrease (inverse relationship).

From all the data and analysis above, I have decreased the cumulative net unamortized premium balance from $3.8 billion at the end of the first quarter of 2013 to $3.5 billion at the end of the second quarter of 2013. I am projecting an overall premium amortization decrease of $29 million for the second quarter vs. the first quarter of 2013 ($105 million vs. $134 million).

Therefore, the projected quarterly interest income AGNC will generate will decrease $12 million for the second quarter vs. the first quarter of 2013 ($535 million vs. $547 million).

2) Interest Expense:

- Estimate of $123 Million; Range $103 - $148 Million

- Confidence Within Range = Moderate to High

- See Boxed Blue Reference "2" in Table 1 Above and Table 3 Below Next to the June 30, 2013 Column

Now let us take a look at AGNC's interest expense account. I base my estimation of this figure via Table 3 below. Some past (ACTUAL) figures within Table 3 (excluding some recalculations + ratio figures) are derived from AGNC's investor presentation slides, AGNC's quarterly SEC submissions (10-Q or 10-K), or a combination of both. Therefore, there will not be an identical sheet AGNC provides that matches the data I have prepared below. I have gathered specific information derived from multiple tables/charts for a more clear analysis of the interest expense account.

Table 3 - AGNC Quarterly Interest Expense Projection


(Click to enlarge)

Recalculating AGNC's quarterly interest expense is pretty straightforward. One takes the average repurchase agreements (repo loans) that were outstanding during a specified time period and multiply this amount by the average cost of funds rate (%) for the quarter. Once this figure is obtained, one needs to back out a portion of the interest expense that is deemed interest costs associated with "other periodic interest costs of interest rate swaps, net" to the account "estimation of gain (loss) on derivative instruments, net" (this account will be discussed later). The ending result will provide AGNC's quarterly interest expense figure.

The two figures that need to be projected to estimate AGNC's quarterly interest expense are the following: a) the average repurchase agreements and b) average cost of funds rate. Based on my calculated estimation within AGNC's interest income projection (see Table 2 above), approximately $3.5 billion of average agency securities will be reduced from AGNC's balance sheet. Now I can estimate the average repurchase agreements' liability account. If one takes the average agency securities, at cost amount (see Table 3's highlighted purple row) and divides this figure by the average repurchase agreements' figure (see Table 3's highlighted blue row), the calculated ratio of average agency securities vs. average repurchase agreements is 1.08 to 1.11 for the past four quarters. Now, for the second quarter of 2013, let us use an average ratio of 1.10 to estimate the average repurchase agreements' figure. For my estimation, if using an average agency security balance for second quarter of 2013 of $74.5 billion and the averaged ratio of 1.10, the average repurchase agreement balance will be $67.7 billion. This is a decrease of approximately $2.8 billion for the second quarter of 2013.

Let us now obtain a suitable average cost of funds rate (%) for the second quarter of 2013. I am estimating an increase in the cost of funds rate of 7 basis points to -1.35% for the second quarter of 2013. Even though most U.S. interest rates have materially increased during the second quarter of 2013, the London Interbank Offered Rate (LIBOR) has remained relatively flat. Therefore, the variable component on AGNC's repo loans has remained somewhat stable. This increase in 7 basis points is somewhat cautious in nature. I feel confident on the slight basis point increase because AGNC has continued to gradually increase the weighted average maturity on its repo loans. This generally leads to a slight increase in AGNC's weighted average interest rate on its repo loans even if LIBOR remain unchanged.

Now that we have determined AGNC's a) average repurchase agreements' figure and b) average cost of funds rate for the quarter, let us calculate AGNC's second quarter of 2013 interest expense. After a reclassification of $106 million of interest expense associated with "other periodic interest costs of interest rate swaps, net," I estimate AGNC will incur approximately $123 million in interest expense for the second quarter of 2013. This is a decrease of $17 million over the first quarter of 2013. This is largely due to the slight decrease of $3.5 billion of agency securities on AGNC's books resulting in a decrease of $2.8 billion of average repo loans for the second quarter of 2013. This is partially offset by a 7 basis point increase on the weighted average interest rate expense of AGNC's repo loans for the second quarter of 2013 vs. the first quarter of 2013. This is due to the slight increase on the weighted average maturity of AGNC's repo loans.

3) Gain (Loss) on Sale of Agency Securities, Net:

- Estimate of ($475) Million; Range ($325 - $625) Million

- Confidence Within Range = Moderate

- See Boxed Blue Reference "3" in Table 1 Above and Table 4 Below Next to the June 30, 2013 Column

Estimating the gain (loss) on sale of agency securities, net account can be somewhat difficult to predict. Only AGNC's management team truly knows how many existing agency securities will be sold during a specific quarter. One can only usually determine the specific agency security's accumulated unrealized gain (loss) balance and the history of interest rates when initially purchased vs. current interest rates to predict whether this account will be positive or negative.

However, management has recently provided some insight impacting this account. As mentioned earlier, the CIO of AGNC (Gary Kain) spoke at the Morgan Stanley Financials Conference on 6/9/2013 (see link above). He stated AGNC sold a modest amount of its lowest-coupon MBS in the second quarter of 2013 to mitigate future unrealized losses in a rising interest rate environment. Through past research and analysis, I can ascertain that AGNC only recently increased its lowest-coupon MBS due to the recent extremely low interest rates in the latter half of 2012. Therefore, if AGNC sold these lowest-coupon MBS in the second quarter of 2013, it has sustained losses on these transactions as interest rates rose during the quarter. This is due to the fact once interest rates rose in the current quarter, the overall demand/value of these specific MBS decreased. As such, the selling price of these MBS will typically be less than what was originally paid when interest rates were lower.

It should be noted that additional losses will be incurred on these sold MBS due to the material unamortized premium balances that have yet to be expensed. I state this assumption because if AGNC only recently purchased these lower-coupon MBS within the past several quarters, these agency securities will still have a fairly large unamortized premium balance remaining on the books that must be written-off/expensed upon the sale. When these assumptions are put together, this will cause a modest loss within the account for the second quarter of 2013.

However, this loss will be offset to an extent. There is one footnote within AGNC's quarterly SEC submissions (10-Q or 10-K) which is important to mention here. AGNC states the figures within the "proceeds from sale of MBS sold" account includes all cash received during the period plus any receivable for agency securities sold during the period. In other words, all quarterly accrued interest income on all sold MBS are reclassified out of the cash interest income account (previously discussed above) and accounted for within this account. Because of this reclassification, the gain (loss) on sale of agency securities account will always start off with a slightly positive balance before taking into consideration the true gain/loss on the MBS sold.

Now let us take a look at AGNC's gain (loss) on sale of agency securities, net account in detail. I base my estimation of this figure via Table 4 below. Some past (ACTUAL) figures within Table 4 (excluding some recalculations + ratio figures) are derived from AGNC's investor presentation slides, AGNC's quarterly SEC submissions (10-Q or 10-K), or a combination of both. Therefore, there will not be an identical sheet AGNC provides that matches the data I have prepared below. I have gathered specific information derived from multiple tables/charts for a more clear analysis of the gain (loss) on sale of agency securities, net account.

Table 4 - AGNC Quarterly Gain (Loss) on Sale of Agency Securities, Net Projection


(Click to enlarge)

Side Note Regarding Table 4: If one looks at the "average total assets, fair value > cost basis" figure in Table 4 above, you will notice an overall decrease from $13.5 billion in the third quarter of 2012 to ($1.8) billion in the fourth quarter of 2012. This was mainly due to the fact of AGNC's large net long TBA position increase beginning in the fourth quarter of 2012. Prior to the fourth quarter of 2012, AGNC had a minimal net long TBA position.

I project AGNC's "average total assets, fair value > cost basis" (including TBA positions) will decrease approximately ($2.6) billion for the second quarter of 2013. For the first quarter of 2013, AGNC had a figure within this account of ($491) million. For the second quarter of 2013, I am projecting a material reduction of this figure to ($3.1) billion. Therefore, the fair value (unrealized loss) of the agency securities in the second quarter of 2013 is estimated to be approximately ($2.6) billion prior to the MBS sold reclassification. Since these are unrealized losses, this material reduction will be further discussed in PART 2 of this article under the "unrealized gain (loss) on available-for-sale securities, net" account within other comprehensive income (loss) (OCI / OCL). All regular (non-TBA) MBS unrealized losses are excluded from AGNC's net income and per share calculations. All TBA MBS losses are accounted for under the "gain (loss) on derivative instruments and other securities, net" account to be discussed shortly.

Since interest rates have dramatically risen during the latter half of the second quarter of 2013, I feel a further reduction in the "average total assets, fair value > cost basis" is needed. Due to this further reduction, I project the ratio of "avg. total assets at fair value > avg. agency securities at cost" needs to be lowered to a factor of 0.97 in the second quarter of 2013. This is a further reduction from a ratio factor of 0.99 in the first quarter of 2013.

The amount of agency securities sold in the second quarter of 2013 in Table 4 is mere speculation on my part. Due to the fact AGNC stated they have sold a modest portion of its lowest-coupon MBS in the second quarter of 2013, I have increased the "agency MBS sold, at cost" account by $4.7 billion. As stated earlier, the more important understanding to take from this account is not the amount of agency securities sold, but whether a gain or loss will generally be accounted for from the sold MBS. This article already discussed that for the second quarter of 2013, a majority of AGNC's MBS sales will result in losses that will be partially offset by all current quarter cash interest income on the sold MBS (reclassified from cash interest income).

To calculate a proper gain on sale of agency securities, I again use a ratio analysis of "proceeds from agency MBS sold vs. agency MBS sold, at cost" to try to estimate the amount of the losses that will occur in the second quarter of 2013. I have lowered the ratio to 0.981 in the second quarter of 2013 from 0.999 in the first quarter of 2013 and 1.019 in the fourth quarter of 2012. As interest rates continue to rise, this ratio will generally continue to decrease due to AGNC's lower-yielding MBS portfolio. If interest rates begin to fall once again, this ratio will rise (inverse relationship). Using this ratio, AGNC's gain (loss) on sale of agency securities, net estimate is ($475) million. This is based on $25.0 billion in quarterly MBS sold with proceeds of $24.5 billion. Again, the proceeds of $24.5 billion include all cash interest income received on the sold MBS in the current quarter.

4) Gain (Loss) on Derivative Instruments and Other Securities, Net:

- Estimate of $1.5 Billion; Range $1.1 - $1.9 Billion

- Confidence Within Range = Moderate

- See Boxed Blue Reference "4" in Table 1 Above and Table 5 Below Next to the June 30, 2013 Column

Estimating the gain (loss) on derivative instruments and other securities, net account is a projection that involves several "sub-accounts" and various assumptions. One will never fully know management's current, detailed derivative activities for the current quarter until it is provided to the public via the quarterly SEC submissions. However, one can understand management's overall derivative strategy and make a projection on these sub-accounts using the balances that were represented at the end of the previous quarter. Such a detailed analysis is critical in the second quarter of 2013 due to the events that have unfolded in the past two months in regards to US interest rates and MBS devaluations.

Side Note: Since this specific account is extremely important to understand for the current quarter, I feel a detailed analysis and "walk-through" of just this account may be deemed necessary (including numerous tables to support my projected figures). If there seems to be a strong demand for such an analysis, I can provide such in a future article. The topics to be discussed in this account alone would encompass a fairly lengthy article. This article's main purpose is to provide a projection on AGNC's second quarter of 2013 income statement with a "line-by-line" mentality. Therefore, I will show my projected quarterly amounts for this specific account broken down by the various hedging/derivative sub-accounts. However, I will omit from this article any detailed discussion or supporting tables on the four main sub-accounts currently implemented by AGNC in regards to its overall hedging strategy. If I included such a lengthy breakdown within this article, it would make this article way too long.

Now let us take a look at AGNC's gain (loss) on derivative instruments and other securities, net account. I base my estimation of this figure via Table 5 below. All past (ACTUAL) figures within Table 5 are derived from AGNC's quarterly SEC submissions (10-Q or 10-K). However, I have used specific information derived from multiple tables/charts (some provided by AGNC; some via my own researched data) for my estimate column of the gain (loss) on derivative instruments and other securities, net account.

Table 5 - AGNC Quarterly Gain (Loss) on Derivative Instruments and Other Securities, Net Projection


(Click to enlarge)

Within AGNC's gain (loss) on derivative instruments and other securities, net account there are four material sub-accounts that will be discussed below. The four sub-accounts are the following:

a) Interest Rate Swaps

b) TBA MBS Forward Contracts

c) Interest Rate Swaptions

d) US Treasuries - Short

Side Note: Even though I have split these derivative sub-accounts into "realized" and "unrealized" positions within Table 5 above, this really does not make a difference in regards to the overall amounts reported within this account. Therefore, any further discussion on the breakout of the realized/unrealized positions will be omitted from this article. As long as the total amounts are represented in Table 5 above, it does not matter whether these specific derivative instruments are termed realized or unrealized for GAAP reporting purposes. There are exceptions to this statement, depending on the specific derivative/hedge in place, but currently any exceptions are not materially applicable to AGNC. Both the realized/unrealized amounts are represented in the overall gain (loss) on derivative instruments and other securities, net account.

a) Interest Rate Swaps:

- Estimate of $1.07 Billion; Range $820 Million - $1.32 Billion

- Confidence Within Range = Moderate to High

- See Purple Highlighted Sub-Accounts "1)" in Table 5 Above Next to the June 30, 2013 Column

AGNC's interest rate swap positions at 3/31/2013 were by far its largest hedging position in regards to notional value. At 3/31/2013, AGNC had a total interest rate swap position of $51.3 billion. AGNC has this large balance of interest rate swaps in anticipation of rising interest rates. 67% of these payer swaps had a maturity less than five years while the remaining 33% were with a maturity over five years. There are three "broken-out" accounts to discuss within Table 5 above when considering a projection on AGNC's interest rate swaps for the second quarter of 2013.

The first account is AGNC's "periodic interest costs of interest rate swaps, net" account. On AGNC's overall interest rate swap position, it had a weighted average fixed pay rate of 1.51% (expense) and a weighted average floating receive rate of 0.26% (income) at the end of the first quarter of 2013. Since its receive rate is based on LIBOR (which has remained flat for the entire quarter), AGNC will once again record a modest periodic interest costs of interest rate swaps, net expense for the second quarter of 2013. I am estimating an expense of $104 million for the current quarter. This is a $20 million increase from the prior quarter's net interest expense for this account. I am anticipating this increase due to an overall slight increase in the fixed pay rate in the current quarter on any new interest rate swap positions AGNC enters into while the receiver rate will remain basically unchanged. Again, the receiver rate will stay relatively the same because one, three, six, and twelve month LIBOR has basically remained flat for the entire second quarter of 2013.

The second account relates to AGNC's interest rate swap valuations. Even though AGNC will continue to record periodic interest costs of interest rate swaps, net expense in the current quarter, there will be a huge material realized/unrealized gain within the interest rate swap account on a valuation perspective. From the sharp rise in US interest rates across the board in the second quarter of 2013, all existing interest rate swap positions AGNC has held will materially increase in value. This is due to the fact these existing interest rate swap positions have become much more attractive to AGNC and potential counterparties if AGNC decides to sell these swaps. While the fixed pay rates on all new interest rate swap agreements have increased dramatically during the current quarter, AGNC has already locked in its existing, lower fixed pay rates from previous quarters.

Using the 4-year interest rate swap as an example, AGNC had a weighted average net pay rate of 1.14% for these types of swaps as of 3/31/2013. As of 3/31/2013, the market valued the 4-year interest swap at a rate of 0.71%. Hence the reason AGNC was still carrying a ($535) loss on these positions at 3/31/2013. However, since overall US interest rates have sharply risen in the second quarter of 2013 (including swap valuations), the 4-year swap now has a market rate of 1.23% as of 6/30/2013. This is an increase of 52 basis points during the second quarter of 2013 for the 4-year interest rate swap. This is a huge increase for a three-month time frame. Again, AGNC's existing interest rate swap positions will not see this increase in its fixed pay rate because it has already been locked-in upon creation of the swap. This spells good news for AGNC's existing interest rate swaps on a valuation basis.

Side Note: It should be noted this is not the entire process of specifically valuing an interest rate swap, but I'm trying to show WHY there will be valuation increases on AGNC's existing interest rate swap positions using a simplified perspective that readers may better understand.

Interest rate swaps across the spectrum of varying maturities had similar increases in rates for the second quarter of 2013. As interest rate swap maturities lengthened, the basis point increases grew larger. For example, a 3-year interest rate swap has increased 32 basis points while a 7-year interest rate swap has increased 75 basis points. Simply put, these quarterly basis point increases are extremely positive for AGNC's existing interest rate swaps in relation to valuations.

Through a detailed analysis that will be omitted from this particular article (see side note at the beginning of the gain (loss) on derivative instruments and other securities, net account above for explanation), I am estimating a $1.2 billion valuation gain on AGNC's existing interest rate swaps of $51.3 billion as of 3/31/2013. As stated earlier, this will be offset against the periodic interest costs of interest rate swaps, net of $104 million. This gain will also be slightly offset by an "interest rate swap termination fees (Markit IOS Index total return swaps) expense of $30 million for the second quarter of 2013 (third account that makes up AGNC's interest rate swap transactions). Therefore, AGNC's total gain on its interest rate swaps will approximately be $1.07 billion. Any interest rate swap positions added during the second quarter of 2013 would also (most likely) see additional minor valuation gains. As such, this notion is taken into consideration in regards to my ranges for this particular account.

b) TBA MBS Forward Contracts:

- Estimate of ($350) Million; Range ($250 - $550) Million

- Confidence Within Range = Moderate

- See Black Highlighted Sub-Accounts "2)" in Table 5 Above Next to the June 30, 2013 Column

AGNC's TBA MBS forward contract positions at 3/31/2013 were the second largest position in regards to notional value within the gain (loss) on derivative instruments and other securities, net account. Within the past two quarters, AGNC has greatly increased its "off-balance sheet" positions of its MBS portfolio. At the end of the third quarter of 2012, AGNC had a net long TBA MBS position of $3.8 billion (based on notional amount). By the end of the fourth quarter of 2012, this position grew to $12.5 billion. At the end of the first quarter of 2013, the balance more than doubled to $26.3 billion. AGNC was increasing this position due to extremely low interest rate environment that occurred throughout 2012 and into 2013 with the implementation of the FED's QE3 purchasing program. AGNC's management wanted to receive additional interest income during this low interest rate environment without financing its position via repo loans. This strategy could be beneficial, so long as interest rates remained suppressed. As such, the faster/higher interest rates rise, the larger the loss these TBA MBS future contracts will sustain. As will be shown next, this strategy really was not beneficial to AGNC in the first quarter of 2013 as rates hovered higher a good majority of the quarter. This strategy has basically "back-fired" in the second quarter of 2013.

There are two main accounts that makeup AGNC's TBA MBS forward contract transactions. These accounts are the dollar-roll income generated on the TBA MBS positions and the realized valuation gains (losses) on the settlement (typically monthly) of the TBA MBS forward contracts. Upon its presentation of results for the first quarter of 2013, AGNC reported a net TBA MBS loss of ($102) million. This was due to the fact of a modest gain in interest rates for a majority of the quarter. AGNC recorded TBA MBS dollar-roll income, net of $142 million. However, AGNC also sustained TBA MBS valuation losses, net of ($244) million.

Therefore, it is a safe assumption to predict an overall net loss in the TBA MBS account when interest rates rise modestly in a given quarter. As indicated earlier, the second quarter of 2013 first saw a modest drop in overall interest rates until the first week of May. Due to the heightened speculation of the FED beginning to "taper" its $85 billion bond purchasing program (QE3), overall US interest rates spiked (including in excess of 80 basis points in relation to fixed mortgage interest rates; both 15 and 30-year rates). Therefore, it is a safe assumption AGNC will report a material net TBA MBS loss in the second quarter of 2013 offset by the current quarter's dollar-roll income generated.

Through a detailed analysis that will be omitted from this particular article (see side note at the beginning of the gain (loss) on derivative instruments and other securities, net account above for explanation), I am estimating an overall net ($350) million loss on AGNC's existing TBA MBS forward contract position of $26.3 billion. This includes an estimate of $150 million in regards to dollar-roll income generated offset by a material TBA MBS valuation loss of approximately ($500) million for the second quarter of 2013. Even though Table 5 above does not specifically reference these two accounts above, if you add up all four black referenced figures from the table, one sees that it comes out to be a net loss of ($350) million for AGNC's TBA MBS forward contracts. I am predicting AGNC's management sold a modest portion of TBA MBS forward contracts when interest rates only began to rise in early May. As such, this ($350) million loss estimate is a rather aggressive estimate and is more towards the lower end of my range in regards to potential losses incurred.

c) Interest Rate Swaptions:

- Estimate of $250 Million; Range $150 - $450 Million

- Confidence Within Range = Moderate

- See Pink Highlighted Sub-Accounts "3)" in Table 5 Above Next to the June 30, 2013 Column

Interest rate swaptions are merely options on interest rate swap positions. AGNC's interest rate swaptions at 3/31/2013 were the third largest position in regards to notional value on the underlying interest rate swaps. Similar to its interest rate swap positions, AGNC has greatly increased its interest rate swaptions position within the past few quarters. At the end of the third quarter of 2012, AGNC had an underlying interest rate swap position of $8.6 billion (based on notional amount). By the end of the fourth quarter of 2012, this position grew to $14.5 billion. At the end of the first quarter of 2013, the balance continued to grow to $22.9 billion. Again, AGNC has this large balance of interest rate swaptions (underlying interest rate swaps) in anticipation of rising interest rates. AGNC's interest rate swaptions have a weighted average of 2.5 years until expiration with an underlying interest rate swap maturity of nearly 8 years.

As was the case with AGNC's interest rate swaps, there will be a material realized/unrealized gain within the interest rate swaptions account on a valuation perspective. From the sharp rise in US interest rates across the board in the current quarter, all existing interest rate swaption positions AGNC has held will materially increase in value. This is due to the fact these existing interest rate swaption positions have become much more attractive to AGNC and potential counterparties if AGNC decides to sell these swaptions. While the fixed pay rate on the underlying interest rate swap, for all new interest rate swaption agreements, has increased dramatically during the current quarter, AGNC has already locked in its existing lower fixed pay rates from previous quarters. As was the case with AGNC's interest rate swaps, the average increase in the fixed payer interest rates are positive for AGNC's existing underlying interest rate swaps (hence its interest rate swaption contracts) in relation to valuations for the second quarter of 2013.

Through a detailed analysis that will be omitted from this particular article (see side note at the beginning of the gain (loss) on derivative instruments and other securities, net account above for explanation), I am estimating an overall $250 million gain on AGNC's existing interest rate swaption position with an underlying interest rate swap notional position of $22.9 billion. This $250 million gain estimate is a rather cautious estimate and is more towards the lower range of my estimate. This is due to the more aggressive estimate in regards to the TBA MBS forward contract account above (balances itself out).

d) U.S. Treasuries - Short:

- Estimate of $500 Million; Range $300 - $700 Million

- Confidence Within Range = Moderate to High

- See Brown Highlighted Sub-Accounts "4)" in Table 5 Above Next to the June 30, 2013 Column

AGNC's U.S. Treasuries - short position at 3/31/2013 was the fourth largest position in regards to notional value within the derivative account. AGNC has steadily increased its U.S. Treasuries - short position within the past few quarters. At the end of the second quarter of 2012, AGNC had a U.S. Treasuries - short position of ($3.2) billion (based on face amount). By the end of the third quarter of 2012, this short position grew to ($7.3) billion. At the end of the fourth quarter of 2012, the short balance continued to grow to ($11.8) billion. By the end of the first quarter of 2013, the short balance increased further and grew to ($12.6) billion. Again, AGNC has continued to increase its short position in U.S. Treasuries in anticipation of rising interest rates. AGNC had a short position of ($6.0) billion with 5-year U.S. Treasuries and a short position of ($6.2) billion with 10-year U.S. Treasuries.

As was the case with AGNC's interest rate swaps and swaptions, there will be a material realized/unrealized gain within the U.S. Treasuries - short account on a valuation perspective. From the sharp rise in U.S. interest rates across the board in the current quarter, AGNC's existing U.S. Treasuries - short position will materially increase in value. This is due to the fact the yield on current U.S. Treasuries has risen dramatically during the second quarter of 2013. Therefore, if AGNC had a net long U.S. Treasuries position, these investments would lose value because a counterparty could obtain a higher yield in the market when compared to the lower-yielding existing U.S. Treasuries AGNC holds. However, AGNC has "shorted" its U.S. Treasuries position. As such, as interest rates increase, AGNC's U.S. Treasuries - short position has valuation gains. This is a proper hedge when trying to mitigate the MBS price declines in a rising interest rate scenario. For instance, the 5-year U.S. Treasuries yield has increased 64 basis points during the second quarter of 2013. A 10-year U.S. Treasuries yield has increased by 67 basis points during the current quarter. These quarterly basis point increases are extremely positive for AGNC's existing U.S. Treasuries - short position in relation to its current valuations.

Through a detailed analysis that will be omitted from this particular article (see side note at the beginning of the gain (loss) on derivative instruments and other securities, net account above for explanation), I am estimating an overall $500 million gain on AGNC's existing U.S. Treasuries - short position.

When adding the four sub-accounts discussed above together, an estimated $1.5 billion gain on derivative instruments and other securities, net account is derived. All remaining accounts within Table 5 above are deemed immaterial for discussion purposes in regards to this article. As such, these accounts will be omitted from any analysis.

5) Management Fees:

- Estimate of $32 Million; Range $29 - $35 Million

- Confidence Within Range = High

- See Boxed Blue Reference "5" in Table 1 Above and Table 6 Below Next to the June 30, 2013 Column

AGNC has a base management fee payable in arrears equal to an amount 1/12th of 1.25% of its stockholders equity. Equity is defined as AGNC's month-end stockholders equity, adjusted to exclude the effect of any unrealized gains or losses included in either retained earnings or accumulated OCI.

I base my estimation of this figure via Table 6 below. Some past (ACTUAL) figures within Table 6 (excluding some recalculations + ratio figures) are derived from AGNC's investor presentation slides, AGNC's quarterly SEC submissions (10-Q or 10-K), or a combination of both. Therefore, there will not be an identical sheet AGNC provides that matches the data I have prepared below. I have gathered specific information derived from multiple tables/charts for a more clear analysis of the management fee expense account.

Table 6 - AGNC Quarterly Management Fees Projection


(Click to enlarge)

The two remaining accounts on AGNC's income statement affecting net income are general/ administrative expenses and income tax provision (benefit). These two accounts are immaterial for projection purposes and will be excluded from any analysis within this article. I don't see any material fluctuations from past quarters when estimating these figures for the second quarter of 2013.

Conclusions Drawn (PART 1):

To sum up all the information above, I am projecting AGNC will report the following income statement figures for the second quarter of 2013 (refer to Table 1 at beginning of article):

A) Quarterly Net Income of $1.39 Billion; $3.49 Per Common Share

Therefore, in regards to quarterly net income, it looks as though AGNC will handily beat analyst forecasts in regards to net income and per share estimates. A net income figure of $1.39 billion is a vast increase for the second quarter of 2013 when compared to the prior quarter. This is mainly due to AGNC's huge valuation gain on its derivative instruments and other securities, net account.

AGNC's derivative/hedging instruments will have an estimated $1.5 billion net gain in the current quarter. This is due to the extremely large move in US market interest rates including large spikes in swap and US Treasuries rates. Specifically, extremely large valuation gains will be obtained on AGNC's interest rate swaps, swaptions, and US Treasuries - short position. This will be partially offset by a rather large net loss on AGNC's TBA MBS forward contract portfolio. AGNC's TBA MBS forward contract portfolio will have continued dollar-roll income. However, due to the "optional" nature of the TBA MBS forward contract positions, realized settlement valuation losses (usually monthly) will overshadow any dollar-roll income during the quarter. These losses have increased in the current quarter when compared to the last quarter due to the increased devaluations sustained on the TBA MBS forward contract positions.

Generally speaking, AGNC's management has properly mitigated some of the extremely large valuation losses that will be shown within its "unrealized gain (loss) on available-for-sale securities, net" account (see PART 2). Since its inception in June of 2008, AGNC has recorded a loss in nearly every quarter on its derivative instruments and other securities, net account. This was due to the continued decrease in overall US interest rates (including flat or extremely small US interest rate movements). However, this pattern has sharply reversed course for the second quarter of 2013. As such, AGNC's derivatives will finally prove worthwhile having.

AGNC will also report a slight reduction to interest income from agency securities and interest expense on a lower balance of repo loans. Furthermore, AGNC will report a rather substantial loss of an estimated ($475) million on the sale of its agency securities, net due to the valuation losses on its lower-coupon MBS sold during the second quarter of 2013. Again, this is due to the generally sharp rise in US interest rates throughout the latter half of the quarter thus resulting in MBS price declines (especially on lower-coupon MBS; will be explained within PART 2 of this article).

Even though this is an extremely positive net income and per share projection, investors should also realize that AGNC will have an extremely large OCL for the second quarter of 2013. As stated earlier in this article, OCL is accounted for on the income statement but excluded from AGNC's net income. The OCL account runs directly through to stockholders equity on AGNC's balance sheet (which affects BV). Therefore, a material reduction in book value for the second quarter of 2013 will occur.

Final Note: AGNC's large projected OCL will be discussed in PART 2 of this article (available to readers next week at the latest). A detailed analysis on the reduction in AGNC's book value as of 6/30/2013 vs. 3/31/2013 will be presented in a future article in the near future (prior to AGNC's press release in early August).

Source: American Capital Agency Corp.'s Upcoming Q2 2013 Income Statement Projection (Part 1)