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Author's Note: PART 2 of this article is a continuation from PART 1 which was discussed in a previous publication. Please see PART 1 of this article to fully understand the topics and discussion points to be covered below in relation to American Capital Agency Corp. (NASDAQ:AGNC) and my income statement projection for the second quarter of 2013. The link to this article is provided below:

PART 1 - American Capital Agency Corp's. Upcoming Q2 2013 Income Statement Projection

B) Other Comprehensive Income (Loss) (OCI / OCL):

- OCL Estimate of ($2.36) Billion; Range ($1.96 - $2.86) Billion

- Confidence Within Range = Moderate to High

- See Table 7 Below Next to the June 30, 2013 Column for References

Having established a net income estimate of $1.39 billion for the second quarter of 2013 (via PART 1 of this article), let us 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) in regards to OCL. The income statement (ACTUAL) figures are derived from AGNC's quarterly SEC submissions via its 10-Q or 10-K where applicable.

Table 7 - AGNC Quarterly OCI / OCL and Comprehensive Income (Loss) Projection


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6) Unrealized Gain (Loss) on Available-For-Sale Securities, Net:

- Estimate of ($2.41) Billion; Range ($2.01 - $2.91) Billion

- Confidence Within Range = Moderate to High

- See Boxed Blue Reference"6" in Table 7 Above and Table 11 Below Next to the June 30, 2013 Column

Estimating the unrealized gain (loss) on available-for-sale securities, net account is an analysis that involves several assumptions and variables that need to be taken into consideration. As such, a wide range should be accompanied with this specific account. With that being said, the same general assumptions that were considered in PART 1 of this article will be applied when analyzing this account.

To fully understand what has occurred within this particular account during the second quarter of 2013, I feel it is necessary to take a step back and see how the Federal Reserve's past and current monetary policies have affected US interest rates (thus MBS price valuations) during the past five years or so.

Summarized Discussion of the Federal Reserve's Quantitative Easing Policies:

In direct response to the financial crisis of 2007-2008 (also known as the Global Financial Crisis), the Federal Reserve ('FED') stated it would be undertaking various "quantitative easing" (QE) measures to help spur growth within the US economy. These will be referred to as QE1 - 3.

QE 1, which informally began on 12/16/2008 via the approval of the Federal Open Market Committee (FOMC), gave the FED authority to purchase up to $600 billion in agency MBS and agency debt. On March 18, 2009, the FOMC announced that the program would be expanded by an additional $750 billion for purchases of agency MBS and agency debt and $300 billion for purchases of US Treasury securities. QE 1 concluded operations in March 2010.

Due to continued economic pressure and weakness, QE 2 informally began on 11/3/2010. QE 2 gave the FED authority to purchase $600 billion of longer-dated US Treasuries at a rate of $75 billion per month. QE 2 concluded in June 2011.

As economic weakness continued to persist in the US, the FED announced its "Operation Twist" Program. This program was launched after QE 2 and prior to QE 3. Operation Twist informally began on 9/21/2011 and gave the FED the authority to purchase $400 billion of bonds with maturities of 6 - 30 years and to sell bonds with maturities less than 3 years. The main reason for such an activity was to extend the average maturity of the FED's balance sheet. This program was similar to the QE programs. However, two main differences should be noted. The FED did not print additional money or expand the FED's balance sheet during this program. This was a strategy to combat potential inflationary fears in future years. On 6/20/2012, the FED announced an amendment to the Operation Twist Program by adding an additional $267 billion worth of longer-range bonds, thus extending this program through 2012.

QE 3, which informally began on 9/13/2012, gave the FED a third round of authorized monetary policy intervention. QE 3 provided for an "open-ended" commitment to purchase $40 billion of MBS per month until the labor market improves "substantially." An amendment to QE 3 (or some people refer to as QE 4) was initiated via the FOMC on 12/12/2012. This additional QE measure authorized the FED to purchase up to $45 billion per month of longer-term US Treasuries. This enactment was in addition to the $40 billion per month of MBS already being purchased. This "open-ended" commitment by the FED drove US interest rates to historic lows.

I think it's important to understand the FED's history of QE policies as it portrays to the markets today. As the FED's rhetoric has been more of a notion of "tapering" and ultimately eliminating its QE 3 program, the market has speculated the ramifications on how such an act will impact the markets in regards to overall interest rates. As such, debt instruments have rapidly declined in value including substantial drops in higher-yielding equity investments. Due to the extremely rapid rise of overall U.S. interest rates, rapid MBS price declines (across the entire secondary mortgage market) has caused substantial market-to-market / fair market value ('FMV') write-downs on assets held by the mREIT sector within the past few months.

As a result, AGNC will sustain material MBS devaluations for the second quarter of 2013. People may argue that the market is ahead of itself in regards to the extremely rapid rise in US interest rates, but the markets themselves dictate the rules in regards to FMV under Generally Accepted Accounting Principles (GAAP).

Side Note: As was discussed in PART 1 of this article, AGNC's derivative instruments have helped offset some of these material MBS devaluations that will be shown in detail shortly. AGNC's derivatives account was discussed within PART 1 of this article because these types of accounts are represented within a different part of AGNC's Income Statement (not OCL). Please refer to PART 1 for further discussion of AGNC's derivative instruments.

It should be known that AGNC (as any mREIT does) changes its MBS portfolio in any given quarter. Per a recent presentation at the Morgan Stanley Financials Conference on 6/12/2013, AGNC's President and Chief Investment Officer (CIO) Gary Kain stated the company has sold a portion of its lower-coupon MBS during the current quarter. He also stated AGNC's leverage was currently around the same factor of 8.1 times equity as of 3/31/2013 (including the "off-balance sheet" TBA MBS forward contract position). Therefore, for this specific account, I am assuming AGNC "re-rolled" these lower-coupon MBS into slightly higher-coupon MBS investments during the second quarter of 2013. These minor portfolio changes will be accounted for at the end of this specific account's analysis.

As such, AGNC's 3/31/2013 MBS portfolio balance will be used as the starting point to see the impact of the material MBS devaluations that have occurred for the second quarter of 2013. Using Table 8 below as a reference, let us first analyze AGNC's 15-year fixed-rate agency MBS price changes for the second quarter of 2013. This will then be followed by a similar analysis (via Table 9) of AGNC's 30-year fixed-rate agency MBS price changes.

Table 8 - AGNC Quarterly 15-Year Fixed-Rate Agency MBS Price Changes


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Table 8 above shows AGNC's 15-year fixed-rate agency MBS price movements during the second quarter of 2013. It breaks out these 15-year fixed agency MBS holdings by government-sponsored entity ("GSE"). This includes both Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) MBS holdings. It further breaks out these 15-year fixed-rate agency MBS into the various coupons on AGNC's books ranging from 2.5% - 4.5%. AGNC holds an immaterial balance of 15-year fixed-rate agency MBS over the 4.5% coupon and thus will not be discussed in this specific analysis.

To summarize, Table 8 breaks down AGNC's Fannie and Freddie 15-year fixed-rate agency MBS holdings as of 3/31/2013 across various coupons. From the information portrayed in Table 8 above, an estimated unrealized valuation gain or loss can be broken down by the various coupons. As briefly stated earlier, all current quarter MBS purchases will be accounted for in Table 10 later on in the analysis of this account. Table 10 will also have the inclusion of a specified pool's ("pay-ups") estimated devaluation as well. All current quarter MBS sales will be reversed out of this specific account in Table 11 below. All MBS sales have been accounted for in PART 1 of this article already and thus must be "reversed-out" of this account via Table 11.

As Table 8 indicates, material price declines have occurred across the broad spectrum of MBS coupon rates for the second quarter of 2013. During this quarter, it seems when a particular MBS coupon rate lowers, the larger the devaluation becomes. This is evidenced within the "Cumulative Quarterly Change" column in Table 8. To illustrate, the Fannie 15-year fixed-rate agency MBS with a 2.5% coupon had a decline in valuation for the current quarter of 3.34 to settle its price at 100.41 (100 being par) by the end of the quarter. The Fannie 15-year fixed-rate agency MBS with a 3.0% coupon had a decline in valuation for the current quarter of 2.38 to settle its price at 102.78 (100 being par) by the end of the quarter. Losses (to a lesser extent as the coupon rises) occurred in the Fannie 15-year fixed-rate agency MBS with a coupon ranging from 3.5% - 4.5%.

For the Freddie 15-year fixed-rate agency MBS, the same conclusions hold true. There are slight differences in devaluations across the specific coupon rates when compared to Fannie, but the same general theme holds true. All the estimated cumulative price declines for both Fannie and Freddie MBS (hence AGNC's devaluations/losses) are shown within the row named "Current Valuation" within Table 8. These losses will be accumulated on Table 10 later on in the discussion.

Having some sense of the losses sustained on AGNC's 15-year fixed-rate MBS (prior to the inclusion of the specified pools aspect of valuation), now let us look at AGNC's 30-year fixed-rate agency MBS holdings.

Table 9 - AGNC Quarterly 30-Year Fixed-Rate Agency MBS Price Changes


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Table 9 above shows AGNC's 30-year fixed-rate agency MBS price movements during the second quarter of 2013. It breaks out these 30-year fixed agency MBS holdings by GSE. As was the case with the 15-year fixed-rate agency MBS, this includes both Fannie Mae and Freddie Mac MBS holdings. It further breaks out these 30-year fixed-rate agency MBS into the various coupons offered ranging from 2.5% - 4.5%. Once again, AGNC holds an immaterial balance of 30-year fixed-rate agency MBS over the 4.5% coupon and thus will not be discussed in this specific analysis.

To summarize, Table 9 breaks down AGNC's Fannie and Freddie 30-year fixed-rate agency MBS holdings as of 3/31/2013 across various coupons. From the information portrayed in Table 9 above, an estimated unrealized valuation gain or loss can be broken down by the various coupons. As stated earlier, all current quarter MBS purchases will be accounted for in Table 10 later on in the analysis of this account. Table 10 will also have the inclusion of a specified pools ("pay-ups") estimated devaluation as well. All current quarter MBS sales will be reversed out of this specific account in Table 11 below. All MBS sales have been accounted for in PART 1 of this article already and thus must be "reversed-out" of this account via Table 11.

As Table 9 indicates, material price declines have also occurred for the 30-year fixed-rate MBS across the broad spectrum of coupon rates for the second quarter of 2013. During this quarter, it seems as a particular MBS coupon rate lowers, the larger the devaluation becomes. This is evidenced within the "Cumulative Quarterly Change" column in Table 9. To illustrate, the Fannie 30-year fixed-rate agency MBS with a 2.5% coupon had a decline in valuation for the current quarter of 6.88 to settle its price at 92.34 (100 being par) at the end of the quarter. The Fannie 30-year fixed-rate agency MBS with a 3.0% coupon had a decline in valuation for the current quarter of 5.48 to settle its price at 97.63 (100 being par) at the end of the quarter. Losses (to a lesser extent as the coupon rises) occurred in the Fannie 30-year fixed-rate agency MBS with a coupon ranging from 3.5% - 4.5%.

For the Freddie 30-year fixed-rate agency MBS, the same conclusions hold true. There are slight differences in devaluations across the specific coupon rates when compared to Fannie, but the same general theme holds true. All the estimated cumulative price declines for both Fannie and Freddie MBS (hence AGNC's devaluations/losses) are shown within the row named "Current Valuation" within Table 9. These losses will also be accumulated on Table 10 later on in the discussion.

As can be seen by comparing Tables 8 vs. 9, the 30-year fixed-rate MBS price changes are in excess of the 15-year fixed-rate MBS price changes for the same coupon rate. For instance, the 15-year fixed-rate MBS with a coupon of 3% had a price decline of 2.38 (as mentioned earlier). The 30-year fixed-rate MBS with a coupon of 3% had a price decline of 5.48 (as mentioned earlier as well). The 30-year fixed-rate MBS price decline for this particular coupon was over double when compared to the 15-year fixed-rate price decline. This does not bode particularly well for AGNC because approximately 66% of its 3/31/2013 MBS portfolio was in 30-year fixed-rate MBS (including its TBA MBS forward contract position). Since the 30-year fixed-rate MBS had larger price declines in the current quarter (throughout the various coupon rates), additional losses will be sustained within this specific account for the second quarter of 2013.

Having some sense of why losses were sustained on AGNC's 15-year and 30-year fixed-rate MBS (prior to the inclusion of the specified pools aspect of valuation), now let us begin to quantify these losses in dollar amounts. Table 10 below shows AGNC's weekly and (more importantly) quarterly cumulative estimated unrealized losses on its 15 and 30-year fixed-rate agency MBS holdings. These particular types of MBS holdings account for over 99% of AGNC's total investment asset holdings as of 3/31/2013.

Table 10 - AGNC Quarterly 15 and 30-Year Fixed-Rate MBS Valuation Change


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Table 10 above shows AGNC's unrealized gain (loss) for the second quarter of 2013 on a cumulative basis. This table quantifies, in dollar amounts, a weekly unrealized gain or loss that has occurred on existing 15-year (see Table 8) and 30-year (see Table 9) fixed-rate agency MBS investments. Table 10 summarizes the weekly changes across all coupon rates for the 15 and 30-year fixed-rate MBS.

Since one can accurately track existing MBS price movements throughout the various coupons, a general sense of a company's MBS portfolio in regards to its unrealized gain or loss can be achieved. The initial estimated unrealized loss on AGNC's 15 and 30-year fixed rate MBS investments is ($2.22) billion.

However, since AGNC currently has a material amount of its MBS holdings within specified pools (mainly through Home Affordable Refinance Program (HARP) and low-loan balance (LLB) securities), additional devaluations need to be quantified and estimated for the second quarter of 2013. LLB securities are defined as specified pools backed by original loan balances of up to $150 thousand. HARP securities are defined as specified pools backed by 100% refinanced loans where the original loan-to-value (LTV) ratio is equal to or greater than 80% of the current market value of a particular home.

At 3/31/2013, AGNC's 15-year fixed-rate MBS holdings are made up of $15.2 billion of LLB securities and $1.4 billion of HARP securities. This equates to 43% and 4%, respectfully, of AGNC's 15-year MBS investments (including its 15-year TBA MBS forward contract position). LLB securities make up $18.0 billion and HARP securities make up $23.5 billion of AGNC's 30-year fixed-rate MBS holdings. This equates to 27% and 35%, respectfully, of AGNC's 30-year MBS investments (including its 30-year TBA MBS forward contract position).

As a result of the continued price deterioration of "pay-ups" in the second quarter of 2013, these quantified devaluations must be included in AGNC's unrealized loss analysis. "Pay-ups" represent the value of the price premium of specified securities over generic MBS pools (LLB and HARP securities). I am estimating an additional quarterly unrealized loss of ($670) million on all specified pool securities and all current quarter MBS purchases. Therefore, the total unrealized loss I am estimating is ($2.89) billion. This figure is prior to all sold MBS being reversed out in the current quarter (shown via Table 11 below; reversal of $475 million).

Table 11- AGNC Quarterly Unrealized Gain (Loss) on Available-For-Sale Securities and Unrealized Gain (Loss) on Derivative Instruments, Net Projection


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Table 11 above shows AGNC's total "unrealized loss, net" estimate of ($2.89) billion. The second account is the "reversal of prior period unrealized gains, net, upon realization" figure. This is the amount that is highlighted in pink with a boxed blue reference "3" for the second quarter of 2013. This amount is the same figure that is represented within my detailed discussion of AGNC's "gain (loss) on sale of agency securities, net" account (see PART 1 of this article). After the current quarter's sold MBS loss of ($475) million is reversed-out, AGNC's total "unrealized loss on available-for-sale securities, net" amount is an estimated ($2.41) billion.

Side Note: The above analysis excludes any discussion of AGNC's TBA MBS portfolio. These specific types of "off-balance sheet" forward contracts, under GAAP, are presented within AGNC's "gain (loss) on derivative instruments and other securities, net" account which was discussed in PART 1 of this article.

Back-Testing Current Quarter's Valuation Methodology:

Some people may question this specific methodology I employ to predict my unrealized gain (loss) on available-for-sale securities, net account. There will never be a prediction technique that can precisely account for (with 100% accurately) how a company will operate in a specified quarter in regards to asset purchases and sales. However, I will show (via Tables 12 and 13 below) AGNC's actual first quarter of 2013 results and compare the unrealized losses in this specific account to my back-tested recalculations using the same methodologies discussed above. This includes the breakout of MBS investments between the 15, 20, and 30-year MBS holdings including a breakout between Fannie and Freddie and the various coupon rates.

Table 12 - AGNC Back-Tested 15, 20, and 30-Year Fixed-Rate MBS Valuation Change (Q1 2013)


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Looking at Table 12, one can see the recalculated valuation change for the first quarter of 2013 on AGNC's MBS portfolio as of 12/31/2013. AGNC's valuation change amounted to a recalculated unrealized loss of ($533) million for the first quarter of 2013 (blue reference "A''). However, since AGNC had a material amount of its MBS holdings within specified pools as of 12/31/2012, (mainly HARP and LLB securities; as is the case at 3/31/2013), additional devaluation need to be quantified and estimated for the first quarter of 2013.

Table 13 - AGNC Back-Tested HARP and LLB Securities (Specified Pools; "Pay-Ups") Valuation Change (Q1 2013)


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Using Table 13 as a reference, AGNC's MBS holdings as of 12/31/2012 were made up of $18.0 billion of LLB loans and $21.6 billion of HARP loans. As a result of the price deterioration of "pay-ups" in the first quarter of 2013, these quantified price devaluations must be included in AGNC's unrealized loss analysis. As stated earlier, "pay-ups" represent the value of the price premium of specified securities over generic MBS pools. I estimated an additional quarterly unrealized loss of ($135) million on all LLB securities (blue reference "B") and ($194) million on all HARP securities (blue reference "C"). This totaled to an amount of ($329) million on all specified pool securities.

Therefore, the total unrealized loss I estimated for the first quarter of 2013 was ($863) million (blue references "A + B + C" in Tables 12 and 13). If one looks once again at Table 13, AGNC reported an actual total unrealized loss (prior to the reclassification of all quarterly MBS sold) of ($863) million. This amount can be tied back to Table 11 for reference (which ultimately flows to Table 7 which is AGNC's Income Statement for the first quarter of 2013). It basically was a precise match. I'm not stating this methodology will be 100% accurate for the current quarter (as was the case for the first quarter of 2013). However, this estimation technique I use is usually fairly close to actual results reported by AGNC within its unrealized gain (loss) on available-for-sale securities, net account (within 10% of the total balance of this specific account). Due to the size of the loss in the current quarter, this range will widen somewhat but should still be around the actual results.

7) Unrealized Gain (Loss) on Interest Rate Swaps, Net:

- Estimate of 48 Million; Range $45 - $50 Million

- Confidence Within Range = High

- See Boxed Blue Reference"7" in Table 11 Above Next to the June 30, 2013 Column

Now let us take a look at AGNC's unrealized gain (loss) on interest rate swaps, net account. I base my estimation of this figure via Table 11 above. All past (ACTUAL) figures within Table 11 are derived from AGNC's quarterly SEC submissions (10-Q or 10-K where applicable). However, I have used specific information derived from multiple tables/charts (some provided by AGNC; some via my own researched data) for my estimates of the gain (loss) on interest rate swaps, net account.

This account consists of two sub-accounts. The first account is named "unrealized gain (loss) on interest rate swaps designated as cash flow hedges". Since AGNC has discontinued accounting for its interest rate swaps as cash flow hedges, this balance will remain $0 in the second quarter of 2013.

The second account is named "reversal of prior period unrealized loss on interest rate swaps, net, upon reclassification to interest expense". AGNC elected to discontinue accounting for its interest rate swaps as cash flow hedges under GAAP as of September 30, 2011. Therefore, this account only has a balance remaining on its net deferred portion of losses from accumulated OCL. This amount will be taken out of OCL and classified into interest expense since it related to AGNC's "de-designated" interest rate swaps. As of 3/31/2013, AGNC had a remaining net deferred loss in accumulated OCL relating to these de-designated interest rate swaps of ($437) million. This remaining amount will be reclassified from OCL into interest expense over a remaining weighted average period of 2.7 years. The net deferred loss expected to be reclassified from OCL into interest expense over the next twelve months is ($184) million. Therefore, a calculated reclassification of $48 million has been estimated for the second quarter of 2013.

After adding up AGNC's total unrealized loss on AFS securities, net of ($2.41) billion and its unrealized gain on interest rate swaps, net of $48 million, you arrive at an OCL figure of ($2.36) billion. This amount is shown via Tables 7 and 11 above.

C) Comprehensive Income (Loss):

- Comprehensive Loss Estimate of ($981) Million; Range ($600) Million - ($1.6) Billion

- Comprehensive Income of ($2.47) Per Share; Range ($1.51 - $4.04) Per Share

- Confidence Within Range = Moderate to High

- See Table 7 Above Next to the June 30, 2013 Column for References

Finally, let us look at AGNC's estimated comprehensive income estimate for the second quarter of 2013. This is basically the summation of AGNC's A) net income of $1.39 billion (see PART 1) and its B) OCL loss of ($2.36) billion. Therefore, my estimated comprehensive loss is ($981) million for the second quarter of 2013.

Conclusions Drawn (PARTS 1 and 2):

To sum up all the information from both parts of the article, I am estimating AGNC will report the following figures for the second quarter of 2013:

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

B) Quarterly Other Comprehensive Loss of ($2.36) Billion

C) Quarterly Comprehensive Loss (A + B Combined) of ($981) Million (($2.47) Per 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 the huge valuation gains of AGNC's derivative/hedging instruments as a whole. AGNC's derivative/hedging instruments will have an estimated $1.5 billion gain in the current quarter. Specifically, extremely large valuation gains will be obtained on AGNC's interest rate swaps, swaptions, and U.S. 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.

However, there is not all good news for AGNC. Along with this large net income figure of 1.39 billion will be an even larger OCL of ($2.36) billion. This is due to the overall material MBS price declines due to the "spike" in US interest rates during the second quarter of 2013. As a result of these two figures, I am projecting a comprehensive loss of ($981) million for the second quarter of 2013.

When taking a step back and looking at the big picture, people unfamiliar with what has occurred in the MBS markets may see this comprehensive loss of ($981) million as a very negative sign. However, it should be noted this overall loss is much less than the "worst-case" scenario that has been portrayed.

AGNC's management team has properly hedged (with the exception of its overall TBA position) its MBS portfolio and repo loan positions. Prior to this quarter, AGNC continued to add to its swap, swaption, and U.S. Treasury - short positions. As such, AGNC has mitigated a fairly large portion of its MBS devaluations for the current quarter. I am estimating AGNC's derivative/hedging instruments "recuperated" a little over half (52%) of the MBS price declines that have occurred in the second quarter of 2013 (including all sold MBS realized losses). In my opinion, this recuperation rate is generally a positive sign. All hedges cannot be absolutely perfect (100% mitigation of risk), but compared to the "doom-and-gloom" predictions on the upcoming quarter by the overall market (some exceptions to the overall trend), AGNC's reported figures in early August will surprise some investors and analysts alike.

Final Note on Upcoming BV Article: Even though AGNC's overall book value will still materially decrease in the second quarter of 2013, its overall derivative/hedging positions will help offset this drop. If AGNC did not have these derivatives/hedges in place, the drop in book value for one quarter would have been rather devastating. The information provided above will directly be used for my book value projection. My next article will calculate (in detail) a projection for AGNC's book value as of 6/30/2013. This article should be out relatively soon.

Disclosure: I am long AGNC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: American Capital Agency Corp.'s Upcoming Q2 2013 Income Statement Projection (Part 2)