American Capital Agency's Mid-Q3 2013 Composition And Valuation Analysis - Part 2 (Derivative Portfolio)

| About: AGNC Investment (AGNC)

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 for a composition and valuation analysis of American Capital Agency Corp.'s (NASDAQ:AGNC) MBS portfolio. AGNC's MBS portfolio composition and valuation analysis helps lead to a better understanding of AGNC's derivative portfolio composition analysis that will be discussed below. The link to PART 1's analysis is provided below:

American Capital Agency Corp.'s Mid-Q3 2013 Composition And Valuation Analysis - Part 1 (MBS Portfolio)

I originally thought AGNC's first-half of the third quarter of 2013 composition and valuation analysis would be comprised of PART 1 and PART 2, respectfully. However, as I was writing PART 2 of this article, I came to the realization that AGNC's derivative portfolio composition and valuation analysis needs to be further broken-out into two separate articles/parts. AGNC's derivative portfolio composition and valuation analysis together would be far too lengthy of an article. I came to the conclusion PART 2 should focus on AGNC's derivative portfolio composition as of 6/30/2013 while PART 3 focuses on the valuation of AGNC's derivative portfolio through 8/16/2013. As such, below are the topics that will be discussed regarding AGNC's derivative portfolio for the first-half of the third quarter of 2013:

1) AGNC's Derivative Portfolio - Composition Analysis (PART 2)

2) AGNC's Derivative Portfolio - Valuation Analysis (PART 3)

Focus of PART 2 of Article:

The focus of PART 2 of this article is to provide a mid-quarter update of AGNC's third quarter of 2013 derivative portfolio regarding its composition. I feel this mid-quarter update will provide readers a general direction on how the first-half of the third quarter of 2013 has panned out regarding AGNC's overall hedging strategy. This article will mainly compare and contrast what has occurred so far in the third quarter of 2013 vs. the second quarter of 2013 regarding AGNC's derivative portfolio composition.

I would like to discuss and analyze AGNC's derivative portfolio as of 6/30/2013 and identify the changes AGNC made in the prior quarter which will impact the current quarter. The information derived in PART 2 of this analysis will ultimately assist in projecting AGNC's derivative portfolio regarding its valuation through 8/16/2013 (which will be determined in PART 3).

B) AGNC's Derivative Portfolio - Composition and Valuation Analysis:

Let us first understand AGNC's derivative portfolio as of 6/30/2013 regarding its overall composition. This will be followed by a first-half of the third quarter of 2013 derivative portfolio composition analysis broken down by the four main hedging instruments currently being used by AGNC.

Side Note: To better illustrate the nature and function of AGNC's derivative instruments, I show each derivative instrument as being net "long" or "(short)." All net long positions have a "direct" relationship with AGNC's MBS portfolio regarding valuation movements. As such, if AGNC's MBS portfolio has a valuation gain during a specified time period, AGNC's net long derivative positions will have a similar valuation gain (and vice versa). All short positions have an "inverse" relationship with AGNC's MBS portfolio regarding valuation movements. As such, if AGNC's MBS portfolio has a valuation gain during a specified time period, AGNC's net short derivative positions will have valuation losses (and vice versa). This can be confusing for some readers, but I feel presenting the information this way is most effective when trying to truly show the nature of AGNC's derivative instruments. If a particular reader ever becomes confused while reading this article, I would suggest referring back to this side note to gain one's bearings.

It should also be noted not all of AGNC's derivative instruments are directly held for the mitigation of its MBS portfolio's valuation losses. AGNC holds different types of derivative instruments for different purposes. For example, AGNC has various hedging instruments which are known to help offset both MBS portfolio valuation losses (via U.S. Treasury securities) and the rising interest costs of repurchase (repo) loans (based on LIBOR; via interest rate swaps and swaptions). AGNC's derivative instruments such as TBA MBS and forward settling securities can have varying uses depending on whether each instrument is net long or short. AGNC's TBA MBS and forward settling securities have a direct relationship to its MBS portfolio position when a net long position exists. However, when these derivative instruments are in a net short position, an inverse relationship is developed and these instruments become hedges per se regarding MBS portfolio valuation movements.

1) AGNC's Derivative Portfolio - Composition Analysis (Including Net Change Analysis):

Table 6 below shows AGNC's derivative portfolio as of 6/30/2013. Table 6 displays the following columns: 1) derivative and other hedging instruments; 2) long or (short) notional amount as of 3/31/2013; 3) additions; 4) settlements, terminations, expirations, or exercises; 5) long or (short) notional amount as of 6/30/2013; and finally 6) amount of gain or (loss) recognized in income on derivatives.

Table 6 - AGNC Derivative Portfolio Balances (As of 6/30/2013)


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Having Table 6 as a reference, let us first discuss how AGNC's derivative portfolio as of 6/30/2013 compared to its derivative portfolio as of 3/31/2013 to better understand what changes were made during the second quarter of 2013 regarding its composition. This will ultimately help when performing a valuation analysis (in PART 3) on AGNC's derivative portfolio for the first-half of the third quarter of 2013.

To better understand how AGNC's derivative portfolio as of 6/30/2013 changed when compared to its derivative portfolio as of 3/31/2013, Table 7 is shown below. Table 7 provides key information about some recent net changes AGNC made to its derivative portfolio regarding the following instruments: 1) net "to-be-announced" (' TBA') MBS and forward settling agency securities; 2) interest rate swaps; 3) interest rate swaptions; and 4) U.S. Treasury securities.

Table 7 - AGNC Derivative Portfolio Net Changes (6/30/2013 vs. 3/31/2013)


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a) Net TBA MBS and Forward Settling Agency Securities (Net Long Position):

As shown in Table 6 above, AGNC's total net TBA MBS and forward settling agency securities position is $14.4 billion as of 6/30/2013. For readers unfamiliar with AGNC's TBA MBS portfolio, I will provide a brief summary. It should be noted all discussions below also refer to AGNC's forward settling agency securities as well (where applicable; unless noted otherwise). AGNC enters into TBA MBS forward contracts as an "off-balance sheet" means of investing in and financing MBS. AGNC enters into TBA MBS forward contracts where it agrees to purchase, for future delivery, MBS with certain principal terms and interest conditions. The date when AGNC is supposed to take future delivery on the TBA MBS is known as the settlement date. There are usually three options available to AGNC in regards to its TBA MBS forward contracts.

First, on or within a rather close timeframe to the settlement date, AGNC may decide to "re-roll" a specific TBA MBS forward contract by moving the settlement date out to a later date by entering into an off-setting short position. This is also known as a "pair-off." By pairing-off an existing TBA MBS forward contract position, AGNC net settles its current position in cash and simultaneously purchases a similar yet new TBA MBS forward contract with a later settlement date. This specific transaction is known as the "dollar-roll." The TBA MBS forward contracts that are purchased with a future settlement date are usually priced at a discount to regular MBS in the current month (depending on market conditions). The difference in the price of a TBA MBS forward contract and a regular MBS in a given month is referred to as the "price-drop." The price-drop is also referred to as AGNC's "dollar-roll income" generated.

The second option in regards to AGNC's TBA MBS forward contracts is to "transfer" the position via selling the contract to a potential market purchaser. Although possible, this option is rarely exercised because such a transaction typically results in additional valuation losses on part of the seller. This usually is a rare occurrence in regards to AGNC's current activities/strategies.

The third option is to take delivery on the TBA MBS forward contract on the settlement date without re-rolling its position. If the third option occurs, then the TBA MBS forward contract is exercised and the TBA MBS converts to a regular MBS regarding its accounting and valuation treatment. As such, it converts from an off-balance sheet MBS to an "on-balance sheet" MBS. AGNC enters into TBA MBS forward contracts because during specific time periods (and rate environments), dollar-roll financing can generate better risk adjusted returns than similar generic MBS investments which are funded via repo loans.

Using Table 7 above as a general reference, as of 6/30/2013, AGNC decreased a material portion of its TBA MBS forward contracts notional balance when compared to 3/31/2013. The net quarterly notional change for this specific derivative instrument was ($11.9) billion or approximately 45% of AGNC's entire TBA MBS forward contracts net long notional balance of $26.2 billion as of 3/31/2013.

To further breakout which TBA MBS coupon rates changed between 6/30/2013 and 3/31/2013, Table 8 is shown below.

Table 8 - AGNC Net TBA MBS and Forward Settling Agency Securities Net Changes (6/30/2013 vs. 3/31/2013)


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Using Table 8 as a reference, the net quarterly notional balance change within AGNC's 15-year 2.5% coupon TBA MBS was ($10.6) billion. This directly correlates to the net quarterly increase within AGNC's 15-year 2.5% coupon MBS of $10.3 billion discussed in PART 1 of this analysis. This is due to the fact AGNC basically took delivery on its entire 15-year 2.5% coupon TBA MBS position of $11.2 billion as of 3/31/2013 during the second quarter of 2013. Rather than sustain continued realized valuation losses on the "re-rolling" of this specific TBA MBS coupon in a rising interest rate environment, AGNC decided to basically vacate the entire position by taking possession of this particular TBA MBS coupon. My assumption is AGNC took possession of the 15-year 2.5% coupon TBA MBS to ultimately sell these newly acquired 15-year 2.5% MBS if interest rates continue to increase (AGNC's MBS portfolio strategy discussed in PART 1 of this article). This would help AGNC offset future additional valuation losses if MBS prices were further suppressed in the coming quarters by a rise in mortgage interest rates/U.S. Treasury yields. Since AGNC took possession of its 15-year 2.5% coupon TBA MBS, a majority of any valuation losses associated with AGNC's newly acquired 15-year 2.5% coupon MBS will now by shown in "other comprehensive income" ('OCI') as unrealized losses until sold. As of 6/30/2013, AGNC only had a net long balance of $612 million remaining on its 15-year 2.5% coupon TBA MBS.

AGNC increased its 15-year 3.0% coupon TBA MBS by $4.1 billion and 30-year 4.0% coupon TBA MBS by $3.5 billion. In comparison, AGNC decreased its 30-year 3.0% and 3.5% coupon TBA MBS by ($5.9) billion and ($5.0) billion, respectfully. This indicates the general strategy of turning over AGNC's lower coupon TBA MBS into higher coupon TBA MBS forward contracts. This should help achieve a slightly higher dollar-roll income while these holdings remain a part of AGNC's TBA MBS portfolio (generally speaking). When settled and taken possession of, the converted MBS will also provide a greater yield when compared to the prior quarter's TBA MBS portfolio.

In fact, AGNC now has a net short position of ($4.4) billion within its 30-year 3.5% coupon TBA MBS. As rates have continued to increase during the first half of the third quarter of 2013, this short position should help alleviate some the valuation losses incurred on the rest of AGNC's TBA MBS portfolio.

AGNC, for the first time since its inception, also had a net short balance of ($1.8) billion as of 6/30/2013 within its 30-year 4.0% coupon forward settling securities account.

b) Interest Rate Swaps (Net Short Position):

As shown in Table 6 above, AGNC's total interest rate swap position is ($55.6) billion as of 6/30/2013. AGNC had ($10.1) billion of interest rate swap additions and $5.7 billion of interest rate swap terminations or expirations during the quarter. Using Table 7 above as a net quarterly change reference, AGNC continued to increase its net short position regarding its interest rate swaps during the second quarter of 2013. The net quarterly notional balance change within this specific hedging instrument was ($4.4) billion or approximately 8% of AGNC's entire interest rate swap net short position of ($51.3) billion as of 3/31/2013. Table 7 above shows the net quarterly changes within this hedging instrument as a whole. However, Table 7 does not breakout the specific interest rate swap durations. To obtain further information regarding the net quarterly changes to AGNC's interest rate swaps, let us look at Table 9 below.

Table 9 - AGNC Interest Rate Swaps Net Changes (6/30/2013 vs. 3/31/2013)


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Using Table 9 as a reference, the net quarterly notional balance change within AGNC's interest rate swaps with durations of less than three years were ($1.2) billion. The net quarterly notional change within AGNC's interest rate swaps with durations of seven to ten years were ($2.1) billion. The rest of the duration groupings had minor short position increases as well. AGNC continued to increase its overall interest rate swaps position due to its "defensive posture" regarding the current environment surrounding interest rates and decreasing MBS valuations. If interest rates continue to increase at a modest to sharp pace, the added interest rate swaps position will help further reduce the associated valuation losses sustained on AGNC's MBS portfolio (discussed in PART 1).

It should be noted that adding to AGNC's interest rate swaps position comes at an added cost regarding a higher average fixed pay rate on new interest rate swaps. This is evidenced in Table 9 under the "average fixed pay rate" column. This column represents the quarterly net change in AGNC's average fixed pay rate that it pays to a counterparty in a specific swap. Most duration classifications had an overall increase to its fixed pay rate. As overall market rates increase, the interest rate associated with the payer side of the interest rate swaps increases as well. In exchange, AGNC receives interest which is shown in Table 9 under the "average receive rate" column. Currently, AGNC's average receive rate is based on the three month LIBOR percentage. As Table 9 shows, this rate actually slightly decreased from 3/31/2013 to 6/30/2013. Since AGNC's average pay rate increased and receiver rate slightly decreased, AGNC will be paying an increased net periodic interest rate swap expense (on top of the notional balance increase). AGNC is willing to incur this added expense at the sake of potentially offsetting MBS valuation losses with valuation gains associated with its interest rate swaps. As noted earlier, the valuation of AGNC's interest rate swaps through 8/16/2013 will be discussed in PART 3 of this analysis.

c) Interest Rate Swaptions (Net Short Position):

Interest rate swaptions are basically options to enter into underlying interest rate swap contracts whereas interest rate swap contracts have no initial upfront costs (gains and losses are incurred as interest rates fluctuate over the life of the swaps), interest rate swaptions have implicit upfront costs (like any typical option contract; generally speaking). As shown in Table 6 above, AGNC's total interest rate swaptions position is now ($23.8) billion as of 6/30/2013. AGNC had ($3.2) billion of interest rate swaption additions and $2.4 billion of interest rate swaption exercises or expirations during the prior quarter. Using Table 7 above as a net quarterly change reference, AGNC continued to acquire positions regarding its interest rate swaptions during the second quarter of 2013. The net quarterly notional balance change within this specific hedging instrument was ($850) million or approximately 4% of AGNC's entire interest rate swaptions short position of ($22.9) billion as of 3/31/2013. However, Table 7 does not breakout the interest rate swaption option expirations or underlying interest rate swap durations. To obtain further information regarding the net quarterly changes to AGNC's interest rate swaptions, let us look at Table 10 below.

Table 10 - AGNC Interest Rate Swaptions Net Changes (6/30/2013 vs. 3/31/2013)


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Using Table 10 as a reference, the net quarterly notional balance change on the underlying swap within AGNC's interest rate swaptions with option expirations of less than one year were ($1.3) billion. The net quarterly notional balance change on the underlying swap within AGNC's interest rate swaptions with option expirations of one to two years were $1.0 billion. The rest of the option expiration groupings had either minor short position increases or no changes. As was the case regarding its interest rate swaps, AGNC continued to increase its overall interest rate swaptions position due to its defensive posture regarding the current environment surrounding interest rates and decreasing MBS valuations (noted earlier). If interest rates continue to increase at a modest to sharp pace, the added interest rate swaptions position will help further reduce the associated valuation losses sustained on AGNC's MBS portfolio (discussed in PART 1) if/when the swaptions are exercised and the underlying swaps are added to AGNC's interest rate swaps position.

It should be noted that adding to AGNC's interest rate swaptions position comes at an added cost. This is evident in Table 10 under the "cost" column. This column represents the quarterly net change in AGNC's option costs in association with entering into a specific interest rate swaption contract. Swaptions with option expirations of less than a year had an added net quarterly cost of $48 million during the second quarter of 2013. The rest of the option expiration groupings had minimal net changes regarding interest rate swaption costs. As noted earlier, the valuation of AGNC's interest rate swaptions through 8/16/2013 will be discussed in PART 3 of this analysis.

d) U.S. Treasury Securities (Net Short Position):

As shown in Table 6 above, AGNC's total U.S. Treasury securities position is ($12.9) billion as of 6/30/2013. AGNC had ($13.0) billion of U.S. Treasury security additions and $13.5 billion of U.S. Treasury security settlements during the quarter. Using Table 7 above as a net quarterly change reference, AGNC slightly lowered its net short U.S. Treasury securities position during the second quarter of 2013. The net quarterly change within this specific hedging instrument was $453 million or approximately 3% of AGNC's entire U.S. Treasury securities short position of ($13.4) billion as of 3/31/2013. However, Table 7 does not breakout the U.S. Treasury security maturities. To obtain further information regarding the net quarterly changes to AGNC's U.S. Treasury securities, let us look at Table 11 below.

Table 11 - AGNC U.S. Treasury Securities Portfolio (As of 6/30/2013) and Net Changes (6/30/2013 vs. 3/31/2013)


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Using the first table shown in Table 11 as a reference, AGNC had a net long position of $1.8 billion regarding its U.S. Treasury securities with maturities of five years. AGNC had a net short position of ($1.1) billion regarding its U.S. Treasury securities with maturities of seven years. AGNC had a net short position of ($7.4) billion regarding its U.S. Treasury securities with maturities of ten years. It should be noted these positions were NET of long U.S. Treasury security positions of $3.8 billion that were considered "non-derivative" instruments per accounting treatment purposes. To properly compare quarterly net changes, this $3.8 billion of long U.S. Treasury securities is reversed out of the first table in Table 11 because these specific assets are deemed to be non-derivative assets in nature per Generally Accepted Accounting Principles ("GAAP") purposes. The fair market value ("FMV") of $3.7 billion pertaining to the $3.8 billion net long U.S. Treasury securities position is shown on AGNC's balance sheet as "U.S. Treasury securities, at fair value" as opposed to "derivative assets, at fair value." This is determined by the specific nature and strategy of holding this particular set of assets. A further discussion of these assets is unwarranted for this particular article. For hedging portfolio purposes, AGNC actually had a ($2.0) billion net short position regarding its U.S. Treasury securities with a maturity of 5 years. Lastly, AGNC had a net short position of ($1.6) billion regarding its U.S. Treasury futures sold short position.

Now using the second table shown in Table 11 as a reference, the net quarterly face amount change within AGNC's U.S. Treasury securities with maturities of five years were $7.7 billion. The net quarterly face amount change within AGNC's U.S. Treasury securities with maturities of seven years were ($700) million. The net quarterly face amount change within AGNC's U.S. Treasury securities with maturities of ten years were ($1.2) billion. Again, these changes were NET of long U.S. Treasury security positions of $3.8 billion that were considered non-derivative instruments. To properly compare quarterly net changes, this $3.8 billion of long U.S. Treasury securities is reversed out of the second table in Table 11 because these specific assets are deemed to be non-derivative assets per GAAP accounting purposes. For hedging portfolio purposes, AGNC actually had a $4.0 billion net change regarding its U.S. Treasury securities with a maturity of 5 years. Lastly, the net quarterly face amount change within AGNC's U.S. Treasury futures sold short was ($1.6) billion.

Including reversing out $3.8 billion of the long U.S. Treasury security positions that were considered non-derivative instruments, AGNC slightly decreased its U.S. Treasury securities short position in the second quarter of 2013 by $453 million. As noted earlier, the valuation of AGNC's U.S. Treasury securities through 8/16/2013 will be discussed in PART 3 of this analysis.

Now that we have an understanding of AGNC's derivative portfolio regarding its 6/30/2013 composition, let us compare and contrast American Capital Mortgage Investment Corp.'s (NASDAQ:MTGE) and AGNC's derivative portfolios as of 6/30/2013.

Brief Discussion of MTGE's Derivative Portfolio - Composition Analysis:

One difference between AGNC's and MTGE's derivative portfolio that should be noted is the composition of TBA MBS and forward settling securities held as of 6/30/2013. AGNC held a net long TBA MBS and forward settling securities position of $15.4 billion as of 6/30/2013. Meanwhile, MTGE only held a total net long TBA MBS and forward settling securities position of $91 million as of 6/30/2013. As will be discussed further during PART 3, I am making the assumption AGNC will follow in MTGE's "footsteps" during the current quarter regarding lowering or basically eliminating its net long TBA MBS and forward settling securities position. This strategy has been implemented due to the overall unfavorable TBA MBS valuation environment that has occurred as a direct result of rising mortgage interest rates and U.S. Treasury yields (discussed earlier).

Other than the TBA MBS and forward settling security balance variances, MTGE had an extremely similar 6/30/2013 hedging portfolio when compared to AGNC. This is not too surprising since we established in PART 1 of this analysis that MTGE's MBS portfolio as of 6/30/2013 was pretty similar in comparison to AGNC's MBS portfolio as of 6/30/2013 regarding overall composition.

Table 12 - AGNC vs. MTGE Hedging Portfolio Composition Summary (As of 6/30/2013)


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Using Table 12 as a reference, both AGNC and MTGE has an overall hedging portfolio that covers its repo loan, other debt, and net long TBA MBS positions by 102%. During the recent increase of mortgage interest rates and U.S. Treasury yields (hence decreases in MBS valuations), both AGNC and MTGE have taken a defensive posture in regards to its MBS portfolio. This is evident by the 102% hedging coverage ratio.

AGNC and MTGE also had pretty similar average months to expiration (regarding interest rate swaptions), terms, and maturity. Furthermore, overall hedging durations were pretty consistent between MTGE and AGNC. The weighted average term/maturity of AGNC's hedging instruments was 6.4 years while MTGE's was 7.0 years. The weighted average hedging durations for AGNC's portfolio was 4.9 years while MTGE's was 5.7 years. One could make the argument that MTGE's overall hedging portfolio has a very slight advantage regarding average terms/maturities and average durations. However, this is basically offset by the slightly higher proportion of 30-year MBS MTGE holds versus AGNC as of 6/30/2013 (see PART 1 for further discussion of MBS portfolio comparisons). When taking this previous statement in consideration, AGNC's and MTGE's hedging portfolios as of 6/30/2013 are nearly identical. As such, when MTGE's hedging portfolio is valued in PART 3 of this analysis, the results should be pretty similar to AGNC's valuations on a proportional basis.

Conclusions Drawn (AGNC's Derivative Portfolio - Composition Analysis):

By examining AGNC's derivative portfolio as of 6/30/2013, I have shown how and analyzed why AGNC continued to slightly increase its overall derivative portfolio during the second quarter of 2013. This was mainly shown via Tables 6 and 7. These two tables showed the compositional changes that AGNC incorporated regarding its four derivative instruments.

AGNC decreased its net long TBA MBS and forward settling securities position by approximately 50% when compared to its 3/31/2013 balance. AGNC's net TBA MBS and forward settling securities dropped from $26.3 billion as of 3/31/2013 to $14.4 billion as of 6/30/2013. If MTGE's TBA MBS and forward settling security balances are any indicator, AGNC should continue to decrease its net long TBA MBS and forward settling security positions in the current quarter. This is an assumption I'm willing to make due to the specific tax and accounting issues associated with the TBA MBS.

When accounted for as a whole, AGNC's interest rate swaps, interest rate swaptions, and U.S. Treasury securities covered 102% of its repo loans, other debt, and net long TBA MBS position. One could argue AGNC is "fully hedged" as of 6/30/2013. The continued high proportion of hedging instruments versus MBS is for the preservation of BV over the short-term in case mortgage interest rates and U.S. Treasury yields continue to increase at a modest to rapid pace. However, it should be noted that as a result of this extremely large hedging position comes increased quarterly hedging expenses (mainly on the interest rate swaps).

MTGE's and AGNC's derivative portfolios as of 6/30/2013 were also very similar in nature. The only exception was within the TBA MBS and forward settling securities. MTGE was better positioned than AGNC regarding the TBA MBS balances in a rising interest rate environment. Other than the TBA MBS and forward settling securities positions as of 6/30/2013 (part of the derivative portfolio), AGNC and MTGE has basically identical hedging portfolios as of 6/30/2013. I see no indications that this will differ in the current quarter as well.

Final Note: PART 3 of this analysis will be out sometime next week. PART 3 will include a projected BV per share amount as of 8/16/2013. This will be followed by an article about AGNC's third quarter of 2013 dividend range scenarios (prior to AGNC's quarterly dividend declaration in September 2013).

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.

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