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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 for a detailed projection of American Capital Agency Corp.'s (NASDAQ:AGNC) third quarter of 2013 income statement regarding the following accounts: 1) interest income; 2) interest expense; and 3) gain (loss) on sale of agency securities, net. PART 1 helps lead to a better understanding of the topics and analysis that will be discussed in PART 2. The link to PART 1's analysis is provided below:

PART 1 - American Capital Agency's Upcoming Q3 2013 Income Statement Projection

This three-part article is a very detailed look at AGNC's income statement. I perform this level of detail for readers who anticipate/want the detailed aspects of such an analysis. For readers who just want the summarized account projections, I would suggest to just look at the bold headers below and/or read the "Conclusions Drawn" section at the bottom of each part of the article.

Focus of PART 2 of Article:

The focus of PART 2 of this article is to provide a detailed projection of American Capital Agency Corp.'s third quarter of 2013 income statement regarding the following accounts: 4) "gain (loss) on derivative instruments and other securities, net" (including four "sub-accounts"); and 5) "management fees." PART 2 will also discuss AGNC's projected net income and earnings per share ('EPS') amounts.

Predicting a company's accounting figures within the mortgage real estate investment trust (mREIT) sector are usually more difficult when compared to other sectors due to the various derivative and asset portfolio strategies that are implemented by management each quarter. As such, there are several assumptions used when performing such an analysis. AGNC's actual reported values may differ materially from my projected values within this article due to unforeseen circumstances. This includes a deviation from the typical business strategies by management in a specific quarter when compared to past quarters. Readers should be aware as such. All projections within this article are my personal estimates and 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-month ended" (quarterly) time frame.

Since all the income statement accounts that will be discussed in PART 2 of this article are referenced back to Table 1 (provided in PART 1 of this article), I feel Table 1 should be shown within PART 2 as well. This also makes sense in case some readers did not read PART 1 of this article. Table 1 shows AGNC's quarterly income statements (ACTUAL) for the trailing twelve months going back to the third quarter of 2012 and my projection for the third quarter of 2013 (ESTIMATE). 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


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Table 1 is the main source of summarized data regarding AGNC's net income. As such, all material accounts within Table 1 above have been (via PART 1) and will be (via PART 2) separately analyzed and discussed in corresponding order to the boxed blue references next to the September 30, 2013 column.

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

- Estimate of ($30) Million; Range ($330) - $270 Million

- Confidence Within Range = Moderate to High

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

Projecting AGNC's gain (loss) on derivative instruments and other securities, net account is an analysis that involves several "sub-accounts." This includes making assumptions within some of the derivative sub-accounts (where applicable). One will never fully know management's current, detailed derivative activities for the current quarter until results are provided to the public via the company's quarterly SEC submissions. However, one can understand management's overall derivative strategy and make a projection on these derivative sub-accounts using the balances that were represented at the end of the previous quarter. Such a detailed analysis was critical for the second quarter of 2013 due to the events that unfolded throughout the quarter in regards to MBS prices, interest rate swap and swaption valuations, and U.S. Treasury yields.

Using my specific valuation methodologies for this account, I was able to project AGNC would report a second quarter of 2013 gain on derivative instruments and other securities, net of $1.50 billion. When compared to AGNC's actual reported gain on derivative instruments and other securities, net of $1.44 billion, my projected figure was off $60 million or off by 4% of the reported balance. As such, my projection for the second quarter of 2013 yielded an accuracy of 96%. I'm not saying each quarter will provide such a close result, however, the specific valuation methodology I use should provide an accurate result within a specified range each quarter.

Side Note: Since AGNC's gain (loss) on derivative instruments and other securities, net account is usually more difficult for readers to understand, I feel two references/links to past articles I wrote regarding this account is warranted. As stated above, this particular account has several sub-accounts that will be discussed in detail below. However, due to the sheer amount of data I'm already presenting within this three-part article, I am omitting from this article all supporting valuation tables on the four main derivative sub-accounts. The main purpose of this three-part article is to provide a projection of AGNC's third quarter of 2013 income statement with a "line-by-line" mentality at each account's "main" level. As such, this particular article will not directly show HOW to value each material derivative instrument. If I included such a lengthy discussion/breakdown within this article, it would make this article entirely too long. Any reader unfamiliar with AGNC's derivative portfolio should really read my past articles. There are also a select few authors on Seeking Alpha who also provide an educational and informative discussion on this topic. Specifically, in regards to AGNC's derivative portfolio and how each derivative instrument is valued, the following two links to my past AGNC articles provides a good detailed discussion and analysis on the subject:

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

American Capital Agency's Mid-Q3 2013 Book Value Projection And Derivative Portfolio Valuation Analysis - Part 3

Now let us take a look at AGNC's gain (loss) on derivative instruments and other securities, net account. I show my projection for this figure via Table 5 below. All past (ACTUAL) figures within Table 5 are derived from AGNC's quarterly SEC submissions via its 10-Q or 10-K where applicable. All projected (ESTIMATE) sub-account figures within Table 5 are calculated and derived from multiple tables/charts that will not be shown within this particular article. As stated earlier, please see the linked article above for some of the detailed spreadsheets used to generate such projections for AGNC's gain (loss) on derivative instruments and other securities, net sub-accounts.

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


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

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

b) Interest Rate Swaps (Net Short Position)

c) Interest Rate Swaptions (Net Short Position)

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

Each of the four material derivative sub-accounts listed above will be separately analyzed and discussed in corresponding order to the blue references under the "Ref." column in Table 5 above.

Side Note: Even though in past AGNC income statement projection articles I have split all derivative sub-accounts into "realized" and "unrealized" figures within Table 5 above, this really does not make a difference in regards to the overall amounts reported within this account. As long as the realized and unrealized amounts are combined and represented in Table 5 above, it does not currently matter if AGNC's derivative instruments are broken out between realized and unrealized for GAAP reporting purposes. Depending on the specific type or nature of the derivative instrument, a possible reclassification of an account to a different part of the income statement may be deemed necessary under GAAP. One example is if AGNC designated its interest rate swaps as cash flow hedges (which it currently does not do). The realized versus unrealized breakout is only currently important for estimated REIT taxable income purposes (which impacts the dividend). However, this figure is a topic suited best for an article regarding AGNC's dividend (not income statement projection). Therefore, any further discussion on the breakout of the realized and unrealized figures will be omitted from this article. Since both realized and unrealized accounts are combined, tracing the four material sub-account balances discussed below to Table 5 above is now easier and more "reader friendly."

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

- Estimate of $170 Million; Range ($30) - $370 Million

- Confidence Within Range = Moderate

- See Black Highlighted, Blue Referenced Sub-Account "a)" in Table 5 Above Within the "Ref." Column

Let us first discuss a brief history of this account, which will lead to a better explanation of its projected value for the third quarter of 2013. AGNC's "to-be-announced" ('TBA') "mortgage-backed securities" ('MBS') and forward settling agency securities position at 3/31/2013 was the largest net long position in regards to notional value within the gain (loss) on derivative instruments and other securities, net account. During the fourth quarter of 2012 and first quarter of 2013, AGNC greatly increased its off-balance sheet position of its TBA MBS and forward settling agency securities. At the end of the third quarter of 2012, AGNC had a net long TBA MBS and forward settling agency securities position of $3.8 billion (again, based on notional amount). By the end of the fourth quarter of 2012, this net long position grew to $12.5 billion. By the end of the first quarter of 2013, this net long position basically doubled to a balance of $26.3 billion. AGNC was increasing this position due to extremely low interest rate environment offered throughout 2012 and into 2013 due to the implementation of the Federal Reserve's ('FED') third round of quantitative easing ('QE3') $85 billion bond purchasing program. AGNC's management wanted to receive additional interest income during this low interest rate environment without financing via repurchase agreements (as is the case with regular MBS). This particular strategy could be very beneficial as long as general interest rates remained suppressed.

AGNC felt the FED's QE3 purchasing program would keep rates relatively low for an extended period of time. However, if mortgage interest rates / U.S. Treasury yields rose, AGNC's "dollar-roll" income would be offset by TBA MBS and forward settling agency security valuation losses (due to the decrease in MBS prices). AGNC's TBA MBS and forward settling agency securities strategy had mixed results in regards to the first quarter of 2013 as mortgage interest rates / U.S. Treasury yields crept higher for a good portion of the quarter (which directly causes MBS prices to decrease). Since AGNC continued to increase its net long position from 12/31/2012 to 3/31/2013, the second quarter of 2013 was shaping up to be detrimental if a rapid rise in rates occurred.

Since most readers know mortgage interest rates / U.S. Treasury yields "spiked" during AGNC's second quarter of 2013, its net long TBA MBS and forward settling agency securities position sustained material valuation losses that must be realized due to the overall nature of this type of derivative instrument. As such, AGNC's net long TBA MBS and forward settling agency securities strategy "back-fired" in the second quarter of 2013. However, during the latter half of the second quarter of 2013, AGNC's management started to realize the potential risks associated with its net long TBA MBS and forward settling agency securities position in a rising interest rate environment and began to dramatically lower this balance. The dollar-roll income generated by these derivative instruments was just not worth the risk of valuation losses if interest rates continued to rapidly climb higher. By the end of the second quarter of 2013, AGNC's net long TBA MBS and forward settling agency securities balance was reduced to $14.4 billion. When calculated, the quarterly reduction to this net long position was nearly 50%. Now that we have a better understanding of AGNC's historical net long position regarding this type of derivative instrument, let us discuss how TBA MBS and forward settling agency securities are valued.

There are two main factors that affect AGNC's net long TBA MBS and forward settling agency securities valuation in a given quarter. The first factor is the dollar-roll income generated on the TBA MBS positions. The second factor is the realized valuation gain (loss) upon the "settlement" of the future/forward TBA MBS and forward settling agency security contracts. A realized gain (loss) must be accounted for on all positions that are "re-rolled" to a future settlement date as well. This transpires when AGNC settles the existing TBA MBS and forward settling agency security contract and immediately enters into a new contract with a new settlement date further out on the time horizon.

For the first quarter of 2013, AGNC reported a net TBA MBS and forward settling agency securities loss of ($102) million. As was briefly discussed above, this was due to mortgage interest rates / U.S. Treasury yields creeping higher for a good portion of the quarter. When broken out, AGNC reported dollar-roll income of $142 million. However, AGNC also sustained TBA MBS and forward settling agency security valuation losses of ($244) million.

For the second quarter of 2013, AGNC reported a net TBA MBS and forward settling agency securities loss of ($572) million. As was briefly discussed above, this was due to mortgage interest rates / U.S. Treasury yields "spiking" higher during the second half of the quarter. When broken out, AGNC reported dollar-roll income of $188 million. However, AGNC also sustained material TBA MBS and forward settling agency security valuation losses of ($760) million.

As will be discussed further in PART 3 of this article, mortgage interest rates / U.S. Treasury yields generally continued to rise throughout most of the third quarter. However, after the FED announced it will not begin to "taper" its QE3 purchasing program in September 2013, mortgage interest rates / U.S. Treasury yields quickly dropped. As a result, valuation losses sustained in regards to AGNC's regular MBS, TBA MBS, and forward settling agency securities quickly reversed course during the last two weeks of the quarter.

As such, the main question regarding this derivative sub-account will be how much dollar-roll income and valuation gains (losses) will occur during the third quarter of 2013. This will depend on how much of AGNC's net long TBA MBS and forward settling agency securities were "converted" prior to the FED's September 2013 "non-tapering" announcement. As such, three possible scenarios likely occurred. If the assumption is made that a majority of AGNC's TBA MBS and forward settling agency securities were converted prior to the FED's announcement in September 2013, AGNC will most likely recognize a slim loss for this derivative account. However, it should be noted if this assumption is correct, a majority of these TBA MBS and forward settling agency securities were converted prior to the FED's announcement in September 2013. As such, modest valuation gains will be recorded within AGNC's "unrealized gain (loss) on available-for-sale securities, net" account (will be discussed in PART 3) because of the conversion to regular MBS. If the assumption is made that a majority of AGNC's TBA MBS and forward settling agency securities were not converted prior to the FED's announcement in September 2013, AGNC will most likely recognize a material gain for this derivative account. As such, most valuation gains in regards to AGNC's TBA MBS and forward settling agency securities will not be recorded within AGNC's "unrealized gain (loss) on available-for-sale securities, net" account (will be discussed in PART 3) because of the non-conversion to regular MBS. If the assumption is made that AGNC sold a steady amount of its MBS TBA and forward settling agency securities throughout the quarter, a slim to modest gain will be accounted for in regards to the third quarter of 2013. Therefore, the underlying question is not if AGNC has gains regarding these derivative instruments but in what account will the valuation gain be recorded.

I have personally made the assumption AGNC has sold its TBA MBS and forward settling agency securities throughout the quarter (third scenario). Therefore, I am assuming a modest conversion of AGNC's TBA MBS and forward settling agency securities took place prior to the FED's non-taper decision in mid-September. Even if this assumption proves to be incorrect, the net valuation effect remains nullified. AGNC's gain (loss) on derivative instruments and other securities, net account and its unrealized gain (loss) on available-for-sale securities, net account would offset each other in regards to AGNC's TBA MBS and forward settling agency security valuations (one balance will be understated and one balance will be overstated; net effect of $0).

Through a detailed analysis that will be omitted from this particular article (which was mentioned in a side note at the beginning of this account), I am projecting a third quarter of 2013 net gain of $170 million in regards to AGNC's TBA MBS and forward settling agency securities position. This includes projected dollar-roll income of $95 million and a projected valuation gain of $75 million for this derivative sub-account for the third quarter of 2013.

b) Interest Rate Swaps (Net Short Position):

- Estimate of ($110) Million; Range ($310) - $110 Million

- Confidence Within Range = Moderate to High

- See Purple Highlighted, Blue Referenced Sub-Accounts "b)" in Table 5 Above Within the "Ref." Column

Let us first discuss a brief history of this account, which will lead to a better explanation of its projected value for the third quarter of 2013. AGNC's interest rate swaps position at 6/30/2013 was by far its largest net short position in regards to notional value within the gain (loss) on derivative instruments and other securities, net account. At 6/30/2013, AGNC had a total interest rate swap net short position of ($55.7) billion (based on notional amount). AGNC had ($10.1) billion of interest rate swap additions and $5.7 billion of interest rate swap terminations or expirations during the second quarter of 2013. AGNC continued to increase its 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 8% of AGNC's entire interest rate swaps net short position of ($51.3) billion as of 3/31/2013. AGNC continued to increase its overall interest rate swaps short position due to its "defensive posture" regarding the current environment surrounding rising 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. AGNC had 70% of its interest rate swaps with maturities less than five years while the remaining 30% had maturities over five years.

There are two "broken-out" accounts to discuss within Table 5 above when considering an overall projected gain (loss) on AGNC's interest rate swaps for the third quarter of 2013. The first figure to discuss is AGNC's "periodic interest costs of interest rate swaps, net" account. If one recalls, this figure was discussed in AGNC's interest expense account during PART 1 of the article. In regards to its interest rate swaps net short position at 6/30/2013, AGNC had a "weighted average fixed pay rate" of 1.51% and a "weighted average floating receive rate" of 0.28%. A fixed pay rate is the rate AGNC pays to a counterparty in a payer swap. As overall market rates rise, the fixed interest rate associated with the payer side of all newly created interest rate swaps will increase as well. It should be noted this increase is only on newly created interest rate swap contracts and not on existing interest rate swap contracts. In exchange, AGNC receives interest, which is known as the floating receive rate. Currently, AGNC's average receive rate is based on three-month LIBOR. When compared to the end of the first quarter of 2013, AGNC's weighted average fixed pay rate increased 10 basis points while its weighted average floating rate decreased 2 basis points.

Since AGNC's average fixed pay rate increased and floating receiver rate slightly decreased during the second quarter of 2013, AGNC had an increased expense regarding its periodic interest costs of interest rate swaps, net account (on top of the notional balance increase). When compared to the first quarter of 2013, AGNC paid an additional expense of $21 million in regards to periodic interest costs of interest rate swaps, net account. AGNC is willing to incur this added expense for the sake of potentially offsetting MBS valuation losses with valuation gains associated with its interest rate swaps.

For all newly created interest rate swap contracts during the third quarter of 2013, the overall trends discussed above continued (until the last two weeks in the quarter). The fixed pay rate of all newly created interest rate swap contracts continued to increase as market interest rates continued to rise. In regards to the floating receive rate of all newly created interest rate swap contracts, three-month LIBOR slightly decreased an additional 2 basis points during the third quarter of 2013.

AGNC will once again record a modest increase in its periodic interest costs of interest rate swaps, net account for the third quarter of 2013. This is due to the following three interest rate swap factors: 1) increase in notional balance at 6/30/2013 when compared to 3/31/2013; 2) continued increase in the weighted average fixed pay rate on all newly created interest rate swaps; and 3) continued slight decrease in the average floating receive rate on AGNC's entire interest rate swap net short position.

Due to the three factors listed above, I am projecting an expense of ($135) million in regards to AGNC's periodic interest costs of interest rate swaps, net account for the third quarter of 2013. This is a ($30) million increase from the prior quarter's expense for this account.

The second account relates to AGNC's interest rate swap valuations. Even though AGNC will continue to record a higher net pay rate expense in the current quarter, there should be a slight realized/unrealized valuation gain within the interest rate swaps account. From the continued rise (then subsequent drop) in the fixed pay rate of the open market interest rate swaps during the third quarter of 2013, some of AGNC's existing interest rate swap positions will slightly increase or decrease in value depending on the duration of the interest rate swap. While the fixed pay rate on all newly created interest rate swaps continued to increase during most of the third quarter of 2013, AGNC's existing interest rate swaps already locked in the lower fixed pay rate when initially created in previous quarters. As such, a valuation gain occurs. However, when the FED announced it will not begin to taper its QE3 purchasing program in September 2013, the fixed pay rate on all newly created interest rate swaps quickly dropped during the last two weeks of the quarter. As such, most unrealized valuation gains within this sub-account that occurred during most of the third quarter of 2013 were basically lost at 9/30/2013. This same general scenario occurred throughout all interest rate swap durations.

Using the 4-year interest rate swap as an example, AGNC had a weighted average fixed pay rate of 1.29% for these types of swaps as of 6/30/2013. As of 6/30/2013, the market valued the fixed pay rate of a 4-year interest rate swap at 1.22%. This was the reason AGNC was still carrying a cumulative ($35) million loss on its 4-year interest rate swaps at 6/30/2013. It should be noticed this same type of interest rate swap had a ($535) loss at 3/31/2013. As such, the second quarter of 2013 saw tremendous valuation gains in regards to AGNC's interest rate swaps across all duration classifications. Since market interest rates first continued to rise but then fall sharply in the third quarter of 2013 (hence fixed pay rates fell as well), the 4-year swap now had a fixed pay rate of 1.18% as of 9/30/2013. This is a decrease of 4 basis points during the third quarter of 2013. As such, a small valuation loss occurred within AGNC's 4-year interest rate swaps. Again, AGNC's EXISTING interest rate swaps will not see the slight decrease in its fixed pay rate because the company has already locked-in its fixed pay rate upon creation of the swap in past quarters. This only applies to newly created interest rate swap contracts. However, all existing and newly obtained interest rate swaps will see valuation changes based on the current market's fixed pay rate percentages and changes in the floating receive rate.

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 changes on AGNC's existing interest rate swap positions using a simplified perspective that readers may better understand. As stated at the beginning of this account, please refer to my past AGNC articles to specifically see how certain derivative instruments are valued.

When compared to the prior quarter's ending date, the third quarter of 2013 saw slightly negative to slightly positive interest rate swap valuation changes. As interest rate swap durations lengthened, basis point changes became more positive. For example, the interest rate change on a 3-year interest rate swap decreased 4 basis points during the third quarter of 2013. However, the interest rate change on a 10-year interest rate swap increased 8 basis points. Simply put, extremely minor valuation gains were achieved regarding AGNC's interest rate swaps due to a weighted average duration of 5.7 years at the beginning of the quarter (including forward starting swaps).

Through a detailed analysis that will be omitted from this particular article (which was mentioned in a side note at the beginning of this account), I am projecting a valuation gain of $25 million on AGNC's interest rate swaps for the third quarter of 2013. This gain includes all "interest rate swap termination fees (Markit IOS Index total return swaps)" expenses/valuations. This $25 million interest rate swaps valuation gain will be offset against ($135) million pertaining to the periodic interest costs of interest rate swaps, net account. Therefore, I am projecting AGNC's total loss on its interest rate swaps will be ($110) million for the current quarter. Any interest rate swaps added during the third quarter of 2013 will also have valuation adjustments. This notion is taken into consideration in regards to my ranges for this particular account.

c) Interest Rate Swaptions (Net Short Position):

- Estimate of ($35) Million; Range ($185) - $115 Million

- Confidence Within Range = Moderate

- See Pink Highlighted, Blue Referenced Sub-Account "c)" in Table 5 Above Within the "Ref." Column

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). Let us first discuss a brief history of this account, which will lead to a better explanation of its projected value for the third quarter of 2013. AGNC's interest rate swaptions position at 6/30/2013 was the second largest net short position in regards to notional value on the underlying interest rate swaps within the gain (loss) on derivative instruments and other securities, net account. Similar to its interest rate swaps net short position, AGNC has greatly increased its underlying interest rate swaptions net short position within the past few quarters. At the end of the fourth quarter of 2012, AGNC had an underlying interest rate swaps net short position of ($14.5) billion (based on notional amount). By the end of the first quarter of 2013, this position grew to ($22.9) billion. At the end of the second quarter of 2013, the balance slightly increased to ($23.8) billion. As was the case with its interest rate swaps, AGNC has maintained this large balance of interest rate swaptions (underlying interest rate swaps) in anticipation of rising interest rates. As of 6/30/2013, AGNC's interest rate swaptions had a weighted average duration of 3.9 years until expiration with an underlying interest rate swaps maturity of 8.4 years. When compared to its interest rate swaptions portfolio at 3/31/2013, AGNC extended the duration of its swaptions by 1.5 years. For just one quarter's worth of activity, this is a material duration extension.

As was the case with AGNC's interest rate swaps, there will be a slight valuation gain within the interest rate swaptions account for the third quarter of 2013. From the continued rise (then subsequent drop) in the fixed pay rate of the open market interest rate swaps during the third quarter of 2013, some of AGNC's existing underlying interest rate swap positions (hence interest rate swaptions) will slightly increase or decrease in value depending on the duration of the interest rate swap. While the fixed pay rate on all newly created interest rate swaps continued to increase during most of the third quarter of 2013, AGNC's existing interest rate swaptions already locked in the lower fixed pay rate of the underlying interest rate swaps when initially created in previous quarters. As such, a valuation gain occurs. However, when the FED announced it will not begin to taper its QE3 purchasing program in September 2013, the fixed pay rate on all newly created underlying interest rate swaps (hence interest rate swaptions) quickly dropped during the last two weeks of the quarter. As such, most unrealized valuation gains within this sub-account that occurred during most of the third quarter of 2013 were basically lost at 9/30/2013. This same general scenario occurred throughout all underlying interest rate swap durations (hence interest rate swaption durations). Specifically, this includes a drop in the fair market value ('FMV') of the interest rate swaptions.

It should be noted that adding to AGNC's interest rate swaptions net short position comes at an added cost. When an interest rate swaption contract is initially created (which includes the underlying interest rate swap contract), there is an initial upfront "option" cost. During the second quarter of 2013, AGNC added ($3.2) billion of interest rate swaptions at an added cost of $76 million.

Through a detailed analysis that will be omitted from this particular article (which was mentioned in a side note at the beginning of this account), I am projecting a valuation gain of $15 million on AGNC's interest rate swaptions for the third quarter of 2013. I am also projecting AGNC will add $2 billion of interest rate swaptions during the third quarter of 2013 at an added cost of ($50) million. Therefore, I am projecting AGNC's total loss on its interest rate swaptions will be ($35) million for the current quarter. Any interest rate swaptions added during the third quarter of 2013 will also have valuation adjustments (already projected cost adjustments). This notion is taken into consideration in regards to my ranges for this particular account.

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

- Estimate of ($60) Million; Range ($260) - $140 Million

- Confidence Within Range = Moderate to High

- See Brown Highlighted, Blue Referenced Sub-Account "d)" in Table 5 Above Within the "Ref." Column

Let us first discuss a brief history of this account, which will lead to a better explanation of its projected value for the third quarter of 2013. AGNC's U.S. Treasury securities position at 6/30/2013 was the third largest net short position in regards to face amount within the gain (loss) on derivative instruments and other securities, net account. AGNC has maintained its U.S. Treasury securities net short position within the past few quarters. At the end of the fourth quarter of 2012, AGNC had a U.S. Treasury securities net short position of ($11.8) billion (based on face amount). By the end of the first quarter of 2013, this net short position slightly grew to ($12.6) billion. At the end of the second quarter of 2013, this net short position modestly decreased to ($10.5) billion. This net short balance excludes ($2.4) billion of U.S. Treasury futures sold short and $3.8 billion of net long U.S. Treasury securities (hence an asset on the balance sheet).

AGNC has continued to relatively maintain its U.S. Treasury securities short position in anticipation of rising interest rates. At 6/30/2013, AGNC had a net short position of ($2.0), ($1.1), and ($7.4) billion regarding U.S. Treasury securities with 5, 7, and 10-year maturities, respectively.

As was the case with AGNC's interest rate swaps and swaptions, there will be a slight valuation gain within the U.S. Treasury securities account for the third quarter of 2013. From the continued rise (then subsequent drop) in U.S. Treasury yields during the third quarter of 2013, some of AGNC's existing U.S. Treasury security positions will slightly increase or decrease in value depending on the maturity of the U.S. Treasury security. While the yield on most U.S. Treasury securities continued to increase during most of the third quarter of 2013, AGNC's existing net short position sustained valuation gains as interest rates rose. However, when the FED announced it will not begin to taper its QE3 purchasing program in September 2013, the yields on all U.S. Treasury securities (new and existing) quickly dropped during the last two weeks of the quarter. As such, most unrealized valuation gains within this sub-account that occurred during most of the third quarter of 2013 were basically lost at 9/30/2013. This same general scenario occurred throughout most of the U.S. Treasury maturities.

When compared to the prior quarter's ending date, the third quarter of 2013 saw slightly negative to slightly positive net short U.S. Treasury security valuation changes. As U.S. Treasury maturities lengthened, changes in yield became more positive. For example, the change in yield on a 5-year U.S. Treasury security decreased 2 basis points during the third quarter of 2013. However, the change in yield on a 7 and 10-year U.S. Treasury security increased 12 and 17 basis points, respectively. However, unique to this specific type of derivative instrument (regarding AGNC's derivatives portfolio), the company must lower all valuation gains (losses) by a quarterly interest expense calculated on the net short U.S. Treasury securities position (based on the stated yield).

Through a detailed analysis that will be omitted from this particular article (which was mentioned in a side note at the beginning of this account), I am projecting a valuation gain of $7 million on AGNC's net short U.S. Treasury securities for the third quarter of 2013. However, AGNC also needs to reverse out ($67) million of quarterly interest expense calculated on the net short U.S. Treasury securities position (based on the stated yield) Therefore, I am projecting AGNC's total loss on its net short U.S. Treasury securities will be ($60) million for the current quarter. Any net short U.S. Treasury securities added during the third quarter of 2013 will also have valuation adjustments. This notion is taken into consideration in regards to my ranges for this particular account.

As stated earlier, all remaining accounts within Table 5 above are deemed immaterial for discussion purposes. As such, these immaterial accounts will be omitted from any analysis even though a projected balance has been included in Table 5 above. When adding the four material derivative sub-account balances and all remaining derivative and other security account balances together, I am projecting AGNC's total loss on its derivative instruments and other securities, net account will be ($30) million for the third quarter of 2013.

5) Management Fees:

- Estimate of $35 Million; Range $30 - $40 Million

- Confidence Within Range = High

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

AGNC has a base management fee paid in arrears equal to an amount that is 1/12th of 1.25% of its 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/ (OCL).

I show my projection for this figure via Table 6 below. Some past (ACTUAL) figures within Table 6 are derived from either AGNC's quarterly investor presentation slides or SEC submissions via its 10-Q or 10-K where applicable (or a combination of both). This excludes all recalculated and ratio figures. As such, there will not be an identical sheet AGNC provides that matches the data I have prepared in Table 6 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)

Using Table 6 as a reference, I am projecting a third quarter of 2013 management fee decrease of $2 million when compared to the second quarter of 2013 ($35 million versus $37 million). This is due to the slight decrease in AGNC's monthly average stockholder's equity balance when compared to the second quarter of 2013. This includes a reduced monthly stockholder's equity balance due to the 11.9 million outstanding common shares bought back by AGNC during the third quarter of 2013 (total repurchase price of approximately $263 million). Further analysis and discussion of this account is unwarranted.

Side Note: Two remaining accounts on AGNC's income statement that affect net income are the following: a) general/administrative expenses and b) income tax provision (benefit). These two accounts are immaterial for discussion purposes and will be excluded from any analysis within this article. I do not anticipate any material fluctuations within these two accounts when compared to the prior quarter.

Conclusions Drawn (PART 2):

To sum up all the information in PART 2 of this article, I am projecting AGNC will report the following income statement figures for the third quarter of 2013 (refer to Table 1 at the beginning of the article):

4) Quarterly (Loss) on Derivative Instruments and Other Securities, Net of ($30) Million

5) Quarterly Management Fees of $35 Million

From the continued rise in mortgage interest rates, swap payer rates, and U.S. Treasury yields during most of the third quarter of 2013, AGNC's existing interest rate swaps, interest rate swaptions, and net short U.S. Treasury security positions saw material valuation gains. However, when the FED announced it will not begin to taper its QE3 purchasing program in September 2013, mortgage interest rates, swap payer rates, and U.S. Treasury yields quickly dropped in the last two weeks of the quarter. As such, most unrealized valuation gains across the spectrum of interest rate swaps, interest rate swaptions, and net short U.S. Treasury securities were basically lost. However, as market rates quickly plummeted, MBS prices spiked higher. As a result, all valuation losses sustained in the first half of the third quarter of 2013 in regards to AGNC's TBA MBS and forward settling agency securities reversed course. In fact, a slight valuation gain on AGNC's TBA MBS and forward settling agency securities should occur for the third quarter of 2013.

When adding the four material derivative sub-account balances and all remaining derivative and other security account balances together, I am projecting AGNC's total loss on its derivative instruments and other securities, net account will be ($30) million for the third quarter of 2013.

AGNC's management has continued to properly mitigate some of the risks associated with a rising interest rate environment. As of 6/30/2013, AGNC's hedging portfolio covered 102% of its repurchase agreements, other debt, and net long TBA MBS positions. AGNC has taken this defensive posture to protect BV. Due to the 102% hedging coverage ratio, I personally feel AGNC is currently "fully hedged." To mitigate further risk, AGNC has continued to extend the durations (in some cases maturities) of its interest rate swaps, interest rate swaptions, and net short U.S. Treasury securities as well. Regarding the current quarter, I do not anticipate much of a decline in AGNC's hedging coverage ratio.

I am projecting AGNC will also report slightly reduced management fees when compared to the prior quarter. When compared to the prior quarter, I am projecting a ($2) million reduction in this account due to a slight decrease in AGNC's monthly average stockholders' equity balance. The reduced monthly average stockholders' equity balance is mainly due to the 11.9 million outstanding common shares bought back by AGNC during the third quarter of 2013.

Conclusions Drawn (PART 1 and PART 2):

To sum up all the information in PART 1 and PART 2 of this article, I am projecting AGNC will report the following income statement net income and EPS figure for the third quarter of 2013:

A) Quarterly Net Income of $330 Million and Earnings of $0.84 Per Share

Therefore, in regards to quarterly net income, it looks as though AGNC will either be in-line or slightly beat most analyst forecasts in regards to EPS estimates. As of the date when this article was finalized, the analysts' consensus estimate for AGNC regarding the third quarter of 2013 is earnings of $0.77 per share.

A net income figure of $330 million for the third quarter of 2013 is much less than the reported $1.83 billion for the second quarter of 2013. This is mainly due to AGNC's huge valuation gain on its derivative instruments and other securities, net account for the second quarter of 2013. Even though this is a projected material reduction of AGNC's net income and EPS projection when compared to the prior quarter, investors should also realize that AGNC will most likely have a positive OCI figure for the third quarter of 2013 (will be discussed in PART 3 of this article). As stated earlier in this article, OCI/ (OCL) is accounted for on the income statement but EXCLUDED from AGNC's net income calculation. The OCI/ (OCL) account runs directly through to stockholders' equity on AGNC's balance sheet (which affects BV).

I would suggest holding off on judging AGNC until PART 3 of my IS projection is released. I personally feel AGNC's comprehensive income (loss) account is more important than its net income / EPS account.

Final Note: PART 2 above is only a PARTIAL analysis of AGNC's income statement for the third quarter of 2013. As such, a "full" conclusion regarding AGNC's income statement will not be provided yet. PART 3 will just pick up where PART 2's analysis ends. PART 3's conclusion will discuss AGNC's projected "OCI/ (OCL)" account and "comprehensive income (loss)" account. PART 3 will also summarize AGNC's entire statement of comprehensive income and major points throughout the three parts of the article (will be available to readers early next week).

This will be followed by a detailed analysis on AGNC's BV as of 9/30/2013 (will be available to readers prior to the company's third quarter of 2013 press release in late October).

Source: American Capital Agency's Upcoming Q3 2013 Income Statement Projection (Part 2)