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Focus of Article:

The focus of this article is to provide a detailed analysis with supporting documentation on the dividend sustainability of American Capital Agency Corp. (NASDAQ:AGNC). This analysis will be provided after a brief overview of AGNC's operations including a discussion of AGNC's real estate investment trust (REIT) classification per the Internal Revenue Code ('IRC'). AGNC's dividend sustainability analysis will first be composed of two tests. These two tests will be termed "TEST 1" and "TEST 2." After these two tests are analyzed, some recent trends to consider in a rising interest rate environment will also be discussed. These trends will have a direct impact on AGNC's future dividend sustainability and therefore should also be addressed.

Due to the length of the material covered in this article, I feel it is necessary to break AGNC's dividend sustainability analysis into two parts. This article will be broken-down by the following categories:

PART 1:

- Brief Overview of AGNC

- AGNC's REIT Classification per the IRC

- Estimated REIT Taxable Income ('ERTI') Overview

- TEST 1: Analysis and Results

- TEST 2: Analysis and Results

- Brief Discussion of MTGE's Dividend Sustainability (When Compared to AGNC):

PART 2:

- Additional Trends to Consider in a Rising Interest Rate Environment Regarding AGNC's Dividend Sustainability

In a future article, I will project AGNC's dividend range scenarios for the fourth quarter of 2013.

Author's Note: This two-part article is a very detailed look at AGNC's dividend sustainability. I perform this detailed analysis for readers who anticipate/want such an analysis performed each quarter. For readers who just want the summarized conclusions/results, I would suggest to just scroll down to the "Conclusions Drawn" section at the bottom of the each part of the article.

Understanding the REIT tax/dividend payout characteristics of AGNC will provide investors with an overall better understanding of the mortgage real estate investment trust (mREIT) sector as a whole. Due to the fact AGNC has produced an annual dividend yield of at least 13% since its inception in 2008, many investors have turned to this stock (including the entire mREIT sector) as an equity investment which has provided an attractive source of dividend income.

From reading this article, investors will better understand how AGNC comes up with its current dividend rate and specific signs when an impending dividend rise or cut will eventually be implemented. At the end of this article, there will be a conclusion on my personal opinion about the overall dividend sustainability of AGNC for several upcoming quarters. A specific analysis of AGNC's dividend range scenarios for the fourth quarter of 2013 will be discussed in a future article next month.

Side Note: I recently wrote a three-part article on AGNC where I projected its income statement for the third quarter of 2013. In a second article, I projected AGNC's book value ('BV') for the third quarter of 2013 (BV as of 9/30/2013). Even though two specific account assumptions (timing of MBS sales and net "to-be-announced" ('TBA') MBS balance at 9/30/2013) proved to be incorrect regarding these articles (contrary to correct assumptions I projected for the second quarter of 2013), these two sets of articles set the foundation for understanding certain types of figures used within several tables that will be shown within my dividend sustainability analysis. It may be wise for readers to first read my previous articles to gain a better understanding of AGNC's accounts and how certain figures are derived. The following are links to my three-part income statement article and separate BV article:

American Capital Agency's Upcoming Q3 2013 Income Statement Projection (Part 1)

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

American Capital Agency's Upcoming Q3 2013 Income Statement Projection (Part 3)

American Capital Agency's Upcoming Q3 2013 Book Value Projection (As Of September 30, 2013)

General Overview of AGNC:

AGNC is classified as an mREIT which earns a majority of its income from investing (through leverage) in agency mortgage-backed securities ('MBS'). These investments consist of residential mortgage pass-through securities ('RMBS') and collateralized mortgage obligations ('CMO') for which the principal and interest payments are guaranteed by government-sponsored entities ('GSE'). AGNC currently has MBS holdings with the following GSE: 1) the Federal National Mortgage Association (Fannie Mae) (OTCQB:FNMA); 2) the Federal Home Loan Mortgage Corporation (Freddie Mac) (OTCQB:FMCC); and 3) the Government National Mortgage Association (Ginnie Mae). AGNC also occasionally invests in agency debenture securities issued by Fannie Mae, Freddie Mac, or the Federal Home Loan Bank ('FHLB'). For simplicity, agency debenture securities are also generally referred to as MBS.

One of the main goals for AGNC is to preserve its BV while yielding attractive risk-adjusted returns which are ultimately distributed to its stockholders. AGNC funds its activities mainly through short-term borrowings structured as repurchase agreements (repo loans). AGNC enters into repo loans with a number of global counterparties. These repo loans are structured to pay variable interest tied to the London Interbank Offered Rate (LIBOR) with typical maturities ranging from one month to three years. In addition to this variable component, AGNC pays a small fixed rate percentage of interest on its repo loans.

Discussion of AGNC's REIT Classification per the IRC:

AGNC currently qualifies to be taxed as a REIT entity under "Subchapter M" of the IRC. There are numerous REIT provisions that AGNC must adhere by to maintain its qualified REIT status for taxation purposes. However, for purposes of this specific article, we will focus on two specific provisions.

First, AGNC is required to distribute at least 90% of its annual REIT taxable income in a given calendar tax year in order to maintain its qualified REIT status. This provision allows for the exclusion of net capital gains within an entity's annual REIT taxable income amount. If AGNC were to fail this provision, it would be declassified as a REIT under Subchapter M of the IRC for four years. This would have extremely negative ramifications for AGNC. If declassified, AGNC would have to pay corporate level taxes on its annual REIT taxable income. Currently, this would result in a corporate level tax of several hundred million dollars based on AGNC's projected annual REIT taxable income. This would occur because a "dividends paid deduction" would be denied at the entity level under Section 561/562 of the IRC. AGNC would still be able to distribute a dividend, but only after its corporate level tax is accounted for. As such, a much smaller amount of dividend distributions would occur. Therefore, management should deem this specific provision extremely important.

Second, AGNC will not be subject to any federal or state corporate taxes if it distributes all (100%) of its annual REIT taxable income to stockholders. AGNC is allowed to treat dividends declared by September 15th and paid by December 31st of a given year as being a distribution of its annual REIT taxable income from the prior tax year. This is referred as AGNC's "paid-in-arrears" provision (AGNC uses the term "spill-back" provision). This is an important concept to understand and will be specifically discussed in a future article on AGNC's dividend range scenarios for the fourth quarter of 2013.

The two REIT provisions above are the most important determinants regarding AGNC's quarterly dividend rates for current and future periods. AGNC must adhere to the first provision to remain in REIT compliance and is encouraged to meet the second provision to avoid paying corporate or state taxes. Regarding the failure of meeting the first REIT provision, the tax consequences would be staggering from a shareholder's perspective. If AGNC were to fail this first REIT provision, stockholders would basically assume management is incompetent and needs to be replaced.

ERTI Overview:

- See Red References "A, B, C, D, E" in Table 1 Below Next to the September 30, 2013 Column

Before we begin AGNC's dividend sustainability analysis, let us first get accustomed to the information provided by AGNC in Table 1 below. Table 1 is the equivalent to AGNC's quarterly shareholder presentation slide called "Reconciliation of Generally Accepted Accounting Principles (GAAP) Net Income to Estimated Taxable Income." Table 1 below shows AGNC's ERTI from the third quarter of 2013 going back to its fourth quarter in 2012. All figures within Table 1 are for the "three-months ended" (quarterly) timeframe. All (ACTUAL) figures provided in Table 1 below are also derived from AGNC's quarterly SEC submissions via its 10-Q or 10-K where applicable.

Table 1 - AGNC Quarterly ERTI Analysis

(click to enlarge)

The data shown within Table 1 above is part of a larger spreadsheet that performs both TEST 1 and TEST 2 mentioned at the beginning of this article. TEST 1 and TEST 2 will be analyzed later in this article. For now, I am just describing what the accounts in Table 1 mean regarding AGNC's ERTI calculation and where the information is derived from. This will make TEST 1 and TEST 2 easier to follow when the time comes. Let us now take a look at the accounts within Table 1 above (in corresponding order) and briefly discuss AGNC's results for the third quarter of 2013.

A) Net Income (Loss):

- See Red Reference "A" in Table 1 Above Next to the September 30, 2013 Column

The quarterly net income (loss) figures shown in Table 1 above are derived from AGNC's income statement. In an article I previously wrote in regards to AGNC's income statement (see links provided above), I explained in great detail how AGNC reports its quarterly net income (loss) figures.

Regarding its third quarter of 2013, AGNC reported a net loss of ($701) million. This was largely due to AGNC's loss of ($733) million within its "gain (loss) on sale of agency securities, net" account. A further "in-depth" discussion of the quarterly net income (loss) figures will not occur in this article. This article's focus is a dividend sustainability analysis. Therefore, please see my three-part AGNC income statement article for a deeper discussion of the accounts that make up AGNC's quarterly net income (loss) figures.

B) Total Book to Tax Differences (Reversals):

- See Red Reference "B" in Table 1 Above Next to the September 30, 2013 Column

In order for AGNC to come up with a proper ERTI figure, there are specific GAAP to IRC adjustments (reversals) that need to be performed each quarter. Income and expense recognition of certain accounting transactions differ between GAAP and the IRC (book vs. tax accounting treatments).

Certain book vs. tax temporary differences can arise for AGNC near the end of a quarter. One example of a temporary difference could pertain to a sale of an MBS between AGNC and a counterparty near the end of the quarter. GAAP would recognize this sale when an agreement is signed by both parties and a receivable is set up prior to the close of a quarter. However, let us assume AGNC did not actually receive any cash proceeds prior to the close of the quarter. Per GAAP (accrual method of accounting), revenue will be recognized and recorded prior to the close of the quarter because a deal was struck and the likelihood of eventually receiving proceeds from this sale are high. In this instance, the pending revenue from the sale is recorded as if the sale has already occurred and a receivable is set up under GAAP. However, per the IRC (based on the cash method of accounting), the sale of this specific MBS would not be recognized until the cash was actually received by AGNC in the following quarter. Therefore, for tax purposes, any sales of this nature do not occur prior to the close of a quarter. As such, this transaction (and all other similar transactions) needs to be "reversed-out" of the GAAP net income figure.

As shown in Table 1 above, AGNC's "premium amortization, net" account is an account where timing differences occur. This is a noncash GAAP account that is expensed over the estimated life of the MBS. However, for taxation purposes, this account does not exist because it is a noncash account and was initially accounted for when AGNC made its initial purchase of a specific MBS (cash premium paid "upfront"). For the third quarter of 2013, a reversal of ($6) million occurred.

A certain book vs. tax reversal that did not have a balance prior to the third quarter of 2013 is the "capital losses in excess of capital gains" account. For the third quarter of 2013, this account drastically increased AGNC's ERTI figure by $849 million. This reversal is in conjunction with AGNC's realized loss of ($733) million per GAAP regarding its sale of MBS (net of reclassified quarterly interest income). This particular reversal has some specific future ERTI implications which will be discussed in PART 2 of this article.

A major portion of AGNC's "realized ('gain') loss, net" and "unrealized ('gain') loss, net" reversals for the third quarter of 2013 was in conjunction with its following derivative accounts: 1) TBA MBS; 2) interest rate swaps; 3) interest rate swaptions; and 4) U.S. Treasuries. Since most of AGNC's derivative accounts consisted of unsold hedging positions, these net unrealized losses need to be reversed out for taxation purposes until a realized activity occurs (termination, expiration, conversion, or sale). A material portion of AGNC's net realized reversal of ($255) million for the third quarter of 2013 will have some specific future ERTI implications which will be discussed in PART 2 of this article.

In addition to the accounts described above, there could be some additional reversals that need to be performed in a given quarter. For the third quarter of 2013, no remaining material reversals occurred.

C) ERTI; D) Dividend on Preferred Stock; and E) ERTI - Common Shareholders:

- See Red References "C, D, E" in Table 1 Above Next to the September 30, 2013 Column

After adding back (or subtracting out) AGNC's book vs. tax reversals from net income, one can now calculate AGNC's ERTI amount (see red reference "C" in Table 1 above). Once this figure is known, one subtracts out AGNC's quarterly dividend distributions on its preferred shares (see red reference "D" in Table 1 above). Once this is complete, the ERTI for common stockholders figure is known (see red reference "E" in Table 1 above). As discussed earlier, this figure is extremely important for AGNC. Due to the specific provision stating an entity must distribute at least 90% of its annual ERTI to retain its qualified REIT status, AGNC bases its current and future dividend per share amount upon this figure. This is not the only figure AGNC bases its quarterly dividend distributions on. However, it's an extremely important figure regarding required MINIMUM annual dividend distributions.

Now that there is a basic understanding of how AGNC calculates its quarterly ERTI, let us perform AGNC's dividend sustainability analysis. This analysis will be a good indicator of AGNC's current dividend sustainability for the foreseeable future (next several quarters) including whether an impending dividend raise or cut could eventually come to fruition.

Side Note: There are various other indicators and calculations that can help assist or add to one's viewpoint on the dividend sustainability of a company. Some researchers like to prepare some kind of discounted cash flow or "true earnings" analysis based solely on cash. With other sectors or even another mREIT company, I would agree with this notion. However, AGNC's management team provides to the public quarterly ERTI figures. Most companies in general do not provide such disclosures to the public because ERTI is non-GAAP in nature (not an SEC requirement). AGNC's ERTI calculation basically converts its quarterly net income per GAAP into its taxable net income figure per the IRC. Since AGNC provides this valuable information to the public, I feel a discounted cash flow or true earnings analysis is "trumped" by the quarterly ERTI figure (which can also be projected for future quarters). As discussed earlier in the article, since AGNC is classified as a REIT per the IRC, it must pay out 90% of its ERTI in a given year (disregarding the spill-back provision). Table 1 above directly provides information regarding the minimum amount of dividend distributions AGNC must pay out in a given year. Management has consistently stated the company bases its quarterly dividend distributions upon its quarterly ERTI and cumulative undistributed taxable income ('UTI') figures. Therefore, I feel TEST 1 and TEST 2 below will be a good "starting point" for an overall dividend sustainability analysis.

TEST 1 - Quarterly ERTI - Common Stockholders vs. Quarterly Distributions Analysis:

- See Red References "E, G, H" in Table 2 Below Next to the September 30, 2013 Column

Before we begin TEST 1 of AGNC's dividend sustainability analysis, let us first briefly get accustomed to the information provided in Table 2 below. Table 2 is an extension of the information provided in Table 1 above. Table 2 below shows AGNC's ERTI from the third quarter of 2013 going back to its fourth quarter in 2012. All figures within Table 2 are for the "three-months ended" (quarterly) timeframe (same as Table 1 above). Table 2 below also shows AGNC's quarterly dividend distributions. Table 2 then compares AGNC's quarterly ERTI figure to its dividend distributions figure and shows the quarterly underpayment or (overpayment).

Table 2 - AGNC Quarterly ERTI - Common Stockholders vs. Quarterly Distributions Analysis (TEST 1)

(click to enlarge)

AGNC does not provide a table that is comparable to the bottom portion of Table 2 (see red references "G, H, G/E" in Table 2 above). Therefore, Table 2 is partially created by my own researched data. Let us briefly describe the new accounts shown within Table 2 above that were not included in Table 1 earlier in the article.

G) Distributions to Stockholders from ERTI:

- See Red Reference "G" in Table 2 Above Next to the September 30, 2013 Column

These figures represent the quarterly accrual AGNC makes in regards to its dividend distributions to common stockholders. This accrual is made in the current quarter and paid the following quarter. Through research, one can calculate these quarterly amounts via disclosed data.

H) Underpayment (Overpayment) of ERTI:

- See Red Reference "(E - G) = H" in Table 2 Above Next to the September 30, 2013 Column

These figures represent the quarterly underpayment (overpayment) of AGNC's ERTI when compared to its dividend distributions to common stockholders (see red reference "(E - G) = H" in Table 2 above). Table 2 also includes what percentage of quarterly ERTI is paid out in the form of dividend distributions for additional clarity and insight. Again, AGNC does not provide this specific information. However, one can calculate AGNC's quarterly underpayments (overpayments).

TEST 1 - Analysis and Results:

Using Table 2 above as a reference, I take AGNC's quarterly "ERTI - common stockholders" figure (see red reference "E" in Table 2 above) and subtract this amount by the quarterly "distributions to stockholders from ERTI" figure (see red reference "G" in Table 2 above). If AGNC's red reference "E" is greater than its red reference "G", then AGNC technically has enough quarterly ERTI to pay out its dividend distributions for a particular quarter. As such, any excess quarterly ERTI left over after accounting for the dividend distributions would be added to AGNC's cumulative UTI balance. UTI will be further discussed within TEST 2 later on in the article. If AGNC's red reference "E" is less than its red reference "G", then AGNC has currently overpaid its quarterly dividend distributions and must use its remaining cumulative UTI balance to help pay for the overpayment.

Second Quarter of 2013 Dividend:

In a prior dividend sustainability article, I concluded AGNC consistently had ample quarterly ERTI to pay its dividend distributions until the company reported its results for the first quarter of 2013. From the company's fourth quarter of 2010 until its fourth quarter of 2012, AGNC had only three quarters where dividend distributions were over 90% of its quarterly ERTI (out of a possible twelve quarters). These quarters were the first quarter of 2011, the fourth quarter of 2011, and the second quarter of 2012. Even within these three quarters, the dividend distributions payout ratio never exceeded 95% of AGNC's quarterly ERTI. This was an extremely positive sign.

In the second quarter of 2012, AGNC cut its dividend rate from $1.40 to $1.25 per share. After performing this dividend cut, AGNC only distributed a measly 58% of its quarterly ERTI for that particular quarter. This dividend cut was anticipatory due to the gradual decrease in overall market interest rates in the latter half of 2012 (hence eventually a lower yield on its MBS portfolio). People could argue whether the dividend cut was even needed at the time because AGNC's cumulative UTI surplus almost quadrupled in size during 2012. As shown in Table 2 above, AGNC only distributed 65% of its quarterly ERTI during the fourth quarter of 2012. This extremely low payout ratio did not even include a dividend cut for that particular quarter.

However, beginning in the first quarter of 2013, AGNC's quarterly ERTI figure began to show signs of distress. The first quarter of 2013 was not particularly a "pretty" quarter regarding AGNC's quarterly ERTI figure. AGNC only generated a quarterly ERTI figure of $0.50 per share while distributing a quarterly dividend of $1.25 per share. This equated to an overpayment ratio of 282% due to a quarterly overpayment of ($322) million. Such a huge overpayment caused AGNC's lofty cumulative UTI surplus to lose approximately 43% of its balance in just one quarter.

As I correctly projected in a prior dividend range scenarios article for the second quarter of 2013, the weak quarterly ERTI figure for the first quarter of 2013 resulted in a more cautionary outlook regarding AGNC's dividend sustainability. This prior article stated a dividend cut would occur in the second quarter of 2013. As such, when AGNC declared a dividend cut of 16% (or $0.20 per share) for the second quarter of 2013, I was not surprised. For some interested parties (including myself), this dividend cut was actually less than anticipated given the weak quarterly ERTI figure reported in the first quarter of 2013.

For the second quarter of 2013, AGNC reported a quarterly ERTI figure of $1.04 per share. This was basically in line with AGNC's reduced dividend of $1.05 per share. As such, AGNC's cumulative UTI surplus only decreased $0.01 per share to $1.07 per share. When compared to the first quarter of 2013, the second quarter of 2013 saw a nice "bounce-back" in AGNC's quarterly ERTI figure. However, AGNC's $411 million of quarterly ERTI for the second quarter of 2013 was not a figure to overly rejoice from. AGNC's payout ratio was still an elevated 102% for the second quarter of 2013. Compared to past quarters, this payout ratio was "mediocre" at best.

Through the first two quarters of 2013, AGNC had ERTI of $588 million available to common stockholders. However, AGNC had already distributed $919 million of dividends. When combining both quarters, this equated to an overpayment of ($331) million or a dividend distributions payout ratio of 156%. When compared to AGNC's past payout ratios through the first half of the year, 2013 was by far the worst year regarding overpayment of its dividend when compared to its ERTI figure. Between the years 2009-2012, the worst payout ratio for the first half of the year was 89% in 2011. The best payout ratio of 69% was in 2012. AGNC's 2013 payout ratio, through the first half of the year, was a pretty glaring deviation from its past results. This was a rather troubling sign for AGNC's future dividend sustainability.

Third Quarter of 2013 Dividend:

As I correctly projected in a past dividend sustainability article, I concluded the relatively average quarterly ERTI figure from AGNC's second quarter of 2013 resulted in a continued negative outlook regarding the company's dividend sustainability. Within this analysis, I noted the MBS market continued to show signs of a material price deterioration that begin in May and continuing through the first half of the third quarter of 2013. The material MBS price declines were attributed to a rapid "spike" in mortgage interest rates and US Treasury yields brought on by the possible "tapering" of the Federal Reserve's ('FED') Quantitative Easing Program (QE3). Due to the MBS market continuing to show signs of a material price deterioration throughout the latter half of the second quarter of 2013 and first half of the third quarter of 2013, AGNC's management made the decision of becoming extremely defensive regarding its MBS portfolio. As such, management aggressively implored three strategies.

First, AGNC converted its entire net long TBA MBS balance. AGNC converted its entire net long TBA MBS balance as of 6/30/2013 into regular MBS thus recognizing realized losses upon the conversion. Second, AGNC continued to decrease its exposure to 30-year fixed-rate MBS and increased its proportion of less price sensitive 15-year MBS. This caused additional realized valuation losses on the sold MBS. Upon these sales, AGNC "re-rolled" its MBS portfolio into higher MBS coupons. Third, AGNC continued to hold a rather large hedging portfolio throughout most of the third quarter of 2013. When combining these three strategies, this caused an excessively low ERTI figure of only $116 million for the third quarter of 2013.

As a result of the three defensive strategies mentioned above, it was not too surprising to hear AGNC's cautious tone regarding its dividend distributions for the third quarter of 2013. Per AGNC's second quarter of 2013 earnings call with participants, Chief Investment Officer (NYSE:CIO) Gary Kain stated the following:

"…However, it is important to point out that our taxable income in the third quarter is currently biased materially lower given some of the actions we took in both the second quarter and third quarters, which will be realized for taxable earnings purposes in Q3..."

From this quote, it was pretty evident AGNC had some short-term disruptions regarding the sustainability of its dividend (as I correctly predicted in my past dividend sustainability article referenced earlier).

Due to the aggressive defensive measures by management (along with MBS price declines), I correctly projected AGNC would further decrease its dividend in the third quarter of 2013. This was provided via my dividend range scenarios article for the third quarter of 2013. As such, when AGNC declared an additional dividend cut of 24% (or $0.25 per share) for the third quarter of 2013, I was not too surprised. For some interested parties (including myself), this dividend cut was actually more than anticipated given the modest ERTI figure reported in the second quarter of 2013. However, the larger than expected dividend cut was countered by the repurchase of 11.9 million shares during the third quarter of 2013 at a material discount to BV.

Using Table 2 above a reference, for the third quarter of 2013, AGNC reported a quarterly ERTI figure of only $0.29 per share. As was the case in the first quarter of 2013, this was materially lower than AGNC's dividend distributions of $0.80 per share for the third quarter of 2013. As such, AGNC's cumulative UTI surplus materially decreased from $1.07 per share to $0.57 per share during the third quarter of 2013. When compared to the second quarter of 2013, this past quarter was a material decline in AGNC's quarterly ERTI figure. Very similar to AGNC's payout ratio of 288% for the first quarter of 2013, the third quarter of 2013 saw a quarterly payout ratio of 275%. When compared to past quarters, this payout ratio was excessively high.

Through the first three quarters of 2013, AGNC had ERTI available to common stockholders of $710 million. However, AGNC had already distributed $1.23 billion of dividends. When combining all three quarters, this equated to an overpayment of ($528) million and a payout ratio of 173%. When compared to AGNC's past payout ratios through the first three quarters of the year, 2013 was by far the worst year regarding the overpayment of its dividend. This is a rather troubling sign for AGNC's future dividend sustainability.

When combining TEST 1 and my recent articles on AGNC together, a good foundation is formed on AGNC's recent performance regarding its quarterly ERTI. However, TEST 1 does not come with certain drawbacks and limitations. This is why additional analysis will be performed within this article. TEST 1 does not specifically account for AGNC's cumulative UTI data (will be discussed in TEST 2 below) or any future trends and considerations (will be discussed in PART 2 of this article). Since TEST 1 does not specifically include these additional features, it would only be prudent to now perform TEST 2 regarding AGNC's cumulative UTI figure and see if similar results can be ascertained. TEST 2 needs to be performed to gain further clarity on the sustainability of AGNC's dividend in the upcoming quarters.

TEST 2 - Cumulative UTI Coverage of Quarterly Dividend Distributions Ratio Analysis:

- See Red References "I, J, K" in Table 3 Below Next to the September 30, 2013 Column

Before we begin TEST 2 of AGNC's dividend sustainability analysis, let us first briefly get accustomed to the information provided in Table 3 below. Table 3 is an extension of the information provided in Table 2 above. Table 3 below shows AGNC's dividend distributions from the third quarter of 2013 going back to its fourth quarter in 2012. Table 3 also shows AGNC's quarterly underpayment (overpayment) of its ERTI (discussed in Table 2 and TEST 1 above). Table 3 below then compares AGNC's quarterly dividend distributions to its cumulative UTI balance for the same quarter. All figures within Table 2 are for the "three-months ended" (quarterly) timeframe (same as Tables 1 and 2 above) except for AGNC's cumulative UTI balance. AGNC's cumulative UTI figure is a "running balance" that either increases or decreases each quarter as the company either underpays (overpays) its quarterly dividend distributions.

Table 3 - AGNC Cumulative UTI Coverage of Quarterly Dividend Distributions Ratio Analysis (TEST 2)

(click to enlarge)

AGNC does not provide a table that is comparable to Table 3 (red references "G, H, I, J, K" in Table 3 above). Therefore, Table 3 is created by my own researched data. Let us briefly describe the new accounts shown within Table 3 above that were not included in Table 2 earlier in the article.

I) Cumulative UTI Recalculation; and J) Cumulative UTI Balance:

- See Red References "I, J" in Table 3 Above Next to the September 30, 2013 Column

UTI is the cumulative running balance of AGNC's past undistributed ERTI after the company accrues for its quarterly dividend distributions. The cumulative UTI balance increases if AGNC's quarterly ERTI figure is more than the accrued quarterly dividend distributions figure. The cumulative UTI balance deceases if AGNC's quarterly ERTI figure is less than the accrued quarterly dividend distributions figure.

TEST 2 - Analysis and Results:

Using Table 3 above as a reference, I take AGNC's "cumulative UTI" figure (see red reference "J" in Table 3 above) and divide this amount by the quarterly "distributions to stockholders from ERTI" figure (see red reference "G" in Table 3 above). From this calculation, AGNC's "cumulative UTI coverage of quarterly dividend distributions ratio" is obtained (see red reference "J / G = K" in Table 3 above). This can also be referred to as AGNC's "UTI per share" amount. The higher this ratio (or per share amount) gets, the more positive the results regarding AGNC's future dividend sustainability. Basically, this ratio/ per share amount shows the amount of cumulative UTI covering the current quarter's dividend distributions (after taking the current quarter's dividend distributions accrual into account).

Prior to the first quarter of 2013, AGNC's cumulative UTI coverage of quarterly dividend distributions ratio gradually increased since the first quarter of 2011. There were a few quarters within 2011 and 2012 where this ratio slightly dropped for a quarter. However, the ratio eventually continued to rise higher in subsequent quarters. For the first quarter of 2011, AGNC's cumulative UTI coverage of quarterly dividend distributions ratio was only a factor of 0.40. However, by the fourth quarter of 2012, this ratio grew to a factor of 1.76. This was AGNC's highest cumulative UTI coverage of quarterly dividend distributions ratio ever. This equated to a cumulative UTI balance of $749 million as of 12/31/2012. This was an extremely positive sign at the time as AGNC had a massive UTI surplus balance.

However, when AGNC reported a very weak quarterly ERTI figure of $0.50 per share for the first quarter of 2013 (as mentioned in TEST 1 above), TEST 2 also began showing signs of stress in regards to AGNC's dividend sustainability. AGNC's cumulative UTI coverage of quarterly dividend distributions ratio fell from a factor of 1.76 as of 12/31/2012 to only a factor of 0.86 as of 3/31/2013. AGNC's results for the first quarter of 2013 were extremely negative regarding TEST 2. As mentioned in TEST 1 above, AGNC had a quarterly overpayment of ($322) million in the first quarter of 2013. Such a material overpayment caused AGNC's cumulative UTI balance to lose approximately 43% of its overall surplus within three months. AGNC's cumulative UTI balance went from $746 million as of 12/31/2012 to $430 million as of 3/31/2013. For just one quarter's worth of activity, this was a huge hit to AGNC's cumulative UTI surplus.

As was the case with TEST 1, TEST 2 showed stabilization during AGNC's second quarter of 2013. For the second quarter of 2013, AGNC reported a cumulative UTI surplus balance of $422 million. As such, only a cumulative UTI decrease of ($8) million occurred during the second quarter of 2013. Since AGNC cut its dividend during the second quarter of 2013, instead of having to achieve a quarterly ERTI amount of nearly $500 million before "breaking-even" within its cumulative UTI balance, AGNC now only needed to achieve a quarterly ERTI amount of approximately $420 million to break-even. This was one positive piece of data from TEST 2's analysis at the time. Furthermore, if AGNC were to repurchase some outstanding common shares in future quarters (strong possibility in the current environment), its quarterly cumulative UTI break-even amount would continue to decrease.

Another piece of positive news was that AGNC still had a cumulative UTI surplus balance as of 6/30/2013. AGNC's cumulative UTI coverage of quarterly dividend distributions ratio rose from a factor of 0.86 as of 3/31/2013 to a factor of 1.01 as of 6/30/2013. This partially occurred from the material dividend cut that occurred in the second quarter of 2013. Even though this ratio's increase was due to AGNC's dividend cut, any rise in this ratio is positive news. To put this ratio in perspective, AGNC had a cumulative UTI coverage of quarterly dividend distributions ratio of 0.57 as of 12/31/2011 before a dividend cut in the first quarter of 2012. If future quarters showed this ratio beginning to lower once again, the probability of a future quarterly dividend cut would increase in likelihood. Unfortunately, this was exactly what occurred during the third quarter of 2013.

Once again, AGNC reported a very weak quarterly ERTI figure of $0.29 per share for the third quarter of 2013 (as stated in TEST 1 above). Therefore, once again TEST 2 shows signs of stress in regards to AGNC's dividend sustainability. AGNC's cumulative UTI coverage of quarterly dividend distributions ratio fell from a factor of 1.01 as of 6/30/2013 to a factor of 0.70 as of 6/30/2013. This factor even takes into consideration the additional dividend cut of $0.25 per share that occurred during the third quarter of 2013. AGNC's results for the third quarter of 2013 were fairly negative regarding TEST 2 (not as bad as TEST 1 though). AGNC had a quarterly overpayment of ($198) million in the third quarter of 2013. Such a material overpayment caused AGNC's cumulative UTI surplus to lose an additional 48% of its overall balance within three months. AGNC's cumulative UTI surplus balance went from $425 million as of 6/30/2013 to $219 million as of 9/30/2013. For just one quarter's worth of activity, this was a material hit to AGNC's cumulative UTI surplus.

However, going forward, there are a few positive points to consider. Since AGNC's current stock price trades materially lower than its stated BV of $25.27 per share as of 9/30/2013, additional equity raises will not occur (extremely low probability; dilution of BV). As such, AGNC's quarterly break-even on its cumulative UTI balance will not materially increase over the next several quarters (at the very least). Considering the recent bearish nature of the market in regards to the mREIT sector, it may be a while until AGNC's stock price climbs above its CURRENT BV. Strictly on a cumulative UTI break-even basis, this spells good news for AGNC.

Back in the first quarter of 2013, AGNC paid out a quarterly dividend of $1.25 per share on outstanding common shares of 396.5 million. When including its preferred stock dividend, AGNC paid out a total quarterly dividend distributions of $499 million. However, mainly due to the material dividend cut from $1.25 to $1.05 per share, AGNC's quarterly dividend distributions dropped to $420 million for the second quarter of 2013. The same trend continued in the third quarter of 2013. AGNC cut its common stock dividend from $1.05 to $0.80 per share resulting in quarterly dividend distributions of only $311 million. This was a $189 million reduction in AGNC's quarterly dividend distributions over the course of three quarters. As such, AGNC currently needs to only maintain a quarterly ERTI figure of approximately $300 million to maintain its cumulative UTI surplus balance of $219 million.

Brief Discussion of MTGE's Dividend Sustainability (When Compared to AGNC):

Using Table 4 below as a reference, let us briefly compare AGNC to its sister company American Capital Mortgage Corp. (NASDAQ:MTGE) regarding TEST 1 and TEST 2.

Table 4 - AGNC Versus MTGE Dividend Sustainability Analysis (TEST 1 and TEST 2)

(click to enlarge)

Let us first discuss TEST 1. When compared to AGNC, MTGE had a much better quarterly ERTI per share figure for the third quarter of 2013. AGNC had a quarterly ERTI figure of $0.29 per share (as mentioned in TEST 1 above) while MTGE had a quarterly ERTI figure of $0.85 per share. As such, for the third quarter of 2013, AGNC had a quarterly overpayment of ($197.9) million while MTGE had a quarterly underpayment of $9.5 million. When calculated, this translated to AGNC having a quarterly payout ratio of 275% (as mentioned in TEST 1 above) while MTGE had a quarterly payout ratio of just 80%. Therefore, MTGE clearly outperformed AGNC regarding TEST 1.

Now let us discuss TEST 2. Using Table 4 above as a reference, it looks like both companies had a similar cumulative UTI per share figure as of 9/30/2013. Since AGNC actually had a better cumulative UTI per share figure as of 6/30/2013 when compared to MTGE, both companies now have an extremely similar cumulative UTI per share surplus balance as of 9/30/2013. As of 9/30/2013, AGNC had a cumulative UTI surplus balance of $0.57 per share while MTGE had a cumulative UTI surplus balance of $0.60 per share.

However, when compared to AGNC, MTGE's cumulative UTI coverage of quarterly dividend distributions ratio seems to be slightly better as of 9/30/2013. AGNC's cumulative UTI coverage of quarterly dividend distributions ratio was a factor of 0.70 while MTGE's ratio was a factor of 0.86 as of 9/30/2013. Therefore, I feel the slight edge goes to MTGE regarding TEST 2.

When combining the results for both TEST 1 and TEST 2, both companies have a very similar current outlook regarding its dividend sustainability. One could argue the slight edge goes to MTGE. However, since both companies now have a nearly identical TBA MBS balance (this was not the case as of 6/30/2013 hence MTGE had a better quarterly ERTI figure), MTGE's edge is extremely small as of 9/30/2013.

Additional comparisons between AGNC and MTGE regarding future dividend sustainability considerations will be provided in PART 2 of this analysis.

Conclusions Drawn (PART 1):

To sum up all the information in PART 1 of this article (mainly the results from TEST 1 and TEST 2), there is rather strong evidence that AGNC's quarterly dividend of $0.80 per share will come under pressure in future quarters. Some troubling signs are still being shown regarding the results from TEST 1 and TEST 2 (especially TEST 1). As concluded from both TEST 1 and TEST 2, if AGNC has another weak quarter or several modestly weaker quarters regarding ERTI, the future sustainability of AGNC's dividend at the $0.80 per share rate will definitely be in jeopardy. This could occur within AGNC's next dividend declaration in the fourth quarter of 2013.

TEST 2 showed any future material overpayments of AGNC's quarterly ERTI figure would cause its cumulative UTI surplus balance to be further reduced. Rather than have this occur, AGNC would seriously consider an additional dividend cut in all likelihood. However, TEST 2 showed that due to AGNC's material dividend cuts in the second and third quarters of 2013, its cumulative quarterly UTI break-even has decreased nearly $190 million from the first quarter of 2013. Furthermore, TEST 2 also showed if AGNC only had a minor shortfall in its quarterly ERTI figure (when compared to its quarterly dividend distributions break-even of approximately $311 million), this minor deficit could be offset by AGNC's cumulative UTI balance of $219 million as of 9/30/2013. AGNC's cumulative UTI coverage of quarterly dividend distributions ratio still is at a modestly positive factor of 0.70 as of 9/30/2013.

From the data presented above regarding TEST 1 and TEST 2, there seems to be a few positive signs regarding AGNC's dividend sustainability for the upcoming quarters. However, I feel these positive factors are overshadowed by the growing negative factors pertaining to AGNC's dividend sustainability (especially in the next quarter or two).

Based on the mixed results shown via TEST 1 and TEST 2 above (more negative versus positive), I feel it is only prudent to include additional research regarding AGNC's current environment regarding interest rates and MBS valuations. Some additional factors to consider, mainly in a rising interest rate environment, will be addressed in PART 2 of this analysis. This analysis should be available to readers within a week.

Source: American Capital Agency's Dividend Sustainability Analysis (Post Q3 2013 Earnings) - Part 1