American Capital Agency's Upcoming Q4 2013 Income Statement Projection (Part 2)

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 |  About: American Capital Agency Corp. (AGNC), Includes: MTGE
by: Scott Kennedy

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) income statement for the fourth quarter of 2013 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:

American Capital Agency's Upcoming Q4 2013 Income Statement Projection (Part 1)

This three-part article is a very detailed look at AGNC's income statement. I perform this detailed analysis for readers who anticipate/want such an analysis performed each quarter. For readers who just want the summarized account projections, I would suggest to just scroll down to 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 AGNC's income statement for the fourth quarter of 2013 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.

Side Note: Predicting a company's accounting figures within the mortgage real estate investment trust (mREIT) sector is usually more difficult when compared to other sectors due to the various hedging 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 could occur because management deviates from a company's prior business strategy and pursues a new strategy that was not previously disclosed. 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-months ended" (quarterly) time frame.

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

- Estimate of $520 Million; Range $120 - $920 Million

- Confidence Within Range = Moderate to High

- See Boxed Blue Reference "4" in Table 1 in PART 1 and Table 5 Below Next to the December 31, 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 these derivative sub-accounts. One will never fully know management's current, exact derivative activities for any given 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 back in the second quarter of 2013 due to the events that unfolded in regards to MBS prices, the fixed pay rate on newly created interest rate swaps, and U.S. Treasury yields. While not as extreme, similar results that occurred during the second quarter of 2013 have once again occurred in the fourth quarter of 2013 regarding the variables stated above.

Using my specific valuation methodologies for this account, I was able to project AGNC would report a gain (loss) on derivative instruments and other securities, net of $1.50 billion for the second quarter of 2013. When compared to AGNC's actual reported gain (loss) on derivative instruments and other securities, net of $1.44 billion, my projected figure was an overvaluation of $60 million or 4% of the reported balance. As such, my projection for the second quarter of 2013 yielded an accuracy of 96%. I'm not saying my projections will yield such a high accuracy each quarter. However, the valuation methodologies 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 income statement for the fourth quarter of 2013 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 read my past articles. There are also a select few authors on Seeking Alpha who also provide an educational and informative indirect discussion on this topic. Specifically, in regards to AGNC's derivative portfolio and how each material instrument is valued, the following two links to my past AGNC articles provide a good detailed discussion and analysis on the subject:

American Capital Agency's Mid-Q4 2013 Composition And Valuation Analysis: Part 2

American Capital Agency's Mid-Q4 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 in Table 5 below. All past (ACTUAL) sub-account figures within Table 5 are derived from AGNC's quarterly SEC submissions via the company's 10-Q or 10-K where applicable. All projected (ESTIMATE) sub-account figures within Table 5 below are calculated and derived from multiple tables/charts that will not be shown within this particular article. As stated earlier, please see the two links 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 (Sub-Accounts)

Click to enlarge

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 MBS

b) Interest Rate Swaps

c) Interest Rate Swaptions

d) U.S. Treasury Securities

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

a) TBA MBS and Forward Settling MBS (Net (Short) Position as of 9/30/2013):

- Estimate of ($30) Million; Range ($280) - $220 Million

- Confidence Within Range = Moderate

- See Black Highlighted, Blue Referenced Sub-Account "a)" in Table 5 Above Next to the December 31, 2013 Column

Let us first briefly get accustomed with this type of derivative instrument. Typically, AGNC uses a combination of both long and (short) TBA MBS and forward settling MBS contracts during any given quarter. AGNC enters into TBA contracts with a long position where it agrees to buy, for future delivery, MBS with certain predetermined prices, face amounts, issuers, coupons, and stated maturities. AGNC enters into TBA contracts with a long position as an "off-balance sheet" means of investing in and financing MBS. Since TBA contracts with a long position are an extension of the balance sheet, this increases AGNC's "at risk" leverage. AGNC enters into TBA contracts with a (short) position where it agrees to sell, for future delivery, MBS with certain predetermined prices, face amounts, issuers, coupons, and stated maturities. Since TBA contracts with a (short) position are ultimately a reduction of the balance sheet, this decreases AGNC's "at risk" leverage.

Let us now discuss the history of this sub-account, which will lead to a better explanation of my projected gain (loss) for the fourth quarter of 2013. AGNC's TBA MBS and forward settling MBS balance as of 3/31/2013 was the company's largest net long position in regards to notional value within the gain (loss) on derivative instruments and other securities, net account. AGNC's net long position within this account grew to a balance of $26.3 billion as of 3/31/2013. AGNC was increasing this net long position due to the extremely low interest rate environment due to the implementation of the Federal Reserve's ('FED') third round of quantitative easing ('QE3') $85 billion bond purchasing program. AGNC felt the FED's QE3 purchasing program would keep rates relatively low for an extended period of time. 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 the company's regular MBS). This particular strategy could be very beneficial as long as overall market interest rates remained historically low (which meant MBS prices would remain elevated).

However, if mortgage interest rates/U.S. Treasury yields rose, AGNC's "dollar-roll" income would be offset by TBA MBS and forward settling MBS valuation losses due to the decrease in MBS prices. Since AGNC continued to increase the company's 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 the second quarter of 2013, the company's net long TBA MBS and forward settling MBS position sustained material valuation losses that were realized due to the overall nature of this type of derivative instrument. As such, AGNC's net long TBA MBS and forward settling MBS strategy "back-fired" during the second quarter of 2013.

During the latter half of the second quarter of 2013, AGNC started to realize the potential risks associated with the company's net long TBA MBS and forward settling MBS position in a rising interest rate environment and began to dramatically lower this sub-account's 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. AGNC's net long TBA MBS and forward settling MBS position was reduced to $14.4 billion as of 6/30/2013. When calculated, the quarterly reduction to AGNC's net long position was nearly 50%.

AGNC continued to aggressively decrease the company's net long TBA MBS and forward settling MBS position during the third quarter of 2013. AGNC went from a net long TBA MBS and forward settling MBS position of $14.8 billion as of 6/30/2013 to a net (short) TBA MBS and forward settling MBS position of ($7.3) billion as of 9/30/2013. Management continued to perform such a large, quick reversal of AGNC's net long TBA MBS and forward settling MBS position due to the rapid rise in mortgage interest rates/U.S. Treasury yields during the latter half of the second quarter of 2013 and most of the third quarter of 2013. Now that we have a better understanding of AGNC's historical position regarding this type of derivative instrument, let us discuss how TBA MBS and forward settling MBS are valued.

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

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

For the third quarter of 2013, AGNC reported a TBA MBS and forward settling MBS net valuation gain (loss) of ($82) million. As discussed above, AGNC rapidly changed the company's TBA MBS and forward settling MBS strategy from a net long position of $14.4 billion as of 6/30/2013 to a net (short) position of ($7.4) billion as of 9/30/2013. If mortgage interest rates/U.S. Treasury yields increased while AGNC has a net (short) TBA MBS and forward settling MBS position, AGNC would record a derivative net valuation gain, which will help offset the on-balance sheet MBS valuation losses. However, since mortgage interest rates/U.S. Treasury yields first rose but then subsequently materially decreased during the last two weeks of the third quarter of 2013, AGNC reported this net minor net valuation loss. When broken out, AGNC reported a dollar-roll income (expense) of ($12) million. AGNC also sustained a TBA MBS and forward settling MBS net valuation gain (loss) of ($70) million.

As will be discussed further in PART 3 of this article, mortgage interest rates/U.S. Treasury yields first continued to decrease but then reversed course and modestly rose throughout most of the remaining part of the fourth quarter of 2013. As such, three possible scenarios likely occurred within this derivative sub-account. If the assumption is made that AGNC continued to have a net (short) TBA MBS and forward settling MBS position throughout the fourth quarter of 2013, then the company would have a modest valuation gain for this derivative sub-account (higher end of my projected range). If the assumption is made that AGNC switched back to a net long TBA MBS and forward settling MBS position during the fourth quarter of 2013, then the company would have a modest valuation loss for this derivative sub-account (lower end of my projected range). If the assumption is made that AGNC alternated between a net (short) and net long TBA MBS and forward settling MBS position throughout the quarter, then the company would have a minor to modest net valuation gain or (loss) for this derivative sub-account. The amount of this net valuation gain (loss) would be dependent on the timing of the net long (short) position as rates fluctuated throughout the quarter.

I have personally made the assumption AGNC first changed the company's net (short) TBA MBS and forward settling MBS position to a net long position prior during the first weeks of the fourth quarter of 2013. However, as AGNC began to see overall market interest rates beginning to rise due to stronger than expected economic indicators, I feel management switched the company's TBA MBS and forward settling MBS balance back to a net (short) position to offset the risks associated with a rising interest rate environment. As such, AGNC's net (short) TBA MBS and forward settling MBS position during the latter half of the quarter would have hedged some of the MBS valuation losses that occurred on the company's regular MBS portfolio. Therefore, I feel the third scenario occurred during the fourth quarter of 2013.

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 AGNC's TBA MBS and forward settling MBS sub-account to have a net valuation gain (loss) of ($30) million for the fourth quarter of 2013.

b) Interest Rate Swaps (Net (Short) Position as of 9/30/2013):

- Estimate of $398 Million; Range $148 - $648 Million

- Confidence Within Range = Moderate to High

- See Purple Highlighted, Blue Referenced Sub-Accounts "b)" in Table 5 Above Next to the December 31, 2013 Column

Let us first discuss the history of this sub-account, which will lead to a better explanation of my projected gain (loss) for the fourth quarter of 2013. AGNC's interest rate swaps balance as of 9/30/2013 was by far the company's largest net (short) position in regards to notional value within the gain (loss) on derivative instruments and other securities, net account. AGNC had a net (short) interest rate swaps position of ($50.2) billion as of 9/30/2013. AGNC had ($0.9) billion of interest rate swap additions and $6.3 billion of interest rate swap expirations or terminations during the third quarter of 2013. AGNC began to slightly decrease the company's net (short) interest rate swaps position during the third quarter of 2013. The quarterly net notional balance change for this specific derivative sub-account was a net (short) reduction of $5.5 billion or approximately 10% of AGNC's interest rate swaps net (short) position of ($55.7) billion as of 6/30/2013.

AGNC slightly decreased the company's overall interest rate swaps net (short) position during the third quarter of 2013 for two main reasons. First, as discussed earlier, AGNC reduced the company's net long TBA MBS and forward settling MBS position by ($21.7) billion during the third quarter of 2013. As such, AGNC reduced the company's at risk leverage from a ratio of 8.5 as of 6/30/2013 to 7.2 as of 9/30/2013. Since, when combined, AGNC's off-balance sheet TBA MBS portfolio and on-balance sheet MBS portfolio decreased ($16.1) billion during the third quarter of 2013, management felt a smaller net (short) interest rate swaps position was appropriate. Second, during the last few weeks of the third quarter of 2013, mortgage interest rates/U.S. Treasury yields sharply decreased. As such, MBS prices quickly increased. As such, the probability of MBS valuation losses slightly decreased. As such, management felt the continued extremely high ratio of interest rate swaps versus MBS/repo loans was unwarranted.

However, when compared to several prior quarters, AGNC's net (short) interest rate swaps position of ($50.2) billion was still a rather large balance. AGNC continued to maintain a relatively high interest rate swaps net (short) position due to the company's "defensive posture" regarding the current environment surrounding rising interest rates and decreasing MBS prices. If interest rates continued to rise at a modest to sharp pace, the relatively high interest rate swaps net (short) position would help further reduce the associated valuation losses sustained on AGNC's MBS portfolio. As of 9/30/2013, AGNC had 63% of the company's interest rate swaps in maturities less than five years while the remaining 37% had maturities over five years.

Using Table 5 above as a reference, there are two "broken-out" figures to discuss when projecting a net valuation gain (loss) for this derivative sub-account. The first figure to discuss is AGNC's "net periodic interest costs of interest rate swaps" expense. If one recalls, this figure was first discussed in AGNC's interest expense account during PART 1 of the article. In regards to the company's interest rate swaps net (short) position as of 9/30/2013, AGNC had a "weighted average fixed pay rate" of 1.65% and a "weighted average floating receive rate" of 0.24%. A fixed pay rate is the rate AGNC pays to a counterparty in a payer swap. Adding to AGNC's net (short) interest rate swaps position in a rising interest rate environment comes at an added cost regarding a slightly higher average fixed pay rate on newly created interest rate swaps (disregards the notion of interest rate swaptions for simplicity). 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 the three-month LIBOR. When compared to 6/30/2013, as of 9/30/2013 AGNC's weighted average fixed pay rate increased 4 bps while the company's weighted average floating receive rate decreased 2 bps.

Since AGNC's weighted average fixed pay rate slightly increased while the company's weighted average floating receive rate slightly decreased during the third quarter of 2013, the company had an increased net periodic interest costs of interest rate swaps expense. During the third quarter of 2013, AGNC had a net periodic interest costs of interest rate swaps expense of $129 million. This calculated to an additional expense of $24 million when compared to the prior quarter. AGNC is willing to incur this added expense for the sake of potentially offsetting MBS valuation losses with interest rate swap valuation gains.

After an initial drop in the fixed pay rate on all newly created interest rate swap contracts, the average fixed pay rate once again increased as mortgage interest rates/U.S. Treasury yields continued to rise during the remainder of the fourth quarter of 2013 (severity of drop/increase dependent on the tenor/maturity of the interest rate swap). In regards to the floating receive rate on both newly created and existing interest rate swap contracts, the three-month LIBOR remained relatively flat during the fourth quarter of 2013.

I project AGNC will record a slight decrease in the company's net periodic interest costs of interest rate swaps expense for the fourth quarter of 2013. This is due to the following three interest rate swap factors during the fourth quarter of 2013: 1) continued minor decrease in the company's weighted average notional balance as a slight deleveraging continues to occur on the MBS portfolio; 2) continued increase in the weighted average fixed pay rate on all newly created interest rate swaps; and 3) continued relatively flat average floating receive rate on AGNC's entire interest rate swap net (short) position.

Still using Table 5 as a reference, I am projecting AGNC will record a net periodic interest costs of interest rate swaps expense of $122 million for the fourth quarter of 2013. This calculates to a reduced expense of ($9) million when compared to the prior quarter.

The second figure to discuss relates to AGNC's interest rate swaps net valuation gain (loss). As stated above, after an initial drop in the fixed pay rate on all newly created interest rate swap contracts, the average fixed pay rate once again increased as mortgage interest rates/U.S. Treasury yields continued to rise during the remainder of the fourth quarter of 2013. As such, AGNC's net (short) interest rate swaps position would eventually have a modest to material net valuation gain by the end of the fourth quarter of 2013. This would occur because while the fixed pay rate on all newly created interest rate swaps continued to increase during the latter half of the fourth quarter of 2013 (after an initial drop in the fixed pay rate earlier in the quarter), 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 would occur. For the fourth quarter of 2013, as the tenor/maturity of an interest rate swap lengthened, the higher the increase of the fixed rate pay rate on a quarterly basis (thus a higher valuation gain). As of 9/30/2013, the rate paid by a fixed-rate payer of a 5-year interest rate swap was 1.57%. As of 12/31/2013, this rate rose to 1.78%. As such, a modest to material valuation gain should occur within AGNC's 5-year interest rate swaps.

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 a valuation gain (loss) on AGNC's net (short) interest rate swaps position 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.

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 AGNC's interest rate swaps sub-account to have a net valuation gain (loss) of $520 million for the fourth quarter of 2013. When this net valuation gain is offset against the company's net periodic interest costs of interest rate swaps expense of $122 million, I am projecting AGNC's interest rate swaps sub-account to have a total net valuation gain (loss) of $398 million for the fourth quarter of 2013.

c) Interest Rate Swaptions (Net (Short) Position as of 9/30/2013):

- Estimate of $140 Million; Range ($110) - $390 Million

- Confidence Within Range = Moderate to High

- See Pink Highlighted, Blue Referenced Sub-Account "c)" in Table 5 Above Next to the December 31, 2013 Column

Let us first briefly get accustomed with this type of derivative instrument. Interest rate swaptions are basically options to enter into underlying interest rate swap contracts. Whereas interest rate swap contracts have no initial "up-front" costs (gains (losses) are incurred as interest rates fluctuate over the life of the swaps), interest rate swaptions have implicit up-front costs (similar to an option contract; generally speaking).

Let us now discuss a brief history of this sub-account, which will lead to a better explanation of my projected gain (loss) for the fourth quarter of 2013. AGNC's interest rate swaptions balance as of 9/30/2013 was the company's 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. AGNC had a net (short) interest rate swaptions position of ($20.2) billion as of 9/30/2013. AGNC had ($9.5) billion of interest rate swaption additions (at an added cost of ($233) million) and $13.0 billion of interest rate swaption exercises, expirations, or terminations during the quarter. Similar to the company's interest rate swaps, management began to slightly decrease the company's net (short) interest rate swaptions position during the third quarter of 2013. The quarterly net notional balance change for this specific derivative sub-account was a net (short) reduction of $3.6 billion or approximately 15% of AGNC's interest rate swaptions net (short) position of ($23.8) billion as of 6/30/2013.

However, when compared to several prior quarters, AGNC's net (short) interest rate swaptions position of ($20.2) billion was still a rather large balance. As was the case with the company's interest rate swaps, AGNC continued to maintain a relatively high interest rate swaptions net (short) position due to the company's "defensive posture" regarding the current environment surrounding rising interest rates and decreasing MBS prices. If interest rates continued to rise at a modest to sharp pace, the relatively high interest rate swaptions net (short) position would help further reduce the associated valuation losses sustained on AGNC's MBS portfolio. As of 9/30/2013, AGNC's interest rate swaptions had a weighted average of 13 months until expiration with an underlying interest rate swaps weighted average maturity of 7.0 years.

As was the case with the company's interest rate swaps, AGNC's net (short) interest rate swaptions position would eventually have a modest to material net valuation gain by the end of the fourth quarter of 2013. This would occur because while the fixed pay rate on all newly created underlying interest rate swaps (hence interest rate swaptions) continued to increase during the latter half of the fourth quarter of 2013 (after an initial drop in the fixed pay rate earlier in the quarter), AGNC's existing underlying interest rate swaps (hence interest rate swaptions) already locked-in the lower fixed pay rate when initially created in previous quarters. As such, a valuation gain would occur. For the fourth quarter of 2013, as the tenor/maturity of the underlying interest rate swap lengthened, the higher the increase of the fixed rate pay rate on a quarterly basis (thus a higher swaption valuation gain). Specifically, this means there should be a FMV increase on most (if not all) interest rate swaptions held or acquired throughout the quarter.

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 AGNC's interest rate swaptions sub-account to have a net valuation gain (loss) of $210 million for the fourth quarter of 2013. Since AGNC had ($13.2) billion of interest rate swaptions set to expire in 1 year or less, I am projecting the company acquired ($6.5) billion of interest rate swaptions with an initial cost of ($170) million. I am also projecting the company exercised, had expired, or terminated $4.0 billion of interest rate swaptions for a net valuation gain (loss) of $100 million. Therefore, I am projecting AGNC's interest rate swaptions sub-account to have a net valuation gain (loss) of $140 million for the fourth quarter of 2013.

d) U.S. Treasury Securities (Net Long Position as of 9/30/2013):

- Estimate of $12 Million; Range ($288) - $312 Million

- Confidence Within Range = Moderate

- See Dark Blue, Brown, and Teal Highlighted, Blue Referenced Sub-Account "d)" in Table 5 Above Next to the December 31, 2013 Column

Let us first discuss a brief history of this sub-account, which will lead to a better explanation of my projected gain (loss) for the fourth quarter of 2013. AGNC's U.S. Treasury securities balance as of 9/30/2013 was the company's lone net long position in regards to face amount within the gain (loss) on derivative instruments and other securities, net account. AGNC had the following three sub-account positions as of 9/30/2013: 1) long U.S. Treasury securities of $4.9 billion; 2) (short) U.S. Treasury securities of ($1.9) billion; and 3) U.S. Treasury security futures sold (short) of ($1.7) billion. When combining all three positions together, AGNC reversed the company's net (short) U.S. Treasury securities position of ($9.2) billion as of 6/30/2013 to a net long U.S. Treasury securities position of $1.2 billion as of 9/30/2013. As such, the quarterly change for this specific derivative sub-account was a net (short) reduction (or net long increase) of $10.4 billion during the third quarter of 2013. As of 9/30/2013, AGNC had a net long 7-year U.S. Treasury securities position of $1.3 billion, a net long 10-year U.S. Treasury securities position of $1.7 billion, and a U.S. Treasury security futures sold (short) position of ($1.7) billion.

Unless management quickly sold the company's net long U.S. Treasury securities position (or switched back to a net (short) position), AGNC will sustain modest valuation losses within this derivative sub-account. This is due to the fact after an initial slight drop to yields during the first-half of the quarter, U.S. Treasury yields once again increased during the second-half of the fourth quarter of 2013 (especially in December). This same general scenario occurred throughout most of the U.S. Treasury securities (especially longer-termed maturities). For example, the quarterly change in yield on a 7 and 10-year U.S. Treasury security increased 43 and 40 basis points, respectively. This would be partially offset by the U.S. Treasury security futures sold (short) position that was most likely held as a net (short) position throughout the quarter. Furthermore, AGNC must calculate interest income (expense) on all long (short) U.S. Treasury securities (based on each security's stated yield).

Three possible scenarios likely occurred within this derivative sub-account during the fourth quarter of 2013. If the assumption is made that AGNC continued to have a net long U.S. Treasury securities position throughout the fourth quarter of 2013, then the company would have a modest valuation loss for this derivative sub-account (lower end of my projected range). If the assumption is made that AGNC switched back to a net (short) U.S. Treasury securities position prior to the second-half of the fourth quarter of 2013, then the company would have a modest valuation gain for this derivative sub-account (higher end of my projected range). If the assumption is made that AGNC alternated between a net long and net (short) U.S. Treasury securities position throughout the quarter, then the company would have a minor to modest net valuation gain or (loss) for this derivative sub-account. The amount of this net valuation gain (loss) would be dependent on the timing of the net long (short) position as yields fluctuated throughout the quarter.

I have personally made the assumption AGNC first continued to keep the company's net long U.S. Treasury securities position throughout the first-half of the fourth quarter of 2013. However, as AGNC began to see overall market interest rates already rising in late November/early December due to stronger than expected economic indicators, I feel management switched the company's U.S. Treasury securities balance back to a net (short) position to offset the risks associated with a rising interest rate environment. As such, when this switch was implemented in late November/early December, all long U.S. Treasury security positions would have slight to modest realized valuation losses upon sale. However, AGNC's net (short) U.S. Treasury securities position at the end of the quarter would have some modest valuation gains that hedged some of the MBS valuation losses that occurred on the company's regular MBS portfolio. Therefore, I feel the third scenario occurred during the fourth quarter of 2013.

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 AGNC's U.S. Treasury securities sub-account to have a net valuation gain (loss) of $12 million for the fourth quarter of 2013.

As stated earlier, all remaining derivative sub-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 valuation gain (loss) has been included in Table 5. When combining all the derivative sub-accounts together (both material and immaterial), I am projecting AGNC's derivative instruments and other securities, net account to have a total net valuation gain (loss) of $520 million for the fourth quarter of 2013.

I also see general similarities between AGNC and its sister company American Capital Mortgage Investment Company (NASDAQ:MTGE) regarding derivative portfolio strategies. There may be a few subtle differences between the two companies' derivative portfolios, but management should implement similar strategies during the fourth quarter of 2013. As such, similar net valuation gains (losses) should occur within the derivative instruments and other securities, net account.

5) Management Fees:

- Estimate of $31 Million; Range $26 - $36 Million

- Confidence Within Range = High

- See Boxed Blue Reference "5" in Table 1 in PART 1 and Table 6 Below Next to the December 31, 2013 Column

AGNC has a base management fee paid in arrears equal to an amount that is 1/12th of 1.25% of the company's equity balance for the quarter. Equity is defined as AGNC's month-ended 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 in Table 6 below. Some past (ACTUAL) figures within Table 6 are derived from either AGNC's quarterly investor presentation slides or SEC submissions via the company's 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 detailed analysis of AGNC's management fees expense account.

Table 6 - AGNC Quarterly Management Fees Projection

Click to enlarge

Using Table 6 above as a reference, I am projecting AGNC's management fees expense to decrease by ($4) million for the fourth quarter of 2013 when compared to the third quarter of 2013 ($31 million versus $35 million). This is due to the modest decrease in AGNC's monthly average equity balance when compared to the third quarter of 2013. This reduction is projected mainly due to the 28.2 million outstanding common shares bought back by AGNC during the fourth quarter of 2013 (total repurchase price of approximately $586 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.

Conclusions Drawn (PART 2):

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

4) Quarterly Gain (Loss) on Derivative Instruments and Other Securities, Net of $520 Million

5) Quarterly Management Fees of $31 Million

From the continued general rise in mortgage interest rates, the fixed pay rate on newly created interest rate swaps,, and U.S. Treasury yields during the second-half of the fourth quarter of 2013, AGNC's (short) TBA MBS + forward settling MBS, (short) interest rate swaps, (short) interest rate swaptions, and (short) U.S. Treasury securities most likely saw modest to material valuation gains. However, these material valuation gains will be partially offset by AGNC's long TBA MBS + forward settling MBS and long U.S. Treasury securities which most likely saw modest to material valuation losses. When combining all the derivative sub-accounts together (both material and immaterial), I am projecting AGNC's derivative instruments and other securities, net account to have a total net valuation gain (loss) of $520 million for the fourth 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 coverage portfolio was 102%. As of 9/30/2013, AGNC's hedging portfolio was only slightly reduced to 91%. This was still a relatively higher ratio. AGNC has continued to take this defensive posture in order to protect BV. I anticipate a flat to slightly higher hedging coverage ratio by the end of the fourth quarter of 2013. However, I also project a reduced weighted average duration on AGNC's derivative portfolio due to the continued MBS portfolio conversion to 15-year fixed-rate agency MBS.

I am also projecting AGNC will report a slightly reduced management fees when compared to the prior quarter. I am projecting AGNC's management fees expense to decrease by ($4) million for the fourth quarter of 2013 when compared to the third quarter of 2013 ($31 million versus $35 million). This is due to the modest decrease in AGNC's monthly average equity balance when compared to the third quarter of 2013. This reduction is projected mainly due to the 28.2 million outstanding common shares bought back by AGNC during the fourth quarter of 2013.

Net Income and EPS Projections:

I am projecting AGNC will report the following net income and EPS amounts for the fourth quarter of 2013 (refer back to Table 1 in PART 1 of the article):

A) Quarterly Net Income (Loss) of $91 Million and Earnings of $0.24 Per Share

AGNC's projected net income (loss) of $91 million for the fourth quarter of 2013 is much better than the reported net income (loss) of ($701) million for the third quarter of 2013. This is mainly due to AGNC's projected net valuation gain (loss) of $520 million on the company's derivative instruments and other securities, net account for the fourth quarter of 2013. For the same account in the prior quarter, AGNC recognized a net valuation gain (loss) of ($339) million. Even though this is a projected material increase of AGNC's net income and EPS amounts when compared to the prior quarter, investors should also realize that AGNC will most likely report a weak OCI/(OCL) amount for the fourth quarter of 2013 (will be discussed in PART 3 of this article). As stated in PART 1 of this article, AGNC's OCI/(OCL) account is part of the income statement but EXCLUDED from the company's net income and EPS amounts. AGNC's OCI/(OCL) account runs directly through to the company's stockholders equity section of the balance sheet (thus bypassing the "retained earnings/(accumulated deficit)" account).

I would suggest holding off on a "final verdict" regarding AGNC's results for the fourth quarter of 2013 until PART 3 of this article is released. I personally feel AGNC's comprehensive income (loss) account is more important than the company's net income and EPS amounts.

Final Note: PART 2 of this article is only a PARTIAL analysis of AGNC's income statement for the fourth quarter of 2013. As such, a "full" conclusion regarding AGNC's income statement will not be provided yet. PART 3 of this article will just pick up where PART 2's analysis ends. PART 3 of this article will discuss AGNC's projected OCI/(OCL) and comprehensive income (loss) accounts. PART 3 will also summarize AGNC's entire statement of comprehensive income (loss) and the major points throughout PARTS 1, 2, and 3 of the article. This will be followed by a detailed projection of AGNC's BV as of 12/31/2013 which will be available to readers prior to the company's earnings press release for the fourth quarter of 2013 (early February).

Disclosure: I am long AGNC, MTGE. 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.