American Capital Agency's Q4 2015 Income Statement Projection - Part 3

| About: AGNC Investment (AGNC)

Summary

Most 15- and 30-year fixed-rate agency MBS coupons had a modest - material price decrease during the fourth quarter of 2015.

Furthermore, additional valuation losses occurred across specified pools due to the decreased demand (lower “pay-ups”) for such investments as interest rates net increased during the fourth quarter of 2015.

As such, I am projecting AGNC will report a material net unrealized loss on available-for-sale securities for the fourth quarter of 2015 (the same for MTGE and NLY).

However, this article also highlights to readers the heightened importance of understanding the correlation between AGNC’s derivatives portfolio and the company’s MBS portfolio regarding changes in quarterly valuations.

My projection for AGNC’s comprehensive income for the fourth quarter of 2015 is stated in the “Conclusions Drawn” section of the article. A future article will project the company’s BV.

Author's Note: Part 3 of this article is a continuation from Part 1 and Part 2 which were discussed in previous publications. Please see Part 1 and Part 2 of this article for a detailed projection of American Capital Agency Corp.'s (NASDAQ:AGNC) income statement (technically speaking, the company's "consolidated statement of comprehensive income") for the fourth quarter of 2015 regarding the following accounts: 1) interest income; 2) interest expense; 3) gain (loss) on sale of agency securities, net; 4) gain (loss) on derivative instruments and other securities, net (including four "sub-accounts"); and 5) management fees. Part 2 also discussed AGNC's projected net income and earnings per share ("EPS") amounts. Part 1 and Part 2 helps lead to a better understanding of the topics and analysis that will be discussed in Part 3. The links to Part 1 and Part 2 are provided below:

American Capital Agency Corp.'s Q4 2015 Income Statement Projection - Part 1

American Capital Agency Corp.'s Q4 2015 Income Statement Projection - Part 2

This three-Part article is a very detailed look at AGNC's consolidated statement of comprehensive income. I perform this detailed analysis for readers who anticipate/want such an analysis performed each quarter to fully understand AGNC's ever-changing MBS and derivative portfolio strategies. For readers who just want the summarized account projections, I would suggest to scroll down to the "Conclusions Drawn" section at the bottom of the each Part of the article. By understanding the trends that occurred within AGNC's operations during the fourth quarter of 2015, one can apply this information to sector peers as well. As such, the discussion/analysis below is not solely applicable to AGNC but to the fixed-rate agency mortgage real estate investment trust (mREIT) sector as a whole. This includes, but is not limited to, the following fixed-rate agency mREIT peers: 1) ARMOUR Residential REIT Inc. (NYSE:ARR); 2) CYS Investments Inc. (NYSE:CYS); 3) Annaly Capital Management Inc. (NYSE:NLY); and 4) Orchid Island Capital Inc. (NYSE:ORC). In Particular, Part 3 provides a discussion of fixed-rate agency MBS price movements which all of the sector peers listed above are currently heavily invested in.

Focus of Article:

The focus of Part 3 of this article is to provide a detailed projection of AGNC's consolidated statement of comprehensive income for the fourth quarter of 2015 regarding the following accounts: 6) "unrealized gain (loss) on available-for-sale ("AFS") securities, net"; and 7) "unrealized gain (loss) on interest rate swaps, net (upon reclassification)". Part 3 will also discuss AGNC's projected other comprehensive income (loss) (OCI/(OCL)) and comprehensive income (loss) amounts.

6) Unrealized Gain (Loss) on AFS Securities, Net:

- Estimate of ($535) Million; Range ($785) - ($285) Million

- Confidence Within Range = Moderate to High

- See Boxed Blue Reference "6" in Tables 10 and 11 Below Next to the December 31, 2015 Column

Projecting AGNC's unrealized gain (loss) on AFS securities, net account is an analysis that includes several assumptions and variables that need to be taken into consideration. Since this account is the summation of the quarterly unrealized valuation changes on AGNC's MBS portfolio (by far the largest asset class on the company's balance sheet), a wider projection range should be accompanied with this specific account. The same assumptions used within AGNC's gain (loss) on sale of agency securities, net account (see Part 1 of article) and gain (loss) on derivative instruments and other securities, net account (regarding the company's TBA MBS position; see Part 2 of article) will be applied when analyzing this account.

Let us discuss the recent history of this account which will lead to a better explanation of my projected loss for the fourth quarter of 2015. Since fixed-rate agency MBS prices across lower coupons modestly - materially increased during the third quarter of 2015, when combining AGNC's net realized loss on sale of agency securities and net unrealized loss on AFS securities together, the company reported a net valuation gain of $428 million for the third quarter of 2015. After AGNC's net realized valuation loss of $39 million was reversed-out, the company's total net unrealized loss on AFS securities was $467 million for the third quarter of 2015.

Having established what occurred to the company's MBS portfolio during the prior quarter, let us now take a look at AGNC's unrealized gain (loss) on AFS securities, net account for the fourth quarter of 2015. Prior to performing an account projection analysis, let us first analyze the fixed-rate agency MBS price movements during the fourth quarter of 2015. Using Table 7 below as a reference, let us first analyze the 15-year fixed-rate agency MBS price movements. This will then be followed by a similar analysis (via Table 8) of the 30-year fixed-rate agency MBS price movements. By doing so, this will help readers understand how I come up with my projected valuations discussed later in the article.

Table 7 - 15-Year Fixed-Rate Agency MBS Price Movements During the Fourth Quarter of 2015

(Source: Table created entirely by myself, using MBS pricing data via private access to a professional resource [Thomson Reuters])

Table 7 above shows the 15-year fixed-rate agency MBS price movements during the fourth quarter of 2015. It breaks out the 15-year fixed-rate agency MBS holdings by government-sponsored entity ("GSE"). This includes both Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) MBS. As of 9/30/2015, AGNC's Ginnie Mae holdings accounted for 1% of the company's MBS portfolio (excluding TBA MBS positions). As such, Ginnie Mae fixed-rate agency MBS price movements are deemed immaterial for discussion purposes and thus excluded from this table. Table 7 further breaks out the 15-year fixed-rate agency MBS price movements into the various coupons on AGNC's books ranging from 2.5% - 4.5%. AGNC holds an immaterial balance of 15-year fixed-rate agency MBS holdings over the 4.5% coupon and thus these specific coupons are excluded from Table 7 above.

From the information provided in Table 7, a valuation gain (loss) can be calculated which is broken down by the various coupons. This valuation gain (loss) is shown in Table 9 later in the article. It should also be noted AGNC continually changes the company's portfolio holdings in any given quarter. As such, I must determine specific purchase and sale assumptions towards the end of my account projection analysis.

Using Table 7 above as a reference, let us look at the 15-year fixed-rate agency MBS price movements for the current quarter regarding a few of the coupon rates where AGNC held a material MBS balance as of 9/30/2015. The cumulative quarterly net MBS price movements for each coupon rate are shown within Table 7 under the "Cumulative Quarterly Change" column. For example, during the fourth quarter of 2015, a Fannie 15-year fixed-rate agency MBS with a 2.5%, 3.0%, 3.5%, 4.0%, and 4.5% coupon had a cumulative quarterly price increase (decrease) of (1.19), (1.10), (0.92), (0.39), and (0.34) to settle its price at 100.81, 103.05, 104.73, 104.31, and 103.34, respectively (100 being par). As such, a material price decrease occurred on the 2.5%, 3.0%, and 3.5% coupons while a modest price decrease occurred on the 4.0% and 4.5% coupons.

When compared to Fannie 15-year fixed-rate agency MBS, Freddie 15-year fixed-rate agency MBS had slight differences in weekly (hence cumulative quarterly) price valuations across the same coupons. As will be shown in Table 9 later in the article, the minor price fluctuations between the two types of 15-year fixed-rate agency MBS only had a minor impact on differing valuations. Now that we have an understanding of the 15-year fixed-rate agency MBS price movements during the fourth quarter of 2015, let us take a look at the 30-year fixed-rate agency MBS price movements.

Table 8 - 30-Year Fixed-Rate Agency MBS Price Movements During the Fourth Quarter of 2015

(Source: Table created entirely by myself, using MBS pricing data via private access to a professional resource [Thomson Reuters]; link provided below Table 7])

Table 8 above shows the 30-year fixed-rate agency MBS price movements during the fourth quarter of 2015. It breaks out the 30-year fixed agency MBS holdings by GSE. As was the case with the 15-year fixed-rate agency MBS, this includes both FNMA.OB and FMCC.OB holdings. As stated earlier, AGNC's Ginnie Mae fixed-rate agency MBS holdings are deemed immaterial for discussion purposes. As such, Ginnie Mae fixed-rate agency MBS price movements are excluded from this table. Table 8 further breaks out the 30-year fixed-rate agency MBS price movements into the various coupons on AGNC's books ranging from 3.0% - 5.0%. AGNC holds an immaterial balance of 30-year fixed-rate agency MBS holdings over the 5.0% coupon and thus these specific coupons are excluded from Table 8 above. From the information provided in Table 8, a valuation gain (loss) can be calculated which is broken down by the various coupons. This valuation gain (loss) is shown in Table 9 later in the article.

Using Table 8 above as a reference, let us look at the 30-year fixed-rate agency MBS price movements for the current quarter regarding a few of the coupon rates where AGNC held a material MBS balance as of 9/30/2015. For example, during the fourth quarter of 2015, a Fannie 30-year fixed-rate agency MBS with a 3.0%, 3.5%, 4.0%, 4.5%, and 5.0% coupon had a cumulative quarterly price increase (decrease) of (1.45), (1.22), (0.90), (0.43), and (0.11) to settle its price at 100.00, 103.19, 105.84, 108.00, and 110.06, respectively (100 being par). As such, a material price decrease occurred on the 3.0%, 3.5%, and 4.0% coupons, a modest price decrease occurred on the 4.5% coupon, and a minor price decrease occurred on the 5.0% coupon.

When compared to Fannie 30-year fixed-rate agency MBS, Freddie 30-year fixed-rate agency MBS had slight differences in weekly (hence cumulative quarterly) price valuations across the same coupons. As will be shown in Table 9 below, the minor price fluctuations between the two types of 30-year fixed-rate agency MBS only had a minor impact on differing valuations. Now that we have an understanding of the 15- and 30-year fixed-rate agency MBS price movements during the fourth quarter of 2015, let us take a look at how these price movements affected AGNC's MBS portfolio regarding the company's weekly and cumulative quarterly valuations (quantified in dollar amounts).

Table 9 - AGNC Summarized Weekly and Cumulative Quarterly Fixed-Rate Agency MBS Portfolio Valuation Gain (Loss) During the Fourth Quarter of 2015

(Source: Table created entirely by myself, including all calculated figures and projected valuations)

Table 9 above first shows AGNC's weekly and cumulative quarterly projected valuation gain (loss) on the company's 15- and 30-year fixed-rate agency MBS holdings across all coupons (including immaterial coupons omitted from Table 7 and Table 8 above). I am projecting an "initial" net valuation loss of ($493) million on AGNC's 15- and 30-year fixed-rate agency MBS holdings for the fourth quarter of 2015. However, as stated earlier, several other adjustments need to be performed within AGNC's unrealized gain (loss) on AFS securities, net account before a final projection can be made. Since AGNC had a notable proportion of the company's fixed-rate agency MBS holdings within "specified pools" (prepayment protected MBS; mainly through the Home Affordable Refinance Program ("HARP") and low-loan balance ("LLB") securities), a quarterly valuation adjustment needs to be calculated. Through a detailed calculation that will be omitted from this Particular article, I am projecting AGNC had an additional net valuation loss of ($88) million for the fourth quarter of 2015 in regards to the company's specified pools (HARP and LLB securities). When these two figures are combined, I am projecting AGNC had a net valuation loss of ($580) million on the company's 15- and 30-year fixed-rate agency MBS portfolio (see blue reference "A" in Table 9 above).

Still using Table 9 above as a reference, through a detailed calculation that will be omitted from this Particular article, I am projecting AGNC had an additional net valuation loss of ($20) million for the fourth quarter of 2015 in regards to the following agency MBS holdings: 1) 20-year fixed-rate; 2) collateralized mortgage obligations ("CMO"); and 3) adjustable-rate mortgages ("ARM") (see blue reference "B" in Table 9 above).

Also, when considering the effects of an assumed Partial conversion on AGNC's net long TBA MBS position of $7.1 billion and the company's realignment of its MBS portfolio throughout the quarter, I am projecting a net valuation gain adjustment of $5 million for the fourth quarter of 2015 (see blue reference "C" in Table 9 above). I deem this as a fairly cautious projection.

Therefore, when all the referenced figures stated above are combined, I am projecting a total net valuation loss of ($595) million on AGNC's MBS portfolio for the fourth quarter of 2015. This figure is PRIOR to all sold MBS being reversed out in the current quarter. As such, the final calculation within AGNC's unrealized gain (loss) on AFS securities, net account is the quarterly reversal of the company's MBS sales shown in Table 10 below. Remember, all MBS sales have already been accounted for within AGNC's gain (loss) on sale of agency securities, net account (discussed in Part 1 of the article).

Table 10- AGNC Quarterly Unrealized Gain (Loss) on AFS Securities, Net and Unrealized Gain (Loss) on Interest Rate Swaps, Net (Upon Reclassification to Interest Expense) Projection

(Source: Table created entirely by myself, partially using AGNC data obtained from the SEC's EDGAR Database)

Table 10 above shows AGNC's projected total net valuation loss of ($595) million on the company's MBS portfolio (see red reference "AB" in Table 10 above). This amount is highlighted in teal. The second amount shown is AGNC's projected "reversal of prior period unrealized ("gain") loss, net, (upon realization)" figure (see red reference "AC" in Table 10 above). This amount is highlighted in pink and also has a boxed blue reference "3" next to the December 31, 2015 column.

Therefore, after AGNC's projected net realized loss on the sale of agency securities of $60 million is reversed-out, the company's total net unrealized loss on AFS securities is projected to be ($535) million for the fourth quarter of 2015 (see red reference "(AB + AC) = AD" in Table 10 above). This amount is highlighted in grey.

Brief Discussion of MTGE's Unrealized Gain (Loss) on Agency Securities, Net Account:

I see general similarities between AGNC and the company's affiliate American Capital Mortgage Investment Corp. (NASDAQ:MTGE) regarding agency MBS portfolio strategies. As such, I see somewhat similar projections between AGNC's unrealized gain (loss) on AFS securities, net account and MTGE's "unrealized gain (loss) on agency securities, net" account for the fourth quarter of 2015 (proportionally speaking). When compared to AGNC, MTGE had a slightly higher proportional share of lower coupon 30-year fixed-rate agency MBS holdings as of 9/30/2015 which needs to be considered regarding projected valuations. Furthermore, MTGE had a slightly greater proportion of 30-year fixed-rate agency MBS holdings as of 9/30/2015 when compared to AGNC.

In addition, MTGE also had a non-agency MBS portfolio. Due to this fact, MTGE also has an "unrealized gain (loss) on non-agency securities, net" account that needs to be incorporated into the company's consolidated statement of comprehensive income. MTGE's non-agency MBS portfolio has different valuation methods which are mainly based on specific indexes and simulated models (mainly based on level 3 asset valuations). This includes, but is not limited to, prime, "credit risk transfer" ("CRT"), Alt-A, option ARM, and subprime holdings. MTGE's non-agency MBS portfolio had a "conditional prepayment rate" ("CPR") of 16% and a "conditional default rate" ("CDR") of 7% as of 9/30/2015. I anticipate a slight decrease in CPR and a slight increase in CDR during the fourth quarter of 2015 which would slightly impact valuations. A further discussion of MTGE's non-agency MBS portfolio is beyond the scope of this article.

Brief Discussion of NLY's Unrealized Gain (Loss) on AFS Securities, Net Account:

When it comes to AGNC's closest sector peer Annaly Capital Management Inc. , I see one modest difference that would affect the account described above. As of 9/30/2015, only 14% of NLY's fixed-rate agency MBS portfolio consisted of 15-year maturities whereas AGNC had 35% of the company's MBS portfolio in 15-year maturities (excluding TBA MBS positions). Since most 30-year fixed-rate agency MBS coupons had more severe price decreases when compared to 15-year fixed-rate agency MBS with similar coupons, NLY should have a higher combined total net valuation loss on AFS securities (realized and unrealized) when compared to AGNC during the fourth quarter of 2015 (proportionally speaking). Slightly offsetting this factor is the fact, as of 9/30/2015, NLY had a slightly lower on-balance sheet leverage ratio when compared to AGNC. A further discussion of NLY's MBS portfolio is beyond the scope of this article.

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

- Estimate of $21 Million; Range $16 - $26 Million

- Confidence Within Range = High

- See Boxed Blue Reference "7" in Table 10 Above and Table 11 Below Next to December 31, 2015 Column

Now let us take a look at AGNC's unrealized gain (loss) on interest rate swaps, net account. I show my projection for this figure in Table 10 above. AGNC's unrealized gain (loss) on interest rate swaps, net account consists of two "sub-accounts". The first sub-account is AGNC's "unrealized gain (loss) on interest rate swaps designated as cash flow hedges" (see red reference "AE" in Table 10 above). Since AGNC has discontinued accounting for the company's interest rate swaps as cash flow hedges under Generally Accepted Accounting Principles ("GAAP") back in 2011, this balance should remain $0 for the fourth quarter of 2015.

The second sub-account is AGNC's "reversal of prior period unrealized ("gain") loss on interest rate swaps, net (upon reclassification to interest expense)" (see red reference "AF" in Table 10 above). Each quarter, a portion of the remaining accumulated net deferred loss prior to the change in accounting treatment is reclassified out of the OCI/(OCL) amount as it relates to AGNC's "de-designated" interest rate swaps. A reclassification of $21 million has been projected for the fourth quarter of 2015. A further discussion of this account is unwarranted.

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

- Estimate of ($514) Million; Range ($764) - ($264) Million

- Confidence Within Range = Moderate to High

- See Red Reference "B" in Table 11 Below Next to the December 31, 2015 Column

Let us take a look at AGNC's projected quarterly consolidated statement of comprehensive income for the fourth quarter of 2015 regarding the company's OCI/(OCL) and comprehensive income (loss) amounts. This information is provided in Table 11 below.

Table 11 - AGNC Quarterly OCI/(OCL) and Comprehensive Income (Loss) Projection

(Source: Table created entirely by myself, Partially using data obtained from AGNC's quarterly investor presentation slides)

After combining the company's net unrealized loss on AFS securities of ($535) million and its net unrealized gain on interest rate swaps (upon reclassification) of $21 million, I am projecting AGNC will report an OCL of ($514) million for the fourth quarter of 2015 (see red reference "B" in Table 11 above).

C) Comprehensive Income (Loss):

- Estimate of $52 Million; Range ($198) - $302 Million

- Comprehensive Income (Loss) Available to Common Shareholders of $0.13 Per Share; Range ($0.60) - $0.86 Per Share

- Confidence Within Range = Moderate to High

- See Red Reference "C" in Table 11 Above Next to the December 31, 2015 Column

Finally, let us look at AGNC's comprehensive income for the fourth quarter of 2015. This is the summation of the following amounts: A) net income of $566 million (see Part 1 and Part 2 of the article); and B) OCL of ($514) million (see analysis above). Therefore, when these two amounts are combined, I am projecting AGNC will report comprehensive income of $52 million for the fourth quarter of 2015.

Conclusions Drawn From Part 1, Part 2, and Part 3:

To sum up the analysis from all three Parts of the article, I am projecting AGNC will report the following amounts for the fourth quarter of 2015:

A) Quarterly Net Income of $566 Million; Earnings Available to Common Shareholders of $1.62 Per Share

B) Quarterly OCL of ($514) Million

C) Quarterly Comprehensive Income (A and B Combined) of $52 Million; Comprehensive Income Available to Common Shareholders of $0.13 Per Share

AGNC's projected net income of $566 million for the fourth quarter of 2015 is materially higher when compared to a net loss of ($633) million for the third quarter of 2015. This is mainly due to AGNC's projected net valuation gain of $385 million on the company's derivatives portfolio for the fourth quarter of 2015. For the same account in the prior quarter, AGNC recognized a net valuation loss of ($778) million.

I am also projecting AGNC will report an OCL of ($514) million for the fourth quarter of 2015. This projected amount is a material decrease when compared to OCI of $491 million for the third quarter of 2015. The main factor for the projected material decrease within this amount is the modest - material cumulative quarterly price decreases seen in most 15- and 30-year fixed-rate agency MBS coupons during the fourth quarter of 2015. Most MBS price movements during the fourth quarter of 2015 were in direct contrast to movements seen during the prior quarter.

Due to the volatile nature of market rates in general and the continued unattractive correlation between MBS prices and derivative instrument valuations during the fourth quarter of 2015 ("option adjusted spreads"; OAS), I believe most mREIT peers will report weak quarterly earnings (several exceptions apply). As such, I believe AGNC's results will be disappointing for some readers. However, I also believe AGNC will outperform most fixed-rate agency mREIT peers in regards to the fourth quarter of 2015. I believe AGNC's projected outperformance of most fixed-rate agency mREIT peers should be seen as a positive trend. Currently, stock prices of most agency mREIT peers appear to have already priced in this weaker performance for the fourth quarter of 2015. Still, there will likely be some short-term volatility surrounding each respective mREIT's earnings press release. Readers should be aware as such.

I believe four key factors to analyze within the fixed-rate agency mREIT sector this quarter are the following: 1) each company's proportion of 15-year MBS holdings versus 30-year MBS holdings; 2) each company's hedging coverage ratio; 3) each company's proportion of long-term derivative instruments versus short-term derivative instruments; and 4) each company's proportion of specified pools (for instance HARP and LLB securities). Dependent upon these factors, I believe results will vary across the fixed-rate agency mREIT sector for the fourth quarter of 2015.

Final Note: The projected amounts from this three-Part article will have a direct impact on projecting AGNC's book value ("BV") as of 12/31/2015. My upcoming AGNC BV projection article will be available to readers prior to the company's earnings press release for the fourth quarter of 2015 in early February. Each investor's BUY, SELL, or HOLD decision is based on one's risk tolerance, time horizon, and dividend income goals. My personal recommendation will not fit each reader's current investing strategy. By reading this article, I hope readers can better understand how AGNC (or any mREIT) generates income, incurs expenses, and values assets held for investment/risk management.

Disclosure: I am/we are long AGNC, MTGE, ORC.

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.

Additional disclosure: I currently have no position in ARR, CYS, FMCC, FNMA, or NLY.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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