®
2 0 1 2 A N N U A L R E P O R T
A G N C . c o m (cid:2) N a s d a q : A G N C
®
Two Bethesda Metro Center, 14th Floor
Bethesda, MD 20814
Phone: (301) 968-9300
Fax: (301) 968-9301
Email: IR@AGNC.com
A G N C . c o m (cid:2) N a s d a q : A G N C
002CSN8182
Dear fellow shareholders,
2012 was characterized by record low interest rates, a third round of quantitative easing (“QE3”) by the
Federal Reserve and stock market volatility typical for an election year. Through these challenges, our
company executed on its business plan of maximizing shareholder value by growing book value by $3.93
per common share and paying $5.00 per common share in dividends, generating total per common share
economic return to our shareholders of $8.93, or 32%, for the year.
“QE3”
On September 13, 2012, the Federal Reserve announced QE3 involving large-scale, open-ended agency
mortgage backed securities (“Agency MBS”) purchases. The Fed is buying approximately $70 billion in
agency securities every month, including $40 billion for QE3 and close to $30 billion to reinvest paydowns
on their existing portfolio of Agency MBS. The Fed is purchasing the lowest coupon fixed rate Agency
MBS because these securities have the greatest impact on the rates offered to borrowers. As such, in
the absence of a material change in interest rates, the Fed’s future Agency MBS purchases are likely to
be focused on 30-year 3% coupons and 15-year 2.5% coupons. QE3 has already driven increases in
prepayment speeds and tighter spreads on lower coupon mortgage securities, which serve as headwinds
for ROEs in the sector.
On our first quarter shareholder call, we highlighted the risks of a potential QE3 scenario and described
it as anything other than a Goldilocks scenario. While we did not know whether or not it would occur, we
were aware of the potential market reaction and took steps to position the portfolio for this potential sce-
nario by focusing our security selection on Agency MBS that had favorable prepayment characteristics,
reducing our exposure to all but the lowest coupons, and by buying securities that would, in our opinion,
be the focus of the Fed’s purchases under a potential QE3 scenario. We continue to be very comfortable
with how our portfolio is positioned, and we believe that prepayments on our specific mortgage assets
will remain muted, despite a more challenging prepayment landscape.
2 012 A N N UA L R EP O R T
1
OWNING PREPAYMENT PROTECTED SECURITIES
As of December 31, 2012, our portfolio was comprised of 66% of securities with favorable prepayment
attributes (including Lower Loan Balance and HARP securities) when we include our forward purchase of
TBA securities.
$98.1 Billion Agency MBS Portfolio as of 12/31/12
Low Loan Balance 39%
HARP 27%
Other 34%
Lower loan balance securities are pools backed by a maximum original loan balance of up to $150,000. The weighted average original loan
balance is $98,000 for 15-year securities and $101,000 for 30-year securities as of December 31, 2012. HARP securities are pools backed
by 100% refinance loans with original LTVs ≥ 80%. The weighted average original LTV is 95% for 15- year securities and 104% for 30-year
securities as of December 31, 2012.
In general, an increase in prepayment rates (“CPR”) will accelerate the amortization of purchase premi-
ums, thereby reducing the interest income earned on the investments. This is why we have emphasized
the impact that prepayment speeds can have on returns, especially in a low interest rate environment.
Through ongoing security selection and emphasis on prepayment protected collateral, we were suc-
cessful in keeping our premium amortization to well below industry levels, thereby enhancing returns for
our shareholders.
2012 Monthly Actual CPRs
40%
30%
20%
10%
0%
AGNC CPR
30 yr. Universe CPR
1/1/12 2/1/12 3/1/12 4/1/12 5/1/12 6/1/12 7/1/12 8/1/12 9/1/12 10/1/12 11/1/12 12/1/12 1/1/13
Actual 1 month annualized CPR released at the beginning of each month during the respective periods based on the securities held as of the
preceding month-end; “30 Yr Universe CPR” represents Fannie Mae fixed rate MBS universe CPR.
Source: JP Morgan.
2
2 012 A N N UA L R EP O R T
We expect that today’s low rates, coupled with the tremendous media attention given to QE3, should
serve to keep prepayment speeds relatively high in the coming months on all but the lowest coupon
generic securities. On the other hand, we expect that prepayment speeds on lower loan balance and
higher LTV HARP securities will remain well-behaved.
ACTIVE HEDGE STRATEGIES
Investing in Agency MBS exposes us to interest rate risk and extension risk, given a homeowner’s option
either to prepay his/her mortgage or just keep it and make payments as prescribed over a 15, 20 or 30
year period. In a falling interest rate environment, homeowners are more likely to prepay their mortgages
than during times when interest rates are increasing, exposing us to prepayment risk. Additionally, in a
rising interest rate environment, homeowners are more likely to stay in their mortgages than during times
when interest rates are decreasing, exposing us to extension risk. These changing risk profiles affect the
value of our MBS as they directly impact the cash flows associated with the underlying mortgages.
The goal of our interest rate risk management activities is to mitigate fluctuations in our book value that
result from changes in interest rates. To accomplish this, we first select a portfolio of assets that we
believe will behave in a reasonably predictable way in response to changes in interest rates. Careful
asset selection and active asset portfolio management are critical elements to our overall interest rate
risk management framework. To further mitigate our interest rate risk, particularly in a rising rate scenario,
we utilize a variety of financial instruments, such as interest rate swaps, options on interest rate swaps
(“swaptions”), treasury securities and mortgage-based instruments.
With interest rates at or near a historical low point, the duration or price sensitivity of the MBS that we
own is very asymmetric, with limited risk of mortgage durations falling further should rates decrease and
significant risk of mortgage durations extending should rates rise.
During 2012, we took additional steps to limit the potential extension risk within our portfolio. Most nota-
bly, we extended the weighted average maturity on our swap portfolio from 3.5 years as of December 31,
2011 to 4.4 years as of December 31, 2012. Similarly, we increased the size of our swaption portfolio from
$3.2 billion to $14.5 billion as of December 31, 2012.
Overall, we increased the amount of hedges we hold relative to the liabilities we have. In total, the ratio
of swaps, swaptions and treasury hedges relative to our liabilities increased from 74% on December 31,
2011 to 80% on December 31, 2012.
While the combination of our swaps, swaptions and other hedges provides a considerable amount of
upfront protection against a rise in interest rates, on-going hedging and active portfolio management will
be critical to our ability to protect book value over a wide range of interest rate scenarios.
A STRONG, CONSISTENT DIVIDEND
In February 2012, we announced an adjustment to the quarterly dividend on our common stock, bringing
it from $1.40 to $1.25 per share. This was our first adjustment since Q3 2009. Our decision to adjust the
dividend was based on our desire to establish a dividend level that was consistent with market condi-
tions, that allowed us to distribute our taxable income in accordance with REIT rules and that was not
expected to reduce our book value over time. Our goal as a management team is to extract value for our
2 012 A N N UA L R EP O R T
3
shareholders through investments across the Agency MBS universe, whether in the form of income or
gains, and we believe this strategy has clearly proven to be the right one.
AGNC Dividend and Taxable Income History
$2.50
$2.00
$1.50
$1.00
$0.50
$0.00
Dividend per
Common Share
Taxable EPS
Q1
2010
Q2
2010
Q3
2010
Q4
2010
Q1
2011
Q2
2011
Q3
2011
Q4
2011
Q1
2012
Q2
2012
Q3
2012
Q4
2012
ECONOMIC RETURN
In 2010, we introduced our shareholders to the concept of “Economic Return,” the sum of cash divi-
dends on common shares paid plus the change in our net asset value (“NAV”) over a specified period.
Economic Return is not affected by differences in the accounting methodologies (e.g., different prepay-
ment assumptions used in calculating yields), and it treats realized and unrealized gains and losses
equally. The following chart compares our Economic Return against that of our peer group since 2009,
and we are proud of the performance we have delivered to our shareholders.
Economic Return
70%
60%
50%
40%
30%
20%
10%
0%
60.6%
29.9%
45.0%
20.7%
30.7%
24.3%
-10%
AGNC
Peer
Average
2009
32.7%
24.9%
7.8%
AGNC
8.8%
15.3%
-6.5%
Peer
Average
37.4%
23.1%
14.3%
32.2%
18.0%
14.2%
22.6%
15.9%
6.7%
15.6%
13.0%
2.6%
AGNC
Peer
Average
AGNC
Peer
Average
2010
2011
2012
%
%
%
Total Economic
Return
Return from
Dividends
Return from
Change in NAV
Peer Average comprised of the following peers on an unweighted basis: ANH, CMO, CYS, HTS and NLY.
Source: Company Filings.
4
2 012 A N N UA L R EP O R T
CAPITAL RAISING AND THE STOCK BUYBACK PROGRAM
During 2012, AGNC raised $3.8 billion in equity capital. While AGNC has grown significantly over the
last few years, we remain disciplined with respect to the timing and deployment of equity raises. The
performance of AGNC over the last several years should demonstrate to investors that equity can be
raised in a manner that is accretive and supportive of shareholder value creation.
During the latter part of the year, agency mortgage REIT stocks experienced some significant headwinds,
as the market sought to digest the impact of QE3 and what it would mean for our sector. On October 29,
2012, we announced that our board had approved a share repurchase plan, authorizing us to repurchase
up to $500 million of common stock until December 31, 2013. During the balance of the year, we repur-
chased $2.7 million of common stock at an average net price of $29.00 per share.
Share repurchases, like share issuances, can be accretive to our book value per common share and
our philosophy to raise capital or to buy back stock is one in the same, taking into consideration current
market conditions, where the stock is trading relative to its book value and the transactions costs associ-
ated with stock offerings. Generally, raising capital can be accretive to our book value per common share
when our common stock is trading above book value and purchasing our common stock can be accretive
to our book value per common share when our common stock is trading below book value.
LOOKING AHEAD
While QE3 is clearly a challenge for investors in Agency MBS, it has also created certain unique opportu-
nities, such as particularly attractive implied financing rates through the “dollar roll” market. A dollar roll
is a transaction where you simultaneously sell and agree to repurchase a TBA mortgage-backed security
with the same term, coupon and issuer, but for a later settlement date. The price difference between the
current month’s settlement date and the next month’s settlement date is referred to as the “price drop,”
which is the economic equivalent of the net interest income earned for holding a mortgage-backed secu-
rity on balance sheet and financing it with repurchase agreements.
As we saw during the fourth quarter, these financing differences were worthy of significant consideration
and were responsible for adding a significant amount to our income for the quarter. While this is a less
traditional form of return than many of our shareholders are used to, we remain steadfastly committed to
looking for opportunities across the Agency MBS spectrum for our shareholders and to explaining our
thoughts and actions as clearly and transparently as possible.
Given that the Fed’s mortgage purchase program is a key driver of these dynamics, we believe that these
financing opportunities could remain in place for most of 2013, which makes them very difficult to ignore.
2 012 A N N UA L R EP O R T
5
CONCLUSION
As we enter 2013, we are faced with the continued Fed involvement in the mortgage market and the ongo-
ing threat that low interest rates can have on a levered portfolio of mortgage-backed securities. With our
emphasis on relative value oriented active portfolio management and thoughtful hedging, our willingness
to reposition as risks and rewards change and a portfolio that is well positioned for the current environ-
ment, we believe we can successfully navigate these challenges while continuing to produce attractive
risk adjusted returns for our stockholders.
Thank you for your trust in us.
Sincerely,
Malon Wilkus
Gary Kain
Chair and Chief Executive Officer
President & Chief Investment Officer
John R. Erickson
Samuel A. Flax
Director, Chief Financial Officer and Executive Vice
President
Director, Executive Vice President and
Secretary
Peter J. Federico
Christopher Kuehl
Senior Vice President and Chief Risk Officer
Senior Vice President, Agency Portfolio
Investments
March 1, 2013
6
2 012 A N N UA L R EP O R T
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
1934
For the year ended December 31, 2012
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
OF 1934
Commission file number 001-34057
AMERICAN CAPITAL AGENCY CORP.
(Exact name of registrant as specified in its charter)
Delaware
(State or Other Jurisdiction of
Incorporation or Organization)
26-1701984
(I.R.S. Employer
Identification No.)
2 Bethesda Metro Center, 14th Floor
Bethesda, Maryland 20814
(Address of principal executive offices)
(301) 968-9300
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Common Stock, $0.01 par value per share
8.000% Series A Cumulative Redeemable Preferred Stock
Name of each exchange
on which registered
The NASDAQ Global Select Market
The NASDAQ Global Select Market
Securities registered pursuant to section 12(g) of the Act: NONE
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes
Indicate by check mark whether the registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the
past 90 days. Yes
No
No
No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to
be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit
and post such files). Yes
No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best
of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-
K.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the
definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
Non-accelerated filer
(Do not check if a smaller reporting company)
Accelerated filer
Smaller Reporting Company
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes
As of June 30, 2012, the aggregate market value of the Registrant's common stock held by non-affiliates of the Registrant was approximately $10.2 billion
based upon the closing price of the Registrant's common stock of $33.61 per share as reported on The NASDAQ Global Select Market on that date. (For this
computation, the Registrant has excluded the market value of all shares of its common stock reported as beneficially owned by executive officers and directors of
the Registrant and certain other stockholders; such an exclusion shall not be deemed to constitute an admission that any such person is an “affiliate” of the Registrant.)
No
The number of shares of the issuer’s common stock, $0.01 par value, outstanding as of January 31, 2013 was 338,936,470.
DOCUMENTS INCORPORATED BY REFERENCE. The Registrant's definitive proxy statement for the 2013 Annual Meeting of Stockholders is incorporated
by reference into certain sections of Part III herein.
Certain exhibits previously filed with the Securities and Exchange Commission are incorporated by reference into Part IV of this report.
AMERICAN CAPITAL AGENCY CORP.
TABLE OF CONTENTS
PART I.
Item 1.
Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Item 1A.
Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Item 1B.
Unresolved Staff Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Item 2.
Item 3.
Item 4.
PART II.
Item 5.
Item 6.
Item 7.
Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Mine Safety Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity
Securities
Selected Financial Data. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Management's Discussion and Analysis of Financial Condition and Results of Operations . . . . . . . . . . . . . . . .
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Item 8.
Item 9.
Financial Statements and Supplementary Data. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure . . . . . . . . . . . . . . . .
Item 9A.
Controls and Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Item 9B.
Other Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
PART III.
Item 10.
Item 11.
Item 12.
Item 13.
Item 14.
PART IV.
Directors, Executive Officers and Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Executive Compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. . . . . . .
Certain Relationships and Related Transactions, and Director Independence . . . . . . . . . . . . . . . . . . . . . . . . . . .
Principal Accounting Fees and Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Item 15. . . Exhibits and Financial Statement Schedules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Signatures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2
14
33
33
33
33
34
36
38
61
64
94
94
95
96
96
96
96
96
97
99
1
Item 1. Business
PART I.
American Capital Agency Corp. (“AGNC”, the “Company”, “we”, “us” and “our”) was organized on January 7, 2008 and
commenced operations on May 20, 2008 following the completion of our initial public offering (“IPO”). Our common stock is
traded on The NASDAQ Global Select Market under the symbol “AGNC”. We are externally managed by American Capital
AGNC Management, LLC (our “Manager”), an affiliate of American Capital, Ltd. (“American Capital”).
We operate so as to qualify to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986,
as amended (the “Internal Revenue Code”). As such, we are required to distribute annually 90% of our taxable net income. As
long as we qualify as a REIT, we will generally not be subject to U.S. federal or state corporate taxes on our taxable net income
to the extent that we distribute all of our annual taxable net income to our stockholders. It is our intention to distribute 100% of
our taxable income, after application of available tax attributes, within the limits prescribed by the Internal Revenue Code, which
may extend into the subsequent taxable year.
We earn income primarily from investing on a leveraged basis in agency mortgage-backed securities. These investments
consist of residential mortgage pass-through securities and collateralized mortgage obligations (“CMOs”) for which the principal
and interest payments are guaranteed by government-sponsored entities, such as the Federal National Mortgage Association
(“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), or by a U.S. Government agency, such as
the Government National Mortgage Association (“Ginnie Mae”) (collectively referred to as “GSEs”). We may also invest in
agency debenture securities issued by Freddie Mac, Fannie Mae or the Federal Home Loan Bank ("FHLB"). We refer to agency
mortgage-backed securities and agency debenture securities collectively as "agency securities" and we refer to the specific
investment securities in which we invest as our "investment portfolio".
Our principal objective is to preserve our net book value (also referred to as "net asset value", "NAV" and "stockholders'
equity") while generating attractive risk-adjusted returns for distribution to our stockholders through regular quarterly dividends
from the combination of our net interest income and net realized gains and losses on our investments and hedging activities. We
fund our investments primarily through short-term borrowings structured as repurchase agreements.
Our Investment Strategy
Our investment strategy is designed to:
• manage an investment portfolio consisting primarily of agency securities that seeks to generate attractive risk-adjusted
returns;
capitalize on discrepancies in the relative valuations in the agency securities market;
•
• manage financing, interest and prepayment rate risks;
•
•
•
•
preserve our net book value;
provide regular quarterly distributions to our stockholders;
qualify as a REIT; and
remain exempt from the requirements of the Investment Company Act of 1940, as amended (the “Investment Company
Act”).
Our Targeted Investments
Agency Mortgage-Backed Securities
The agency mortgage-backed securities in which we invest consist of agency residential pass-through certificates and
collateralized mortgage obligations:
• Agency Residential Pass-Through Certificates. Agency residential pass-through certificates are securities representing
interests in “pools” of mortgage loans secured by residential real property where payments of both interest and principal,
on the securities are guaranteed by a GSE or U.S. Government agency, and made monthly to holders of the securities,
in effect “passing through” monthly payments made by the individual borrowers on the mortgage loans that underlie
the securities, net of fees paid to the issuer/guarantor and servicers of the securities. In general, mortgage pass-through
certificates distribute cash flows from the underlying collateral on a pro rata basis among holders of the securities.
Holders of the securities also receive guarantor advances of principal and interest for delinquent loans in the mortgage
pools.
2
• Agency Collateralized Mortgage Obligations. Agency CMOs are securities that are structured instruments representing
interests in agency residential pass-through certificates. Agency CMOs consist of multiple classes of securities, with
each class having specified characteristics, including stated maturity dates, weighted average lives and rules governing
principal and interest distribution. Monthly payments of interest and principal, including prepayments, are typically
returned to different classes based on rules described in the trust documents. Principal and interest payments may also
be divided between holders of different securities in the agency CMO and some securities may only receive interest
payments while others receive only principal payments.
The agency mortgage-backed securities that we acquire provide funds for mortgage loans made to residential homeowners.
These securities generally represent interests in pools of mortgage loans made by savings and loan institutions, mortgage bankers,
commercial banks and other mortgage lenders. These pools of mortgage loans are assembled for sale to investors, such as us, by
various government-related or private organizations.
Agency mortgage-backed securities differ from other forms of traditional debt securities, which normally provide for periodic
payments of interest in fixed amounts with principal payments at maturity or on specified call dates. Instead, agency mortgage-
backed securities provide for a monthly payment, which may consist of both interest and principal. In effect, these payments are
a “pass-through” of the monthly interest and principal payments made by the individual borrower on the mortgage loans, net of
any fees paid to the issuer, servicer or guarantor of the securities. In addition, principal may be prepaid, without penalty, at par at
any time due to prepayments on the underlying mortgage loans. These differences can result in significantly greater price and
yield volatility than is the case with traditional fixed-income securities.
Various factors affect the rate at which mortgage prepayments occur, including changes in the level of and directional trends
in housing prices, interest rates, general economic conditions, loan age and size, loan-to-value ratio, the location of the property
and social and demographic conditions. Additionally, changes to GSE underwriting practices or other governmental programs
could also significantly impact prepayment rates or expectations. Also, the pace at which the loans underlying our securities
become seriously delinquent or are modified and the timing of GSE repurchases of such loans from our securities can materially
impact the rate of prepayments. Generally, prepayments on agency mortgage-backed securities increase during periods of falling
mortgage interest rates and decrease during periods of rising mortgage interest rates. However, this may not always be the case.
We may reinvest principal repayments at a yield that is lower or higher than the yield on the repaid investment, thus affecting our
net interest income by altering the average yield on our assets.
When interest rates are declining, the value of agency mortgage-backed securities with prepayment options may not increase
as much as other fixed income securities or could even decrease. The rate of prepayments on underlying mortgages affect the price
and volatility of agency mortgage-backed securities and may have the effect of shortening or extending the duration of the security
beyond what was anticipated at the time of purchase. When interest rates rise, our holdings of agency mortgage-backed securities
may experience reduced returns if the owners of the underlying mortgages pay off their mortgages slower than anticipated. This
could cause the prices of our mortgage assets to fall more than we anticipated and for our hedge portfolio to underperform relative
to the decline in the value of our mortgage assets, thus reducing our net book value. This is generally referred to as “extension
risk”.
Payments of principal and interest on agency mortgage-backed securities, although not the market value of the securities
themselves, are guaranteed either by the full faith and credit of the United States, such as those issued by Ginnie Mae, or by a
GSE, such as those issued by Fannie Mae or Freddie Mac.
Agency mortgage-backed securities are collateralized by pools of fixed-rate mortgage loans or adjustable-rate mortgage
loans (“ARMs”), including hybrid ARMs. Hybrid ARMs are mortgage loans that have interest rates that are fixed for an initial
period (typically three, five, seven or 10 years) and, thereafter, reset at regular intervals subject to interest rate caps. Our allocation
of investments among securities collateralized by fixed-rate mortgage loans, ARMs or hybrid ARMs depends on our Manager's
assessment of the relative value of the securities, which is based on numerous factors including, but not limited to, expected future
prepayment trends, supply and demand, costs of financing, costs of hedging, expected future interest rate volatility and the overall
shape of the U.S. Treasury and interest rate swap yield curves.
Fannie Mae and Freddie Mac:
We primarily invest in Fannie Mae and Freddie Mac agency mortgage-backed securities. Fannie Mae and Freddie Mac
are stockholder-owned corporations chartered by Congress with a public mission to provide liquidity, stability, and affordability
to the U.S. housing market. Fannie Mae and Freddie Mac are currently regulated by the Federal Housing Finance Agency (“FHFA”),
the U.S. Department of Housing and Urban Development ("HUD"), the U.S. Securities and Exchange Commission, and the
U.S. Department of the Treasury (“U.S. Treasury”), and are currently operating under the conservatorship of FHFA. The U.S.
Treasury has agreed to support the continuing operations of Fannie Mae and Freddie Mac with any necessary capital contributions
3
while in conservatorship. However, the U.S. government does not guarantee the securities, or other obligations, of Fannie Mae
or Freddie Mac.
Fannie Mae and Freddie Mac operate in the secondary mortgage market. They purchase residential mortgage loans and
mortgage-related securities from primary mortgage market institutions, such as commercial banks, savings and loan associations,
mortgage banking companies, seller/servicers, securities dealers and other investors. Through the mortgage securitization process,
they package the purchased mortgage loans into guaranteed mortgage-backed securities for sale to investors, such as us, in the
form of pass-through certificates and guarantee the payment of principal and interest on the securities or, on the underlying loans
held within the securitization trust, in exchange for guarantee fees. The underlying loans must meet certain underwriting standards
established by Fannie Mae and Freddie Mac (referred to as “conforming loans”) and may be fixed or adjustable rate loans with
original terms to maturity generally up to 40 years.
Ginnie Mae:
Ginnie Mae is a wholly-owned corporate instrumentality of the United States within HUD. Ginnie Mae guarantees the timely
payment of the principal of and interest on certificates that represent an interest in a pool of mortgages insured by the Federal
Housing Administration, or FHA, or partially guaranteed by the Department of Veterans Affairs and other loans eligible for inclusion
in mortgage pools underlying Ginnie Mae certificates. Section 306(g) of the Housing Act provides that the full faith and credit of
the United States is pledged to the payment of all amounts which may be required to be paid under any guaranty by Ginnie Mae.
At present, most Ginnie Mae certificates are backed by single-family mortgage loans.
Agency Debenture Securities
We may also invest in agency debenture securities issued by Freddie Mac, Fannie Mae or the FHLB, a GSE. The agency
debentures in which we may invest are not backed by collateral, but by the credit worthiness of the issuing GSE.
Investment Methods
We purchase agency securities either in initial offerings or on the secondary market through broker-dealers or similar entities.
We may also utilize to-be-announced forward contracts ("TBA securities") in order to invest in agency mortgage-backed securities
or to hedge our investments. A TBA security is a forward contract for the purchase or the sale of agency securities at a predetermined
price, face amount, issuer, coupon and stated maturity on an agreed-upon future date, but the particular agency securities to be
delivered are not identified until shortly before the TBA settlement date. We may also choose, prior to settlement, to move the
settlement of these securities out to a later date by entering into an offsetting position (referred to as a "pair off"), net settling the
paired off positions for cash, and simultaneously entering into a similar TBA contract for a later settlement date, which is commonly
collectively referred to as a “dollar roll” transaction.
Our Active Portfolio Management Strategy
Our Manager employs on our behalf an active management strategy to achieve our principal objectives of generating attractive
risk-adjusted returns and preservation of our net book value. Our active management strategy involves buying and selling securities
in all sectors of the agency securities market, including fixed-rate agency securities, adjustable-rate agency securities, options on
agency securities, agency CMOs and agency debenture securities based on our Manager's continual assessment of the relative
value and risk and return of these securities and ability to economically hedge a portion of our exposure to market risks. Therefore,
the composition of our portfolio and hedging strategies will vary as our Manager believes changes to market conditions, risks and
valuations warrant. Consequently, we may experience investment gains or losses when we sell securities that our Manager no
longer believes provide attractive risk-adjusted returns or when our Manager believes more attractive alternatives are available in
the agency securities market. We may also experience gains or losses as a result of our hedging strategies. Our leverage may also
fluctuate as we pursue our active management strategy, but we generally would expect our leverage to be six to eleven times our
stockholders' equity.
Investment Committee and Investment Guidelines
The investment committee established by our Manager consists of Messrs. Malon Wilkus, John R. Erickson, Samuel A. Flax
and Thomas A. McHale, each of whom is an officer of our Manager. The role of the investment committee is to monitor the
performance of our Manager with respect to our investment guidelines and investment strategy, to monitor our investment portfolio
and to monitor our compliance requirements related to our intention to qualify as a REIT and to remain exempt from registration
as an investment company under the Investment Company Act. The investment committee meets as frequently as it believes is
required to maintain prudent oversight of our investment activities. Our Board of Directors receives an investment report and
reviews our investment portfolio and related compliance with the investment guidelines on at least a quarterly basis. Our Board
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of Directors does not review or approve individual investments, but receives notification in the event that we operate outside of
our operating policies or investment guidelines.
Our Board of Directors has approved the following investment guidelines:
•
•
•
•
all of our investments shall be in agency securities (other than for hedging purposes and investments in approved broker-
dealers);
no investment shall be made that would cause us to fail to qualify as a REIT for federal income tax purposes;
no investment shall be made that would cause us to be regulated as an investment company under the Investment
Company Act; and
prior to entering into any proposed investment transaction with American Capital or any of its affiliates, a majority of
our independent directors must approve the terms of the transaction.
The investment committee may change these investment guidelines at any time, including a change that would permit us to
invest in other mortgage related investments, with the approval of our Board of Directors, (which must include a majority of our
independent directors), but without any approval from our stockholders.
Our Financing Strategy
As part of our investment strategy, we leverage our investment portfolio to increase potential returns to our stockholders.
Our primary source of financing is through short-term repurchase agreements. A repurchase transaction acts as a financing
arrangement under which we effectively pledge our investment securities as collateral to secure a short-term loan. Our borrowings
pursuant to these repurchase transactions generally have maturities that range from 30 days to one year, but may have maturities
of fewer than 30 days or up to five or more years. Under our repurchase agreements we typically pay a floating rate based on the
one, three or six month London Interbank Offered Rate, or LIBOR, plus or minus a fixed spread.
Our leverage may vary periodically depending on market conditions and our Manager's assessment of risk and returns. We
generally would expect our leverage to be within six to eleven times the amount of our stockholders' equity. However, under
certain market conditions, we may operate at leverage levels outside of this range for extended periods of time. We also cannot
assure you that we will continue to be successful in borrowing sufficient amounts to fund our intended acquisitions of agency
securities.
We have master repurchase agreements with 32 financial institutions as of December 31, 2012. The terms of the repurchase
transaction borrowings under our master repurchase agreements generally conform to the terms in the standard master repurchase
agreement as published by the Securities Industry and Financial Markets Association ("SIFMA") as to repayment, margin
requirements and the segregation of all securities we have initially sold under the repurchase transaction. In addition, each lender
typically requires that we include supplemental terms and conditions to the standard master repurchase agreement. Typical
supplemental terms and conditions include changes to the margin maintenance requirements, required haircuts, purchase price
maintenance requirements, requirements that all controversies related to the repurchase agreement be litigated in a particular
jurisdiction and cross default provisions. These provisions differ for each of our lenders and certain of these terms are not determined
until we engage in a specific repurchase transaction.
We may also seek to obtain other sources of financing depending on market conditions. We may finance the acquisition of
agency mortgage-backed securities by entering into TBA dollar roll transactions in which we would sell a TBA contract for current
month settlement and simultaneously purchase a similar, but not identical, TBA contract for a forward settlement date. Prior to
the forward settlement date, we may choose to roll the position out to a later date by entering into an offsetting TBA position, net
settling the paired off positions for cash, and simultaneously entering into a similar TBA contract for a later settlement date. In
such transactions, the TBA contract purchased for a forward settlement date is priced at a discount to the TBA contract sold for
settlement/pair off in the current month. This difference (or discount) is referred to as the “price drop”. The price drop is the
economic equivalent of net interest carry income on the underlying agency mortgage-backed securities over the roll period (interest
income less implied financing cost) and is commonly referred to as "dollar roll income." Consequently, dollar roll transactions
represent a form of off-balance sheet financing. In evaluating our overall leverage at risk, our Manager considers both our on-
balance and off-balance sheet financing.
Our Risk Management Strategy
We use a variety of strategies to economically hedge a portion of our exposure to market risks, including interest rate and
prepayment risk, to the extent that our Manager believes is prudent, taking into account our investment strategy, the cost of the
hedging transactions and our intention to qualify as a REIT. As a result, we may not hedge certain interest rate or prepayment
5
risks if our Manager believes that bearing such risks enhances our return relative to our risk/return profile, or the hedging transaction
would negatively impact our REIT status.
•
Interest Rate Risk. We hedge some of our exposure to potential interest rate mismatches between the interest we earn
on our longer term investments and the costs on our shorter term borrowings. Because a majority of our leverage is in
the form of repurchase agreements, our financing costs fluctuate based on short-term interest rate indices, such as LIBOR.
Because our investments are assets that primarily have fixed rates of interest and could mature in up to 40 years, the
interest we earn on those assets generally does not move in tandem with the interest rates that we pay on our repurchase
agreements. We may experience reduced income or losses based on these rate movements. In order to mitigate such risk,
we utilize certain hedging techniques to effectively lock in a portion of the spread between the interest we earn on our
assets and the interest we pay on our financing costs.
• Prepayment Risk. Because residential borrowers are able to prepay their mortgage loans at par at any time, we face the
risk that we will experience a return of principal on our investments earlier than anticipated, and we may have to invest
that principal at potentially lower yields. Because prepayments on residential mortgages generally accelerate when interest
rates decrease and slow when interest rates increase, mortgage securities typically have "negative convexity." In other
words, certain mortgage securities in which we invest may increase in price more slowly than most bonds, or even fall
in value, as interest rates decline. Conversely, certain mortgage securities in which we invest may decrease in value more
quickly than similar duration bonds as interest rates increase. In order to manage our prepayment and interest rate risks,
we monitor, among other things, our "duration gap" and our convexity exposure. Duration is the relative expected
percentage change in market value of our assets that would be caused by a parallel change in short and long-term interest
rates. Convexity exposure relates to the way the duration of a mortgage security changes when the interest rate and
prepayment environment changes.
The principal instruments that we use to hedge a portion of our exposure to interest rate and prepayment risks are interest
rate swaps and options to enter into interest rate swaps (“interest rate swaptions”). We also purchase or sell TBAs, specified agency
securities on a forward basis, U.S. Treasury securities and U.S. Treasury futures contracts; purchase or write put or call options
on TBA securities; and invest in other types of mortgage derivatives, such as interest-only securities, and synthetic total return
swaps, such as the Markit IOS Synthetic Total Return Swap Index (“Markit IOS Index”).
The risk management actions we take may lower our earnings and dividends in the short term to further our objective of
maintaining attractive levels of earnings and dividends over the long term. However, there can be no certainty that our Manager's
projections of our exposures to interest rates, prepayments or other risks will be accurate or that our hedging activities will be
effective and, therefore, actual results could differ materially.
Income from hedging transactions that we enter into to manage risk may not constitute qualifying gross income under one
or both of the gross income tests applicable to REITs. Therefore, we may have to limit our use of certain advantageous hedging
techniques, which could expose us to greater risks than we would otherwise want to bear, or implement those hedges through a
taxable REIT subsidiary ("TRS"). Implementing our hedges through a TRS could increase the cost of our hedging activities
because a TRS is subject to tax on income and gains.
Other Investment Strategies
We may enter into other short or long term investment strategies as the opportunities arise.
Our Manager
We are externally managed and advised by our Manager pursuant to the terms of a management agreement. Our Manager
is an indirect subsidiary of American Capital Asset Management, LLC, which is a portfolio company of American Capital, Ltd.,
a publicly-traded private equity firm and global asset manager (NASDAQ: ACAS). American Capital, both directly and through
its asset management business, originates, underwrites and manages investments in private equity, leveraged finance, real estate
and structured products. Founded in 1986, American Capital had $117 billion in assets under management and eight offices in the
United States and Europe as of December 31, 2012.
The sister company of our Manager is the external manager of American Capital Mortgage Investment Corp. (NASDAQ:
MTGE) ("MTGE"), a publicly-traded REIT that invests in agency mortgage investments, non-agency mortgage investments and
other mortgage related investments. In connection with our initial public offering, American Capital committed not to sponsor
another investment vehicle that invests predominantly in agency securities that represent undivided beneficial interests in a group
or pool of one or more mortgages, or whole-pool agency securities, for so long as we are managed by an affiliate of American
Capital. Thus, MTGE's investment portfolio is expected to consist of assets that are not predominantly whole-pool agency securities
for so long as we are managed by an affiliate of American Capital.
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Our Manager is responsible for administering our business activities and day-to-day operations, subject to the supervision
and oversight of our Board of Directors. All of our officers and the members of our mortgage investment team and other support
personnel are employees of either the parent company of our Manager or American Capital. Because neither we nor our Manager
have any employees, our Manager has entered into an administrative services agreement with American Capital and the
parent company of our Manager, pursuant to which our Manager has access to their employees, infrastructure, business
relationships, management expertise, information technologies, capital raising capabilities, legal and compliance functions, and
accounting, treasury and investor relations capabilities, to enable our Manager to fulfill all of its responsibilities under the
management agreement. We are not a party to the administrative services agreement.
Malon Wilkus is our Chair and Chief Executive Officer and the Chief Executive Officer of our Manager and its parent
company, American Capital Mortgage Management, LLC. Mr. Wilkus is also the Chair and Chief Executive Officer of MTGE
and the Chief Executive Officer of its manager, American Capital MTGE Management, LLC. In addition, Mr. Wilkus is the founder
of American Capital, and has served as its Chief Executive Officer and Chairman of the Board of Directors since 1986, except for
the period from 1997 to 1998 during which he served as Chief Executive Officer and Vice Chairman of the Board of Directors.
He also served as President of American Capital from 2001 to 2008 and from 1986 to 1999. Mr. Wilkus has also been the Chairman
of European Capital Limited, a European private equity and mezzanine fund, since its formation in 2005. Additionally, Mr. Wilkus
is the Chief Executive Officer and President of American Capital Asset Management, LLC, which is the asset fund management
portfolio company of American Capital. He has also served on the board of directors of over a dozen middle-market companies
in various industries.
Gary Kain is the President of our Manager and also serves as our President and Chief Investment Officer, with primary
oversight for all of our investments. He is also the President and Chief Investment Officer of MTGE and the President of its
manager. Mr. Kain joined American Capital in January 2009 as a Senior Vice President and Managing Director and has served
in various other roles with American Capital and its affiliates. Prior to joining American Capital, Mr. Kain served as Senior Vice
President of Investments and Capital Markets of Freddie Mac from May 2008 to January 2009. Since joining Freddie Mac in
1988, Mr. Kain served as Senior Vice President of Mortgage Investments & Structuring of Freddie Mac from February 2005 to
April 2008, during which time he was responsible for managing all of Freddie Mac's mortgage investment activities for its $700
billion retained portfolio. From 2001 to 2005, Mr. Kain served as Vice President of Mortgage Portfolio Strategy at Freddie Mac.
John R. Erickson is our Executive Vice President and Chief Financial Officer and a member of our Board of Directors,
and Executive Vice President and Treasurer of our Manager and American Capital Mortgage Management, LLC. Mr. Erickson is
also the Executive Vice President and Chief Financial Officer and a member of the board of directors of MTGE and the Executive
Vice President and Treasurer of its manager, American Capital MTGE Management, LLC. In addition, he is the Executive Vice
President and Treasurer of American Capital Asset Management, LLC. Mr. Erickson has also served as President, Structured
Finance of American Capital since 2008 and as its Chief Financial Officer since 1998. From 1991 to 1998, Mr. Erickson was the
Chief Financial Officer of Storage USA, Inc., a REIT formerly traded on the New York Stock Exchange (NYSE: SUS).
Samuel A. Flax is our Executive Vice President and Secretary and a member of our Board of Directors, and Executive
Vice President, Chief Compliance Officer and Secretary of our Manager and American Capital Mortgage Management, LLC. Mr.
Flax is also Executive Vice President and Secretary and a member of the board of directors of MTGE and the Executive Vice
President, Chief Compliance Officer and Secretary of its manager, American Capital MTGE Management, LLC. In addition, he
is the Executive Vice President, Chief Compliance Officer and Secretary of American Capital Asset Management, LLC. Mr. Flax
has also served as the Executive Vice President, General Counsel, Chief Compliance Officer and Secretary of American Capital,
Ltd. since January 2005. Mr. Flax was a partner in the corporate and securities practice group of the Washington, D.C. law firm
of Arnold & Porter LLP from 1990 to January 2005. At Arnold & Porter LLP, he represented American Capital in raising debt and
equity capital, advised the company on corporate, securities and other legal matters and represented the company in many of its
investment transactions.
Peter J. Federico is the Senior Vice President and Chief Risk Officer of our Manager and also serves as our Senior Vice
President and Chief Risk Officer. He is also the Senior Vice President and Chief Risk Officer of affiliates of our Manager and of
MTGE. He is primarily responsible for overseeing risk management activities for us and other funds managed by affiliates of our
Manager. Mr. Federico joined our Manager in May 2011. Prior to that, Mr. Federico served as Executive Vice President and
Treasurer of Freddie Mac from October 2010 through May 2011, where he was primarily responsible for managing the company's
investment activities for its retained portfolio and developing, implementing and managing risk mitigation strategies. He was also
responsible for managing Freddie Mac's $1.2 trillion interest rate derivative portfolio and short and long-term debt issuance
programs. Mr. Federico also served in a number of other capacities at Freddie Mac, including as Senior Vice President, Asset &
Liability Management, after he joined the company in 1988.
Christopher J. Kuehl is a Senior Vice President of our Manager and also serves as our Senior Vice President of Mortgage
Investments. He is also the Senior Vice President of Mortgage Investments of affiliates of our Manager and of MTGE. He is
7
primarily responsible for directing purchases and sales of agency securities for us and other funds managed by affiliates of our
Manager. Mr. Kuehl joined American Capital in August 2010. Prior to that, Mr. Kuehl served as Vice President of Mortgage
Investments & Structuring of Freddie Mac, where he was primarily responsible for directing Freddie Mac's purchases, sales and
structuring activities for all MBS products, including fixed-rate mortgages, ARMs and CMOs. Prior to joining Freddie Mac in
2000, Mr. Kuehl was a Portfolio Manager with TeleBanc/Etrade Bank.
The Management Agreement
We have entered into a management agreement with our Manager with a current renewal term through May 20, 2013, and
automatic one-year extension options thereafter. The management agreement may only be terminated by either us or our Manager
without cause, as defined in the management agreement, after the completion of the current renewal term, or the expiration of any
automatic subsequent renewal term, provided that either party provides 180-days prior written notice of non-renewal of the
management agreement. If we were not to renew the management agreement without cause, we must pay a termination fee on the
last day of the applicable term, equal to three times the average annual management fee earned by our Manager during the prior
24-month period immediately preceding the most recently completed month prior to the effective date of termination. We may
only not renew the management agreement with or without cause with the consent of a majority of our independent directors. Our
Manager is responsible for, among other things, performing all of our day-to-day functions, determining investment criteria in
conjunction with our Board of Directors, sourcing, analyzing and executing investments, asset sales and financings and performing
asset management duties.
We pay our Manager a base management fee payable monthly in arrears in an amount equal to one twelfth of 1.25% of our
Equity. Our Equity is defined as our month-end stockholders' equity, adjusted to exclude the effect of any unrealized gains or
losses included in either retained earnings or accumulated other comprehensive income (“OCI”) (a separate component of
stockholders' equity), each as computed in accordance with GAAP. There is no incentive compensation payable to our Manager
pursuant to the management agreement.
In addition, we reimburse our Manager for expenses directly related to our operations incurred by our Manager, but excluding
employment-related expenses of our Manager's officers and employees and any American Capital employees who provide services
to us pursuant to the management agreement.
Exemption from Regulation under the Investment Company Act
We conduct our business so as not to become regulated as an investment company under the Investment Company Act, in
reliance on the exemption provided by Section 3(c)(5)(C) of the Investment Company Act. Section 3(c)(5)(C), as interpreted by
the staff of the SEC, requires us to invest at least 55% of our assets in "mortgages and other liens on and interest in real estate" or
"qualifying real estate interests" and at least 80% of our assets in qualifying real estate interests and "real estate-related assets."
In satisfying this 55% requirement, based on pronouncements of the SEC staff, we treat agency mortgage-backed securities issued
with respect to an underlying pool of mortgage loans in which we hold all of the certificates issued by the pool ("whole pool"
securities) as qualifying real estate interests. We currently treat agency mortgage-backed securities in which we hold less than all
of the certificates issued by the pool ("partial pool" securities) as real estate-related assets. We treat CMO securities as real-estate
related assets. We treat agency debenture securities as non-qualifying real estate assets.
Real Estate Investment Trust Requirements
We have elected to be taxed as a REIT under the Internal Revenue Code. As long as we qualify as a REIT, we generally
will not be subject to federal income taxes on our taxable income to the extent that we annually distribute all of our taxable income
to stockholders. We believe that we have been organized and operate in such a manner as to qualify for taxation as a REIT.
Qualification and taxation as a REIT depends on our ability to meet on a continuing basis various qualification requirements
imposed upon REITs by the Internal Revenue Code. Our ability to qualify as a REIT also requires that we satisfy certain asset
tests, some of which depend upon the fair market values of assets that we own directly or indirectly. Such values may not be
susceptible to precise determination. Accordingly, no assurance can be given that the actual results of our operations for any
taxable year will satisfy such requirements for qualification and taxation as a REIT.
Taxation of REITs in General
Provided that we continue to qualify as a REIT, we will generally be entitled to a deduction for dividends that we pay and
therefore will not be subject to federal corporate income tax on our taxable income that is currently distributed to our stockholders.
This treatment substantially eliminates the “double taxation” at the corporate and stockholder levels that generally results from
investment in a corporation. In general, the income that we generate is taxed only at the stockholder level upon a distribution of
dividends to our stockholders.
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As a REIT, we will nonetheless be subject to federal tax under certain circumstances including the following:
• We will be taxed at regular corporate rates on any undistributed taxable income, including undistributed net capital
gains.
• We may be subject to the “alternative minimum tax” on our items of tax preference, including any deductions of net
operating losses.
•
•
•
•
If we have net income from prohibited transactions, which are, in general, sales or other dispositions of inventory or
property held primarily for sale to customers in the ordinary course of business, other than foreclosure property, such
income will be subject to a 100% tax.
If we should fail to satisfy the 75% gross income test or the 95% gross income test, as discussed below, but nonetheless
maintain our qualification as a REIT because we satisfy other requirements, we will be subject to a 100% tax on an
amount based on the magnitude of the failure, as adjusted to reflect the profit margin associated with our gross income.
If we should violate the asset tests (other than certain de minimis violations) or other requirements applicable to REITs,
as described below, and yet maintain our qualification as a REIT because there is reasonable cause for the failure and
other applicable requirements are met, we may be subject to a penalty tax. In that case, the amount of the penalty tax
will be at least $50,000 per failure, and, in the case of certain asset test failures, will be determined as the amount of
net income generated by the assets in question multiplied by the highest corporate tax rate (currently 35%) if that amount
exceeds $50,000 per failure.
If we should fail to distribute during each calendar year at least the sum of (a) 85% of our REIT ordinary income for
such year, (b) 95% of our REIT capital gain net income for such year, and (c) any undistributed taxable income from
prior periods, we would be subject to a nondeductible 4% excise tax on the excess of the required distribution over the
sum of (i) the amounts that we actually distributed and (ii) the amounts we retained and upon which we paid income
tax at the corporate level.
• We may be required to pay monetary penalties to the IRS in certain circumstances, including if we fail to meet record
keeping requirements intended to monitor our compliance with rules relating to the composition of a REIT's stockholders,
as described below in “Requirements for Qualification-General.”
• A 100% tax may be imposed on transactions between us and our TRSs (as described below), that do not reflect arm's-
length terms.
•
If we acquire appreciated assets from a corporation that is not a REIT (i.e., a corporation taxable under subchapter C
of the Internal Revenue Code) in a transaction in which the adjusted tax basis of the assets in our hands is determined
by reference to the adjusted tax basis of the assets in the hands of the subchapter C corporation, we may be subject to
tax on such appreciation at the highest corporate income tax rate then applicable if we subsequently recognize a gain
on a disposition of any such assets during the ten-year period following their acquisition from the subchapter C
corporation.
•
The earnings of our subsidiaries, including our TRSs, are subject to federal corporate income tax to the extent that such
subsidiaries are subchapter C corporations and not qualified REIT subsidiaries ("QRS").
Requirements for Qualification-General
The Internal Revenue Code defines a REIT as a corporation, trust or association:
(1)
that is managed by one or more trustees or directors;
(2)
the beneficial ownership of which is evidenced by transferable shares, or by transferable certificates of beneficial
interest;
(3)
that would be taxable as a domestic corporation but for its election to be subject to tax as a REIT;
(4)
that is neither a financial institution nor an insurance company subject to specific provisions of the Internal Revenue
Code;
(5)
the beneficial ownership of which is held by 100 or more persons;
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(6)
in which, during the last half of each taxable year, not more than 50% in value of the outstanding stock is owned,
directly or indirectly, by five or fewer “individuals” (as defined in the Internal Revenue Code to include specified tax-
exempt entities); and
(7) which meets other tests described below, including with respect to the nature of its income and assets.
The Internal Revenue Code provides that conditions (1) through (4) must be met during the entire taxable year, and that
condition (5) must be met during at least 335 days of a taxable year of 12 months. Our amended and restated articles of incorporation
provides restrictions regarding the ownership and transfers of our stock, which are intended to assist us in satisfying the stock
ownership requirements described in conditions (5) and (6) above.
To monitor compliance with the stock ownership requirements, we generally are required to maintain records regarding the
actual ownership of our stock. To do so, we must demand written statements each year from the record holders of significant
percentages of our stock pursuant to which the record holders must disclose the actual owners of the stock (i.e., the persons required
to include our dividends in their gross income). We must maintain a list of those persons failing or refusing to comply with this
demand as part of our records. We could be subject to monetary penalties if we fail to comply with these record-keeping requirements.
If a stockholder fails or refuses to comply with the demands, the stockholder will be required by Treasury regulations to submit
a statement with their tax return disclosing their actual ownership of our stock and other information.
The Internal Revenue Code provides relief from violations of the REIT gross income requirements, as described below
under “Income Tests,” in cases where a violation is due to reasonable cause and not to willful neglect, and other requirements are
met, including the payment of a penalty tax that is based upon the magnitude of the violation. In addition, certain provisions of
the Internal Revenue Code extend similar relief in the case of certain violations of the REIT asset requirements (see “Asset Tests”
below) and other REIT requirements, again provided that the violation is due to reasonable cause and not willful neglect and other
conditions are met, including the payment of a penalty tax. If we fail to satisfy any of the various REIT requirements, there can
be no assurance that these relief provisions would be available to enable us to maintain our qualification as a REIT, and, if such
relief provisions are available, the amount of any resultant penalty tax could be substantial.
Effect of Taxable Subsidiaries
In general, we may jointly elect with a subsidiary corporation, whether or not wholly-owned, to treat such subsidiary
corporation as a taxable REIT subsidiary. We generally may not own more than 10% of the securities of a taxable corporation, as
measured by voting power or value, unless we and such corporation elect to treat such corporation as a taxable REIT subsidiary.
The separate existence of a taxable REIT subsidiary or other taxable corporation is not ignored for federal income tax purposes.
Accordingly, such entities generally are subject to corporate income tax on their earnings, which may reduce the cash flow that
we and our subsidiaries generate in the aggregate, and may reduce our ability to make distributions to our stockholders.
For determining compliance with the "Income Tests" and "Asset Tests" applicable to REITs described below, the gross
income and assets of TRSs and other taxable subsidiaries are excluded. Instead, actual dividends paid to the REIT from such
taxable subsidiaries, if any, are included in the REIT's gross income tests and the value of the REIT's net investment in such entities
is included in the gross asset tests. Because the gross income and assets of a TRS or other taxable subsidiary corporations are
excluded in determining compliance with the REIT requirements, we may use such entities to undertake indirectly activities that
the REIT rules might otherwise preclude us from doing directly or through pass-through subsidiaries. For example, we may use
our TRS or other taxable subsidiary corporations to conduct activities that give rise to certain categories of income or to conduct
activities that, if conducted by us directly, could be treated in our hands as non-real estate related or prohibited transactions.
We jointly elected to treat our wholly-owned subsidiary, American Capital Agency TRS, LLC as a TRS.
The TRS rules limit the deductibility of interest paid or accrued by a TRS to its parent REIT to assure that the TRS is subject
to an appropriate level of corporate taxation. Further, the rules impose a 100% excise tax on transactions between a TRS and its
parent REIT that are not conducted on an arm's-length basis. We intend that all of our transactions with our TRSs will be conducted
on an arm's-length basis.
Qualified REIT Subsidiaries
A qualified REIT subsidiary (or "QRS") is any corporation in which we own 100% of such corporation's outstanding
stock and for which no election has been made to classify it as a taxable REIT subsidiary. As such, their assets, liabilities and
income would generally be treated as our assets, liabilities and income for purposes of each of the below REIT qualification tests.
We currently do not have a QRS.
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Income Tests
In order to continue to qualify as a REIT, we must satisfy two gross income requirements on an annual basis.
1. At least 75% of our gross income for each taxable year, excluding gross income from sales of inventory or dealer property
in “prohibited transactions” and certain hedging transactions, generally must be derived from investments relating to
real property or mortgages on real property, including interest income derived from mortgage loans secured by real
property (including, generally, agency mortgage-backed securities and certain other types of mortgage-backed
securities), “rents from real property,” dividends received from other REITs, and gains from the sale of real estate assets,
as well as specified income from temporary investments.
2. At least 95% of our gross income in each taxable year, excluding gross income from prohibited transactions and certain
hedging transactions, must be derived from some combination of income that qualifies under the 75% gross income test
described above, as well as other dividends, interest, and gain from the sale or disposition of stock or securities, which
need not have any relation to real property.
Interest income constitutes qualifying mortgage interest for purposes of the 75% gross income test described above to the
extent that the obligation upon which such interest is paid is secured by a mortgage on real property. If we receive interest income
with respect to a mortgage loan that is secured by both real property and other property, and the highest principal amount of the
loan outstanding during a taxable year exceeds the fair market value of the real property on the date that we acquired or originated
the mortgage loan, the interest income will be apportioned between the real property and the other collateral, and our income from
the arrangement will qualify for purposes of the 75% gross income test only to the extent that the interest is allocable to the real
property. Even if a loan is not secured by real property, or is under secured, the income that it generates may nonetheless qualify
for purposes of the 95% gross income test.
We treat our investments in agency mortgage-backed securities either as interests in a grantor trust or as interests in a real
estate mortgage investment conduit (“REMIC”) for federal income tax purposes and, therefore, treat all interest income from our
agency mortgage-backed securities as qualifying income for the 95% gross income test. In the case of agency mortgage-backed
securities treated as interests in grantor trusts, we treat these as owning an undivided beneficial ownership interest in the mortgage
loans held by the grantor trust. Such mortgage loans generally qualify as real estate assets to the extent that they are secured by
real property. The interest on such mortgage loans are qualifying income for purposes of the 75% gross income test to the extent
that the obligation is secured by real property, as discussed above. In the case of agency mortgage-backed securities treated as
interests in a REMIC, income derived from REMIC interests is generally treated as qualifying income for purposes of the 75%
gross income tests. If less than 95% of the assets of the REMIC are real estate assets, however, then only a proportionate part of
our interest in the REMIC and income derived from the interest qualifies for purposes of the 75% gross income test. In addition,
some REMIC securitizations include embedded interest rate swap or cap contracts or other derivative instruments that potentially
could produce non-qualifying income for the holder of the related REMIC securities. We expect that substantially all of our income
from agency mortgage-backed securities will continue to be qualifying income for purposes of the REIT gross income tests.
We purchase and sell agency mortgage-backed securities through TBA contracts and recognize income or gains from the
disposition of those TBAs, through dollar roll transactions or otherwise, and may continue to do so in the future. While there is
no direct authority with respect to the qualification of income or gains from dispositions of TBAs as gains from the sale of real
property (including interests in real property and interests in mortgages on real property) or other qualifying income for purposes
of the 75% gross income test, we treat income and gains from our TBAs as qualifying income for purposes of the 75% gross
income test, based on an opinion of Skadden, Arps, Slate, Meagher & Flom LLP substantially to the effect that, for purposes of
the 75% REIT gross income test, any gain recognized by us in connection with the settlement of our TBAs should be treated as
gain from the sale or disposition of the underlying agency securities. Opinions of counsel are not binding on the IRS, and no
assurance can be given that the IRS will not successfully challenge the conclusions set forth in such opinions. In addition, it must
be emphasized that the opinion of Skadden, Arps, Slate, Meagher & Flom LLP is based on various assumptions relating to our
TBAs and is conditioned upon fact-based representations and covenants made by our management regarding our TBAs. No
assurance can be given that the IRS would not assert that such income is not qualifying income. If the IRS were to successfully
challenge the opinion of Skadden, Arps, Slate, Meagher & Flom LLP, we could be subject to a penalty tax or we could fail to
qualify as a REIT if a sufficient portion of our income consists of income or gains from the disposition of TBAs.
We may directly or indirectly receive distributions from our TRSs or other corporations that are not REITs or qualified REIT
subsidiaries. These distributions generally are treated as dividend income to the extent of the earnings and profits of the distributing
corporation. Such distributions will generally constitute qualifying income for purposes of the 95% gross income test, but not for
purposes of the 75% gross income test. Any dividends that we receive from a REIT, however, will be qualifying income for
purposes of both the 95% and 75% gross income tests.
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Any income or gain that we derive from instruments that hedge the risk of changes in interest rates will generally be excluded
from both the numerator and the denominator for purposes of the 75% and 95% gross income test, provided that specified
requirements are met, including the requirement that the instrument is entered into during the ordinary course of our business, the
instrument hedges risks associated with indebtedness issued by us that is incurred to acquire or carry “real estate assets” (as
described below under “Asset Tests”), and the instrument is properly identified as a hedge along with the risk that it hedges within
prescribed time periods. Income and gain from all other hedging transactions will not be qualifying income for either the 95% or
75% gross income test.
Under The Housing and Economic Recovery Tax Act of 2008, the Secretary of the Treasury has been given broad authority
to determine whether particular items of gain or income recognized after July 30, 2008 qualify or not under the 75% and 95%
gross income tests, or are to be excluded from the measure of gross income for such purposes.
If we fail to satisfy one or both of the 75% or 95% gross income tests for any taxable year we may still qualify as a REIT
for such year if we are entitled to relief under applicable provisions of the Internal Revenue Code. These relief provisions will be
generally available if (1) our failure to meet these tests was due to reasonable cause and not due to willful neglect and (2) following
our identification of the failure to meet the 75% or 95% gross income test for any taxable year, we file a schedule with the IRS
setting forth each item of our gross income for purposes of the 75% or 95% gross income test for such taxable year in accordance
with Treasury regulations yet to be issued. It is not possible to state whether we would be entitled to the benefit of these relief
provisions in all circumstances. If these relief provisions are inapplicable to a particular set of circumstances, we will not qualify
as a REIT. As discussed above under “Taxation of REITs in General,” even where these relief provisions apply, the Internal Revenue
Code imposes a tax based upon the amount by which we fail to satisfy the particular gross income test.
Asset Tests
At the close of each calendar quarter, we must also satisfy four tests relating to the nature of our assets.
1. At least 75% of the value of our total assets must be represented by some combination of “real estate assets,” cash, cash
items, U.S. Government securities, and, under some circumstances, stock or debt instruments purchased with new capital.
For this purpose, real estate assets include some kinds of mortgage-backed securities and mortgage loans, as well as
interests in real property and stock of other corporations that qualify as REITs. Assets that do not qualify for purposes of
the 75% asset test are subject to the additional asset tests described below.
2. The value of any one issuer's securities that we own may not exceed 5% of the value of our total assets.
3. We may not own more than 10% of any one issuer's outstanding securities, as measured by either voting power or value.
The 5% and 10% asset tests do not apply to securities of TRSs and qualified REIT subsidiaries and the 10% asset test
does not apply to “straight debt” having specified characteristics and to certain other securities.
4. The aggregate value of all securities of all TRSs that we hold may not exceed 25% of the value of our total assets.
We enter into sale and repurchase agreements under which we nominally sell certain of our investment securities to a
counterparty and simultaneously enter into an agreement to repurchase the sold assets in exchange for a purchase price that reflects
a financing charge. We believe that we would be treated for REIT asset and income test purposes as the owner of the collateral
that is the subject of any such agreement notwithstanding that such agreement may transfer record ownership of the assets to the
counterparty during the term of the agreement. It is possible, however, that the IRS could assert that we did not own such collateral
during the term of the sale and repurchase agreement, in which case we could fail to qualify as a REIT.
As discussed above, we purchase and sell agency mortgage-backed securities through TBAs and may continue to do so in
the future. While there is no direct authority with respect to the qualification of TBAs as real estate assets or U.S. Government
securities for purposes of the 75% asset test, we treat our TBAs as qualifying assets for purposes of the REIT asset tests, based
on an opinion of Skadden, Arps, Slate, Meagher & Flom LLP substantially to the effect that, for purposes of the REIT asset tests,
our ownership of a TBA should be treated as ownership of the underlying agency mortgage-backed securities. Opinions of counsel
are not binding on the IRS, and no assurance can be given that the IRS will not successfully challenge the conclusions set forth
in such opinions. In addition, it must be emphasized that the opinion of Skadden, Arps, Slate, Meagher & Flom LLP is based on
various assumptions relating to our TBAs and is conditioned upon fact-based representations and covenants made by our
management regarding our TBAs. No assurance can be given that the IRS would not assert that such assets are not qualifying
assets. If the IRS were to successfully challenge the opinion of Skadden, Arps, Slate, Meagher & Flom LLP, we could be subject
to a penalty tax or we could fail to qualify as a REIT if a sufficient portion of our assets consists of TBAs.
No independent appraisals have been obtained to support our conclusions as to the value of our total assets or the value of
any particular security or securities. Moreover, values of some assets, including instruments issued in securitization transactions,
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may not be susceptible to a precise determination, and values are subject to change in the future. Furthermore, the proper
classification of an instrument as debt or equity for federal income tax purposes may be uncertain in some circumstances, which
could affect the application of the REIT asset requirements. Accordingly, there can be no assurance that the IRS will not contend
that our interests in our subsidiaries or in the securities of other issuers will not cause a violation of the REIT asset tests.
If we should fail to satisfy the asset tests at the end of a calendar quarter, such a failure would not cause us to lose our REIT
qualification if we (1) satisfied the asset tests at the close of the preceding calendar quarter and (2) the discrepancy between the
value of our assets and the asset requirements was not wholly or partly caused by an acquisition of non-qualifying assets, but
instead arose from changes in the market value of our assets. If the condition described in (2) were not satisfied, we still could
avoid disqualification by eliminating any discrepancy within 30 days after the close of the calendar quarter in which it arose or
by making use of relief provisions described below.
Annual Distribution Requirements
In order to qualify as a REIT, we are required to distribute dividends, other than capital gain dividends, to our stockholders
in an amount at least equal to:
(a) the sum of
(1) 90% of our “REIT taxable income,” computed without regard to our net capital gains and the deduction for
dividends paid, and
(2) 90% of our net income after tax, if any, from foreclosure property minus
(b) the sum of specified items of non-cash income.
We generally must make these distributions in the taxable year to which they relate, or in the following taxable year if
declared before we timely file our tax return for the year and if paid with or before the first regular dividend payment after such
declaration.
To the extent that we distribute at least 90%, but less than 100%, of our “REIT taxable income,” within the period described
above, we will be subject to tax at ordinary corporate tax rates on the retained portion. We may elect to retain, rather than distribute,
our net long-term capital gains and pay tax on such gains. In this case, we could elect for our stockholders to include their
proportionate shares of such undistributed long-term capital gains in income, and to receive a corresponding credit for their share
of the tax that we paid. Our stockholders would then increase their adjusted basis of their stock by the difference between (a) the
amounts of capital gain dividends that we designated and that they include in their taxable income, minus (b) the tax that we paid
on their behalf with respect to that income.
To the extent that in the future we may have available net operating losses carried forward from prior tax years, such losses
may reduce the amount of distributions that we must make in order to comply with the REIT distribution requirements. Such
losses, however, will generally not affect the character, in the hands of our stockholders, of any distributions that are actually made
as ordinary dividends or capital gains.
If we should fail to distribute during each calendar year at least the sum of (a) 85% of our REIT ordinary income for such
year, (b) 95% of our REIT capital gain net income for such year, and (c) any undistributed taxable income from prior periods, we
would be subject to a non-deductible 4% excise tax on the excess of such required distribution over the sum of (x) the amounts
actually distributed, plus (y) the amounts of income we retained and on which we have paid corporate income tax.
It is possible that, from time to time, we may not have sufficient cash to meet the distribution requirements due to timing
differences between our actual receipt of cash and our inclusion of items in income for federal income tax purposes. For example,
mortgage-backed securities that are issued at a discount generally require the accrual of taxable economic interest in advance of
receipt in cash.
Derivatives and Hedging Transactions
We maintain a risk management strategy, under which we may use a variety of derivative instruments to economically hedge
some of our exposure to market risks, including interest rate and prepayment risk. Any such hedging transactions could take a
variety of forms, including the use of derivative instruments such as interest rate swap agreements, interest rate swaptions, interest
rate cap or floor contracts and futures or forward contracts. We may also purchase or short TBA and U.S. Treasury securities,
purchase or write put or call options on TBA securities or we may invest in other types of mortgage derivative securities. To the
extent that we enter into a hedging transaction to reduce interest rate risk on indebtedness incurred to acquire or carry real estate
assets and the instrument is properly identified as a hedge along with the risk it hedges within prescribed time periods, any periodic
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income from the instrument, or gain from the disposition of such instrument, would be excluded altogether from the 75% and 95%
gross income test.
To the extent that we hedge in other situations, the resultant income may not qualify under the 75% or the 95% gross income
tests. We intend to structure any hedging transactions in a manner that does not jeopardize our status as a REIT. We may conduct
some of our hedging activities through our TRS, the income from which would be subject to federal and state income tax, rather
than by participating in the arrangements directly.
Failure to Qualify
If we fail to satisfy one or more requirements for REIT qualification other than the income or asset tests, we could avoid
disqualification if our failure is due to reasonable cause and not to willful neglect and we pay a penalty of $50,000 for each such
failure. Relief provisions are available for failures of the income tests and asset tests, as described above in “Income Tests” and
“Asset Tests.”
If we fail to qualify for taxation as a REIT in any taxable year, and the relief provisions described above do not apply, we
would be subject to tax, including any applicable alternative minimum tax, on our taxable income at regular corporate rates. We
cannot deduct distributions to stockholders in any year in which we are not a REIT, nor would we be required to make distributions
in such a year. In this situation, to the extent of current and accumulated earnings and profits, distributions to domestic common
stockholders that are individuals, trusts and estates will generally be taxable as a qualified dividend eligible for the maximum
federal tax rate of 20% provided that the shares have been held for more than 60 days during the 121 day period beginning 60
days before the ex-dividend date. For certain distributions to preferred stockholders, the relevant holding period is at least 91 days
out of the 181 day period beginning 90 days before the ex–dividend date. In addition, subject to the limitations of the Internal
Revenue Code, corporate distributees may be eligible for the dividends received deduction. Unless we are entitled to relief under
specific statutory provisions, we would also be disqualified from re-electing to be taxed as a REIT for the four taxable years
following the year during which we lost qualification. It is not possible to state whether, in all circumstances, we would be entitled
to this statutory relief.
Corporate Information
Our executive offices are located at Two Bethesda Metro Center, 14th Floor, Bethesda, MD 20814 and our telephone number
is (301) 968-9300.
We make available all of our Annual Reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K
and amendments to such reports as well as our Code of Ethics and Conduct free of charge on our internet website at www.AGNC.com
as soon as reasonably practical after such material is electronically filed with or furnished to the Securities and Exchange
Commission (“SEC”). These reports are also available on the SEC internet website at www.sec.gov.
Competition
Our success depends, in large part, on our ability to acquire assets at favorable spreads over our borrowing costs. In acquiring
agency securities, we compete with mortgage REITs, mortgage finance and specialty finance companies, savings and loan
associations, banks, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, other
lenders, governmental bodies and other entities. These entities and others that may be organized in the future may have similar
asset acquisition objectives and increase competition for the available supply of agency securities suitable for purchase.
Additionally, our investment strategy is dependent on the amount of financing available to us in the repurchase agreement market,
which may also be impacted by competing borrowers. Our investment strategy will be adversely impacted if we are not able to
secure financing on favorable terms, if at all.
Employees
We have no employees. We are managed by our Manager pursuant to the management agreement between our Manager
and us.
Item 1A. Risk Factors
You should carefully consider the risks described below and all other information contained in this Annual Report on Form
10-K, including our annual consolidated financial statements and the related notes thereto before making a decision to purchase
our securities. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties not
presently known to us, or not presently deemed material by us, may also impair our operations and performance.
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If any of the following risks actually occur, our business, financial condition or results of operations could be materially
adversely affected. If that happens, the trading price of our securities could decline, and you may lose all or part of your investment.
Risks Related to Our Investing, Portfolio Management and Financing Activities
Our Board of Directors has approved very broad investment guidelines for our Manager and will not approve each investment
and financing decision made by our Manager.
Our Manager is authorized to follow very broad investment guidelines that may be amended from time-to-time. Our
Board of Directors periodically reviews our investment guidelines and our investment portfolio but does not, and will not be
required to, review all of our proposed investments on an individual basis. In conducting periodic reviews, our Board of Directors
relies primarily on information provided to it by our Manager. Furthermore, our Manager may use complex strategies and
transactions that may be costly, difficult or impossible to unwind if our Board of Directors determines that they are not consistent
with our investment guidelines. In addition, because our Manager has a certain amount of discretion in investment, financing and
hedging decisions, our Manager's decisions could result in investment returns that are substantially below expectations or that
result in losses, which would materially and adversely affect our business, financial condition and results of operations.
We may experience significant short-term gains or losses and, consequently, greater earnings volatility as a result of our active
portfolio management strategy.
Our Manager employs an active management strategy on our behalf to achieve our principal objective of generating
attractive risk-adjusted returns. Our active management strategy involves buying and selling financial instruments in all sectors
of the agency securities market, including fixed-rate and adjustable-rate agency securities, CMOs, mortgage-related derivatives
and agency debenture securities, based on our Manager's continual assessment of the relative risk/return of those investments.
Therefore, the composition of our investment portfolio will vary as our Manager believes changes to market conditions, risks and
valuations warrant. Consequently, we may experience significant investment gains or losses when we sell investments that our
Manager no longer believes provide attractive risk-adjusted returns or when our Manager believes more attractive alternatives are
available. With an active management strategy, our Manager may be incorrect in its assessment of our investment portfolio and
select an investment portfolio that could generate lower returns than a more static management strategy. Also, investors are less
able to assess the changes in our valuation and performance by observing changes in the mortgage market since we may have
changed our strategy and portfolio from the last publicly available data. We may also experience fluctuations in leverage as we
pursue our active management strategy.
Our strategy involves significant leverage, which increases the risk that we may incur substantial losses.
We expect our leverage to vary with market conditions and our assessment of risk/return on investments. We incur this
leverage by borrowing against a substantial portion of the market value of our assets. By incurring this leverage, we could enhance
our returns. Nevertheless, this leverage, which is fundamental to our investment strategy, also creates significant risks.
Because of our significant leverage, we may incur substantial losses if our borrowing costs increase. Our borrowing costs
may increase for any of the following reasons:
short-term interest rates increase;
the market value of our investments decreases;
the "haircut" applied to our assets under the repurchase agreements we are party to increases;
interest rate volatility increases; or
the availability of financing in the market decreases.
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We operate in a highly competitive market for investment opportunities and our competitors may be able to compete more
effectively for investment opportunities than we can. This competition may limit our ability to acquire desirable investments
in our target assets and could affect the pricing of these investments.
A number of entities compete with us to make investments. We compete with other REITs and public and private funds,
including those that may be managed by affiliates of American Capital, such as American Capital Mortgage Investment Corp.,
commercial and investment banks, commercial finance and insurance companies and other financial institutions. Our competitors
may have greater financial, technical and marketing resources than we do. Some competitors may have a lower cost of funds than
we do or access to funding sources that may not be available to us. Many of our competitors are not subject to the operating
constraints associated with REIT tax compliance and maintenance of an exemption from the Investment Company Act. In addition,
some of our competitors may have higher risk tolerances or different risk assessments, which may allow them to consider a wider
variety of investments and establish more relationships than we can. Furthermore, competition for investments in mortgage-related
investments may lead to the price of such assets increasing, which may further limit our ability to generate desired returns. The
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competitive pressures we face could have a material adverse effect on our business, financial condition and results of operations.
Also, as a result of this competition, we may not be able to take advantage of attractive investment opportunities from time to
time, and we may not be able to identify and make investments that are consistent with our investment objectives.
The federal conservatorship of Fannie Mae and Freddie Mac and related efforts, along with any changes in laws and regulations
affecting the relationship between these agencies and the U.S. Government, may adversely affect our business.
The payments of principal and interest we receive on the agency securities in which we may invest are guaranteed by
Fannie Mae, Freddie Mac or Ginnie Mae. Fannie Mae and Freddie Mac are GSEs, but their guarantees are not backed by the full
faith and credit of the United States. Ginnie Mae is part of a U.S. Government agency and its guarantees are backed by the full
faith and credit of the United States.
In response to general market instability and, more specifically, the financial conditions of Fannie Mae and Freddie Mac,
in July 2008, the Housing and Economic Recovery Act of 2008, or HERA, established FHFA as the new regulator for Fannie Mae
and Freddie Mac. In September 2008, the U.S. Treasury, the FHFA and the U.S. Federal Reserve announced a comprehensive
action plan to help stabilize the financial markets, support the availability of mortgage financing and protect taxpayers. Under this
plan, among other things, the FHFA was appointed as conservator of both Fannie Mae and Freddie Mac, allowing the FHFA to
control the actions of the two GSEs, without forcing them to liquidate, which would be the case under receivership. Importantly,
the primary focus of the plan was to increase the availability of mortgage financing by allowing these GSEs to continue to grow
their guarantee business without limit, while limiting the size of their retained mortgage and agency security portfolios and requiring
that these portfolios be reduced over time.
Although the U.S. Government has committed to support the positive net worth of Fannie Mae and Freddie Mac, the two
GSEs could default on their guarantee obligations, which would materially and adversely affect the value of our agency securities.
Accordingly, if these government actions are inadequate and the GSEs continue to suffer losses or cease to exist, our business,
operations and financial condition could be materially and adversely affected.
In addition, the future roles of Fannie Mae and Freddie Mac could be significantly reduced and the nature of their guarantee
obligations could be considerably limited relative to historical measurements. Any such changes to the nature of their guarantee
obligations could re-define what constitutes an agency security and could have broad adverse implications for the market and our
business, operations and financial condition.
We could be negatively affected in a number of ways depending on the manner in which related events unfold for Fannie
Mae and Freddie Mac. We rely on our agency securities as collateral for our financings. Any decline in the value of agency
securities, or perceived market uncertainty about their value, would make it more difficult for us to obtain financing on favorable
terms or at all, or to maintain our compliance with the terms of any financing transactions for such investments. Further, the current
support provided by the U.S. Treasury to Fannie Mae and Freddie Mac, and any additional support it may provide in the future,
could have the effect of lowering the interest rates we expect to receive from agency securities, thereby tightening the spread
between the interest we earn on our agency securities and the cost of financing those assets. A reduction in the supply of agency
securities could also negatively affect the pricing of agency securities by reducing the spread between the interest we earn on our
investment portfolio of agency securities and our cost of financing that portfolio.
As indicated above, recent legislation has changed the relationship between Fannie Mae and Freddie Mac and the U.S.
Government. Future legislation could further change the relationship between Fannie Mae and Freddie Mac and the U.S.
Government, and could also nationalize, privatize, or eliminate such entities entirely. Any law affecting these GSEs may create
market uncertainty and have the effect of reducing the actual or perceived credit quality of securities issued or guaranteed by
Fannie Mae or Freddie Mac. As a result, such laws could increase the risk of loss on our investments in agency securities guaranteed
by Fannie Mae and/or Freddie Mac. It also is possible that such laws could adversely impact the market for such securities and
spreads at which they trade. All of the foregoing could materially and adversely affect our financial condition and results of
operations.
Purchases and sales of agency mortgage-backed securities by the Federal Reserve may adversely affect the price and return
associated with agency securities.
On September 13, 2012, the Federal Reserve announced their third quantitative easing program, commonly known as QE3,
and extended their guidance to keep the federal funds rate at "exceptional low levels" through at least mid-2015. QE3 entails large-
scale purchases of agency mortgage-backed securities at the pace of $40 billion per month in addition to the Federal Reserve's
existing policy of reinvesting principal payments from its holdings of agency mortgage-backed securities into new agency
mortgage-backed securities purchases. While we cannot predict the impact of this program or any future actions by the Federal
Reserve on the prices and liquidity of agency mortgage-backed securities, we expect that during periods in which the Federal
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Reserve purchases significant volumes of agency mortgage-backed securities, yields on agency mortgage-backed securities will
be lower and refinancing volumes will be higher than would have been absent their large scale purchases. As a result, returns on
agency mortgage-backed securities may be adversely affected. There is also a risk that as the Federal Reserve reduces their
purchases of agency mortgage-backed securities or if they decide to sell some or all of their holdings of agency mortgage-backed
securities, the pricing of our agency mortgage-backed securities portfolio may be adversely affected.
Mortgage loan modification and refinancing programs and future legislative action may adversely affect the value of, and our
returns on, agency mortgage-backed securities.
The U.S. Government, through the U.S. Federal Reserve, the FHA, and the Federal Deposit Insurance Corporation, has
implemented a number of federal programs designed to assist homeowners, including the Home Affordable Modification Program,
or HAMP, which provides homeowners with assistance in avoiding residential mortgage loan foreclosures, the Hope for
Homeowners Program, or H4H Program, which allows certain distressed borrowers to refinance their mortgages into FHA-insured
loans in order to avoid residential mortgage loan foreclosures, and the Home Affordable Refinance Program, or HARP, which for
loans sold or guaranteed by the GSEs on or prior to May 31, 2009, allows borrowers who are current on their mortgage payments
to refinance and reduce their monthly mortgage payments, with no current loan-to-value ratio upper limit and without requiring
new mortgage insurance. HAMP, the H4H Program and other loss mitigation programs may involve, among other things, the
modification of mortgage loans to reduce the principal amount of the loans (through forbearance and/or forgiveness) and/or the
rate of interest payable on the loans, or the extension of payment terms of the loans. These loan modification programs, future
legislative or regulatory actions, including possible amendments to the bankruptcy laws, which result in the modification of
outstanding residential mortgage loans, as well as changes in the requirements necessary to qualify for refinancing mortgage loans
with Fannie Mae, Freddie Mac or Ginnie Mae, may adversely affect the value of, and the returns on, agency mortgage-backed
securities that we may purchase.
Actions of the U.S. Government, including the U.S. Congress, U.S. Federal Reserve, U.S. Treasury and other governmental
and regulatory bodies, to stabilize or reform the financial markets may not achieve the intended effect and may adversely affect
our business.
U.S. Government actions may not have a beneficial impact on the financial markets. To the extent the markets do not
respond favorably to any such actions by the U.S. Government or such actions do not function as intended, our business may not
receive the anticipated positive impact from the legislation and such result may have broad adverse market implications.
In July 2010, the U.S. Congress enacted the Dodd Frank Wall Street Reform and Consumer Protection Act, or the Dodd-
Frank Act, in part to impose significant investment restrictions and capital requirements on banking entities and other organizations
that are significant to U.S. financial markets. For instance, the Dodd-Frank Act imposes significant restrictions on the proprietary
trading activities of certain banking entities and subjects other systemically significant organizations regulated by the U.S. Federal
Reserve to increased capital requirements and quantitative limits for engaging in such activities. The Dodd-Frank Act also seeks
to reform the asset-backed securitization market (including the mortgage-backed securities market) by requiring the retention of
a portion of the credit risk inherent in the pool of securitized assets and by imposing additional registration and disclosure
requirements. Certain of the new requirements and restrictions exempt agency securities, other government issued or guaranteed
securities, or other securities. Nonetheless, the Dodd-Frank Act also imposes significant regulatory restrictions on the origination
of residential mortgage loans and will impact the formation of new issuances of mortgage-backed securities. The Dodd-Frank Act
has also created a new regulator, the Consumer Financial Protection Bureau, or the CFPB, which now oversees many of the core
laws which regulate the mortgage industry, including among others, the Real Estate Settlement Procedures Act and the Truth in
Lending Act. While the full impact of the Dodd-Frank Act and the role of the CFPB cannot be assessed until all implementing
regulations are released, the Dodd-Frank Act's extensive requirements may have a significant effect on the financial markets, and
may affect the availability or terms of financing from our lender counterparties and the availability or terms of mortgage-backed
securities, both of which may have an adverse effect on our financial condition and results of operations.
In addition, the U.S. Government, Federal Reserve, U.S. Treasury and other governmental and regulatory bodies have
taken or are considering taking other actions to address the financial crisis. We cannot predict whether or when such actions may
occur or what effect, if any, such actions could have on our business, results of operations and financial condition.
We are subject to the risk that the GSEs may not be able to satisfy fully their guarantee obligations or that these guarantee
obligations may be repudiated, which may adversely affect the value of our investment portfolio and our ability to sell or finance
these securities.
The interest and principal payments we receive on the agency securities in which we invest are guaranteed by Fannie
Mae, Freddie Mac or Ginnie Mae. Unlike the Ginnie Mae certificates in which we invest, the principal and interest on securities
issued by Fannie Mae and Freddie Mac are not explicitly guaranteed by the U.S. Government. All the agency mortgage-backed
securities in which we invest depend on a steady stream of payments on the mortgages underlying the securities.
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As conservator of Fannie Mae and Freddie Mac, the FHFA may disaffirm or repudiate contracts (subject to certain
limitations for qualified financial contracts) that Freddie Mac or Fannie Mae entered into prior to the FHFA's appointment as
conservator if it determines, in its sole discretion, that performance of the contract is burdensome and that disaffirmation or
repudiation of the contract promotes the orderly administration of its affairs. The HERA requires the FHFA to exercise its right
to disaffirm or repudiate most contracts within a reasonable period of time after its appointment as conservator. Fannie Mae and
Freddie Mac have disclosed that the FHFA has disaffirmed certain consulting and other contracts that these entities entered into
prior to the FHFA's appointment as conservator. Freddie Mac and Fannie Mae have also disclosed that the FHFA has advised that
it does not intend to repudiate any guarantee obligation relating to Fannie Mae and Freddie Mac's mortgage-related securities,
because the FHFA views repudiation as incompatible with the goals of the conservatorship. In addition, the HERA provides that
mortgage loans and mortgage-related assets that have been transferred to a Freddie Mac or Fannie Mae securitization trust must
be held for the beneficial owners of the related mortgage-related securities, and cannot be used to satisfy the general creditors of
Freddie Mac or Fannie Mae.
If the guarantee obligations of Freddie Mac or Fannie Mae were repudiated by FHFA, payments of principal and/or
interest to holders of agency securities issued by Freddie Mac or Fannie Mae would be reduced in the event of any borrower's late
payments or failure to pay or a servicer's failure to remit borrower payments to the trust. In that case, trust administration and
servicing fees could be paid from mortgage payments prior to distributions to holders of agency securities. Any actual direct
compensatory damages owed due to the repudiation of Freddie Mac or Fannie Mae's guarantee obligations may not be sufficient
to offset any shortfalls experienced by holders of agency securities. FHFA also has the right to transfer or sell any asset or liability
of Freddie Mac or Fannie Mae, including its guarantee obligation, without any approval, assignment or consent. If FHFA were to
transfer Freddie Mac or Fannie Mae's guarantee obligations to another party, holders of agency securities would have to rely on
that party for satisfaction of the guarantee obligation and would be exposed to the credit risk of that party.
Market conditions may disrupt the historical relationship between interest rate changes and prepayment trends, which may
make it more difficult for our Manager to analyze our investment portfolio.
Our success depends, in part, on our Manager's ability to analyze the relationship of changing interest rates on prepayments
of the mortgage loans that underlie securities we may own. Changes in interest rates and prepayments affect the market price of
the assets that we purchase and any assets that we may hold at a given time. As part of our overall portfolio risk management, our
Manager analyzes interest rate changes and prepayment trends separately and collectively to assess their effects on our investment
portfolio. In conducting its analysis, our Manager depends on certain assumptions based upon historical trends with respect to the
relationship between interest rates and prepayments under normal market conditions. Dislocations in the residential mortgage
market and other developments may disrupt the relationship between the way that prepayment trends have historically responded
to interest rate changes and, consequently, may negatively impact our Manager's ability to (i) assess the market value of our
investment portfolio, (ii) implement our hedging strategies and (iii) implement techniques to reduce our prepayment rate volatility,
which could materially adversely affect our financial position and results of operations.
Continued adverse developments in the broader residential mortgage market may adversely affect the value of our investments.
Since 2008, the residential mortgage market in the United States has experienced a variety of unprecedented difficulties
and changed economic conditions, including defaults, credit losses and liquidity concerns. Many of these conditions are expected
to continue in 2013 and beyond. These factors have impacted investor perception of the risk associated with real estate related
assets, including mortgage-related investments. As a result, values for these assets have experienced a certain amount of volatility.
Further increased volatility and deterioration in the broader residential mortgage and RMBS markets may adversely affect the
performance and market value of the assets in which we invest.
The risks associated with our business are more severe during economic recessions and are compounded by declining
real estate values. Declining real estate values will likely reduce the level of new mortgage loan originations since borrowers often
use appreciation in the value of their existing properties to support the purchase of additional properties. Borrowers will also be
less able to pay principal and interest on loans underlying the securities in which we invest if the value of residential real estate
weakens further. Any sustained period of increased payment delinquencies, foreclosures or losses could increase the rate that the
GSEs buyout the delinquent loans from pools underlying the agency securities in which we invest, resulting in an increased rate
of prepayments that could adversely affect our net interest income from our agency securities, which could have an adverse effect
on our financial condition, results of operations and our ability to make distributions to our stockholders.
Our investments are recorded at fair value, and quoted prices or observable inputs may not be available to determine such
value, resulting in the use of significant unobservable inputs to determine value.
The values of our investments may not be readily determinable or ultimately realizable. We measure the fair value of our
investments quarterly, in accordance with guidance set forth in FASB Accounting Standards Codification ("ASC") Topic 820, Fair
Value Measurements and Disclosures. Ultimate realization of the value of an asset depends to a great extent on economic and
18
other conditions that are beyond the control of our Manager, our Company or our Board of Directors. Further, fair value is only
an estimate based on good faith judgment of the price at which an investment can be sold since market prices of investments can
only be determined by negotiation between a willing buyer and seller. If we were to liquidate a particular asset, the realized value
may be more than or less than the amount at which such asset is valued. Accordingly, the value of our common stock could be
adversely affected by our determinations regarding the fair value of our investments, whether in the applicable period or in the
future. Additionally, such valuations may fluctuate over short periods of time.
Our Manager's determination of the fair value of our investments includes inputs provided by third-party dealers and
pricing services. Valuations of certain investments in which we invest may be difficult to obtain or unreliable. In general, dealers
and pricing services heavily disclaim their valuations. Dealers may claim to furnish valuations only as an accommodation and
without special compensation, and so they may disclaim any and all liability for any direct, incidental, or consequential damages
arising out of any inaccuracy or incompleteness in valuations, including any act of negligence or breach of any warranty. Depending
on the complexity and illiquidity of a security, valuations of the same security can vary substantially from one dealer or pricing
service to another. Therefore, our results of operations for a given period could be adversely affected if our determinations regarding
the fair market value of these investments are materially different than the values that we ultimately realize upon their disposal.
Declines in value of the assets in which we invest will adversely affect our financial position and results of operations, and
make it more costly to finance these assets.
We use our investments as collateral for our financings. Any decline in their value, or perceived market uncertainty about
their value, could make it difficult for us to obtain financing on favorable terms or at all, or maintain our compliance with terms
of any financing arrangements already in place. Our investments in mortgage-related securities are recorded at fair value with
changes in fair value reported in other comprehensive income (a component of equity). As a result, a decline in fair values of our
mortgage-related securities could reduce both our comprehensive income and stockholders' equity. If market conditions result in
a decline in the fair value of our assets, our financial position and results of operations could be adversely affected.
Failure to procure adequate repurchase agreement financing or to renew or replace existing repurchase agreement financing
as it matures (to which risk we are specifically exposed due to the short-term nature of the repurchase agreement financing
we employ) would adversely affect our results of operations.
We use debt financing as a strategy to increase our return on equity. However, we may not be able to achieve our desired
leverage ratio for a number of reasons, including the following:
•
•
our lenders do not make repurchase or other financing agreements available to us at acceptable rates;
lenders with whom we enter into repurchase or other financing agreements subsequently exit the market for such
financing;
our lenders require that we pledge additional collateral to cover our borrowings, which we may be unable to do; or
•
• we determine that the leverage would expose us to excessive risk.
We cannot assure you that any, or sufficient, financing will be available to us in the future on terms that are acceptable
to us. In the event that we cannot obtain sufficient funding on acceptable terms, there may be a negative impact on the value of
our common stock and our ability to make distributions, and you may lose part or all of your investment.
Furthermore, because we rely primarily on short-term borrowings, our ability to achieve our investment objectives depends
not only on our ability to borrow money in sufficient amounts and on favorable terms, but also on our ability to renew or replace
on a continuous basis our maturing short-term borrowings. If we are not able to renew or replace maturing borrowings, we may
have to sell some or all of our assets, possibly under adverse market conditions. In addition, if the regulatory capital requirements
imposed on our lenders change, they may be required to significantly increase the cost of the financing that they provide to us.
Our lenders also may revise their eligibility requirements for the types of assets they are willing to finance or the terms of such
financings, based on, among other factors, the regulatory environment and their management of perceived risk, particularly with
respect to assignee liability.
Pursuant to the terms of borrowings under master repurchase agreements, we are subject to margin calls that could result in
defaults or force us to sell assets under adverse market conditions or through foreclosure.
We enter into master repurchase agreements with a number of financial institutions. We borrow under these master
repurchase agreements to finance the assets for our investment portfolio. Pursuant to the terms of borrowings under our master
repurchase agreements, a decline in the value of the collateral may result in our lenders initiating margin calls. A margin call means
that the lender requires us to pledge additional collateral to re-establish the ratio of the value of the collateral to the amount of the
borrowing. The specific collateral value to borrowing ratio that would trigger a margin call is not set in the master repurchase
agreements and is not determined until we engage in a repurchase transaction under these agreements. Our fixed-rate collateral
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generally may be more susceptible to margin calls as increases in interest rates tend to affect more negatively the market value of
fixed-rate securities. In addition, some collateral may be more illiquid than other instruments in which we invest, which could
cause them to be more susceptible to margin calls in a volatile market environment. Moreover, collateral that prepays more quickly
increases the frequency and magnitude of potential margin calls as there is a significant time lag between when the prepayment
is reported (which reduces the market value of the security) and when the principal payment is actually received. If we are unable
to satisfy margin calls, our lenders may foreclose on our collateral. The threat of or occurrence of a margin call could force us to
sell, either directly or through a foreclosure, our collateral under adverse market conditions. Because of the leverage we expect
to have, we may incur substantial losses upon the threat or occurrence of a margin call.
If lenders pursuant to our repurchase transactions default on their obligations to resell the underlying collateral back to us at
the end of the transaction term, or if the value of the collateral has declined by the end of the term or if we default on our
obligations under the transaction, we will lose money on these transactions.
When we engage in a repurchase transaction, we initially transfer securities or loans to the financial institution under one
of our master repurchase agreements in exchange for cash, and our counterparty is obligated to resell such assets to us at the end
of the term of the transaction, which is typically from 30 days to one year, but which may have terms from one day to up to five
years or more. The cash we receive when we initially sell the collateral is less than the value of that collateral, which is referred
to as the "haircut." As a result, we are able to borrow against a smaller portion of the collateral that we initially sell in these
transactions. Increased haircuts require us to post additional collateral. The haircut rates under our master repurchase agreements
are not set until we engage in a specific repurchase transaction under these agreements. If our counterparty defaults on its obligation
to resell collateral to us, we would incur a loss on the transaction equal to the amount of the haircut (assuming there was no change
in the value of the securities). Any losses we incur on our repurchase transactions could adversely affect our earnings, and, thus,
our cash available for distribution to our stockholders.
If we default on one of our obligations under a repurchase transaction, the counterparty can terminate the transaction and
cease entering into any other repurchase transactions with us. In that case, we would likely need to establish a replacement
repurchase facility with another financial institution in order to continue to leverage our investment portfolio and carry out our
investment strategy. We may not be able to secure a suitable replacement facility on acceptable terms or at all.
Further, financial institutions providing the repurchase agreements may require us to maintain a certain amount of cash
uninvested or to set aside non-leveraged assets sufficient to maintain a specified liquidity position which would allow us to satisfy
our collateral obligations. As a result, we may not be able to leverage our assets as fully as we would choose, which could reduce
our return on equity. If we are unable to meet these collateral obligations, our financial condition could deteriorate rapidly.
Additionally, our counterparties can unilaterally choose to cease entering into any further repurchase transactions with us.
Our rights under our repurchase agreements are subject to the effects of the bankruptcy laws in the event of the bankruptcy
or insolvency of us or our lenders under the repurchase agreements.
In the event of our insolvency or bankruptcy, certain repurchase agreements may qualify for special treatment under the
U.S. Bankruptcy Code, the effect of which, among other things, would be to allow the lender under the applicable repurchase
agreement to avoid the automatic stay provisions of the U.S. Bankruptcy Code and to foreclose on the collateral agreement without
delay. In the event of the insolvency or bankruptcy of a lender during the term of a repurchase agreement, the lender may be
permitted, under applicable insolvency laws, to repudiate the contract, and our claim against the lender for damages may be treated
simply as an unsecured creditor. In addition, if the lender is a broker or dealer subject to the Securities Investor Protection Act of
1970, or an insured depository institution subject to the Federal Deposit Insurance Act, our ability to exercise our rights to recover
our assets under a repurchase agreement or to be compensated for any damages resulting from the lender's insolvency may be
further limited by those statutes. These claims would be subject to significant delay and, if and when received, may be substantially
less than the damages we actually incur.
It may be uneconomical to "roll" our TBA dollar roll transactions or we may be unable to meet margin calls on our TBA
contracts, which could negatively affect our financial condition and results of operations.
We may utilize TBA dollar roll transactions as a means of investing in and financing agency mortgage-backed securities.
TBA contracts enable us to purchase or sell, for future delivery, agency securities with certain principal and interest terms and
certain types of collateral, but the particular agency securities to be delivered are not identified until shortly before the TBA
settlement date. Prior to settlement of the TBA contract we may choose to move the settlement of the securities out to a later date
by entering into an offsetting position (referred to as a "pair off"), net settling the paired off positions for cash, and simultaneously
purchasing a similar TBA contract for a later settlement date, collectively referred to as a “dollar roll.” The agency securities
purchased for a forward settlement date under the TBA contract are typically priced at a discount to agency securities for settlement
in the current month. This difference (or discount) is referred to as the “price drop.” The price drop is the economic equivalent
of net interest carry income on the underlying agency securities over the roll period (interest income less implied financing cost)
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and is commonly referred to as "dollar roll income." Consequently, dollar roll transactions and such forward purchases of agency
securities represent a form of off-balance sheet financing and increase our "at risk" leverage.
Under certain market conditions, TBA dollar roll transactions may result in negative carry income whereby the agency
securities purchased for a forward settlement date under the TBA contract are priced at a premium to agency securities for settlement
in the current month. Under such conditions, it would generally be uneconomical to roll our TBA positions prior to the settlement
date and we could have to take physical delivery of the underlying securities and settle our obligations for cash. We may not have
sufficient funds or alternative financing sources available to settle such obligations. In addition, pursuant to the margin provisions
established by the Mortgage-Backed Securities Division ("MBSD") of the Fixed Income Clearing Corporation we are subject to
margin calls on our TBA contracts. Further, our prime brokerage agreements may require us to post additional margin above the
levels established by the MBSD. Negative carry income on TBA dollar roll transactions or failure to procure adequate financing
to settle our obligations or meet margin calls under our TBA contracts could result in defaults or force us to sell assets under
adverse market conditions or through foreclosure and adversely affect our financial condition and results of operations.
An increase in our borrowing costs would adversely affect our financial condition and results of operations.
Increases in interest rates reduce the difference, or spread, that we may earn between the yield on the investments we
make and the cost of the leverage we employ to finance such investments. An increase in short-term interest rates would increase
the amount of interest owed on the financing arrangements we enter into to finance the purchase of the assets, such as repurchase
agreements. It is possible that the spread on investments could be reduced to a point at which the profitability from investments
would be significantly reduced. This would adversely affect our returns on our assets, financial condition and results of operations
and could require us to liquidate certain or all of our assets.
Differences in timing of interest rate adjustments on adjustable-rate assets or the tenor of fixed rate assets we acquire and our
borrowings may adversely affect our profitability.
Assets we acquire may have interest rates that vary over time based upon changes in an objective index, such as:
• LIBOR, which is the interest rate that banks in London offer for deposits in London of U.S. dollars; or
•
the U.S. Treasury rate, which is a monthly or weekly average yield of benchmark U.S. Treasury securities, as published
by the Federal Reserve Board.
These indices generally reflect short-term interest rates but these assets may not reset in a manner that matches our
borrowings. In addition, we may rely primarily on short-term and/or variable rate borrowings to acquire fixed-rate securities with
long-term maturities. The relationship between short-term and longer-term interest rates is often referred to as the "yield curve."
Ordinarily, short-term interest rates are lower than longer-term interest rates. If short-term interest rates rise disproportionately
relative to longer-term interest rates (a flattening of the yield curve), our borrowing costs may increase more rapidly than the
interest income earned on our assets. Because our investments generally bear interest at longer-term rates than we pay on our
borrowings, a flattening of the yield curve would tend to decrease our net interest income and the market value of our investment
portfolio. Additionally, to the extent cash flows from investments that return scheduled and unscheduled principal are reinvested,
the spread between the yields on the new investments and available borrowing rates may decline, which would likely decrease
our net income. It is also possible that short-term interest rates may exceed longer-term interest rates (a yield curve inversion), in
which event, our borrowing costs may exceed our interest income and we could incur operating losses and our ability to make
distributions to our stockholders could be hindered.
Interest rate caps on mortgages backing our adjustable rate securities may adversely affect our profitability.
Adjustable-rate mortgages that we may purchase or that may back securities that we purchase will typically be subject
to periodic and lifetime interest rate caps. Periodic interest rate caps limit the amount an interest rate can increase during any given
period. Lifetime interest rate caps limit the amount an interest rate can increase through the maturity of a mortgage loan we may
purchase or that may back securities that we may purchase. Our borrowings typically will not be subject to similar restrictions.
Accordingly, in a period of rapidly increasing interest rates, the interest rates paid on our borrowings could increase without
limitation while caps on mortgages could limit the interest rates on our investments in ARMs. This problem is magnified for hybrid
ARMs and ARMs that are not fully indexed. Further, some hybrid ARMs and ARMs may be subject to periodic payment caps on
the mortgages that result in a portion of the interest being deferred and added to the principal outstanding. As a result, we may
receive less cash income on hybrid ARMs and ARMs than we need to pay interest on our related borrowings. These factors could
reduce our net interest income and cause us to suffer a loss.
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An increase in interest rates may cause a decrease in the volume of newly issued, or investor demand for, mortgages, which
could adversely affect our ability to acquire assets that satisfy our investment objectives and to generate income and pay
dividends, while a decrease in interest rates may cause an increase in the volume of newly issued, or investor demand for,
mortgages, which could negatively affect the valuations for our investments and may adversely affect our liquidity.
A reduction in the volume of mortgage loans originated may affect the volume of investments available to us, which
could affect our ability to acquire assets that satisfy our investment objectives. An increase in the volume of mortgage loans
originated may negatively impact the valuation for our investment portfolio. A negative impact on valuations of our assets could
have an adverse impact on our liquidity profile in the event that we are required to post margin under our repurchase agreements,
which could materially and adversely impact our business.
Because we may invest in fixed-rate assets, an increase in interest rates on our borrowings may adversely affect our book value
or our net interest income.
Increases in interest rates may negatively affect the market value of our investments. Any fixed-rate securities we invest
in generally will be more negatively affected by these increases than adjustable-rate securities. In accordance with GAAP, we are
required to reduce the book value of our investments by the amount of any decrease in their fair value. Reductions in the fair value
of our investments could decrease the amounts we may borrow to purchase additional mortgage-related investments, which may
restrict our ability to increase our net income. Furthermore, if our funding costs are rising while our interest income is fixed, our
net interest income will contract and could become negative.
Changes in prepayment rates may adversely affect our profitability.
Our investment portfolio includes securities backed by pools of mortgage loans. For securities backed by pools of mortgage
loans, we receive payments, generally, from the payments that are made on these underlying mortgage loans. When borrowers
prepay their mortgage loans at rates that are faster or slower than expected, it results in prepayments that are faster or slower than
expected on our assets. These faster or slower than expected payments may adversely affect our profitability.
We may purchase securities that have a higher interest rate than the then prevailing market interest rate. In exchange for
this higher interest rate, we may pay a premium to par value to acquire the security. In accordance with GAAP, we amortize this
premium over the expected term of the security based on our prepayment assumptions. If a security is prepaid in whole or in part
at a faster than expected rate, however, we must expense all or a part of the remaining unamortized portion of the premium that
was paid at the time of the purchase, which will adversely affect our profitability.
We also may purchase securities that have a lower interest rate than the then prevailing market interest rate. In exchange
for this lower interest rate, we may pay a discount to par value to acquire the security. We accrete this discount over the expected
term of the security based on our prepayment assumptions. If a security is prepaid at a slower than expected rate, however, we
must accrete the remaining portion of the discount at a slower than expected rate. This will extend the expected life of our investment
portfolio and result in a lower than expected yield on securities purchased at a discount to par.
Prepayment rates generally increase when interest rates fall and decrease when interest rates rise, but changes in
prepayment rates are difficult to predict. Prepayments can also occur when borrowers sell the property and use the sale proceeds
to prepay the mortgage as part of a physical relocation or when borrowers default on their mortgages and the mortgages are prepaid
from the proceeds of a foreclosure sale of the property. Fannie Mae and Freddie Mac will generally, among other conditions,
purchase mortgages that are 120 days or more delinquent from mortgage-backed securities trusts when the cost of guarantee
payments to security holders, including advances of interest at the security coupon rate, exceeds the cost of holding the
nonperforming loans in their portfolios. Consequently, prepayment rates also may be affected by conditions in the housing and
financial markets, which may result in increased delinquencies on mortgage loans, the government-sponsored entities cost of
capital, general economic conditions and the relative interest rates on fixed and adjustable rate loans, which could lead to an
acceleration of the payment of the related principal. Additionally, changes in the government-sponsored entities' decisions as to
when to repurchase delinquent loans can materially impact prepayment rates.
In addition, the introduction of new government programs could increase the availability of mortgage credit to a large
number of homeowners in the United States, which we expect would impact the prepayment rates for the entire mortgage securities
market, but primarily for Fannie Mae and Freddie Mac agency securities. These new programs along with any new additional
programs or changes to existing programs may cause substantial uncertainty around the magnitude of changes in prepayment
speeds. To the extent that actual prepayment speeds differ from our expectations, it could adversely affect our operating results.
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Our hedging strategies may not be successful in mitigating the risks associated with changes in interest rates.
Subject to complying with REIT tax requirements, we employ techniques that limit, or "hedge," the adverse effects of
changes in interest rates on our short-term repurchase agreements and our net book value. In general, our hedging strategy depends
on our Manager's view of our entire investment portfolio, consisting of assets, liabilities and derivative instruments, in light of
prevailing market conditions. Our hedging activities are generally designed to limit certain exposures and not to eliminate them.
In addition, they may be unsuccessful and we could misjudge the condition of our investment portfolio or the market. Our hedging
activity will vary in scope based on the level and volatility of interest rates and principal repayments, credit market conditions,
the type of assets held and other changing market conditions. Our actual hedging decisions will be determined in light of the facts
and circumstances existing at the time and may differ from our currently anticipated hedging strategy. These techniques may
include entering into interest rate swap agreements, interest rate swaptions, TBAs, short sales, caps, collars, floors, forward
contracts, options, futures or other types of hedging transactions. We may conduct certain hedging transactions through a TRS,
which may subject those transactions to federal, state and, if applicable, local income tax.
There are no perfect hedging strategies, and interest rate and credit hedging may fail to protect us from loss. Additionally,
our business model calls for accepting certain amounts of interest rate, prepayment, liquidity, and other exposures and thus some
risks will generally not be hedged. Alternatively, our Manager may fail to properly assess a risk to our investment portfolio or
may fail to recognize a risk entirely, leaving us exposed to losses without the benefit of any offsetting hedging activities. The
derivative financial instruments we select may not have the effect of reducing our risk. The nature and timing of hedging transactions
may influence the effectiveness of these strategies. Poorly designed hedging strategies or improperly executed transactions could
actually increase our risk and losses. In addition, hedging activities could result in losses if the event against which we hedge does
not occur. For example, interest rate hedging could fail to protect us or adversely affect us because, among other things:
•
•
•
•
•
•
•
interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates;
available interest rate hedges may not correspond directly with the interest rate risk for which protection is sought;
the duration of the hedge may not match the duration of the related liability;
the amount of income that a REIT may earn from hedging transactions other than hedging transactions that satisfy
certain requirements of the Internal Revenue Code or that are done through a TRS to offset interest rate losses is
limited by federal tax provisions governing REITs;
as explained in further detail in the risk factor immediately below, the party owing money in the hedging transaction
may default on its obligation to pay;
the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our
ability to sell or assign our side of the hedging transaction; and
the value of derivatives used for hedging are adjusted from time to time in accordance with GAAP to reflect changes
in fair value. Downward adjustments, or "mark-to-market losses," reducing our stockholders' equity.
Our hedging strategies may adversely affect us because hedging activities involve costs that we incur regardless of the
effectiveness of the hedging activity. Those costs may be higher in periods of market volatility, both because the counterparties
to our derivative agreements may demand a higher payment for taking risks, and because repeated adjustments of our hedges
during periods of interest rate changes also may increase costs. We could incur significant hedging-related costs without any
corresponding economic benefits, especially if our hedging strategies are not effective.
Our use of certain hedging techniques may expose us to certain risks.
Hedging instruments often are not traded on regulated exchanges, guaranteed by an exchange or it's clearing house, or
regulated by any U.S. or foreign governmental authorities and involves risks and costs that could result in material losses. The
cost of using hedging instruments increases as the period covered by the instrument increases and, during periods of rising and
volatile interest rates, we may increase our hedging activity and thus increase our hedging costs. In addition, hedging instruments
involve risk because they often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated
by any U.S. or foreign governmental authorities. Consequently, there are no requirements with respect to record keeping, financial
responsibility or segregation of customer funds and positions. Furthermore, the enforceability of agreements underlying hedging
transactions may depend on compliance with applicable statutory and commodity and other regulatory requirements and, depending
on the domicile of the counterparty, applicable international requirements.
If a swap counterparty under an interest rate swap agreement that we enter into as part of our hedging strategy cannot
perform under the terms of the interest rate swap agreement, we may not receive payments due under that agreement, and, thus,
we may lose any potential benefit associated with the interest rate swap. Additionally, we may also risk the loss of any collateral
we have pledged to secure our obligations under these swap agreements if the counterparty becomes insolvent or files for bankruptcy.
Similarly, if an interest rate cap counterparty fails to perform under the terms of the interest rate cap agreement, in addition to not
23
receiving payments due under that agreement that would off-set our interest expense, we could also incur a loss for all remaining
unamortized premium paid for that security.
Pursuant to the terms of our master swap agreements, we are subject to margin calls that could result in defaults or force us
to sell assets under adverse market conditions.
Certain of our master swap agreements (governed by the International Swaps and Derivatives Association, Inc., or ISDA)
require that we post initial collateral upon execution of swap agreements. In addition, our master swap agreements contain provisions
under which we are required to collateralize fully our obligations under the derivative instrument, such that if at any point the fair
value of the derivative represents a liability greater than the minimum transfer amount contained within our agreement, the
counterparty may initiate a margin call for the difference. If we fail to satisfy the margin call, we will be required to settle our
obligations under the agreements at their termination values.
Further, our master swap agreements may also contain cross default provisions under which a default under certain of
our other indebtedness in excess of a certain threshold amount causes an event of default under the agreement. Following an event
of default, we could be required to settle our obligations under the agreements at their termination values.
The threat of or occurrence of margin calls or the forced settlement of our obligations under our master swap agreements
at their termination values could force us to sell, either directly or through a foreclosure, our investments under adverse market
conditions. Because of the leverage we have, we may incur substantial losses upon the threat or occurrence of either of these
events.
We may change our targeted investments, investment guidelines and other operational policies without stockholder consent,
which may adversely affect the market price of our common stock and our ability to make distributions to stockholders.
We may change our targeted investments and investment guidelines at any time, including a change that would permit
us to invest in other mortgage related investments, without the consent of our stockholders, which could result in our making
investments that are different from, and possibly riskier than, the investments described herein. Our Board of Directors also
determines our other operational policies and may amend or revise such policies, including our policies with respect to our REIT
qualification, acquisitions, dispositions, operations, indebtedness and distributions, or approve transactions that deviate from these
policies, without a vote of, or notice to, our stockholders. A change in our targeted investments, investment guidelines and other
operational policies may increase our exposure to interest rate risk, default risk, credit risk and real estate market fluctuations, all
of which could adversely affect the market price of our common stock and our ability to make distributions to our stockholders.
Risks Related to Our Relationship with Our Manager and American Capital
There are conflicts of interest in our relationship with our Manager and American Capital.
Because we have no employees, our Manager is responsible for making all of our investment decisions. Certain of our
and our Manager's officers are employees of American Capital or its affiliates and these persons do not devote their time exclusively
to us. Our Manager's Investment Committee consists of Messrs. Wilkus, Erickson, Flax, Kain and McHale, each of whom is an
officer of American Capital or the parent company of our Manager and has significant responsibilities to American Capital and
certain of its portfolio companies, affiliated entities or managed funds. Mr. Kain is our President and Chief Investment Officer
and also serves as the President of our Manager and as the President and a member of its parent company. Mr. Kain is also the
President and Chief Investment Officer of American Capital Mortgage Investment Corp. and the President of its manager. Thus,
he has, and may in the future have, significant responsibilities for other funds that are managed by the parent company of our
Manager or entities affiliated therewith. In addition, because certain of our and our Manager's officers are also responsible for
providing services to American Capital and/or certain of its portfolio companies, affiliated entities or managed funds, they may
not devote sufficient time to the management of our business operations.
Additionally, our Manager is a wholly-owned subsidiary of American Capital Mortgage Management, LLC, which is
also the parent company of the external manager of American Capital Mortgage Investment Corp., a publicly-traded REIT that
invests in agency and non-agency mortgage investments, CMBS and mortgage loans and may compete with us for acquisitions
of agency mortgage-related investments. American Capital Mortgage Management, LLC is a subsidiary of American Capital Asset
Management, LLC, which is a wholly-owned portfolio company of American Capital. There are no restrictions on American
Capital that prevent American Capital from sponsoring another investment vehicle that competes with us. Accordingly, American
Capital or one or more of its affiliates may also compete with us for investments, except that American Capital has agreed that so
long as our Manager or affiliate of American Capital continues to manage our company, it will not sponsor another investment
vehicle that invests predominantly in whole pool agency mortgage-backed securities.
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Although our Manager and its affiliates have policies in place that seek to mitigate the effects of conflicts of interest,
including any potential conflict relating to the allocation of certain types of securities that meet our investment objectives and
those of other managed funds or affiliates of our Manager, these policies do not eliminate the conflicts of interest that our officers
and the officers and employees of our Manager and its affiliates face in making investment decisions on behalf of American Capital,
any other American Capital-sponsored investment vehicles and us. Further, we do not have any agreement or understanding with
American Capital that would give us any priority over American Capital, any of its affiliates, or any such American Capital-
sponsored investment vehicle in opportunities to invest in mortgage-related investments. Accordingly, we may compete for access
to the benefits that we expect from our relationship with our Manager and American Capital.
Our management agreement was not negotiated on an arm's-length basis and the terms, including fees payable, may not be
as favorable to us as if they were negotiated with an unaffiliated third party.
The management agreement was originally negotiated between related parties, and we did not have the benefit of arm's-
length negotiations of the type normally conducted with an unaffiliated third party. The terms of the management agreement,
including fees payable, may not reflect the terms that we may have received if it were negotiated with an unrelated third party. In
addition, we may choose not to enforce, or to enforce less vigorously, our rights under the management agreement because of our
desire to maintain our ongoing relationship with our Manager.
We are completely dependent upon our Manager and certain personnel of American Capital or the parent company of our
Manager who provide services to us through the management agreement and the administrative services agreement and we
may not find suitable replacements for our Manager and these personnel if the management agreement and the administrative
services agreement are terminated or such personnel are no longer available to us.
Because we have no employees or separate facilities, we are completely dependent on our Manager and its affiliates to
conduct our operations pursuant to the management agreement. Our Manager does not have any employees and relies upon certain
employees of its parent company and American Capital to conduct our day-to-day operations pursuant to an administrative services
agreement. Under the administrative services agreement, our Manager is provided with those services and resources necessary
for our Manager to perform its obligations and responsibilities under the management agreement in exchange for certain fees
payable by our Manager. Neither the administrative services agreement nor the management agreement requires our Manager or
its parent company or American Capital to dedicate specific personnel to our operations. It also does not require any specific
personnel of our Manager or its parent company or American Capital to dedicate a specific amount of time to our business.
Additionally, because our Manager is relying upon American Capital, we may be negatively impacted by events or factors that
negatively impact American Capital's business, financial condition or results of operations.
If we terminate the management agreement without cause, we may not, without the consent of our Manager, employ any
employee of the Manager or any of its affiliates, including American Capital, or any person who has been employed by our Manager
or any of its affiliates at any time within the two-year period immediately preceding the date on which the person commences
employment with us for two years after such termination of the management agreement. We believe that the successful
implementation of our investment, financing and hedging strategies depends upon the experience of certain of American Capital
and our Manager's officers. American Capital or the parent company of our Manager has entered into retention agreements with
certain of these officers. However, none of these individuals' continued service is guaranteed. Furthermore, if the management
agreement is terminated or these individuals leave the parent company of our Manager or American Capital, we may be unable
to execute our business plan.
We have no recourse to American Capital if it does not fulfill its obligations under the administrative services agreement.
Neither we nor our Manager have any employees or separate facilities. Our day-to-day operations are conducted by
employees of American Capital or the parent company of our Manager pursuant to an administrative services agreement among
our Manager, its parent company and American Capital. Under the administrative services agreement, our Manager is also provided
with the services and other resources necessary for our Manager to perform its obligations and responsibilities under the management
agreement in exchange for certain fees payable by our Manager. Although the administrative services agreement may not be
terminated unless the management agreement has been terminated pursuant to its terms, American Capital and the parent company
of our Manager may assign their rights and obligations thereunder to any of their affiliates, including American Capital Asset
Management, LLC, the majority member of the parent company of our Manager. In addition, because we are not a party to the
administrative services agreement, we do not have any recourse to American Capital or the parent company of our Manager if
they do not fulfill their obligations under the administrative services agreement or if they elect to assign the agreement to one of
their affiliates. Also, our Manager only has nominal assets and we will have limited recourse against our Manager under the
Management Agreement to remedy any liability to us from a breach of contract or fiduciary duties.
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If we elect not to renew the management agreement without cause, we would be required to pay our Manager a substantial
termination fee. These and other provisions in our management agreement make non-renewal of our management agreement
difficult and costly.
Electing not to renew the management agreement without cause would be difficult and costly for us. With the consent
of the majority of the independent members of our Board of Directors, we may elect not to renew our management agreement
upon the expiration of any automatic annual renewal term, upon 180-days prior written notice. If we elect not to renew the
management agreement because of a decision by our Board of Directors that the management fee is unfair, our Manager has the
right to renegotiate a mutually agreeable management fee. If we elect to not renew the management agreement without cause, we
are required to pay our Manager a termination fee equal to three times the average annual management fee earned by our Manager
during the prior 24-month period immediately preceding the most recently completed month prior to the effective date of
termination. These provisions may increase the effective cost to us of electing to not renew the management agreement.
Our Manager's management fee is based on the amount of our Equity and is payable regardless of our performance.
Our Manager is entitled to receive a monthly management fee from us that is based on the amount of our Equity (as
defined in our management agreement), regardless of the performance of our investment portfolio. For example, we would pay
our Manager a management fee for a specific period even if we experienced a net loss during the same period. The amount of the
monthly management fee is equal to one-twelfth of 1.25% of our Equity and therefore is only increased by increases in our Equity.
Increases to our Equity will primarily result from equity issuances, which could result in a conflict of interest between our Manager
and our stockholders with respect to the timing and terms of our equity issuances. While our stockholders bear the risk of our
future equity issuances reducing the price of our common stock and diluting the value of their stock holdings in us, the compensation
payable to our Manager will increase as a result of future issuances of our equity securities. Our Manager's entitlement to substantial
nonperformance-based compensation may reduce its incentive to devote sufficient time and effort to seeking investments that
provide attractive risk-adjusted returns for our investment portfolio. This in turn could harm our ability to make distributions to
our stockholders and the market price of our common stock.
Our Manager's liability is limited under the management agreement, and we have agreed to indemnify our Manager against
certain liabilities.
The management agreement provides that our Manager will not assume any responsibility other than to provide the
services specified in the management agreement. The agreement further provides that our Manager is not responsible for any
action of our Board of Directors in following or declining to follow its advice or recommendations. In addition, our Manager and
its respective affiliates, managers, officers, directors, employees and members will be held harmless from, and indemnified by us
against, certain liabilities on customary terms.
Our results are dependent upon the efforts of our Manager.
Our Manager's success, which is largely determinative of our own success, depends on many factors, including the
availability of attractive risk-adjusted investment opportunities that satisfy our targeted investment strategies and then identifying
and consummating them on favorable terms, the level and volatility of interest rates, its ability to access on our behalf short-term
and long-term financing on favorable terms and conditions in the financial markets, real estate market and the economy, as to
which no assurances can be given. In addition, our Manager may face substantial competition for attractive investment opportunities.
Our Manager may not be able to successfully cause us to make investments with attractive risk-adjusted returns.
Risks Related to Our Taxation as a REIT
If we fail to remain qualified as a REIT, we will be subject to tax as a regular corporation and could face a substantial tax
liability, which would reduce the amount of cash available for distribution to our stockholders.
We operate in a manner that allows us to qualify as a REIT for federal income tax purposes. Although we do not intend
to request a ruling from the IRS as to our REIT qualification, we have received an opinion of Skadden, Arps, Slate, Meagher &
Flom LLP with respect to our qualification as a REIT. Investors should be aware, however, that opinions of counsel are not binding
on the IRS or any court. The opinion of Skadden, Arps, Slate, Meagher & Flom LLP represents only the view of our counsel based
on our counsel's review and analysis of existing law and on certain representations as to factual matters and covenants made by
us and our Manager, including representations relating to the values of our assets and the sources of our income. The opinion is
expressed as of the date issued and does not cover subsequent periods. Skadden, Arps, Slate, Meagher & Flom LLP has no obligation
to advise us or the holders of our common stock of any subsequent change in the matters stated, represented or assumed, or of
any subsequent change in applicable law. Furthermore, both the validity of the opinion of Skadden, Arps, Slate, Meagher & Flom
LLP, and our qualification as a REIT depend on our satisfaction of certain asset, income, organizational, distribution, stockholder
26
ownership and other requirements on a continuing basis, the results of which are not monitored by Skadden, Arps, Slate, Meagher &
Flom LLP. Our ability to satisfy the asset tests depends upon our analysis of the characterization and fair market values of our
assets, some of which are not susceptible to a precise determination, and for which we will not obtain independent appraisals. Our
compliance with the annual REIT income and quarterly asset requirements also depends upon our ability to successfully manage
the composition of our income and assets on an ongoing basis. Moreover, the proper classification of an instrument as debt or
equity for federal income tax purposes may be uncertain in some circumstances, which could affect the application of the REIT
qualification requirements as described below. Accordingly, there can be no assurance that the IRS will not contend that our
interests in subsidiaries or in securities of other issuers will not cause a violation of the REIT requirements.
If we were to fail to qualify as a REIT in any taxable year, we would be subject to federal income tax, including any
applicable alternative minimum tax, on our taxable income at regular corporate rates, and dividends paid to our stockholders would
not be deductible by us in computing our taxable income. Any resulting corporate tax liability could be substantial and would
reduce the amount of cash available for distribution to our stockholders, which in turn could have an adverse impact on the value
of our common stock. Unless we were entitled to relief under certain Internal Revenue Code provisions, we also would be
disqualified from taxation as a REIT for the four taxable years following the year in which we failed to qualify as a REIT.
Distributions payable by REITs do not qualify for the reduced tax rates available for some dividends.
The maximum tax rate applicable to income from "qualified dividends" payable to domestic stockholders that are
individuals, trusts and estates is currently 20%. Distributions of ordinary income payable by REITs, however, generally are not
eligible for the reduced rates. Although this legislation does not adversely affect the taxation of REITs or distributions payable by
REITs, the more favorable rates applicable to regular corporate qualified dividends could cause investors who are individuals,
trusts and estates to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT
corporations that pay dividends, which could adversely affect the value of the stock of REITs, including our common stock.
REIT distribution requirements could adversely affect our ability to execute our business plan.
We generally must distribute annually at least 90% of our taxable income, subject to certain adjustments and excluding
any net capital gain, in order for federal corporate income tax not to apply to earnings that we distribute. To the extent that we
satisfy this distribution requirement, but distribute less than 100% of our taxable income, we will be subject to federal corporate
income tax on our undistributed taxable income. In addition, we will be subject to a non-deductible 4% excise tax if the actual
amount that we pay out to our stockholders in a calendar year is less than a minimum amount specified under federal tax laws.
We intend to make distributions to our stockholders to comply with the REIT qualification requirements of the Internal Revenue
Code.
From time to time, we may generate taxable income greater than our income for financial reporting purposes prepared
in accordance with GAAP, or differences in timing between the recognition of taxable income and the actual receipt of cash may
occur. For example, if we purchase agency securities at a discount, we are generally required to accrete the discount into taxable
income prior to receiving the cash proceeds of the accreted discount at maturity. If we do not have other funds available in these
situations we could be required to borrow funds on unfavorable terms, sell investments at disadvantageous prices or distribute
amounts that would otherwise be invested in future acquisitions to make distributions sufficient to enable us to pay out enough of
our taxable income to satisfy the REIT distribution requirement and to avoid corporate income tax and the 4% excise tax in a
particular year. These alternatives could increase our costs or reduce our stockholders' equity. Thus, compliance with the REIT
requirements may hinder our ability to grow, which could adversely affect the value of our common stock.
We may in the future choose to pay dividends in our own stock, in which case you may be required to pay income taxes in
excess of the cash dividends you receive.
We may in the future distribute taxable dividends that are payable in cash and shares of our common stock at the election
of each stockholder. Taxable stockholders receiving such dividends will be required to include the full amount of the dividend as
ordinary income to the extent of our current and accumulated earnings and profits for U.S. federal income tax purposes. As a
result, stockholders may be required to pay income taxes with respect to such dividends in excess of the cash dividends received.
If a U.S. stockholder sells the stock that it receives as a dividend in order to pay this tax, the sales proceeds may be less than the
amount included in income with respect to the dividend, depending on the market price of our stock at the time of the sale.
Furthermore, with respect to certain non-U.S. stockholders, we may be required to withhold U.S. tax with respect to such dividends,
including in respect of all or a portion of such dividend that is payable in stock. In addition, if a significant number of our stockholders
determine to sell shares of our common stock in order to pay taxes owed on dividends, it may put downward pressure on the
trading price of our common stock.
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Even if we remain qualified as a REIT, we may face other tax liabilities that reduce our cash flow.
Even if we remain qualified for taxation as a REIT, we may be subject to certain federal, state and local taxes on our
income and assets, including taxes on any undistributed income, tax on income from some activities conducted as a result of a
foreclosure, excise taxes, state or local income, property and transfer taxes, such as mortgage recording taxes, and other taxes. In
addition, in order to meet the REIT qualification requirements, prevent the recognition of certain types of non-cash income, or to
avert the imposition of a 100% tax that applies to certain gains derived by a REIT from dealer property or inventory, we may hold
some of our assets through our TRS or other subsidiary corporations that will be subject to corporate level income tax at regular
rates. In addition, if we lend money to a TRS, the TRS may be unable to deduct all or a portion of the interest paid to us, which
could result in an even higher corporate level tax liability. Any of these taxes would decrease cash available for distribution to our
stockholders.
Complying with REIT requirements may cause us to forgo otherwise attractive opportunities.
To remain qualified as a REIT for federal income tax purposes, we must continually satisfy tests concerning, among other
things, the sources of our income, the nature and diversification of our assets, the amounts that we distribute to our stockholders
and the ownership of our stock. We may be required to make distributions to stockholders at disadvantageous times or when we
do not have funds readily available for distribution, and may be unable to pursue investments that would be otherwise advantageous
to us in order to satisfy the source-of-income or asset-diversification requirements for qualifying as a REIT. Thus, compliance
with the REIT requirements may hinder our ability to make and, in certain cases, to maintain ownership of, certain attractive
investments.
Complying with REIT requirements may force us to liquidate otherwise attractive investments.
To remain qualified as a REIT, we must ensure that at the end of each calendar quarter, at least 75% of the value of our
assets consists of cash, cash items, government securities and qualified REIT real estate assets. The remainder of our investment
in securities (other than government securities and qualified real estate assets) generally cannot include more than 10% of the
outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer.
In addition, in general, no more than 5% of the value of our assets (other than government securities and qualified real estate
assets) can consist of the securities of any one issuer, and no more than 25% of the value of our total securities can be represented
by securities of one or more TRSs. If we fail to comply with these requirements at the end of any calendar quarter, we must correct
the failure within 30 days after the end of the calendar quarter or qualify for certain statutory relief provisions to avoid losing our
REIT qualification and suffering adverse tax consequences. As a result, we may be required to liquidate from our investment
portfolio otherwise attractive investments. These actions could have the effect of reducing our income and amounts available for
distribution to our stockholders.
The failure of assets subject to repurchase agreements to qualify as real estate assets could adversely affect our ability to remain
qualified as a REIT.
We enter into certain financing arrangements that are structured as sale and repurchase agreements pursuant to which we
nominally sell certain of our assets to a counterparty and simultaneously enter into an agreement to repurchase these assets at a
later date in exchange for a purchase price. Economically, these agreements are financings that are secured by the assets sold
pursuant thereto. We believe that we would be treated for REIT asset and income test purposes as the owner of the assets that are
the subject of any such sale and repurchase agreement notwithstanding that such agreement may transfer record ownership of the
assets to the counterparty during the term of the agreement. It is possible, however, that the IRS could assert that we did not own
the assets during the term of the sale and repurchase agreement, in which case we could fail to remain qualified as a REIT.
Distributions to tax-exempt investors may be classified as unrelated business taxable income.
Neither ordinary nor capital gain distributions with respect to our common stock nor gain from the sale of common stock
should generally constitute unrelated business taxable income to a tax-exempt investor. However, there are certain exceptions to
this rule. In particular:
•
•
part of the income and gain recognized by certain qualified employee pension trusts with respect to our common
stock may be treated as unrelated business taxable income if shares of our common stock are predominantly held by
qualified employee pension trusts, and we are required to rely on a special look-through rule for purposes of meeting
one of the REIT ownership tests, and we are not operated in a manner to avoid treatment of such income or gain as
unrelated business taxable income;
part of the income and gain recognized by a tax-exempt investor with respect to our common stock would constitute
unrelated business taxable income if the investor incurs debt in order to acquire the common stock;
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•
•
part or all of the income or gain recognized with respect to our common stock by social clubs, voluntary employee
benefit associations, supplemental unemployment benefit trusts and qualified group legal services plans which are
exempt from federal income taxation under the Internal Revenue Code may be treated as unrelated business taxable
income; and
to the extent that we are (or a part of us, or a disregarded subsidiary of ours, is) a "taxable mortgage pool," or if we
hold residual interests in a REMIC, a portion of the distributions paid to a tax-exempt stockholder that is allocable
to excess inclusion income may be treated as unrelated business taxable income.
Liquidation of assets may jeopardize our REIT qualification or create additional tax liability for us.
To remain qualified as a REIT, we must comply with requirements regarding the composition of our assets and our sources
of income. If we are compelled to liquidate our investments to repay obligations to our lenders, we may be unable to comply with
these requirements, ultimately jeopardizing our qualification as a REIT, or we may be subject to a 100% tax on any resultant gain
if we sell assets that are treated as dealer property or inventory.
Complying with REIT requirements may limit our ability to hedge effectively and may cause us to incur tax liabilities.
The REIT provisions of the Internal Revenue Code could substantially limit our ability to hedge our liabilities. Any
income from a properly designated hedging transaction we enter into to manage risk of interest rate changes with respect to
borrowings made or to be made, or ordinary obligations incurred or to be incurred, to acquire or carry real estate assets generally
does not constitute "gross income" for purposes of the 75% or 95% gross income tests. To the extent that we enter into other types
of hedging transactions, the income from those transactions is likely to be treated as non-qualifying income for purposes of both
of the gross income tests. As a result of these rules, we may have to limit our use of advantageous hedging techniques or implement
those hedges through our TRS. This could increase the cost of our hedging activities because our TRS would be subject to tax on
gains or expose us to greater risks associated with changes in interest rates than we would otherwise want to bear. In addition,
losses in our TRS will generally not provide any tax benefit, except for being carried forward against future taxable income in the
TRS.
Uncertainty exists with respect to the treatment of our TBAs for purposes of the REIT asset and income tests.
We purchase and sell agency mortgage-backed securities through TBAs and recognize income or gains from the disposition
of those TBAs, through dollar roll transactions or otherwise, and may continue to do so in the future. While there is no direct
authority with respect to the qualification of TBAs as real estate assets or U.S. Government securities for purposes of the 75%
asset test or the qualification of income or gains from dispositions of TBAs as gains from the sale of real property (including
interests in real property and interests in mortgages on real property) or other qualifying income for purposes of the 75% gross
income test, we treat our TBAs as qualifying assets for purposes of the REIT asset tests, and we treat income and gains from our
TBAs as qualifying income for purposes of the 75% gross income test, based on an opinion of Skadden, Arps, Slate, Meagher &
Flom LLP substantially to the effect that (i) for purposes of the REIT asset tests, our ownership of a TBA should be treated as
ownership of the underlying agency securities, and (ii) for purposes of the 75% REIT gross income test, any gain recognized by
us in connection with the settlement of our TBAs should be treated as gain from the sale or disposition of the underlying agency
securities. Opinions of counsel are not binding on the IRS, and no assurance can be given that the IRS will not successfully
challenge the conclusions set forth in such opinions. In addition, it must be emphasized that the opinion of Skadden, Arps, Slate,
Meagher & Flom LLP is based on various assumptions relating to our TBAs and is conditioned upon fact-based representations
and covenants made by our management regarding our TBAs. No assurance can be given that the IRS would not assert that such
assets or income are not qualifying assets or income. If the IRS were to successfully challenge the opinion of Skadden, Arps, Slate,
Meagher & Flom LLP, we could be subject to a penalty tax or we could fail to remain qualified as a REIT if a sufficient portion
of our assets consists of TBAs or a sufficient portion of our income consists of income or gains from the disposition of TBAs.
Qualifying as a REIT involves highly technical and complex provisions of the Internal Revenue Code.
Qualification as a REIT involves the application of highly technical and complex Internal Revenue Code provisions for
which only limited judicial and administrative authorities exist. Even a technical or inadvertent violation could jeopardize our
REIT qualification. Our qualification as a REIT depends on our satisfaction of certain asset, income, organizational, distribution,
stockholder ownership and other requirements on a continuing basis. In addition, our ability to satisfy the requirements to remain
qualified as a REIT depends in part on the actions of third parties over which we have no control or only limited influence, including
in cases where we own an equity interest in an entity that is classified as a partnership for federal income tax purposes.
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The tax on prohibited transactions will limit our ability to engage in transactions, including certain methods of structuring
CMOs, which would be treated as prohibited transactions for federal income tax purposes.
Net income that we derive from a prohibited transaction is subject to a 100% tax. The term "prohibited transaction"
generally includes a sale or other disposition of property (including agency securities, but other than foreclosure property, as
discussed below) that is held primarily for sale to customers in the ordinary course of a trade or business by us or by a borrower
that has issued a shared appreciation mortgage or similar debt instrument to us. We could be subject to this tax if we were to
dispose of or structure CMOs in a manner that was treated as a prohibited transaction for federal income tax purposes.
We intend to conduct our operations at the REIT level so that no asset that we own (or are treated as owning) will be
treated as, or as having been, held for sale to customers, and that a sale of any such asset will not be treated as having been in the
ordinary course of our business. As a result, we may choose not to engage in certain transactions at the REIT level, and may limit
the structures we utilize for our CMO transactions, even though the sales or structures might otherwise be beneficial to us. In
addition, whether property is held "primarily for sale to customers in the ordinary course of a trade or business" depends on the
particular facts and circumstances. No assurance can be given that any property that we sell will not be treated as property held
for sale to customers, or that we can comply with certain safe-harbor provisions of the Internal Revenue Code that would prevent
such treatment. The 100% tax does not apply to gains from the sale of property that is held through a TRS or other taxable
corporation, although such income will be subject to tax in the hands of the corporation at regular corporate rates. We intend to
structure our activities to avoid prohibited transaction characterization.
New legislation or administrative or judicial action, in each instance potentially with retroactive effect, could make it more
difficult or impossible for us to remain qualified as a REIT.
The present federal income tax treatment of REITs may be modified, possibly with retroactive effect, by legislative,
judicial or administrative action at any time, which could affect the federal income tax treatment of an investment in us. The federal
income tax rules dealing with REITs constantly are under review by persons involved in the legislative process, the IRS and the
U.S. Treasury Department, which results in statutory changes as well as frequent revisions to regulations and interpretations.
Revisions in federal tax laws and interpretations thereof could affect or cause us to change our investments and commitments and
affect the tax considerations of an investment in us.
Risks Related to Our Business Structure
Loss of our exemption from regulation pursuant to the Investment Company Act would adversely affect us.
We conduct our business so as not to become regulated as an investment company under the Investment Company Act
in reliance on the exemption provided by Section 3(c)(5)(C) of the Investment Company Act. Section 3(c)(5)(C), as interpreted
by the staff of the SEC, requires that: (i) at least 55% of our investment portfolio consist of "mortgages and other liens on and
interest in real estate," or "qualifying real estate interests," and (ii) at least 80% of our investment portfolio consist of qualifying
real estate interests plus "real estate-related assets."
In satisfying this 55% requirement, based on pronouncements of the SEC staff, we treat agency mortgage-backed securities issued
with respect to an underlying pool of mortgage loans in which we hold all of the certificates issued by a pool, or a "whole pool",
as qualifying real estate interests. However, the real estate related assets that we acquire are limited by the provisions of the
Investment Company Act and the rules and regulations promulgated thereunder. If the SEC determines that any of these securities
are not qualifying interests in real estate or real estate-related assets, adopts a contrary interpretation with respect to these securities
or otherwise believes we do not satisfy the above exceptions or changes its interpretation of the above exceptions, we could be
required to restructure our activities or sell certain of our assets. We may be required at times to adopt less efficient methods of
financing certain of our mortgage related investments and we may be precluded from acquiring certain types of higher yielding
securities. The net effect of these factors would be to lower our net interest income. If we fail to qualify for an exemption from
registration as an investment company or an exclusion from the definition of an investment company, our ability to use leverage
would be substantially reduced. Our business will be materially and adversely affected if we fail to qualify for this exemption
from regulation pursuant to the Investment Company Act.
We are highly dependent on information and communications systems. Any systems failures could significantly disrupt our
business, which may, in turn, negatively affect our operations and the market price of our common stock and our ability to pay
dividends to our stockholders.
Our business is highly dependent on communications and information systems. Any failure or interruption of our or our
Manager's systems could cause delays or other problems in our securities trading activities, which could have a material adverse
30
effect on our operating results and negatively affect the market price of our common stock and our ability to pay dividends to our
stockholders.
Changes in laws or regulations governing our operations or our failure to comply with those laws or regulations may adversely
affect our business.
We are subject to regulation by laws at the local, state and federal level, including securities and tax laws and financial
accounting and reporting standards. These laws and regulations, as well as their interpretation, may be changed from time to time.
Accordingly, any change in these laws or regulations or the failure to comply with these laws or regulations could have a material
adverse impact on our business. Certain of these laws and regulations pertain specifically to REITs.
Risks Related to Our Common Stock
The market price and trading volume of our common stock may be volatile.
The market price of our common stock may be highly volatile and be subject to wide fluctuations. In addition, the trading
volume in our common stock may fluctuate and cause significant price variations to occur. The stock market has experienced
extreme price and volume fluctuations that have affected the market price of many companies in industries similar or related to
ours and that have been unrelated to these companies' operating performances. If the market price of our common stock declines
significantly, you may be unable to resell your shares at a gain. Further, fluctuations in the trading price of our common stock may
adversely affect the liquidity of the trading market for our common stock and, in the event that we seek to raise capital through
future equity financings, our ability to raise such equity capital.
We cannot assure you that the market price of our common stock will not fluctuate or decline significantly in the future. Some
of the factors that could negatively affect our share price or result in fluctuations in the price or trading volume of our common
stock include:
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
actual or anticipated variations in our quarterly operating results or distributions;
changes in our earnings estimates or publication of research reports about us or the real estate or specialty finance
industry;
increases in market interest rates that lead purchasers of our shares of common stock to demand a higher yield;
changes in market valuations of similar companies;
adverse market reaction to any increased indebtedness we incur in the future;
issuance of additional equity securities;
actions by institutional stockholders;
additions or departures of key management personnel, or changes in our relationship with our Manager or American
Capital;
speculation in the press or investment community;
price and volume fluctuations in the stock market from time to time, which are often unrelated to the operating
performance of particular companies;
changes in regulatory policies, tax laws and financial accounting and reporting standards, particularly with respect
to REITs, or applicable exemptions from the Investment Company Act of 1940, as amended;
actual or anticipated changes in our dividend policy and earnings or variations in operating results;
any shortfall in revenue or net income or any increase in losses from levels expected by securities analysts;
decreases in our net asset value per share;
loss of major repurchase agreement providers; and
general market and economic conditions.
Future offerings of debt securities, which would rank senior to our common stock upon our liquidation, and future offerings
of equity securities, which would dilute our existing stockholders and may be senior to our common stock for the purposes of
dividend and liquidating distributions, may adversely affect the market price of our common stock.
In the future, we may raise capital through the issuance of debt or equity securities. Upon liquidation, holders of our debt
securities and preferred stock, if any, and lenders with respect to other borrowings will be entitled to our available assets prior to
the holders of our common stock. Additional equity offerings may dilute the holdings of our existing stockholders or reduce the
market price of our common stock, or both. Our preferred stock, if issued, could have a preference on liquidating distributions or
a preference on dividend payments that could limit our ability to pay dividends to the holders of our common stock. Sales of
substantial amounts of our common stock, or the perception that these sales could occur, could have a material adverse effect on
the price of our common stock. Because our decision to issue debt or equity securities in any future offering will depend on market
conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings.
31
Thus holders of our common stock bear the risk of our future offerings reducing the market price of our common stock and diluting
the value of their stock holdings in us.
Future sales of shares of our common stock may depress the price of our shares.
We cannot predict the effect, if any, of future sales of our common stock or the availability of shares for future sales on
the market price of our common stock. Any sales of a substantial number of our shares in the public market, or the perception that
sales might occur, may cause the market price of our shares to decline.
We have not established a minimum dividend payment level and we cannot assure you of our ability to pay dividends in the
future.
We intend to pay quarterly dividends and to make distributions to our stockholders in amounts such that all or substantially
all of our taxable income in each year is distributed to our stockholders. We have not established a minimum dividend payment
level and the amount of our dividend will fluctuate. Our ability to pay dividends may be adversely affected by the risk factors
described herein. All distributions will be made at the discretion of our Board of Directors and will depend on our earnings, our
financial condition, the requirements for REIT qualification and such other factors as our Board of Directors may deem relevant
from time to time. We may not be able to make distributions in the future or our Board of Directors may change our dividend
policy in the future. In addition, some of our distributions may include a return of capital. To the extent that we decide to pay
dividends in excess of our current and accumulated tax earnings and profits, such distributions would generally be considered a
return of capital for federal income tax purposes. A return of capital reduces the basis of a stockholder's investment in our common
stock to the extent of such basis and is treated as capital gain thereafter.
An increase in market interest rates may cause a material decrease in the market price of our common stock.
One of the factors that investors may consider in deciding whether to buy or sell shares of our common stock is our
distribution rate as a percentage of our share price relative to market interest rates. If the market price of our common stock is
based primarily on the earnings and return that we derive from our investments and income with respect to our investments and
our related distributions to stockholders, and not from the market value of the investments themselves, then interest rate fluctuations
and capital market conditions are likely to affect adversely the market price of our common stock. For instance, if market rates
rise without an increase in our distribution rate, the market price of our common stock could decrease as potential investors may
require a higher distribution yield on our common stock or seek other securities paying higher distributions or interest. In addition,
rising interest rates would result in increased interest expense on our variable rate debt, thereby reducing cash flow and our ability
to service our indebtedness and pay distributions.
The stock ownership limit imposed by the Internal Revenue Code for REITs and our amended and restated certificate of
incorporation may restrict our business combination opportunities.
To qualify as a REIT under the Internal Revenue Code, not more than 50% in value of our outstanding stock may be owned,
directly or indirectly, by five or fewer individuals (as defined in the Internal Revenue Code to include certain entities) at any time
during the last half of each taxable year in which we qualify as a REIT. Our amended and restated certificate of incorporation,
with certain exceptions, authorizes our Board of Directors to take the actions that are necessary and desirable to qualify as a REIT.
Pursuant to our amended and restated certificate of incorporation, no person may beneficially or constructively own more than
9.8% in value or in number of shares, whichever is more restrictive, of our common or capital stock. Our Board of Directors may
grant an exemption from this 9.8% stock ownership limitation, in its sole discretion, subject to such conditions, representations
and undertakings as it may determine are reasonably necessary. Pursuant to our amended and restated certificate of incorporation,
our Board of Directors has the power to increase or decrease the percentage of common or capital stock that a person may
beneficially or constructively own. However, any decreased stock ownership limit will not apply to any person whose percentage
ownership of our common or capital stock, as the case may be, is in excess of such decreased stock ownership limit until that
person's percentage ownership of our common or capital stock, as the case may be, equals or falls below the decreased stock
ownership limit. Until such a person's percentage ownership of our common or capital stock, as the case may be, falls below such
decreased stock ownership limit, any further acquisition of common stock will be in violation of the decreased stock ownership
limit. The ownership limits imposed by the tax law are based upon direct or indirect ownership by “individuals,” but only during
the last half of a tax year. The ownership limits contained in our amended and restated certificate of incorporation apply to the
ownership at any time by any “person,” which term includes entities. These ownership limitations are intended to assist us in
complying with the tax law requirements, and to minimize administrative burdens. However, these ownership limits might also
delay or prevent a transaction or a change in our control that might involve a premium price for our common stock or otherwise
be in the best interest of our stockholders.
32
The stock ownership limitation contained in our amended and restated certificate of incorporation generally does not permit
ownership in excess of 9.8% of our common or capital stock, and attempts to acquire our common or capital stock in excess
of these limits will be ineffective unless an exemption is granted by our Board of Directors.
As described above, our amended and restated certificate of incorporation generally prohibits beneficial or constructive
ownership by any person of more than 9.8% (by value or by number of shares, whichever is more restrictive) of our common or
capital stock, unless exempted by our Board of Directors. Our amended and restated certificate of incorporation's constructive
ownership rules are complex and may cause the outstanding stock owned by a group of related individuals or entities to be deemed
to be constructively owned by one individual or entity. As a result, the acquisition of less than these percentages of the outstanding
stock by an individual or entity could cause that individual or entity to own constructively in excess of these percentages of the
outstanding stock and thus be subject to our amended and restated certificate of incorporation's ownership limit. Any attempt to
own or transfer shares of our common or preferred stock (if and when issued) in excess of the ownership limit without the consent
of the Board of Directors will result in the shares being automatically transferred to a charitable trust or, if the transfer to a charitable
trust would not be effective, such transfer being treated as invalid from the outset.
Anti-takeover provisions in our amended and restated certificate of incorporation and bylaws could discourage a change of
control that our stockholders may favor, which could also adversely affect the market price of our common stock.
Provisions in our amended and restated certificate of incorporation and bylaws may make it more difficult and expensive
for a third party to acquire control of us, even if a change of control would be beneficial to our stockholders. We could issue a
series of preferred stock to impede the completion of a merger, tender offer or other takeover attempt. The anti-takeover provisions
in our amended and restated certificate of incorporation and bylaws may impede takeover attempts, or other transactions, that may
be in the best interests of our stockholders and, in particular, our common stockholders. In addition, the market price of our common
stock could be adversely affected to the extent that provisions of our amended and restated certificate of incorporation and bylaws
discourage potential takeover attempts, or other transactions, that our stockholders may favor.
Item 1B. Unresolved Staff Comments
None.
Item 2. Properties
We do not own any property. Our executive offices are located in Bethesda, Maryland in office space shared with American
Capital.
Item 3. Legal Proceedings
From time to time, we may be involved in various claims and legal actions arising in the ordinary course of business. As
of December 31, 2012, we had no legal proceedings.
Item 4. Mine Safety Disclosures
Not applicable.
33
PART II.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Quarterly Stock Prices and Dividend Declarations
Our common stock is listed on The NASDAQ Global Select Market under the symbol “AGNC”. As of January 31, 2013,
we had 1,057 stockholders of record. Most of the shares of our common stock are held by brokers and other institutions on behalf
of stockholders.
The following table sets forth the range of high and low sales prices of our common stock as reported on The NASDAQ
Global Select Market and dividends declared on our common stock for fiscal years 2012 and 2011:
Common Stock
Sales Prices
High
Low
Dividends
Declared
2012
Fourth Quarter ............................. $
35.16 $
Third Quarter ............................... $
36.77 $
Second Quarter ............................ $
33.95 $
First Quarter................................. $
31.17 $
2011
Fourth Quarter ............................. $
29.21 $
Third Quarter ............................... $
30.34 $
Second Quarter ............................ $
30.76 $
First Quarter................................. $
30.68 $
28.08
30.30
29.60
28.08
22.84
22.03
27.70
28.02
$
$
$
$
$
$
$
$
1.25
1.25
1.25
1.25
1.40
1.40
1.40
1.40
We intend to pay quarterly dividends and to distribute to our stockholders all of our annual taxable income in a timely
manner. This will enable us to qualify for the tax benefits accorded to a REIT under the Internal Revenue Code. We have not
established a minimum dividend payment level and our ability to pay dividends may be adversely affected for the reasons described
under the caption “Risk Factors.” All distributions will be made at the discretion of our Board of Directors and will depend on
our earnings, our financial condition, maintenance of our REIT status and such other factors as our Board of Directors may deem
relevant from time to time.
The following table summarizes dividends declared for fiscal years 2012 and 2011 and their related tax characterization:
Dividends Declared
Tax Characterization
Dividends
Declared Per
Share
Ordinary
Income Per
Share
Long-Term
Capital Gains Per
Share
Fiscal year 2012......................
Fiscal year 2011......................
$
$
5.00
5.60
$
$
4.5092
5.3324
$
$
0.4908
0.2676
Our stock transfer agent and registrar is Computershare Investor Services. Requests for information from Computershare
can be sent to Computershare Investor Services, P.O. Box 43078, Providence, RI 02940-3078 and their telephone number is
1-800-733-5001.
Stock Repurchase Program
The following table presents information with respect to purchases of our common stock made during the three months
ended December 31, 2012, by us or any “affiliated purchaser” of us, as defined in Rule 10b-18(a)(3) under the Exchange Act (in
millions, except per share amounts):
34
Total Number
of Shares
Purchased (1)
Average
Net Price
Paid Per
Share
Total Number of
Shares Purchased
as Part of
Publicly
Announced Plans
or Programs (2)
Maximum Number of
Shares That May Yet
Be Purchased Under
the Publicly
Announced Plans or
Programs
November 13-15, 2012 .........
2.7
$
29.00
2.7
N/A
___________________________
1. All shares were purchased by us pursuant to the stock repurchase program described in footnote 2 below.
2.
In October 2012, our Board of Directors adopted a plan that may provide for stock repurchases of up to $500 million of our outstanding shares of
common stock through December 31, 2013.
Equity Compensation Plan Information
We have adopted a long term stock incentive plan, or Incentive Plan, to provide for the issuance of equity-based awards,
including stock options, restricted stock units and unrestricted stock awards to our independent directors.
The following table provides information as of December 31, 2012 concerning shares of our common stock authorized
for issuance under our existing Incentive Plan.
Plan Category
Equity compensation plans approved by security
holders (1) ..................................................................
Equity compensation plans not approved by
security holders.........................................................
Total..........................................................................
Number of securities to
be issued upon exercise
of outstanding options,
warrants and rights
Weighted
average exercise
price of
outstanding
options, warrants
and rights
Number of securities
remaining available for
future issuance under
equity compensation plans
(excluding securities
reflected in the first
column of this table)
21,500
—
21,500
$
$
—
—
—
62,500
—
62,500
_________________________________________________________
1. Represents unvested shares of restricted stock awarded to our independent directors.
Performance Graph
The following graph and table compare a stockholder's cumulative total return, assuming $100 invested at May 15, 2008,
with the reinvestment of all dividends, as if such amounts had been invested in: (i) our common stock; (ii) the stocks included in
the Standard & Poor's 500 Stock Index (“S&P 500”); (iii) the stocks included in the FTSE NAREIT Mortgage REIT Index; (iv) an
index of selected issuers in our Agency REIT Peer group, composed of Annaly Capital Management, Inc., Anworth Mortgage
Asset Corporation, Capstead Mortgage Corporation, Hatteras Financial Corp. and CYS Investments, Inc.
35
December 31,
2012
2011
2010
2009
2008
American Capital Agency...........................
S&P 500 ......................................................
FTSE NAREIT Mortgage REITs................
Agency REIT Peer group............................
$
$
$
$
362.22
114.35
142.75
160.61
$
$
$
$
301.60
98.57
119.07
160.58
$
$
$
$
254.26
96.54
122.01
155.94
$
$
$
$
192.42
83.90
99.53
131.96
$
$
$
$
125.51
66.34
79.86
103.02
The information in the share performance graph and table has been obtained from sources believed to be reliable, but neither
its accuracy nor its completeness can be guaranteed. The historical information set forth above is not necessarily indicative of
future performance. Accordingly, we do not make or endorse any predictions as to future share performance.
Item 6. Selected Financial Data.
The following selected financial data are derived from our audited financial statements for fiscal years 2012, 2011, 2010,
2009 and the period from May 20, 2008 (date operations commenced) through December 31, 2008. The selected financial data
should be read in conjunction with the more detailed information contained in the Financial Statements and Notes thereto and
“Management's Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Annual
Report on Form 10-K.
($ in millions, except per share amounts)
2012
2011
2010
2009
2008
December 31,
Balance Sheet Data:
Investment portfolio, at fair value..................................... $
85,245
Total assets........................................................................ $
100,453
Repurchase agreements and other debt............................. $
Total liabilities................................................................... $
75,415
89,557
36
$
$
$
$
54,683
57,972
47,735
51,760
$
$
$
$
13,510
14,476
11,753
12,904
$
$
$
$
4,300
4,626
3,842
4,079
$
$
$
$
1,573
1,656
1,346
1,398
Total stockholders' equity.................................................. $
Net asset value per common share (1)................................ $
10,896
31.64
$
$
6,212
27.71
$
$
1,572
24.24
$
$
547
22.48
$
$
258
17.20
2012
2011
2010
2009
Fiscal Year
For the period
from May 20,
2008 through
December 31,
2008
2,109
$
1,109
$
Statement of Operations Data:
Interest income.................................................................. $
Interest expense (2).............................................................
Net interest income ...........................................................
Other (loss) income, net (2) ................................................
Expenses............................................................................
Income before tax..............................................................
Provision for income taxes, net.........................................
Net income ........................................................................
Dividend on preferred stock..............................................
512
1,597
(157)
144
1,296
19
1,277
10
Net income available to common shareholders ................ $
1,267
Net income ........................................................................ $
Other comprehensive income (loss) (2)..............................
Comprehensive income.....................................................
Dividend on preferred stock..............................................
Comprehensive income available to common
shareholders ...................................................................... $
Weighted average common shares outstanding-basic and
diluted................................................................................
Net income per common share-basic and diluted ............. $
Comprehensive income per common share-basic and
diluted................................................................................ $
Dividends declared per common share ............................. $
1,277
1,244
2,521
10
2,511
303.9
4.17
8.26
5.00
Other Data (unaudited)*:
Average agency securities, at par...................................... $
Average agency securities, at cost..................................... $
Average total assets, at fair value (3).................................. $
Average repurchase agreements and other debt................ $
Average stockholders' equity (4) ........................................ $
Average coupon (5).............................................................
Average asset yield (6)........................................................
Average cost of funds (7)....................................................
Average net interest rate spread ........................................
Average coupon (as of period end) ...................................
Average asset yield (as of period end) ..............................
Average cost of funds (as of period end) ..........................
Average net interest rate spread (as of period end)...........
Net comprehensive income return on average common
equity - annualized (8) ........................................................
2012
71,002
74,588
86,172
68,810
9,473
3.90 %
2.82 %
(1.11)%
1.71 %
3.69 %
2.61 %
(1.22)%
1.39 %
$
$
$
$
$
$
$
$
$
$
$
285
824
26
74
776
6
770
—
770
770
379
1,149
—
1,149
153.3
5.02
7.50
5.60
$
$
$
$
$
$
253
76
177
130
19
288
—
288
—
288
288
(88)
200
—
200
36.5
7.89
5.49
5.60
$
128
$
44
84
46
11
119
—
119
—
119
119
45
164
—
164
17.5
6.78
9.33
5.15
$
$
$
$
$
$
$
$
$
$
$
$
55
25
30
11
6
35
—
35
—
35
35
(25)
10
—
10
15.0
2.36
0.65
2.51
Fiscal Year
2011
2010
2009
For the period
from May 20,
2008 through
December 31,
2008
33,243
34,726
38,548
31,840
4,169
$
$
$
$
$
4.42 %
3.19 %
(1.00)%
2.19 %
4.23 %
3.07 %
(1.13)%
1.94 %
$
$
$
$
$
6,992
7,335
8,100
6,865
859
5.03 %
3.44 %
(1.11)%
2.33 %
4.70 %
3.31 %
(1.03)%
2.28 %
$
$
$
$
$
2,668
2,752
3,086
2,542
373
5.77 %
4.64 %
(1.71)%
2.93 %
5.28 %
3.99 %
(1.17)%
2.82 %
1,733
1,772
1,826
1,530
266
6.10 %
5.04 %
(2.63)%
2.41 %
6.11 %
4.98 %
(3.52)%
1.46 %
26.9 %
27.6 %
23.3 %
43.8 %
5.9 %
37
Economic return on common equity - annualized (9) ........
Leverage (average during the period)(10)..........................
Leverage (as of period end)(11)..........................................
Expenses % of average assets(12).......................................
Expenses % of average equity(13) ......................................
32.2 %
37.4 %
32.7 %
60.6 %
7.3:1
7.0:1
0.17 %
1.52 %
7.6:1
7.9:1
0.19 %
1.77 %
8.0:1
7.8:1
0.23 %
2.19 %
6.8:1
7.3:1
0.36 %
2.99 %
5.5 %
5.7:1
5.2:1
0.51 %
3.49 %
*
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
Unless otherwise noted, average numbers for each period are weighted based on days on our books and records. All percentages are annualized.
Net asset value per common share calculated as our total stockholders' equity, less our 8.000% Series A Cumulative Redeemable Preferred Stock liquidation
preference of $25 per preferred share, divided by our number of common shares outstanding as of period end.
We voluntarily discontinued hedge accounting for our interest rate swap agreements as of September 30, 2011. Please refer to Notes 2 and 5 of our
Consolidated Financial Statements in this Annual Report on Form 10-K for additional information regarding our discontinuance of hedge accounting.
Average total assets calculated using a combination of daily weighted averages and average month-end balances when daily weighted averages are not
available.
Weighted average stockholders' equity calculated as the average month-ended stockholders' equity during the period.
Weighted average coupon calculated by dividing the total coupon (or cash) interest income on agency securities by the daily weighted average agency
securities held for the period.
Weighted average asset yield calculated by dividing our total interest income on agency securities, including amortization of premiums and discounts, by
the weighted average amortized cost basis of our agency securities for the period.
Cost of funds includes repurchase agreements, debt of consolidated VIEs and interest rate swaps, but excludes interest rate swap termination fees and costs
associated with other supplemental hedges such as interest rate swaptions and short U.S. Treasury or TBA positions. Weighted average cost of funds for
the period was calculated by dividing our total cost of funds by our average repurchase agreements and debt of consolidated VIEs outstanding.
Net comprehensive income return on average common equity for the period was calculated by dividing comprehensive income available to common
shareholders by our average shareholders' equity, net of the 8.000% Series A Cumulative Redeemable Preferred Stock liquidation preference on an annualized
basis.
Economic return on common equity represents the sum of the change in net asset value per common share over the period and dividends declared on
common stock during the period over the beginning net asset value per common share on an annualized basis.
Leverage during the period was calculated by dividing our daily weighted average repurchase agreements and debt of consolidated VIEs outstanding for
the period by our average stockholders' equity for the period on an annualized basis.
Leverage at period end was calculated by dividing the sum of the amount outstanding under our repurchase agreements, net receivable / payable for
unsettled agency securities and debt of consolidated VIEs by our total stockholders' equity at period end.
Expenses as a % of average total assets calculated by dividing our total expenses by our average total assets for the period on an annualized basis.
Expenses as a % of average stockholders' equity calculated by dividing our total expenses by our average stockholders' equity on an annualized basis.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is designed to provide
a reader of American Capital Agency Corp.’s consolidated financial statements with a narrative from the perspective of management.
Our MD&A is presented in five sections:
• Executive Overview
•
Financial Condition
• Results of Operations
• Liquidity and Capital Resources
•
Forward-Looking Statements
EXECUTIVE OVERVIEW
The size and composition of our investment portfolio depends on investment strategies implemented by our Manager, the
availability of investment capital and overall market conditions, including the availability of attractively priced investments and
suitable financing to appropriately leverage our investment portfolio. Market conditions are influenced by, among other things,
current levels of and expectations for future levels of, interest rates, mortgage prepayments, market liquidity, housing prices,
unemployment rates, general economic conditions, government participation in the mortgage market, evolving regulations or
legal settlements that impact servicing practices or other mortgage related activities.
Trends and Recent Market Impacts
On September 13, 2012, the Federal Reserve announced their third quantitative easing program, commonly known as
QE3, and extended their guidance to keep the federal funds rate at "exceptional low levels" through at least mid-2015. QE3
entails large-scale purchases of agency mortgage-backed securities at the pace of $40 billion per month in addition to the Federal
Reserve's existing policy of reinvesting principal payments from its holdings of agency mortgage-backed securities into new
agency mortgage-backed security purchases. The program is open-ended in nature, and is intended to put downward pressure
on longer-term interest rates, support mortgage markets, and help make the broader financial conditions more accommodative.
38
The Federal Reserve plans to continue their purchases of agency mortgage-backed securities and employ other policy tools, as
appropriate, until they foresee substantial improvement in the outlook for the U.S. labor market.
The Federal Reserve's purchases are and likely will continue to be concentrated in newly-issued, fixed-rate agency
mortgage-backed securities (i.e., the part of the mortgage market with the greatest impact on mortgage rates offered to borrowers).
The combined total purchases of agency mortgage-backed securities by the Federal Reserve were approximately $70 billion
per month during the fourth quarter of 2012, representing approximately half of the average monthly gross issuance of fixed-
rate agency mortgage-backed securities. Prices across the agency mortgage-backed security spectrum generally increased
following the Federal Reserve's announcement of QE3, with the lowest coupon 30-year and 15-year fixed-rate agency mortgage-
backed securities outperforming higher coupon securities. During the fourth quarter of 2012, some of the initial gains reversed;
however, as of December 31, 2012 prices generally remained above those seen prior to the announcement of QE3. The table
below summarizes interest rates and prices of generic fixed-rate agency mortgage-backed securities as of the end of each
respective quarter:
Interest Rate/Security Price (1)
December 31,
2012
September 30,
2012
June 30,
2012
March 31,
2012
December 31,
2011
LIBOR:
1-Month ..................................
3-Month ..................................
6-Month ..................................
U.S. Treasury Security Rate:
2-Year U.S. Treasury...............
5-Year U.S. Treasury...............
10-Year U.S. Treasury.............
Interest Rate Swap Rate:
2-Year Swap............................
5-Year Swap............................
10-Year Swap..........................
30-Year Fixed Rate MBS Price:
3.0% ........................................
3.5% ........................................
4.0% ........................................
4.5% ........................................
5.0% ........................................
5.5% ........................................
6.0% ........................................
15-Year Fixed Rate MBS Price:
2.5% ........................................
3.0% ........................................
3.5% ........................................
4.0% ........................................
4.5% ........................................
0.21%
0.31%
0.51%
0.25%
0.72%
1.76%
0.39%
0.86%
1.84%
$104.84
$106.66
$107.22
$108.03
$108.33
$108.64
$109.22
$104.61
$105.61
$106.14
$107.00
$107.55
0.21%
0.36%
0.64%
0.23%
0.63%
1.63%
0.37%
0.76%
1.70%
$105.58
$107.25
$107.75
$108.25
$109.06
$109.63
$110.44
$105.13
$106.00
$106.41
$106.91
$107.84
0.25%
0.46%
0.73%
0.30%
0.72%
1.65%
0.55%
0.97%
1.78%
$102.55
$105.11
$106.44
$107.28
$108.23
$109.08
$109.91
$103.09
$104.77
$105.66
$106.34
$107.17
0.24%
0.47%
0.73%
0.33%
1.04%
2.21%
0.58%
1.27%
2.29%
$99.67
$102.72
$104.86
$106.38
$108.03
$108.97
$110.20
$101.42
$103.56
$104.92
$106.00
$107.20
0.30%
0.58%
0.81%
0.24%
0.83%
1.88%
0.73%
1.22%
2.03%
$100.22
$102.88
$105.03
$106.42
$108.03
$108.89
$110.16
$101.34
$103.28
$104.58
$105.50
$106.59
December 31,
2012
vs.
June 30, 2012
(Pre - QE3)
December 31,
2012
vs.
December 31,
2011
-0.04 bps
-0.15 bps
-0.22 bps
-0.09 bps
-0.27 bps
-0.30 bps
-0.05 bps
+0.01 bps
— bps
+0.11 bps
-0.11 bps
-0.12 bps
-0.16 bps
-0.11 bps
+0.06 bps
-0.34 bps
-0.36 bps
-0.19 bps
+$2.29
+$1.55
+$0.78
+$0.75
+$0.10
-$0.44
-$0.69
+$1.52
+$0.84
+$0.48
+$0.66
+$0.38
+$4.62
+$3.78
+$2.19
+$1.61
+$0.30
-$0.25
-$0.94
+$3.27
+$2.33
+$1.56
+$1.50
+$0.96
________________________
1.
Price information is for generic instruments only and is not reflective of our specific portfolio holdings. Price information can vary by source. Prices in
the table above obtained from a combination of Bloomberg and dealer indications. Interest rates obtained from Bloomberg.
We expect during periods in which the Federal Reserve purchases significant volumes of mortgages, yields on agency
mortgage-backed securities will be lower and refinancing volumes will be higher than would have been absent QE3. Since
returns on agency mortgage-backed securities are highly sensitive to prepayment speeds, we have positioned our investment
portfolio towards agency securities that we believe have favorable prepayment attributes. As of December 31, 2012, 77% of
our fixed-rate investment portfolio was comprised of agency securities backed by lower loan balance mortgages (pools backed
by original loan balances of up to $150,000) and loans originated under HARP (pools backed by 100% refinance loans with
original loan-to-value ratios of greater than 80%), which we believe have a lower risk of prepayment relative to generic agency
securities. The remainder of our portfolio as of December 31, 2012 was primarily comprised of low coupon, new issuance
39
fixed-rate agency securities. (See Financial Condition below for further details of our portfolio composition as of December 31,
2012).
The following table summarizes recent prepayment trends for our portfolio and, for comparison, Fannie Mae 2011 30-
year 4.0% fixed-rate generic mortgage-backed securities for fiscal year 2012.
Annualized Monthly
Constant Prepayment
Rates (1)
Jan.
2012
Feb.
2012
Mar.
2012
Apr.
2012
May
2012
June
2012
July
2012
Aug.
2012
Sept.
2012
Oct.
2012
Nov.
2012
Dec.
2012
AGNC portfolio.............
8%
8%
12%
12%
10%
8%
8%
9%
11%
9%
10%
10%
Fannie Mae 2011 30-
year 4.0% fixed-rate
MBS (2)...........................
11%
13%
19%
21%
14%
15%
21%
29%
35%
32% 34%
35%
________________________
1. Weighted average actual one-month annualized CPR released at the beginning of the month based on securities held/outstanding as of the preceding
month-end.
Source: JP Morgan.
2.
Summary of Critical Accounting Estimates
Our critical accounting estimates relate to the recognition of interest income and the fair value of our investments and
derivatives. Certain of these items involve estimates that require management to make judgments that are subjective in nature.
We rely on our Manager's experience and analysis of historical and current market data in order to arrive at what we believe to
be reasonable estimates. Under different conditions, we could report materially different amounts based on such estimates. The
remainder of our significant accounting policies are described in Note 2 to the consolidated financial statements included under
Item 8 of this Annual Report on Form 10-K.
Interest Income
The effective yield on our agency securities is highly impacted by our estimate of future prepayments. We accrue interest
income based on the outstanding principal amount of our investment securities and their contractual terms and we amortize or
accrete premiums and discounts associated with the purchase of investment securities into interest income over the projected
lives of our securities, including contractual payments and estimated prepayments, using the interest method. The weighted
average cost basis of our securities as of December 31, 2012 was 105.6% of par value; therefore, faster actual or projected
prepayments can have a meaningful negative impact, while slower actual or projected prepayments can have a meaningful
positive impact, on our asset yields.
Future prepayment rates are difficult to predict and we rely on a third-party service provider and our Manager's experience
and analysis of historical and current market data in order to arrive at what we believe to be reasonable estimates. Our third-
party service provider estimates prepayment speeds using models that incorporate the forward yield curve, current mortgage
rates and mortgage rates of the outstanding loans, age and size of the outstanding loans, loan-to-value ratios, volatility and other
factors. We review the prepayment speeds estimated by the third-party service and compare the results to market consensus
prepayment speeds, if available. We also consider historical prepayment speeds and current market conditions to validate the
reasonableness of the prepayment speeds estimated by the third-party service and, based on our Manager’s judgment, we may
make adjustments to their estimates.
We review our actual and anticipated prepayment experience on at least a quarterly basis and effective yields are recalculated
when differences arise between (i) our previously estimated future prepayments and (ii) actual prepayments to date plus current
estimated future prepayments. If the actual and estimated future prepayment experience differs from our prior estimate of
prepayments, we are required to record an adjustment in the current period to the amortization or accretion of premiums and
discounts for the cumulative difference in the effective yield through the reporting date.
The most significant factor impacting prepayment rates on our securities is changes to long-term interest rates. Prepayment
rates generally increase when interest rates fall and decrease when interest rates rise. However, there are a variety of other
factors that may impact the rate of prepayments on our securities. Prepayments can also occur when borrowers sell the property
and use the sale proceeds to prepay the mortgage as part of a physical relocation. In addition, changes to the GSE's underwriting
standards, further modifications to existing U.S. Government sponsored programs such as HARP, or the implementation of new
programs can have a significant impact on the rate of prepayments. Further, GSE buyouts of loans in imminent risk of default,
40
loans that have been modified, or loans that have defaulted will generally be reflected as prepayments on agency securities and
also increase the uncertainty around our estimates. Consequently, under different conditions, we could report materially different
amounts. Item 7A. Quantitative and Qualitative Disclosures About Market Risk in this Annual Report on Form 10-K includes
the estimated change in our net interest income should interest rates go up or down by 50 and 100 basis points, assuming the
yield curves of the rate shocks will be parallel to each other and the current yield curve.
Fair Value of Investment Securities
We estimate the fair value of our investment securities based on a market approach using Level 2 inputs from third-party
pricing services and non-binding dealer quotes. The third-party pricing services use pricing models that incorporate such factors
as coupons, primary and secondary mortgage rates, prepayment speeds, spread to the Treasury and interest rate swap curves,
convexity, duration, periodic and life caps and credit enhancements. The dealer quotes incorporate common market pricing
methods, including a spread measurement to the Treasury or interest rate swap curve as well as underlying characteristics of the
particular security including coupon, periodic and life caps, rate reset period, issuer, additional credit support and expected life
of the security. We generally obtain 3 to 6 quotes or prices (referred to as "marks") per investment security. We attempt to
validate marks obtained from pricing services and broker dealers by comparing them to our recent completed transactions
involving the same or similar securities on or near the reporting date. Changes in the market environment and other events that
may occur over the life of our investments may cause the gains or losses ultimately realized on these investments to be different
than the valuations currently estimated.
Derivative Financial Instruments/Hedging Activity
We maintain a risk management strategy, under which we may use a variety of derivative instruments to economically
hedge some of our exposure to market risks, including interest rate and prepayment risk. Our risk management objective is to
reduce fluctuations in net book value over a range of market conditions. The principal instruments that we use to hedge a portion
of our exposure to interest rate and prepayment risks are interest rate swaps and swaptions. We also purchase or sell TBAs and
specified agency securities on a forward basis as well as U.S. Treasury securities and U.S. Treasury futures contracts; purchase
or write put or call options on TBA securities; and invest in other types of mortgage derivatives, such as interest-only securities,
and synthetic total return swaps, such as the Markit IOS Synthetic Total Return Swap Index (“Markit IOS Index”).
We recognize all derivatives as either assets or liabilities on the balance sheet, measured at fair value. During the third
quarter of 2011, we elected to discontinue hedge accounting for our interest rate swaps. Accordingly, subsequent to the third
quarter of 2011, all changes in the fair value of our derivative instruments are reported in earnings in our consolidated statement
of comprehensive income in gain (loss) on derivatives and other securities, net during the period in which they occur.
The use of derivatives creates exposure to credit risk relating to potential losses that could be recognized in the event that
the counterparties to these instruments fail to perform their obligations under the contracts. We attempt to minimize this risk by
limiting our counterparties to major financial institutions with acceptable credit ratings, monitoring positions with individual
counterparties and adjusting posted collateral as required.
We estimate the fair value of interest rate swaps using a third-party pricing model. The third-party pricing model incorporates
such factors as the LIBOR curve and the pay rate on our interest rate swaps. We also incorporate both our own and our
counterparties’ nonperformance risk in estimating the fair value of our interest rate swaps. In considering the effect of
nonperformance risk, we consider the impact of netting and credit enhancements, such as collateral postings and guarantees,
and have concluded that our own and our counterparty risk is not significant to the overall valuation of these agreements.
We estimate the fair value of interest rate swaptions using a third-party pricing model based on the fair value of the future
interest rate swap that we have the option to enter into as well as the remaining length of time that we have to exercise the option,
adjusted for non-performance risk, if any.
Recent Accounting Pronouncements
A summary of recent accounting pronouncements is included in Note 2 of the accompanying consolidated financial
statements in this Annual Report on Form 10-K.
41
FINANCIAL CONDITION
As of December 31, 2012 and 2011, our investment portfolio consisted of $85.2 billion and $54.7 billion, respectively, of
agency mortgage-backed securities ("agency MBS"). The following tables summarize certain characteristics of our agency MBS
investment portfolio as of December 31, 2012 and 2011 (dollars in millions):
Agency MBS Classified as Available-for-
Sale ("AFS")
Par Value
Amortized
Cost
Amortized
Cost Basis
Fair Value
Coupon
Yield
Age
(Months)
December 31, 2012
Weighted Average
December
2012
Projected
Life CPR (1)
Investments By Issuer:
Fannie Mae ..............................................
$
58,912
$
Freddie Mac.............................................
Ginnie Mae ..............................................
19,336
238
62,120
20,284
248
105.4%
104.9%
104.2%
$
63,687
20,758
254
3.59%
3.58%
3.77%
2.60%
2.58%
1.60%
Total / Weighted Average.............................
$
78,486
$
82,652
105.3%
$
84,699
3.59%
2.59%
Investments By Security Type:
Fixed-Rate
Lower Loan Balance (2) .......................
HARP (3) ..............................................
Other (2009-2012 Vintages) (4) ...........
Other (Pre 2009 Vintages) ..................
........................................
Total 20-Year:..........................................
30-Year:
Lower Loan Balance (2) .......................
HARP (3) ..............................................
Other (2009-2012 Vintages) (4) ...........
Other (Pre 2009 Vintages) (4) ..............
Total 30-Year...........................................
Total Fixed-Rate...........................................
Adjustable-Rate............................................
CMO ............................................................
$
15,686
$
16,296
1,312
11,134
31
28,163
1,517
19,004
22,897
5,510
394
47,805
77,485
837
164
1,363
11,612
33
29,304
1,591
20,169
24,316
5,815
422
50,722
81,617
865
170
Total / Weighted Average.............................
$
78,486
$
82,652
103.9%
103.9%
104.3%
104.7%
104.1%
104.9%
106.1%
106.2%
105.5%
107.1%
106.1%
105.3%
103.4%
103.2%
105.3%
$
16,871
1,404
11,670
34
29,979
1,616
20,736
24,998
5,875
431
52,040
83,635
891
173
$
84,699
3.57%
3.53%
2.70%
4.61%
3.22%
3.33%
3.76%
3.84%
3.63%
5.62%
3.80%
3.58%
4.12%
3.75%
3.59%
2.53%
2.46%
1.62%
2.71%
2.17%
2.37%
2.84%
2.87%
2.70%
3.64%
2.84%
2.59%
2.40%
2.85%
2.59%
13
14
24
13
20
17
7
88
15
8
13
11
9
87
12
13
43
66
13
10%
12%
19%
11%
13%
14%
13%
16%
13%
10%
9%
9%
10%
19%
9%
11%
22%
15%
11%
Agency MBS Remeasured at Fair Value Through
Earnings
Interest-Only Strips
Underlying
Unamortized
Principal
Balance
December 31, 2012
Weighted Average
Amortized
Cost
Fair
Value
Coupon
Yield
Age
(Months)
December
2012
Projected
Life CPR (1)
Fannie Mae...............................................................
$
1,332
$
245
$
Freddie Mac .............................................................
Principal-Only Strips....................................................
Fannie Mae...............................................................
328
302
Total / Weighted Average..............................................
$
1,962
$
55
241
541
$
249
43
254
546
5.82%
5.60%
—%
4.89%
6.98%
11.84%
3.17%
5.78%
30
82
14
28
16%
17%
9%
13%
_______________________
1.
2.
Portfolio yield incorporates a projected life CPR assumption based on forward rate assumptions as of December 31, 2012.
Lower loan balance securities represent pools backed by a maximum original loan balance of up to $150,000. Our lower loan balance securities had a
weighted average original loan balance of $98,000 and $101,000 for 15-year and 30-year securities, respectively, as of December 31, 2012.
3. HARP securities are defined as pools backed by100% refinance loans with loan-to-value ratios ("LTV") 80%. Our HARP securities had a weighted
average LTV of 95% and 104% for 15-year and 30-year securities, respectively, as of December 31, 2012.
4. Other 15-year and 30-year securities include $1.2 billion and $920 million, respectively, of securities backed by loans with original loan balances
$175,000.
42
December 31, 2011
Weighted Average
Agency MBS Classified as AFS
Par Value
Amortized
Cost
Amortized
Cost Basis
Fair
Value
Coupon
Yield
Age
(Months)
Investments By Issuer:
Fannie Mae ..................................................
$
37,232
$
38,891
Freddie Mac.................................................
Ginnie Mae ..................................................
13,736
258
14,342
270
Total / Weighted Average.................................
$
51,226
$
53,503
104.5%
104.4%
104.7%
104.4%
$ 39,567
14,664
273
$ 54,504
4.07%
4.21%
3.74%
4.11%
3.02%
3.16%
1.71%
3.05%
Investments By Security Type:
Fixed-Rate
Lower Loan Balance (2) ...........................
HARP (3) ..................................................
Other (4) ...................................................
............................................
Total 20-Year:..............................................
30-Year:
Lower Loan Balance (2) ...........................
HARP (3) ..................................................
Other (2009-2011 Vintages)....................
Other (Pre 2009 Vintages) ......................
Total 30-Year...............................................
Total Fixed-Rate...............................................
Adjustable-Rate................................................
CMO ................................................................
$
16,033
$
16,626
1,160
1,814
19,007
5,462
4,577
11,676
6,987
655
23,895
48,364
2,627
235
1,208
1,873
19,707
5,659
4,847
12,318
7,307
697
25,169
50,535
2,725
243
103.7%
104.2%
103.2%
103.7%
103.6%
105.9%
105.5%
104.6%
106.3%
105.3%
104.5%
103.7%
103.1%
$ 17,027
1,235
1,898
20,160
5,710
4,927
12,591
7,380
715
25,613
51,483
2,774
247
3.81%
3.93%
3.54%
3.79%
3.71%
4.48%
4.48%
4.24%
5.59%
4.44%
4.10%
4.29%
3.74%
Total / Weighted Average.................................
$
51,226
$
53,503
104.4%
$ 54,504
4.11%
2.84%
2.87%
2.58%
2.82%
2.72%
3.40%
3.50%
3.17%
3.37%
3.38%
3.09%
2.58%
1.69%
3.05%
11
13
12
12
12
10
10
12
4
15
9
6
72
11
11
31
56
12
December
2011
Projected
Life CPR (1)
14%
14%
25%
14%
12%
12%
15%
13%
16%
11%
11%
15%
25%
12%
13%
32%
29%
14%
Agency MBS Remeasured at Fair Value Through
Earnings
Interest-Only Strips
December 31, 2011
Underlying
Unamortized
Principal
Balance
Amortized
Cost
Fair
Value
Coupon
Yield
Age
(Months)
Weighted Average
December
2011
Projected
Life CPR (1)
Fannie Mae.........................................................................
$
Freddie Mac .......................................................................
Principal-Only Strips..............................................................
Fannie Mae .............................................................................
$
687
453
40
90
66
35
$
86
56
5.55%
5.48%
6.62%
10.35%
37
—%
5.40%
7.70%
63
79
48
65
31%
25%
31%
29%
Total / Weighted Average........................................................
$
1,180
$
191
$ 179
5.33%
______________________
1.
2.
Portfolio yield incorporates a projected life CPR assumption based on forward rate assumptions as of December 31, 2011.
Lower loan balance securities represent pools backed by a maximum original loan balance of up to $150,000. Our lower loan balance securities had
a weighted average original loan balance of $102,000 and $108,000 for 15-year and 30-year securities, respectively, as of December 31, 2011.
3. HARP securities are defined as pools backed by100% refinance loans with LTVs 80%. Our HARP securities had a weighted average LTV of 98%
and 97% for 15-year and 30-year securities, respectively, as of December 31, 2011.
4. Other 15-year securities include $687 million of securities backed by loans with original loan balances $175,000.
As of December 31, 2012 and 2011, the combined weighted average yield of our agency MBS portfolio (inclusive of interest
and principal-only strips) was 2.61% and 3.07%, respectively.
43
The stated contractual final maturity of the mortgage loans underlying our agency MBS portfolio ranges up to 40 years. As
of December 31, 2012 and 2011, the weighted average final contractual maturity of our agency MBS portfolio was 24 and 23
years, respectively.
The actual maturities of agency MBS are generally shorter than their stated contractual maturities primarily as a result of
prepayments of principal of the underlying mortgages. The weighted average expected maturity of our agency MBS portfolio was
6.6 and 5.1 years as of December 31, 2012 and 2011, respectively. In determining the estimated weighted average years to maturity
of our agency MBS and the yield on our agency MBS, we have assumed a weighted average CPR over the remaining life of our
agency MBS portfolio of 11% and 14% as of December 31, 2012 and 2011, respectively. We amortize or accrete premiums and
discounts associated with purchases of our agency MBS into interest income over the estimated life of our securities based on
actual and projected CPRs, using the effective yield method. Since the weighted average cost basis of our agency MBS portfolio
was 105.6% of par value as of December 31, 2012, slower actual and projected prepayments can have a meaningful positive impact
on our asset yields, while faster actual or projected prepayments can have a meaningful negative impact on our asset yields.
The following table summarizes our agency MBS classified as available-for-sale, at fair value, according to their estimated
weighted average life classifications as of December 31, 2012 and 2011 (dollars in millions):
December 31, 2012
December 31, 2011
Estimated Weighted Average Life of
Agency MBS Classified as
Available-for-Sale
Fair
Value
Amortized
Cost
Weighted
Average
Coupon
Weighted
Average
Yield
Fair
Value
Amortized
Cost
Weighted
Average
Coupon
Weighted
Average
Yield
................................................
$
— $
> 1 year and 3 years ..........................
........................
> 5 years and
years .......................
> 10 years.............................................
1,119
27,448
54,054
2,078
—
1,108
26,750
52,735
2,059
Total ............................................
$
84,699
$
82,652
—%
4.18%
3.36%
3.69%
3.44%
3.59%
—% $
214
$
2.14%
2.29%
2.75%
2.65%
3,392
26,168
24,710
20
210
3,338
25,616
24,320
19
2.59% $
54,504
$
53,503
4.61%
4.38%
3.99%
4.19%
5.02%
4.11%
3.51%
2.54%
2.89%
3.29%
2.12%
3.05%
The weighted average life of our interest-only strips was 5.7 and 3.0 years as of December 31, 2012 and 2011, respectively,
and the weighted average life of our principal-only strips was 6.4 and 2.6 years as of December 31, 2012 and 2011, respectively.
As of December 31, 2012 and 2011, we held pass-through agency MBS collateralized by adjustable rate mortgage loans
with coupons linked to various indices. The following table details the characteristics of our agency ARM MBS portfolio by
interest rate index as of December 31, 2012 and 2011 (dollars in millions):
ARM Characteristics
Weighted average term to next reset (months).......
Weighted average margin.......................................
Weighted average annual period cap .....................
Six-
Month
Libor
22
1.59%
1.11%
Weighted average lifetime cap...............................
10.61%
December 31, 2012
December 31, 2011
One-Year
Libor
One-Year
Treasury
Twelve-
Month
Treasury
Average
Six-
Month
Libor
One-Year
Libor
One-Year
Treasury
58
1.78%
2.00%
9.24%
36
1.56%
1.09%
8.90%
20
1.84%
1.00%
33
1.59%
1.08%
10.06%
10.59%
75
1.79%
2.00%
9.25%
45
1.72%
1.31%
9.25%
Twelve-
Month
Treasury
Average
26
1.83%
1.00%
10.07%
Par value.................................................................
$
69
$
386
$
258
$
124
$
95
$
1,967
$
366
$
199
Percentage of investment portfolio at par value ....
0.09%
0.49%
0.33%
0.16%
0.19%
3.84%
0.71%
0.38%
The following table details the number of months to the next reset for our agency MBS collateralized by ARMs as of
December 31, 2012 and 2011 (dollars in millions):
44
December 31, 2012
December 31, 2011
ARM Months to Reset
Fair Value
% Total
Average
Reset
Fair Value % Total
Average
Reset
< 1 year......................................................................
$
...............................................
..............................................
..............................................
....................................................................
Total / Weighted Average...........................................
$
127
178
105
269
212
891
14%
20%
12%
30%
24%
100%
6
19
26
50
83
43
$
$
29
156
397
479
1,713
2,774
1%
6%
14%
17%
62%
100%
6
17
28
48
85
66
As of December 31, 2012 and 2011, we did not have investments in agency debenture securities.
RESULTS OF OPERATIONS
FISCAL YEAR 2012 COMPARED TO FISCAL YEAR 2011:
In addition to the results presented in accordance with GAAP, our results of operations discussed below include certain non-
GAAP financial information, including adjusted net interest expense, net spread income and estimated taxable income and certain
financial metrics derived from non-GAAP information, such as cost of funds and estimated undistributed taxable income. By
providing users of our financial information with such measures in addition to the related GAAP measures, we believe it gives
users greater transparency into the information used by our management in its financial and operational decision-making and, in
the case of estimated taxable income, information that is directly related to the amount of dividends we are required to distribute
in order to maintain our REIT qualification status. However, because such measures are incomplete measures of our financial
performance and involve differences from results computed in accordance with GAAP, they should be considered as supplementary
to, and not as a substitute for, our results computed in accordance with GAAP. In addition, because not all companies use identical
calculations, our presentation of such non-GAAP measures may not be comparable to other similarly-titled measures of other
companies. Furthermore, estimated taxable income can include certain information that is subject to potential adjustments up to
the time of filing our income tax returns, which occurs after the end of our calendar year.
Interest Income and Asset Yield
The following table summarizes our interest income for fiscal year 2012 and 2011 (dollars in millions):
Fiscal Year 2012
Fiscal Year 2011
Amount
Cash interest income ...........................................................................
$2,776
Premium amortization.........................................................................
(667)
Interest income....................................................................................
$2,109
Actual portfolio CPR ..........................................................................
Projected life CPR as of period end....................................................
Average 30-year fixed-rate mortgage rate as of period end (1)............
10-year U.S. Treasury rate as of period end........................................
10%
11%
3.35%
1.76%
Yield
3.90%
(1.08)%
2.82%
Yield
4.42%
(1.23)%
3.19%
Amount
$1,470
(361)
$1,109
9%
14%
3.95%
1.88%
1.
Source: Freddie Mac Primary Fixed Mortgage Rate Mortgage Market Survey
Interest income increased 90% to $2.1 billion for fiscal year 2012 from $1.1 billion for fiscal year 2011 due to a 115%
increase in our average investment portfolio partially offset by a 37 basis point ("bps") decline in our weighted average asset yield.
The increase in our average investment portfolio was a function of follow-on equity raises during fiscal years 2011 and 2012. The
decline in our average asset yield is reflective of the decline in long-term interest rates of the period primarily due to the Federal
Reserve's quantitative easing measures and the result of our acquiring lower yielding securities due to changes in portfolio
composition, reinvestment of proceeds received from principal repayments and deployment of capital from follow-on equity raises.
We believe the impact of the decline in long-term interest rates on our portfolio was partially mitigated by repositioning our
portfolio into securities that our Manager believes have more favorable prepayment attributes in a historically low rate environment.
45
Our weighted average actual prepayment rate during the year was 10%, a slight increase over the prior year, and our projected
life CPR decreased by 300 bps to a projected life CPR of 11% as of December 31, 2012 from 14% as of December 31, 2011,
despite the 60 bps decline in the average 30-year fixed-rate mortgage rate from December 31, 2011 to December 31, 2012.
The following is a summary of the impact of changes from fiscal year 2012 to fiscal year 2011 in the principal elements of
interest income (in millions):
Fiscal Year 2012 vs. Fiscal Year 2011
Due to Change in Average (1)
Increase
Volume
Yield
Interest Income ................ $
1,000
$
1,112
$
(112)
____________________
1. Variances that are the combined effect of volume and yield, but cannot be separately identified, are allocated to the volume and yield variances based
on their respective relative amounts.
Leverage
Our leverage was 6.9 times and 7.7 times our stockholders' equity as of December 31, 2012 and 2011, respectively. When
adjusted for the net payables and receivables for unsettled securities, our leverage ratio was 7.0 times and 7.9 times our stockholders'
equity as of December 31, 2012 and 2011, respectively.
The table below presents our quarterly average and quarter-end repurchase agreement and debt of consolidated variable
interest entities ("VIEs"), or other debt, balance outstanding and leverage ratios for fiscal year 2012 and 2011 (dollars in millions):
Repurchase Agreements and Other Debt
Average
Daily
Amount
Outstanding
Maximum
Daily Amount
Outstanding
Ending
Amount
Outstanding
Average
Daily
Interest
Rate on
Amounts
Outstanding
Average
Interest
Rate on
Ending
Amount
Outstanding
Average
Leverage(1)
Leverage
as of
Period
End(2)
Quarter Ended
December 31, 2012................ $
September 30, 2012............... $
June 30, 2012......................... $
March 31, 2012...................... $
December 31, 2011................ $
September 30, 2011............... $
June 30, 2011 (4)..................... $
March 31, 2011 (4).................. $
74,649
75,106
67,997
57,480
42,184
38,484
28,668
17,756
$
$
$
$
$
$
$
$
80,262
81,227
70,495
69,867
48,012
41,638
33,567
22,147
$
$
$
$
$
$
$
$
75,415
80,262
70,494
69,866
47,735
38,898
33,567
22,062
0.51%
0.47%
0.40%
0.38%
0.34%
0.25%
0.25%
0.28%
0.51%
0.46%
0.42%
0.37%
0.40%
0.28%
0.23%
0.28%
6.7:1
7.1:1
7.5:1
8.2:1
7.6:1
7.9:1
7.6:1
7.4:1
6.9:1
7.1:1
7.7:1
8.0:1
7.7:1
7.9:1
7.0:1
6.6:1
Leverage
as of
Period
End,
Net of
Unsettled
Trades(3)
7.0:1
7.0:1
7.6:1
8.4:1
7.9:1
7.7:1
7.5:1
7.6:1
1. Average leverage during the period was calculated by dividing the daily weighted average repurchase agreements and debt of consolidated VIEs
2.
3.
outstanding for the period by our average month-ended stockholders’ equity for the period.
Leverage as of period end was calculated by dividing the amount outstanding under our repurchase agreements and debt of consolidated VIEs by our
stockholders’ equity at period end.
Leverage as of period end, net of unsettled trades was calculated by dividing the sum of the amount outstanding under our repurchase agreements, net
liabilities and receivables for unsettled agency securities and debt of consolidated VIEs by our total stockholders’ equity at period end.
4. Average leverage for the quarters ended March 31, 2011 and June 30, 2011 was 8.2x and 8.3x, pro forma, when average equity is adjusted to exclude
the March 2011 and June 2011 follow-on equity offerings that closed on March 25, 2011 and June 28, 2011, respectively.
Our leverage included in the table above does not include the impact of TBA and forward settling agency securities positions,
which have the effect of increasing or decreasing our "at risk" leverage. A net long position increases our at risk leverage, while
a net short position reduces our at risk leverage. As of December 31, 2012, we had a net long TBA and forward settling agency
securities position of $12.5 billion notional value and total "at risk" leverage of 8.2 times our stockholders' equity including net
unsettled securities. As of December 31, 2011, we had a net short TBA and forward settling agency securities position of $103
million notional value and at risk leverage of 7.9 times including net unsettled securities.
Interest Expense and Cost of Funds
Interest expense of $512 million for fiscal year 2012 was primarily comprised of interest expense on our repurchase
agreements and the reclassification of accumulated OCI into interest expense related to previously de-designated interest rate
swaps described further below. When adjusted for other periodic swap expense included in our consolidated statement of
46
comprehensive income in gain (loss) on derivative instruments and other securities, net, our adjusted net interest expense was
$764 million for fiscal year 2012.
Interest expense of $285 million for fiscal year 2011 was primarily comprised of interest expense on our repurchase
agreements and periodic swap costs for the period prior to hedge de-designation. When adjusted for other periodic swap expense
included in our consolidated statement of comprehensive income in gain (loss) on derivative instruments and other securities, net,
our adjusted net interest expense was $320 million for fiscal year 2011.
Prior to the third quarter of 2011, we entered into interest rate swap agreements typically with the intention of qualifying for
hedge accounting under GAAP. However, as of September 30, 2011, we elected to discontinue hedge accounting for our interest
rate swaps. Subsequent to our discontinuance of hedge accounting, the net deferred loss related to our de-designated interest rate
swaps is being reclassified from accumulated OCI into interest expense on a straight-line basis over the remaining term of each
interest rate swap. Although the reclassification of accumulated OCI into interest expense is similar to as if the interest rate swaps
had not been de-designated, the actual net periodic interest costs associated with our de-designated interest rates swaps may be
greater or less than the amounts reclassified into interest expense. The difference, as well as net periodic interest costs on interest
rate swaps that were never in a hedge designation, is reported in our consolidated statement of comprehensive income in gain
(loss) on derivative instruments and other securities, net. We refer to the sum of our total net periodic interest costs on our interest
rate swaps and interest expense on our repurchase agreements and other debt as our "adjusted net interest expense" or as our "cost
of funds" when stated as a percentage of our outstanding repurchase agreements and other debt balance. Our cost of funds does
not include swap termination fees and costs associated with our other supplemental hedges, such as swaptions, short U.S. Treasury
or TBA positions.
The table below presents a reconciliation of our interest expense (the most comparable GAAP financial measure) to our
adjusted net interest expense (a non-GAAP financial measure) for fiscal year 2012 and 2011 (dollars in millions):
Adjusted Net Interest Expense and Cost of Funds
Interest expense:
Fiscal Year 2012
% (1)
Amount
Fiscal Year 2011
% (1)
Amount
Repurchase agreement and other debt interest expense..............
$
307
0.44% $
91
0.28%
Periodic interest costs of interest rate swaps previously
designated as hedges under GAAP, net................................
Total interest expense....................................................................
Other periodic interest costs of interest rate swaps, net .............
Total adjusted net interest expense and cost of funds................
$
205
512
252
764
0.30%
0.74%
0.37%
1.11% $
194
285
35
320
0.61%
0.89%
0.11%
1.00%
_______________________
1.
Percent of our average repurchase agreements and other debt outstanding for the period annualized.
The table below presents a summary of our debt and interest rate swaps outstanding for fiscal year 2012 and 2011 (dollars
in millions):
Average Debt and Interest Rate Swaps Outstanding
Average repurchase agreements and other debt ................................................................
Average notional amount of interest rate swaps................................................................
Average notional amount of interest rate swaps as a percentage of repurchase
agreements and other debt ............................................................................................
Weighted average pay rate on interest rate swaps.............................................................
Fiscal Year
2012
2011
$
$
68,810
$ 31,840
38,885
$ 16,448
57%
1.50%
52%
1.62%
Our average interest rate swaps outstanding in the table above exclude our forward starting swaps not in effect during the
periods presented. Forward starting interest rate swaps do not impact our adjusted net interest expense and cost of funds until
they commence accruing net interest settlements on their forward start dates. We enter into forward starting interest rate swaps
based on a variety of factors, including our Manager's view of the forward yield curve and the timing of potential changes in short-
term interest rates, time to deploy new capital, amount and timing of expirations of our existing interest swap portfolio and current
and anticipated swap spreads. As of December 31, 2012, we had $2.8 billion of forward starting interest rate swaps outstanding
with forward start dates through April 2013 and no interest rate swaps set to expire over the same period. As of December 31,
2011, we had $2.6 billion of forward starting interest rate swaps outstanding with forward start dates through May 2012, compared
to $0.2 billion of interest rate swaps set to expire over the same time period.
47
The period-over-period increase in our adjusted net interest expense was largely attributable to the increase in our investment
portfolio and the corresponding increase in our average repurchase agreements and other debt balances outstanding and a higher
cost of funds. Our higher cost of funds was reflective of higher repurchase agreement financing ("repo") rates and a higher ratio
of interest rate swaps outstanding to repurchase agreements and other debt, which was partially offset by a decrease in the weighted
average pay rate on our interest rate swaps. Our higher repo cost is primarily a function of higher repo rates in the market and
extending the average original days-to-maturity of our repo funding to 181 days as of December 31, 2012 from 90 days as of
December 31, 2011.
The following is a summary of the impact of changes from fiscal year 2012 to fiscal year 2011 in the principal elements of
our total adjusted net interest expense and cost of funds (in millions):
Fiscal Year 2012 vs. Fiscal Year 2011
Due to Change in Average (1)
Increase
Volume
Interest Rate
Repurchase agreement and other debt interest expense .................. $
Periodic interest rate swap costs (2)..................................................
Total adjusted net interest expense and cost of funds...................... $
216
$
228
444
$
142
$
241
383
$
74
(13)
61
____________________
1. Variances that are the combined effect of volume and yield, but cannot be separately identified, are allocated to the volume and yield variances based
2.
on their respective relative amounts.
Includes amounts recognized in interest expense and in gain (loss) on derivatives and other securities in our consolidated statements of comprehensive
income. Change due to interest rate reflects impact of change in the weighted average fixed pay rate, net of change in the weighted average receive
rate.
Net Spread Income
The table below presents a reconciliation of our net interest income (the most comparable GAAP financial measure) to our
net spread income (a non-GAAP financial measure) for fiscal year 2012 and 2011 (dollars in millions).
Fiscal Year
2012
2011
Net interest income............................................................................................................. $
1,597
$
Other periodic interest costs of interest rate swaps, net ..................................................
Adjusted net interest income ..............................................................................................
Operating expenses..........................................................................................................
Net spread income ..............................................................................................................
Dividend on preferred stock ............................................................................................
Net spread income available to common shareholders ...................................................... $
Weighted average number of common shares outstanding - basic and diluted.................
Net spread income per common share - basic and diluted ................................................. $
252
1,345
144
1,201
10
1,191
303.9
3.92
$
$
824
35
789
74
715
—
715
153.3
4.66
The period-over-period decline in net spread income per common share is primarily a function of margin compression due
to lower asset yields and higher cost of funds.
Gain on Sale of Agency Securities, Net
The following table is a summary of our net gain on sale of agency MBS for fiscal year 2012 and 2011 (in millions):
48
Agency MBS sold, at cost............................................................................... $
Proceeds from agency MBS sold (1)................................................................
Net gains on sale of agency MBS ................................................................... $
Gross gains on sale of agency MBS ............................................................... $
Gross losses on sale of agency MBS ..............................................................
Net gains on sale of agency MBS ................................................................... $
Fiscal Year
2012
2011
(63,610) $
64,806
1,196
1,209
(13)
1,196
$
$
$
(37,579)
38,052
473
510
(37)
473
_______________________
1.
Proceeds include cash received during the period, plus receivable for agency MBS sold during the period as of period end.
Asset sales during the periods presented were primarily a function of repositioning our agency MBS portfolio towards
securities with attributes our Manager believes provide a greater relative value and risk-adjusted returns in light of current and
anticipated interest rates, federal government programs, general economic conditions and other factors.
Gain (Loss) on Derivative Instruments and Other Securities, Net
The following table is a summary of our gain (loss) on derivative instruments and other securities, net for fiscal year 2012
and 2011 (in millions):
Fiscal Year
2012
2011
(252) $
(35)
Periodic interest costs of interest rate swaps, net (1)............................................................... $
Realized loss on derivative instruments and other securities, net:
Purchase of TBAs and forward settling agency securities..............................................
Sale of TBAs and forward settling agency securities .....................................................
Interest rate payer swaptions...........................................................................................
U.S. Treasury securities...................................................................................................
Short sales of U.S. Treasury securities............................................................................
U.S. Treasury futures sold short......................................................................................
Interest rate swap termination fees..................................................................................
Other................................................................................................................................
Total realized loss on derivative instruments and other securities, net..................................
Unrealized loss on derivative instruments and other securities, net: (2)
Purchase of TBAs and forward settling agency securities..............................................
Sale of TBAs and forward settling agency securities .....................................................
Interest-only and principal-only strips ............................................................................
Interest rate swaps ...........................................................................................................
Interest rate payer swaptions...........................................................................................
Short sales of U.S. Treasury securities............................................................................
U.S. Treasury futures sold short......................................................................................
Unrealized loss on debt of consolidated VIEs ................................................................
Total unrealized loss on derivative instruments and other securities, net..............................
384
(434)
(42)
(1)
(144)
(104)
(180)
—
(521)
60
21
17
(602)
(64)
2
14
(28)
(580)
106
(247)
(13)
34
(116)
1
(7)
1
(241)
54
(55)
(17)
(72)
(51)
(17)
(13)
—
(171)
(447)
Total loss on derivative instruments and other securities, net ............................................... $
(1,353) $
_______________________
1.
Please refer to Interest Expense and Cost of Funds discussion above for additional information regarding other periodic interest costs of interest rate
swaps, net.
2. Unrealized gain (loss) from derivative instruments and other securities, net includes reversals of prior period amounts for settled or expired derivative
instruments and other securities.
We use derivative instruments and other securities in addition to interest rate swaps to supplement our interest rate risk
management strategies. Our increased use of derivative instruments and other securities during fiscal year 2012 was a function
of the overall increase in our investment portfolio and continued interest rate volatility. For further details regarding our use of
derivative instruments and related activity refer to Notes 2 and 5 of our consolidated financial statements in this Annual Report
on Form 10-K.
49
Management Fees and General and Administrative Expenses
We pay our Manager a base management fee payable monthly in arrears in amount equal to one twelfth of 1.25% of our
Equity. Our Equity is defined as our month-end stockholders' equity, adjusted to exclude the effect of any unrealized gains or
losses included in either retained earnings or accumulated OCI, each as computed in accordance with GAAP. There is no incentive
compensation payable to our Manager pursuant to the management agreement. We incurred management fees of $113 million and
$55 million during fiscal year 2012 and 2011, respectively; the year-over-year increase of which was primarily a function of our
follow-on equity raises. General and administrative expenses were $31 million and $19 million during fiscal year 2012 and 2011,
respectively. Our general and administrative expenses primarily consisted of prime broker fees, information technology costs,
allocation of overhead expenses from our Manager, accounting fees, legal fees, Board of Director fees and insurance expense.
Our total operating expense as a percentage of our average stockholders' equity declined year-over-year to 1.52% from 1.77% due
to improved operating leverage.
Dividends and Income Taxes
For fiscal year 2012 and 2011, we had estimated taxable income of $2.1 billion and $1.0 billion (or $6.87 and $6.70 per
common share), respectively.
As a REIT, we are required to distribute annually 90% of our taxable income to maintain our status as a REIT and all of our
taxable income to avoid Federal and state corporate income taxes. We can treat dividends declared by September 15 and paid by
December 31 as having been a distribution of our taxable income for our prior tax year ("spill-back provision"). Income as
determined under GAAP differs from income as determined under tax rules because of both temporary and permanent differences
in income and expense recognition. The primary differences are (i) unrealized gains and losses associated with interest rate swaps
and other derivatives and securities marked-to-market in current income for GAAP purposes, but excluded from taxable income
until realized or settled, (ii) temporary differences related to the amortization of premiums paid on investments, (iii) timing
differences in the recognition of certain realized gains and losses and (iv) permanent differences for excise tax expense. Furthermore,
our estimated taxable income is subject to potential adjustments up to the time of filing our appropriate tax returns, which occurs
after the end of our fiscal year. The following is a reconciliation of our GAAP net income to our estimated taxable income for
the fiscal year 2012 and 2011 (dollars in millions).
Net income
Book to tax differences:
Premium amortization, net
Realized loss, net
Unrealized loss, net
Other
Total book to tax differences
Estimated REIT taxable income
Dividend on preferred stock
Fiscal Year
2012
2011
$
1,277
$
770
51
159
574
38
822
2,099
10
2,089
303.9
6.87
$
$
57
71
133
(3)
258
1,028
—
1,028
153.3
6.70
Estimated REIT taxable income available to common shareholders
Weighted average number of common shares outstanding - basic and diluted
Estimated REIT taxable income per common share - basic and diluted
$
$
For fiscal year 2012 and 2011, we declared common dividends of $5.00 and $5.60 per common share, respectively. For
fiscal year 2012, we declared dividends on our Series A Preferred Stock of $1.056 per preferred share, which excludes the preferred
stock dividend of $0.50 per share declared on December 17, 2012 with a record date of January 1, 2013, which is treated as a
fiscal year 2013 dividend for federal income tax purposes. We did not have preferred stock outstanding prior to fiscal year 2012.
As of December 31, 2012, we have distributed all of our taxable income for the 2011 tax year and we have an estimated
$749 million of undistributed taxable income related to our 2012 tax year, net of our December 31, 2012 common dividend payable
of $424 million. We expect to distribute our remaining fiscal year 2012 taxable income during fiscal year 2013 under the available
spill-back provision so that we will not be subject to federal or state corporate income tax. However, as a REIT, we are still subject
to a nondeductible federal excise tax of 4% to the extent that the sum of (i) 85% of our ordinary taxable income, (ii) 95% of our
capital gains and (iii) any undistributed taxable income from the prior year exceeds our dividends declared in such year and paid
by January 31 of the subsequent year. For fiscal year 2012 and 2011, we accrued a federal excise tax of $25 million and $2 million,
50
respectively, which is included in our net income tax provision on our accompanying consolidated statements of comprehensive
income because our respective 2012 and 2011 calendar year distributions were less than the total of these amounts.
In addition, our TRS is subject to corporate federal and state income taxes at the combined federal and state corporate
statutory tax rate of 39.5%. For fiscal years 2012 and 2011, we recorded an income tax benefit of $6 million and an income tax
provision of $4 million, respectively, attributable to our TRS, which is included in our net income tax provision on our accompanying
consolidated statements of comprehensive income.
Other Comprehensive Income
The following table summarizes the components of our other comprehensive income for fiscal year 2012 and 2011 (in
millions):
Fiscal Year
2012
2011
Unrealized gain on AFS securities, net:
Unrealized gain, net..................................................................................................
$
2,235
$
1,512
Reversal of prior period unrealized gains, net, upon realization..............................
Unrealized gain on AFS securities, net: .....................................................................
Unrealized gain (loss) on interest rate swaps designated as cash flow hedges:
Unrealized loss, net ..................................................................................................
Reversal of prior period unrealized loss on interest rate swaps, net, upon
reclassification to interest expense ...........................................................................
Unrealized gain (loss) on interest rate swaps, net: .....................................................
(1,196)
1,039
—
205
205
Total other comprehensive income.............................................................................
$
1,244
$
(483)
1,029
(844)
194
(650)
379
FISCAL YEAR 2011 COMPARED TO FISCAL YEAR 2010:
Interest Income and Asset Yield
The following table summarizes our interest income for fiscal year 2011 and 2010 (dollars in millions):
Fiscal Year 2011
Fiscal Year 2010
Cash interest income ....................................
Premium amortization ..................................
Interest income .............................................
Actual portfolio CPR....................................
Projected life CPR as of period end .............
Yield
4.42%
(1.23)%
3.19%
Amount
$1,470
(361)
$1,109
9%
14%
10-year U.S. Treasury rate as of period end .
1.88%
Yield
5.03%
(1.59)%
3.44%
Amount
$352
(99)
$253
19%
12%
3.30%
Interest income was $1.1 billion and $253 million for fiscal year 2011 and 2010, respectively. The increase in interest income
was due to an increase in our average investment portfolio, partially offset by a decline in our average asset yield.
Our average asset yield declined 25 bps to 3.19% from 3.44% for fiscal year 2011 and 2010, respectively. The decline in
our average asset yield was reflective of the decline in long-term interest rates, higher projected prepayments and the result of
acquiring lower yielding securities due to changes in portfolio composition, reinvestment of proceeds received from principal
repayments and deployment of capital from follow-on equity raises.
Our projected CPR estimate increased to 14% as of December 31, 2011 from 12% as of December 31, 2010. The actual
CPR realized for individual securities in our investment portfolio was 9% and 19% for fiscal year 2011 and 2010, respectively.
Interest income was net of premium amortization of $361 million and $99 million for fiscal year 2011 and 2010, respectively.
The net unamortized premium balance of our investment portfolio, including interest-only and principal-only strips, was $2.4
billion and $0.6 billion as of December 31, 2011 and 2010, respectively.
51
The following is a summary of the impact of changes from fiscal year 2011 to fiscal year 2010 in the principal elements of
our interest income (in millions):
Fiscal Year 2011 vs. Fiscal Year 2010
Due to Change in Average (1)
Increase
Volume
Yield
Interest Income ................ $
856
$
873
$
(17)
____________________
1. Variances that are the combined effect of volume and yield, but cannot be separately identified, are allocated to the volume and yield variances based
on their respective relative amounts.
Leverage
Our leverage was 7.7 and 7.5 times our stockholders' equity as of December 31, 2011 and 2010, respectively. When adjusted
for the net payables and receivables for unsettled securities, our leverage ratio was 7.9 and 7.8 times our stockholders' equity as
of December 31, 2011 and 2010, respectively.
The table below presents our quarterly average and quarter-end repurchase agreement and other debt outstanding and leverage
ratios for fiscal year 2011 and 2010 (dollars in millions):
Repurchase Agreements and Other Debt
Average
Daily
Amount
Outstanding
Maximum
Daily Amount
Outstanding
Ending
Amount
Outstanding
Average
Daily
Interest
Rate on
Amounts
Outstanding
Average
Interest
Rate on
Ending
Amount
Outstanding
Average
Leverage(1)
Leverage
as of
Period
End(2)
Quarter Ended
December 31, 2011................ $
September 30, 2011............... $
June 30, 2011(4)(5)................... $
March 31, 2011(4)(5)................ $
December 31, 2010(5)............. $
September 30, 2010............... $
June 30, 2010......................... $
March 31, 2010...................... $
42,184
38,484
28,668
17,756
10,814
7,242
5,548
3,788
$
$
$
$
$
$
$
$
48,012
41,638
33,567
22,147
12,341
8,050
6,634
4,651
$
$
$
$
$
$
$
$
47,735
38,898
33,567
22,062
11,753
8,050
6,634
4,651
0.34%
0.25%
0.25%
0.28%
0.29%
0.28%
0.26%
0.22%
0.40%
0.28%
0.23%
0.28%
0.31%
0.28%
0.28%
0.21%
7.6:1
7.9:1
7.6:1
7.4:1
8.4:1
8.5:1
7.9:1
6.5:1
7.7:1
7.9:1
7.0:1
6.6:1
7.5:1
8.8:1
8.4:1
7.6:1
Leverage
as of
Period
End,
Net of
Unsettled
Trades(3)
7.9:1
7.7:1
7.5:1
7.6:1
7.8:1
9.8:1
8.2:1
7.9:1
1. Average leverage during the period was calculated by dividing the daily weighted average repurchase agreements and debt of consolidated VIEs
2.
3.
outstanding for the period by our average month-ended stockholders’ equity for the period.
Leverage as of period end was calculated by dividing the amount outstanding under our repurchase agreements and debt of consolidated VIEs by our
stockholders’ equity at period end.
Leverage as of period end, net of unsettled trades was calculated by dividing the sum of the amount outstanding under our repurchase agreements, net
liabilities and receivables for unsettled agency securities, and debt of consolidated VIEs by our total stockholders’ equity at period end.
4. Average leverage for the quarters ended March 31, 2011 and June 30, 2011 was 8.2x and 8.3x, pro forma, when average equity is adjusted to exclude
the March 2011 and June 2011 follow-on equity offerings that closed on March 25, 2011 and June 28, 2011, respectively.
5. Average leverage for the period was higher than leverage as of period end because we had not fully invested net proceeds raised from follow-on equity
offerings occurring late in the period.
Interest Expense and Cost of Funds
Interest expense of $285 million for fiscal year 2011 was primarily comprised of interest expense on our repurchase
agreements and the reclassification of accumulated OCI into interest expense related to previously de-designated interest rate
swaps (refer in Note 2 of our consolidated financial statements in this Annual Report on Form 10-K for further discussion regarding
our discontinuance of hedge accounting). When adjusted for other periodic swap expense included in our consolidated statement
of comprehensive income in gain (loss) on derivative instruments and other securities, net, our adjusted net interest expense was
$320 million for fiscal year 2011.
Interest expense of $76 million for fiscal year 2010 was primarily comprised of interest expense on our repurchase agreements
and periodic swap costs.
52
The table below presents a reconciliation of our interest expense (the most comparable GAAP financial measure) to our
adjusted net interest expense (a non-GAAP financial measure) for fiscal years 2011 and 2010 (dollars in millions).
Adjusted Net Interest Expense and Cost of Funds
Interest expense:
Fiscal Year 2011
% (1)
Amount
Fiscal Year 2010
% (1)
Amount
Repurchase agreement and other debt interest expense..............
$
91
0.28% $
Periodic interest costs of interest rate swaps previously
designated as hedges under GAAP, net................................
194
0.61%
Amortization of termination fees on interest rate swaps
designated as hedges under GAAP ..................................
Total interest expense....................................................................
Other periodic interest costs of interest rate swaps, net .............
Total adjusted net interest expense and cost of funds................
$
—
285
35
320
—%
0.89%
0.11%
1.00% $
19
51
6
76
—
76
0.27%
0.74%
0.09%
1.11%
—%
1.11%
_______________________
1.
Percent of our average repurchase agreements and other debt outstanding for the period.
The table below presents a summary of our debt and interest rate swaps outstanding for fiscal year 2011 and 2010 (dollars
in millions).
Average Debt and Interest Rate Swaps Outstanding
Average repurchase agreements and other debt ................................................................
Average notional amount of interest rate swaps................................................................
Average notional amount of interest rate swaps as a percentage of repurchase
agreements and other debt ............................................................................................
Weighted average pay rate on interest rate swaps.............................................................
Fiscal Year
2011
31,840
16,448
$
$
2010
$
$
6,865
3,059
52%
1.62%
45%
1.93%
Our average interest rate swaps outstanding in the table above exclude our forward starting swaps not in effect during the
periods presented. Forward starting interest rate swaps do not impact our adjusted net interest expense and cost of funds until
they commence accruing net interest settlements on their forward start dates. As of December 31, 2011, we had $2.6 billion of
forward starting interest rate swaps outstanding with forward start dates through May 2012, compared to $0.2 billion of interest
rate swaps set to expire over the same time period. As of December 31, 2010, we had $1.7 billion of forward starting interest rate
swaps outstanding with forward start dates through June 2011, compared to $0.3 billion of interest rate swaps set to expire over
the same time period.
The period-over-period increase in our adjusted net interest expense was largely attributable to the increase in our investment
portfolio and the corresponding increase in our average repurchase agreements and other debt balances outstanding partially offset
by a lower cost of funds. Our lower cost of funds was reflective of a decrease in the weighted average pay rate on our interest rate
swaps, which was partially offset by a higher ratio of interest rate swaps outstanding to repurchase agreements and other debt.
The following is a summary of the impact of changes from fiscal year 2011 to fiscal year 2010 in the principal elements of
our total adjusted net interest expense and cost of funds (in millions):
Fiscal Year 2011 vs. Fiscal Year 2010
Due to Change in Average (1)
Increase
Volume
Interest Rate
Repurchase agreement and other debt interest expense ...... $
Periodic interest rate swap costs (2) ......................................
Total adjusted net interest expense and cost of funds.......... $
72
$
172
244
$
71
$
179
250
$
1
(7)
(6)
____________________
1. Variances that are the combined effect of volume and yield, but cannot be separately identified, are allocated to the volume and yield variances based
2.
on their respective relative amounts.
Includes amounts recognized in interest expense and in gain (loss) on derivatives and other securities in our consolidated statements of comprehensive
income. Change due to interest rate reflects impact of change in the weighted average fixed pay rate, net of change in the weighted average receive
rate.
53
Net Spread Income
The table below presents a reconciliation of our net interest income (the most comparable GAAP financial measure) to our
net spread income (a non-GAAP financial measure) for fiscal years 2011 and 2010 (dollars in millions):
Fiscal Year
2011
2010
Net interest income............................................................................................................. $
824
$
Other periodic interest costs of interest rate swaps, net ..................................................
Adjusted net interest income ..............................................................................................
Operating expenses..........................................................................................................
Net spread income available to common shareholders ......................................................
35
789
74
715
Weighted average number of common shares outstanding - basic and diluted.................
153.3
Net spread income per common share - basic and diluted ................................................. $
4.66
$
177
—
177
19
158
36.5
4.33
The period-over-period increase in net spread income per common share is primarily a function of increased operating
efficiency, partially offset by lower average net interest rate spreads and average leverage.
Gain on Sale of Agency Securities, Net
The following table is a summary of our net gain on sale of agency MBS for fiscal years 2011 and 2010 (in millions):
Agency MBS sold, at cost............................................................................... $
Proceeds from agency MBS sold (1)................................................................
Net gains on sale of agency MBS ................................................................... $
Gross gains on sale of agency MBS ............................................................... $
Gross losses on sale of agency MBS ..............................................................
Net gains on sale of agency MBS ................................................................... $
Fiscal Year
2011
2010
(37,579) $
38,052
473
510
(37)
473
$
$
$
(12,182)
12,274
92
126
(34)
92
_______________________
1.
Proceeds include cash received during the period, plus receivable for agency MBS sold during the period as of period end.
Asset sales during the periods presented were primarily a function of repositioning our agency MBS portfolio towards
securities with attributes our Manager believed provided a greater relative value and risk-adjusted returns in light of current and
anticipated interest rates, federal government programs, general economic conditions and other factors.
Gain (Loss) on Derivative Instruments and Other Securities, Net
The following table is a summary of our gain (loss) on derivative instruments and other securities, net for fiscal years 2011
and 2010 (in millions):
54
Periodic interest costs of interest rate swaps, net (1)............................................................... $
Realized (loss) gain on derivative instruments and other securities, net:
Purchase of TBAs and forward settling agency securities..............................................
Sale of TBAs and forward settling agency securities .....................................................
Interest rate payer swaptions...........................................................................................
U.S. Treasury securities...................................................................................................
Short sales of U.S. Treasury securities............................................................................
U.S. Treasury futures.......................................................................................................
Termination fees on interest rate swaps not designated as hedges..................................
Other................................................................................................................................
Total realized (loss) gain on derivative instruments and other securities, net .......................
Unrealized (loss) gain on derivative instruments and other securities, net: (2)
Purchase of TBAs and forward settling agency securities..............................................
Sale of TBAs and forward settling agency securities .....................................................
Interest-only and principal-only strips ............................................................................
Interest rate swaps not designated as hedges (3) ..............................................................
Interest rate payer swaptions...........................................................................................
Short sales of U.S. Treasury securities............................................................................
U.S. Treasury futures.......................................................................................................
Fiscal Year
2011
2010
(35) $
106
(247)
(13)
34
(116)
1
(7)
1
(241)
54
(55)
(17)
(72)
(51)
(17)
(13)
Total unrealized (loss) gain on derivative instruments and other securities, net ...................
Total (loss) gain on derivative instruments and other securities, net..................................... $
(171)
(447) $
—
15
2
7
(5)
(1)
—
—
(2)
16
4
9
(1)
(1)
12
(1)
—
22
38
_______________________
1.
Please refer to Interest Expense and Cost of Funds discussion above for additional information regarding other periodic interest costs of interest rate
swaps, net.
2. Unrealized gain (loss) from derivative instruments and other securities, net includes reversals of prior period amounts for settled or expired derivative
instruments and other securities.
3. Amount excludes $650 million and $24 million of net unrealized losses on interest rate swaps recorded in other comprehensive income (loss) for fiscal
year 2011 and 2010, respectively.
We use derivative instruments and other securities in addition to interest rate swaps to supplement our interest rate risk
management strategies. We increased our use of derivative instruments and other securities during fiscal year 2011 due to the
overall increase in our investment portfolio and continued interest rate volatility. For further details regarding our use of derivative
instruments and related activity, refer to Notes 2 and 5 of our consolidated financial statements in this Annual Report on Form 10-
K.
Management Fees and General and Administrative Expenses
We incurred management fees of $55 million and $11 million during fiscal year 2011 and 2010, respectively, the increase
of which was primarily a function of our follow-on equity raises. General and administrative expenses were $19 million and $8
million during fiscal year 2011 and 2010, respectively. Our general and administrative expenses primarily consisted of prime
broker fees, information technology costs, allocation of overhead expenses from our Manager, accounting fees, legal fees, Board
of Director fees and insurance expenses. Our total expenses as a percentage of our average stockholders' equity declined year-
over-year to 1.77% from 2.19% for fiscal year 2011 and 2010, respectively, due to improved operating leverage.
Dividends and Income Taxes
For fiscal year 2011 and 2010, we had taxable income of $1.0 billion and $247 million (or $6.70 and $6.76 per common
share), respectively. The following is a reconciliation of our GAAP net income to our taxable income for fiscal year 2011 and
2010 (dollars in millions).
55
Net income
Book to tax differences:
Premium amortization, net
Realized loss, net
Unrealized loss (gain), net
Other
Total book to tax differences
REIT taxable income available to common shareholders
Weighted average number of common shares outstanding - basic and diluted
Fiscal Year
2011
2010
$
770
$
288
57
71
133
(3)
258
1,028
153.3
(7)
3
(38)
1
(41)
247
36.5
6.76
REIT taxable income per common share - basic and diluted
$
6.70
$
For fiscal year 2011 and 2010, we declared common dividends of $5.60 per common share.
We distributed all of our 2011 and 2010 REIT taxable income in a timely manner so that we were not subject to any federal
or state income tax for those fiscal years. However, as a REIT, we were still subject to a nondeductible federal excise tax of 4%
to the extent that the sum of (i) 85% of our ordinary taxable income, (ii) 95% of our capital gains and (iii) any undistributed taxable
income from the prior year exceeds our dividends declared in such year and paid by January 31 of the subsequent year. For fiscal
year 2011 and 2010, we accrued federal excise tax of $2 million and $0.5 million, respectively.
Further, our TRS is subject to corporate federal and state income taxes. For fiscal year 2011, we recognized an income tax
provision of $4 million attributable to our TRS, which is included in our income tax provision, net on the accompanying consolidated
statements of comprehensive income. For fiscal year 2010, we did not accrue an income tax provision or benefit attributable to
our TRS.
Other Comprehensive Income
The following table summarizes the components of our other comprehensive income for fiscal year 2011 and 2010 (in
millions):
Fiscal Year
2011
2010
Unrealized gain on AFS securities, net:
Unrealized gain, net..................................................................................................
$
1,512
$
Reversal of prior period unrealized gains, net, upon realization..............................
Unrealized gain (loss) on AFS securities, net: ...........................................................
Unrealized loss on interest rate swaps designated as cash flow hedges:
Unrealized loss, net ..................................................................................................
Reversal of prior period unrealized loss on interest rate swaps, net, upon
reclassification to interest expense ...........................................................................
Unrealized loss on interest rate swaps, net:................................................................
(483)
1,029
(844)
194
(650)
Total other comprehensive income (loss)...................................................................
$
379
$
29
(93)
(64)
(75)
51
(24)
(88)
LIQUIDITY AND CAPITAL RESOURCES
Our primary sources of funds are borrowings under master repurchase agreements, equity offerings, asset sales and monthly
principal and interest payments on our investment portfolio. Because the level of our borrowings can be adjusted on a daily basis,
the level of cash and cash equivalents carried on the balance sheet is significantly less important than the potential liquidity available
under our borrowing arrangements. We currently believe that we have sufficient liquidity and capital resources available for the
acquisition of additional investments, repayments on borrowings, maintenance of any margin requirements and the payment of
cash dividends as required for our continued qualification as a REIT. To qualify as a REIT, we must distribute annually at least
90% of our taxable income. To the extent that we annually distribute all of our taxable income in a timely manner, we will generally
not be subject to federal and state income taxes. We currently expect to distribute all of our taxable income in a timely manner so
56
that we are not subject to federal and state income taxes. This distribution requirement limits our ability to retain earnings and
thereby replenish or increase capital from operations.
Equity Capital
To the extent we raise additional equity capital through follow-on equity offerings, through our at-the-market offering
program or under our dividend reinvestment and direct stock purchase plan, we currently anticipate using cash proceeds from
such transactions to purchase additional investment securities, to make scheduled payments of principal and interest on our
repurchase agreements and for other general corporate purposes. There can be no assurance, however, that we will be able to raise
additional equity capital at any particular time or on any particular terms.
Common Stock Repurchase
In October 2012, our Board of Directors adopted a plan that may provide for stock repurchases of up to $500 million of our
outstanding shares of common stock through December 31, 2013. Shares of our common stock may be purchased in the open
market, including through block purchases, or through privately negotiated transactions, or pursuant to any trading plan that may
be adopted in accordance with Rule 10b5-1 of the Securities and Exchange Commission. The timing, manner, price and amount
of any repurchases will be determined at our discretion and the program may be suspended, terminated or modified at any time
for any reason. We intend to repurchase shares only when the purchase price is less than our estimate of our current net asset
value per share of our common stock. Generally, when we repurchase our common stock at a discount to our net asset value, the
net asset value of our remaining shares of common stock outstanding increases. In addition, we do not intend to repurchase any
shares from directors, officers or other affiliates. The program does not obligate us to acquire any specific number of shares and
all repurchases will be made in accordance with SEC Rule 10b-18, which sets certain restrictions on the method, timing, price
and volume of stock repurchases. During fiscal year 2012, we made open market purchases of 2.7 million shares of our common
stock at an average net repurchase price of $29.00 per share, or $77 million.
Preferred Stock Offering
Pursuant to our amended and restated certificate of incorporation, we are authorized to designate and issue up to 10.0 million
shares of preferred stock in one or more classes or series. Our board of directors has designated 6.9 million shares as 8.000%
Series A Cumulative Redeemable Preferred Stock ("Series A Preferred Stock"). As of December 31, 2012, we have 3.1 million
of authorized but unissued shares of preferred stock. Our board of directors may designate additional series of authorized preferred
stock ranking junior to or in parity with our Series A Preferred Stock or designate additional shares of Series A Preferred Stock
and authorize the issuance of such shares.
In April 2012, we completed a public offering in which 6.9 million shares of our Series A Preferred Stock were sold to the
underwriters at a price of $24.21 per share. Upon completion of the offering we received proceeds, net of offering expenses, of
approximately $167 million. Our Series A Preferred Stock has no stated maturity and is not subject to any sinking fund or mandatory
redemption. Under certain circumstances upon a change of control, the Series A Preferred Stock is convertible to shares of our
common stock. Holders of Series A Preferred Stock have no voting rights, except under limited conditions, and holders are entitled
to receive cumulative cash dividends at a rate of 8.00% per annum of the $25.00 per share liquidation preference before holders
of our common stock are entitled to receive any dividends. Shares of our Series A Preferred Stock are redeemable at $25.00 per
share plus accumulated and unpaid dividends (whether or not declared) exclusively at our option commencing on April 5, 2017,
or earlier under certain circumstances intended to preserve our qualification as a REIT for Federal income tax purposes. Dividends
are payable quarterly in arrears on the 15th day of each January, April, July and October. As of December 31, 2012, we had
declared all required quarterly dividends on the Series A Preferred Stock.
Follow-on Common Stock Offerings
During fiscal years 2012, 2011 and 2010, we completed follow-on public offerings of shares of our common stock summarized
in the table below (in millions, except per share amounts):
57
Public Offering
Fiscal Year 2012
March 2012.............................
July 2012 ................................
Total fiscal year 2012 .........
Fiscal Year 2011
January 2011...........................
March 2011.............................
June 2011................................
November 2011 ......................
Total fiscal year 2011 .........
Fiscal Year 2010
May 2010................................
October 2010 ..........................
December 2010.......................
Total fiscal year 2010 .........
Price Received
Per Share (1)
Shares
Net Proceeds (2)
$29.00
$33.70
$28.00
$27.72
$27.56
$27.36
$25.75
$26.00
$27.44
71.2
36.8
108.0
$
$
26.9
$
32.2
49.7
40.5
149.3
$
6.9
$
13.2
8.3
28.4
$
2,063
1,240
3,303
719
892
1,369
1,108
4,088
169
328
227
724
________________________
Price received per share is gross of underwriters’ discount, if applicable.
1.
2. Net proceeds are net of the underwriters’ discount, if applicable, and other offering costs.
At-the-Market Offering Program
We have sales agreements with sales agents to publicly offer and sell shares of our common stock in privately negotiated
and/or at-the-market transactions from time to time. The table below summarizes sales our common stock under such sales
agreements during fiscal years 2012, 2011 and 2010 (in millions, except per share amounts):
Price Received
Per Share
At-the-Market Offering
Fiscal year 2012......................... $
Fiscal year 2011......................... $
Fiscal year 2010......................... $
Shares
Net Proceeds
9.5
9.4
4.4
$
$
$
298
273
127
31.41
29.25
29.13
As of December 31, 2012, 16.7 million shares remain available for issuance under our sales agreements.
Dividend Reinvestment and Direct Stock Purchase Plan
We sponsor a dividend reinvestment and direct stock purchase plan through which stockholders may purchase additional
shares of our common stock by reinvesting some or all of the cash dividends received on shares of our common stock. Stockholders
may also make optional cash purchases of shares of our common stock subject to certain limitations detailed in the plan prospectus.
During the fiscal years 2011 and 2010, we issued 0.5 million and 7.7 million shares under the plan for net cash proceeds of $15
million and $204 million, respectively. During fiscal year 2012, there were no shares issued under the plan. As of December 31,
2012, 4.7 million shares remain available for issuance under the plan.
Debt Capital
As part of our investment strategy, we borrow against our investment portfolio pursuant to master repurchase agreements.
We expect that our borrowings under such master repurchase agreements will generally have maturities ranging up to one year,
but may have maturities up to five years or longer. Our leverage may vary periodically depending on market conditions and our
Manager's assessment of risk and returns. We generally would expect our leverage to be within six to eleven times the amount of
our stockholders' equity. However, under certain market conditions, we may operate at leverage levels outside of this range for
extended periods of time. Our leverage ratio was 7.0 times the amount of our stockholders’ equity as of December 31, 2012,
including our total borrowings and net payables/receivables for agency securities not yet settled. Our cost of borrowings under
master repurchase agreements generally corresponds to LIBOR plus or minus a margin and was 0.51% as of December 31, 2012.
58
Following our election to discontinue accounting for our interest rate swaps as cash flow hedges under GAAP as of September
30, 2011, we extended the terms of our repurchase agreements to reduce the "roll risk" associated with maturing repurchase
agreements. As of December 31, 2012, our repurchase agreements had a weighted average original days-to-maturity of 181 days
and had a remaining weighted average days-to-maturity of 118 days.
To limit our exposure to counterparty credit risk, we diversify our funding across multiple counterparties and by counterparty
region. As of December 31, 2012, we had master repurchase agreements with 32 financial institutions, subject to certain conditions,
located throughout North America, Europe and Asia. As of December 31, 2012, less than 4% of our stockholders' equity was at
risk with any one repo counterparty, with the top five repo counterparties representing less than 16% of our stockholders' equity.
The table below includes a summary of our repurchase agreement funding by number of repo counterparties and counterparty
region as of December 31, 2012. For further details regarding our borrowings under repurchase agreements and other debt as of
December 31, 2012, please refer to Note 4 to our consolidated financial statements in this Annual Report on Form 10-K.
Counter-Party Region
North America......................
Europe ..................................
Asia.......................................
As of December 31, 2012
Number of
Counter-Parties
17
10
5
32
Percent of
Repurchase
Agreement
Funding
58%
28%
14%
100%
Amounts available to be borrowed under our repurchase agreements are dependent upon lender collateral requirements and
the lender’s determination of the fair value of the securities pledged as collateral, which fluctuates with changes in interest rates,
credit quality and liquidity conditions within the investment banking, mortgage finance and real estate industries. In addition, our
counterparties apply a "haircut” to our pledged collateral, which means our collateral is valued at slightly less than market value.
This haircut reflects the underlying risk of the specific collateral and protects our counterparty against a change in its value, but
conversely subjects us to counterparty risk and limits the amount we can borrow against our investment securities. Our master
repurchase agreements do not specify the haircut; rather haircuts are determined on an individual repurchase transaction basis.
Throughout fiscal year 2012, haircuts on our pledged collateral remained stable and as of December 31, 2012, our weighted average
haircut was less than 5% of the value of our collateral.
Under our repurchase agreements, we may be required to pledge additional assets to the repurchase agreement counterparties
in the event the estimated fair value of the existing pledged collateral under such agreements declines and such counterparties
demand additional collateral (a margin call), which may take the form of additional securities or cash. Specifically, margin calls
would result from a decline in the value of our agency securities securing our repurchase agreements and prepayments on the
mortgages securing such agency securities. Similarly, if the estimated fair value of our investment securities increases due to
changes in interest rates or other factors, counterparties may release collateral back to us. Our repurchase agreements generally
provide that the valuations for the agency MBS securing our repurchase agreements are to be obtained from a generally recognized
source agreed to by the parties. However, in certain circumstances under certain of our repurchase agreements our lenders have
the sole discretion to determine the value of the agency MBS securing our repurchase agreements. In such instances, our lenders
are required to act in good faith in making such valuation determinations. Our repurchase agreements generally provide that in
the event of a margin call, we must provide additional securities or cash on the same business day that a margin call is made if the
lender provides us notice prior to the margin notice deadline on such day.
As of December 31, 2012, we have met all of our margin requirements and we had unrestricted cash and cash equivalents
of $2.4 billion and unpledged agency securities of $3.7 billion available to settle our net payable for agency securities, meet margin
calls on our repurchase agreements and derivative instruments and for other corporate purposes.
Although we believe we will have adequate sources of liquidity available to us through repurchase agreement financing to
execute our business strategy, there can be no assurances that repurchase agreement financing will be available to us upon the
maturity of our current repurchase agreements to allow us to renew or replace our repurchase agreement financing on favorable
terms or at all. If our repurchase agreement lenders default on their obligations to resell the underlying agency securities back to
us at the end of the term, we could incur a loss equal to the difference between the value of the agency securities and the cash we
originally received.
59
To help manage the adverse impact of interest rate changes on the value of our investment portfolio as well as our cash
flows, we maintain an interest rate risk management strategy under which we use derivative financial instruments. In particular,
we attempt to mitigate the risk of the cost of our variable rate liabilities increasing at a faster rate than the earnings of our long-
term fixed-rate assets during a period of rising interest rates. The principal derivative instruments that we use are interest rate
swaps, supplemented with the use of interest rate swaptions, TBA securities, U.S. Treasury securities, futures and other instruments.
Please refer to Notes 2 and 5 to our consolidated financial statements in this Annual Report on Form 10-K for further details
regarding our use of derivative instruments.
Our derivative agreements typically require that we pledge/receive collateral on such agreements to/from our counterparties
in a similar manner as we are required to under our repurchase agreements. However, our swaption agreements do not require
our counterparties to post collateral to us in the event that such agreements increase in value. Our counterparties typically have
the sole discretion to determine the value of the derivative instruments and the value of the collateral securing such instruments.
In the event of a margin call, we must generally provide additional collateral on the same business day.
TBA Dollar Roll Transactions
We may also enter into TBA dollar roll transactions as a means of investing in and financing agency securities. TBA dollar
roll transactions represent a form of off-balance sheet financing and are accounted for as derivative instruments in our accompanying
consolidated financial statements in this Form 10-K. Inclusive of our net TBA position as of December 31, 2012, our total "at
risk" leverage, net of unsettled securities, was 8.2x our stockholders' equity.
Under certain market conditions it may be uneconomical for us to enter into or to roll our TBA contracts and we may need
to settle our obligations for cash and take delivery of the underlying securities. Our TBA dollar roll contracts are also subject to
margin requirements governed by the Mortgage-Backed Securities Division ("MBSD") of the Fixed Income Clearing Corporation
and by our prime brokerage agreements, which may establish margin levels in excess of the MBSD. Such provisions require that
we establish an initial margin based on the notional value of the TBA contract, which is subject to increase if the estimated fair
value of our TBA contract or the estimated fair value of our collateral pledged declines. The MBSD has the sole discretion to
determine the value of our TBA contracts and of the pledged collateral securing such contracts. In the event of a margin call, we
must generally provide additional collateral on the same business day.
Settlement of our TBA obligations and satisfying margin requirements could negatively impact our liquidity position,
but since we do not use TBA dollar roll transactions as our primary source of financing we believe that we will have adequate
sources of liquidity to meet such obligations.
Asset Sales and TBA Eligible Securities
We maintain a portfolio of highly liquid agency MBS securities. We may sell our agency MBS securities through the TBA
market by delivering securities into TBA contracts for the sale of agency securities, subject to "good delivery" provisions
promulgated by the Securities Industry and Financial Markets Association ("SIFMA"). We may alternatively sell agency MBS
securities that have more unique attributes on a specified basis when such securities trade at a premium over generic TBA securities
or if the securities are not otherwise eligible for TBA delivery. Since the TBA market is the second most liquid market (second
to the U.S. Treasury market), maintaining a significant level of agency MBS securities eligible for TBA delivery enhances our
liquidity profile and provides price support for our TBA eligible securities in a rising interest rate scenario at or above generic
TBA prices. As of December 31, 2012, approximately 94% of our fixed-rate agency MBS portfolio (or approximately 92% of
our total agency MBS portfolio) was eligible for TBA delivery.
Off-Balance Sheet Arrangements
As of December 31, 2012, we did not maintain any relationships with unconsolidated entities or financial partnerships, such
as entities often referred to as structured finance, or special purpose or variable interest entities, established for the purpose of
facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Further, as of December 31, 2012,
we had not guaranteed any obligations of unconsolidated entities or entered into any commitment or intent to provide funding to
any such entities.
Aggregate Contractual Obligations
The following table summarizes the effect on our liquidity and cash flows from contractual obligations for repurchase
agreements and interest expense on repurchase agreements (in millions):
60
Fiscal Year
2013
2014
2015
2016
2017
Total
Repurchase agreements.................................................................
$
69,656
$
1,917
$
2,803
$
— $
102
$
74,478
Interest expense on repurchase agreements (1) ..............................
102
30
18
Total ..............................................................................................
$
69,758
$
1,947
$
2,821
$
1
1
1
152
$
103
$
74,630
________________________
1.
Interest expense on repurchase agreements is calculated based on the weighted average interest rates as of December 31, 2012.
FORWARD-LOOKING STATEMENTS
All statements contained herein that are not historical facts including, but not limited to, statements regarding anticipated
activity are forward looking in nature and involve a number of risks and uncertainties. Actual results may differ materially. Among
the factors that could cause actual results to differ materially are the following: (i) changes in the market value of our assets; (ii)
changes in net interest rate spreads; (iii) changes in prepayment rates of the mortgage loans underlying our agency securities;
(iv) risks associated with our hedging activities; (v) availability and terms of financing arrangements; (vi) further actions by the
U.S. government to stabilize the economy; (vii) changes in our business or investment strategy; (viii) legislative and regulatory
changes (including changes to laws governing the taxation of REITs); (ix) our ability to meet the requirements of a REIT (including
income and asset requirements); and (x) our ability to remain exempt from registration under the Investment Company Act of
1940. For a discussion of the risks and uncertainties which could cause actual results to differ from those contained in the forward-
looking statements, please see the information under the caption “Risk Factors” described in this Form 10-K. We caution readers
not to place undue reliance on any such forward-looking statements, which statements are made pursuant to the Private Securities
Litigation Reform Act of 1995 and, as such, speak only as of the date made.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Market risk is the exposure to loss resulting from changes in market factors such as interest rates, foreign currency exchange
rates, commodity prices and equity prices. The primary market risks that we are exposed to are interest rate risk, prepayment risk,
spread risk, liquidity risk, extension risk and counterparty credit risk.
Interest Rate Risk
Interest rate risk is highly sensitive to many factors, including governmental monetary and tax policies, domestic and
international economic and political considerations and other factors beyond our control.
Changes in the general level of interest rates can affect our net interest income, which is the difference between the interest
income earned on interest-earning assets and the interest expense incurred in connection with our interest-bearing liabilities, by
affecting the spread between our interest-earning assets and interest-bearing liabilities. Changes in the general level of interest
rates can also affect our periodic settlements of interest rate swaps and the value of our interest rate swaps, which impact our net
income. Changes in the level of interest rates can also affect the rate of prepayments of our securities and the value of the agency
securities that constitute our investment portfolio, which affects our net income and ability to realize gains from the sale of these
assets and impacts our ability and the amount that we can borrow against these securities.
We may utilize a variety of financial instruments in order to limit the effects of changes in interest rates on our operations,
including interest rate swap agreements, interest rate swaptions, interest rate cap or floor contracts and futures or forward contracts.
We may also purchase or short TBA securities, U.S. Treasury securities and U.S. Treasury futures contracts, purchase or write put
or call options on TBA securities or we may invest in other types of mortgage derivative securities, such as interest-only securities,
and synthetic total return swaps, such as the Markit IOS Index. When we use these types of derivatives to hedge the risk of interest-
earning assets or interest-bearing liabilities, we may be subject to certain risks, including the risk that losses on a hedge position
will reduce the funds available for payments to holders of our common stock and that the losses may exceed the amount we
invested in the instruments.
Our profitability and the value of our investment portfolio (including derivatives used for economic hedging purposes) may
be adversely affected during any period as a result of changing interest rates including changes in the forward yield curve.
Primary measures of an instrument's price sensitivity to interest rate fluctuations are its duration and convexity. The duration
of our investment portfolio changes with interest rates and tends to increase when rates rise and decrease when rates fall. This
"negative convexity" generally increases the interest rate exposure of our investment portfolio in excess of what is measured by
duration alone.
61
We estimate the duration and convexity of our portfolio using both a third-party risk management system and market data.
We review the duration estimates from the third-party model and may make adjustments based on our Manager's judgment. These
adjustments are intended to, in our Manager's opinion, better reflect the unique characteristics and market trading conventions
associated with certain types of securities. These adjustments generally result in shorter durations than what the unadjusted third-
party model would otherwise produce. Without these adjustments, in rising rate scenarios, the longer unadjusted durations may
underestimate price projections on certain securities with slower prepayment characteristics, such as HARP and lower loan balance
securities, to a level below those of generic or TBA securities. However, in our Manager's judgment, because these securities are
typically deliverable into TBA contracts, the price of these securities is unlikely to drop below the TBA price in rising rate scenarios.
The accuracy of the estimated duration of our portfolio and projected agency security prices depends on our Manager's assumptions
and judgments. Our Manager may discontinue making these duration adjustments in the future or may choose to make different
adjustments. Other models could produce materially different results.
The table below quantifies the estimated changes in net interest income (including periodic interest costs on our interest rate
swaps) and the estimated changes in the fair value of our investment portfolio (including derivatives and other securities used for
economic hedging purposes) and in our net asset value should interest rates go up or down by 50 and 100 basis points, assuming
the yield curves of the rate shocks will be parallel to each other and the current yield curve and includes the impact of both duration
and convexity.
All changes in income and value in the table below are measured as percentage changes from the projected net interest
income, investment portfolio value and net asset value at the base interest rate scenario. The base interest rate scenario assumes
interest rates as of December 31, 2012. Given the low level of interest rates, we also apply a floor of 0% for all anticipated interest
rates included in our analysis, such that any hypothetical interest rate decrease would have a limited positive impact on our funding
costs beyond a certain level. However, because estimated prepayment speeds are impacted to a lesser degree by this floor, it is
expected that an increase in our prepayment speeds as a result of a hypothetical interest rate decrease would result in an acceleration
of our premium amortization and could result in reinvestment of such prepaid principal into lower yielding assets.
Actual results could differ materially from estimates, especially in the current market environment. To the extent that these
estimates or other assumptions do not hold true, which is likely in a period of high price volatility, actual results will likely differ
materially from projections and could be larger or smaller than the estimates in the table below. Moreover, if different models
were employed in the analysis, materially different projections could result. Lastly, while the tables below reflect the estimated
impact of interest rate increases and decreases on a static portfolio, we may from time to time sell any of our agency securities as
a part of our overall management of our investment portfolio.
Percentage Change in Projected
Change in Interest Rate
+100 Basis Points ...........
+50 Basis Points .............
-50 Basis Points ..............
-100 Basis Points ............
Net Interest
Income (1)
Portfolio
Value (2) (3)
-10.3%
-3.5%
2.1%
-16.6%
-1.11%
-0.25%
-0.67%
-1.83%
Net Asset
Value (2) (4)
-9.11%
-2.04%
-5.48%
-15.06%
________________
1.
2.
3.
4.
Estimated dollar change in net interest income expressed as a percent of net interest income based on asset yields and cost of funds as of December 31,
2012. Includes the effect of periodic interest costs on our interest rate swaps that are not designated as hedges under U.S. GAAP, but excludes costs
associated with our other supplemental hedges, such as swaptions and short U.S. Treasury or TBA positions. Base case scenario assumes a forecasted
CPR of 11% as of December 31, 2012. Rate shock scenarios assume a forecasted CPR of 7%, 8%, 15% and 20% for the +100 basis points, +50 basis
points, - 50 basis points and -100 basis points scenarios, respectively. Estimated dollar change in net interest income does not include the one time
impact of retroactive "catch-up" premium amortization benefit/cost due to an increase/decrease in the forecasted CPR. Down rate scenarios assume
a floor of 0% for anticipated interest rates.
Includes the effect of derivatives and other securities used for economic hedging purposes.
Estimated dollar change in investment portfolio value expressed as a percent of the total fair value of our investment portfolio as of December 31,
2012.
Estimated dollar change in portfolio value expressed as a percent of stockholders' equity, net of the Series A Preferred Stock liquidation preference, as
of December 31, 2012.
Prepayment Risk
Premiums and discounts associated with the purchase of agency MBS are amortized or accreted into interest income over
the projected lives of the securities, including contractual payments and estimated prepayments using the interest method. Changes
to the GSE's underwriting standards, further modifications to existing U.S. Government sponsored programs such as HARP, or
the implementation of new programs could materially impact prepayment speeds. In addition, GSE buyouts of loans in imminent
62
risk of default, loans that have been modified, or loans that have defaulted will generally be reflected as prepayments on agency
securities and also increase the uncertainty around these estimates. Our policy for estimating prepayment speeds for calculating
the effective yield is to evaluate published prepayment data for similar agency securities, market consensus and current market
conditions. If the actual prepayment experienced differs from our estimate of prepayments, we will be required to make an
adjustment to the amortization or accretion of premiums and discounts that would have an impact on future income.
Spread Risk
Our available-for-sale securities are reflected at their estimated fair value with unrealized gains and losses excluded from
earnings and reported in OCI. As of December 31, 2012, the fair value of these securities was $85.2 billion. When the market
spread between the yield on our agency securities and U.S. Treasury securities or swap rates widens, the value of our agency
securities and/or our net book value could decline, creating what we refer to as spread risk. The spread risk associated with our
agency securities and the resulting fluctuations in fair value of these securities can occur independent of interest rates and may
relate to other factors impacting the mortgage and fixed income markets such as liquidity or changes in required rates of return
on different assets.
Liquidity Risk
The primary liquidity risk for us arises from financing long-term assets with shorter-term borrowings through repurchase
agreements. Our assets that are pledged to secure repurchase agreements are agency securities and cash. As of December 31, 2012,
we had unrestricted cash and cash equivalents of $2.4 billion and unpledged agency securities of $3.7 billion available to settle
our net payable for agency securities, meet margin calls on our repurchase agreements and derivative contracts and for other
corporate purposes. However, should the value of our agency securities pledged as collateral or the value of our derivative
instruments suddenly decrease, margin calls relating to our repurchase and derivative agreements could increase, causing an
adverse change in our liquidity position. Further, there is no assurance that we will always be able to renew (or roll) our repurchase
agreements. In addition, our counterparties have the option to increase our haircuts (margin requirements) on the assets we pledge,
against repurchase agreements thereby reducing the amount that can be borrowed against an asset even if they agree to renew or
roll the repurchase agreement. Significantly higher haircuts can reduce our ability to leverage our portfolio or even force us to sell
assets, especially if correlated with asset price declines or faster prepayment rates on our assets.
In addition, we may utilize TBA dollar roll transactions as a means of investing in and financing agency mortgage-backed
securities. Under certain economic conditions it may be uneconomical to roll our TBA dollar roll transactions prior to the settlement
date and we could have to take physical delivery of the underlying securities and settle our obligations for cash, which could
negatively impact our liquidity position, result in defaults or force us to sell assets under adverse conditions.
Extension Risk
The projected weighted-average life and the duration (or interest rate sensitivity) of our investments is based on our Manager’s
assumptions regarding the rate at which the borrowers will prepay the underlying mortgage loans. In general, we use interest rate
swaps and swaptions to help manage our funding cost on our investments in the event that interest rates rise. These swaps (or
swaptions) allow us to reduce our funding exposure on the notional amount of the swap for a specified period of time by establishing
a fixed-rate to pay in exchange for receiving a floating rate that generally tracks our financing costs under our repurchase agreements.
However, if prepayment rates decrease in a rising interest rate environment, the average life or duration of our fixed-rate
assets or the fixed-rate portion of the ARMs or other assets generally extends. This could have a negative impact on our results
from operations, as our interest rate swap maturities are fixed and will, therefore, cover a smaller percentage of our funding
exposure on our mortgage assets to the extent that their average lives increase due to slower prepayments. This situation may also
cause the market value of our agency securities collateralized by fixed rate mortgages or hybrid ARMs to decline by more than
otherwise would be the case while most of our hedging instruments (with the exception of short TBA mortgage positions, interest-
only securities, Markit IOS Index total return swaps and certain other supplemental hedging instruments) would not receive any
incremental offsetting gains. In extreme situations, we may be forced to sell assets to maintain adequate liquidity, which could
cause us to incur realized losses.
Counterparty Credit Risk
We are exposed to counterparty credit risk relating to potential losses that could be recognized in the event that the
counterparties to our repurchase agreements and derivative contracts fail to perform their obligations under such agreements. The
amount of assets we pledge as collateral in accordance with our agreements varies over time based on the market value and notional
amount of such assets as well as the value of our derivative contracts. In the event of a default by a counterparty we may not
receive payments provided for under the terms of our agreements and may have difficulty obtaining our assets pledged as collateral
under such agreements. Our credit risk related to certain derivative transactions is largely mitigated through a daily mark-to-
63
market of collateral pledged and we limit our counterparties to major financial institutions with acceptable credit ratings. However,
there is no guarantee our efforts to manage counterparty credit risk will be successful and we could suffer significant losses if
unsuccessful.
Item 8. Financial Statements and Supplementary Data
Our management is responsible for the preparation, integrity and objectivity of the accompanying consolidated financial
statements and the related financial information. The financial statements have been prepared in conformity with accounting
principles generally accepted in the United States and necessarily include certain amounts that are based on estimates and informed
judgments. Our management also prepared the related financial information included in this Annual Report on Form 10-K and is
responsible for its accuracy and consistency with the consolidated financial statements.
The consolidated financial statements have been audited by Ernst & Young LLP, an independent registered public accounting
firm, who conducted their audit in accordance with the standards of the Public Company Accounting Oversight Board (United
States) as of December 31, 2012 and 2011 and for the years ended December 31, 2012, 2011 and 2010. The independent registered
public accounting firm's responsibility is to express an opinion as to the fairness with which such consolidated financial statements
present our financial position, results of operations and cash flows in accordance with accounting principles generally accepted
in the United States.
Management's Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined
in Rule 13a-15(f) under the Securities Exchange Act of 1934. Our internal control over financial reporting is designed to provide
reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial statements for
external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting
includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary
to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and
expenditures are being made only in accordance with authorizations of our management and Board of Directors; and (iii) provide
reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that
could have a material effect on the consolidated financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also,
projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because
of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2012, utilizing
the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-
Integrated Framework. Based on this assessment and those criteria, management determined that our internal control over financial
reporting was effective as of December 31, 2012. The effectiveness of our internal control over financial reporting as of
December 31, 2012 has been audited by Ernst & Young LLP, our independent registered public accounting firm, as stated in their
attestation report included in this Annual Report on Form 10-K.
64
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of American Capital Agency Corp.
We have audited American Capital Agency Corp.'s internal control over financial reporting as of December 31, 2012, based on
criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (the COSO criteria). American Capital Agency Corp.'s management is responsible for maintaining effective
internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting
included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express
an opinion on the company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control
over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control
over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating
effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in
the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability
of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted
accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain
to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets
of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial
statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable
assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company's assets that
could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also,
projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because
of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, American Capital Agency Corp. maintained, in all material respects, effective internal control over financial
reporting as of December 31, 2012, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the
consolidated balance sheets of American Capital Agency Corp. as of December 31, 2012 and 2011, and the related consolidated
statements of comprehensive income, stockholders' equity, and cash flows for each of the three years in the period ended
December 31, 2012 of American Capital Agency Corp., and our report dated February 27, 2013 expressed an unqualified opinion
thereon.
McLean, Virginia
February 27, 2013
/s/ Ernst & Young LLP
65
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of American Capital Agency Corp.
We have audited the accompanying consolidated balance sheets of American Capital Agency Corp. as of December 31, 2012 and
2011, and the related consolidated statements of comprehensive income, stockholders' equity, and cash flows for each of the three
years in the period ended December 31, 2012. These financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable
basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position
of American Capital Agency Corp. at December 31, 2012 and 2011, and the consolidated results of its operations and its cash
flows for each of the three years in the period ended December 31, 2012, in conformity with U.S. generally accepted accounting
principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States),
American Capital Agency Corp.'s internal control over financial reporting as of December 31, 2012, based on criteria established
in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission
and our report dated February 27, 2013 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
McLean, Virginia
February 27, 2013
66
December 31,
2012
2011
83,710
$
54,625
AMERICAN CAPITAL AGENCY CORP.
CONSOLIDATED BALANCE SHEETS
(in millions, except per share data)
Assets:
Agency securities, at fair value (including pledged securities of $79,966 and
$50,667, respectively) ................................................................................................. $
Agency securities transferred to consolidated variable interest entities, at fair value
(pledged securities)......................................................................................................
U.S. Treasury securities, at fair value (pledged security)............................................
Cash and cash equivalents ...........................................................................................
Restricted cash and cash equivalents...........................................................................
Derivative assets, at fair value.....................................................................................
Receivable for securities sold (including pledged securities of $0 and $319,
respectively) ................................................................................................................
Receivable under reverse repurchase agreements .......................................................
Other assets..................................................................................................................
1,535
—
2,430
399
301
—
11,818
260
Total assets ........................................................................................................... $
100,453
Liabilities:
Repurchase agreements ............................................................................................... $
Debt of consolidated variable interest entities, at fair value .......................................
Payable for securities purchased .................................................................................
Derivative liabilities, at fair value ...............................................................................
Dividends payable .......................................................................................................
Obligation to return securities borrowed under reverse repurchase agreements, at
fair value......................................................................................................................
Accounts payable and other accrued liabilities ...........................................................
Total liabilities......................................................................................................
74,478
937
556
1,264
427
11,763
132
89,557
$
$
Stockholders’ equity:
8.000% Series A Cumulative Redeemable Preferred Stock; $0.01 par value; 6.9
and 0 shares issued and outstanding, respectively; liquidation preference of $25 per
share ($173 and $0, respectively)................................................................................
Common stock, $0.01 par value; 600.0 and 300.0 shares authorized; 338.9 and
224.2 shares issued and outstanding, respectively ......................................................
Additional paid-in capital ............................................................................................
Retained deficit............................................................................................................
Accumulated other comprehensive income.................................................................
Total stockholders’ equity ....................................................................................
Total liabilities and stockholders’ equity.............................................................. $
167
3
9,460
(289)
1,555
10,896
100,453
$
See accompanying notes to consolidated financial statements.
67
58
101
1,367
336
82
443
763
197
57,972
47,681
54
1,919
853
314
899
40
51,760
—
2
5,937
(38)
311
6,212
57,972
AMERICAN CAPITAL AGENCY CORP.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in millions, except per share data)
For the year ended December 31,
2010
2011
2012
Interest income:
Interest income........................................................................................................... $
Interest expense..........................................................................................................
Net interest income .............................................................................................
$
2,109
512
1,597
$
1,109
285
824
Other (loss) income, net:
Gain on sale of agency securities, net........................................................................
(Loss) gain on derivative instruments and other securities, net.................................
Total other (loss) income, net .............................................................................
1,196
(1,353)
(157)
473
(447)
26
Expenses:
Management fees .......................................................................................................
General and administrative expenses.........................................................................
Total expenses.....................................................................................................
Income before income tax...............................................................................................
Provision for income taxes, net..................................................................................
Net income .......................................................................................................................
Dividend on preferred stock.......................................................................................
Net income available to common shareholders ............................................................ $
Net income ....................................................................................................................... $
Other comprehensive income (loss):..............................................................................
Unrealized gain (loss) on available-for-sale securities, net .......................................
Unrealized gain (loss) on derivative instruments, net................................................
Other comprehensive income (loss) ...................................................................
Comprehensive income...................................................................................................
Dividend on preferred stock.......................................................................................
Comprehensive income available to common shareholders........................................ $
113
31
144
1,296
19
1,277
10
1,267
1,277
1,039
205
1,244
2,521
10
$
$
55
19
74
776
6
770
—
770
770
$
$
1,029
(650)
379
1,149
—
2,511
$
1,149
$
Weighted average number of common shares outstanding - basic and diluted........
Net income per common share - basic and diluted ...................................................... $
Comprehensive income per common share - basic and diluted.................................. $
Dividends declared per common share ......................................................................... $
303.9
4.17
8.26
5.00
$
$
$
153.3
5.02
7.50
5.60
$
$
$
See accompanying notes to consolidated financial statements.
253
76
177
92
38
130
11
8
19
288
—
288
—
288
288
(64)
(24)
(88)
200
—
200
36.5
7.89
5.49
5.60
68
AMERICAN CAPITAL AGENCY CORP.
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(in millions)
Preferred Stock
Common Stock
Shares
Amount
Additional
Paid-in
Capital
Retained
Earnings
(Deficit)
Accumulated
Other
Comprehensive
Income (Loss)
Total
Shares Amount
Balance, December 31, 2009....................... — $ —
—
Net income................................................. —
Other comprehensive loss:
Unrealized loss on available- for-sale
securities, net.......................................... —
Unrealized loss on derivative
instruments, net ...................................... —
Issuance of common stock......................... —
Common dividends declared ..................... —
Balance, December 31, 2010....................... —
Net income................................................. —
Other comprehensive income (loss):
Unrealized gain on available- for-sale
securities, net.......................................... —
Unrealized loss on derivative
instruments, net ...................................... —
Issuance of common stock......................... —
Common dividends declared ..................... —
Balance, December 31, 2011....................... —
Net income................................................. —
Other comprehensive income:
Unrealized gain on available- for-sale
securities, net.......................................... —
Unrealized gain on derivative
instruments, net ...................................... —
Issuance of preferred stock........................
6.9
Issuance of common stock......................... —
Repurchase of common stock.................... —
Preferred dividends declared ..................... —
Common dividends declared ..................... —
6.9
Balance, December 31, 2012.......................
—
—
—
—
—
—
—
—
—
—
—
—
—
—
167
—
—
—
—
$ 167
24.3
—
$ — $
—
$
507
—
$
20
288
$
20
—
547
288
—
—
40.6
—
64.9
—
—
—
159.3
—
224.2
—
—
—
—
117.4
(2.7)
—
—
338.9
$
—
—
1
—
1
—
—
—
1
—
2
—
—
—
—
1
—
—
—
3
$
—
—
—
1,055
—
1,562
—
—
—
4,375
—
5,937
—
—
—
—
3,600
(77)
—
—
9,460
—
—
(230)
78
770
—
—
—
(886)
(38)
1,277
—
—
—
—
—
(10)
(1,518)
$
(289) $
(64)
(24)
—
—
(68)
—
(64)
(24)
1,056
(230)
1,573
770
1,029
1,029
(650)
—
—
311
—
1,039
205
—
—
—
—
(650)
4,376
(886)
6,212
1,277
1,039
205
167
3,601
(77)
(10)
—
1,555
$
(1,518)
10,896
See accompanying notes to consolidated financial statements.
69
AMERICAN CAPITAL AGENCY CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions)
For the year ended December 31,
2012
2011
2010
Operating activities:
Net income ................................................................................................................................. $
1,277
$
770
$
288
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of agency securities premiums and discounts, net.......................................
Amortization of accumulated other comprehensive loss on interest rate swaps de-
designated as qualifying hedges.........................................................................................
Gain on sale of agency securities, net................................................................................
Loss (gain) on derivative instruments and other securities, net.........................................
Increase in other assets.......................................................................................................
Increase in accounts payable and other accrued liabilities ................................................
Accretion of discounts on debt of consolidated variable interest entities..........................
667
205
(1,196)
1,353
(76)
86
5
361
54
(473)
447
(121)
32
—
Net cash provided by operating activities..................................................................................
2,321
1,070
Investing activities:
99
—
(92)
(38)
(28)
4
—
233
Purchases of agency securities...........................................................................................
(104,703)
(81,484)
(22,645)
Proceeds from sale of agency securities ............................................................................
Principal collections on agency securities .........................................................................
Purchases of U.S. Treasury securities................................................................................
Proceeds from sale of U.S. Treasury securities..................................................................
Proceeds from short sales of U.S. Treasury securities.......................................................
Purchases of U.S. Treasury securities to cover short sales ................................................
Proceeds from reverse repurchase agreements ..................................................................
65,249
9,576
(2,444)
2,545
36,467
(25,752)
91,741
Payments made on reverse repurchase agreements ...........................................................
(102,796)
Net (payments) receipts on other derivative instruments not designated as qualifying
hedges ................................................................................................................................
Increase in restricted cash ..................................................................................................
(1,001)
(63)
37,868
4,633
(5,163)
5,096
17,301
(16,781)
37,349
(37,865)
(266)
(260)
12,062
1,581
(1,305)
1,300
—
—
—
(248)
256
(57)
Net cash used in investing activities ..........................................................................................
(31,181)
(39,572)
(9,056)
Financing activities:
Proceeds from repurchase arrangements ...........................................................................
Payments made on repurchase agreements........................................................................
Proceeds from debt of consolidated variable interest entities............................................
Repayments on debt of consolidated variable interest entities ..........................................
Net proceeds from preferred stock issuances.....................................................................
Net proceeds from common stock issuances .....................................................................
Payments made on common stock repurchases .................................................................
Cash dividends paid ...........................................................................................................
Net cash provided by financing activities..................................................................................
Net change in cash and cash equivalents ...................................................................................
Cash and cash equivalents at beginning of period .....................................................................
404,853
(378,056)
1,000
(150)
167
3,601
(77)
(1,415)
29,923
1,063
1,367
339,046
(303,044)
—
(19)
—
4,377
—
(664)
39,696
1,194
173
Cash and cash equivalents at end of period ............................................................................... $
2,430
$
1,367
$
83,819
(75,981)
81
(8)
—
1,055
—
(173)
8,793
(30)
203
173
Supplemental disclosure to cash flow information:..............................................................
Interest Paid ....................................................................................................................... $
Taxes Paid.......................................................................................................................... $
409
10
$
$
249
$
— $
66
—
See accompanying notes to consolidated financial statements.
70
AMERICAN CAPITAL AGENCY CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Organization
American Capital Agency Corp. ("AGNC", the "Company", "we", "us", and "our") was organized in Delaware on January 7,
2008, and commenced operations on May 20, 2008 following the completion of our initial public offering (“IPO”). Our common
stock is traded on The NASDAQ Global Select Market under the symbol “AGNC”.
We operate so as to qualify to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986,
as amended (the “Internal Revenue Code”). Therefore, substantially all of our assets, other than our taxable REIT subsidiary
("TRS"), consist of qualified real estate assets (as defined under the Internal Revenue Code). As a REIT, we are required to
distribute annually 90% of our taxable net income. As long as we continue to qualify as a REIT, we will generally not be subject
to U.S. federal or state corporate taxes on our taxable net income to the extent that we distribute all of our annual taxable net
income to our stockholders. It is our intention to distribute 100% of our taxable income, after application of available tax attributes,
within the limits prescribed by the Internal Revenue Code, which may extend into the subsequent taxable year.
We are externally managed by American Capital AGNC Management, LLC (our “Manager”), an affiliate of American
Capital, Ltd. (“American Capital”).
We earn income primarily from investing on a leveraged basis in agency mortgage-backed securities ("agency MBS").
These investments consist of residential mortgage pass-through securities and collateralized mortgage obligations (“CMOs”) for
which the principal and interest payments are guaranteed by government-sponsored entities, such as the Federal National Mortgage
Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), or by a U.S. Government agency,
such as the Government National Mortgage Association (“Ginnie Mae”) (collectively referred to as “GSEs”). We may also invest
in agency debenture securities issued by Freddie Mac, Fannie Mae or the Federal Home Loan Bank ("FHLB"). We refer to agency
MBS and agency debenture securities collectively as "investment securities" and we refer to the specific investment securities in
which we invest as our "investment portfolio".
Our principal objective is to preserve our net asset value (also referred to as "net book value", "NAV" and "stockholders'
equity") while generating attractive risk-adjusted returns for distribution to our stockholders through regular quarterly dividends
from the combination of our net interest income and net realized gains and losses on our investments and hedging activities. We
fund our investments primarily through short-term borrowings structured as repurchase agreements.
Note 2. Summary of Significant Accounting Policies
Basis of Presentation and Consolidation
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United
States ("GAAP").
Our consolidated financial statements include the accounts of our wholly-owned subsidiary, American Capital Agency TRS,
LLC, and variable interest entities for which the Company is the primary beneficiary. Significant intercompany accounts and
transactions have been eliminated.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial
statements and revenues and expenses during the period reported. Actual results could differ from those estimates.
Earnings per Share
Basic earnings per share ("EPS") is computed by dividing net income by the weighted average number of common shares
outstanding during the period. Diluted EPS assumes the conversion, exercise or issuance of all potential common stock equivalents
unless the effect is to reduce a loss or increase the income per share.
Accumulated Other Comprehensive Income (Loss)
Accounting Standards Codification ("ASC") Topic 220, Comprehensive Income ("ASC 220") divides comprehensive income
into net income and other comprehensive income (loss) ("OCI"), which includes unrealized gains and losses on securities classified
71
as available-for-sale and unrealized gains and losses on derivative financial instruments that are designated and qualify for cash
flow hedge accounting under ASC Topic 815, Derivatives and Hedging ("ASC 815"). See Derivatives and Hedging Instruments
below and Note 5 regarding our discontinuation of cash flow hedge accounting for interest rate swaps during fiscal year 2011.
Cash and Cash Equivalents
Cash and cash equivalents consist of unrestricted demand deposits and highly liquid investments with original maturities of
three months or less. Cash and cash equivalents are carried at cost, which approximates fair value.
Restricted Cash and Cash Equivalents
Restricted cash and cash equivalents includes cash pledged as collateral for clearing and executing trades, repurchase
agreements, interest rate swaps and other derivative instruments. Restricted cash and cash equivalents are carried at cost, which
approximates fair value.
Investment Securities
ASC Topic 320, Investments—Debt and Equity Securities (“ASC 320”), requires that at the time of purchase, we designate
a security as held-to-maturity, available-for-sale or trading, depending on our ability and intent to hold such security to maturity.
Securities classified as trading and available-for-sale are reported at fair value, while securities classified as held-to-maturity are
reported at amortized cost. We may, from time to time, sell any of our investment securities as part of our overall management of
our investment portfolio. Accordingly, we typically designate our investment securities as available-for-sale. All securities
classified as available-for-sale are reported at fair value, with unrealized gains and losses reported in accumulated OCI, a separate
component of stockholders’ equity. Upon the sale of a security, we determine the cost of the security and the amount of unrealized
gains or losses to reclassify out of accumulated OCI into earnings based on the specific identification method.
Interest-only securities and inverse interest-only securities (collectively referred to as “interest-only securities”) represent
our right to receive a specified proportion of the contractual interest flows of specific agency CMO securities. Principal-only
securities represent our right to receive the contractual principal flows of specific agency CMO securities. Interest-only and
principal-only securities are measured at fair value through earnings in gain (loss) on derivative instruments and other securities,
net in our consolidated statements of comprehensive income. Our investments in interest-only and principal-only securities are
included in agency MBS securities, at fair value on the accompanying consolidated balance sheets.
We estimate the fair value of our investment securities based on a market approach using Level 2 inputs from third-party
pricing services and non-binding dealer quotes. The third-party pricing services use pricing models that incorporate such factors
as coupons, primary and secondary mortgage rates, prepayment speeds, spread to the Treasury and interest rate swap curves,
convexity, duration, periodic and life caps and credit enhancements. The dealer quotes incorporate common market pricing methods,
including a spread measurement to the Treasury or interest rate swap curve as well as underlying characteristics of the particular
security including coupon, periodic and life caps, rate reset period, issuer, additional credit support and expected life of the security.
Refer to Note 6 for further discussion of fair value measurements.
We evaluate securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently
when economic or market conditions warrant such evaluation. The determination of whether a security is other-than-temporarily
impaired involves judgments and assumptions based on subjective and objective factors. When an investment security is impaired,
an OTTI is considered to have occurred if (i) we intend to sell the investment security (i.e. a decision has been made as the reporting
date) or (ii) it is more likely than not that we will be required to sell the investment security before recovery of its amortized cost
basis. If we intend to sell the security or if it is more likely than not that we will be required to sell the investment security before
recovery of its amortized cost basis, the entire amount of the impairment loss, if any, is recognized in earnings as a realized loss
and the cost basis of the security is adjusted to its fair value.
We did not recognize any OTTI charges on our investment securities for fiscal years 2012, 2011 and 2010.
Interest Income
Interest income is accrued based on the outstanding principal amount of the investment securities and their contractual terms.
Premiums and discounts associated with the purchase of investment securities are amortized or accreted into interest income over
the projected lives of the securities, including contractual payments and estimated prepayments using the interest method in
accordance with ASC Subtopic 310-20, Receivables—Nonrefundable Fees and Other Costs (“ASC 310-20”).
We estimate long-term prepayment speeds of our agency securities using a third-party service and market data. The third-
party service estimates prepayment speeds using models that incorporate the forward yield curve, current mortgage rates and
mortgage rates of the outstanding loans, age and size of the outstanding loans, loan-to-value ratios, volatility and other factors.
72
We review the prepayment speeds estimated by the third-party service and compare the results to market consensus prepayment
speeds, if available. We also consider historical prepayment speeds and current market conditions to validate the reasonableness
of the prepayment speeds estimated by the third-party service and, based on our Manager’s judgment, we may make adjustments
to their estimates. Actual and anticipated prepayment experience is reviewed quarterly and effective yields are recalculated when
differences arise between (i) our previously estimated future prepayments and (ii) actual prepayments to date plus current estimated
future prepayments. If the actual and estimated future prepayment experience differs from our prior estimate of prepayments, we
are required to record an adjustment in the current period to the amortization or accretion of premiums and discounts for the
cumulative difference in the effective yield through the reporting date.
The yield on our adjustable rate securities further assumes that the securities reset at a rate equal to the underlying index
rate in effect as of the date we acquired the security plus the stated margin.
Repurchase Agreements
We finance the acquisition of securities for our investment portfolio through repurchase transactions under master repurchase
agreements. Pursuant to ASC Topic 860, Transfers and Servicing ("ASC 860"), we account for repurchase transactions as
collateralized financing transactions, which are carried at their contractual amounts (cost), plus accrued interest, as specified in
the respective transactions. Our repurchase agreements have maturities of generally less than one year, but may extend up to five
years or more. Interest rates under our repurchase agreements generally correspond to one, three or six month LIBOR plus or
minus a fixed spread. The fair value of our repurchase agreements is assumed to equal cost as the interest rates are considered to
be at market.
Manager Compensation
Our management agreement provides for the payment to our Manager of a management fee and reimbursement of certain
operating expenses, which are accrued and expensed during the period for which they are earned or incurred. Refer to Note 7 for
the terms of our management agreement and the administrative services agreement between American Capital and our Manager.
Derivative Instruments
We use a variety of derivative instruments to economically hedge a portion of our exposure to market risks, including interest
rate and prepayment risk. The objective of our risk management strategy is to reduce fluctuations in net book value over a range
of interest rate scenarios. In particular, we attempt to mitigate the risk of the cost of our variable rate liabilities increasing during
a period of rising interest rates. The principal instruments that we use are interest rate swaps and options to enter into interest rate
swaps (“interest rate swaptions”). We also purchase or sell to-be-announced agency MBS forward contracts (“TBAs”), specified
agency MBS on a forward basis, U.S. Treasury securities and U.S. Treasury futures contracts. We may also purchase or write put
or call options on TBA securities and invest in other types of mortgage derivatives, such as interest-only securities, and synthetic
total return swaps, such as the Markit IOS Synthetic Total Return Swap Index (“Markit IOS Index”).
We may also enter into TBA contracts as a means of investing in and financing agency securities. Pursuant to TBA contracts,
we agree to purchase, for future delivery, agency securities with certain principal and interest terms and certain types of collateral,
but the particular agency securities to be delivered are not identified until shortly before the TBA settlement date. We also may
choose, prior to settlement, to move the settlement of these securities out to a later date by entering into an offsetting short position
(referred to as a "pair off"), net settling the paired off positions for cash, and simultaneously purchasing a similar TBA contract
for a later settlement date. This transaction is commonly referred to as a “dollar roll.” The agency securities purchased for a
forward settlement date are typically priced at a discount to agency securities for settlement in the current month. This difference
(or discount) is referred to as the “price drop.” The price drop is the economic equivalent of net interest carry income on the
underlying agency securities over the roll period (interest income less implied financing cost) and is commonly referred to as
"dollar roll income." Consequently, forward purchases of agency securities and dollar roll transactions represent a form of off-
balance sheet financing.
We account for derivative instruments in accordance with ASC Topic 815, Derivatives and Hedging (“ASC 815”). ASC
815 requires an entity to recognize all derivatives as either assets or liabilities in the balance sheet and to measure those instruments
at fair value.
The accounting for changes in the fair value of derivative instruments depends on whether the instruments are designated
and qualify as part of a hedging relationship pursuant to ASC 815.
Changes in fair value related to derivatives not in hedge designated relationships are recorded in gain (loss) on derivative
instruments and other securities, net; whereas changes in fair value related to derivatives in hedge designated relationships are
initially recorded in OCI and later reclassified to income at the time that the hedged transactions affect earnings. Any portion of
73
the changes in fair value due to hedge ineffectiveness is immediately recognized in gain (loss) on derivative instruments and other
securities, net.
Our derivative agreements and repurchase agreements generally contain provisions that allow for netting or setting off
receivables and payables with each counterparty. We report amounts in our consolidated balance sheets on a gross basis without
regard for such rights of offset or master netting arrangements.
Derivative instruments in a gain position are reported as derivative assets at fair value and derivative instruments in a loss
position are reported as derivative liabilities at fair value in our consolidated balance sheets. In our consolidated statements of
cash flows, cash receipts and payments related to derivative instruments are classified according to the underlying nature or purpose
of the derivative transaction, generally in the operating section for derivatives designated in hedging relationships and the investing
section for derivatives not designated in hedging relationships.
The use of derivatives creates exposure to credit risk relating to potential losses that could be recognized in the event that
the counterparties to these instruments fail to perform their obligations under the contracts. We attempt to minimize this risk by
limiting our counterparties to major financial institutions with acceptable credit ratings, monitoring positions with individual
counterparties and adjusting posted collateral as required.
Discontinuation of hedge accounting for interest rate swap agreements
Prior to the third quarter of 2011, we entered into interest rate swap agreements typically with the intention of qualifying
for hedge accounting under ASC 815. However, as of September 30, 2011, we elected to discontinue hedge accounting for our
interest rate swaps. Our net asset value was not impacted by our election to discontinue hedge accounting since our net asset value
is the same irrespective of whether we apply hedge accounting.
Upon discontinuation of hedge accounting, the net deferred loss related to our de-designated interest rate swaps remained
in accumulated OCI and is being reclassified from accumulated OCI into interest expense on a straight-line basis over the remaining
term of each interest rate swap. Although the reclassification of accumulated OCI into interest expense is similar to as if the
interest rate swaps had not been de-designated, the actual net periodic interest costs associated with our de-designated interest
rates swaps may be more or less than amounts reclassified into interest expense. The difference, as well as net periodic interest
costs on interest rate swaps that were never in a hedge designation, along with subsequent changes in the fair value of our interest
rates swaps, is reported in our consolidated statement of comprehensive income in gain (loss) on derivative instruments and other
securities, net.
Interest rate swap agreements
We use interest rate swaps to economically hedge the variable cash flows associated with borrowings made under our
repurchase agreement facilities. Under our interest rate swap agreements, we typically pay a fixed rate and receive a floating rate
based on one, three or six-month LIBOR ("payer swap") with terms up to 10 years, which has the effect of modifying the repricing
characteristics of our repurchase agreements and cash flows on such liabilities.
We estimate the fair value of interest rate swaps using a third-party pricing model. The third-party pricing model incorporates
such factors as the LIBOR curve and the pay rate on the interest rate swaps. We also incorporate both our own and our counterparties’
nonperformance risk in estimating the fair value of our interest rate swaps. In considering the effect of nonperformance risk, we
consider the impact of netting and credit enhancements, such as collateral postings and guarantees, and have concluded that our
own and our counterparty risk is not significant to the overall valuation of these agreements.
Interest rate swaptions
We purchase interest rate swaptions to help mitigate the potential impact of increases or decreases in interest rates on the
performance of our investment portfolio (referred to as “convexity risk”). The interest rate swaptions provide us the option to enter
into an interest rate swap agreement for a predetermined notional amount, stated term and pay and receive interest rates in the
future. Our swaption agreements typically provide us the option to enter into a pay fixed rate interest rate swap, which we refer
as “payer swaptions”. We may also enter into swaption agreements that provide us the option to enter into a receive fixed interest
rate swap, which we refer to as "receiver swaptions". The premium paid for interest rate swaptions is reported as an asset in our
consolidated balance sheets. The premium is valued at an amount equal to the fair value of the swaption that would have the effect
of closing the position adjusted for nonperformance risk, if any. The difference between the premium and the fair value of the
swaption is reported in gain (loss) on derivative instruments and other securities, net in our consolidated statement of comprehensive
income. If a swaption expires unexercised, the loss on the swaption would be equal to the premium paid. If we sell or exercise a
swaption, the realized gain or loss on the swaption would be equal to the difference between the cash or the fair value of the
underlying interest rate swap received and the premium paid.
74
We estimate the fair value of interest rate swaptions using a third-party pricing model based on the fair value of the future
interest rate swap that we have the option to enter into as well as the remaining length of time that we have to exercise the option,
adjusted for non-performance risk, if any.
TBA securities
A TBA security is a forward contract for the purchase ("long position") or sale ("short position") of agency MBS at a
predetermined price, face amount, issuer, coupon and stated maturity on an agreed-upon future date. The specific agency MBS
delivered into the contract upon the settlement date, published each month by the Securities Industry and Financial Markets
Association, are not known at the time of the transaction. We enter into TBA contracts as means of hedging against short-term
changes in interest rates. We may also enter into TBA contracts as a means of acquiring agency securities and we may from time
to time utilize TBA dollar roll transactions to finance agency MBS purchases.
We estimate the fair value of TBA securities based on similar methods used to value our agency MBS securities.
Forward commitments to purchase or sell specified agency MBS
We enter into forward commitments to purchase or sell specified agency MBS from time to time as a means of acquiring
assets or as a hedge against short-term changes in interest rates. We account for contracts for the purchase or sale of specified
agency MBS securities as derivatives if the delivery of the specified agency MBS and settlement extends beyond the shortest
period possible for that type of security. Realized and unrealized gains and losses associated with forward commitments accounted
for as derivatives are recognized in our consolidated statements of comprehensive income in gain (loss) on derivative instruments
and other securities, net.
We estimate the fair value of forward commitments to purchase or sell specified agency MBS based on similar methods
used to value agency MBS, as well as the remaining length of time of the forward commitment.
U.S. Treasury securities
We purchase or sell short U.S. Treasury securities and U.S. Treasury futures contracts to help mitigate the potential impact
of changes in interest rates on the performance of our portfolio. We borrow securities to cover short sales of U.S. Treasury securities
under reverse repurchase agreements. We account for these as securities borrowing transactions and recognize an obligation to
return the borrowed securities at fair value on the balance sheet based on the value of the underlying borrowed securities as of the
reporting date. Gains and losses associated with purchases and short sales of U.S. Treasury securities are recognized in gain (loss)
on derivative instruments and other securities, net in our consolidated statements of comprehensive income.
Total return swaps
We may enter into total return swaps to obtain exposure to a security or market sector without owning such security or
investing directly in that market sector. Total return swaps are agreements in which there is an exchange of cash flows whereby
one party commits to make payments based on the total return (coupon plus the mark-to-market movement) of an underlying
instrument or index in exchange for fixed or floating rate interest payments. To the extent the total return of the instrument or
index underlying the transaction exceeds or falls short of the offsetting interest rate obligation, we will receive a payment from
or make a payment to the counterparty.
The primary total return swap index in which we invest is the Markit IOS Index. Total return swaps based on the Markit
IOS Index are intended to synthetically replicate the performance of interest-only securities. We determine the fair value of our
total return swaps based on published index prices. Gains and losses associated with changes in market value of the underlying
index and coupon interest are recognized in gain (loss) on derivative instruments and other securities, net in our consolidated
statements of comprehensive income.
Variable Interest Entities
ASC Topic 810, Consolidation (“ASC 810”), requires an enterprise to consolidate a variable interest entity ("VIE") if it is
deemed the primary beneficiary of the VIE. Further, ASC 810 requires a qualitative assessment to determine the primary beneficiary
of a VIE and ongoing assessments of whether an enterprise is the primary beneficiary of a VIE as well as additional disclosures
for entities that have variable interests in VIEs.
We have entered into transactions involving CMO trusts (e.g. a VIE) whereby, in each case, we transferred agency MBS to
an investment bank in exchange for cash proceeds and at the same time entered into a commitment with the same investment bank
to purchase to-be-issued securities collateralized by the agency MBS transferred, which resulted in our consolidation of the CMO
trusts. We will consolidate a CMO trust if we are the CMO trust’s primary beneficiary; that is, if we have a variable interest that
75
provides us with a controlling financial interest in the CMO trust. An entity is deemed to have a controlling financial interest if
the entity has the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance and the
obligation to absorb losses of or right to receive benefits from the VIE that could potentially be significant to the VIE. As part of
the qualitative assessment in determining if we have a controlling financial interest, we evaluate whether we control the selection
of financial assets transferred to the CMO trust.
Agency MBS transferred to consolidated VIEs are reported on our consolidated balance sheets in agency securities transferred
to consolidated variable interest entities, at fair value and can only be used to settle the obligations of each respective VIE.
We report debt issued in connection with the CMO trusts on our consolidated balance sheets in debt of consolidated VIEs,
at fair value, which represents tranches within the trusts sold to third-parties and excludes tranches acquired by us that eliminate
in consolidation. The third-party beneficial interest holders in the VIEs have no recourse against our general credit. We elected
the option to account for the consolidated debt at fair value, with changes in fair value reflected in earnings during the period in
which they occur, because we believe this election more appropriately reflects our financial position as both the consolidated assets
and consolidated debt are presented in a consistent manner on our consolidated balance sheets. We estimate the fair value of the
consolidated debt based on a market approach using Level 2 inputs from third-party pricing services and dealer quotes.
Income Taxes
We elected to be taxed as a REIT under the provisions of the Internal Revenue Code and the corresponding provisions of
state law, commencing with our initial tax year ended December 31, 2008. In order to qualify as a REIT, we must annually
distribute, in a timely manner to our stockholders, at least 90% of our taxable ordinary income. A REIT is not subject to tax on
its earnings to the extent that it distributes its annual taxable income to its stockholders and as long as certain asset, income and
stock ownership tests are met. We operate in a manner that will allow us to be taxed as a REIT. As permitted by the Internal
Revenue Code, a REIT can designate dividends paid in the subsequent year as dividends of the current year if those dividends are
both declared by the extended due date of the REIT's federal income tax return and paid to stockholders by the last day of the
subsequent year.
As a REIT, if we fail to distribute in any calendar year at least the sum of (i) 85% of our ordinary income for such year, (ii)
95% of our capital gain net income for such year and (iii) any undistributed taxable income from the prior year, we are subject to
a non-deductible 4% excise tax on the excess of such required distribution over the sum of (a) the amounts actually distributed
and, if applicable, (b) the amounts of income we retained and on which we have paid corporate income tax. Dividends declared
by December 31 and paid by January 31 are treated as having been a distribution of our taxable income for the prior tax year.
We and our domestic subsidiary, American Capital Agency TRS, LLC, have made a joint election to treat our subsidiary as
a taxable REIT subsidiary. As such, American Capital Agency TRS, LLC, is subject to federal and state income tax.
We evaluate uncertain income tax positions, if any, in accordance with ASC Topic 740, Income Taxes (“ASC 740”). To the
extent we incur interest and/or penalties in connection with our tax obligations, such amounts shall be classified as income tax
expense on our consolidated statements of operations.
Recent Accounting Pronouncements
In December 2011, the FASB issued ASU No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and
Liabilities (“ASU 2011-11”). The update requires new disclosures about balance sheet offsetting and related arrangements. For
derivatives and financial assets and liabilities, the amendments require disclosure of gross asset and liability amounts, amounts
offset on the balance sheet, and amounts subject to the offsetting requirements but not offset on the balance sheet. Additionally,
in January 2013, the FASB issued ASU No. 2013-01, Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities
(“ASU 2013-01”), which clarifies that the scope of ASU 2011-11 applies to derivatives accounted for in accordance with ASC
Topic 815, Derivatives and Hedging, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase
agreements, and securities borrowing and securities lending transactions that are either offset or subject to an enforceable master
netting arrangement or similar agreement. The guidance is effective January 1, 2013 and is to be applied retrospectively. This
guidance does not amend the existing guidance on when it is appropriate to offset. As a result, we do not expect this guidance to
have a material effect on our financial statements.
In February 2013, the FASB issued ASU No. 2013-02, Reporting of Amounts Reclassified out of Accumulated Other
Comprehensive Income (“ASU 2013-02”), an amendment to FASB ASC Topic 220, Comprehensive Income. The update requires
disclosure of amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required
to present either on the face of the statement of operations or in the notes, significant amounts reclassified out of accumulated
other comprehensive income by the respective line items of net income but only if the amount reclassified is required to be
reclassified to net income in its entirety in the same reporting period. For amounts not reclassified in their entirety to net income,
76
an entity is required to cross-reference to other disclosures that provide additional detail about those amounts. For public entities,
the guidance is effective prospectively for reporting periods beginning after December 15, 2012. We are currently evaluating the
impact on our consolidated financial statements of adopting ASU 2013-02.
Reclassifications
Certain prior period amounts in the consolidated financial statements have been reclassified to conform to the current period
presentation.
Note 3. Investment Securities
As of December 31, 2012, we had agency MBS at fair value of $85.2 billion, with a total cost basis of $83.2 billion. The net
unamortized premium balance on our investment portfolio as of December 31, 2012 was $4.4 billion, including interest-only and
principal-only strips. The following tables summarize our investments in agency MBS as of December 31, 2012 (dollars in
millions):
Agency MBS
Available-for-sale agency MBS:
December 31, 2012
Fannie Mae
Freddie Mac Ginnie Mae
Total
Agency MBS, par ....................................................................................... $
58,912
$
19,336
$
Unamortized premium................................................................................
Amortized cost .......................................................................................
Gross unrealized gains................................................................................
3,208
62,120
1,585
Gross unrealized losses ..............................................................................
(18)
948
20,284
481
(7)
Total available-for-sale agency MBS, at fair value................................
63,687
20,758
Agency MBS remeasured at fair value through earnings:
Interest-only and principal-only strips, amortized cost (1) ..........................
Gross unrealized gains................................................................................
Gross unrealized losses ..............................................................................
Total agency MBS remeasured at fair value through earnings ..............
486
26
(9)
503
55
1
(13)
43
238
10
248
6
—
254
—
—
—
—
$
78,486
4,166
82,652
2,072
(25)
84,699
541
27
(22)
546
Total agency MBS, at fair value..................................................................... $
Weighted average coupon as of December 31, 2012 (2)..................................
Weighted average yield as of December 31, 2012 (3)......................................
Weighted average yield for the year ended December 31, 2012 (3) ................
64,190
$
20,801
$
254
$
85,245
3.70%
2.62%
2.83%
3.67%
2.61%
2.83%
3.77%
1.60%
1.63%
3.69%
2.61%
2.82%
________________________
1.
2.
3.
The underlying unamortized principal balance (“UPB” or “par value”) of our interest-only agency MBS strips was $1.7 billion and the weighted average
contractual interest we are entitled to receive was 5.78% of this amount as of December 31, 2012. The par value of our principal-only agency MBS
strips was $302 million as of December 31, 2012.
The weighted average coupon includes the interest cash flows from our interest-only agency MBS strips taken together with the interest cash flows
from our fixed-rate, adjustable-rate and CMO agency MBS as a percentage of the par value of our agency MBS (excluding the UPB of our interest-
only securities) as of December 31, 2012.
Incorporates a weighted average future constant prepayment rate assumption of 11% based on forward rates as of December 31, 2012 and a weighted
average reset rate for adjustable rate securities of 2.64%, which is equal to a weighted average underlying index rate of 0.93% based on the current
spot rate in effect as of the date we acquired the securities and a weighted average margin of 1.71%.
Agency MBS
Amortized
Cost
December 31, 2012
Gross
Unrealized
Gain
Gross
Unrealized
Loss
Fair Value
Fixed-Rate ............................................................. $
81,617
$
2,043
$
(25) $
83,635
Adjustable-Rate .....................................................
CMO ......................................................................
Interest-only and principal-only strips...................
865
170
541
26
3
27
—
—
(22)
891
173
546
Total agency MBS................................................. $
83,193
$
2,099
$
(47) $
85,245
77
As of December 31, 2011, we had agency MBS at fair value of $54.7 billion, with a total cost basis of $53.7 billion. The
net unamortized premium balance on our investment portfolio as of December 31, 2011 was $2.4 billion, including interest-only
and principal-only strips. The following tables summarize our investments in agency MBS as of December 31, 2011 (dollars in
millions):
Agency MBS
Available-for-sale agency MBS:
Fannie Mae
Freddie Mac
Ginnie Mae
Total
December 31, 2011
Agency MBS, par ................................................................................ $
37,232
$
13,736
$
Unamortized premium .........................................................................
Amortized cost.................................................................................
Gross unrealized gains.........................................................................
Gross unrealized losses........................................................................
1,659
38,891
680
(4)
606
14,342
324
(2)
Available-for-sale agency MBS, at fair value..................................
39,567
14,664
Agency MBS remeasured at fair value through earnings:
Interest-only and principal-only strips, amortized cost (1) ...................
Gross unrealized gains.........................................................................
Gross unrealized losses........................................................................
Agency MBS remeasured at fair value through earnings................
124
6
(8)
122
67
3
(13)
57
$
258
12
270
3
—
273
—
—
—
—
51,226
2,277
53,503
1,007
(6)
54,504
191
9
(21)
179
Total agency MBS, at fair value .............................................................. $
Weighted average coupon as of December 31, 2011 (2)...........................
Weighted average yield as of December 31, 2011 (3)...............................
Weighted average yield for the year ended December 31, 2011 (3) .........
39,689
$
14,721
$
273
$
54,683
4.18%
3.03%
3.19%
4.39%
3.20%
3.20%
3.74%
1.71%
2.05%
4.23%
3.07%
3.19%
________________________
1.
2.
3.
The UPB of our interest-only securities was $1.1 billion and the weighted average contractual interest we are entitled to receive was 5.52% of this
amount as of December 31, 2011. The par value of our principal-only agency MBS strips was $40 million as of December 31, 2011.
The weighted average coupon includes the interest cash flows from our interest-only securities taken together with the interest cash flows from our
fixed-rate, adjustable-rate and CMO securities as a percentage of the par value of our agency securities (excluding the UPB of our interest-only securities)
as of December 31, 2011.
Incorporates a weighted average future constant prepayment rate assumption of 14% based on forward rates as of December 31, 2011 and a weighted
average reset rate for adjustable rate securities of 2.71%, which is equal to a weighted average underlying index rate of 0.94% based on the current
spot rate in effect as of the date we acquired the securities and a weighted average margin of 1.77%.
Agency MBS
Amortized
Cost
December 31, 2011
Gross
Unrealized
Gain
Gross
Unrealized
Loss
Fixed-Rate...................................... $
50,535
$
952
$
(4) $
Adjustable-Rate..............................
CMO ..............................................
Interest-only strips .........................
2,725
243
191
51
4
9
(2)
—
(21)
Fair Value
51,483
2,774
247
179
Total agency MBS.......................... $
53,694
$
1,016
$
(27) $
54,683
As of December 31, 2012 and 2011, we did not have investments in agency debenture securities.
The actual maturities of our agency MBS securities are generally shorter than the stated contractual maturities. Actual
maturities are affected by the contractual lives of the underlying mortgages, periodic contractual principal payments and principal
prepayments. As of December 31, 2012 and 2011, our weighted average expected constant prepayment rate (“CPR”) over the
remaining life of our aggregate agency MBS portfolio was 11% and 14%, respectively. Our estimates differ materially for different
types of securities and thus individual holdings have a wide range of projected CPRs. We estimate long-term prepayment
assumptions for different securities using a third-party service and market data. The third-party service estimates prepayment
speeds using models that incorporate the forward yield curve, current mortgage rates and mortgage rates of the outstanding loans,
age and size of the outstanding loans, loan-to-value ratios, volatility and other factors. We review the prepayment speeds estimated
78
by the third-party service and compare the results to market consensus prepayment speeds, if available. We also consider historical
prepayment speeds and current market conditions to validate reasonableness. As market conditions may change rapidly, we may
make adjustments for different securities based on our Manager's judgment. Various market participants could use materially
different assumptions.
The following table summarizes our agency MBS classified as available-for-sale as of December 31, 2012 and 2011 according
to their estimated weighted average life classification (dollars in millions):
December 31, 2012
December 31, 2011
Estimated Weighted Average Life of
Agency MBS Classified as
Available-for-Sale (1)
Fair
Value
Amortized
Cost
Weighted
Average
Coupon
Weighted
Average
Yield
Fair
Value
Amortized
Cost
Weighted
Average
Coupon
Weighted
Average
Yield
................................................
$
— $
> 1 year and 3 years ..........................
........................
> 5 years and
years .......................
> 10 years.............................................
1,119
27,448
54,054
2,078
—
1,108
26,750
52,735
2,059
Total .....................................................
$
84,699
$
82,652
—%
4.18%
3.36%
3.69%
3.44%
3.59%
—% $
214
$
2.14%
2.29%
2.75%
2.65%
3,392
26,168
24,710
20
210
3,338
25,616
24,320
19
2.59% $
54,504
$
53,503
4.61%
4.38%
3.99%
4.19%
5.02%
4.11%
3.51%
2.54%
2.89%
3.29%
2.12%
3.05%
_______________________
1.
Excludes interest and principal-only strips.
The weighted average life of our interest-only strips was 5.7 and 3.0 years as of December 31, 2012 and 2011, respectively.
The weighted average life of our principal-only strips was 6.4 and 2.6 years as of December 31, 2012 and 2011, respectively.
Our agency securities classified as available-for-sale are reported at fair value, with unrealized gains and losses excluded
from earnings and reported in accumulated OCI. The following table summarizes changes in accumulated OCI, a separate
component of stockholders equity, for our available-for-sale securities for fiscal years 2012, 2011 and 2010 (in millions):
Agency Securities Classified as
Available-for-Sale
Fiscal year 2012 .....................................................................
Fiscal year 2011 .....................................................................
Fiscal year 2010 .....................................................................
Beginning
Accumulated
OCI
Balance
$
$
$
1,002
(28)
36
Unrealized Gains
and (Losses), Net
Reversal of Prior
Period Unrealized
(Gains) and Losses,
Net on Realization
Ending
Accumulated
OCI
Balance
2,235
1,513
29
(1,196) $
(483) $
(93) $
2,041
1,002
(28)
The following table presents the gross unrealized loss and fair values of our available-for-sale agency securities by length
of time that such securities have been in a continuous unrealized loss position as of December 31, 2012 and 2011 (in millions):
Less than 12 Months
12 Months or More
Total
Unrealized Loss Position For
Agency Securities Classified as
Available-for-Sale
Estimated
Fair
Value
Unrealized
Loss
Estimated
Fair Value
Unrealized
Loss
Estimated
Fair
Value
Unrealized
Loss
December 31, 2012..................
December 31, 2011..................
$
$
8,430
1,135
$
$
(25) $
(6) $
— $
— $
— $
— $
8,430
1,135
$
$
(25)
(6)
As of December 31, 2012, we did not intend to sell any of these agency securities and we do not believe it is more likely
than not we will be required to sell the agency securities before recovery of their amortized cost basis. The unrealized losses on
these agency securities are not due to credit losses given the government-sponsored entity or government guarantees, but are rather
due to changes in interest rates and prepayment expectations.
Gains and Losses
The following table is a summary of our net gain from the sale of agency MBS for fiscal years 2012, 2011 and 2010 (in
millions):
79
Agency MBS
Agency MBS sold, at cost ...........................................................
Proceeds from agency MBS sold (1).............................................
Fiscal Year
2012
2011
2010
$
(63,610) $
(37,579) $
(12,182)
64,806
38,052
Net gains on sale of agency MBS................................................
$
1,196
$
473
$
Gross gains on sale of agency MBS ............................................
$
1,209
$
Gross losses on sale of agency MBS ...........................................
(13)
Net gains on sale of agency MBS................................................
$
1,196
$
510
$
(37)
473
$
________________________
1.
Proceeds include cash received during the period, plus receivable for agency MBS sold during the period as of period end.
12,274
92
126
(34)
92
For fiscal years 2012, 2011 and 2010, we recognized an unrealized gain of $17 million and an unrealized loss of $16 million
and $1 million, respectively, in gain (loss) on derivative instruments and other securities, net in our consolidated statements of
comprehensive income for the change in value of investments in interest-only and principal-only strips, net of prior period reversals.
For fiscal years 2011 and 2010, we recognized a realized net loss of $10 million and $1 million, respectively, in gain on sale of
agency securities, net in our consolidated statements of comprehensive income on sales of interest and principal-only securities.
No such sales occurred during fiscal year 2012.
Pledged Assets
The following tables summarize our assets pledged as collateral under repurchase agreements, debt of consolidated VIEs,
derivative agreements and prime broker agreements by type, including securities pledged related to securities sold but not yet
settled, as of December 31, 2012 and 2011 (in millions):
Assets Pledged
December 31, 2012
Repurchase
Agreements
Debt of
Consolidated
VIEs
Derivative
Agreements
Prime Broker
Agreements
Total
Agency MBS - fair value ..........................
$
78,400
$
1,535
$
1,065
$
501
$
81,501
Accrued interest on pledged securities......
Restricted cash ..........................................
217
—
5
—
3
249
Total ......................................................
$
78,617
$
1,540
$
1,317
$
1
150
652
226
399
$
82,126
Assets Pledged
December 31, 2011
Repurchase
Agreements
Debt of
Consolidated
VIEs
Derivative
Agreements
Prime Broker
Agreements
Agency MBS - fair value..........................
$
50,255
$
U.S. Treasury securities - fair value .........
Accrued interest on pledged securities .....
Restricted cash..........................................
101
161
—
Total......................................................
$
50,517
$
58
—
—
—
58
$
$
644
$
—
2
336
982
$
87
—
—
—
87
$
$
Total
51,044
101
163
336
51,644
The following table summarizes our securities pledged as collateral under repurchase agreements and debt of consolidated
VIEs by remaining maturity, including securities pledged related to sold but not yet settled securities, as of December 31, 2012
and 2011 (in millions):
80
Securities Pledged by Remaining
Maturity of Repurchase Agreements
and Debt of Consolidated VIEs
Fair Value of
Pledged
Securities
Amortized
Cost of
Pledged
Securities
Accrued
Interest on
Pledged
Securities
Fair Value of
Pledged
Securities
Amortized
Cost of
Pledged
Securities
Accrued
Interest on
Pledged
Securities
December 31, 2012
December 31, 2011
Agency MBS:
Less than 30 days.............................
$
29,284
$
28,525
$
31 - 59 days .....................................
60 - 90 days .....................................
Greater than 90 days........................
Total agency MBS .............................
U.S. Treasury securities:
21,716
16,188
12,747
79,935
21,251
15,780
12,447
78,003
1 day ................................................
—
—
Total securities...................................
$
79,935
$
78,003
$
82
58
45
37
222
—
222
$
19,772
$
19,361
$
16,964
8,337
5,240
50,313
16,648
8,179
5,154
49,342
101
101
$
50,414
$
49,443
$
63
55
26
17
161
—
161
As of December 31, 2012 and 2011, none of our repurchase agreement borrowings backed by agency MBS were due on
demand or mature overnight.
Securitizations
All of our CMO securities are backed by fixed or adjustable-rate agency MBS. Fannie Mae or Freddie Mac guarantees the
payment of interest and principal and acts as the trustee and administrator of their respective securitization trusts. Accordingly,
we are not required to provide the beneficial interest holders of the CMO securities any financial or other support. Our maximum
exposure to loss related to our involvement with CMO trusts is the fair value of the CMO securities and interest and principal-
only securities held by us, less principal amounts guaranteed by Fannie Mae and Freddie Mac.
As of December 31, 2012 and 2011, the fair value of our CMO securities and interest and principal-only securities, excluding
the consolidated CMO trusts discussed below, was $719 million and $426 million, respectively, or $1.3 billion and $429 million,
respectively, including the net asset value of our consolidated CMO trusts discussed below. Our maximum exposure to loss related
to our CMO securities and interest and principal-only securities, including our consolidated CMO trust, was $343 million and
$155 million as of December 31, 2012 and 2011, respectively.
We have consolidated CMO trusts for which we have determined we are the primary beneficiary of the trusts. In connection
with the consolidated trusts, as of December 31, 2012 and 2011, we recognized agency securities with a total fair value of $1.5
billion and $58 million, respectively, and debt, at fair value of $0.9 billion and $54 million, respectively, in our accompanying
consolidated balance sheets. As of December 31, 2012 and 2011, such agency securities had an aggregate unpaid principal balance
of $1.4 billion and $55 million, respectively, and such debt had an aggregate unpaid principal balance of $0.9 billion and $54
million, respectively. During fiscal year 2012, we recognized a loss of $28 million from debt of consolidated VIEs re-measured
at fair value through earnings in gain (loss) on derivative instruments and other securities, net in our consolidated statement of
comprehensive income. We did not recognize any such gains or losses during fiscal years 2011 and 2010.
Our involvement with the consolidated trusts is limited to the agency securities transferred to the trusts and the CMO
securities subsequently held by us. There are no arrangements that could require us to provide financial support to the trusts.
Note 4. Repurchase Agreements and Other Debt
We pledge certain of our agency securities as collateral under repurchase arrangements with financial institutions, the terms
and conditions of which are negotiated on a transaction-by-transaction basis. Interest rates on these borrowings are generally based
on LIBOR plus or minus a margin and amounts available to be borrowed are dependent upon the fair value of the securities pledged
as collateral, which fluctuates with changes in interest rates, type of security and liquidity conditions within the banking, mortgage
finance and real estate industries. In response to declines in fair value of pledged securities, lenders may require us to post additional
collateral or pay down borrowings to re-establish agreed upon collateral requirements, referred to as margin calls. As of
December 31, 2012 and 2011, we have met all margin call requirements.
The following table summarizes our borrowings under repurchase arrangements and weighted average interest rates classified
by original maturities as of December 31, 2012 and 2011 (dollars in millions):
81
Original Maturity
Agency MBS:
1 month ..............................
> 1 to 3 months ..................
> 3 to 6 months ..................
> 6 to 9 months ..................
> 9 to 12 months ................
> 12 to 24 months ..............
> 24 to 36 months ..............
> 36 months ..........................
Total agency MBS ..................
U.S. Treasury securities:
1 day......................................
Total / Weighted Average........
$
$
December 31, 2012
December 31, 2011
Repurchase
Agreements
Weighted
Average
Interest
Rate
Weighted
Average Days
to Maturity
Repurchase
Agreements
Weighted
Average
Interest
Rate
Weighted
Average Days
to Maturity
4,011
28,307
24,303
5,222
7,813
1,917
2,803
102
74,478
—
74,478
0.48%
0.49%
0.49%
0.54%
0.58%
0.65%
0.69%
0.73%
0.51%
—
0.51%
$
13
37
63
79
222
564
963
1,751
118
2,558
24,518
16,475
2,423
1,006
600
—
—
47,580
—
118
$
101
47,681
0.43%
0.39%
0.37%
0.45%
0.53%
0.51%
—
—
0.40%
0.40%
0.40%
10
32
53
141
244
268
—
—
51
1
51
As of December 31, 2012 and 2011, we did not have an amount at risk with any repurchase agreement counterparty greater
than 4% of our stockholders’ equity.
As of December 31, 2012 and 2011, debt of consolidated VIEs, at fair value ("other debt") was $937 million and $54 million,
respectively. As of December 31, 2012 and 2011, our other debt had a weighted average interest rate of LIBOR plus 43 and 25
basis points and a principal balance of $908 million and $54 million, respectively. The actual maturities of our other debt are
generally shorter than the stated contractual maturities. The actual maturities are affected by the contractual lives of the underlying
agency MBS securitizing our other debt and periodic principal prepayments of such underlying securities. The estimated weighted
average life of our other debt as of December 31, 2012 was 5.2 years.
As of December 31, 2012, we also had forward purchase commitments, including TBA dollar roll transactions, outstanding
of $12.9 billion, at fair value (see Notes 2 and 5). Forward purchase commitments and TBA dollar roll transactions represent a
form of off-balance sheet financing. Pursuant to ASC 815, we typically account for such transactions as one or more series of
derivative transactions and, consequently, they are not reflected in our on-balance debt and leverage ratios.
Note 5. Derivative and Other Hedging Instruments
In connection with our risk management strategy, we hedge a portion of our interest rate risk by entering into derivative and
other hedging instrument contracts. We may enter into agreements for interest rate swaps, interest rate swaptions, interest rate cap
or floor contracts and futures or forward contracts. We may also purchase or short TBA and U.S. Treasury securities, purchase or
write put or call options on TBA securities or we may invest in other types of mortgage derivative securities, such as interest-only
securities, and synthetic total return swaps, such as the Markit IOS Index. Our risk management strategy attempts to manage the
overall risk of the portfolio, reduce fluctuations in book value and generate additional income distributable to stockholders. For
additional information regarding our derivative instruments and our overall risk management strategy, please refer to the discussion
of derivative and other hedging instruments in Note 2.
Prior to September 30, 2011, our interest rate swaps were typically designated as cash flow hedges under ASC 815; however,
as of September 30, 2011, we elected to discontinue hedge accounting for our interest rate swaps in order to increase our funding
flexibility. For fiscal years 2012 and 2011, we reclassified $205 million and $54 million, respectively, of net deferred losses from
accumulated OCI into interest expense related to our de-designated interest rate swaps and recognized an equal, but offsetting,
amount in other comprehensive income. Our total net periodic interest costs on our swap portfolio were $457 million and $89
million for fiscal years 2012 and 2011, respectively. The difference of $252 million and $35 million for fiscal years 2012 and
2011, respectively, is reported in our accompanying consolidated statement of comprehensive income in gain (loss) on derivative
instruments and other securities, net. As of December 31, 2012, the remaining net deferred loss in accumulated OCI related to
de-designated interest rate swaps was $486 million and will be reclassified from OCI into interest expense over a remaining
weighted average period of 2.9 years. The net deferred loss expected to be reclassified from OCI into interest expense over the
next twelve months is $189 million as of December 31, 2012.
82
Derivative Assets (Liabilities), at Fair Value
The table below summarizes fair value information about our derivative assets and liabilities as of December 31, 2012 and
2011 (in millions):
Derivatives Instruments
Balance Sheet Location
2012
2011
December 31,
Interest rate swaps .............................................................................. Derivative assets, at fair value
Payer swaptions.................................................................................. Derivative assets, at fair value
Purchase of TBA and forward settling agency securities................... Derivative assets, at fair value
Sale of TBA and forward settling agency securities .......................... Derivative assets, at fair value
Markit IOS total return swaps - long.................................................. Derivative assets, at fair value
Interest rate swaps .............................................................................. Derivative liabilities, at fair value
U.S. Treasury futures - short .............................................................. Derivative liabilities, at fair value
Purchase of TBA and forward settling agency securities................... Derivative liabilities, at fair value
Sale of TBA and forward settling agency securities .......................... Derivative liabilities, at fair value
$
$
$
14
$
171
116
—
—
301
$
13
11
54
3
1
82
(1,243) $
(795)
—
(1)
(20)
(14)
—
(44)
$
(1,264) $
(853)
Additionally, as of December 31, 2012 and 2011, we had obligations to return U.S. Treasury securities borrowed under
reverse repurchase agreements accounted for as securities borrowing transactions at a fair value of $11.8 billion and $899 million,
respectively. The borrowed securities were used to cover short sales of U.S. Treasury securities from which we received total
proceeds of $11.7 billion and $880 million, respectively. The change in fair value of the borrowed securities is recorded in gain
(loss) on derivative instruments and other securities, net in our consolidated statements of comprehensive income.
The following tables summarize our interest rate swap agreements outstanding as of December 31, 2012 and 2011 (dollars
in millions):
Interest Rate Swaps (1)
December 31, 2012
Notional
Amount
Average
Fixed
Pay Rate
Average
Receive
Rate
Net
Estimated
Fair Value
Average
Maturity
(Years)
Three years or less ....................................................................
$
Greater than 3 years and less than/equal to 5 years..................
Greater than 5 years and less than/equal to 7 years..................
Greater than 7 years and less than/equal to 10 years................
Greater than 10 years................................................................
14,600
20,250
5,600
5,200
1,200
Total Payer Interest Rate Swaps...............................................
$
46,850
1.23%
1.48%
1.53%
1.89%
1.79%
1.46%
0.26% $
0.29%
0.34%
0.35%
0.31%
(294)
(666)
(163)
(113)
7
0.29% $
(1,229)
2.0
4.1
6.1
9.2
10.2
4.4
________________________
1. Amounts include forward starting swaps of $1.7 billion ranging up to four months from December 31, 2012.
Interest Rate Swaps (1)
December 31, 2011
Notional
Amount
Average
Fixed
Pay Rate
Average
Receive
Rate
Net
Estimated
Fair Value
Average
Maturity
(Years)
Three years or less ....................................................................
$
Greater than 3 years and less than/equal to 5 years..................
Greater than 5 years and less than/equal to 7 years..................
Greater than 7 years and less than/equal to 10 years................
11,350
16,700
950
1,250
Total Payer Interest Rate Swaps...............................................
$
30,250
1.22%
1.77%
1.56%
1.99%
1.57%
0.30% $
0.35%
0.57%
0.55%
0.35% $
(148)
(607)
(9)
(18)
(782)
2.1
3.9
5.7
8.2
3.5
________________________
1. Amounts include forward starting swaps of $2.6 billion ranging up to five months from December 31, 2011.
83
The following tables summarize our interest rate swaption agreements outstanding as of December 31, 2012 and 2011 (dollars
in millions):
Payer Swaptions
Option
Underlying Swap
December 31, 2012
Cost
Fair
Value
Average
Months to
Expiration
Notional
Amount
Average
Fixed
Pay
Rate
Average
Receive
Rate
Average
Term
(Years)
One year or less............................................................
$ 76
$
Greater than 1 year and less than/equal to 2 years .......
Greater than 2 years and less than/equal to 3 years .....
Greater than 3 years and less than/equal to 4 years .....
Greater than 4 years and less than/equal to 5 years .....
65
97
12
24
15
34
87
11
24
Total/Wtd Avg ..............................................................
$ 274
$171
4
19
33
46
59
21
$
$
$
$
$
5,150
4,050
3,900
450
900
2.65% 1M / 3M LIBOR
2.82%
3.51%
3.20%
3.33%
3M LIBOR
3M LIBOR
3M LIBOR
3M LIBOR
$ 14,450
2.99% 1M / 3M LIBOR
8.6
6.7
8.6
6.1
5.0
7.8
Payer Swaptions
December 31, 2011
Option
Underlying Swap
Cost
Fair
Value
Average
Months to
Expiration
Notional
Amount
Average
Fixed
Pay
Rate
Average
Receive
Rate
One year or less............................................................
$ 22
Greater than 1 year and less than/equal to 2 years .......
27
Total/Wtd Avg ..............................................................
$ 49
$
$
4
7
11
4
15
7
$
$
2,200
1,000
3,200
3.13% 1M / 3M LIBOR
4.04% 1M / 3M LIBOR
3.41% 1M / 3M LIBOR
Average
Term
(Years)
6.5
10.2
7.7
The following table summarizes our contracts to purchase and sell TBA and specified agency securities on a forward basis
as of December 31, 2012 and 2011 (in millions):
Purchase and Sale Contracts for TBAs and
Forward Settling Securities
Notional
Amount
Forward
Settlement
Price
Net
Fair Value
Notional
Amount
Forward
Settlement
Price
Net
Fair Value
December 31, 2012
December 31, 2011
TBA securities:
Purchase contracts ......................................
$
21,705
$
22,603
$
116
$
3,188
$
3,252
$
Sale contracts..............................................
TBA securities, net (1) .........................................
(9,378)
12,327
(9,991)
12,612
Forward settling securities:
Purchase contracts ......................................
Forward settling securities, net (2).......................
150
150
163
163
(20)
96
(1)
(1)
(3,803)
(615)
(3,935)
(683)
512
512
530
530
Total TBA and forward settling securities, net...
$
12,477
$
12,775
$
95
$
(103) $
(153) $
49
(41)
8
5
5
13
________________________
1.
2.
Includes 15-year and 30-year TBA securities of varying coupons
Includes 20-year and 30-year fixed securities of varying coupons
Gain (Loss) From Derivative Instruments and Other Securities, Net
During fiscal year 2012, none of our derivative instruments were designated as hedges under ASC 815. The table below
summarizes the effect of derivative instruments on our consolidated statements of comprehensive income for fiscal year 2012 (in
millions):
84
Derivative and Other Hedging Instruments
Purchase of TBA and forward settling agency securities ..
Sale of TBA and forward settling agency securities..........
Interest rate swaps..............................................................
Payer swaptions .................................................................
Short sales of U.S. Treasury securities...............................
U.S. Treasury futures - short..............................................
Markit IOS total return swaps - long .................................
Markit IOS total return swaps - short ................................
$
$
$
$
$
$
$
$
Notional
Amount
as of
December 31,
2011
3,700
3,803
30,250
3,200
880
783
41
206
Additions
140,731
176,905
25,000
18,250
36,555
3,838
—
—
Fiscal Year 2012
Settlement,
Termination,
Expiration or
Exercise
Notional
Amount
as of
December 31,
2012
Amount of
Gain/(Loss)
Recognized in
Income on
Derivatives(1)
(122,576) $
21,855
$
(171,330) $
(8,400) $
(7,000) $
(25,600) $
(4,621) $
(41) $
(206) $
9,378
46,850
14,450
11,835
—
—
—
444
(413)
(1,034)
(106)
(142)
(90)
—
—
$
(1,341)
________________________________
1.
Excludes a gain of $17 million from interest-only and principal-only securities, a loss of $1 million from U.S. Treasury securities and a loss of $28
million from debt of consolidated VIEs re-measured at fair value through earnings recognized in gain (loss) on derivative instruments and other
securities, net in our consolidated statement of comprehensive income.
During fiscal years 2011 and 2010, we held both designated and non-hedge designated derivative instruments under ASC
815.
The following tables summarize the effect of non-hedge designated derivative instruments on our consolidated statements
of comprehensive income for fiscal years 2011 and 2010 (in millions):
Fiscal Year 2011
Notional
Amount
as of
December
31, 2010
Additions Due
to Hedge De-
Designations
Settlement,
Termination,
Expiration or
Exercise
Additions
Notional
Amount
as of
December
31, 2011
Amount of
Gain/(Loss)
Recognized in
Income on
Derivatives(1)
(48,300) $
3,700
$
160
512
51,488
1,361
100,077
—
—
(97,635) $
3,803
50
850
—
250
—
—
—
—
—
6,750
5,600
250
15,794
50
1,133
200
1,195
685
23,900
(450) $
30,250
—
—
—
—
—
—
—
—
(3,250) $
3,200
(250) $
(15,164) $
(50) $
(350) $
(200) $
(1,154) $
(479) $
—
880
—
783
—
41
206
(302)
(119)
(63)
(1)
(133)
—
(12)
1
(7)
14
$
(462)
Non Designated Derivative and Other
Hedging Instruments
Purchase of TBA and forward settling agency
securities ................................................................
Sale of TBA and forward settling agency
securities ................................................................
Interest rate swaps .................................................
Payer swaptions .....................................................
Receiver swaptions................................................
Short sales of U.S. Treasury securities..................
US Treasury futures - long ....................................
US Treasury futures - short....................................
Put options .............................................................
Markit IOS total return swaps - long.....................
Markit IOS total return swaps - short ....................
______________________
$
$
$
$
$
$
$
$
$
$
$
1.
Excludes a loss of $17 million from interest-only and principal-only securities re-measured at fair value through earnings, a loss of $2 million for hedge
ineffectiveness on our outstanding interest rate swaps and a gain of $34 million from U.S. Treasury securities in gain (loss) on derivative instruments
and other securities, net in our consolidated statement of comprehensive income.
85
Non Designated Derivative and Other
Hedging Instruments
Notional
Amount
as of
December
31, 2009
Purchase of TBA and forward settling agency securities ...............
Sale of TBA and forward settling agency securities.......................
Interest rate swaps...........................................................................
Payer swaptions ..............................................................................
Receiver swaptions .........................................................................
Short sales of U.S. Treasury securities ...........................................
Put options ......................................................................................
$
$
$
$
$
$
$
597
617
—
200
100
—
—
Fiscal Year 2010
Settlement,
Termination,
Expiration or
Exercise
Notional
Amount
as of
December
31, 2010
Amount of
Gain/(Loss)
Recognized in
Income on
Derivatives(1)
(6,747) $
512
$
(16,193) $
1,361
(300) $
(200) $
(400) $
(500) $
(75) $
50
850
—
250
—
$
19
11
(3)
19
—
(2)
—
44
Additions
6,662
16,937
350
850
300
750
75
______________________
1.
Excludes a loss of $1 million from interest-only and principal-only securities re-measured at fair value through earnings and a loss of $5 million from
U.S. Treasury securities in gain (loss) on derivative instruments and other securities, net in our consolidated statement of comprehensive income for
the year ended December 31, 2010.
The following tables summarize information about our outstanding interest rate swaps designated as hedging instruments
under ASC 815 and their effect on our consolidated statement of comprehensive income for fiscal years 2011 and 2010 (in
millions):
Interest Rate Swaps Designated
as Hedging Instruments
Beginning
Notional
Amount
Additions
Expirations /
Terminations
Hedge De-
Designations
Ending
Notional Amount
Fiscal year 2011............................................................ $
Fiscal year 2010............................................................ $
6,450
2,050
17,900
4,400
(450)
—
(23,900) $
— $
—
6,450
Interest Rate Swaps Designated
as Hedging Instruments:
Amount of
Gain or (Loss)
Recognized in
OCI
(Effective
Portion)
Location of Gain
or (Loss)
Reclassified from
OCI into
Earnings (Effective
Portion)
Amount of (Gain) or
Loss Reclassified
from OCI into
Earnings
(Effective Portion)
Fiscal year 2011 ........................
Fiscal year 2010 ........................
$
$
(707)
Interest expense
(21)
Interest expense
$
$
(140)
(57)
Amount of Gain
or (Loss)
Recognized in
Earnings
(Ineffective
Portion and
Amount
Excluded from
Effectiveness
Testing)
$
$
(2)
—
Location of Gain or (Loss)
Recognized in Earnings
(Ineffective Portion and
Amount Excluded from
Effectiveness Testing)
Gain (loss) on derivative
instruments and other
securities, net
Gain (loss) on derivative
instruments and other
securities, net
During fiscal years 2011 and 2010, we also held forward contracts to purchase TBA and specified agency securities that
were designated as cash flow hedges under to ASC 815. The following tables summarize information about these securities and
their effect on our consolidated statement of comprehensive income for fiscal years 2011 and 2010 (dollars in millions):
Purchases of TBAs and Forward
Settling Agency Securities
Designated as Hedging Instruments
Beginning
Notional
Amount
Additions
Settlement /
Expirations
Ending
Notional
Amount
Fair Value
as of
Period End
Average
Maturity
as of
Period End
(Months)
Fiscal year 2011................................... $
Fiscal year 2010................................... $
245
$
— $
— $
742
$
(245) $
(497) $
— $
245
$
—
(3)
—
1
86
Purchases of TBAs and Forward
Settling Agency Securities
Designated as Hedging Instruments
Amount of Gain
or (Loss)
Recognized
in OCI for Cash
Flow Hedges
(Effective
Portion)
Amount of (Gain) or
Loss Recognized in
OCI for Cash Flow
Hedges and
Reclassified to OCI for
Available-for-Sale
Securities
(Effective Portion)
Fiscal year 2011 ............................................
Fiscal year 2010 ............................................
$
$
— $
(3) $
(3)
(3)
Location of Gain or (Loss)
Recognized in Earnings
(Ineffective Portion and
Amount Excluded from
Effectiveness Testing)
Gain (loss) on derivative
instruments and other
securities, net
Gain (loss) on derivative
instruments and other
securities, net
Amount of Gain or
(Loss) Recognized
in Earnings
(Ineffective Portion
and Amount
Excluded from
Effectiveness
Testing)
$
$
—
—
Credit Risk-Related Contingent Features
The use of derivatives creates exposure to credit risk relating to potential losses that could be recognized in the event that
the counterparties to these instruments fail to perform their obligations under the contracts. We minimize this risk by limiting our
counterparties to major financial institutions with acceptable credit ratings and monitoring positions with individual counterparties.
In addition, we may be required to pledge assets as collateral for our derivatives, whose amounts vary over time based on the
market value, notional amount and remaining term of the derivative contract. In the event of a default by a counterparty we may
not receive payments provided for under the terms of our derivative agreements, and may have difficulty obtaining our assets
pledged as collateral for our derivatives. The cash and cash equivalents and agency securities pledged as collateral for our derivative
instruments is included in restricted cash and agency securities, respectively, on our consolidated balance sheets.
Each of our International Swaps and Derivatives Association ("ISDA") Master Agreements contains provisions under which
we are required to fully collateralize our obligations under the swap instrument if at any point the fair value of the swap represents
a liability greater than the minimum transfer amount contained within our agreements. We were also required to post initial collateral
upon execution of certain of our swap transactions. If we breach any of these provisions, we will be required to settle our obligations
under the agreements at their termination values.
Further, each of our ISDA Master Agreements also contains a cross default provision under which a default under certain
of our other indebtedness in excess of a certain threshold causes an event of default under the agreement. Threshold amounts vary
by lender. Following an event of default, we could be required to settle our obligations under the agreements at their termination
values. Additionally, under certain of our ISDA Master Agreements, we could be required to settle our obligations under the
agreements at their termination values if we fail to maintain certain minimum shareholders’ equity thresholds or our REIT status
or if we fail to comply with limits on our leverage above certain specified levels.
As of December 31, 2012, the fair value and termination value of our interest rate swaps in a liability position related to
these agreements was $1.2 billion. We had agency securities with fair values of $1.1 billion and restricted cash of $249 million
pledged as collateral against our interest rate swap agreements.
Note 6. Fair Value Measurements
We determine the fair value of our agency securities and debt of consolidated VIEs based upon fair value estimates obtained
from multiple third party pricing services and dealers. In determining fair value, third party pricing sources use various valuation
approaches, including market and income approaches. Factors used by third party sources in estimating the fair value of an
instrument may include observable inputs such as coupons, primary and secondary mortgage rates, pricing information, credit
data, volatility statistics, and other market data that are current as of the measurement date. The availability of observable inputs
can vary by instrument and is affected by a wide variety of factors, including the type of instrument, whether the instrument is
new and not yet established in the marketplace and other characteristics particular to the instrument. Third party pricing sources
may also use certain unobservable inputs, such as assumptions of future levels of prepayment, defaults and foreclosures, especially
when estimating fair values for securities with lower levels of recent trading activity. We make inquiries of third party pricing
sources to understand the significant inputs and assumptions they used to determine their prices. For further information regarding
valuation of our derivative instruments, please refer to the discussion of derivative and other hedging instruments in Note 2.
We review the various third party fair value estimates and perform procedures to validate their reasonableness, including an
analysis of the range of third party estimates for each position, comparison to recent trade activity for similar securities, and
management review for consistency with market conditions observed as of the measurement date. While we do not adjust prices
87
we obtain from third party pricing sources, we will exclude third party prices for securities from our determination of fair value
if we determine (based on our validation procedures and our market knowledge and expertise) that the price is significantly different
than observable market data would indicate and we cannot obtain an understanding from the third party source as to the significant
inputs used to determine the price.
The validation procedures described above also influence our determination of the appropriate fair value measurement
classification. We utilize a three-level valuation hierarchy for disclosure of fair value measurement. The valuation hierarchy is
based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. A financial instrument's
categorization within the hierarchy is based upon the lowest level of input that is significant to the fair value measurement. There
were no transfers between hierarchy levels during fiscal year 2012 and 2011. The three levels of hierarchy are defined as follows:
• Level 1 Inputs —Quoted prices (unadjusted) for identical unrestricted assets and liabilities in active markets that are
accessible at the measurement date.
• Level 2 Inputs —Quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar
instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant
value drivers are observable.
• Level 3 Inputs —Instruments with primarily unobservable market data that cannot be corroborated.
The following table provides a summary of our assets and liabilities that are measured at fair value on a recurring basis as
of December 31, 2012 and 2011 (dollars in millions):
88
Fair Value Hierarchy
Level 1
Level 2
Level 3
December 31, 2012
Assets:
Agency securities........................................................................ $
— $
85,245
$
Interest rate swaps.......................................................................
Payer swaptions ..........................................................................
Other derivative instruments.......................................................
—
—
—
14
171
116
Total ................................................................................................ $
— $
85,546
Liabilities:
Debt of consolidated VIEs.......................................................... $
— $
937
Obligation to return U.S. Treasury securities borrowed under
reverse repurchase agreements ...................................................
Interest rate swaps.......................................................................
Other derivative instruments.......................................................
11,763
—
—
—
1,243
21
$
$
Total ................................................................................................ $
11,763
$
2,201
$
December 31, 2011
Assets:
Agency securities........................................................................ $
— $
54,683
$
U.S. Treasury securities ..............................................................
Interest rate swaps.......................................................................
Other derivative instruments.......................................................
101
—
—
—
13
69
Total ................................................................................................ $
101
$
54,765
Liabilities:
Debt of consolidated VIEs (1)...................................................... $
Obligation to return U.S. Treasury securities borrowed under
reverse repurchase agreements ...................................................
U.S. Treasury futures ..................................................................
Interest rate swaps.......................................................................
Other derivative instruments.......................................................
— $
899
14
—
—
54
—
—
795
44
$
$
Total ................................................................................................ $
913
$
893
$
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
_______________________
1.
This amount is recorded at cost basis which closely approximates its fair value.
Note 7. Management Agreement and Related Party Transactions
We are externally managed and advised by our Manager pursuant to the terms of a management agreement. The management
agreement has been renewed through May 20, 2013 and provides for automatic one-year extension options thereafter. The
management agreement may only be terminated by either us or our Manager without cause, as defined in the management agreement,
after the completion of the current renewal term, or the expiration of each subsequent automatic annual renewal term, provided
that either party provide 180-days prior written notice of non-renewal of the management agreement. If we were to not renew the
management agreement without cause, we must pay a termination fee on the last day of the applicable term, equal to three times
the average annual management fee earned by our Manager during the prior 24-month period immediately preceding the most
recently completed month prior to the effective date of termination. We may only not renew the management agreement with or
without cause with the consent of the majority of our independent directors. We pay our Manager a base management fee payable
monthly in arrears in amount equal to one twelfth of 1.25% of our Equity. Our Equity is defined as our month-end stockholders'
equity, adjusted to exclude the effect of any unrealized gains or losses included in either retained earnings or OCI, each as computed
in accordance with GAAP. There is no incentive compensation payable to our Manager pursuant to the management agreement.
For fiscal years 2012, 2011 and 2010, we recorded an expense for management fees of $113 million, $55 million and $11 million,
respectively.
89
We are obligated to reimburse our Manager for its expenses incurred directly related to our operations, excluding employment-
related expenses of our Manager's officers and employees and any American Capital employees who provide services to us pursuant
to the management agreement. Our Manager has entered into an administrative services agreement with American Capital, pursuant
to which American Capital will provide personnel, services and resources necessary for our Manager to perform its obligations
under the management agreement. For fiscal years 2012, 2011 and 2010, we recorded expense reimbursements to our Manager
of $9 million, $7 million and $3 million, respectively. As of December 31, 2012 and 2011, $1 million and $8 million was payable
to our Manager, respectively.
Concurrent with our IPO, American Capital purchased 5.0 million shares of our common stock in a private placement at our
IPO price of $20.00 per share for aggregate proceeds of $100 million. In July 2009, through a public secondary offering, American
Capital sold 2.5 million shares of our common stock that it had purchased in the private placement. In November 2010, through
a subsequent private placement, American Capital sold its remaining 2.5 million shares of our common stock that it had purchased
in the original private placement. As of December 31, 2012 American Capital does not hold any shares of our common stock.
Note 8. Income Taxes
The following table summarizes dividends for federal income tax purposes declared for fiscal years 2012, 2011 and 2010
and their related tax characterization (in millions, except per share amounts):
Fiscal Tax Year
Series A Cumulative Redeemable Preferred Stock Dividends
Fiscal year 2012 (1) ................................................................................
Common Stock Dividends
Fiscal year 2012 ....................................................................................
Fiscal year 2011 ....................................................................................
Fiscal year 2010 ....................................................................................
Dividends
Declared Per
Share
Dividends
Declared
Ordinary
Income Per
Share
Long-Term
Capital Gains
Per Share
Tax Characterization
$
$
$
$
1.056
5.00
5.60
5.60
$
$
$
$
7
1,518
886
230
$
$
$
$
0.9523
4.5092
5.3324
4.9314
$
$
$
$
0.1037
0.4908
0.2676
0.6686
______________________
1. Excludes preferred stock dividend of $0.50 per share declared on December 17, 2012 having a record date of January 1, 2013, which for federal income tax
purposes is a fiscal year 2013 dividend.
As of December 31, 2012, we had approximately $749 million of estimated undistributed taxable income that we expect to
declare by the extended due date of our 2012 federal income tax return and pay in 2013. Accordingly, we do not expect to incur
any income tax liability on our 2012 taxable income.
For fiscal years 2012 and 2011, we did not distribute the required minimum amount of taxable income pursuant to federal
excise tax requirements, as described in Note 2, and consequently we accrued an excise tax of $25 million and $2 million,
respectively, which is included in our net income tax provision on our accompanying consolidated statements of operations and
comprehensive income.
For fiscal years 2012 and 2011, we recorded an income tax benefit of $6 million and an income tax provision of $4 million,
respectively, attributable to our TRS, which is included in our net income tax provision on our accompanying consolidated
statements of comprehensive income. The statutory combined federal and state corporate tax rate for our TRS was 39.5% for fiscal
years 2012 and 2011. For the fiscal year 2010 we had no activity in our TRS.
Based on our analysis of any potential uncertain income tax positions, we concluded that we do not have any uncertain tax
positions that meet the recognition or measurement criteria of ASC 740 as of December 31, 2012, 2011 and 2010. Our tax returns
for tax years 2008 through 2012 are open to examination by the IRS. In the event that we incur income tax related interest and
penalties, our policy is to classify them as a component of provision for income taxes.
90
Note 9. Stockholders' Equity
Preferred Stock Offering
Pursuant to our amended and restated certificate of incorporation, we are authorized to designate and issue up to 10.0 million
shares of preferred stock in one or more classes or series. Our board of directors has designated 6.9 million shares as 8.000%
Series A Cumulative Redeemable Preferred Stock ("Series A Preferred Stock"). As of December 31, 2012, we have 3.1 million
of authorized but unissued shares of preferred stock. Our board of directors may designate additional series of authorized preferred
stock ranking junior to or in parity with the Series A Preferred Stock or designate additional shares of the Series A Preferred Stock
and authorize the issuance of such shares.
In April 2012, we completed a public offering in which 6.9 million shares of our Series A Preferred Stock were sold to the
underwriters at a price of $24.21 per share. Upon completion of the offering we received proceeds, net of offering expenses, of
approximately $167 million. Our Series A Preferred Stock has no stated maturity and is not subject to any sinking fund or mandatory
redemption. Under certain circumstances upon a change of control, the Series A Preferred Stock is convertible to shares of our
common stock. Holders of Series A Preferred Stock have no voting rights, except under limited conditions, and holders are entitled
to receive cumulative cash dividends at a rate of 8.000% per annum of the $25.00 per share liquidation preference before holders
of our common stock are entitled to receive any dividends. Shares of our Series A Preferred Stock are redeemable at $25.00 per
share plus accumulated and unpaid dividends (whether or not declared) exclusively at our option commencing on April 5, 2017,
or earlier under certain circumstances intended to preserve our qualification as a REIT for Federal income tax purposes. Dividends
are payable quarterly in arrears on the 15th day of each January, April, July and October. As of December 31, 2012, we had
declared all required quarterly dividends on our Series A Preferred Stock.
Equity Offerings
During fiscal years 2012, 2011 and 2010, we completed follow-on public offerings of shares of our common stock summarized
in the table below (in millions, except per share amounts):
Public Offering
Fiscal Year 2012
March 2012.............................
July 2012 ................................
Total fiscal year 2012 .........
Fiscal Year 2011
January 2011...........................
March 2011.............................
June 2011................................
November 2011 ......................
Total fiscal year 2011 .........
Fiscal Year 2010
May 2010................................
October 2010 ..........................
December 2010.......................
Total fiscal year 2010 .........
Price Received
Per Share (1)
Shares
Net Proceeds (2)
$29.00
$33.70
$28.00
$27.72
$27.56
$27.36
$25.75
$26.00
$27.44
71.2
36.8
108.0
$
$
26.9
$
32.2
49.7
40.5
149.3
$
6.9
$
13.2
8.3
28.4
$
2,063
1,240
3,303
719
892
1,369
1,108
4,088
169
328
227
724
________________________
Price received per share is gross of underwriters’ discount, if applicable.
1.
2. Net proceeds are net of the underwriters’ discount, if applicable, and other offering costs.
At-the-Market Offering Program
We have sales agreements with sales agents to publicly offer and sell shares of our common stock in privately negotiated
and/or at-the-market transactions from time to time. The table below summarizes sales our common stock under such sales
agreements during fiscal years 2012, 2011 and 2010 (in millions, except per share amounts):
91
Price Received
Per Share
At-the-Market Offering
Fiscal year 2012......................... $
Fiscal year 2011......................... $
Fiscal year 2010......................... $
Shares
Net Proceeds
9.5
9.4
4.4
$
$
$
298
273
127
31.41
29.25
29.13
As of December 31, 2012, 16.7 million shares remain available of issuance under our sales agreements.
Dividend Reinvestment and Direct Stock Purchase Plan
We sponsor a dividend reinvestment and direct stock purchase plan through which stockholders may purchase additional
shares of our common stock by reinvesting some or all of the cash dividends received on shares of our common stock. Stockholders
may also make optional cash purchases of shares of our common stock subject to certain limitations detailed in the plan prospectus.
During fiscal years 2011 and 2010, we issued 0.5 million and 7.7 million shares under the plan for net cash proceeds of $15 million
and $204 million, respectively. During the fiscal year 2012, there were no shares issued under the plan. As of December 31, 2012,
4.7 million shares remain available for issuance under the plan.
Stock Repurchase Program
In October 2012, our Board of Directors adopted a plan that may provide for stock repurchases of up to $500 million of
our outstanding shares of common stock through December 31, 2013. Shares of our common stock may be purchased in the open
market, including through block purchases, or through privately negotiated transactions, or pursuant to any trading plan that may
be adopted in accordance with Rule 10b5-1 of the Securities and Exchange Commission. The timing, manner, price and amount
of any repurchases will be determined at our discretion and the program may be suspended, terminated or modified at any time
for any reason. We intend to repurchase shares only when the purchase price is less than our estimate of our current net asset
value per share of our common stock. Generally, when we repurchase our common stock at a discount to our net asset value, the
net asset value of our remaining shares of common stock outstanding increases. In addition, we do not intend to repurchase any
shares from directors, officers or other affiliates. The program does not obligate us to acquire any specific number of shares, and
all repurchases will be made in accordance with SEC Rule 10b-18, which sets certain restrictions on the method, timing, price
and volume of stock repurchases. During fiscal year 2012, we made open market purchases of 2.7 million share of our common
stock at an average net repurchase price of $29.00 per share, or $77 million.
Long-term Incentive Plan
We sponsor an equity incentive plan to provide for the issuance of equity-based awards, including stock options, restricted
stock, restricted stock units and unrestricted stock awards to our independent directors. During fiscal years 2012, 2011 and 2010,
our independent directors received restricted common stock awards under the plan. The restricted stock awards have a grant date
fair value equal to the price of our common stock on such date and vest annually over three years. During fiscal year 2012, we
granted 3,000 shares of restricted stock to each independent director, or a total of 12,000 shares, with a grant date fair value of
$29.48 per share. During fiscal year 2011, we granted 3,000 shares of restricted stock to each independent director, or a total of
12,000 shares, with a weighted average grant date fair value of $29.05 per share. During fiscal year 2010, we granted 1,500 shares
of restricted stock to each independent director, or a total of 4,500 shares, with a grant date fair value of $25.73 per share. During
fiscal years 2012, 2011 and 2010, an aggregate of 7,000, 4,500 and 3,000 shares of restricted stock vested under the plan, respectively.
During fiscal years 2012, 2011 and 2010, we recognized approximately $282,000, $176,000 and $94,000 of compensation expense
under the plan, respectively. As of December 31, 2012 and 2011, there was an aggregate 21,500 and 16,500 shares of unvested
restricted stock outstanding under the plan, respectively. As of December 31, 2012, 62,500 common shares remained available
for future issuance under the plan.
92
Note 10. Quarterly Results (Unaudited)
The following is a presentation of the quarterly results of operations and comprehensive income for fiscal years 2012 and
2011 (in thousands, except per share data).
Interest income:
Interest income ............................................................................ $
Interest expense ...........................................................................
Net interest income...............................................................
Other income (loss):
Gain on sale of agency securities, net .........................................
Gain (loss) on derivative instruments and other securities, net...
Total other income (loss), net...............................................
Expenses:
Management fees.........................................................................
General and administrative expenses ..........................................
Total expenses ......................................................................
Income (loss) before income tax (benefit)
Income tax provision (benefit), net .............................................
Net income (loss).............................................................................
Dividend on preferred stock ........................................................
Net income (loss) available (attributable) to common
shareholders.................................................................................... $
Net income (loss).............................................................................
Other comprehensive income:.......................................................
Unrealized (loss) gain on available-for-sale securities, net ......
Unrealized gain on derivative instruments, net.........................
Other comprehensive (loss) income...................................
Comprehensive income ..................................................................
Dividend on preferred stock ........................................................
Comprehensive income available to common shareholders....... $
Weighted average number of common shares outstanding-
basic and diluted .......................................................................
Net income (loss) per common share - basic and diluted............ $
Comprehensive income per common share - basic and diluted. $
Dividends declared per common share......................................... $
Quarter Ended
March 31,
2012
June 30,
2012
September 30,
2012
December 31,
2012
514
106
408
216
47
263
22
6
28
643
2
641
—
$
$
504
120
384
$
520
139
381
417
(1,029)
(612)
28
8
36
(264)
(3)
(261)
3
210
(460)
(250)
32
8
40
91
5
86
3
641
$
(264) $
83
$
641
(261)
86
570
147
423
353
89
442
31
9
40
825
15
810
3
807
810
(106)
52
(54)
587
—
587
240.6
2.66
2.44
1.25
$
$
$
$
689
52
741
480
3
477
$
301.0
(0.88) $
$
1.58
$
1.25
1,190
51
1,241
1,327
3
1,324
332.8
0.25
3.98
1.25
$
$
$
$
(734)
50
(684)
126
3
123
340.3
2.37
0.36
1.25
93
Interest income:
Interest income ............................................................................ $
Interest expense ...........................................................................
Net interest income...............................................................
Other income (loss):
Gain on sale of agency securities, net .........................................
Gain (loss) on derivative instruments and other securities, net...
Total other income (loss), net...............................................
Expenses:
Management fees.........................................................................
General and administrative expenses ..........................................
Total expenses ......................................................................
Income before taxes
Provision for income taxes ..........................................................
Net income....................................................................................... $
Other comprehensive income:.......................................................
Unrealized (loss) gain on available-for-sale securities, net ......
Unrealized gain (loss) on derivative instruments, net...............
Other comprehensive income ............................................
Comprehensive income .................................................................. $
Weighted average number of common shares outstanding-
basic and diluted .......................................................................
Net income per common share - basic and diluted...................... $
Comprehensive income per common share - basic and diluted. $
Dividends declared per common share......................................... $
Quarter Ended
March 31,
2011
June 30,
2011
September 30,
2011
December 31,
2011
165
36
129
4
12
16
8
3
11
134
—
134
(41)
61
20
154
90.3
1.48
1.71
1.40
$
$
$
$
$
$
$
265
65
200
$
327
94
233
94
(100)
(6)
12
5
17
177
—
177
319
(252)
67
244
130.5
1.36
1.87
1.40
$
$
$
$
$
263
(222)
41
16
6
22
252
1
251
535
(513)
22
273
180.7
1.39
1.51
1.40
$
$
$
$
$
353
91
262
112
(137)
(25)
18
6
24
213
5
208
216
54
270
478
210.3
0.99
2.27
1.40
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A. Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our
Securities Exchange Act of 1934, as amended (the “Exchange Act”) reports is recorded, processed, summarized and reported
within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to
our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions
regarding required disclosure based on the definition of “disclosure controls and procedures” as promulgated under the Exchange
Act and the rules and regulations thereunder. In designing and evaluating the disclosure controls and procedures, management
recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance
of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-
benefit relationship of possible controls and procedures.
We, including our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation
of our disclosure controls and procedures as of December 31, 2012. Based on the foregoing, our Chief Executive Officer and Chief
Financial Officer concluded that our disclosure controls and procedures were effective.
Changes in Internal Controls over Financial Reporting
There have been no changes in our “internal control over financial reporting” (as defined in Rule 13a-15(f) of the Exchange
Act) that occurred during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting.
94
Item 9B. Other Information
None.
95
Item 10. Directors, Executive Officers and Corporate Governance.
PART III.
Information in response to this Item is incorporated herein by reference to the information provided in our Proxy Statement
for our 2013 Annual Meeting of Stockholders (the “2013 Proxy Statement”) under the headings “PROPOSAL 1: ELECTION OF
DIRECTORS”, "EXECUTIVE OFFICERS", “SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE”
and “CODE OF ETHICS AND CONDUCT.”
Item 11. Executive Compensation.
Information in response to this Item is incorporated herein by reference to the information provided in the 2013 Proxy
Statement under the headings "PROPOSAL 1: ELECTION OF DIRECTORS", "EXECUTIVE COMPENSATION" and "REPORT
OF THE COMPENSATION AND GOVERNANCE COMMITTEE."
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
Information in response to this Item is incorporated herein by reference to the information provided in the 2013 Proxy
Statement under the heading “SECURITY OWNERSHIP OF MANAGEMENT AND CERTAIN BENEFICIAL OWNERS.”
Item 13. Certain Relationships and Related Transactions, and Director Independence.
Information in response to this Item is incorporated herein by reference to the information provided in the 2013 Proxy
Statement under the headings “CERTAIN TRANSACTIONS WITH RELATED PERSONS” and "PROPOSAL 1: ELECTION
OF DIRECTORS."
Item 14. Principal Accounting Fees and Services.
Information in response to this Item is incorporated herein by reference to the information provided in the 2013 Proxy
Statement under the heading “PROPOSAL 4: RATIFICATION OF SELECTION OF INDEPENDENT PUBLIC
ACCOUNTANT.”
96
PART IV.
Item 15.
Exhibits and Financial Statement Tables
(a) List of documents filed as part of this report:
(1) The following financial statements are filed herewith:
Consolidated Balance Sheets as of December 31, 2012 and 2011
Consolidated Statements of Comprehensive Income for the years ended December 31, 2012, 2011 and
2010
Consolidated Statements of Stockholders' Equity for the years ended December 31, 2012, 2011 and 2010
Consolidated Statements of Cash Flows for the years ended December 31, 2012, 2011 and 2010
(2) The following exhibits are filed herewith or incorporated herein by reference
Exhibit No.
Description
*3.1 American Capital Agency Corp. Amended and Restated Certificate of Incorporation, as amended, incorporated
herein by reference to Exhibit 3.1 of Form 10-Q for the quarter ended March 31, 2012(File No. 001-34057),
filed May 9, 2012.
*3.2 American Capital Agency Corp. Second Amended and Restated Bylaws, as amended, incorporated herein by
reference to Exhibit 3.2 of Form 10-K for the year ended December 31, 2011 (File No. 001-34057), filed
February 23, 2012.
*3.3 Certificate of Designations of 8.000% Series A Cumulative Redeemable Preferred Stock, incorporated herein
by reference to Exhibit 3.1 of Form 8-K (File No 001-34057), filed April 3, 2012.
*4.1 Instruments defining the rights of holders of securities: See Article IV of our Amended and Restated Certificate
of Incorporation, as amended, incorporated herein by reference to Exhibit 3.1 of Form 10-Q for the quarter
ended March 31, 2012 (File No. 001-34057), filed May 9, 2012.
*4.2 Instruments defining the rights of holders of securities: See Article VI of our Second Amended and Restated
Bylaws, as amended, incorporated herein by reference to Exhibit 3.2 of Form 10-K for the year ended
December 31, 2011 (File No. 001-34057), filed February 23, 2012.
*4.3 Form of Certificate for Common Stock, incorporated herein by reference to Exhibit 4.1 to Amendment No. 4 to
the Registration Statement on Form S-11 (Registration No. 333-149167), filed May 9, 2008.
*4.4 Specimen 8.000% Series A Cumulative Redeemable Preferred Stock Certificate, incorporated herein by
reference to Exhibit 4.1 of Form 8-K (File No. 001-34057), filed April 3, 2012.
*10.1 Management Agreement between American Capital Agency Corp. and American Capital Agency Management,
LLC, dated May 20, 2008, incorporated herein by reference to Exhibit 10.2 of Form 10-Q for the quarter ended
June 30, 2008 (File No. 001-34057), filed August 14, 2008.
*10.2 Assignment and Amendment Agreement, dated July 29, 2011, among American Capital Agency Management,
LLC, American Capital AGNC Management, LLC and American Capital Agency Corp., incorporated herein by
reference to Exhibit 10.1 of Form 10-Q for the quarter ended September 30, 2011 (File No. 001-34057), filed
November 7, 2011.
*10.3 Amendment and Joinder to Management Agreement, dated September 30, 2011, between American Capital
Agency TRS, LLC and American Capital AGNC Management, LLC, incorporated herein by reference to
Exhibit 10.2 of Form 10-Q for the quarter ended September 30, 2011 (File No. 001-34057), filed November 7,
2011.
†*10.4 American Capital Agency Corp. Equity Incentive Plan for Independent Directors, incorporated herein by
reference to Exhibit 10.1 of Registration Statement on Form S-8 (File No. 333-151027), filed May 20, 2008.
†*10.5 Form of Restricted Stock Agreement for independent directors, incorporated herein by reference to Exhibit 10.1
of Form 8-K (File No. 001-34057), filed December 12, 2011.
*10.6 Sales Agreement, dated December 1, 2011, among American Capital Agency Corp., American Capital AGNC
Management, LLC and Cantor Fitzgerald & Co., incorporated herein by reference to Exhibit 10.10 of Form 10-
K for the year ended December 31, 2011 (File No. 001-34057), filed February 23, 2012.
97
*10.7 Sales Agreement, dated December 1, 2011, among American Capital Agency Corp., American Capital AGNC
Management, LLC and Mitsubishi UFJ Securities (USA), Inc., incorporated herein by reference to Exhibit
10.11 of Form 10-K for the year ended December 31, 2011 (File No. 001-34057), filed February 23, 2012.
12.1 Computation of ratio of earnings to combined fixed charges and preferred stock dividends and ratio of earnings
to fixed charges.
*14 American Capital Agency Corp. Code of Ethics and Conduct, adopted May 12, 2008, incorporated herein by
reference to Exhibit 14.1 of Form 10-K for the year ended December 31, 2010 (File No. 001-34057), filed
February 25, 2011.
21 Subsidiaries of the Company and jurisdiction of incorporation:
1) American Capital Agency TRS, LLC, a Delaware limited liability company
23 Consent of Ernst & Young LLP, filed herewith
24 Powers of Attorneys of directors and officers, filed herewith.
31.1 Certification of CEO Pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.
31.2 Certification of CFO Pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.
32 Certification of CEO and CFO Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS** XBRL Instance Document
101.SCH** XBRL Taxonomy Extension Schema Document
101.CAL** XBRL Taxonomy Extension Calculation Linkbase Document
101.LAB** XBRL Taxonomy Extension Labels Linkbase Document
101.PRE** XBRL Taxonomy Extension Presentation Linkbase Document
101.DEF** XBRL Taxonomy Extension Definition Linkbase Document
______________________
*
**
Previously filed
This exhibit is being furnished rather than filed, and shall not be deemed incorporated by reference into any filing, in
accordance with Item 601 of Regulation S-K
Management contract or compensatory plan or arrangement
†
(b) Exhibits
See the exhibits filed herewith.
(c) Additional financial statement schedules
NONE
98
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly
caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
SIGNATURES
AMERICAN CAPITAL AGENCY CORP.
By:
/s/ MALON WILKUS
Malon Wilkus
Chair of the Board of Directors and
Chief Executive Officer
Date: February 27, 2013
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons
on behalf of the registrant and in the capacities and on the dates indicated.
Name
Title
Date
*
Malon Wilkus
Chair of the Board of Directors
and Chief Executive Officer
(Principal Executive Officer)
February 27, 2013
February 27, 2013
February 27, 2013
February 27, 2013
February 27, 2013
February 27, 2013
February 27, 2013
February 27, 2013
/s/ JOHN R. ERICKSON
Director, Chief Financial Officer
and Executive Vice President
(Principal Financial and
Accounting Officer)
John R. Erickson
*
Robert M. Couch
*
Morris A. Davis
*
Randy E. Dobbs
*
Samuel A. Flax
*
Larry K. Harvey
*
Alvin N. Puryear
*By:
/s/ JOHN R. ERICKSON
John R. Erickson
Attorney-in-fact
Director
Director
Director
Director
Director
Director
99
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[THIS PAGE INTENTIONALLY LEFT BLANK]
Board of Directors
Malon Wilkus
Chair & Chief Executive Officer, American Capital
Agency Corp.; Chief Executive Officer, American
Capital AGNC Management, LLC
Samuel A. Flax
Director, Executive Vice President & Secretary,
American Capital Agency Corp.; Executive Vice
President, Chief Compliance Officer & Secretary,
American Capital AGNC Management, LLC
Morris A. Davis, Ph.D.
Academic Director of the James A. Graaskamp Center
for Real Estate and the James A. Graaskamp Chair of
Real Estate in the Department of Real Estate and
Urban Land Economics at the University of
Wisconsin-Madison
Larry K. Harvey
Executive Vice President & Chief Financial Officer,
Host Hotels & Resorts, Inc. (NYSE: HST)
Executive Officers
John R. Erickson
Director, Chief Financial Officer & Executive Vice
President, American Capital Agency Corp.; Executive
Vice President & Treasurer, American Capital AGNC
Management, LLC
Robert M. Couch
Counsel, Bradley Arant Boult Cummings LLP;
Chairman, ARK Real Estate Strategies, LLC
Randy E. Dobbs
President & Chief Executive Officer, Matrix Medical
Network
Prue B. Larocca
Director
Alvin N. Puryear, Ph.D.
Professor Emeritus of Management and
Entrepreneurship, Baruch College of the City
University of New York; Management Consultant
Malon Wilkus
Chair & Chief Executive Officer, American Capital
Agency Corp.; Chief Executive Officer, American
Capital AGNC Management, LLC
Gary Kain
President & Chief Investment Officer, American
Capital Agency Corp.; President, American Capital
AGNC Management, LLC
John R. Erickson
Director, Chief Financial Officer & Executive Vice
President, American Capital Agency Corp.; Executive
Vice President & Treasurer, American Capital AGNC
Management, LLC
Samuel A. Flax
Director, Executive Vice President & Secretary,
American Capital Agency Corp.; Executive Vice
President, Chief Compliance Officer & Secretary,
American Capital AGNC Management, LLC
Peter J. Federico
Senior Vice President & Chief Risk Officer, American
Capital Agency Corp.; Senior Vice President & Chief
Risk Officer, American Capital AGNC Management,
LLC
Christopher J. Kuehl
Senior Vice President, Agency Portfolio Investments,
American Capital Agency Corp.; Senior Vice
President, American Capital AGNC
Management, LLC
Corporate Information
Auditors
Ernst & Young LLP, McLean, VA
Legal Counsel
Skadden, Arps, Slate, Meagher & Flom LLP, New
York, NY
Stock Exchange Listing
American Capital Agency Corp. common stock trades
on The NASDAQ Global Select Market under the
symbol AGNC. American Capital Agency Corp.
preferred stock trades on The NASDAQ Global Select
Market under the symbol AGNCP.
Transfer Agent and Registrar
Computershare Trust Company, N.A.
P.O. Box 43078
Providence, RI 02940-3078 (800) 733-5001
www.computershare.com/investor
Financial Publications
Stockholders may receive a copy of our 2012 Annual
Report on Form 10-K and our quarterly reports on
Form 10-Q filed with the Securities and Exchange
Commission by writing to:
American Capital Agency Corp.
Investor Relations
Two Bethesda Metro Center, 14th Floor
Bethesda, MD 20814
Investor Inquiries
Stockholders, securities analysts, portfolio managers
and others seeking information about our business
operations and financial performance are invited to
contact Investor Relations at: (301) 968-9300 or
IR@AGNC.com.
®
2 0 1 2 A N N U A L R E P O R T
A G N C . c o m (cid:2) N a s d a q : A G N C
®
Two Bethesda Metro Center, 14th Floor
Bethesda, MD 20814
Phone: (301) 968-9300
Fax: (301) 968-9301
Email: IR@AGNC.com
A G N C . c o m (cid:2) N a s d a q : A G N C
002CSN8182