Bringing Private Capital
to the U.S. Housing Market
Through Investment Excellence
2013 ANNUAL REPORTAGNC.COM | NASDAQ:AGNC Dear fellow shareholders,
2013 was a challenging and difficult year for the fixed income markets. As the economy began to show signs of
improvement and communication from the Federal Reserve (“Fed”) surrounding ending its third quantitative eas-
ing program (“QE3”) increased, interest rates rose and all fixed income markets suffered. The agency mortgage-
backed securities (“MBS”) market, being a direct beneficiary of the Fed’s large scale asset purchases, and because
of its inherent negative convexity, size and liquidity, was one of the hardest hit sectors across the broader fixed
income markets. As a result, our book value fell during 2013.
The open ended nature of QE3 significantly magnified the normal response of the bond market to stronger than
expected economic activity, triggering a dramatic rise in interest rates, with the 10 year Treasury rate increasing 64
basis points and 30 year mortgage rates increasing 70 basis points over the second quarter of 2013. By historical
standards, these rate moves are among the most violent ever experienced. The improving economic data and the
anticipation of QE3 tapering caused agency MBS to underperform relative to our swap and Treasury hedges.
Given that the Fed action was sooner than expected and the market’s reaction was very rapid, we couldn’t adjust
our positions as efficiently as if these events had occurred in a more measured fashion. Nevertheless, our manage-
ment team took steps to reduce leverage, increase the amount of hedges and dramatically alter the composition
of our asset portfolio. Together, these moves meaningfully reduced our exposure to rising rates and our exposure
to widening spreads between agency MBS and our hedges. These actions, however, incurred cost and the extra
expense negatively impacted the net spread income of our portfolio. Consistent with our more defensive portfo-
lio and our lower book value, our taxable income declined, which caused us to reduce our dividend. In 2013, we
declared $3.75 in dividends per common share, down from $5.00 per common share in 2012, but still sufficient to
produce a very attractive dividend yield of 13%.
Although agency MBS underperformed last year, these episodes of weakness have historically tended to be rela-
tively short-lived. In fact, conditions in the agency MBS market have already started to improve in 2014. As a result
of the Fed exiting its unprecedented participation in the mortgage market, we believe that the mortgage market
is returning to a normalized risk return environment. That, coupled with the portfolio rebalancing actions we took
last year, leads us to believe we will be able to continue to generate attractive returns for our shareholders in the
years ahead.
Risk Management
We seek to limit our exposure to changes in interest rates through the combination of our asset selection and
hedging strategies. As shown in the chart below, interest rate fluctuations in 2013 were extreme and rapid, as the
market sentiment shifted between “QE3 forever” to “taper tantrum.” The combination of improving economic
fundamentals and often “hawkish” comments from various members of the Federal Open Market Committee
(“FOMC”) created significant interest rate volatility. This volatility was most acute in the second and third quarters
of 2013, when the Fed indicated a possible tapering of its QE3 program.
2 013 A N N U A L R E P O R T
1
FIGURE 1 10-Year U.S. Treasury Rate during 2013
3.50%
3.00%
2.50%
2.00%
1.50%
Q1 2013
Q2 2013
Q3 2013
Q4 2013
Source: www.federalreserve.gov.
In response to this challenging interest rate environment, we assumed a more conservative posture with regard
to interest rate risk by gradually increasing the size of our hedge portfolio. As a result, our hedge ratio, which
measures the size of our hedge portfolio relative to our liabilities, peaked in the second quarter of 2013 at 101%,
its highest level ever. Through this action, we sought to reduce significantly our exposure to rising interest rates.
FIGURE 2 AGNC Hedge Ratio as of Quarter End, 2012–2013
88%
91%
81%
80%
94%
101%
91%
86%
120%
100%
80%
60%
40%
20%
0%
3/31/12
6/30/12
9/30/12
12/31/12
3/31/13
6/30/13
9/30/13
12/31/13
As an investor in MBS, a key risk that is inherent to our business model is “spread risk,” which is the risk that the
yield spread between our assets and our hedges changes in an adverse way. The spread risk associated with our
agency securities and the resulting fluctuations in fair value of these securities can occur independent of changes
in other benchmark interest rates such as interest rate swaps and treasury bonds. When the yield differential or
spread widens, our net book value is adversely impacted as the decline in value of our agency securities exceeds
the increase in value of our hedges.
2
A M E R I C A N C A P I TA L A G E N C Y
In 2013, the yield spread between agency MBS and other benchmark rates, like Treasuries and swap rates, widened
substantially as MBS investors became increasingly concerned about the uncertain timing of the Fed’s tapering of
its QE3 asset purchase program and its adverse impact on the agency MBS market. As shown in the graph below,
agency MBS spreads widened significantly early in the year as investors priced in the risk of sooner-than-expected
Fed tapering.
FIGURE 3 Current Coupon MBS vs. Blended 5- and 10-Year U.S. Treasury Yield
)
%
(
d
a
e
r
p
S
1.50%
1.25%
1.00%
0.75%
0.50%
0.25%
0.00%
Oct 31
2012
Nov 30
2012
Dec 31
2012
Jan 31
2013
Feb 28
2013
Mar 31
2013
Apr 30
2013
May 31
2013
June 30
2013
July 31
2013
Aug 31
2013
Sep 30
2013
Oct 31
2013
Nov 30
2013
Dec 31
2013
Source: Bloomberg and Citi, 10/1/12–12/31/13.
Asset Composition
During 2013, we shifted both the size and composition of our asset portfolio. Our December 31, 2013, “at-risk”
leverage was 7.5x, down from 8.2x as of December 31, 2012, inclusive of our net TBA position. In terms of asset
composition, we significantly reduced our exposure to 30-year MBS, particularly the lowest coupons, in favor of
15-year MBS. We increased our exposure to 15-year MBS from 39% of our agency MBS portfolio, inclusive of our net
TBA position, at December 31, 2012, to 51% at December 31, 2013, due to the lower duration and spread risk profile
of these securities. Importantly, 15-year MBS also return principal and “de-risk” at a much faster rate than 30-year
MBS over time. We believe these attributes, coupled with faster paydowns, will help our portfolio performance in
the post-QE3 environment.
2 013 A N N U A L R E P O R T
3
FIGURE 4 Hypothetical Cumulative Principal Paydown
15-Year MBS vs. 30-Year MBS as a % of Original Principal Balance
72%
57%
45%
37%
34%
FNMA 30-Year 4.0%
FNMA 15-Year 3.5%
22%
80%
60%
40%
20%
0%
Year 3
Year 5
Year 7
The hypothetical examples in the table above are derived from models that are dependent on inputs and assumptions and, accordingly, actual results could differ materially
from these estimates. The examples in the table above are represented by 30-year FNMA 4.0% and 15-year FNMA 3.5% MBS with the following Day 1 characteristics and
assumptions: 30-year 4.0% MBS with a 4.5% WAC, 330 WAM, 30 WALA and 6 CPR. 15-year 3.5% MBS with a 4.0% WAC, 150 WAM, 30 WALA and 8 CPR.
FIGURE 5 AGNC Portfolio Composition
12/31/12
12/31/13
≤ 15-Year Fixed, $38.6 B, 39%
20-Year Fixed, $1.6 B, 2%
30-Year Fixed, $56.3 B, 57%
Hybrid ARM, $0.9 B, 1%
CMO, $0.7 B, 1%
≤ 15-Year Fixed, $34.5 B, 51%
20-Year Fixed, $1.4 B, 2%
30-Year Fixed, $29.3 B, 43%
Hybrid ARM, $1.2 B, 2%
CMO, $1.8 B, 2%
Portfolio composition includes agency MBS and net TBA position. TBAs represent forward purchases or sales of agency MBS in the “to-be-announced” market.
Economic Return
The open ended nature of the Fed’s QE3 program created substantial volatility in the agency MBS market and in
our returns. Despite this volatility, our economic returns, as measured by the change in our net book value per
common share plus dividends declared per common share divided by our beginning net book value per common
share, have notably been positive when calculated for the full duration of QE3, which began in the third quarter
of 2012. While absolute returns are very important, performance relative to an index or to a peer group is equally
important. As the following chart shows, our active and conservative approach to portfolio management contin-
ues to provide industry-leading performance over a wide range of interest rate and prepayment environments.
4
A M E R I C A N C A P I TA L A G E N C Y
FIGURE 6 AGNC Economic Returns vs. Peer Average
PRE QE3
POST QE3
TOTAL
200%
180.5%
150%
100%
50%
0%
87.5%
AGNC
Peer Average
1/1/09–6/30/12
10%
5%
0%
-5%
-10%
2.6%
-6.7%
AGNC
Peer Average
7/1/12–12/31/13
200%
185.0%
150%
100%
50%
0%
79.5%
AGNC
Peer Average
1/1/09–12/31/13
Source: Company Filings.
Peer group average consists of Annaly Capital, Anwoth Mortgage, ARMOUR Residential, Capstead Mortgage, CYS Investments, and Hatteras Financial on an unweighted basis.
FIGURE 7 AGNC Annual Economic Returns IPO—20131
75%
50%
25%
0%
-25%
-50%
19.8%
-22.1%
-2.3%
IPO—12/31/08
Annualized
60.6%
29.9%
30.7%
32.7%
24.9%
7.8%
37.4%
23.1%
14.3%
32.2%
18.0%
14.2%
11.9%
-24.4%
-12.5%
2009
2010
2011
2012
2013
Economic Return from Change in Net Book Value
Economic Return from Dividends3
18.3%2
16.0%
2.3%
IPO—2013
Annualized
1. May 14, 2008 IPO date.
2. The total economic return for the period of IPO—2013 was 157.7%.
3. Economic return from dividends represents dividends per common share divided by beginning net book value per common share.
Stock Repurchase Program
Given the significant volatility discussed above, our stock price came under significant pressure during the year,
at times trading at a meaningful discount to our stated book value. In response, our Board increased our existing
stock repurchase authorization, authorizing us to repurchase up to an aggregate $2 billion in shares of our com-
mon stock from the inception of the program through December 31, 2014.
2 013 A N N U A L R E P O R T
5
Share repurchases can be accretive to our book value per common share when our common stock is trading
below our book value. In the fourth quarter of 2013, when our stock price relative to our book value was at its weak-
est point, we bought back approximately $586 million, or 7%, of our outstanding shares of common stock. During
2013, we made open market purchases of approximately 40.3 million shares of our common stock. The shares were
purchased at an average price of $21.25 per share, totaling $856 million, including expenses. Since commencing
our stock repurchase program in the fourth quarter of 2012, we have purchased approximately 43.0 million shares
of our common stock, or approximately 10% of our outstanding common shares from their peak in March 2013, for
total consideration of approximately $934 million, including expenses.
Looking Ahead
The dominant theme for 2013 was risk management. As we enter 2014, the environment is changing, interest rates
have stabilized, the yield curve has steepened, tapering is now priced into the agency MBS market, and risk posi-
tions across all fixed income markets are better balanced. Given our views on the current economic landscape,
we expect to be in a more normal environment through 2014, and we have considerable flexibility to respond to
attractive investment opportunities as they arise. Against this backdrop, we are confident in our ability to generate
attractive returns for our shareholders in the years ahead.
Sincerely,
Malon Wilkus
Chair and Chief Executive Officer
Gary Kain
President and Chief Investment Officer
John R. Erickson
Director, Chief Financial Officer and Executive Vice President
Samuel A. Flax
Director, Executive Vice President and Secretary
Peter J. Federico
Senior Vice President and Chief Risk Officer
Christopher Kuehl
Senior Vice President, Agency Portfolio Investments
March 12, 2014
6
A M E R I C A N C A P I TA L A G E N C Y
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
1934
For the year ended December 31, 2013
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, 2013, the aggregate market value of the Registrant's common stock held by non-affiliates of the Registrant was approximately $8.6 billion based
upon the closing price of the Registrant's common stock of $23.01 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, 2014 was 356,151,654.
DOCUMENTS INCORPORATED BY REFERENCE. The Registrant's definitive proxy statement for the 2014 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.
[THIS PAGE INTENTIONALLY LEFT BLANK]
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.
Financial Statements and Supplementary Data. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. . . . . . . . . . . . . . . .
Controls and Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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 9.
Item 9A.
Item 9B.
PART III.
Item 10.
Item 11.
Item 12.
Item 13.
Item 14.
PART IV.
Item 15.
Exhibits and Financial Statement Schedules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Signatures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2
15
34
34
34
34
35
37
40
66
70
102
102
103
103
103
103
103
103
103
106
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. 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 net 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 ("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 a government-sponsored enterprise, 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 and in other assets reasonably
related to agency securities.
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 borrowings structured as repurchase agreements.
Our Investment Strategy
Our investment strategy is designed to:
• manage an investment portfolio consisting primarily of agency securities and assets reasonably related to 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 rate, prepayment and extension risks;
•
•
•
•
preserve our net book value;
provide regular quarterly distributions to our stockholders;
continue to 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 MBS 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, 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.
• 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
2
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 MBS that we acquire provide funds for mortgage loans made to residential homeowners. These securities
generally represent interests in pools of mortgage loans made by mortgage bankers, commercial banks, savings and loan institutions,
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 MBS 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 MBS 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 MBS 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 MBS 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 MBS 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 MBS 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 MBS, 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 MBS are collateralized by pools of fixed-rate mortgage loans or adjustable-rate mortgage loans ("ARMs") and
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 MBS. 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
while in conservatorship. However, the U.S. government does not guarantee the securities, or other obligations, of Fannie Mae
or Freddie Mac.
3
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 MBS 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 and interest on certificates that represent an interest in a pool of mortgages insured by the Federal Housing
Administration ("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.
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 MBS 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 other assets reasonably related to agency securities based on our Manager's continual
assessment of the relative value and risk and return of these securities and ability to 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
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 or in assets reasonably related to 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;
4
•
•
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, 2013. 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 MBS 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 MBS 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 hedge a portion of our exposure to market risks, including interest rate, prepayment and
extension risks, 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, prepayment or
extension 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 interest we pay on our shorter term borrowings. Because a majority of our funding
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 that we pay on our repurchase
agreements; therefore, we may experience reduced income or losses due to adverse rate movements. In order to attempt
5
to mitigate a portion of such risk, we utilize certain hedging techniques to attempt to lock in a portion of the net interest
spread between the interest we earn on our assets and the interest we pay on our financing costs.
Additionally, 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 similar duration 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 this risk, we monitor, among other things, the
"duration gap" between our mortgage assets and our hedge portfolio as well as our convexity exposure. Duration is the
estimated percentage change in market value of our mortgage assets or our hedge portfolio that would be caused by a
parallel change in short and long-term interest rates. Convexity exposure relates to the way the duration of our mortgage
assets or our hedge portfolio changes when the interest rate or prepayment environment changes.
The value of our mortgage assets may also be adversely impacted by fluctuations in the shape of the yield curve or by
changes in the market's expectation about the volatility of future interest rates. We analyze our exposure to non-parallel
changes in interest rates and to changes in the market's expectation of future interest rate volatility and take actions to
attempt to mitigate these risks.
• Prepayment Risk. Because residential borrowers have the option 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 faster than anticipated. Prepayment risk
generally increases when interest rates decline. In this scenario, our financial results may be adversely affected as we
may have to invest that principal at potentially lower yields.
• Extension Risk. Because residential borrowers have the option to make only scheduled payments on their mortgage
loans, rather than prepay their mortgage loans, we face the risk that a return of capital on our investment will occur slower
than anticipated. Extension risk generally increases when interest rates rise. In this scenario, our financial results may
be adversely affected as we may have to finance our investments at potentially higher costs without the ability to reinvest
principal into higher yielding securities.
The principal instruments that we use to hedge a portion of our exposure to interest rate, prepayment and extension risks
are interest rate swaps and options to enter into interest rate swaps ("interest rate swaptions"). We also utilize forward contracts
for the purchase or sale of agency MBS securities on a generic pool, or a TBA contract, basis and on a non-generic, specified pool
basis, and we utilize U.S. Treasury securities and U.S. Treasury futures contracts, primarily through short sales. We may also
purchase or write put or call options on TBA securities and we may invest in other types of mortgage derivatives, such as interest
and principal-only securities.
Our hedging instruments are generally not designed to protect our net book value from "spread risk" (also referred to as
"basis risk"), which is the risk of an increase of the market spread between the yield on our agency securities and the benchmark
yield on U.S. Treasury securities or interest rate swap rates. The inherent 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 actual or anticipated monetary policy actions by the Federal Reserve
("Fed"), liquidity, or changes in required rates of return on different assets. Consequently, while we use interest rate swaps and
other supplemental hedges to attempt to protect our net book value against moves in interest rates, such instruments typically will
not protect our net book value against spread risk and, therefore, the value of our agency securities and our net book value could
decline.
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. In addition, some of our hedges are intended to provide
protection against larger rate moves and as a result may be relatively ineffective for smaller changes in interest rates. There can
be no certainty that our Manager's projections of our exposures to interest rates, prepayments, extension 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.
6
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 $93 billion in assets under management and eight offices in the
United States and Europe as of December 31, 2013.
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.
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 Chair
and Chief Executive Officer of American Capital Senior Floating, Ltd. (NASDAQ: ACSF), a publicly traded non-diversified
closed-end investment management company. 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. He also 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. From 1995 to 2001, he served as head
trader in Freddie Mac’s Securities Sales & Trading Group, where he was responsible for managing all trading decisions, including
REMIC structuring and underwriting, hedging all mortgage positions, income generation, and risk management. Prior to that, he
served as a senior trader, responsible for managing the adjustable-rate mortgage and REMIC sectors.
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 Chief Financial Officer of American Capital Senior Floating, Ltd. and 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
7
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 Senior Floating, Ltd. and 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 MTGE and its manager. He is
primarily responsible for overseeing risk management activities for us and other funds managed by affiliates of our Manager. Mr.
Federico joined the parent company of 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, Agency Portfolio
Investments. He is also the Senior Vice President, Agency Portfolio Investments of MTGE and Senior Vice President of its
manager. He is primarily responsible for directing purchases and sales of agency securities for us and other funds managed by
affiliates of our Manager. Mr. Kuehl joined the parent Company of our Manager 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, 2014, 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
8
"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 MBS 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 MBS 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 domestic corporation. In general, the income that we generate is taxed only at the stockholder level upon a
distribution of dividends to our stockholders.
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, (ii) the amounts we retained and upon which we paid income tax
at the corporate level and (iii) any over distributions from prior periods.
• 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.
9
•
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;
(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 taxable 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.
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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.
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 MBS 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 MBS 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 MBS as qualifying
income for the 95% gross income test. In the case of agency MBS 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 MBS 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 MBS will continue to be qualifying income for purposes of the REIT gross income
tests.
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We purchase and sell agency MBS 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.
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 MBS 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.
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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 MBS 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 MBS. 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,
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 the applicable 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 if required. 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
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losses, however, will generally not affect the character, in the hands of our stockholders, of any distributions that are actually made
as ordinary or capital gain dividends.
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, (y) the amounts of income we retained and on which we have paid corporate income tax and (z) any excess
distributions over required distributions from prior periods.
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 hedge some of our
exposure to market risks, including interest rate, prepayment and extension 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
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.
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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.
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 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 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 preserving our net
book value while 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, agency debenture securities and other assets reasonably related to agency securities, such as
marketable equity securities of other agency focused mortgage REITs, 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.
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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 its third quantitative easing program, commonly known as QE3,
and extended its guidance to keep the federal funds rate at "exceptional low levels" through at least mid-2015. QE3 entails large-
scale purchases of agency MBS at the pace of $40 billion per month and U.S. Treasury securities of $45 billion per month in
addition to the Federal Reserve's existing policy of reinvesting principal payments from its holdings of agency MBS into new
agency MBS. On December 18, 2013, the Federal Reserve announced that it would begin reducing the pace of its asset purchases
by $10 billion per month beginning in January 2014, to $35 billion per month for agency MBS and $40 billion per month for U.S.
Treasury securities. The Federal Reserve also stated that more reductions to its asset purchases are expected "in measured steps"
at future meetings, but that it is not on a preset course and the level of future asset purchases would depend on the economy living
up to its expectations. The Federal Reserve also extended its guidance on short-term interest rates and stated that it will likely be
appropriate to maintain the federal funds rate at exceptional low levels well past the time that the unemployment rate declines
below 6.5%, especially if projected inflation continues to run below its 2% longer-run goal.
We cannot predict the impact of this program, future reductions of such asset purchases, or any future actions by the Federal
Reserve on the prices and liquidity of agency MBS. During periods in which the Federal Reserve purchases significant volumes
of agency MBS, yields on agency MBS securities will likely be lower, refinancing volumes will likely be higher, and market
volatility will be considerably higher than would have been absent its large scale purchases. Further, there is also a risk that as
the Federal Reserve reduces its purchases of agency MBS, or if they decide to sell some or all of their holdings of agency MBS,
it could adversely affect the pricing of our agency MBS portfolio. As a result, returns on agency MBS and our net book value
may be adversely affected.
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. For example,
because of our significant leverage, we may incur substantial losses if our borrowing costs increase or if the value of our investments
declines.
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 financial condition and 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.
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An increase in our borrowing costs would adversely affect our financial condition and results of operations.
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.
An increase in our borrowing costs will 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. Moreover, due to the short-term nature of our
repurchase agreements used to finance our investments, our borrowing costs are particularly sensitive to increases in short-term
interest rates. It is possible that due to higher borrowing costs, 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 the stated maturity of our fixed rate assets, or in timing of interest rate adjustments on our adjustable-rate assets,
and our borrowings may adversely affect our profitability.
We rely primarily on short-term and/or variable rate borrowings to acquire fixed-rate securities with long-term maturities.
In addition, we may have adjustable rate assets with interest rates that vary over time based upon changes in an objective index,
such as LIBOR or the U.S. Treasury rate. These indices generally reflect short-term interest rates but these assets may not reset
in a manner that matches our borrowings.
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.
Declines in value of the assets in which we invest will adversely affect our financial condition and results of operations, and
make it more costly to finance these assets.
We use our investments as collateral for our financings. A 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. Any fixed-rate securities we invest in generally will be more negatively affected by
increases in interest rates than adjustable-rate securities. 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 it will decrease the amounts we may borrow to purchase additional mortgage-
related investments, which may restrict our ability to increase our net income, and our financial condition and results of operations
could be adversely affected.
17
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 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 hedging may fail to protect us from loss. Additionally, our business
model calls for accepting certain amounts of interest rate, mortgage spread, prepayment, extension, 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:
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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;
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, with downward adjustments, or "mark-to-market losses," reducing our stockholders' equity.
Furthermore, 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 hedging strategies are generally not designed to mitigate spread risk.
When the market spread widens between the yield on our agency securities and benchmark interest rates, our net book value
could decline if the value of our agency securities fall by more than the offsetting fair value increases on our hedging instruments
tied to the underlying benchmark interest rates. We refer to this as "spread risk" or "basis risk". The spread risk associated with
our mortgage assets and the resulting fluctuations in fair value of these securities can occur independent of changes in benchmark
interest rates and may relate to other factors impacting the mortgage and fixed income markets, such as actual or anticipated
monetary policy actions by the Federal Reserve, market liquidity, or changes in required rates of return on different assets.
Consequently, while we use interest rate swaps and other supplemental hedges to attempt to protect against moves in interest rates,
such instruments typically will not protect our net book value against spread risk, which could adversely affect our financial
condition and results of operations.
Changes in prepayment rates may adversely affect our profitability and are difficult to predict.
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.
18
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 receive 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, which will result in a lower than expected yield
on securities purchased at a discount to par.
Moreover, if prepayment rates decrease due to 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 will generally extend. 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 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.
Although prepayment rates generally increase when interest rates fall and decrease when interest rates rise, 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.
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 condition and results of operations.
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 government actions and such result may have broad adverse market implications.
19
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. 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. In addition, the Federal Reserve, the Federal Deposit Insurance Corporation and other regulatory entities are
currently in the process of implementing new, and possibly more stringent, capital rules on large financial institutions. These
new regulatory requirements, when implemented, could adversely 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.
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 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.
Our derivative agreements expose us to margin calls that could result in defaults or force us to sell assets under adverse market
conditions.
Our derivative agreements typically require that we pledge collateral on such agreements to our counterparties in a similar
manner as we are required to under our repurchase agreements. Our counterparties, or the clearing agency in the case of centrally
cleared interest rate swaps, 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.
Further, our derivative 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 derivative 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.
20
Increasingly restrictive rules and regulations adopted by the U.S. Commodity Futures Trading Commission and regulators of
other countries impose increased margin requirements and require additional operational and compliance costs, which could
negatively affect our financial condition and results of operations.
Title VII of the Dodd-Frank Act and the rules and regulations adopted and to be adopted by the U.S. Commodity Futures
Trading Commission (the "CFTC") introduce a comprehensive regulatory regime for swaps (as defined in the Commodity Exchange
Act, as amended). The new laws and regulations subject certain swaps to clearing and exchange trading requirements, and subject
us to new burdens, including but not limited to, margin requirements, reporting, record keeping and business conduct rules. The
final rules under Title VII, including those rules that have already been adopted, for both cleared and uncleared swap transactions
will impose increased margin requirements and require additional operational and compliance costs that will likely affect our
business and results of operations.
As we also enter into derivative agreements with non-U.S. counterparties, which are subject to increasingly restrictive local
regulations similar to the Dodd-Frank Act, we are required to follow some of these local regulations or help the non-U.S.
counterparties comply with these local regulations. For example, the EU's Regulation on OTC derivatives, central counterparties
and trade repositories (the "EMIR Regulation") came into force on August 16, 2012 and was implemented in the course of 2013
through a number of implementation measures. The EMIR Regulation has not yet been fully implemented. The EMIR Regulation
is intended, among other things, to reduce counterparty risk by requiring that all standardized over-the-counter derivatives meeting
specific thresholds be cleared through a central counterparty. In addition, OTC derivatives that are not centrally cleared will be
subject to margin requirements. It is possible that EMIR Regulation will result in increased costs for OTC derivative counterparties
and also lead to an increase in the costs of collateral. These increased trading costs and collateral costs may have an adverse impact
on our business and results of operations.
As the CFTC and regulators of other countries continue to promulgate new rules and regulations on derivatives, our derivative
agreements and ability to engage in derivative transactions with certain counterparties may be adversely affected, which could
negatively affect our financial condition and results of operations.
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)
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. Additionally, the pace at which the Fed reduces or stops altogether its purchases of agency MBS under QE3
could adversely impact the dollar roll market. Under such conditions, it may 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.
21
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.
Our use of derivative agreements may expose us to counterparty risk.
Hedging instruments often are not traded on regulated exchanges, guaranteed by an exchange or its clearinghouse, or regulated
by any U.S. or foreign governmental authorities and involves risks and costs that could result in material losses. Consequently,
there may not be 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. Consequently, if a counterparty fails to perform under a derivative agreement we could
incur a significant loss.
For example, 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 swaption counterparty fails to perform under the terms of the interest rate swaption
agreement, in addition to not being able to exercise or otherwise cash settle the agreement, we could also incur a loss for the
premium paid for that swaption.
22
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 2014 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 may be 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 buy out 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.
An increase in interest rates may cause a decrease in the volume of newly issued, or an increase in 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 a decrease
in 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.
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
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.
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, spread, default, credit, prepayment, extension, liquidity and other risks as well
as exposure to 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 common and and preferred stockholders.
23
Our investments in the common stock of other publicly traded mortgage REITs expose us to incremental risks and costs and
may adversely affect our financial condition and results of operations.
The mortgage REITs in which we invest primarily invest in agency MBS on a leveraged basis and utilize short-term repurchase
agreements as their primary source of funding and, therefore, are exposed to similar risk factors as those described herein. In
addition, our investments in other mortgage REITs expose us to incremental risks and costs due to our lack of control, lack of
transparency into their underlying investment portfolios and business operations, stock market volatility and additional management
fees, which could adversely affect our financial condition and results of operations.
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
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.
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
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securities, or perceived market uncertainty about their value, could 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.
Future legislation could change the relationship between Fannie Mae and Freddie Mac and the U.S. Government, and could
also nationalize, privatize, or eliminate these 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.
Moreover, 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.
As a result, such laws or changes could increase the risk of loss on our investments in agency mortgage investments
guaranteed by Fannie Mae and/or Freddie Mac and 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.
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.
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 mortgage investments, non-agency mortgage investments and mortgage related investments and may compete with us
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for purchases 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.
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
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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.
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 or decreased by changes in our
Equity. Increases to our Equity, and a corresponding increase to our management fee, will primarily result from equity issuances
and realization of gains from our investment portfolio, whereas decreases to our Equity, and a corresponding decrease to our
management fee, will primarily result from repurchases of our common stock and realization of losses on our investment portfolio,
each of 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, share repurchases and realization of gains and losses on our investment portfolio. Thus, 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
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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
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
distributed 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. Additionally, if we incur capital losses in excess
of capital gains, such net capital losses are not allowed to reduce our taxable income for purposes of determining our distribution
requirement. Such net capital losses may be carried forward for a period of up to five years and applied against future capital gains
subject to the limitation of our ability to generate sufficient capital gains, which cannot be assured. 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 maintain our
qualification as a REIT, or 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
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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.
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 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 assets 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:
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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;
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 75% asset test, 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
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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.
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.
31
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
effect on our operating results and negatively affect the market price of our common stock and our ability to pay dividends to our
common and preferred 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;
our repurchases of shares of our common stock;
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.
32
Future offerings of debt securities, which would rank senior to our preferred and 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 has 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. 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
33
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. Any attempt to own or transfer shares of our common stock
or capital stock in violations of these restrictions may result in the shares being transferred to a charitable trust or may be void.
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.
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 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, 2013, we had no legal proceedings.
Item 4. Mine Safety Disclosures
Not applicable.
34
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, 2014,
we had 1,098 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 quarterly dividends declared on our common stock for fiscal years 2013 and 2012:
Common Stock
Sales Prices
High
Low
Dividends
Declared
2013
Fourth Quarter ............................. $
24.30 $
Third Quarter ............................... $
24.58 $
Second Quarter ............................ $
33.31 $
First Quarter................................. $
33.28 $
2012
Fourth Quarter ............................. $
35.16 $
Third Quarter ............................... $
36.77 $
Second Quarter ............................ $
33.95 $
First Quarter................................. $
31.17 $
18.84
20.20
22.22
29.40
28.08
30.30
29.60
28.08
$
$
$
$
$
$
$
$
0.65
0.80
1.05
1.25
1.25
1.25
1.25
1.25
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." In addition, holders of our Series A Redeemable Preferred Stock 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. Under certain circumstances upon a change of control, the Series A Redeemable Preferred
Stock is convertible to shares of our common stock. 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 on our common stock for fiscal years 2013 and 2012 and their related
tax characterization:
Dividends Declared
Dividends
Declared Per
Share
Ordinary
Income Per
Share
Qualified
Dividends
Long-Term
Capital Gains Per
Share
Fiscal year 2013......................
Fiscal year 2012......................
$
$
3.75
5.00
$
$
3.750000
4.509200
$
$
0.029963
$
—
— $
0.490800
Tax Characterization
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.
35
Stock Repurchase Program
The following table presents information with respect to purchases of our common stock made during the fourth quarter
ended December 31, 2013 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):
Settlement Date
November 4 - 29, 2013 ...............
December 2 - 18, 2013................
Fourth Quarter 2013....................
Total Number
of Shares
Purchased
Average Net
Price Paid
Per Share
16.4
11.8
28.2
$21.39
$20.04
$20.82
Total Number of
Shares Purchased
as Part of Publicly
Announced Plans
or Programs 1
Maximum Number
of Shares That
May Yet Be
Purchased Under
the Publicly
Announced Plans
or Programs
16.4
11.8
28.2
N/A
N/A
N/A
___________________________
1. All shares were purchased by us pursuant to the stock repurchase program adopted by our Board of Directors described in Note 10 of our
accompanying Consolidated Financial Statements in this Form 10-K.
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, 2013 concerning shares of our common stock authorized
for issuance under our existing Incentive Plan.
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)
$
$
—
—
—
47,500
—
47,500
Plan Category
Equity compensation plans approved by security holders 1......
Equity compensation plans not approved by security holders..
27,000
—
Total ..........................................................................................
27,000
_________________________________________________________
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 December 31,
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. ("Agency REIT Peer
Group (old)"); and (v) an updated index of peers adding Armour Residential REIT, Inc., given its agency MBS focus, to Agency
REIT Peer Group (old) ("Agency REIT Peer Group (new)").
36
December 31,
2013
2012
2011
2010
2009
American Capital Agency...........................
S&P 500 ......................................................
FTSE NAREIT Mortgage REITs................
Agency REIT Peer Group (old) ..................
Agency REIT Peer Group (new).................
$
$
$
$
$
224.20
228.19
175.25
127.69
125.90
$
$
$
$
$
288.61
172.37
178.75
159.16
158.28
$
$
$
$
$
240.30
148.59
149.10
157.92
156.67
$
$
$
$
$
202.58
145.51
152.79
152.40
151.18
$
$
$
$
$
153.31
126.46
124.63
128.48
127.46
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 the five fiscal years ended
December 31, 2013. The selected financial data should be read in conjunction with the more detailed information contained in
37
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)
2013
2012
2011
2010
2009
December 31,
Balance Sheet Data:...................................................................................
Investment portfolio, at fair value ...............................................................
Total assets...................................................................................................
Repurchase agreements and other debt........................................................
Total liabilities .............................................................................................
Total stockholders' equity............................................................................
Net asset value per common share as of period end 1..................................
$
$
$
$
$
$
65,941
$ 85,245
$ 54,683
$ 13,510
76,255
$ 100,453
$ 57,972
$ 14,476
64,443
$ 75,415
$ 47,735
$ 11,753
67,558
$ 89,557
$ 51,760
$ 12,904
8,697
$ 10,896
23.93
$
31.64
$
$
6,212
27.71
$
$
1,572
24.24
$
$
$
$
$
$
4,300
4,626
3,842
4,079
547
22.48
Statement of Comprehensive Income Data
Interest income.............................................................................................
Interest expense 2 .........................................................................................
Net interest income ......................................................................................
Other (loss) income, net 2 ............................................................................
Expenses ......................................................................................................
Income before income tax ...........................................................................
Provision for income tax, net.......................................................................
Net income...................................................................................................
Dividend on preferred stock ........................................................................
Net income available to common shareholders ...........................................
Net income...................................................................................................
Other comprehensive (loss) income 2 ..........................................................
Comprehensive (loss) income......................................................................
Dividend on preferred stock ........................................................................
Comprehensive (loss) income (attributable) available to common
shareholders ...........................................................................................
Weighted average number of common shares outstanding - basic and
diluted ..........................................................................................................
Net income per common share - basic and diluted......................................
Comprehensive (loss) income per common share - basic and diluted.........
Dividends declared per common share........................................................
Other Data (unaudited)
Average agency securities, at par.................................................................
Average agency securities, at cost ...............................................................
Average total assets, at fair value ................................................................
Net TBA dollar roll position - as of period end, at par................................
Net TBA dollar roll position - as of period end, at cost...............................
Net TBA dollar roll position - as of period end, at market value ................
Net TBA dollar roll position - as of period end, carrying value 3................
38
2013
2012
2011
2010
2009
Fiscal Year
$
2,193
$
2,109
$
1,109
$
253
$
128
536
1,657
(217)
168
1,272
13
1,259
14
1,245
1,259
(2,938)
(1,679)
14
$
$
512
1,597
(157)
144
1,296
19
1,277
10
1,267
1,277
1,244
2,521
10
$
$
285
824
26
74
776
6
770
—
770
770
379
1,149
—
$
$
$
$
76
177
130
19
288
—
288
—
288
288
(88)
200
—
$
$
44
84
46
11
119
—
119
—
119
119
45
164
—
$
(1,693) $
2,511
$
1,149
$
200
$
164
379.1
303.9
153.3
3.28
$
(4.47) $
3.75
$
4.17
8.26
5.00
$
$
$
5.02
7.50
5.60
$
$
$
36.5
7.89
5.49
5.60
$
$
$
17.5
6.78
9.33
5.15
2013
2012
2011
2010
2009
Fiscal Year
75,263
$ 71,002
$ 33,243
79,056
$ 74,588
$ 34,726
96,956
$ 86,172
$ 38,548
$
$
$
6,992
7,335
8,100
$
$
$
2,668
2,752
3,086
2,119
$ 12,477
2,276
$ 12,775
2,271
$ 12,870
(5) $
95
NM
NM
NM
NM
NM
NM
NM
NM
NM
NM
NM
NM
$
$
$
$
$
$
$
$
$
$
Average net TBA dollar roll position, at cost..............................................
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 net interest rate spread, including estimated TBA dollar roll
income 8 .......................................................................................................
Average coupon (as of period end)..............................................................
Average asset yield (as of period end).........................................................
Average cost of funds (as of period end) 9...................................................
Average net interest rate spread (as of period end)......................................
Net comprehensive (loss) income return on average common equity 10 .....
Economic (loss) return on common equity 11 ..............................................
Leverage (average during the period) 12 ......................................................
Leverage, including net TBA dollar roll position (average during the
period) 13 ......................................................................................................
Leverage (as of period end) 14 .....................................................................
Leverage, including net TBA dollar roll position (as of period end) 15 .......
Expenses % of average total assets..............................................................
Expenses % of average assets, including average net TBA dollar roll
position ........................................................................................................
Expenses % of average stockholders equity................................................
$
$
$
11,383
$
3,294
NM
NM
NM
71,753
$ 68,810
$ 31,840
10,394
$
9,473
$
4,169
$
$
6,865
859
$
$
2,542
373
3.59%
2.77%
3.90%
2.82%
4.42%
3.19%
5.03%
3.44%
5.77%
4.64%
(1.34)%
(1.11)%
(1.00)%
(1.11)%
(1.71)%
1.43%
1.71%
2.19%
2.33%
2.93%
1.87%
3.58%
2.70%
1.84%
3.69%
2.61%
NM
4.23%
3.07%
NM
4.70%
3.31%
NM
5.28%
3.99%
(1.31)%
(1.22)%
(1.13)%
(1.03)%
(1.17)%
1.39%
(16.6)%
(12.5)%
6.9:1
8.0:1
7.3:1
7.5:1
1.39%
26.9%
32.2%
7.3:1
7.6:1
7.0:1
8.2:1
1.94%
27.6%
37.4%
7.6:1
NM
7.9:1
NM
2.28%
23.3%
32.7%
8.0:1
NM
7.8:1
NM
2.82%
43.8%
60.6%
6.8:1
NM
7.3:1
NM
0.17%
0.17%
0.19%
0.23%
0.36%
0.15%
1.61%
0.16%
1.52%
NM
1.77%
NM
2.19%
NM
2.99%
* Except as noted below, average numbers for each period are weighted based on days on our books and records. All percentages are annualized.
NM = Not meaningful. Prior to the fourth quarter of 2012, our net TBA position primarily consisted of short TBAs used for hedging purposes.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
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 swaps as of September 30, 2011. Please refer to our Interest Expense and Cost of Funds
discussion further below and Notes 2 and 5 of our Consolidated Financial Statements in this Form 10-K for additional information regarding our
discontinuance of hedge accounting.
The carrying value of our net TBA position represents the difference between the market value and the cost basis of the TBA contract as of period-end and
is reported in derivative assets / (liabilities), at fair value on our accompanying consolidated balance sheets.
Average stockholders' equity calculated as our average month-end stockholders' equity during the period.
Average coupon for the period was calculated by dividing our total coupon (or cash) interest income on agency securities by our average agency securities
held at par.
Average asset yield for the period was calculated by dividing our total cash interest income on agency securities, adjusted for amortization of premiums
and discounts, by our average amortized cost of agency securities held.
Average cost of funds includes repurchase agreements, debt of consolidated variable interest entities ("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.
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 for the period.
Estimated TBA dollar roll income/(loss) is net of short TBAs used for hedging purposes. Dollar roll income excludes the impact of other supplemental
hedges, and is recognized in gain (loss) on derivative instruments and other securities, net.
Average cost of funds as of period end includes repurchase agreements and debt of consolidated VIEs outstanding, plus the impact of interest rate swaps
in effect as of each period end and forward starting swaps becoming effective, net of swaps expiring, within three months of each period end, but excludes
costs associated with other supplemental hedges such as swaptions, U.S. Treasuries and TBA positions.
Net comprehensive income (loss) return on average common equity for the period was calculated by dividing our comprehensive income/(loss) available /
(attributable) to common shareholders by our average stockholders' equity, net of the 8.000% Series A Cumulative Redeemable Preferred Stock liquidation
preference.
Economic return (loss) on common equity represents the sum of the change in our net asset value per common share and our dividends declared on common
stock during the period over our beginning net asset value per common share.
Leverage during the period was calculated by dividing our daily weighted average agency MBS repurchase agreements and debt of consolidated VIEs
outstanding for the period by our average stockholders' equity for the period. Leverage excludes U.S. Treasury repurchase agreements.
Leverage, including net TBA dollar roll position, during the period includes the components of "leverage (average during the period)", plus our daily
weighted average net TBA dollar position (at cost) during the period.
39
14.
15.
Leverage at period end was calculated by dividing the sum of the amount outstanding under our agency MBS repurchase agreements, net receivable /
payable for unsettled agency securities and debt of consolidated VIEs by the sum of our total stockholders' equity less the fair value of investments in
REIT equity securities at period end. Leverage excludes U.S. Treasury repurchase agreements.
Leverage at period end, including net TBA dollar roll position, includes the components of "leverage (as of period end)" plus our net TBA position
outstanding as of period end, at cost.
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 seven sections:
• Executive Overview
•
Financial Condition
• Results of Operations
• Liquidity and Capital Resources
• Off-Balance Sheet Arrangements
• Aggregate Contractual Obligations
•
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
Fiscal year 2013 was a challenging and difficult year for all fixed income markets and the agency MBS market was one
of the hardest hit sectors. As a result, our net book value per common share fell.
Throughout much of 2013, MBS investors struggled with uncertainty surrounding when the Fed would alter its open-
ended, third quantitative easing, asset purchase program, commonly known as QE3, as stronger than expected employment
reports early in the year triggered a significant rise in interest rates. For the year, the 10 year U.S. Treasury rate increased 127
basis points and 30 year mortgage rates increased 138 basis points. Agency MBS prices came under pressure and underperformed
other fixed income instruments as agency MBS investors significantly pared back their holdings in anticipation of a sooner-
than-expected Fed tapering of QE3. As a result, agency MBS spreads widened relative to U.S. Treasury and swap rates. This
spread widening was the primary driver of our 24% decline in net book value per common share over the course of 2013.
In December 2013, the Fed announced that it would begin reducing the pace of its asset purchases by $10 billion per
month beginning in January 2014, split equally between agency MBS and U.S. Treasury securities. The Fed stated that additional
reductions to its asset purchases are expected "in measured steps" at future meetings, but that it is not on a preset course and
the level of future asset purchases will depend on the pace of economic activity. The Fed stated that it would maintain its policy
of reinvestment of principal payments on its holdings of agency MBS into new agency MBS. The Fed also extended its guidance
on short-term interest rates and stated that it will likely maintain the current exceptionally low target range of 0.0% to 0.25%
for the federal funds rate well past the time that the unemployment rate declines below 6.5%, especially if projected inflation
continues to run below its 2% longer-run goal.
Given the challenging market conditions and significant volatility throughout 2013, we prioritized risk management over
near term earnings. To this end, our Manager took steps to reduce leverage, increase our hedge positions and alter the composition
of our asset portfolio. Together, we believe these actions meaningfully reduced our exposure to rising rates and widening agency
MBS spreads.
These portfolio rebalancing actions, however, drove a decline in our net spread income per common share. Our more
defensive positioning, coupled with the reduction in our net book value and taxable income, caused us to reduce our dividend.
40
In 2013, we declared $3.75 per common share in dividends, down from $5.00 per common share in 2012. Combining the
dividends we paid and the decline in our net book value per common share we experienced during 2013, our economic return
for the year was a negative 12.5%. However, as a result of the Fed exiting its unprecedented participation in the mortgage
market, we believe that the mortgage market is returning to a more normalized risk return environment. In light of the portfolio
rebalancing actions we took during 2013, we are well positioned to respond to attractive investment opportunities as they arise
in the current steeper yield curve, wider spread environment.
Additionally, given the significant volatility during 2013 in the agency MBS market and the broader fixed income market,
our stock price came under significant pressure during the year, at times trading at a substantial discount to our estimated book
value. In response, in September 2013, our Board of Directors expanded our common stock repurchase program by $500 million,
authorizing us to repurchase up to $1 billion of our outstanding shares of common stock, and extended the program through
December 31, 2014. During 2013, we made open market purchases of approximately 40.3 million shares of our common stock.
The shares were purchased at an average price of $21.25 per share, totaling $856 million, including expenses. Since commencing
our stock repurchase program in the fourth quarter of 2012, we have purchased approximately 43.0 million shares of our common
stock, or approximately 10% of our outstanding common shares from their peak in March 2013, for total consideration of $934
million, including expenses. As of December 31, 2013, $66 million remained available for repurchases of our common stock
and, during January 2014, our Board of Directors authorized additional repurchases of $1 billion of our common stock through
December 31, 2014.
The table below summarizes interest rates and prices of generic fixed-rate agency mortgage-backed securities as of the
end of each respective quarter since December 31, 2012:
Interest Rate/Security Price 1
Dec. 31,
2013
Sept 30,
2013
June 30,
2013
Mar. 31,
2013
Dec. 31,
2012
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:
0.17%
0.25%
0.35%
0.38%
1.74%
3.03%
0.49%
1.79%
3.09%
0.18%
0.25%
0.37%
0.32%
1.38%
2.61%
0.46%
1.54%
2.77%
3.0% ............................................................................................
3.5% ............................................................................................
$95.11
$99.48
$97.70
$101.83
4.0% ............................................................................................
$103.11
$104.86
4.5% ............................................................................................
$106.06
$106.80
5.0% ............................................................................................
$108.80
$108.45
5.5% ............................................................................................
$110.05
$109.03
6.0% ............................................................................................
$111.09
$109.39
15-Year Fixed Rate MBS Price:
2.5% ............................................................................................
$99.00
$100.61
3.0% ............................................................................................
$102.05
$103.53
3.5% ............................................................................................
$104.58
$105.58
4.0% ............................................................................................
$105.94
$106.25
4.5% ............................................................................................
$106.44
$106.25
0.19%
0.27%
0.41%
0.36%
1.39%
2.49%
0.51%
1.57%
2.70%
0.20%
0.28%
0.44%
0.24%
0.77%
1.85%
0.42%
0.95%
2.01%
0.21%
0.31%
0.51%
0.25%
0.72%
1.76%
0.39%
0.86%
1.84%
$97.72
$103.11
$104.84
$101.50
$104.16
$105.82
$107.65
$108.65
$108.78
$100.45
$102.82
$104.20
$105.32
$106.00
$105.58
$106.66
$106.61
$107.22
$107.73
$108.03
$108.34
$108.33
$109.08
$108.64
$109.56
$109.22
$103.75
$104.61
$105.17
$105.61
$106.03
$106.14
$107.00
$107.00
$107.67
$107.55
Dec. 31, 2013
vs.
Dec. 31, 2012
-0.04 bps
-0.06 bps
-0.16 bps
+0.13 bps
+1.02 bps
+1.27 bps
+0.10 bps
+0.93 bps
+1.25 bps
-$9.73
-$7.18
-$4.11
-$1.97
+$0.47
+$1.41
+$1.87
-$5.61
-$3.56
-$1.56
-$1.06
-$1.11
________________________
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 were obtained from a combination of Bloomberg and dealer indications. Interest rates were obtained from Bloomberg.
41
The table below summarizes pay-ups on specified pools over the corresponding generic agency MBS as of the end of
each respective quarter for a select sample of specified securities. Price information provided in the table below is for illustrative
purposes only and is not meant to be reflective of our specific portfolio holdings. Actual pay-ups are dependent on specific
securities held in our portfolio and prices can vary depending on the source:
Pay-ups on Specified Mortgage Pools over Generic TBA Price 1,2
Dec. 31,
2013
Sept 30,
2013
June 30,
2013
Mar. 31,
2013
Dec. 31,
2012
Dec. 31, 2013
vs.
Dec. 31, 2012
30-Year Lower Loan Balance Pay-ups ($85k - $110k): 3
3.0% ..................................................................................................
3.5% ..................................................................................................
4.0% ..................................................................................................
30-Year HARP Pay-ups (95% - 100% LTV): 4
3.0% ..................................................................................................
3.5% ..................................................................................................
$0.02
$0.09
$0.23
$—
$—
4.0% ..................................................................................................
$0.06
$0.03
$0.22
$0.70
$—
$0.03
$0.21
$—
$0.22
$0.91
$—
$0.16
$0.59
$0.13
$0.91
$3.28
$0.07
$0.70
$2.85
$0.69
$1.64
$4.19
$0.47
$1.52
$4.06
-$0.67
-$1.55
-$3.96
-$0.47
-$1.52
-$4.00
________________________
1.
2.
Source: Bloomberg and dealer indications
"Pay-ups" represent the value of the price premium of specified securities over generic TBA pools. The table above includes pay-ups for newly originated
specified pools. Price information is provided for information only and is not meant to be reflective of our specific portfolio holdings. Prices can vary
materially depending on the source.
3.
Lower loan balance securities in table above represent pools backed by an original loan balance of $85,000 to $110,000.
4. HARP securities in table above represent pools backed by 100% refinance loans with loan-to-values ("LTV") of 95% to 100%.
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, 2013 was 104.6% 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
42
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,
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 agency securities based on a market approach using "Level 2" inputs from third-party
pricing services and non-binding dealer quotes derived from common market pricing methods. Such methods incorporate, but
are not limited to, reported trades and executable bid and ask prices for similar securities, benchmark interest rate curves, such
as the spread to the U.S. Treasury rate and interest rate swap curves, convexity, duration and the 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 agency 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.
We also evaluate our agency securities for other-than-temporary impairment ("OTTI") on at least a quarterly basis. The
determination of whether a security is other-than-temporarily impaired may involve judgments and assumptions based on
subjective and objective factors. When a security is impaired, an OTTI is considered to have occurred if any one of the following
three conditions exist as of the financial reporting date: (i) we intend to sell the security (that is, a decision has been made to
sell the security), (ii) it is more likely than not that we will be required to sell the security before recovery of its amortized cost
basis or (iii) we do not expect to recover the security's amortized cost basis, even if we do not intend to sell the security and it
is not more likely than not that we will be required to sell the security. A general allowance for unidentified impairments in a
portfolio of securities is not permitted.
If either of the first two conditions exists as of the financial reporting date, 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. If the third condition
exists, the OTTI is separated into (i) the amount relating to credit loss (the "credit component") and (ii) the amount relating to
all other factors (the "non-credit components"). Only the credit component is recognized in earnings, with the non-credit
components recognized in OCI. However, in evaluating if the third condition exists, our investments in agency securities
typically would not have a credit component since the principal and interest are guaranteed by a GSE and, therefore, any
unrealized loss is not the result of a credit loss. In addition, since we designate our agency securities as available-for-sale securities
with unrealized gains and losses already recognized in OCI, any impairment loss for non-credit components is already recognized
in OCI.
The liquidity of the agency securities market allows us to obtain competitive bids and execute on a sale transaction typically
within a day of making the decision to sell a security and, therefore, we generally do not make decisions to sell specific agency
securities until shortly prior to initiating a sell order. In some instances, we may sell specific agency securities by delivering
such securities into existing short to-be-announced ("TBA") contracts. TBA market conventions require the identification of
the specific securities to be delivered no later than 48 hours prior to settlement. If we settle a short TBA contract through the
delivery of securities, we will generally identify the specific securities to be delivered within one to two days of the 48-hour
deadline.
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 risk, prepayment risk and extension risk. Our risk management
objective is to reduce fluctuations in net book value over a range of interest rate scenarios. The principal instruments that we
use are interest rate swaps and options to enter into interest rate swaps ("interest rate swaptions"). We also utilize forward
contracts for the purchase or sale of agency MBS securities on a generic pool, or a TBA contract, basis and on a non-generic,
specified pool basis, and we utilize U.S. Treasury securities and U.S. Treasury futures contracts, primarily through short sales.
We may also purchase or write put or call options on TBA securities and we may 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").
43
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.
44
FINANCIAL CONDITION
As of December 31, 2013 and 2012, our investment portfolio consisted of $65.9 billion and $85.2 billion of agency MBS,
respectively, and a $2.3 billion and $12.9 billion net long TBA position, at fair value, respectively.
Our TBA positions are recorded as derivative instruments in our accompanying consolidated financial statements, with the
TBA dollar roll transactions representing a form of off-balance sheet financing. As of December 31, 2013 and 2012, our net TBA
position had a net carrying value of $(5) million and $95 million, respectively, reported in derivative assets/(liabilities) on our
accompanying consolidated balance sheets. The net carrying value represents the difference between the fair value of the underlying
agency security in the TBA contract and the cost basis or the forward price to be paid or received for the underlying agency security.
The following tables summarize certain characteristics of our agency MBS investment portfolio and our net TBA position
as of December 31, 2013 and 2012 (dollars in millions):
December 31, 2013
Agency MBS Classified as
Available-for-Sale ("AFS")
Par
Value
Amortized
Cost
Amortized
Cost Basis
Fair
Value
Investments By Issuer:
Fannie Mae...............................
$ 50,914
$
53,099
Freddie Mac .............................
12,640
Ginnie Mae...............................
223
13,264
230
Total / Weighted Average..............
$ 63,777
$
66,593
104.3%
104.9%
103.1%
104.4%
$ 52,289
12,980
235
$ 65,504
Investments By Coupon: 1
Fixed-Rate
................................
$ 11,189
$
11,400
3.0%.....................................
3.5%.....................................
4.0%.....................................
4.5%.....................................
.................................
6,037
14,049
5,700
588
8
6,220
14,632
5,981
619
9
........................
37,571
38,861
20-Year
................................
3.5%.....................................
4.0%.....................................
4.5%.....................................
.................................
350
770
93
116
6
347
788
97
125
7
Total 20-Year:...........................
1,335
1,364
30-Year:
................................
3.5%.....................................
4.0%.....................................
4.5%.....................................
5.0%.....................................
.................................
Total 30-Year............................
Total Fixed-Rate...........................
Adjustable-Rate ............................
CMO.............................................
231
8,530
9,077
4,075
211
271
22,395
61,301
1,196
1,280
236
9,051
9,669
4,355
226
295
23,832
64,057
1,223
1,313
Total / Weighted Average..............
$ 63,777
$
66,593
101.9%
103.0%
104.2%
104.9%
105.3%
104.5%
103.4%
99.2%
102.4%
105.0%
107.3%
106.7%
102.2%
101.8%
106.1%
106.5%
106.9%
106.6%
108.8%
106.4%
104.5%
102.2%
102.6%
104.4%
$ 11,109
6,166
14,716
6,056
631
9
38,687
346
785
97
124
7
1,359
220
8,477
9,359
4,332
229
298
22,915
62,961
1,235
1,308
$ 65,504
45
% Lower
Loan
Balance &
HARP 2,3
Weighted Average
WAC 4
Yield 5
Age
(Months)
Projected
Life
CPR 5
62%
81%
—%
66%
31%
69%
51%
88%
99%
23%
55%
28%
63%
47%
97%
—%
56%
69%
99%
92%
88%
65%
36%
93%
69%
—%
—%
66%
3.89%
4.08%
3.94%
3.93%
2.64%
2.85%
1.66%
2.68%
2.96%
3.48%
3.93%
4.40%
4.87%
6.49%
3.66%
3.55%
4.05%
4.53%
4.89%
5.89%
4.05%
3.69%
4.02%
4.46%
4.95%
5.46%
6.25%
4.41%
3.95%
2.58%
4.30%
3.93%
2.11%
2.34%
2.52%
2.78%
3.15%
4.40%
2.42%
3.10%
3.11%
3.10%
3.20%
3.39%
3.11%
2.78%
2.76%
3.14%
3.53%
3.84%
3.46%
3.08%
2.68%
2.41%
2.88%
2.68%
24
27
27
24
14
21
31
37
40
73
25
7
10
28
37
67
13
11
19
22
33
69
84
24
24
26
21
24
7%
7%
21%
7%
6%
7%
9%
9%
10%
14%
8%
5%
6%
7%
8%
16%
6%
5%
5%
6%
7%
10%
19%
6%
7%
17%
7%
7%
Agency MBS Remeasured at Fair Value Through
Earnings
Interest-Only Strips
Underlying
Unamortized
Principal
Balance
December 31, 2013
Weighted Average
Amortized
Cost
Fair
Value
Coupon 1
Yield 5
Age
(Months)
Fannie Mae...............................................................
$
1,167
$
191
$
Freddie Mac .............................................................
Principal-Only Strips....................................................
Fannie Mae...............................................................
213
270
Total / Weighted Average..............................................
$
1,650
$
32
209
432
$
200
32
205
437
5.49%
5.51%
—%
4.59%
7.11%
10.74%
3.84%
5.80%
37
90
25
35
_______________________
Projected
Life
CPR 5
10%
13%
8%
9%
1.
2.
The weighted average coupon on our agency MBS classified as "AFS" was 3.47% and the weighted average coupon on our total agency MBS portfolio,
including agency MBS remeasured at fair value through earnings, was 3.58% as of December 31, 2013.
Lower loan balance securities represent pools backed by an original loan balance of $150,000. Our lower loan balance securities had a weighted
average original loan balance of $100,000 and $95,000 for 15-year and 30-year securities, respectively, as of December 31, 2013.
3. HARP securities are defined as pools backed by100% refinance loans with LTV 80%. Our HARP securities had a weighted average LTV of 106%
and 105% for 15-year and 30-year securities, respectively, as of December 31, 2013. Includes $1.1 billion and $2.1 billion of 15-year and 30-year
securities with >105 LTV pools which are not deliverable into TBA securities.
4. WAC represents the weighted average coupon of the underlying collateral.
5.
Portfolio yield incorporates a projected life CPR assumption based on forward rate assumptions as of December 31, 2013.
TBAs and Forward Settling Securities
15-Year TBA securities:
December 31, 2013
Notional
Amount -
Long (Short)
1
Cost Basis 2
Market
Value 3
Net
Carrying
Value 4
2.5% ............................................................................
$
(1,184) $
(1,174) $
(1,171) $
3.0% ............................................................................
3.5% ............................................................................
4.0% ............................................................................
Total 15-Year TBAs
30-Year TBA securities:
3.0% ............................................................................
3.5% ............................................................................
4.0% ............................................................................
4.5% ............................................................................
Total 30-Year TBAs
(2,429)
(428)
(50)
(4,091)
54
600
4,131
1,425
6,210
(2,481)
(450)
(53)
(4,158)
52
598
4,274
1,510
6,434
(2,475)
(447)
(53)
(4,146)
52
598
4,256
1,511
6,417
Total TBAs and forward settling securities.....................
$
2,119
$
2,276
$
2,271
$
3
6
3
—
12
—
—
(18)
1
(17)
(5)
________________________
1. Notional amount represents the par value (or principal balance) of the underlying agency security.
2. Cost basis represents the forward price to be paid (received) for the underlying agency security.
3. Market value represents the current market value of the TBA contract (or of the underlying agency security) as of period-end.
4. Net carrying value represents the difference between the market value and the cost basis of the TBA contract as of period-end and is reported in
derivative assets / (liabilities), at fair value on the accompanying consolidated balance sheets.
46
December 31, 2012
Par
Value
Amortized
Cost
Amortized
Cost Basis
Fair
Value
% Lower
Loan
Balance &
HARP 2,3
Weighted Average
WAC 4
Yield 5
Age
(Months)
Projected
Life
CPR 5
Agency MBS Classified as AFS
Investments By Issuer:
Fannie Mae...............................
$ 58,912
$
62,120
Freddie Mac .............................
19,336
Ginnie Mae...............................
238
20,284
248
Total / Weighted Average..............
$ 78,486
$
82,652
105.4%
104.9%
104.2%
105.3%
$ 63,687
20,758
254
$ 84,699
Investments By Coupon: 1
Fixed-Rate
................................
$ 11,483
$
11,979
3.0%.....................................
3.5%.....................................
4.0%.....................................
4.5%.....................................
.................................
1,787
6,409
7,709
763
12
1,859
6,600
8,051
802
12
........................
28,163
29,303
20-Year
................................
3.5%.....................................
4%........................................
4.5%.....................................
.................................
938
315
113
141
10
983
330
118
151
10
Total 20-Year:...........................
1,517
1,592
30-Year:
................................
3.5%.....................................
4%........................................
4.5%.....................................
5.0%.....................................
.................................
Total 30-Year............................
Total Fixed-Rate...........................
Adjustable-Rate ............................
CMO.............................................
3,675
20,005
17,790
5,163
731
441
47,805
77,485
837
164
3,866
21,180
18,946
5,475
778
477
50,722
81,617
865
170
104.3%
104.0%
103.0%
104.4%
105.0%
104.4%
104.1%
104.7%
104.7%
104.5%
106.9%
106.6%
104.9%
105.2%
105.9%
106.5%
106.0%
106.4%
108.2%
106.1%
105.3%
103.4%
103.2%
$ 12,014
1,910
6,888
8,323
831
13
29,979
987
338
123
158
10
1,616
3,863
21,579
19,605
5,706
803
484
52,040
83,635
891
173
Total / Weighted Average..............
$ 78,486
$
82,652
105.3%
$ 84,699
77%
75%
—%
76%
18%
97%
93%
85%
98%
34%
61%
1%
49%
45%
96%
—%
23%
58%
89%
96%
85%
59%
31%
88%
77%
—%
—%
76%
4.06%
4.06%
4.12%
4.06%
2.60%
2.58%
1.60%
2.59%
3.01%
3.45%
3.93%
4.40%
4.86%
6.34%
3.68%
3.60%
4.04%
4.52%
4.89%
5.93%
3.90%
3.58%
4.01%
4.46%
4.94%
5.41%
6.31%
4.29%
4.06%
3.76%
5.22%
4.06%
1.52%
2.07%
2.69%
2.64%
3.03%
4.29%
2.17%
2.15%
2.57%
2.92%
2.88%
3.50%
2.37%
2.34%
2.67%
2.95%
3.35%
3.56%
3.61%
2.84%
2.59%
2.40%
2.85%
2.59%
13
14
24
13
3
12
21
25
28
58
15
4
10
16
26
56
8
3
7
13
22
41
72
12
13
43
66
13
10%
12%
19%
11%
11%
10%
13%
16%
15%
17%
13%
9%
10%
14%
14%
18%
10%
7%
8%
10%
12%
15%
18%
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 1
Yield 5
Age
(Months)
Projected
Life CPR 5
Fannie Mae....................................................................
$
1,332
$
245
$ 249
Freddie Mac ..................................................................
Principal-Only Strips.........................................................
Fannie Mae ........................................................................
328
302
Total / Weighted Average...................................................
$
1,962
$
______________________
55
43
5.82%
5.60%
6.98%
11.84%
241
541
254
—%
$ 546
4.89%
3.17%
5.78%
30
82
14
28
16%
17%
9%
13%
1.
The weighted average coupon on our agency MBS classified as "AFS" held as of December 31, 2012 was 3.59% and the weighted average coupon on
our total agency MBS portfolio, including agency MBS remeasured at fair value through earnings, held as of December 31, 2012 was 3.69%.
47
2.
Lower loan balance securities represent pools backed by an 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 LTVs 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. WAC represents the weighted average coupon of the underlying collateral.
5.
Portfolio yield incorporates a projected life CPR assumption based on forward rate assumptions as of December 31, 2012.
TBAs and Forward Settling Securities
15-Year TBA securities
December 31, 2012
Notional
Amount
Long /
(Short) 1
Cost Basis 2
Market
Value 3
Net
Carrying
Value 4
2.0%.................................................................
$
(50) $
(51) $
(51) $
2.5%.................................................................
8,448
8,797
3.0%.................................................................
3.5%.................................................................
Total 15-Year TBAs
30-Year TBA securities
3.0%.................................................................
3.5%.................................................................
4.0%.................................................................
Total 30-Year TBAs
30-Year 3.5% forward settling securities.............
(25)
(90)
(26)
(95)
8,283
8,625
13,256
(5,793)
(3,419)
4,044
150
13,805
(6,162)
(3,656)
3,987
163
8,837
(26)
(95)
8,665
13,880
(6,172)
(3,665)
4,043
162
Total TBAs...........................................................
$
12,477
$
12,775
$
12,870
$
—
40
—
—
40
75
(10)
(9)
56
(1)
95
________________________
1. Notional amount represents the par value (or principal balance) of the underlying agency security.
2. Cost basis represents the forward price to be paid (received) for the underlying agency security.
3. Market value represents the current market value of the TBA contract (or of the underlying agency security) as of period-end.
4. Net carrying value represents the difference between the market value and the cost basis of the TBA contract as of period-end and is reported in
derivative assets / (liabilities), at fair value on the accompanying consolidated balance sheets.
As of December 31, 2013 and 2012, the combined weighted average yield of our agency MBS portfolio, inclusive of interest
and principal-only strips, was 2.70% and 2.61%, respectively.
The stated contractual final maturity of the mortgage loans underlying our agency MBS portfolio ranges up to 40 years. As
of December 31, 2013 and 2012, the weighted average final contractual maturity of our agency MBS portfolio was 19 and 24
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
6.5 and 6.6 years as of December 31, 2013 and 2012, 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 7% and 11% as of December 31, 2013 and 2012, 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,
including principal and interest-only strips, was 104.6% of par value as of December 31, 2013, 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.
48
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, 2013 and 2012 (dollars in millions):
December 31, 2013
December 31, 2012
Estimated Weighted Average Life of
Agency MBS Classified as Available-
for-Sale 1
...................................................
$
............................
...........................
..........................
> 10 years ...............................................
Fair
Value
Amortized
Cost
$
129
498
24,471
38,522
1,884
129
491
24,342
39,635
1,996
Total...............................................
$
65,504
$
66,593
_______________________
1.
Excludes interest and principal-only strips.
Weighted
Average
Coupon
Weighted
Average
Yield
3.07%
4.08%
3.59%
3.39%
3.66%
3.47%
2.53%
2.25%
2.57%
2.73%
2.96%
2.68%
Fair
Value
Amortized
Cost
$
— $
—
1,119
27,448
54,054
2,078
1,108
26,750
52,735
2,059
$
84,699
$
82,652
Weighted
Average
Coupon
Weighted
Average
Yield
—%
4.18%
3.36%
3.69%
3.44%
3.59%
—%
2.14%
2.29%
2.75%
2.65%
2.59%
The weighted average life of our interest-only strips was 6.3 and 5.7 years as of December 31, 2013 and 2012, respectively,
and the weighted average life of our principal-only strips was 8.6 and 6.4 years as of December 31, 2013 and 2012, respectively.
Our pass-through agency MBS collateralized by adjustable rate mortgage loans ("ARMs") have coupons linked to various
indices. As of December 31, 2013 and 2012, our ARM securities had a weighted average next reset date of 64 months and 43
months, respectively.
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, 2013 and 2012 (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
December 31, 2013 ........................
December 31, 2012 ........................
$
$
42,853
8,430
$
$
(1,248) $
1,586
$
(101) $
44,439
(25) $
— $
— $
8,430
Unrealized
Loss
$
$
(1,349)
(25)
As of December 31, 2013, a decision had not been made 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 GSE guarantees, but are rather due to changes in interest
rates and prepayment expectations. Accordingly, we did not recognize any OTTI charges on our investment securities for fiscal
years 2013, 2012 and 2011. However, as we continue to actively manage our portfolio, we may recognize additional realized
losses on our agency securities upon selecting specific securities to sell.
RESULTS OF OPERATIONS
FISCAL YEAR 2013 COMPARED TO FISCAL YEAR 2012:
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
49
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 fiscal year.
Interest Income and Asset Yield
The following table summarizes our interest income for fiscal years 2013 and 2012 (dollars in millions):
Fiscal Year 2013
Fiscal Year 2012
Amount
Yield
Amount
Yield
Cash/coupon interest income.................................................... $
2,710
3.59 % $
2,776
3.90 %
Premium amortization ..............................................................
(517)
(0.82)%
(667)
(1.08)%
Interest income ......................................................................... $
2,193
2.77 % $
2,109
2.82 %
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%
7%
4.48%
3.03%
10%
11%
3.35%
1.76%
_______________________
1.
Source: Freddie Mac Primary Fixed Mortgage Rate Mortgage Market Survey
The principal elements impacting interest income are the size of our agency MBS investment portfolio and the yield on our
investments. The following is a summary of the estimated impact of each of these elements on changes in interest income between
fiscal years 2013 and 2012 (in millions):
Fiscal Year 2013 vs. 2012
Due to Change in Average 1
Net
Increase
Portfolio
Size
Asset
Yield
Interest Income .................................. $
84
$
119
$
(35)
_______________________
1. Variances that are the combined effect of changes in portfolio size and asset yield, but cannot be separately identified, are allocated to the portfolio
size and asset yield variances based on their respective relative amounts.
The modest increase in interest income during fiscal year 2013 was due to a 6% increase in our average portfolio size, as a
function of our larger equity capital base, which was partially offset by a decline in our average asset yield, primarily due to a
decrease in the average coupon on our assets from 3.90% during fiscal year 2012 to 3.59% for fiscal year 2013 as a result of
portfolio repositioning.
Additionally, our average asset yield during fiscal year 2013 was favorably impacted by a "catch-up" premium amortization
benefit of approximately $103 million due to a decrease in our average projected CPR, compared to a $9 million "catch-up" benefit
during 2012.
Leverage
Our leverage was 7.3 times and 7.0 times our stockholders' equity as of December 31, 2013 and 2012, respectively, measured
as the sum of our agency MBS repurchase agreements, net receivable / payable for unsettled agency securities and debt of
consolidated VIEs divided by the sum of our total stockholders' equity less the fair value of our investments in REIT equity
securities as of period end. Since the individual agency mortgage REITs in which we invest employ similar leverage as within
our agency portfolio, we acquire these securities on an unlevered basis and, therefore, exclude from our leverage measurements
the portion of our stockholders' equity allocated to investments in other mortgage REITs. In addition, our measurement of leverage
excludes repurchase agreements used to fund short-term investments in U.S. Treasury securities due to the highly liquid and
temporary nature of these investments.
Inclusive of our net TBA position, our total "at risk" leverage was 7.5 times and 8.2 times our stockholders' equity as of
December 31, 2013 and 2012, respectively. We recognize our TBA commitments as derivatives under GAAP and, thus, they are
50
not included in our repurchase agreement ("repo") and other debt leverage calculations; however, a long TBA position carries
similar risks as if we had purchased the underlying MBS assets and funded such purchases with on-balance sheet repurchase
agreements. Similarly, a short TBA position has substantially the same effect as selling the underlying MBS assets and reducing
our on-balance sheet repurchase commitments. (Refer to Liquidity and Capital Resources for further discussion of TBA dollar
roll positions). Therefore, we commonly refer to our leverage adjusted for TBA positions as our "at risk" leverage.
The table below presents our quarterly average and quarter-end repo and other debt balance outstanding and leverage ratios
for fiscal years 2013 and 2012 (dollars in millions):
Repurchase Agreements and Other Debt 1
Quarter Ended
Average Daily
Amount
Outstanding
Maximum
Daily Amount
Outstanding
Ending
Amount
Outstanding
Average
Leverage
during the
Period 1,2
Average Total
"At Risk"
Leverage
during the
Period 1,3
Leverage
as of
Period End 1,4
"At Risk"
Leverage
as of
Period End 1,5
December 31, 2013 .............. $
September 30, 2013 ............. $
June 30, 2013 ....................... $
March 31, 2013 .................... $
December 31, 2012 .............. $
September 30, 2012 ............. $
June 30, 2012 ....................... $
March 31, 2012 .................... $
_______________________
71,260
78,845
66,060
70,591
74,649
75,106
67,997
57,480
$
$
$
$
$
$
$
$
80,706
83,859
71,102
75,580
80,262
81,227
70,354
69,867
$
$
$
$
$
$
$
$
62,124
79,117
71,102
67,122
75,415
80,262
70,290
69,866
7.6:1
7.8:1
5.9:1
6.5:1
6.7:1
7.1:1
7.5:1
8.2:1
7.5:1
7.8:1
8.4:1
8.2:1
7.8:1
NM
NM
NM
7.3:1
7.9:1
7.0:1
5.7:1
7.0:1
7.0:1
7.6:1
8.4:1
7.5:1
7.2:1
8.5:1
8.1:1
8.2:1
NM
NM
NM
1.
2.
3.
4.
Excludes U.S. Treasury repo agreements.
Average leverage during the period was calculated by dividing the sum of our daily weighted average agency repurchase agreements and debt of consolidated
VIEs outstanding for the period by the sum of our average month-end stockholders' equity for the period less the fair value of our average investment in
REIT equity securities.
Average "at risk" leverage during the period includes the components of "average leverage during the period", plus our daily weighted average net TBA
position (at cost) during the period.
Leverage as of period end was calculated by dividing the sum of the amount outstanding under our agency MBS repurchase agreements, net payables and
receivables for unsettled agency MBS securities and debt of consolidated VIEs by the sum of our total stockholders' equity less the fair value of our
investment in REIT equity securities at period end.
"At risk" leverage as of period end includes the components of "leverage as of period end" plus the cost basis (or contract price) of our net TBA position.
5.
NM = Not meaningful. Prior to the fourth quarter of 2012, our net TBA position primarily consisted of short TBAs used for hedging purposes.
Interest Expense and Cost of Funds
Our interest expense is 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. Upon our election to discontinue
hedge accounting under GAAP as of September 30, 2011, 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.
Our "adjusted net interest expense", also referred to as our "cost of funds" when stated as a percentage of our outstanding
repurchase agreements and other debt balance, includes periodic interest costs on our interest rate swaps reported in gain (loss)
on derivatives and other securities, net in our consolidated statements of comprehensive income. Our cost of funds does not
include swap termination fees and costs associated with our other supplemental hedges, such as swaptions and short U.S. Treasury
positions. Our cost of funds also does not include costs associated with TBAs, including the implied financing cost/benefit of our
net TBA dollar roll position.
51
The table below presents a reconciliation of our interest expense (the most comparable GAAP financial measure) to our
adjusted net interest expense and cost of funds (non-GAAP financial measures) for fiscal years 2013 and 2012 (dollars in millions):
Adjusted Net Interest Expense and Cost of Funds
Interest expense:
Fiscal Year 2013
% 1
Amount
Fiscal Year 2012
% 1
Amount
Repurchase agreement and other debt interest expense ......
$
347
0.48% $
307
0.44%
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........
$
189
536
424
960
0.26%
0.74%
0.60%
1.34% $
205
512
252
764
0.30%
0.74%
0.37%
1.11%
_______________________
1.
Percent of our average repurchase agreements and other debt outstanding for the period annualized.
The principal elements impacting our adjusted net interest expense are the size of our repurchase agreements and interest
rate swap portfolio and our cost of funds. The following is a summary of the estimated impact of these elements on changes in
adjusted net interest expense between fiscal year 2013 and 2012 (in millions):
Fiscal Year 2013 vs. 2012
Due to Change in Average 1
Increase
Repo / Swap
Balance
Repo / Swap
Rate
Repurchase agreements and other debt expense ........................ $
Periodic interest rate swap costs 2 ..............................................
Total change in adjusted net interest expense............................. $
40
156
196
$
$
15
135
150
$
$
25
21
46
_______________________
1. Variances that are the combined effect of changes in our repurchase agreement/interest rate swap balance and changes in repurchase agreement/swap
2.
interest rates, but cannot be separately identified, are allocated to each variance based on their respective relative amounts.
Includes amounts recognized in interest expense and in gain (loss) on derivatives and other securities, net 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.
The increase in our adjusted net interest expense was primarily a function of maintaining a higher ratio of interest rate swaps
to repurchase agreements and other debt during fiscal year 2013 compared to 2012. Adjusted net interest expense was also impacted
by an increase in our overall average repo balance attributable to a larger investment portfolio and moderately higher average repo
and swap rates during fiscal year 2013. The table below presents a summary of our average repo and interest rates swaps outstanding
for fiscal years 2013 and 2012 (dollars in millions):
Average Debt and Interest Rate Swaps Outstanding
Average repurchase agreements and other debt ......................................................
Average notional amount of interest rate swaps 1 ...................................................
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
2013
2012
$ 71,753
$ 68,810
$ 47,007
$ 38,885
66%
1.55%
57%
1.50%
_______________________
1. Average notional amount of interest rate swaps excludes forward starting swaps not in effect during the periods presented.
52
Net Spread Income
The table below presents a reconciliation of our net interest income (the most comparable GAAP financial measure) to our
net spread and dollar roll income (a non-GAAP financial measure) for fiscal years 2013 and 2012 (dollars in millions):
Net interest income................................................................................................ $
Other periodic interest costs of interest rate swaps, net 1 ...................................
Dividend on REIT equity securities ...................................................................
Adjusted net interest income .................................................................................
Operating expenses.............................................................................................
Net spread income .................................................................................................
Dividend on preferred stock ...............................................................................
Net spread income available to common shareholders .........................................
TBA dollar roll income 1 ....................................................................................
Net spread and dollar roll income available to common shareholders.................. $
Weighted average number of common shares outstanding - basic and diluted....
Net spread income per common share - basic and diluted .................................... $
Net spread and dollar roll income per common share - basic and diluted ............ $
Fiscal Year
2013
2012
1,657
$
1,597
(424)
5
1,238
168
1,070
14
1,056
320
1,376
379.1
2.79
3.63
$
$
$
(252)
—
1,345
144
1,201
10
1,191
98
1,289
303.9
3.92
4.24
_______________________
1. Reported in gain (loss) on derivatives and other securities, net in our consolidated statements of comprehensive income.
The decline in net spread and dollar roll income per common share for fiscal year 2013 was primarily a function of lower
asset yields and higher swap costs.
Gain (Loss) on Sale of Agency Securities, Net
The following table is a summary of our net gain (loss) on sale of agency MBS for fiscal years 2013 and 2012 (in millions):
Fiscal Year
2013
2012
Agency MBS sold, at cost ...................................................... $
Proceeds from agency MBS sold 1 .........................................
Net (loss) gain on sale of agency MBS .................................. $
(81,516) $
(63,610)
80,108
(1,408) $
64,806
1,196
Gross gain on sale of agency MBS ........................................ $
217
$
Gross loss on sale of agency MBS .........................................
(1,625)
Net (loss) gain on sale of agency MBS .................................. $
(1,408) $
1,209
(13)
1,196
_______________________
1.
Proceeds include cash received during the period, plus receivable for agency MBS sold during the period as of period end.
Asset sales were primarily to reposition our agency MBS portfolio towards securities with attributes that our Manager
believed would provide greater relative value and risk-adjusted returns in light of current and anticipated interest rates, federal
government programs, general economic conditions and other factors. The net loss on asset sales during fiscal year 2013 was
primarily a function of declining asset values throughout most of fiscal year 2013, owing to higher interest rates and wider mortgage
spreads, compared to a lower rate environment and rising asset values throughout most of fiscal year 2012.
53
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 the fiscal years
2013 and 2012 (in millions):
Periodic interest costs of interest rate swaps, net 1 ..................................................
Realized gain (loss) on derivative instruments and other securities, net:
Net TBAs and forward settling agency securities 2...........................................
Payer swaptions.................................................................................................
U.S. Treasury securities - long position ............................................................
U.S. Treasury securities - short position ...........................................................
U.S. Treasury futures - short position ...............................................................
Interest rate swap termination fees....................................................................
Dividend from REIT equity securities ..............................................................
Other..................................................................................................................
Total realized gain (loss) on derivative instruments and other securities, net .........
Unrealized gain (loss) on derivative instruments and other securities, net: 3
Net TBAs and forward settling agency securities 2...........................................
Interest rate swaps .............................................................................................
Payer swaptions.................................................................................................
Interest and principal-only strips.......................................................................
U.S. Treasury securities - long position ............................................................
U.S. Treasury securities - short position ...........................................................
U.S. Treasury futures - short position ...............................................................
Debt of consolidated VIEs ................................................................................
REIT equity securities.......................................................................................
Fiscal Year
2013
2012
$
(424) $
(252)
(626)
233
13
412
10
29
5
(6)
70
(100)
1,540
25
—
(55)
60
39
39
(3)
(50)
(42)
(1)
(144)
(104)
(180)
—
—
(521)
81
(602)
(64)
17
—
2
14
(28)
—
(580)
Total unrealized gain (loss) on derivative instruments and other securities, net .....
1,545
Total gain (loss) on derivative instruments and other securities, net.......................
$
1,191
$
(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. Gain (loss) from purchases and sales of TBAs and forward settling positions includes TBA dollar roll income (see Net Spread Income above) and net
gains and losses due to changes in fair value.
3. Unrealized gain (loss) from derivative instruments and other securities, net includes reversals of prior period amounts for settled, terminated or expired
derivative instruments and other securities.
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 Form 10-K.
Management Fees and General and Administrative Expenses
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 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 $136 million
and $113 million during fiscal years 2013 and 2012, respectively. The year-over-year increase was primarily due to follow-on
equity raises during fiscal year 2012, partially offset by share repurchases and realized losses on sales of agency securities during
fiscal year 2013.
General and administrative expenses were $32 million and $31 million during fiscal years 2013 and 2012, respectively, and
primarily consisted of prime broker fees, information technology costs, accounting fees, legal fees, Board of Director fees, insurance
expense and general overhead expense.
Our total operating expense as a percentage of our average stockholders' equity was 1.61% and 1.52% as of December 31,
2013 and 2012, respectively.
54
Dividends and Income Taxes
For the fiscal years 2013 and 2012, we had estimated taxable income available to common shareholders of $940 million
and $2.1 billion (or $2.48 and $6.87 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) timing differences, both temporary and potentially permanent, in the recognition of certain realized
gains and losses and (iii) temporary differences related to the amortization of net premiums paid on investments. 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 fiscal years 2013 and 2012
(dollars in millions).
Fiscal Year
2013
2012
Net income .............................................................................................................. $
1,259
$
1,277
Estimated book to tax differences:
Premium amortization, net...................................................................................
Realized (gain) loss, net.......................................................................................
Capital losses in excess of capital gains ..............................................................
Unrealized (gain) loss, net ...................................................................................
Other ....................................................................................................................
Total book to tax differences ..........................................................................
Estimated REIT taxable income .............................................................................
Dividend on preferred stock.................................................................................
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 ................ $
(137)
(414)
1,785
(1,546)
7
(305)
954
14
940
379.1
2.48
$
$
51
159
—
574
38
822
2,099
10
2,089
303.9
6.87
Taxable income for fiscal year 2013 excludes $1.8 billion of estimated net capital losses, which are not deductible from our
ordinary taxable income. The net capital losses may be carried forward and applied against future net capital gains for up to five
years through fiscal year 2018.
The decrease in our estimated taxable income is a function of lower net interest spreads during fiscal year 2013 and a decline
in net taxable capital gains on our investments and hedging instruments from fiscal year 2012 to a net capital loss during fiscal
year 2013.
We declared Series A Preferred Stock dividends with record dates falling within fiscal year 2013 and 2012 of $2.000 and
$1.056 per preferred share, respectively. Additionally, during fiscal years 2013 and 2012, we declared common dividends of $3.75
and $5.00 per common share, respectively.
As of December 31, 2013, we had distributed all of our 2012 taxable income under the available spill-back provision so that
we will not be subject to federal or state corporate income tax for our 2012 tax year. As of December 31, 2013, we had an estimated
$210 million of current year undistributed taxable income, net of dividends declared. We expect to distribute all of our 2013
taxable income within the allowable time frame, including 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 the
fiscal years 2013 and 2012, we accrued a federal excise tax of $3 million and $25 million, respectively, which is included in our
net income tax provision on our accompanying consolidated statements of comprehensive income.
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 year 2013, we recorded an income tax provision of $10 million and, for fiscal year 2012,
55
we recorded an income tax benefit of $6 million 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 years 2013 and 2012 (in
millions):
Fiscal Year
2013
2012
Unrealized (loss) gain on AFS securities, net:
Unrealized (loss) gain, net ............................................................................................
$
(4,535) $
2,235
Reversal of prior period unrealized loss (gain), net, upon realization..........................
1,408
(1,196)
Unrealized (loss) gain on AFS securities, net:................................................................
(3,127)
1,039
Unrealized gain on interest rate swaps designated as cash flow hedges:
Reversal of prior period unrealized loss on interest rate swaps, net, upon
reclassification to interest expense ...............................................................................
189
205
Total other comprehensive (loss) income .......................................................................
$
(2,938) $
1,244
FISCAL YEAR 2012 COMPARED TO FISCAL YEAR 2011:
Interest Income and Asset Yield
The following table summarizes our interest income for the fiscal years 2012 and 2011 (dollars in millions):
Fiscal Year 2012
Fiscal Year 2011
Cash/coupon interest income.................................................... $
2,776
3.90 %
$1,470
Amount
Yield
Amount
Yield
4.42%
Premium amortization ..............................................................
(667)
(1.08)%
(361)
(1.23)%
Interest income ......................................................................... $
2,109
2.82 %
$1,109
3.19%
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%
9%
14%
3.95%
1.88%
_______________________
1.
Source: Freddie Mac Primary Fixed Mortgage Rate Mortgage Market Survey
The principal elements impacting interest income are the size of our agency MBS investment portfolio and the yield on our
investments. The following is a summary of the estimated impact of each of these elements on changes in interest income between
fiscal years 2012 and 2011(in millions):
Fiscal Year 2012 vs. 2011
Due to Change in Average 1
Net
Increase
Portfolio
Size
Asset
Yield
Interest Income .................................. $
1,000
$
1,112
$
(112)
_______________________
1. Variances that are the combined effect of changes in portfolio size and asset yield, but cannot be separately identified, are allocated to the portfolio
size and asset yield variances based on their respective relative amounts.
56
The primary driver of the increase in our interest income during fiscal year 2012 was a 115% increase in our average portfolio
size as a function of our larger equity capital base. Partially offsetting the increase was a decline in our average asset yield primarily
due to a decrease in the average coupon on our assets from 4.42% for fiscal year 2011 to 3.90% for fiscal year 2012.
Leverage
Our leverage was 7.0 times and 7.9 times our stockholders' equity as of December 31, 2012 and 2011, respectively, measured
as the sum of our repurchase agreements, net receivable / payable for unsettled securities and debt of consolidated VIEs divided
by our total stockholders' equity as of period end.
The table below presents our quarterly average and quarter-end repo and other debt balance outstanding and leverage ratios
for fiscal years 2012 and 2011 (dollars in millions):
Repurchase Agreements and Other Debt
Quarter Ended
December 31, 2012...................................... $
September 30, 2012..................................... $
June 30, 2012............................................... $
March 31, 2012............................................ $
December 31, 2011...................................... $
September 30, 2011..................................... $
June 30, 2011 3............................................. $
March 31, 2011 3 ......................................... $
Average Daily
Amount
Outstanding
Maximum
Daily Amount
Outstanding
Ending
Amount
Outstanding
Average
Leverage during
the Period 1
74,649
75,106
67,997
57,480
42,184
38,484
28,668
17,756
$
$
$
$
$
$
$
$
80,262
81,227
70,354
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
6.7:1
7.1:1
7.5:1
8.2:1
7.6:1
7.9:1
7.6:1
7.4:1
Leverage
as of
Period End,
Including Net
Unsettled
Trades 2
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 agency repurchase agreements and debt of consolidated VIEs
outstanding for the period by our average month-end stockholders' equity for the period.
Leverage as of period end was calculated by dividing the sum of the amount outstanding under our agency MBS repurchase agreements, net payables and
receivables for unsettled agency MBS securities and debt of consolidated VIEs by our total stockholders' equity at period end.
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.
2.
3.
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. 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
The table below presents a reconciliation of our interest expense (the most comparable GAAP financial measure) to our
adjusted net interest expense and cost of funds (non-GAAP financial measures) for fiscal years 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.
57
The following is a summary of the estimated impact of changes in the principal elements of our adjusted net interest expense
between fiscal year 2012 and 2011(in millions):
Fiscal Year 2012 vs. 2011
Due to Change in Average 1
Increase
Repo / Swap
Balance
Repo / Swap
Rate
Repurchase agreements and other debt expense ........................ $
Periodic interest rate swap costs 2 ..............................................
Total change in adjusted net interest expense............................. $
216
228
444
$
$
142
241
383
$
$
74
(13)
61
_______________________
1. Variances that are the combined effect of changes in our repurchase agreement/interest rate swap balance and changes in repurchase agreement/swap
2.
interest rates, but cannot be separately identified, are allocated to each variance based on their respective relative amounts.
Includes amounts recognized in interest expense and in gain (loss) on derivatives and other securities, net 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.
The increase in our adjusted net interest expense was a function a larger repo balance due to a larger investment portfolio
and a higher cost of funds. Our higher cost of funds was reflective of higher 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 was a function of the combination of higher repo rates in the market and extending
the average remaining days-to-maturity of our repo funding to 118 days as of December 31, 2012 from 51 days as of December 31,
2011. The table below presents a summary of our debt and interest rate swaps outstanding for fiscal years 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 1 ...................................................
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%
_______________________
1. Average notional amount of interest rate swaps excludes forward starting swaps not in effect during the periods presented.
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 2012 and 2011 (dollars in millions):
Fiscal Year
2012
2011
Net interest income................................................................................................ $
Other periodic interest costs of interest rate swaps, net 1 ...................................
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....
1,597
$
252
1,345
144
1,201
10
1,191
303.9
Net spread income per common share - basic and diluted .................................... $
3.92
$
824
35
789
74
715
—
715
153.3
4.66
_______________________
1. Reported in gain (loss) on derivatives and other securities, net in our consolidated statements of comprehensive income.
58
The decline in net spread income per common share was primarily a function of margin compression due to lower asset
yields and higher cost of funds.
Gain (Loss) on Sale of Agency Securities, Net
The following table is a summary of our net gain on sale of agency MBS for fiscal years 2012 and 2011 (in millions):
Agency MBS sold, at cost ...................................................... $
Proceeds from agency MBS sold 1 .........................................
Net gain on sale of agency MBS ............................................ $
Gross gain on sale of agency MBS ........................................ $
Gross loss on sale of agency MBS .........................................
Net gain on sale of agency MBS ............................................ $
Fiscal Year
2012
2011
(63,610) $
(37,579)
64,806
1,196
1,209
(13)
1,196
$
$
$
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 were primarily to reposition our agency MBS portfolio towards securities with attributes that our Manager
believed would provide 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 2012
and 2011 (in millions):
Periodic interest costs of interest rate swaps, net 1 ..................................................
Realized (loss) on derivative instruments and other securities, net:
Net TBAs and forward settling agency securities.............................................
Payer swaptions.................................................................................................
U.S. Treasury securities - long position ............................................................
U.S. Treasury securities - short position ...........................................................
U.S. Treasury futures - short position ...............................................................
Interest rate swap termination fees....................................................................
Other..................................................................................................................
Total realized (loss) gain on derivative instruments and other securities, net .........
Unrealized (loss) on derivative instruments and other securities, net: 2
Net TBAs and forward settling agency securities.............................................
Interest rate swaps .............................................................................................
Payer swaptions.................................................................................................
Interest-only and principal-only strips ..............................................................
U.S. Treasury securities - short position ...........................................................
U.S. Treasury futures - short position ...............................................................
Debt of consolidated VIEs ................................................................................
Total unrealized (loss)on derivative instruments and other securities, net..............
Fiscal Year
2012
2011
$
(252) $
(35)
(50)
(42)
(1)
(144)
(104)
(180)
—
(521)
81
(602)
(64)
17
2
14
(28)
(580)
(141)
(13)
34
(116)
1
(7)
8
(234)
(1)
(79)
(51)
(17)
(17)
(13)
—
(178)
(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, terminated or expired
derivative instruments and other securities.
59
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 Form 10-K.
Management Fees and General and Administrative Expenses
We incurred management fees of $113 million and $55 million during fiscal years 2012 and 2011, respectively; the period-
over-period increase was primarily a function of our follow-on equity raises.
General and administrative expenses were $31 million and $19 million during fiscal years 2012 and 2011, respectively. Our
general and administrative expenses primarily consisted of prime broker fees, information technology costs, accounting fees, legal
fees, Board of Director fees, insurance expense and general overhead expense.
Our total operating expense as a percentage of our average stockholders' equity on an annualized basis was 1.52% and 1.77%
for fiscal years 2012 and 2011, respectively, due to improved operating leverage.
Dividends and Income Taxes
For fiscal years 2012 and 2011, we had estimated taxable income available to common shareholders of $2.1 billion and $1.0
billion (or $6.87 and $6.70 per common share), respectively. The following is a reconciliation of our GAAP net income to our
estimated taxable income for fiscal years 2012 and 2011 (dollars in millions).
Fiscal Year
2012
2011
Net income .............................................................................................................. $
1,277
$
770
Estimated 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.................................................................................
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 ................ $
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
During fiscal years 2012 and 2011, we declared common dividends of $5.00 and $5.60 per common share, respectively.
During 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 income tax purposes. We did not have preferred stock outstanding prior to fiscal year 2012.
We distributed all of our 2012 and 2011 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
years 2012 and 2011, we accrued federal excise tax of $25 million and $2 million, respectively.
For fiscal year 2012, we recorded an income tax benefit of $6 million and, for fiscal year 2011, we recorded an income tax
provision of $4 million, attributable to our TRS, at the combined federal and state corporate statutory tax rate of 39.5%, which is
included in our net income tax provision on our accompanying consolidated statements of comprehensive income.
60
Other Comprehensive Income
The following table summarizes the components of our other comprehensive income for fiscal years 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 ..................................
(1,196)
Unrealized gain on AFS securities, net:..........................................................................
1,039
Unrealized gain 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:..........................................................
—
205
205
(483)
1,029
(844)
194
(650)
Total other comprehensive income.................................................................................
$
1,244
$
379
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 our 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 net taxable income. To the extent that we annually distribute all of our net 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 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. In addition, during fiscal year 2013, we repurchased approximately
$856 million of our common stock under our common stock repurchase program as our common stock was trading at a meaningful
discount to our estimated net asset value per common share.
Common Stock Repurchase Program
In October 2012, our Board of Directors adopted a program that provides for stock repurchases of up to $500 million of our
outstanding shares of common stock through December 31, 2013. In September 2013, our Board of Directors increased the
authorized amount to $1 billion of our outstanding shares of common stock and extended its authorization through December 31,
2014. In January 2014, our Board of Directors increased the authorized amount by an additional $1 billion of our outstanding
shares of common stock through December 31, 2014. 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 Exchange Act of 1934, as amended. 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
61
repurchases will be made in accordance with Rule 10b-18, which sets certain restrictions on the method, timing, price and volume
of stock repurchases.
During fiscal year 2013, we repurchased approximately 40.3 million shares of our common stock at an average repurchase
price of $21.25 per share, including expenses, totaling $856 million. During fiscal year 2012, we repurchased 2.7 million shares
of our common stock at an average repurchase price of $29.00 per share, including expenses, totaling $77 million. As of
December 31, 2013, the total remaining amount authorized for repurchases of our common stock was $66 million, excluding the
additional amount authorized in January 2014.
Preferred Stock
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, 2013, 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.
Follow-on Common Stock Offering
During fiscal years 2013, 2012 and 2011, 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 2013
Price Received
Per Share 1
Shares
Net Proceeds 2
March 2013.............................
$31.34
Total fiscal year 2013 .........
Fiscal year 2012
March 2012.............................
July 2012 ................................
$29.00
$33.70
Total fiscal year 2012 .........
Fiscal year 2011
January 2011...........................
March 2011.............................
June 2011................................
November 2011 ......................
Total fiscal year 2011 .........
$28.00
$27.72
$27.56
$27.36
57.5
57.5
$
$
71.2
$
36.8
108.0
$
26.9
$
32.2
49.7
40.5
149.3
$
1,803
1,803
2,063
1,240
3,303
719
892
1,369
1,108
4,088
________________________
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 entered into 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 of our common stock under
such sales agreements during fiscal years 2012 and 2011 (in millions, except per share amounts):
At-the-Market Offering
Fiscal year 2012.........................
Fiscal year 2011.........................
Price Received
Per Share
$
$
31.41
29.25
Shares
Net Proceeds
9.5
9.4
$
$
298
273
62
During fiscal year 2013, we had no sales under this program. As of December 31, 2013, 16.7 million shares remain available
for issuance under this program.
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 year 2011, we issued 0.5 million shares under the plan for net cash proceeds of $15 million. During fiscal years
2013 and 2012, there were no shares issued under the plan. As of December 31, 2013, 21.7 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 risks 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 as of December 31, 2013 was 7.3 times our stockholders' equity, measured as the sum of
our agency MBS repurchase agreements, net receivable / payable for unsettled agency securities and debt of consolidated VIEs
divided by the sum of our total stockholders' equity less the fair value of our investment in REIT equity securities as of period
end. Since the individual agency mortgage REITs in which we invest employ similar leverage as within our agency portfolio, we
acquire these securities on an unlevered basis and, therefore, exclude from our leverage measurements the portion of our
stockholders' equity allocated to investments in other mortgage REITs. In addition, our measurement of leverage excludes
repurchase agreements used to fund short-term investments in U.S. Treasury securities due to the highly liquid and temporary
nature of these investments.
As of December 31, 2013, our agency MBS repurchase agreements had a weighted average cost of funds of 0.45% and a
weighted average remaining days-to-maturity of 124 days, excluding amounts borrowed under U.S. Treasury repurchase
agreements.
To limit our exposure to counterparty credit risk, we diversify our funding across multiple counterparties and by counterparty
region. As of December 31, 2013, we had master repurchase agreements with 32 financial institutions, subject to certain conditions,
located throughout North America, Europe and Asia. As of December 31, 2013, less than 4% of our stockholders' equity was at
risk with any one repo counterparty, with the top five repo counterparties representing approximately 14% 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, 2013. For further details regarding our borrowings under repurchase agreements and other debt as of
December 31, 2013, please refer to Note 4 to our consolidated financial statements in this Form 10-K.
Counter-Party Region
North America..................................
Asia ..................................................
Europe ..............................................
December 31, 2013
Number of
Counter-Parties
17
5
10
32
Percent of
Repurchase
Agreement
Funding
62%
25%
13%
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 2013, haircuts on our pledged collateral remained stable and as of December 31, 2013, our weighted average
haircut was approximately 5% of the value of our collateral.
63
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 determinations of value. 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, 2013, we had met all of our margin requirements and we had unrestricted cash and cash equivalents
of $2.1 billion and unpledged securities of approximately $1.9 billion, including securities pledged to us, available to 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.
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, U.S. Treasury futures
contracts and other instruments. Please refer to Notes 2 and 5 to our consolidated financial statements in this 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. Our counterparties, or the clearing agency in the case
of centrally cleared interest rate swaps, 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.
Similar to repurchase agreements, our use of derivatives exposes us to counterparty 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 by monitoring
positions with individual counterparties.
Excluding centrally cleared interest rate swaps, as of December 31, 2013, our amount at risk with any counterparty related
to our interest rate swap and swaption agreements was less than 2% of our stockholders' equity.
In the case of centrally cleared interest rate swap contracts, we could be exposed to credit risk if the central clearing agency
or a clearing member defaults on its respective obligation to perform under the contract. However, we believe that the risk is
minimal due to the exchange's initial and daily mark to market margin requirements and a clearinghouse guarantee fund and other
resources that are available in the event of a clearing member default.
TBA Dollar Roll Transactions
We may also enter into TBA dollar roll transactions as a means of leveraging (long TBAs) or deleveraging (short TBAs)
our investment portfolio. 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, 2013, our total "at risk" leverage was 7.5 times our stockholders' equity.
Under certain market conditions, it may be uneconomical for us to roll our TBA contracts into future months and we may
need to take or make physical delivery of the underlying securities. If we were required to take physical delivery to settle a long
TBA contract, we would have to fund our total purchase commitment with cash or other financing sources and our liquidity position
64
could be negatively impacted. As of December 31, 2013, we had a net long TBA position with a market value of $2.3 billion, a
total contract price of $2.3 billion and a total carrying value of $(5) million recognized in derivative assets/(liabilities), at fair value
on our consolidated balance sheets in this Form 10-K.
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 pledged collateral
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 by taking delivery of the underlying securities as well as satisfying margin requirements
could negatively impact our liquidity position. However, 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, 2013, approximately 95% of our fixed-rate agency MBS portfolio was eligible for TBA delivery.
OFF-BALANCE SHEET ARRANGEMENTS
As of December 31, 2013, 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, 2013,
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):
Fiscal Year
2014
2015
2016
2017
2018
Total
Repurchase agreements.......................................................................
$ 59,170
$
3,261
$
500
$
202
$
400
$ 63,533
Interest expense on repurchase agreements 1......................................
82
13
2
1
1
99
Total ....................................................................................................
$ 59,252
$
3,274
$
502
$
203
$
401
$ 63,632
________________________
1.
Interest expense on repurchase agreements is calculated based on the weighted average interest rates as of December 31, 2013.
65
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 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.
The principal instruments that we use are interest rate swaps and options to enter into interest rate swaps. We also utilize forward
contracts for the purchase or sale of agency MBS securities on a generic pool, or a TBA contract, basis and on a non-generic,
specified pool basis, and we utilize U.S. Treasury securities and U.S. Treasury futures contracts, primarily through short sales.
We may also purchase or write put or call options on TBA securities and we may invest in other types of mortgage derivatives,
such as interest and principal-only securities, and synthetic total return swaps. Derivative instruments may expose us 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 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.
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
66
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.
Further, since we do not control the other agency mortgage REITs in which we invest in, we have limited transparency into
their underlying investment and hedge portfolios. Therefore, our Manager must make certain assumptions to estimate the duration
and convexity of the underlying portfolios and their sensitivity to changes in interest rates. Such estimates do not include the
potential impact of other factors which may affect the fair value of our investments in other REITs, such as stock market volatility.
Accordingly, actual results could differ from our estimates.
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
instantaneous parallel shifts in the yield curve and including 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 and prepayment projections as of December 31, 2013 and 2012. We apply a floor of 0% for the down rate scenarios
on our interest bearing liabilities and the variable leg of our interest rate swaps, such that any hypothetical interest rate decrease
would have a limited positive impact on our funding costs beyond a certain level.
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 table below reflects 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.
Interest Rate Sensitivity 1
Change in Interest Rate
As of December 31, 2013
-100 Basis Points .....................
-50 Basis Points .......................
+50 Basis Points ......................
+100 Basis Points ....................
As of December 31, 2012
-100 Basis Points .....................
-50 Basis Points .......................
+50 Basis Points ......................
+100 Basis Points ....................
Percentage Change in Projected
Portfolio
Market
Value 3,4
Net Interest
Income 2
Net Asset
Value 3,5
+1.8%
+6.8%
-3.6%
-7.2%
-16.6%
+2.1%
-3.5%
-10.3%
+1.1%
+0.8%
-0.8%
-1.7%
-1.8%
-0.7%
-0.2%
-1.1%
+9.0%
+6.1%
-6.4%
-13.1%
-15.1%
-5.5%
-2.0%
-9.1%
________________
1.
Interest rate sensitivity is derived from models that are dependent on inputs and assumptions provided by third parties as well as by our Manager,
assumes there are no changes in mortgage spreads and assumes a static portfolio. Actual results could differ materially from these estimates.
2. Represents the 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 such date. It includes the effect of periodic interest costs on our interest rate swaps, but excludes costs associated with our other supplemental
hedges, such as swaptions and U.S. Treasury securities. Also excludes costs associated with our TBA position and TBA dollar roll income/loss. Base
case scenario assumes interest rates and forecasted CPR of 7% and 11% as of December 31, 2013 and 2012, respectively. As of December 31, 2013,
rate shock scenarios assume a forecasted CPR of 6%, 7%, 8% and 10% for the +100 basis points, +50 basis points, - 50 basis points and -100 basis
points scenarios, respectively. As of December 31, 2012, rate shock scenarios assume a forecasted CPR of 7%, 8%, 15% and 20% for such 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 a decrease/increase in the forecasted CPR and does not include dividend income from investments in other REITs. Down rate
scenarios assume a floor of 0% for anticipated interest rates.
Includes the effect of derivatives and other securities used for hedging purposes.
Estimated dollar change in investment portfolio value expressed as a percent of the total fair value of our investment portfolio as of such date.
Estimated dollar change in portfolio value expressed as a percent of stockholders' equity, net of the Series A Preferred Stock liquidation preference, as
of such date.
3.
4.
5.
67
The change in our interest rate sensitivity as of December 31, 2013 compared to December 31, 2012 was a function of a
steeper yield curve, partially mitigated by changes in the size and composition of our asset and hedge portfolio.
Prepayment Risk
Because residential borrowers have the option 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 faster than anticipated. 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 MBS 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. We also amortize or accrete premiums and discounts associated
with the purchase of agency MBS into interest income over the projected lives of the securities, including contractual payments
and estimated prepayments using the interest method. 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
When the market spread widens between the yield on our agency securities and benchmark interest rates, our net book value
could decline if the value of our agency securities fall by more than the offsetting fair value increases on our hedging instruments
tied to the underlying benchmark interest rates. We refer to this as "spread risk" or "basis risk." The spread risk associated with
our mortgage assets and the resulting fluctuations in fair value of these securities can occur independent of changes in benchmark
interest rates and may relate to other factors impacting the mortgage and fixed income markets, such as actual or anticipated
monetary policy actions by the Federal Reserve, market liquidity, or changes in required rates of return on different assets.
Consequently, while we use interest rate swaps and other supplemental hedges to attempt to protect against moves in interest rates,
such instruments typically will not protect our net book value against spread risk.
The table below quantifies the estimated changes in the fair value of our investment portfolio (including derivatives and
other securities used for hedging purposes) and in our net asset value should spreads between our mortgage assets and benchmark
interest rates go up or down by 10 and 25 basis points. These estimated impacts of spread changes are in addition to our sensitivity
to interest rate shocks included in the above interest rate shock table. The table below assumes a spread duration of 5.5 years and
4.7 years based on interest rates and MBS prices as of December 31, 2013 and 2012, respectively. However, our portfolio's
sensitivity of mortgage spread changes will vary with changes in interest rates and will generally increase as interest rates rise and
prepayments slow. Additionally, we have limited transparency into the underlying investment and hedge portfolios of the other
agency mortgage REITs in which we invest. Therefore, actual results could differ materially from our estimates.
68
Spread Sensitivity of Agency MBS Portfolio 1
Change in MBS Spread
As of December 31, 2013
-25 Basis Points .......................................
-10 Basis Points .......................................
+10 Basis Points ......................................
+25 Basis Points ......................................
As of December 31, 2012
-25 Basis Points .......................................
-10 Basis Points .......................................
+10 Basis Points ......................................
+25 Basis Points ......................................
Percentage Change in Projected
Portfolio
Market
Value 2,3
Net Asset
Value 2,4
+1.3%
+0.5%
-0.5%
-1.3%
+1.2%
+0.5%
-0.5%
-1.2%
+10.1%
+4.1%
-4.1%
-10.1%
+10.5%
+4.2%
-4.2%
-10.5%
________________
1.
2.
3.
4.
Spread sensitivity is derived from models that are dependent on inputs and assumptions provided by third parties as well as by our Manager, assumes
there are no changes in interest rates and assumes a static portfolio. Actual results could differ materially from these estimates.
Includes the effect of derivatives and other securities used for hedging purposes.
Estimated dollar change in investment portfolio value expressed as a percent of the total fair value of our investment portfolio as of such date.
Estimated dollar change in portfolio value expressed as a percent of stockholders' equity, net of the Series A Preferred Stock liquidation preference, as
of such date.
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, 2013,
we had unrestricted cash and cash equivalents of $2.1 billion and unpledged securities of approximately $1.9 billion, including
securities pledged to us, available to 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-
69
only securities 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 daily adjustments to
collateral pledged based on changes in market value 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, 2013 and 2012 and fiscal years 2013, 2012 and 2011. 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, 2013, utilizing
the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in its Internal Control-
Integrated Framework (1992 framework). Based on this assessment and those criteria, management determined that our internal
control over financial reporting was effective as of December 31, 2013. The effectiveness of our internal control over financial
reporting as of December 31, 2013 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.
70
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, 2013, based on
criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (1992 framework) (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, 2013, 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, 2013 and 2012, 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, 2013 of American Capital Agency Corp., and our report dated February 27, 2014 expressed an unqualified opinion
thereon.
/s/ Ernst & Young LLP
McLean, Virginia
February 27, 2014
71
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, 2013 and
2012, 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, 2013. 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, 2013 and 2012, and the consolidated results of its operations and its cash
flows for each of the three years in the period ended December 31, 2013, 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, 2013, based on criteria established
in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission
(1992 framework) and our report dated February 27, 2014 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
McLean, Virginia
February 27, 2014
72
December 31,
2013
2012
64,482
$
83,710
AMERICAN CAPITAL AGENCY CORP.
CONSOLIDATED BALANCE SHEETS
(in millions, except per share data)
Assets:
Agency securities, at fair value (including pledged securities of $62,205 and
$79,966, respectively) ................................................................................................. $
Agency securities transferred to consolidated variable interest entities, at fair value
(pledged securities)......................................................................................................
U.S. Treasury securities, at fair value (including pledged securities of $3,778).........
REIT equity securities, at fair value ............................................................................
Cash and cash equivalents ...........................................................................................
Restricted cash.............................................................................................................
Derivative assets, at fair value.....................................................................................
Receivable for securities sold (including pledged securities of $622) ........................
Receivable under reverse repurchase agreements .......................................................
Other assets..................................................................................................................
1,459
3,822
237
2,143
101
1,194
652
1,881
284
Total assets ........................................................................................................... $
76,255
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......................................................................................................
63,533
910
118
422
235
1,848
492
67,558
$
$
Stockholders' equity:
Preferred stock - $0.01 par value; 10.0 shares authorized:
8.000% Series A Cumulative Redeemable Preferred Stock; 6.9 shares issued
and outstanding; liquidation preference of $25 per share ($173) ..........................
Common stock - $0.01 par value; 600.0 shares authorized:
356.2 and 338.9 shares issued and outstanding, respectively ................................
Additional paid-in capital ............................................................................................
Retained deficit............................................................................................................
Accumulated other comprehensive (loss) income.......................................................
Total stockholders' equity.....................................................................................
Total liabilities and stockholders' equity.............................................................. $
167
4
10,406
(497)
(1,383)
8,697
76,255
$
See accompanying notes to consolidated financial statements.
73
1,535
—
—
2,430
399
301
—
11,818
260
100,453
74,478
937
556
1,264
427
11,763
132
89,557
167
3
9,460
(289)
1,555
10,896
100,453
AMERICAN CAPITAL AGENCY CORP.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in millions, except per share data)
For the year ended December 31,
2013
2012
2011
Interest income:
Interest income....................................................................................................... $
Interest expense......................................................................................................
Net interest income .........................................................................................
2,193
536
1,657
$
$
2,109
512
1,597
1,109
285
824
Other (loss) income, net:
(Loss) gain on sale of agency securities, net..........................................................
Gain (loss) on derivative instruments and other securities, net .............................
Total other (loss) income, net .........................................................................
(1,408)
1,191
(217)
1,196
(1,353)
(157)
473
(447)
26
Expenses:
Management fees ...................................................................................................
General and administrative expenses.....................................................................
Total expenses.................................................................................................
Income before income tax...........................................................................................
Provision for income tax, net .................................................................................
Net income ...................................................................................................................
Dividend on preferred stock...................................................................................
Net income available to common shareholders ........................................................ $
Net income ................................................................................................................... $
Other comprehensive (loss) income:..........................................................................
Unrealized (loss) gain on available-for-sale securities, net ...................................
Unrealized gain (loss) on derivative instruments, net............................................
Other comprehensive (loss) income ...............................................................
Comprehensive (loss) income .....................................................................................
Dividend on preferred stock...................................................................................
136
32
168
1,272
13
1,259
14
1,245
1,259
(3,127)
189
(2,938)
(1,679)
14
$
$
Comprehensive (loss) income (attributable) available to common shareholders.. $ (1,693) $
113
31
144
1,296
19
1,277
10
1,267
1,277
1,039
205
1,244
2,521
10
2,511
Weighted average number of common shares outstanding - basic and diluted....
Net income per common share - basic and diluted .................................................. $
Comprehensive (loss) income per common share - basic and diluted.................... $
379.1
$
3.28
(4.47) $
303.9
4.17
8.26
See accompanying notes to consolidated financial statements.
55
19
74
776
6
770
—
770
770
1,029
(650)
379
1,149
—
1,149
153.3
5.02
7.50
$
$
$
$
$
74
AMERICAN CAPITAL AGENCY CORP.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(in millions)
Shares Amount
Balance, December 31, 2010....................... — $ —
—
Net income................................................. —
Other comprehensive income (loss):
Preferred Stock
Common Stock
Shares
Amount
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 ...................................... —
6.9
Issuance of preferred stock........................
Issuance of common stock......................... —
Repurchase of common stock.................... —
Preferred dividends declared ..................... —
Common dividends declared ..................... —
6.9
Net income................................................. —
Other comprehensive (loss) income:
Balance, December 31, 2012.......................
Unrealized loss on available-for-sale
securities, net.......................................... —
Unrealized gain on derivative
instruments, net ...................................... —
Issuance of common stock......................... —
Repurchase of common stock.................... —
Preferred dividends declared ..................... —
Common dividends declared ..................... —
6.9
Balance, December 31, 2013.......................
—
—
—
—
—
—
—
—
167
—
—
—
—
167
—
—
—
—
—
—
—
Additional
Paid-in
Capital
Retained
Earnings
(Deficit)
Accumulated
Other
Comprehensive
(Loss) Income
Total
$
$
1,562
—
$
78
770
(68) $
—
1,573
770
—
—
1,029
1,029
—
4,375
—
5,937
—
—
—
—
3,600
(77)
—
—
9,460
—
—
—
1,802
(856)
—
—
—
—
(886)
(38)
1,277
—
—
—
—
—
(10)
(1,518)
(289)
1,259
—
—
—
—
(14)
(1,453)
$ 10,406
$
(497) $
(650)
—
—
311
—
1,039
205
—
—
—
—
—
1,555
—
(650)
4,376
(886)
6,212
1,277
1,039
205
167
3,601
(77)
(10)
(1,518)
10,896
1,259
(3,127)
(3,127)
189
—
—
—
—
(1,383) $
189
1,803
(856)
(14)
(1,453)
8,697
1
—
—
—
1
—
2
—
—
—
—
1
—
—
—
3
—
—
—
1
—
—
—
4
$
64.9
—
—
—
159.3
—
224.2
—
—
—
—
117.4
(2.7)
—
—
338.9
—
—
—
57.5
(40.2)
—
—
$ 167
356.2
$
See accompanying notes to consolidated financial statements.
75
AMERICAN CAPITAL AGENCY CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions)
For the year ended December 31,
2013
2012
2011
Operating activities:
Net income .................................................................................................................. $
1,259
$
1,277
$
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of agency securities premiums and discounts, net ........................
517
Amortization of accumulated other comprehensive loss on interest rate swaps
de-designated as qualifying hedges.....................................................................
Loss (gain) on sale of agency securities, net.......................................................
(Gain) loss 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 ...........
189
1,408
(1,191)
(24)
325
18
667
205
(1,196)
1,353
(76)
86
5
770
361
54
(473)
447
(121)
32
—
Net cash provided by operating activities ...................................................................
2,501
2,321
1,070
Investing activities:
Purchases of agency securities ............................................................................
(76,892)
(104,703)
(81,484)
Proceeds from sale of agency securities..............................................................
Principal collections on agency securities...........................................................
79,456
10,589
Purchases of U.S. Treasury securities .................................................................
(68,261)
Proceeds from sale of U.S. Treasury securities...................................................
Net proceeds from (payments on) reverse repurchase agreements .....................
Net payments on other derivative instruments....................................................
Purchases of REIT equity securities....................................................................
Decrease (increase) in restricted cash .................................................................
Net cash provided by (used in) investing activities.....................................................
54,952
9,937
(1,007)
(197)
298
8,875
65,249
9,576
(28,196)
39,012
(11,055)
(1,001)
—
(63)
37,868
4,633
(21,944)
22,397
(516)
(266)
—
(260)
(31,181)
(39,572)
Financing activities:
Proceeds from repurchase arrangements.............................................................
564,971
404,853
339,046
Repayments on repurchase agreements...............................................................
(575,916)
(378,056)
(303,044)
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 for common stock repurchases ...........................................................
Cash dividends paid ............................................................................................
Net cash (used in) provided by financing activities ....................................................
Net change in cash and cash equivalents ....................................................................
Cash and cash equivalents at beginning of period ......................................................
203
(209)
—
1,803
(856)
(1,659)
(11,663)
(287)
2,430
1,000
(150)
167
3,601
(77)
(1,415)
29,923
1,063
1,367
Cash and cash equivalents at end of period................................................................. $
2,143
$
2,430
$
—
(19)
—
4,377
—
(664)
39,696
1,194
173
1,367
Supplemental disclosure to cash flow information: ...............................................
Interest paid ................................................................................................................. $
Taxes paid.................................................................................................................... $
347
25
$
$
256
10
$
$
202
—
See accompanying notes to consolidated financial statements.
76
AMERICAN CAPITAL AGENCY CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Organization
We were 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 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 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 net 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 ("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 a government-sponsored enterprise, 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") and in other assets
reasonably related to agency securities.
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 we are 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
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"). During fiscal year 2011, we discontinued
77
designating our derivative financial instruments, principally interest rate swaps, as cash flow hedges. See Derivatives Instruments
below and Note 5 for further information regarding our discontinuation of cash flow hedge accounting.
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
Restricted cash includes cash pledged as collateral for clearing and executing trades, repurchase agreements, interest rate
swaps and other derivative instruments. Restricted cash is 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 agency securities as part of our overall management of our
investment portfolio. Accordingly, we typically designate our agency 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 securities, at fair value on the accompanying consolidated balance sheets.
REIT equity securities represent investments in the common stock of other publicly traded mortgage REITs that invest
predominantly in agency MBS. We designate our investments in REIT equity securities as trading securities and report them at
fair value on the accompanying consolidated balance sheets.
We estimate the fair value of our agency securities based on a market approach using "Level 2" inputs from third-party
pricing services and non-binding dealer quotes derived from common market pricing methods. Such methods incorporate, but are
not limited to, reported trades and executable bid and asked prices for similar securities, benchmark interest rate curves, such as
the spread to the U.S. Treasury rate and interest rate swap curves, convexity, duration and the 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 estimate the fair value of our REIT equity securities on a market approach using "Level 1" inputs based on
quoted market prices. Refer to Note 7 for further discussion of fair value measurements.
We evaluate our agency securities for other-than-temporary impairment ("OTTI") on at least a quarterly basis. The
determination of whether a security is other-than-temporarily impaired may involve judgments and assumptions based on subjective
and objective factors. When a security is impaired, an OTTI is considered to have occurred if any one of the following three
conditions exist as of the financial reporting date: (i) we intend to sell the security (that is, a decision has been made to sell the
security), (ii) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis or
(iii) we do not expect to recover the security's amortized cost basis, even if we do not intend to sell the security and it is not more
likely than not that we will be required to sell the security. A general allowance for unidentified impairments in a portfolio of
securities is not permitted.
If either of the first two conditions exists as of the financial reporting date, 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. If the third condition
exists, the OTTI is separated into (i) the amount relating to credit loss (the "credit component") and (ii) the amount relating to all
other factors (the "non-credit components"). Only the credit component is recognized in earnings, with the non-credit components
recognized in OCI. However, in evaluating if the third condition exists, our investments in agency securities typically would not
have a credit component since the principal and interest are guaranteed by a GSE and, therefore, any unrealized loss is not the
result of a credit loss. In addition, since we designate our agency securities as available-for-sale securities with unrealized gains
and losses recognized in OCI, any impairment loss for non-credit components is already recognized in OCI.
78
The liquidity of the agency securities market allows us to obtain competitive bids and execute on a sale transaction typically
within a day of making the decision to sell a security and, therefore, we generally do not make decisions to sell specific agency
securities until shortly prior to initiating a sell order. In some instances, we may sell specific agency securities by delivering such
securities into existing short to-be-announced ("TBA") contracts. TBA market conventions require the identification of the specific
securities to be delivered no later than 48 hours prior to settlement. If we settle a short TBA contract through the delivery of
securities, we will generally identify the specific securities to be delivered within one to two days of the 48-hour deadline.
We did not recognize any OTTI charges on our investment securities for fiscal years 2013, 2012 and 2011.
Interest Income
Interest income is accrued based on the outstanding principal amount of the investment securities and their contractual terms.
Premiums or discounts associated with the purchase of investment securities are amortized or accreted into interest income,
respectively, 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.
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 its 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) the actual prepayments to date plus our currently
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.
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.
Reverse Repurchase Agreements and Obligation to Return Securities Borrowed under Reverse Repurchase Agreements
We from time to time borrow securities to cover short sales of U.S. Treasury securities through reverse repurchase transactions
under our master repurchase agreements (see Derivatives Instruments below). 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. Our reverse repurchase agreements generally mature daily. The fair
value of our reverse repurchase agreements is assumed to equal cost as the interest rates are reset daily.
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 8 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 hedge a portion of our exposure to market risks, including interest rate risk,
prepayment risk and extension 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 utilize forward contracts for the purchase or sale of agency MBS securities on a
generic pool, or a TBA contract, basis and on a non-generic, specified pool basis, and we utilize U.S. Treasury securities and U.S.
Treasury futures contracts, primarily through short sales. We may also purchase or write put or call options on TBA securities and
79
we may invest in other types of mortgage derivatives, such as interest and principal-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 (thereby increasing our "at
risk" leverage) or as a means of disposing of or reducing our exposure to agency securities (thereby reducing our "at risk" leverage).
Pursuant to TBA contracts, we agree 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. 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 or long position (referred to as a "pair off"), net settling the paired off positions for cash, and
simultaneously purchasing or selling a similar TBA contract for a later settlement date. This transaction is commonly referred to
as a "dollar roll." The agency securities purchased or sold 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/loss." 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.
Our derivative agreements generally contain provisions that allow for netting or setting off derivative assets and liabilities
with each counterparty; however, we report related assets and liabilities on a gross basis in our consolidated balance sheets.
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. Changes in fair value of derivative instruments
and periodic settlements related to our derivative instruments are recorded in gain (loss) on derivative instruments and other
securities, net in our consolidated statements of comprehensive income. Cash receipts and payments related to derivative
instruments are classified in our consolidated statements of cash flows according to the underlying nature or purpose of the derivative
transaction, generally in the investing section.
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 September 30, 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. 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.
Interest rate swap agreements
We use interest rate swaps to 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 swaps") with terms up to 20 years. The floating rate we receive under our swap agreements has the
effect of offsetting the repricing characteristics of our repurchase agreements and cash flows on such liabilities. Our swap agreements
are privately negotiated in the over-the-counter ("OTC") market and may be centrally cleared through a registered commodities
exchange ("centrally cleared swaps").
We estimate the fair value of our centrally cleared interest rate swaps using the daily settlement price determined by the
respective exchange. Centrally cleared swaps are valued by the exchange using a pricing model that references the underlying
rates including the overnight index swap rate and LIBOR forward rate to produce the daily settlement price.
We estimate the fair value of our "non-centrally cleared" swaps using a combination of inputs from counterparty and third-
party pricing models to estimate the net present value of the future cash flows using a forward interest rate yield curve in effect
as of the end of the measurement period. 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.
80
Interest rate swaptions
We purchase interest rate swaptions to help mitigate the potential impact of larger 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 statements of
comprehensive income. If a swaption expires unexercised, the realized 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.
Our interest rates swaption agreements are privately negotiated in the OTC market and are not subject to central clearing.
We estimate the fair value of interest rate swaptions using a combination of inputs from counterparty and third-party pricing models
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 may enter into TBA contracts as a means of hedging against short-
term changes in interest rates. We may also enter into TBA contracts as a means of acquiring or disposing of agency securities
and we may from time to time utilize TBA dollar roll transactions to finance agency MBS purchases.
We account for TBA contracts as derivative instruments since we cannot assert that it is probable at inception and throughout
the term of the TBA contract that we will take physical delivery of the agency security upon settlement of the contract. We account
for TBA dollar roll transactions as a series of derivative transactions. Gains, losses and dollar roll income associated with our TBA
contracts and dollar roll transactions 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 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. Such forward commitments typically require physical settlement.
We account for such forward commitments as derivatives if the delivery of the specified agency MBS and settlement extend beyond
established market conventions. 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. Gains and losses associated with purchases and short sales of
U.S. Treasury securities and U.S. Treasury futures contracts 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.
81
We have entered into transactions involving CMO trusts, which are VIEs. We will consolidate a CMO trust if we are the
CMO trust's primary beneficiary; that is, if we have a variable interest that 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. For
each of our consolidated CMO trusts we controlled the selection of the agency MBS transferred from our investment portfolio to
an investment bank in exchange for cash proceeds and at the same time entered into a commitment with the investment bank to
purchase to-be-issued securities collateralized by the agency MBS transferred, which resulted in our consolidation of the CMO
trusts.
Agency MBS transferred to consolidated VIEs are reported on our consolidated balance sheets in agency securities transferred
to consolidated VIEs, 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
upon 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.
Reclassifications
Certain prior period amounts in the consolidated financial statements have been reclassified to conform to the current period
presentation.
82
Note 3. Investment Securities
As of December 31, 2013, we had agency MBS of $65.9 billion at fair value, with a total cost basis of $67.0 billion. The net
unamortized premium balance on our agency MBS as of December 31, 2013 was $3.0 billion, including interest and principal-
only strips. The following tables summarize our investments in agency MBS as of December 31, 2013 (dollars in millions):
Agency MBS
Available-for-sale agency MBS:
December 31, 2013
Fannie Mae
Freddie Mac
Ginnie Mae
Total
Agency MBS, par..........................................................................................
$
50,914
$
12,640
$
223
$
63,777
Unamortized discount ...................................................................................
Unamortized premium ..................................................................................
Amortized cost .........................................................................................
Gross unrealized gains ..................................................................................
Gross unrealized losses .................................................................................
(25)
2,210
53,099
181
(991)
Total available-for-sale agency MBS, at fair value..................................
52,289
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.................
Total agency MBS, at fair value........................................................................
Weighted average coupon as of December 31, 2013 2 ......................................
Weighted average yield as of December 31, 2013 3 ..........................................
Weighted average yield for the year ended December 31, 2013 3.....................
________________________
(7)
631
13,264
74
(358)
12,980
32
3
(2)
33
—
7
230
5
—
235
—
—
—
—
(32)
2,848
66,593
260
(1,349)
65,504
432
16
(11)
437
400
13
(9)
404
$
52,693
$
13,013
$
235
$
65,941
3.53%
2.66%
2.74%
3.78%
2.87%
2.87%
3.56%
1.66%
1.79%
3.58%
2.70%
2.77%
1.
2.
3.
The underlying unamortized principal balance ("UPB" or "par value") of our interest-only agency MBS strips was $1.4 billion and the weighted average
contractual interest we are entitled to receive was 5.50% of this amount as of December 31, 2013. The par value of our principal-only agency MBS
strips was $271 million as of December 31, 2013.
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, 2013.
Incorporates a weighted average future constant prepayment rate assumption of 7% based on forward rates as of December 31, 2013.
Agency MBS
Amortized
Cost
December 31, 2013
Gross
Unrealized
Gain
Gross
Unrealized
Loss
Fair Value
Fixed-Rate ...............................................................
$
64,057
$
242
$
(1,338) $
62,961
Adjustable-Rate .......................................................
CMO........................................................................
Interest-only and principal-only strips ....................
1,223
1,313
432
15
3
16
(3)
(8)
(11)
1,235
1,308
437
Total agency MBS...................................................
$
67,025
$
276
$
(1,360) $
65,941
83
As of December 31, 2012, we had agency MBS of $85.2 billion at fair value, with a total cost basis of $83.2 billion. The
net unamortized premium balance on our agency MBS as of December 31, 2012 was $4.4 billion, including interest 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:
Fannie Mae
Freddie Mac
Ginnie Mae
Total
December 31, 2012
Agency MBS, par ...................................................................................................
$
58,912
$
19,336
$
238
$
78,486
Unamortized premium............................................................................................
Amortized cost ...................................................................................................
Gross unrealized gains............................................................................................
Gross unrealized losses ..........................................................................................
Total available-for-sale agency MBS, at fair value............................................
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..........................
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 ..............................
________________________
3,208
62,120
1,585
(18)
63,687
486
26
(9)
503
948
20,284
481
(7)
20,758
55
1
(13)
43
10
248
6
—
254
—
—
—
—
4,166
82,652
2,072
(25)
84,699
541
27
(22)
546
$
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 UPB of our interest-only securities 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 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, 2012.
Incorporates a weighted average future constant prepayment rate assumption of 11% based on forward rates as of December 31, 2012.
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
As of December 31, 2013 and 2012, we did not have investments in agency debenture securities.
The actual maturities of our agency MBS 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, 2013 and 2012, our weighted average expected constant prepayment rate ("CPR") over the remaining life of
our aggregate agency MBS portfolio was 7% and 11%, 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 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
84
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, 2013 and 2012 according
to their estimated weighted average life classification (dollars in millions):
December 31, 2013
December 31, 2012
Estimated Weighted Average Life of
Agency MBS Classified as
Available-for-Sale 1
................................................
$
..........................
........................
.......................
> 10 years.............................................
Fair
Value
Amortized
Cost
$
129
498
24,471
38,522
1,884
129
491
24,342
39,635
1,996
Total .....................................................
$
65,504
$
66,593
_______________________
1.
Excludes interest and principal-only strips.
Weighted
Average
Coupon
Weighted
Average
Yield
3.07%
4.08%
3.59%
3.39%
3.66%
3.47%
2.53%
2.25%
2.57%
2.73%
2.96%
2.68%
Fair
Value
Amortized
Cost
$
— $
—
1,119
27,448
54,054
2,078
1,108
26,750
52,735
2,059
$
84,699
$
82,652
Weighted
Average
Coupon
Weighted
Average
Yield
—%
4.18%
3.36%
3.69%
3.44%
3.59%
—%
2.14%
2.29%
2.75%
2.65%
2.59%
The weighted average life of our interest-only strips was 6.3 and 5.7 years as of December 31, 2013 and 2012, respectively.
The weighted average life of our principal-only strips was 8.6 and 6.4 years as of December 31, 2013 and 2012, 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 2013, 2012 and 2011 (in millions):
Agency Securities Classified as
Available-for-Sale
Beginning
Accumulated
OCI
Balance
Unrealized
Gains and
(Losses), Net
Reversal of
Unrealized
(Gains) and Losses,
Net on Realization
Ending
Accumulated
OCI
Balance
Fiscal year 2013 .................................................................................
Fiscal year 2012 .................................................................................
Fiscal year 2011 .................................................................................
$
$
$
2,040
1,001
(28)
(4,535)
2,235
1,512
1,408
$
(1,196) $
(483) $
(1,087)
2,040
1,001
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, 2013 and 2012 (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, 2013 ........................
December 31, 2012 ........................
$
$
42,853
8,430
$
$
(1,248) $
1,586
$
(101) $
(25) $
— $
— $
44,439
8,430
$
$
(1,349)
(25)
As of December 31, 2013 and 2012, a decision had not been made 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 GSE guarantees, but are rather due to changes
in interest rates and prepayment expectations. Accordingly, we did not recognize any OTTI charges on our investment securities
for fiscal years 2013 and 2012. However, as we continue to actively manage our portfolio, we may recognize additional realized
losses on our agency securities upon selecting specific securities to sell.
85
Gains and Losses
The following table is a summary of our net gain (loss) from the sale of agency securities classified as available-for-sale for
fiscal years 2013, 2012 and 2011 (in millions):
Agency Securities Classified as
Available-for-Sale
Fiscal Year
2013
2012
2011
Agency MBS sold, at cost........................................................
$
(81,516) $
(63,610) $
(37,579)
Proceeds from agency MBS sold 1...........................................
80,108
64,806
Net (loss) gain on sale of agency MBS....................................
$
(1,408) $
1,196
$
Gross gain on sale of agency MBS ..........................................
$
217
$
1,209
$
Gross loss on sale of agency MBS...........................................
(1,625)
(13)
Net (loss) gain on sale of agency MBS....................................
$
(1,408) $
1,196
$
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.
For fiscal years 2012 and 2011, we recognized a net unrealized gain of $17 million and a net unrealized loss of $16 million,
respectively, for the change in value of investments in interest and principal-only strips in gain (loss) on derivative instruments
and other securities, net in our consolidated statements of comprehensive income. For fiscal year 2013, we did not recognize a
net unrealized gain or loss on our interest and principal-only investments. For fiscal year 2011, we recognized a net realized loss
of $10 million for the sale of interest and principal-only strips in gain (loss) on sale of agency securities, net in our consolidated
statements of comprehensive income. There were no sales of interest and principal-only strips during fiscal years 2013 and 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, 2013 and 2012 (in millions):
December 31, 2013
Assets Pledged
Repurchase
Agreements
Debt of
Consolidated
VIEs
Derivative
Agreements
Prime Broker
Agreements
Total
Agency MBS - fair value ..................................
$
62,708
$
1,459
$
U.S. Treasury securities - fair value..................
Accrued interest on pledged securities .............
Restricted cash ..................................................
3,708
189
3
—
5
—
$
28
70
1
41
$
91
—
—
57
64,286
3,778
195
101
Total..............................................................
$
66,608
$
1,464
$
140
$
148
$
68,360
December 31, 2012
Assets Pledged
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
In addition, as of December 31, 2013, we had $82 million of agency MBS, $164 million of U.S. Treasury securities and
$366 million of cash pledged to use (at fair value) as collateral for our derivative agreements. As of December 31, 2012, we had
$249 million of cash pledged to use as collateral for our derivative agreements.
86
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, 2013
and 2012 (in millions):
Agency 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, 2013
December 31, 2012
Agency MBS:
..........................................
$
27,694
$
28,125
$
..........................
..........................
> 90 days .........................................
Total agency MBS.............................
U.S. Treasury securities:....................
14,955
10,117
11,401
64,167
15,210
10,290
11,623
65,248
1 day ...............................................
3,708
3,760
76
42
28
32
178
16
$
29,284
$
28,525
$
21,716
16,188
12,747
79,935
21,251
15,780
12,447
78,003
—
—
Total...................................................
$
67,875
$
69,008
$
194
$
79,935
$
78,003
$
82
58
45
37
222
—
222
As of December 31, 2013 and 2012, none of our repurchase agreement borrowings backed by agency MBS were due on
demand or mature overnight.
Securitizations and Variable Interest Entities
As of December 31, 2013 and 2012, we held investments in CMO trusts, which are VIEs. We have consolidated certain of
these CMO trusts in our consolidated financial statements where we have determined we are the primary beneficiary of the trusts.
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.
In connection with our consolidated CMO trusts, we recognized agency securities with a total fair value of $1.5 billion as
of December 31, 2013 and 2012 and debt, at fair value, of $910 million and $937 million, respectively, in our accompanying
consolidated balance sheets. As of December 31, 2013 and 2012, such agency securities had an aggregate unpaid principal balance
of $1.4 billion and such debt had an aggregate unpaid principal balance of $900 million and $908 million, respectively. We re-
measure our consolidated debt at fair value through earnings in gain (loss) on derivative instruments and other securities, net in
our consolidated statements of comprehensive income. For fiscal years 2013 and 2012, we recognized a net gain of $39 million
and a net loss of $28 million in earnings, respectively, associated with our consolidated debt. We did not recognize any gains or
losses during fiscal year 2011. Our involvement with the consolidated trusts is limited to the agency securities transferred by us
upon the formation of 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.
As of December 31, 2013 and 2012, the fair value of our CMO securities and interest and principal-only securities, excluding
the consolidated CMO trusts discussed above, was $1.7 billion and $719 million, respectively, or $2.3 billion and $1.3 billion,
respectively, including the net asset value of our consolidated CMO trusts. Our maximum exposure to loss related to our CMO
securities and interest and principal-only securities, including our consolidated CMO trusts, was $246 million and $343 million
as of December 31, 2013 and 2012, respectively.
Note 4. Repurchase Agreements and Other Debt
We pledge certain of our 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, 2013 and 2012, we have met all margin call requirements.
87
The following table summarizes our borrowings under repurchase arrangements and weighted average interest rates classified
by remaining maturities as of December 31, 2013 and 2012 (dollars in millions):
Remaining Maturity
Agency MBS:
..............................
..................
..................
..................
................
..............
..............
> 36 months ..........................
Total agency MBS ..................
U.S. Treasury securities:
1 day......................................
Total / Weighted Average........
$
$
December 31, 2013
December 31, 2012
Repurchase
Agreements
Weighted
Average
Interest
Rate
Weighted
Average Days
to Maturity
Repurchase
Agreements
Weighted
Average
Interest
Rate
Weighted
Average Days
to Maturity
23,577
20,490
6,946
2,232
3,607
3,261
500
602
61,215
2,318
63,533
0.42%
0.43%
0.45%
0.53%
0.54%
0.60%
0.62%
0.68%
0.45%
0.02%
0.44%
$
15
61
140
230
323
603
930
1,468
124
25,474
30,402
7,208
4,509
2,149
2,142
2,492
102
74,478
1
119
$
—
74,478
0.48%
0.49%
0.53%
0.57%
0.60%
0.65%
0.69%
0.73%
0.51%
—%
0.51%
17
57
128
234
312
591
1,002
1,751
118
—
118
As of December 31, 2013 and 2012, we did not have an amount at risk with any repurchase agreement counterparty greater
than 4% of our stockholders' equity.
As of December 31, 2013 and 2012, debt of consolidated VIEs, at fair value ("other debt") was $910 million and $937
million, respectively. As of December 31, 2013 and 2012, our other debt had a weighted average interest rate of LIBOR plus 42
and 43 basis points and a principal balance of $900 million and $908 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, 2013 was 5.4 years.
As of December 31, 2013 and 2012, we also had outstanding forward commitments to purchase and sell agency securities,
including TBA dollar roll transactions, (see Notes 2 and 5). These transactions represent a form of off-balance sheet financing and
serve to either increase, in the case of forward purchases, or decrease, in the case of forward sales, our "at risk" leverage. However,
pursuant to ASC 815, we typically account for such transactions as one or more series of derivative transactions and, consequently,
they are not included in our on-balance sheet debt or measurement of commensurate 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 typically enter into agreements for interest rate swaps and interest rate swaptions. 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 and principal-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 2013 and 2012 and for the period from September 30, 2011 to December 31, 2011, we reclassified
$189 million, $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 for these periods were $613 million, $457 million and $89 million, respectively.
The difference of $424 million, $252 million and $35 million for these periods, respectively, is reported in our accompanying
88
consolidated statements of comprehensive income in gain (loss) on derivative instruments and other securities, net. As of
December 31, 2013, the remaining net deferred loss in accumulated OCI related to de-designated interest rate swaps was $296
million and will be reclassified from OCI into interest expense over a remaining weighted average period of 2.1 years. The net
deferred loss expected to be reclassified from OCI into interest expense over the next twelve months as of December 31, 2013
was $156 million.
Derivative Assets (Liabilities), at Fair Value
The table below summarizes fair value information about our derivative assets and liabilities as of December 31, 2013 and
2012 (in millions):
Derivatives Instruments
Balance Sheet Location
December 31,
2013
December 31,
2012
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
U.S. Treasury futures - short
Derivative assets, at fair value
Interest rate swaps ............................................................................. 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
$
$
$
$
$
880
258
2
15
39
1,194
$
14
171
116
—
—
301
(400) $
(1,243)
(20)
(2)
(1)
(20)
(422) $
(1,264)
Additionally, as of December 31, 2013 and 2012, 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 $1.8 billion and $11.8 billion,
respectively. The borrowed securities were used to cover short sales of U.S. Treasury securities from which we received total
proceeds of $1.9 billion and $11.7 billion, 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, 2013 and 2012 (dollars
in millions):
December 31, 2013
Payer Interest Rate Swaps
Notional
Amount 1
Average
Fixed
Pay Rate 2
Average
Receive
Rate 3
Net
Estimated
Fair Value
Average
Maturity
(Years) 4
.......................................................
$
16,750
.............................................
10,225
.............................................
...........................................
> 10 years .....................................................
5,700
8,825
1,750
Total Payer Interest Rate Swaps...................
$
43,250
1.57%
1.07%
1.97%
2.28%
2.79%
1.70%
0.19% $
(382)
0.24%
0.26%
0.24%
0.24%
0.22% $
81
113
499
169
480
1.6
3.9
6.0
8.8
14.7
4.7
________________________
1. Notional amount includes forward starting swaps of $4.0 billion with an average forward start date of 1.9 years from December 31, 2013.
2. Average fixed pay rate includes forward starting swaps. Excluding forward starting swaps, the average fixed pay rate was 1.57% as of December 31,
2013.
3. Average receive rate excludes forward starting swaps.
4. Average maturity measured from December 31, 2013 through stated maturity date.
89
December 31, 2012
Payer Interest Rate Swaps 1
Notional
Amount
Average
Fixed
Pay Rate
Average
Receive
Rate
Net
Estimated
Fair Value
Average
Maturity
(Years)
.......................................................
$
14,600
.............................................
20,250
.............................................
...........................................
> 10 years .....................................................
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%
0.29%
$
(294)
(666)
(163)
(113)
7
$
(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.
The following tables summarize our interest rate swaption agreements outstanding as of December 31, 2013 and 2012 (dollars
in millions):
Payer Swaptions
Cost
...........................
$
...............
...............
...............
Total/Wtd Avg.................
$
Payer Swaptions
Cost
...........................
$
...............
...............
...............
...............
Option
Fair
Value
$
117
92
45
4
$258
Option
Fair
Value
$
15
34
87
11
24
193
105
35
2
335
76
65
97
12
24
Total/Wtd Avg................
$
274
$
171
December 31, 2013
Underlying Swap
Average
Months to
Expiration
Notional
Amount
Average
Fixed Pay
Rate
Average
Receive
Rate
(LIBOR)
Average
Term
(Years)
4
19
30
52
10
$
9,400
3,600
1,150
100
$
14,250
2.87%
3.40%
3.81%
4.80%
3.09%
3M
3M
3M
3M
3M
7.8
5.6
5.8
7.0
7.0
December 31, 2012
Underlying Swap
Average
Receive
Rate
(LIBOR)
1M / 3M
3M
3M
3M
3M
1M / 3M
Average
Term
(Years)
8.6
6.7
8.6
6.1
5.0
7.8
Average
Months to
Expiration
Notional
Amount
Average
Fixed Pay
Rate
$
5,150
4,050
3,900
450
900
$
14,450
2.65%
2.82%
3.51%
3.20%
3.33%
2.99%
4
19
33
46
59
21
90
The following table summarizes our contracts to purchase and sell TBA and specified agency securities on a forward basis
as of December 31, 2013 and 2012 (in millions):
Purchase and Sale Contracts for TBAs and
Forward Settling Securities
Notional
Amount 1
Cost Basis 2
Market
Value 3
Net
Carrying
Value 4
Notional
Amount 1
Cost Basis 2
Market
Value 3
Net
Carrying
Value 4
December 31, 2013
December 31, 2012
TBA securities:
Purchase contracts............................
$ 6,660
$
6,882
$ 6,864
$
(18)
$ 21,705
$
22,603
$ 22,719
$
Sale contracts ...................................
TBA securities, net 5.................................
Forward settling securities:
Purchase contracts............................
Forward settling securities, net 6 ..............
Total TBA and forward settling
securities, net............................................
________________________
(4,541)
2,119
(4,606)
(4,593)
2,276
2,271
—
—
—
—
—
—
13
(5)
—
—
(9,378)
12,327
(9,991)
(10,011)
12,612
12,708
150
150
163
163
162
162
116
(20)
96
(1)
(1)
$ 2,119
$
2,276
$ 2,271
$
(5)
$ 12,477
$
12,775
$ 12,870
$
95
1. Notional amount represents the par value (or principal balance) of the underlying agency security.
2. Cost basis represents the forward price to be paid/(received) for the underlying agency security.
3. Market value represents the current market value of the TBA contract (or of the underlying agency security) as of period-end.
4. Net carrying value represents the difference between the market value and the cost basis of the TBA contract as of period-end and is reported in derivative
assets / (liabilities), at fair value in our consolidated balance sheets.
Includes 15-year and 30-year TBA securities of varying coupons
Includes 30-year fixed securities of varying coupons
5.
6.
Gain (Loss) From Derivative Instruments and Other Securities, Net
The tables below summarize the effect of derivative instruments on our consolidated statements of comprehensive income
for fiscal years 2013, 2012 and 2011 related to our derivative and other hedging instruments (in millions):
Derivative and Other Hedging Instruments
Notional
Amount
Long/(Short)
December 31,
2012
Net TBA and forward settling agency securities.................
Interest rate swaps................................................................
Payer swaptions ...................................................................
U.S. Treasury securities - short position..............................
U.S. Treasury securities - long position...............................
U.S. Treasury futures contracts - short position ..................
TBA put option ....................................................................
$
$
$
$
$
$
$
12,477
(46,850)
(14,450)
(11,835)
—
—
—
Fiscal year 2013
Settlement,
Termination,
Expiration or
Exercise
Notional
Amount Long/
(Short)
December 31,
2013
Amount of
Gain/(Loss)
Recognized in
Income on
Derivatives 1
(53,065) $
2,119
$
24,350
24,000
41,769
$
$
$
(23,878) $
7,359
50
$
$
(43,250)
(14,250)
(2,007)
3,927
(1,880)
—
$
(726)
1,145
258
472
(42)
49
—
1,156
Additions
42,707
(20,750)
(23,800)
(31,941)
27,805
(9,239)
(50)
________________________________
1.
Excludes a net gain of $2 million from investments in REIT equity securities, a net gain of $39 million from debt of consolidated VIEs, and other
miscellaneous net losses of $6 million recognized in gain (loss) on derivative instruments and other securities, net in our consolidated statements of
comprehensive income.
91
Derivative and Other Hedging Instruments
Notional
Amount
Long/(Short)
December 31,
2011
Net TBA and forward settling agency securities................
Interest rate swaps ..............................................................
Payer swaptions..................................................................
U.S. Treasury securities - short position.............................
U.S. Treasury securities - long position .............................
U.S. Treasury futures contracts - short position.................
Markit IOS total return swaps, net .....................................
$
$
$
$
$
$
$
(104)
(30,250)
(3,200)
(880)
100
(783)
(165)
Fiscal year 2012
Settlement,
Termination,
Expiration or
Exercise
Notional
Amount
Long/(Short)
December 31,
2012
Amount of
Gain/(Loss)
Recognized in
Income on
Derivatives 1
48,755
8,400
7,000
25,600
$
$
$
$
(2,545) $
4,621
165
$
$
12,477
$
(46,850)
(14,450)
(11,835)
—
—
—
31
(1,034)
(106)
(142)
(1)
(90)
—
$
(1,342)
Additions
(36,174)
(25,000)
(18,250)
(36,555)
2,445
(3,838)
—
______________________
1.
Excludes a net gain of $17 million on interest-only and principal-only securities and a net loss of $28 million from debt of consolidated VIEs recognized
in gain (loss) on derivative instruments and other securities, net in our consolidated statements of comprehensive income.
Derivative and Other Hedging Instruments 1
Fiscal year 2011
Notional
Amount
Long/
(Short)
December
31, 2010
Additions Due
to Hedge De-
Designations
Settlement,
Termination,
Expiration or
Exercise
Additions
Notional
Amount
Long/
(Short)
December
31, 2011
Amount of
Gain/(Loss)
Recognized in
Income on
Derivatives 2
Net TBA and forward settling agency securities .......
Interest rate swaps......................................................
Payer swaptions .........................................................
U.S. Treasury securities - short position....................
U.S. Treasury securities - long position.....................
U.S. Treasury futures contracts - short position, net..
TBA put option ..........................................................
Markit IOS total return swaps, net.............................
$
$
$
$
$
$
$
$
(849)
(48,589)
—
49,334
$
(104) $
(50)
(850)
(250)
—
—
—
—
(6,750)
(5,350)
(15,794)
5,140
(1,083)
(200)
510
(23,900)
450
$ (30,250)
—
—
—
—
—
—
3,000
15,164
$
$
(5,040) $
300
200
$
$
(3,200)
(880)
100
(783)
—
(675) $
(165)
(142)
(119)
(64)
(133)
34
(12)
1
7
$
(428)
________________________________
1.
2.
Table excludes activity related to interest rate swaps designated as hedging instruments under ASC 815 prior to our discontinuation of hedge accounting
in September 2011.
Excludes a net loss of $17 million from interest and principal-only securities and a net loss of $2 million for hedge ineffectiveness recognized in gain
(loss) on derivative instruments and other securities, net in our consolidated statements of comprehensive income.
The tables below 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 year 2011, prior to discontinuation of
hedge accounting in September 2011 (in millions):
Interest Rate Swaps Designated
as Hedging Instruments
Beginning
Notional
Amount
Additions
Expirations /
Terminations
Hedge De-
Designations
Ending
Notional Amount
Fiscal year 2011............................................................ $
6,450
17,900
(450)
(23,900) $
—
92
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 ........................
$
(707)
Interest expense
$
(140)
Credit Risk-Related Contingent Features
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
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 for instruments which are not centrally cleared on a registered exchange 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 are included in restricted cash and agency securities, at
fair value, respectively, on our consolidated balance sheets.
Each of our International Swaps and Derivatives Association ("ISDA") Master Agreements and central clearing exchange
agreements contains provisions under which we are required to fully collateralize our obligations under our interest rate swap
agreements 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, which
approximates fair value.
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 stockholders' 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, 2013, the fair value of
additional collateral that could be required to be posted as a result of the credit-risk related contingent features being triggered was
not material to our consolidated financial statements.
Excluding centrally cleared swaps, as of December 31, 2013, our amount at risk with any counterparty related to our interest
rate swap and swaption agreements was less than 2% of our stockholders' equity.
In the case of centrally cleared interest rate swap contracts, we could be exposed to credit risk if the central clearing agency
or a clearing member defaults on its respective obligation to perform under the contract. However, we believe that the risk is
minimal due to the exchange's initial and daily mark to market margin requirements and a clearinghouse guarantee fund and other
resources that are available in the event of a clearing member default.
Note 6. Offsetting Assets and Liabilities
Certain of our repurchase agreements and derivative transactions are governed by underlying agreements that generally
provide for a right of setoff under master netting arrangements (or similar agreements), including in the event of default or in the
event of bankruptcy of either party to the transactions. We present our assets and liabilities subject to such arrangements on a
gross basis in our consolidated balance sheets.
93
The following tables present information about our assets and liabilities that are subject to such arrangements and can
potentially be offset on our consolidated balance sheets as of December 31, 2013 and 2012 (in millions):
Offsetting of Financial Assets and Derivative Assets
Gross
Amounts
Offset in the
Consolidated
Balance
Sheets
Net Amounts
of Assets
Presented in
the
Consolidated
Balance
Sheets
Gross
Amounts of
Recognized
Assets
Gross Amounts Not Offset
in the
Consolidated Balance Sheets
Financial
Instruments
Collateral
Received 2
Net Amount
December 31, 2013
Interest rate swap and swaption agreements, at fair
value 1 ........................................................................
Receivable under reverse repurchase agreements .....
Total derivative, other hedging instruments and
other assets.............................................................
December 31, 2012
Interest rate swap and swaption agreements, at fair
value 1 ........................................................................
Receivable under reverse repurchase agreements .....
Total derivative, other hedging instruments and
other assets.............................................................
$
$
$
$
1,138
$
— $
1,138
$
(331) $
(610) $
1,881
—
1,881
(1,881)
—
3,019
$
— $
3,019
$
(2,212) $
(610) $
185
$
11,818
— $
—
185
$
(185) $
— $
11,818
(10,482)
(1,157)
12,003
$
— $
12,003
$
(10,667) $
(1,157) $
197
—
197
—
179
179
Offsetting of Financial Liabilities and Derivative Liabilities
Gross
Amounts
Offset in the
Consolidated
Balance
Sheets
Net Amounts
of Liabilities
Presented in
the
Consolidated
Balance
Sheets
Gross
Amounts of
Recognized
Liabilities
Gross Amounts Not Offset
in the
Consolidated Balance Sheets
Financial
Instruments
Collateral
Pledged 2
Net Amount
December 31, 2013
Interest rate swap agreements, at fair value 1 ............
Repurchase agreements .............................................
Total derivative, other hedging instruments and
other liabilities .......................................................
December 31, 2012
Interest rate swap agreements, at fair value 1.............
Repurchase agreements .............................................
Total derivative, other hedging instruments and
other liabilities .......................................................
_______________________
$
$
$
$
400
$
63,533
— $
—
400
$
(331) $
(69) $
63,533
(1,881)
(61,652)
63,933
$
— $
63,933
$
(2,212) $
(61,721) $
1,243
$
— $
1,243
$
(185) $
(1,058) $
74,478
—
74,478
(10,482)
(63,996)
75,721
$
— $
75,721
$
(10,667) $
(65,054) $
—
—
—
—
—
—
1. Reported under derivative assets / liabilities, at fair value in the accompanying consolidated balance sheets. Refer to Note 5 for a reconciliation of
2.
derivative assets / liabilities, at fair value to their sub-components.
Includes cash and securities received / pledged as collateral, at fair value. Amounts presented are limited to collateral pledged sufficient to reduce
the net amount to zero for individual counterparties, as applicable. Refer to Note 3 for additional information regarding assets pledged as collateral.
Note 7. 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
94
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
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 years 2013 and 2012. 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.
95
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, 2013 and 2012 (dollars in millions):
Fair Value Hierarchy
Level 1
Level 2
Level 3
December 31, 2013
Assets:
Agency securities........................................................................ $
— $
65,941
$
U.S. Treasury securities ..............................................................
3,822
Interest rate swaps.......................................................................
Payer swaptions ..........................................................................
REIT equity securities ................................................................
U.S. Treasury futures ..................................................................
Net TBA and forward settling agency securities ........................
—
—
237
39
—
—
880
258
—
—
17
Total ................................................................................................ $
4,098
$
67,096
$
Liabilities:
Debt of consolidated VIEs.......................................................... $
— $
910
$
Obligation to return U.S. Treasury securities borrowed under
reverse repurchase agreements ...................................................
Interest rate swaps.......................................................................
Net TBA and forward settling agency securities ........................
1,848
—
—
—
400
22
Total ................................................................................................ $
1,848
$
1,332
$
December 31, 2012
Assets:
Agency securities........................................................................ $
— $
85,245
$
Interest rate swaps.......................................................................
Payer swaptions ..........................................................................
Net TBA and forward settling agency securities ........................
—
—
—
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.......................................................................
Net TBA and forward settling agency securities ........................
11,763
—
—
—
1,243
21
Total ................................................................................................ $
11,763
$
2,201
$
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
Note 8. 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, 2014 and provides for automatic one-year extension options thereafter. The
management agreement may only be terminated by 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'
96
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 2013,
2012 and 2011, we recorded an expense for management fees of $136 million, $113 million and $55 million, respectively.
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 2013, 2012 and 2011, we recorded expense reimbursements to our Manager
of $10 million, $9 million and $7 million, respectively, consisting mostly of costs related to information technology systems. As
of December 31, 2013 and 2012, $13 million and $1 million was payable to our Manager, respectively.
Note 9. Income Taxes
The following table summarizes dividends for federal income tax purposes declared for fiscal years 2013, 2012 and 2011
and their related tax characterization (in millions, except per share amounts):
Fiscal Tax Year
Tax Characterization
Dividends
Declared
Per Share
Dividends
Declared
Ordinary
Income
Per Share
Qualified
Dividends
Long-Term
Capital
Gains Per
Share
Series A Cumulative Redeemable Preferred Stock Dividends
Fiscal year 2013.............................................................................
$ 2.000000
Fiscal year 2012.............................................................................
$ 1.056000
Common Stock Dividends
Fiscal year 2013.............................................................................
$ 3.750000
Fiscal year 2012.............................................................................
$ 5.000000
Fiscal year 2011.............................................................................
$ 5.600000
$
$
$
$
$
14
7
$2.000000
$ 0.015980
$
—
$0.952300
$
— $ 0.103700
1,453
$3.750000
$ 0.029963
$
—
1,518
$4.509200
886
$5.332400
$
$
— $ 0.490800
— $ 0.267600
As of December 31, 2013, we had approximately $210 million of estimated undistributed taxable income that we expect to
declare dividends for by the extended due date of our 2013 federal income tax return and pay in 2014. Accordingly, we do not
expect to incur any income tax liability on our 2013 taxable income.
For fiscal years 2013, 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 $3 million, $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 2013, 2012 and 2011, we recorded an income tax provision of $10 million, 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 2013, 2012 and 2011.
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, 2013, 2012 and 2011. Our tax returns
for tax years 2010 and forward 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.
Note 10. Stockholders' Equity
Preferred Stock
Pursuant to our amended and restated certificate of incorporation, we are authorized to designate and issue up to 10 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%
97
Series A Cumulative Redeemable Preferred Stock ("Series A Preferred Stock"). As of December 31, 2013, 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, 2013, we had
declared all required quarterly dividends on our Series A Preferred Stock.
Common Stock Repurchase Program
In October 2012, our Board of Directors adopted a program that provides for stock repurchases of up to $500 million of our
outstanding shares of common stock through December 31, 2013. In September 2013, our Board of Directors increased the
authorized amount to $1 billion of our outstanding shares of common stock and extended its authorization through December 31,
2014. In January 2014, our Board of Directors increased the authorized amount by an additional $1 billion of our outstanding
shares of common stock through December 31, 2014. 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 Exchange Act of 1934, as amended. 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 Rule 10b-18, which sets certain restrictions on the method, timing, price and volume
of stock repurchases.
During fiscal year 2013, we repurchased approximately 40.3 million shares of our common stock at an average repurchase
price of $21.25 per share, including expenses, totaling $856 million. During fiscal year 2012, we repurchased 2.7 million shares
of our common stock at an average repurchase price of $29.00 per share, including expenses, totaling $77 million. As of
December 31, 2013, the total remaining amount authorized for repurchases of our common stock was $66 million, excluding the
additional amount authorized in January 2014.
98
Follow-On Equity Offering
During fiscal years 2013, 2012 and 2011, 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 2013
Price Received
Per Share 1
Shares
Net Proceeds 2
March 2013.............................
$31.34
Total fiscal year 2013 .........
Fiscal year 2012
March 2012.............................
July 2012 ................................
$29.00
$33.70
Total fiscal year 2012 .........
Fiscal year 2011
January 2011...........................
March 2011.............................
June 2011................................
November 2011 ......................
Total fiscal year 2011 .........
$28.00
$27.72
$27.56
$27.36
57.5
57.5
$
$
71.2
$
36.8
108.0
$
26.9
$
32.2
49.7
40.5
149.3
$
1,803
1,803
2,063
1,240
3,303
719
892
1,369
1,108
4,088
________________________
Price received per share is gross of underwriters' discount, if applicable, and other offering costs.
1.
2. Net proceeds are net of the underwriters' discount, if applicable, and other offering costs.
At-the-Market Offering Program
We have entered into 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 and 2011 (in millions, except per share amounts):
At-the-Market Offering
Fiscal year 2012.........................
Fiscal year 2011.........................
Price Received
Per Share
$
$
31.41
29.25
Shares
Net Proceeds
9.5
9.4
$
$
298
273
During fiscal year 2013, we had no sales under this program. As of December 31, 2013, 16.7 million shares remain available
for issuance under this program.
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 year 2011, we issued 0.5 million shares under the plan for net cash proceeds of $15 million. During fiscal years
2013 and 2012 , there were no shares issued under the plan. As of December 31, 2013, 21.7 million shares remain available for
issuance under the plan.
99
Accumulated Other Comprehensive Income (Loss)
The following table summarizes changes to accumulated OCI for fiscal years 2013, 2012 and 2011 (in millions):
Accumulated Other Comprehensive (Loss) Income
Net Unrealized
Gain (Loss) on
Available-for-
Sale MBS
Net Unrealized
Gain (Loss) on
Swaps
Total
Accumulated
OCI
Balance
Balance as of December 31, 2010 ............................................
$
(28) $
(40) $
OCI before reclassifications .......................................................
Amounts reclassified from accumulated OCI ............................
Balance as of December 31, 2011 ............................................
OCI before reclassifications .......................................................
Amounts reclassified from accumulated OCI ............................
Balance as of December 31, 2012 ............................................
OCI before reclassifications .......................................................
Amounts reclassified from accumulated OCI ............................
1,512
(483)
1,001
2,235
(1,196)
2,040
(4,535)
1,408
(844)
194
(690)
—
205
(485)
—
189
Balance as of December 31, 2013 ............................................
$
(1,087) $
(296) $
(68)
668
(289)
311
2,235
(991)
1,555
(4,535)
1,597
(1,383)
The following table summarizes reclassifications out of accumulated OCI for fiscal years 2013, 2012 and 2011 (in millions):
Amounts Reclassified from Accumulated OCI
2013
2012
2011
Fiscal Year
(Gain) loss amounts reclassified from accumulated
OCI for available-for-sale MBS ................................
Periodic interest costs of interest rate swaps
previously designated as hedges under GAAP, net...
$
1,408
$
(1,196) $
(483)
189
205
194
Interest expense
Line Item in the Consolidated
Statements of Comprehensive Income
Where Net Income is Presented
Gain (loss) on sale of agency securities,
net
Total reclassifications...........................................
$
1,597
$
(991) $
(289)
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 2013, 2012 and 2011,
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 2013, we
granted 3,000 shares of restricted common stock to each independent director, or a total of 15,000 shares, with a grant date fair
value of $31.20 per share. During fiscal year 2012, we granted 3,000 shares of restricted common stock to each independent
director, or a total of 12,000 shares, with a weighted average grant date fair value of $29.48 per share. During fiscal year 2011,
we granted 3,000 shares of restricted common stock to each independent director, or a total of 12,000 shares, with a grant date
fair value of $29.05 per share.
During fiscal years 2013, 2012 and 2011, an aggregate of 9,500, 7,000 and 4,500 shares of restricted common stock vested
under the plan, respectively. The total fair value of restricted stock awards vested during fiscal years 2013, 2012 and 2011 was
approximately $290,000, $222,000 and $131,000, respectively, based upon the fair market value of our common stock on the
vesting date. During fiscal years 2013, 2012 and 2011, we recognized approximately $383,000, $282,000 and $176,000 of
compensation expense under the plan, respectively.
As of December 31, 2013 and 2012, there was an aggregate 27,000 and 21,500 shares, respectively, of unvested restricted
common stock outstanding under the plan and unrecognized compensation costs related to such awards of $481,919 and $397,415,
respectively. As of December 31, 2013, 47,500 shares of common stock remained available for future issuance under the plan.
100
Note 11. Quarterly Results (Unaudited)
The following is a presentation of the quarterly results of operations and comprehensive income for fiscal years 2013 and
2012 (in millions, except per share data).
Quarter Ended
March 31,
2013
June 30,
2013
September 30,
2013
December 31,
2013
Interest income:
Interest income ............................................................................. $
Interest expense ............................................................................
Net interest income ...............................................................
$
547
140
407
$
545
131
414
$
558
145
413
Other (loss) income:
(Loss) gain on sale of agency securities, net ................................
(Loss) gain on derivative instruments and other securities, net ...
Total other (loss) income, net................................................
(26)
(98)
(124)
542
120
422
(667)
184
(483)
31
6
37
(98)
3
(101)
3
(733)
(339)
(1,072)
35
7
42
(701)
—
(701)
3
$
$
(704) $
(104)
(701) $
(101)
833
47
880
179
3
(311)
46
(265)
(366)
3
17
1,444
1,461
37
9
46
1,829
—
1,829
3
1,826
1,829
(2,813)
48
(2,765)
(936)
3
33
9
42
241
10
231
3
228
231
(837)
49
(788)
(557)
3
$
$
(560) $
(939) $
176
$
(369)
356.2
396.4
0.64
$
4.61
$
(1.57) $
$
1.25
(2.37) $
$
1.05
390.6
(1.80) $
0.45
0.80
$
$
373.0
(0.28)
(0.99)
0.65
Expenses:
Management fees..........................................................................
General and administrative expenses ...........................................
Total expenses.......................................................................
Income (loss) before income tax
Provision for income tax, net .......................................................
Net income (loss)..............................................................................
Dividend on preferred stock .........................................................
Net income (loss) available (attributable) to common
shareholders..................................................................................... $
Net income (loss).............................................................................. $
Other comprehensive (loss) income:..............................................
Unrealized (loss) gain on available-for-sale securities, net .......
Unrealized gain on derivative instruments, net..........................
Other comprehensive (loss) income ...................................
Comprehensive (loss) income .........................................................
Dividend on preferred stock .........................................................
Comprehensive (loss) income (attributable) available to
common shareholders................................................................ $
Weighted average number of common shares outstanding-
basic and diluted ........................................................................
Net income (loss) per common share - basic and diluted............. $
Comprehensive (loss) income per common share - basic and
diluted............................................................................................... $
Dividends declared per common share ......................................... $
101
Quarter Ended
March 31,
2012
June 30,
2012
September 30,
2012
December 31,
2012
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 taxes
Income tax provision (benefit) .......................................................
Net income (loss)................................................................................ $
Dividend on preferred stock ...........................................................
Net income (loss) available (attributable) to common
shareholders....................................................................................... $
Net income (loss)................................................................................ $
Other comprehensive (loss) 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 (loss) income (attributable) 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 ........................................... $
$
$
$
$
514
106
408
216
47
263
22
6
28
643
2
641
—
641
641
(106)
52
(54)
587
—
$
504
120
384
$
520
139
381
417
(1,029)
(612)
210
(460)
(250)
28
8
36
(264)
(3)
(261) $
3
(264) $
(261) $
689
52
741
480
3
32
8
40
91
5
86
3
83
86
$
$
$
1,190
51
1,241
1,327
3
570
147
423
353
89
442
31
9
40
825
15
810
3
807
810
(734)
50
(684)
126
3
587
$
477
$
1,324
$
123
240.6
2.66
2.44
1.25
$
$
$
301.0
(0.88) $
$
1.58
$
1.25
332.8
0.25
3.98
1.25
$
$
$
340.3
2.37
0.36
1.25
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.
102
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, 2013. Based on the foregoing, our Chief Executive Officer and Chief
Financial Officer concluded that our disclosure controls and procedures were effective.
Management's Report on Internal Control over Financial Reporting
Management's Report on Internal Control over Financial reporting is included in “Item 8. Financial Statements and
Supplementary Data.”
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.
Item 9B. Other Information
None.
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 2014 Annual Meeting of Stockholders (the "2014 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 2014 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 2014 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 2014 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 2014 Proxy
Statement under the heading "PROPOSAL 2: RATIFICATION OF SELECTION OF INDEPENDENT PUBLIC ACCOUNTANT."
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, 2013 and 2012
Consolidated Statements of Comprehensive Income for fiscal years 2013, 2012 and 2011
Consolidated Statements of Stockholders' Equity for fiscal years 2013, 2012 and 2011
103
Consolidated Statements of Cash Flows for fiscal years 2013, 2012 and 2011
(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.
*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 fixed charges and ratio of earnings to combined fixed charges and preferred
stock dividends, filed herewith
*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
104
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
105
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, 2014
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, 2014
/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
*
Prue B. Larocca
*
Alvin N. Puryear
*By:
/s/ JOHN R. ERICKSON
John R. Erickson
Attorney-in-fact
Director
Director
Director
Director
Director
Director
Director
106
February 27, 2014
February 27, 2014
February 27, 2014
February 27, 2014
February 27, 2014
February 27, 2014
February 27, 2014
February 27, 2014
BOARD OF DIRECTORS
Malon Wilkus
Chair & Chief Executive Officer, American Capital Agency Corp.;
Chief Executive Officer, 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
Robert M. Couch
Counsel, Bradley Arant Boult Cummings LLP;
Chairman, ARK Real Estate Strategies, 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
Randy E. Dobbs
President & Chief Executive Officer, Matrix Medical Network
Prue B. Larocca
Director
Larry K. Harvey
Director
Alvin N. Puryear, Ph.D.
Professor Emeritus of Management and Entrepreneurship, Baruch College
of the City University of New York; Management Consultant
EXECUTIVE OFFICERS
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
Peter J. Federico
Senior Vice President & Chief Risk Officer, American Capital Agency
Corp.; Senior Vice President & Chief Risk 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
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. 8.000% Series A Cumulative Redeemable Preferred Stock trades
on The NASDAQ Global Select Market under the symbol AGNCP.
Transfer Agent and Registrar
Computershare Investor Services
P.O. Box 30170
College Station, TX 77842-3170
(800) 733-5001
www.computershare.com/investor
Financial Publications
Stockholders may receive a copy of our 2013 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.
Two Bethesda Metro Center | 14th Floor | Bethesda, MD 20814
Phone: (301) 968-9300 | Fax: (301) 968-9301 | Email: IR@AGNC.com
AGNC.COM | NASDAQ: AGNC
002CSN337F