American Capital Agency - 2010 Annual Report
American Capital Agency Corp - Home NASDAQ: AGNC
Dear Fellow Shareholders,
Two thousand and ten was another volatile year in the market for residential mortgage-backed securities (MBS).
A volatile MBS market is hardly new, but many of the challenges we confronted in 2010 were new and not
entirely foreseeable. Nevertheless, we performed for you in 2010 by managing our balance sheet and adjusting to
the changes, while producing consistently strong returns. We believe that our emphasis on asset selection and an
active approach to portfolio management were instrumental in our success. In this report, we will discuss some of
the key events that impacted the MBS market in 2010 and how we addressed them, give some perspective on
measuring our performance and provide some thoughts on 2011 and beyond.
GSE BUYOUTS
In early February 2010, the government-sponsored enterprises (GSEs) announced that they would buy out all the
seriously delinquent loans backing their MBS pools. While the GSEs always had the right to buy out seriously
delinquent loans, they had previously elected not to do so to avoid taking a charge to their capital base. However,
a January 1, 2010, change in accounting rules effectively eliminated the benefit of leaving the seriously
delinquent loans in MBS pools and the “buyouts” followed. The buyouts created massive one-time prepayments
on higher coupon fixed-rate and hybrid adjustable-rate MBS. The markets reacted swiftly and harshly to the
buyout announcements, as prices of many higher coupon mortgage securities immediately dropped by 1 to 2
percentage points.
We began positioning AGNC for a potential significant prepayment event from GSE buyouts in September 2009.
We communicated these concerns to our shareholders on our third quarter earnings call in October 2009, months
in advance of the GSE announcements. We remained focused on this risk throughout the fourth quarter of 2009
and into 2010 and we went to great lengths to minimize our exposure. By early 2010, we had dramatically
“de-risked” the portfolio by reducing our leverage and repositioning away from agency MBS that we expected
were backed by a significant amount of delinquent loans. A byproduct of our efforts was that we generated
substantial gains for our shareholders by selling MBS that we believed were significantly at risk for buyout
prepayments. Market prices were extremely attractive while we were selling these MBS because many investors
were focused on slow historical prepayment performance rather than the impending GSE buyout risk. Thus, we
locked in gains based on very favorable future prepayment expectations, ahead of the significant price declines
that occurred once the GSEs announced the buyouts.
THE FED’S EXIT FROM THE MBS MARKET
Starting in 2008, the Federal Reserve committed to purchasing MBS as part of the government’s multi-faceted
approach to stabilizing the economy. Over the course of the program, the Fed and the US Treasury acquired
approximately $1.5 trillion of MBS. March 31, 2010 marked the end of this program.
The days leading up to March 31 presented the mortgage market with another significant concern — the risk that
mortgage prices could fall significantly with the exit of the market’s largest buyer. We believe that many
investors chose to underweight MBS securities in their portfolios in anticipation of this event. However, we
thought that any impacts would be modest, believing that the market impact of the Fed and Treasury purchases
had been offset somewhat by other investors reducing their MBS investing activities. Therefore, we elected not
to underweight or delever our portfolio in the days leading up to the Fed exit. This ended up being the right
strategy, as the Fed’s exit was largely a non-event and mortgage prices performed well.
EUROPEAN DEBT CRISIS
The European debt crisis in the second quarter of 2010 proved to be another significant event for the MBS
market. As the second quarter of 2010 approached, the economic picture was improving and interest rates were
generally expected to rise through the remainder of the year. After a brief sell-off during the first few days of
April 2010, fears about the financial health of European sovereigns and banks reversed the market. The bond
market began a massive “flight to quality” rally, driving Treasury bond yields down almost 100 bps. It quickly
became clear to us that these record low rates would probably give rise to increases in prepayments driven by
refinancing activity by healthy borrowers.
Rising prepayments from declining interest rates create reinvestment risk for an MBS investor, negatively
impacting asset yields and net asset values (NAV). We believe that our ability to invest across the agency
security universe is a competitive advantage in this environment. Through careful asset selection strategies, we
were able to identify specific types of assets whose prepayment behavior would be less impacted by record low
interest rates.
An example of this proactive approach was investments we made in new Fannie Mae 30-year 5.5% coupon MBS
with unusually high loan-to-value (LTV) ratios of between 105 and 125. Average prepayment speeds on these
pools were around 2% CPR during the third quarter while more generic securities had prepayment speeds well
above 30%. When the market began to focus on the growing prepayment risk from declining interest rates, the
prices of call protected MBS such as these high LTV securities increased significantly. Thus, our shareholders
benefitted from significant price increases during a time when more generic MBS declined in price. The
following chart illustrates the deviation in prices in 2010 between high LTV MBS and generic MBS.
Figure 1: Prices of High LTV MBS vs Generic MBS
100.00
102.00
104.00
106.00
108.00
110.00
30 Yr 5% High LTV 30 Yr 5.5% High LTV
30 Yr 5% TBA 30 Yr 5.5% TBA
Price
108.50
106.91
106.31
105.28
Source: Bloomberg and Bank of America, 12/31/09 – 9/30/10.
Overall, our strategy worked well. During the second and third quarters, we maintained a quarterly dividend
payment of $1.40 per share and our book value per share grew from $22.91 to $23.43, while many of our peers
experienced book value declines or cut their dividends.
MORE INTEREST RATE RISK AND VOLATILITY
While interest rates remained steady for several months following the European debt crisis, interest rate volatility
reappeared later in the year. The fourth quarter began with a further decline in interest rates as the market priced
in the likelihood of the next round of quantitative easing (a/k/a QE2), which the Fed had been signaling. We
believe that most mortgage investors responded by rebalancing their portfolios to deal with predicted
prepayments and record low interest rates. However, in early November 2010, the actual announcement of QE2,
the midterm election results and some stronger economic numbers led to a largely unanticipated result — a
massive sell-off in bond prices. Interest rates rose dramatically with the 10-year Treasury jumping back to 3% by
early December 2010 from a low of 2.4% earlier in the fourth quarter. Then, the agreement to extend the current
tax rates, the extension of unemployment benefits and the reduction in Social Security taxes further “spooked”
the bond market by stoking deficit concerns. The result was that the bond market sell-off gained momentum with
10-year Treasury rates rising above 3.5% in a few days, capping a dramatic move of over 100 bps within the
fourth quarter. The two-year trend in the 10-year Treasury rate appears below.
What a time to be managing a fixed income portfolio!
Figure 2: Significant Interest Rate Volatility
2
2.5
3
3.5
4
(%)
Benign Prepayment GSE Buyouts
Speeds
High
Refi Risk
Interest
Rate
Selloff
Q1 09 Q2 09 Q3 09
10 yr UST Rate
Q4 09 Q1 10 Q2 10 Q3 10 Q4 10
Source: CapitalIQ, 1/1/09 – 12/31/10.
On our third quarter earnings call in October 2010 (when interest rates were still near historic lows), we stated
that we had reduced our portfolio exposure to rising interest rates. This was accomplished largely through the
purchase of payer swaptions and short TBA positions. Given the large increase in interest rates we saw during the
latter part of the fourth quarter, the steps we took in October to insulate the portfolio from rising rates were
significant drivers of our results for the quarter. These positions increased materially in value and helped us
produce our highest quarterly earnings per share to date. Perhaps more importantly, we were able to grow our
NAV per share during the quarter from $23.43 to $24.24, even though many investors and analysts expected the
opposite result, especially in light of our very strong relative performance during the prior quarters when interest
rates were falling.
Despite the volatility and challenges that we witnessed during 2010, we were able to produce very strong results
for our shareholders as highlighted in this Annual Report. Indeed, by successfully managing our portfolio during
these various events, we were able to position the Company to capitalize on new opportunities as they presented
themselves during the year and to transition to the current investment environment.
ECONOMIC RETURN
In 2010, we asked our shareholders to consider a metric we call “Economic Return” in evaluating us and our
competitors. We define Economic Return as the sum of cash dividends paid plus the change in our NAV over a
specified period. It is similar to the way mutual funds, hedge funds and many other professionally-managed
investment vehicles report their results. Economic Return is not influenced by differences in accounting
methodologies (e.g., different prepayment assumptions used in calculating yields) and it treats realized and
unrealized gains and losses equally. It also fully captures any impacts of both settled and unsettled positions. The
following chart compares our Economic Return against that of our peer group in 2009 and 2010.
Figure 3: Economic Return
-8%
-4%
0%
4%
8%
12%
16%
20%
AGNC Peer Average Peer High Peer Low
Economic Return
Q1 09 Q2 09 Q3 09 Q4 09 Q1 10 Q2 10 Q3 10 Q4 10
Source: CapitalIQ and Company Filings. Peer Average comprised of the following peers
on an unweighted basis: ANH, CMO, CYS, HTS and NLY.
RAISING ACCRETIVE EQUITY CAPITAL
AGNC grew significantly this year. We believe that our success in navigating the challenges that we experienced
in the mortgage market resulted in AGNC gaining significant investor confidence. This confidence was evident
in the strong investor acceptance of our equity offerings in 2010. AGNC raised over $1.05 billion last year and
added 40.5 million shares to the Company’s float through three public follow-on offerings, as well as an
at-the-market offering program and a dividend reinvestment and direct purchase program. All of the offerings
were accretive to book value. More importantly, we maintained our strong performance as we grew.
OUTLOOK FOR 2011 AND BEYOND
While we have demonstrated that we can manage prepayment risk in a volatile interest rate environment and
following exogenous events such as the GSE buyouts, we would certainly appreciate a more benign environment.
We believe that the increase in interest rates we witnessed during the fourth quarter of 2010 will lead to
significantly slower prepayment speeds and also will serve to reduce near term prepayment uncertainty. In
addition, the steeper yield curve and higher investment yields on new purchases are very favorable developments,
especially because we believe the Federal Reserve will likely keep the Fed Funds rate unchanged through 2011
and, very possibly, beyond. We believe that the combination of slower prepayments and wider margins creates a
favorable investment environment.
Longer term, we are excited about the opportunities presented by the massive changes that we are witnessing in
the $5 trillion agency MBS market. Beyond its size, there are a number of other compelling aspects of the
business to think about.
We believe that the prospective changes to the GSEs are likely to be positive for agency MBS REITs. In the past,
the GSEs ran the largest private sector levered investment portfolios in the world, benefitting from competitive
advantages such as 40:1 leverage and being able to issue longer term debt at lower rates than other investors.
While none of us know exactly what the future holds for Freddie Mac and Fannie Mae, we believe that their
portfolios will have a significantly smaller role in the markets going forward. This should benefit the rest of the
market participants.
The new prepayment landscape is another longer term positive for the MBS market. Given the continued
prospects for a weak housing market and tighter underwriting standards, we believe that prepayments are likely
to be considerably more benign going forward than what we saw over the decade leading up to the housing crash.
We believe that these macro changes and our monetary policy expectations will be very favorable for our
business. We are excited about both the current and longer term prospects for AGNC.
CONCLUSION
The challenges that we will face in 2011 and beyond will likely be different than those we faced in 2010, just as
2010 differed from prior years. But as we witnessed in 2010, these new challenges often bring new opportunities.
We believe that the combination of our active management, diversification in investment products, ability to
source securities with favorable loan characteristics and proactive hedging strategies should enable AGNC to
produce attractive risk-adjusted returns over the long term.
Thank you for your confidence and support.
Sincerely,
Gary Kain
Chief Investment Officer, American Capital Agency Corp.
February 22, 2011
