We have been following the Annaly Capital Management (NLY) and American Capital Agency (AGNC) quarterly earnings releases for some time now. The original intent of this was to try to predict which of these two mortgage REITs might have an advantage from an investment standpoint, but now, it serves as an interesting illustration of what has happened to this entire industry over the last year.
Here is a stock chart for these two companies for the last 90 days:
I made the statement a quarter ago that I expected AGNC to do a little better than NLY, and I suppose in essence, I was right, except to say that AGNC did "less poorly" than NLY, and the bulk of this negative activity happened roughly since the declaration of the dividends for these two companies, which happened in mid-September.
Here are the current stock prices and dividend yields for these to companies:
At the moment, given the current beatdown of the price of these two stocks, the yield on AGNC is more than 16%, and for NLY still over 13%. The dividend yields above are, of course, annualized based on the current dividend, which is making an assumption about the future that might not come true.
If we wanted to get the whole story of the last quarter into one graph, this would have to be it:
This is the 90-day chart for a fixed rate mortgage in the US, which reflects a trend that has gone on since July of 2011, namely steadily declining rates. Both of these companies make a living borrowing money at the lowest possible rate, and originating mortgage backed securities which are issued at the market rate. The difference between these two rates is the interest rate spread, which for these two companies was as follows:
|Interest Rate Spread||Q1 2012||Q2 2012||Q3 2012|
Obviously this business has been difficult for both of these companies. You may well ask the question: If both of these companies are in the same business, namely government-backed mortgage loans, how is it that the spread for NLY can decline by 52 basis points whereas the spread for AGNC only declined by only 22 basis points? The answer to that is: the AGNC hedging activity causes it to have lower net borrowing costs than NLY, and this has given it some insulation from the interest rate decline. This is illustrated in the tables(s) below:
|Net Interest Income ($B)||$ 408||$ 384||$ 381|
|Gain on Sale of Securities ($B)||$ 216||$ 417||$ 210|
|Loss on Derivatives (Net) ($B)||$ 47||$(1,029)||$ (460)|
|Unrealized Gain on AFS Securities ($B)||$ (106)||$ 689||$ 1,190|
|Unrealized Gain on Derivative Instruments ($B)||$ 52||$ 52||$ 51|
|Net of Income and Hedging ($B)||$ 617||$ 513||$ 1,372|
|Net Effect of Hedging Program ($B)||$ 209||$ 129||$ 991|
|NLY Q1||NLY Q2||NLY Q3|
|Net Interest Income ($B)||$ 721||$ 719||$ 579|
|Gain on Sale of Securities ($B)||$ 80||$ 94||$ 142|
|Unrealized Gains(loss) on Interest Only MBS ($B)||$ 31||$ (26)||$ (34)|
|Realized Gain (Loss) on Interest Rate Swaps ($B)||$ (219)||$ (222)||$ (224)|
|Unrealized Gain (Loss) on Interest Rate Swaps ($B)||$ 341||$ (611)||$ (104)|
|Net Loss on Extinguishment of Senior Notes ($B)||$ (87)|
|Net of Income and Hedging ($B)||$ 954||$ (46)||$ 273|
|Net Effect of Hedging Program ($B)||$ 233||$ (765)||$ (307)|
You can see from the above two tables that the net result of all of the hedging activity for both of these companies has been a net benefit for AGNC and a net negative for NLY. The argument can and has been made that having a negative result in hedging is "good," because it means that the hedging program successfully insured the company against losses elsewhere in the system. The market does not particularly see it that way, however.
The idea of "prepayment rate" comes into play as well. The "prepayment rate" or CPR is the rate at which the mortgagees refinance their mortgages, and the lower interest rates go, the more likely this is to happen. For AGNC, the prepayment rate is about 10%, and for NLY, the prepayment rate is around 20%. The reason for the difference is that the mortgage term for AGNC is shorter than for NLY so the mortgagees are less likely to refinance, so this, too, is more of a headwind for NLY.
The net result of all of this is pressure on the dividends, which has been more severe in the case of NLY than for AGNC:
No one buys these mREITs because they love the mortgage business. People buy them because they like to collect high dividends. Everything being equal, declining mortgage rates equals a lower spread equals a lower dividend equals a lower stock price, and that is exactly what we saw in the case of NLY. The explanation as what happened to AGNC, despite its dividend being constant, will be the topic of a future article.
|Cash Position ($B)||Q1 2012||Q2 2012||Q4 2012|
|AGNC||$ 1,762||$ 2,099||$ 2,569|
|NLY||$ 932||$ 924||$ 2,264|
If there is a good sign in all of this, it is in the above table: Because of its good quarter in hedging, AGNC's cash position is just as good as it was a quarter ago. Dividend security is good. The case of NLY is even more interesting. Here is a company whose cash position has more than doubled in the last quarter, implying that a strategy change is afoot.
|MBS Portfolio ($B)||Q1 2012||Q2 2012||Q3 2012|
In order to cope with the continued decay in interest rates, both of these companies have announced share buybacks, and have begun to do financing via the issuance of lower-cost preferred stock. For further explanation as to why this makes sense, I would refer you to this article of a couple of weeks ago that explains the strategy in some detail.
There has been an additional development in the last few days, as NLY has announced the purchase of the remaining shares of Crexus (CXS) which is a provider of commercial mortgage backed securities, that it previously partially owned. According to its most recent earnings announcement, Crexus' portfolio consisted of about $700M in commercial mortgage backed securities, which would make it less than 0.5% of NLY's total portfolio of $129.5B. The average yield of Crexus' portfolio in the last quarter was 9%, with a cost of financing of 3.6%, for a net interest rate spread of over 5%, so you can see NLY's motivation, but because CRX was quite small compared to NLY, this was probably more of a signal to the marketplace than anything that will affect NLY's bottom line in a major way.
The much more significant announcement was in this press release, which states that NLY will now allocate up to 25% of shareholders equity in non-agency-backed mortgages, which is a major departure in strategy.
So, what are we to make of all of this:
I am actually encouraged at AGNC's ability to maintain a strong cash position, and only have a decline of 22 basis points in its spread, despite operating in an extremely difficult environment. In the case of NLY, the raising of cash. the announcement of its intent to buy back shares, along with this shift to a more profitable marketplace represents a major strategy departure.
Of the two, I believe AGNC is still the more attractive at the moment, but if NLY follows through on this strategy to compete in the commercial mortgage market, NLY could be a really interesting investment, and is worthy of some additional consideration.
I would also throw out the idea that when one of these companies does a strategy shift, the other one follows shortly thereafter, and in light of the increased cash position of AGNC, it would not be shocking to see AGNC make some changes as well, within a few weeks.
Do with this information what you will, keeping in mind what we always say: The world is full of chaos, and there are no guarantees on anything.