The Fed remained the biggest buyer of mortgage backed securities in 2012 as it acquired $500 billion of MBS to support the US housing market. In September, the Fed accelerated its MBS acquisition by launching the third round of quantitative easing (QE3). Under the program, the central bank seeks to purchase Agency mortgage backed securities worth $40 billion a month. QE3 delivered its results as demonstrated by latest housing data, the fact that mortgage rates have touched record lows (30-year mortgage rate 3.35%) and 34% acceleration in refinancing.
According to the latest statistics compiled by Mortgage Bankers Association and reported by Bloomberg, sale of Agency MBS reached a three-year high. This was a result of the direct actions from the Fed, which intends to make home ownership affordable. Securities issued by government sponsored Agencies (Fannie Mae or Freddie Mac or Ginnie Mae) increased 41% from a year ago to $1.72 trillion, reflecting increased capacity through hiring by most of the mortgage originators.
Mortgage Market Outlook
The growth in Agency mortgage bond issuance during 2012 is not expected to continue. Agency MBS issuance is expected to decline to $1.65 billion as acceleration in refinancing and higher Freddie Mac and Fannie Mae fees push banks to retain more mortgages on their balance sheets to increase their interest income.
However, the sale of non-Agency MBS is expected to surge to $20 billion to $30 billion as expected by analysts at JPMorgan. Independently, Bank of America and Barclays have forecasts of $30 billion and $20 billion, respectively.
Agency Mortgage REITs
Looking at the expectations for issuance of Agency MBS, I believe among other Agency mREITs, Annaly Capital Management's (NLY) net interest margins will further be hurt during 2013. It already reported an over 100 basis points decline in its net interest margin year over year. Lower MBS issuance, record low mortgage rates and accelerated prepayments during the next year will continue to hurt the company that invests exclusively in Agency MBS with weighted average coupons as high as 4.1%. Annaly reported one of the highest conditional prepayment rates (CPR) of 20% at the end of the most recent quarter, which means it is facing high amortization costs too. The proposed change in strategy by Annaly has not worked out either, as the board of CreXus Investment is not in a hurry to evaluate Annaly's proposal. Annaly currently trades at 0.85 times its third quarter book value and offers a dividend yield of 12.7%. Analysts have a mean price target of $15.35 for the stock of Annaly, which is currently trading at $14.
Though American Capital Agency (AGNC) invests exclusively in Agency MBS, its portfolio is prepayment protected and it owns MBS with low coupon (weighted average coupon of 3.86%) and low balances. This makes the company less exposed to the Fed's aggressive MBS buying and the resultant accelerated prepayments. Therefore, I believe the company is better positioned compared to Annaly Capital. American Capital trades at 0.89 times its book value and offers an unmatched dividend yield of 17.19%. Analysts have a mean target price of $34.5 for American Capital's stock, which is currently trading at $28.99.
Conclusion
Given the week outlook of Agency MBS issuance and strong demand from the biggest buyer, I believe Agency mortgage REITs in general and Annaly Capital in particular will underperform in 2013. However, I believe Agency mREITs with prepayment protected MBS portfolios like American Capital Agency will not be hurt as much. Therefore, I recommend investors to consider investing in American Capital Agency.
