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The 2012 fourth quarter earnings results from American Capital Agency (AGNC) dropped some very interesting tidbits into the agency mortgage REIT swimming pool. The company has shifted gears to take advantage of the MBS TBA markets, but at the same time there were several significant negatives in the quarterly earnings report.

TBA Dollar Roll "Free" Money

The TBA - to be announced - MBS market is a one to three-month forward market for the delivery of newly formed mortgage-backed securities. Money is made with a TBA dollar roll by purchasing the near or current month delivery and selling a later month TBA MBS. This "buying the roll" results in positive interest rate carry to the buyer. With the Federal Reserve buying $40 billion plus of MBS per month, this forward dollar roll trade has become quite profitable and American Capital Agency generated a nice boost to income in the fourth quarter.

By adding approximately of $13 billion of TBA mortgage positions to its $85 billion MBS portfolio, American Capital Agency was able to increase the net interest rate spread for the quarter by 22 basis points to 1.61% at the end of the quarter compared to 1.39% net earned on the owned securities portfolio.

Quarterly Numbers of Interest

A couple of the numbers published in the Q4 earnings report caught my attention. First, some basic numbers that are important to shareholders and then a discussion of the interesting portfolio losses/hedge gains posted for the quarter.

  • Book value dropped by 2.6% or 85 cents per share to $31.64 during the quarter. Book value was up by 14% for the full year, but the quarterly decline breaks a long running upward trend and this number needs to be watched. American Capital Agency will not be alone in reporting lower book values for the final quarter of 2012.
  • The company earned 89 cents per share of net spread income for the quarter compared to 79 cents reported in the third quarter. The difference was due to the TBA roll earnings an adjustments due to premium amortization costs.
  • The net interest rate spread on the portfolio holdings at the end of the quarter was 1.39%, not much different from the 1.42% in the third quarter. Asset yield - not including TBA business - stayed level and cost of funds bumped up a few basis points.

Balancing Gains and Losses

The moving parts of the American Capital Agency portfolio can make it tough to see where the gains and losses are working themselves through. If the value of the MBS holdings goes down the offsetting interest rate swaps, swaptions and short Treasury holdings should provide offsetting gains. However some of these events hit GAAP and/or taxable income and others do not. Here are some of the major numbers out of the Q4 earnings report.

  • $353 million net realized gain on sales of agency securities
  • $734 million of net unrealized loss on agency securities
  • $90 million of net TBA dollar roll income
  • $145 million of net unrealized gains on interest rate swaps
  • $37 million of net losses on other derivatives and securities
  • $107 million of other losses/costs related to hedging activities

The unrealized portfolio losses do not hit the net income statement, so when all is done, American Capital Agency reported taxable income of $1.93 per share and $2.37 of GAAP income per share. The $1.25 dividend payment was handily covered and the amount of undistributed taxable income increased to $2.18 per share.

Conclusions

The last time I wrote about the American Capital Agency results, I predicted that the company would reduce the dividend to the 90 cents to a $1.00 for the 2013 first quarter. With the move into the TBA roll business, increased hedging operations and the $2.18 of undistributed income, I hedge that prediction. With the 90 cents of portfolio earnings per quarter and using the undistributed taxable income - which must be paid out at some point - American Capital Agency has the potential to maintain the current $1.25 dividend rate.

Do note however, that the book value eroded in the fourth quarter, probably due to the $700 million of unrealized losses. If this turns into a trend, the results could get very interesting in future quarters if market value drops off the bond holdings and net income stays reasonably high.

AGNC Chart

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Source: American Capital Agency Shifts Gears To Profit From Fed MBS Purchases