The Federal Agricultural Mortgage Corporation (AGM), also known as Farmer Mac, is a government sponsored enterprise with a mission similar to its ill-fated cousins, Fannie Mae and Freddie Mac, but with a focus on agricultural mortgages. Farmer Mac survived the crisis as a private company, and it looks like it is on the road to recovery. The quarterly dividend was just increased 20% from $0.10 to $0.12, giving the stock a yield of 1.5%.
Despite these positive developments, investors should avoid the stock because the underlying business model is just too risky. The business model has two characteristics that should raise red flags for investors in financial companies: 1.) Razor thin margins 2.) Too much leverage
Fact of the matter is that Farmer Mac's underlying business is just not all that profitable. In normal times, the company seems to be able to earn about 0.50% on assets or perhaps a bit more. That is pretty poor for what is essentially a long-term bond portfolio.
Partly because of this profitability problem, Farmer Mac leverages itself to the gills. The figure below shows shareholder equity as a percent of total assets for the last decade. While Farmer Mac is not exactly a bank, it is important to note that since 2008, the company has a much smaller equity cushion than a well-capitalized bank. If it were not for its ambiguous status as an instrument of government policy, I suspect that the company would either be forced by regulators to close its doors or raise more equity.
What is also concerning is that Farmer Mac is distributing dividends to shareholders even though it is more poorly capitalized than it was in 2004 or 2005. This should worry investors, because here's what low return on assets and high leverage meant during the last market cycle:
This is the problem with leverage. Not too much has to go wrong when you are highly levered. The following chart displays the cumulative loss rate on original loans, guarantees, and long-term purchase commitments by year of origination as of the recently filed annual report.
Many banks would envy these sorts of results, but when you mix them with high leverage the company is always just one step away from insolvency.
A Broken Business Model
The American mortgage market is broken. Most of it was nationalized when Fannie and Freddie were placed in receivership, although Farmer Mac is a surviving relic of the old system. Among other things, that old system did not work for shareholders. GSE's have conflicted mandates to politicians and shareholders, which often means that they will do the government's bidding so long as public officials look the other way on leverage. This is a recipe for disaster for common stock holders, because this story can only have three endings: nationalization, massive dilution, or $0.
Investors seem to have forgotten this basic fact, because AGM currently trades at 1.2 times book value. If you want the level of leveraged exposure to the mortgage market that AGM provides, I'd recommend buying mortgage REITs on margin. You may go to zero doing this as well, but at least the investment would yield 20%-30% or more in the meantime, not 1.5%.
How to Play This
Although I do not like AGM common stock as an investment, AGM's uniquely leveraged business model provides interesting opportunities for shorting. Shorting AGM can be used to express a bearish opinion on credit. Its financial structure provides an asymmetric risk-return scenario, because the downside for a short is capped by the fact that AGM has a barely profitable business that almost never trades above 1.5 times book value, while there is a very real possibility of the stock going to zero.
I like the short AGM trade much better than the leveraged sector ETFs like Direxion Daily Financial Bull 3X (FAS), Direxion Daily Financial Bear (FAZ), Proshares UltraShort Financials (SKF) where the upside and downside are more symmetrical. These vehicles reference indices of financial companies that are half as leveraged as AGM, many of which have much better business prospects.