American Capital Agency Corp. (AGNC) is an mREIT investing principally in agency guaranteed mortgage securities. It had a shocker for a Q1 report: $557 million loss - $1.57 per share. Book value dropped 8.5% to $28.93 per share. All data below is taken from either American Capital's 2012 10-K or the 2013 Q1 earnings release from its web site.
The horrific drop in earnings comes almost entirely from unrealized losses in mark-to-market value of mortgages held. Realized losses ($.55 per share) and losses on dollar roll positions ($0.15 per share) were significant as well. Gary Kain, president and chief investment officer, explained this as a reaction to expectations of an early end to QE3.
Asset yields have been dropping over the last four years. While this is not surprising, given the interest rate environment, it leaves little cushion for profit and shocks. For the last 6 quarters, the average daily interest rate on American Capital's repurchase debt was moderately increasing. This quarter that trend reversed with repo rates returning to 0.47%. However, the trend towards increasing cost of funds continues - cost of funds is up 27bps from last year. The increase in cost of funds is partly due to a shift towards longer maturity agreements as American Capital moves from 1 month agreements out to 3 - 6 month agreements and longer term interest swaps.
Prior to this quarter, the drop in yields has gone along with an increase in security value. Declining net income was compensated by increasing comprehensive income (unrealized gains). American Capital's stock price and dividends were secured by capital gains and dollar roll gains. This quarter shows what happens when the appreciation trend reverses. The net asset yield is still dropping, cost of funds is increasing as American Capital takes on fixed rate interest rate swaps, but now asset value is dropping rapidly.
In a bit of good news, American Capital's low prepayment rates have continued. American Capital attempts to minimize prepayment risk by weighting its portfolio towards lower balance (<$150,000) mortgages and HARP mortgages. During 2012, this strategy was highly successful in keeping a low prepayment rate and in the first quarter of 2013 has remained far below the average for 30 year mortgages.
Even better, premiums for specific asset selections over generic pools have dropped 56-91 bps during Q1. Looking forward, American Capital should be able to continue cherry-picking its assets but with lower prices.
Also good news, for investors who bought in before 2013 - now that the drop in book value is public, we know that the recent secondary equity offering was done above book value. American Capital has promised to only make offerings above book value and it has so far delivered.
So is this the beginning of the end or merely a hard bump in the road? If we take Mr. Kain at his word that the drop was due to market expectation of an end to QE, then we should not see these losses continue. The recent uncertain economic data and the commitment from the Fed suggest that QE3 will continue further into the year. That should stabilize the market and stop the devaluations in the immediate future.
However, this quarter can be seen as a warning or preview of what is likely to happen when QE3 does end. American Capital earns income on the spread between long and short interest rates. Many commenters have expressed concern on what could happen if an interest rate shock left the company with the short end of the stick. Even a gradual flattening or inversion of the yield curve would have a similar effect. American Capital provides an interest rate sensitivity analysis each quarter:
Note that the recent quarter was consistent with an ~80bps change. Interestingly, the recent changes were not even close to that large an interest rate shock. It appears that changes at the long end of the yield curve may have larger impacts on book value than this suggests. Over time the increased rates should lead to higher income, but this quarter gives an indication of how much short-term capital loss can be expected.
What I will be looking for in the earnings call
I will be looking for two things in the earnings call. First is whether the company has been able to take advantage of the mortgage price decline to improve average asset yield. If prices are declining, the company should be able to pick up increasing yields over time. I would also like to know if premium amortization was accelerated with the market value drop. If so, and if the market stabilizes, then future amortization could be reduced, leading to improved earnings. Second, now that the impact of the end of QE can be estimated, will management change any of their hedging strategies to deal with asset value decline when QE really does end.