The pain continues. May has been an awful month for investors in the mortgage real estate investment trusts (mREITs) as the entire sector has seen a sell-off after poor earnings from both American Capital Agency (AGNC) and Annaly Capital (NLY). There was also disappointment reported from the hybrid mREIT American Capital Mortgage (MTGE). Last week, we saw a similarly depressing earnings announcement from an up and comer in the mREIT space, Western Asset Mortgage (WMC). After being inundated with inquiries regarding the future of AGNC and its main competitors, I felt compelled to share my thoughts on whether it was time to abandon ship on the entire space.
Earnings Headlines a Major Cause For Concern
The AGNC earnings report was indeed worrisome as it registered its worst Q1 ever. For the first quarter, it reported a comprehensive loss per common share of $1.57. This included $0.64 net income per share with a $2.21 loss per common share in other comprehensive areas (such as unrealized losses on investments). AGNC also reported a $0.78 net income spread per share (that is, the income made after cost of borrowing, expenses and interest income). Its total economic return, which is calculated by taking the dividends paid plus the change in book value, was a loss of $1.46 per share, or 4.6% for the quarter. Much of the losses came from $837 million (about $2.20 per share) of unrealized losses on agency securities. AGNC had realized losses of $26 million related to the sale of agency securities. In addition, AGNC realized about $0.55 per share in losses related to the recognition of tax during the quarter. Overall, this was AGNC's worst quarter in a long time, if not ever.
Book Value Dropped
The AGNC book value dipped 9% to $28.93, down from $31.64 at the end of the 4th quarter. At the end of the third quarter of 2012, AGNC had a book value of $32.49. When the company reported its earnings for the second quarter of 2012, the book value was $29.41 per share. Thus, AGNC has seen movement in its book value over the last few quarters, however after this dismal first quarter, it is at its lowest in nearly a year. For more on why book value is a key driver to the stock price of your mREIT, I highly recommend consulting this recent piece.
So What Is The Risk And Why Is The Company Under Pressure?
All the REIT companies that purchase bundles of residential mortgage-backed securities issued and guaranteed by any of the federal agencies in the United States will be under unremitting pressure, as Wall Street continues to question when the Federal Reserve will cease its asset purchasing. In fact, the pressure has been rising for the last few months of this unending rally in the markets as the U.S. economy has been gaining some steam. What is important for you to realize is that it is not a question of if the Fed backs off (as purchasing cannot go on forever) but when they will. What investors in AGNC and its competitors NLY and WMC need to realize is that the issue is whether the Street perceives the exit as premature. In my opinion, this would mean a Fed exit before or right after a single 6.5% unemployment rate handle, as this is one of the Fed's targets. I think it would also be premature to exit before we see sustained 2.5-4.0% GDP growth. All of this Fed action has been both good and bad for the mREITs. First, the government-backed quantitative easing policies have made it cheaper for mREITs to borrow funds to invest in the residential mortgage-backed securities. Second, the low borrowing rates have helped the housing market rebound in general, which is also good for business. The issue that has plagued the mREITs is that while the borrowing rates are low, at the same time the rates at which AGNC can sell longer-term debt are also quite low, which have caused these mREITs to earn less, resulting in the aforementioned book value depreciation and cuts to the dividends paid to shareholders. This is known as a narrowing of the interest rate spread. This spread is absolutely key to profitability. The ideal situation is a booming real estate market with a low short-term borrowing rate and a high long-term borrowing rate. Right now, both the short and long-term rates are quite low, which is known as a flattening of the yield curve. If the Fed exits too soon, first investors may dump the stock in consideration of the second issue, which is that short-term interest rates may rise too quickly, costing the companies more to borrow and hurting the profit margin.
Consider a Hybrid REIT
One thing that I am encouraging REIT investors to do is to consider diversifying into hybrid REITs, companies that have exposure to both residential mortgage-backed securities and commercial-backed mortgage securities. AGNC is heavily invested in residential mortgage-backed securities. However, other companies have recognized that the commercial real estate market has yet to pick up steam compared to the residential market. Take NLY for example. This company is the largest REIT financier of public residential mortgages. However, they have recently completed the purchase of CreXus (CXS). CreXus acquires, manages and finances, directly or through its subsidiaries, commercial mortgage loans and other commercial real estate debt, commercial real property, commercial mortgage-backed securities and other commercial and residential real estate-related assets. Also, NLY will rename the company to Annaly Commercial Real Estate Group following the closing of the merger. This purchase will allow NLY to diversify its investment portfolio and when the commercial real estate mortgage picks up, help future earnings growth. Chief Executive and Chair of the Board, Wellington Denahan said of the acquisition:
"The CreXus's acquisition is accretive to the Annaly dividend and represents a meaningful step in the evolution of Annaly's capital allocation strategy, one that will enable us to take advantage of a broader spectrum of investments. Since the announcement of this acquisition in November, we have continued to build out our commercial expertise and we remain confident that CreXus' capabilities and growth may be significantly enhanced when coupled with Annaly's broader capital base."
One hybrid REIT that can be considered is MTGE (which has the same management of AGNC). MTGE manages a large portfolio of mortgage-related investments, such as agency mortgage investments, non-agency mortgage investments and other mortgage-related investments. Its agency mortgage investments include residential mortgage pass-through certificates and collateralized mortgage obligations; non-agency mortgage investments comprise residential mortgage-backed securities backed by residential mortgages, as well as prime and non-prime residential mortgage loans. It also has strong commercial exposure including commercial mortgage-backed securities, commercial mortgage loans and commercial mortgage derivatives.
In fairness to AGNC, despite the continued pressure it has faced, it has been able to increase its assets significantly during the quantitative easing periods of the last couple of years. At the end of the first quarter 2013, it reported $93.4 billion worth of assets under its management, versus $84 billion at the end of the second quarter 2012. With the labor market seemingly performing better and a rebound in the housing market, the Federal Reserve is considering its tapering of assets. The recently released FOMC minutes of the April 30th-May 1st meeting on Wednesday (5/22) showed that several FOMC participants are pushing to taper asset purchases as early June, when the FOMC is scheduled to have its next meeting. Sparking some fear into the markets Wednesday, participants also hinted that a stock market bubble could be in the works, while others warned of the risks of deflation and pushed for more QE. Clearly the FOMC is divided, however, the voices calling for ending the asset purchases are on the rise. Overall, AGNC is using caution in positioning its investment exposure to absorb a potential premature Fed exit. On the earnings call, it became evident that AGNC is taking some defensive posturing and slowing its investment as it realizes the issue is when the Fed exits.
So What Am I Doing With The Stock
In a recent piece, I wrote that I sold some of my position in AGNC after earnings. Despite the pressure the mREITs are facing, there is still value to be had, and there are long-term benefits to holding quality dividend paying stocks. That said, on Friday I picked a small portion of it back up because of where it is trading relative to its quarter end book value. I added to the position when AGNC hit $27.50. Given comments from WMC, AGNC and NLY management regarding the anomaly of the first quarter 2013 on the conference call, I believe current book value is higher than where it was quoted at the end of March. Further, I continue to hold the small position in WMC I established at $19.80. The final move I made was to establish a position in NLY. I think its diversification into the commercial space was wise and opens it up to a new source of revenues, especially once the commercial market picks up. If AGNC would shift a percentage of its portfolio to commercial assets, I'd likely reestablish my entire position. However, given the uncertainty in the market, the defensive route is probably a wise move as well.