Focus of Article:
The focus of this article (after a brief company description) is to first provide an overview of the Fed Chairman's statement on June 19, 2013 about the recent Federal Open Market Committee (FOMC) meeting. This includes the Fed Chairman's question and answer session (Q + A) with the press. After this summarization, the article will then focus on the how this stated information (and the market's reaction to such information) has specifically affected American Capital Agency Corporation (AGNC) in regards to its overall agency mortgage-backed securities (MBS) asset portfolio. This analysis will be broken down into AGNC's 15-year and 30-year fixed-rate agency MBS valuation changes. For illustrative purposes, four supporting tables will be shown as evidence to prove the points the article makes.
I am writing this particular article due to the recent demand that such an analysis be performed in light of the past week's events unfolding. Due to the extreme volatility within the mortgage interest rate, MBS, and stock markets, I feel such a discussion should be written now. From reading this article, investors will better understand how sharp interest rate increases and subsequent existing MBS price declines can affect AGNC's current and future asset valuations. Last week's Wednesday through Friday MBS price declines were the sharpest drops over the same time frame in nearly ten years. This caused great stress for the entire mREIT sector (including several other sectors like financials and homebuilding) over the course of these three days. In particular, AGNC's stock price fell approximately 10% during these three days. On Wednesday, AGNC opened at $26.08 per share and closed at $23.45 per share by Friday's market close. This article will show how AGNC's MBS asset investments fared during last week in regards to valuation.
General Overview of AGNC:
AGNC is classified as a mREIT which earns a majority its income from investing (through leverage) in agency MBS. These investments consist of residential mortgage pass-through securities ('RMBS') and collateralized mortgage obligations ("CMO") for which the principal and interest payments are guaranteed by a government-sponsored entity ("GSE"). A few examples of a GSEs are: 1) the Federal National Mortgage Association (Fannie Mae) (OTCQB:FNMA); 2) the Federal Home Loan Mortgage Corporation (Freddie Mac) (OTCQB:FMCC); and 3) the Government National Mortgage Association (Ginnie Mae). AGNC also occasionally invests in agency debenture securities issued by Fannie Mae, Freddie Mac, or the Federal Home Loan Bank (FHLB). For simplicity, agency debenture securities are also generally referred to as a MBS investment.
One of the main goals for AGNC is to preserve its book value ("BV") while yielding attractive "risk-adjusted" returns which ultimately are distributed to its stockholders via quarterly dividends. These quarterly dividends are usually distributed from the following accounts: 1) net interest income; 2) net realized gains on MBS investments; and 3) various realized gains from derivative/hedging strategies. AGNC funds its activities mainly through short-term borrowings structured as repurchase agreements (repo loans) which it enters into with a number of major global investment banks. These repo loans are structured to pay variable interest tied to the London Interbank Offered Rate (LIBOR) of varying lengths ranging from one month to twelve months. On top of this variable component, AGNC pays a small fixed interest percentage on these repo loans.
Summary of Fed Chairman's Statement and Q + A Session on June 19, 2013:
The Fed Chairman's statement and comments during the Q + A session had a more bullish tone than the market was expecting. He stated recent economic indicators showed positive signs to the overall health of the economy. This included a current strong housing recovery and strengthening of various state and local government balance sheets. The Fed Chairman stated it was forecasting a rise in its gross domestic product ("GDP") forecast to a 2.3% - 2.6% annual growth rate in 2014. This would increase to a 2.9% - 3.2% annual growth rate in 2015. The Fed Chairman also stated its forecast was for a 7.25% unemployment rate by the end of 2013. This rate would decrease to a rate of 6.5% - 6.8% by the end of 2014 and a further reduction by the end of 2015 to a rate of 5.5% - 6.2%.
I feel the most important update was in regards to the Fed's quantitative easing program (QE3) timeline. Currently, the Fed's QE3 program purchases approximately $85 billion of fixed income securities per month. Out of this $85 billion, MBS purchases account for $40 billion and U.S. Treasuries account for $45 billion. The Fed Chairman stated that if the current, positive economic indicators persisted throughout the remainder of this year, the Fed would begin talks and subsequent action to "taper" its monthly purchases of MBS/treasury instruments in the coming months. Most speculators now currently believe the "tapering" of the QE3 program could begin as early as September of this year. Again, this would only occur if economic indicators in the coming months continue to show a strong, healthy economy. As the Fed Chairman stated, "economic conditions will dictate future fiscal policies".
Furthermore, the Fed expects to completely eliminate the QE3 program when unemployment levels begin to hover around the 7% mark. From current economic forecasts, the Fed Chairman stated the Fed expects a 7% unemployment rate by mid-2014. The Fed Chairman made the public aware that this target rate is not a trigger, but more of a threshold to implement talks of ending the QE3 program. The market was somewhat taken by surprise on this bullish sentiment. This would suggest the Fed would possibly begin tapering by late-2013 with a total elimination of the QE3 program by mid-2014. This would be a nine month time frame from the initial tapering to complete elimination of the QE3 program. This seems like a very fast timetable. However, it should also be noted that if the economy begins to show signs of stress from the increasing interest rates associated with the tapering of the QE3 program, the Fed could suspend its QE3 purchase reductions. If economic indicators begin to show strong signs of another recession looming, the Fed could re-initiate or increase once again the monthly fixed income securities. The Fed Chairman also noted that the Fed would not be selling its already accumulated MBS/U.S. Treasury portfolio anytime soon. The elimination of the QE3 purchasing program would be to halt the monthly purchases the Fed makes in regards to the fixed income securities. The Fed Chairman stated keeping these fixed income securities on the Fed's balance sheet should still keep interest rates relatively low.
However, it already seems evident the market may have a mind of its own in regards to interest rate movements. After the Fed Chairman's remarks, mortgage interest rates have "spiked" once again while existing MBS price valuations have plummeted. Within three days last week, mortgage interest rates increased over 25 basis points. This extremely rapid increase over a relatively short time frame is on top of a recent sharp rise of mortgage interest rates from the prior month of May. As such, existing MBS prices (especially in the lower coupon MBS) had its greatest price changes in nearly a decade last week. On the lower coupon MBS, these fixed income securities lost in three days time what was nearly lost in the entire second quarter of 2013 up until last week. Therefore, it would seem the market has already priced-in the eventual "taper" and ultimate elimination of the Fed's QE3 purchase program.
Impact of Last Week's Events on AGNC's MBS Portfolio (Valuation Standpoint):
As the notion of the Fed beginning to taper and ultimately exiting the fixed income security market comes to fruition, overall mortgage interest rates (among most other US rates) will rise and existing MBS prices will continue to decrease. In light of the recent low interest rate environment, this will be extremely negative for AGNC on a portfolio valuation basis. As time passes, AGNC will be able to "roll-over" its investment portfolio into higher yielding MBS. AGNC will ultimately benefit from the increased spreads generated from higher coupon yields and a lowered increase in interest expense on repo loans. This is also known as the "steepening" of the yield curve. This especially currently holds true because LIBOR rates have yet to rise where most other U.S.-based rates have done so. LIBOR rates have yet to rise because LIBOR rates are more based on global economic indicators. As people following global market trends should know, the global economy as a whole has yet to see the same type of positive economic indicators that the U.S. is currently reporting. This is yet another reason skeptic market followers are questioning the overall bullish statements stated by the Fed. Also, in this interest rate environment, most MBS maturities will be "extended" out thus decreasing AGNC's constant prepayment rate ("CPR").
Until AGNC sells most of its lower coupon MBS, the benefit of this "roll-over" of MBS assets will be delayed. As indicated in past articles, the faster the rise in mortgage interest rates, the sharper the MBS price declines. The sharper the MBS price declines, the larger the overall book value reduction AGNC will incur. These points will be evidenced in this article shortly. First, let us look at AGNC's MBS portfolio as of March 31, 2013 to see the various fixed-rate agency MBS that were held.
Table 1 - AGNC's Fixed-Rate Agency MBS Portfolio Balance at March 31, 2013
Table 1 shows AGNC's MBS portfolio as of 3/31/2013. This table (see bottom) further indicates the proportion of Fannie Mae, Ginnie Mae, and Freddie Mac MBS as a percentage of its entire investment portfolio. This information is not directly provided by the company. However, through research and analytics, one can retrieve such information. It should also be noted that AGNC currently has an overwhelming proportion of its MBS investments in fixed rate, agency holdings (roughly 99% of its total MBS portfolio).
Side Note: AGNC has changed its MBS portfolio in the current quarter (as it does in any given quarter). Per a recent presentation at the Morgan Stanley Financials Conference on 6/12/2013, AGNC's President and Chief Investment Officer Gary Kain stated the company has sold a portion of its lower-coupon MBS during the current quarter. He also stated AGNC's leverage was currently around the same factor of 8.1x as of 3/31/2013 (including the "off-balance sheet" TBA MBS). Therefore, one would assume AGNC "re-rolled" these lower-coupon MBS into slightly higher yielding MBS investments. However, for this specific analysis and points that will be illustrated in this article, these minor portfolio changes will not have a material impact. Therefore, AGNC's 3/31/2013 MBS portfolio balances will be used as the starting point to see the impact of how last week's events caused a further material devaluation of AGNC's MBS portfolio as a whole.
Using Table 1 as a base for AGNC's fixed-rate agency MBS portfolio, let us analysis AGNC's asset valuation changes for the second quarter of 2013. The first analysis will look at AGNC's 15-year fixed-rate agency MBS holdings. This will then be followed by a similar analysis of AGNC's 30-year fixed-rate agency MBS holdings.
Table 2 - AGNC's 15-Year Fixed-Rate Agency MBS Price Valuations (Q2 2013)
Table 2 shows AGNC's 15-year fixed-rate agency MBS price movements during the second quarter of 2013. It breaks out these 15-year fixed agency MBS holdings by government GSE. This includes both Fannie Mae and Freddie Mac MBS holdings. It further breaks out these 15-year fixed-rate agency MBS into the various coupons on AGNC's books ranging from 2.5% - 4.5%. AGNC holds an immaterial balance of 15-year fixed-rate agency MBS over the 4.5% coupon and thus will not be discussed in this specific analysis. To summarize, the table breaks down AGNC's Fannie and Freddie 15-year fixed-rate agency MBS holdings as of 3/31/2013 across various coupons. From the information portrayed in Table 2, an estimated unrealized valuation gain or loss can be performed broken down by the various coupons. As stated earlier, an exact valuation figure cannot be obtained because AGNC constantly changes its portfolio holdings during the quarter. However, the overall valuations calculated from this table have been pretty close when comparing this table's past quarterly estimates to actual results reported by AGNC (< 5% total variance).
Strictly looking at the 15-year fixed-rate agency MBS price valuations for the week of 6/21/2013, one will notice huge MBS price valuation declines across the 2.5% - 4.5% coupon spectrum. As a particular MBS coupon rate lowers, the larger the devaluation becomes. This is evidenced within the "Cumulative Quarterly Change" column in Table 2. To illustrate, for the week of 6/21/2013, the Fannie 15-year fixed-rate agency MBS with a 2.5% coupon had a decline in valuation of 1.69 to settle its price at 100.12 (100 being par). This past week's worth of devaluation was basically the same devaluation that occurred for the entire second quarter of 2013 up till last week (ten weeks worth of MBS price changes). For example, let us say AGNC had a $50 million valuation loss within this specific type of MBS for the first ten weeks of the second quarter of 2013. Last week's MBS price movement caused a further $50 million loss for this specific type of MBS. This is extremely negative news; this is an additional 100% devaluation to the Fannie 15-year fixed-rate agency MBS with a 2.5% coupon.
Further losses (to a lesser extent as the coupon rises) occurred in the Fannie 15-year fixed-rate agency MBS with a coupon ranging from 3% - 4.5%. In the Fannie 15-year fixed-rate agency MBS with a 3.0% coupon, a devaluation of 0.81 was sustained. For this specific coupon MBS, an additional 66% loss occurred last week. This amount is added to the cumulative devaluation already sustained in the second quarter of 2013. This specific type of MBS with a 3.0% coupon had a 1.28 devaluation prior to last week. This devaluation climbed to 2.08 by the end of the week. These valuation losses are staggering when computed into dollar amounts.
For the Freddie 15-year fixed-rate agency MBS, the same conclusions hold true. There are slight differences in devaluations across the specific coupon rates when compared to Fannie, but the same general theme holds true. Last week dramatically decreased the current fair-market-value ('FMV') of all 15-year fixed-rate agency MBS holdings. This is regardless the type of coupon rate held. A weekly and quarterly cumulative estimated unrealized loss on AGNC's 15-year fixed-rate agency MBS will be shown later. For now, let us look at AGNC's 30-year fixed-rate agency MBS holdings.
Table 3 - AGNC's 30-Year Fixed-Rate Agency MBS Price Valuations (Q2 2013)
Table 3 shows AGNC's 30-year fixed-rate agency MBS price valuation movements during the second quarter of 2013. It breaks out these 30-year fixed-rate agency MBS by GSE. As was the case with the 15-year fixed-rate agency MBS, this includes both Fannie Mae and Freddie Mac MBS holdings. It further breaks down these 30-year fixed-rate agency MBS into the various coupons offered ranging from 2.5% - 4.5%. Once again, AGNC holds an immaterial balance of 30-year fixed-rate agency MBS over the 4.5% coupon and thus will not be discussed in this specific analysis. To summarize, the table breaks down AGNC's Fannie and Freddie 15-year fixed-rate agency MBS holdings as of 3/31/2013 across various coupons. From the information portrayed in Table 3, an estimated unrealized valuation gain or loss can be performed broken down by the various coupons. As stated earlier, an exact valuation figure cannot be obtained because AGNC constantly changes its portfolio holdings during the quarter. However, the overall valuations calculated from this table have been pretty close when comparing this table's past quarterly estimates to actual results reported by AGNC (< 5% total variance).
When looking at the 30-year fixed-rate agency MBS price valuations for the week of 6/21/2013, one will notice similar huge MBS price valuation declines across the 2.5% - 4.5% coupon spectrum as was the case with the 15-year fixed-rate agency MBS holdings. As a particular MBS coupon rate lowers, the larger the devaluation becomes. This is evidenced within the "Cumulative Quarterly Change" column in Table 3. To illustrate, for the week of 6/21/2013, the Fannie 30-year fixed-rate agency MBS with a 2.5% coupon had a decline in valuation of 3.16 to settle its price around 93.00 (represents a 7% discount to par). This past week's worth of devaluation was basically the same devaluation that occurred for the entire second quarter of 2013 up till last week (ten weeks worth of MBS price changes). For example, let us say AGNC had a $100 million valuation loss within this specific type of MBS for the first ten weeks of the second quarter of 2013. Last week's MBS price movement caused a further $100 million loss for this specific type of MBS. This is extremely negative news; this is an additional 100% devaluation to the Fannie 30-year fixed-rate agency MBS with a 2.5% coupon. Again, this is just one week's worth of existing MBS price movements.
Further losses (to a lesser extent as the coupon rises) occurred in the Fannie 30-year fixed-rate agency MBS with a coupon ranging from 3% - 4.5%. In the Fannie 30-year fixed-rate agency MBS with a 3.0% coupon, a devaluation of 2.44 was sustained. For this specific coupon MBS, an additional 66% loss occurred last week. This amount is added to the cumulative devaluation already sustained in the second quarter of 2013. This specific type of MBS with a 3.0% coupon had a 2.61 devaluation prior to last week. This devaluation climbed to 5.05 by the end of the week. Again, these valuation losses are staggering when computed into dollar amounts.
For the Freddie 30-year fixed-rate agency MBS, the same conclusions hold true. There are slight differences in devaluations across the specific coupon rates when compared to Fannie, but the same general theme holds true. Last week dramatically decreased the current fair-market-value ("FMV") of all 30-year fixed-rate agency MBS holdings. This is regardless the type of coupon rate held.
Now that we have seen what kinds of devaluations were sustained in regards to AGNC's fixed-rate agency MBS, let us analyze how these devaluations are quantified in dollar amounts. Table 4 shows AGNC's weekly and quarterly cumulative estimated unrealized losses on its 15 + 30-year fixed-rate agency MBS holdings. Again, this accounts for over 99% of AGNC's total investment holdings as of 3/31/2013. Most importantly, we will compare last week's change in valuation when compared to the rest of the quarter.
Table 4 - AGNC's Fixed-Rate Agency MBS Cumulative Weekly Changes (Q2 2013)
Table 4 shows AGNC's unrealized gains and losses for the second quarter of 2013 on a cumulative weekly basis. This table quantifies, in dollar amounts, weekly unrealized gains or losses that have occurred as existing 15-year (see Table 2) and 30-year (see Table 3) fixed-rate agency MBS price valuations change.
Specifically looking at the week of 6/14/2013, AGNC had an estimated weekly cumulative unrealized loss of $1.12 billion on its fixed-rate agency MBS portfolio. More importantly, look what happened during the week of 6/21/2013. AGNC's unrealized loss went from $1.12 billion to a staggering $2.13 billion in just one week. As stated at the beginning of this article, last week's Wednesday through Friday MBS price declines were the sharpest drops over the same timeframe in nearly ten years. Since one can accurately track existing MBS price movements throughout the various coupons, a general sense of gain or loss on a company's MBS portfolio can be achieved. The loss sustained by AGNC basically doubled from JUST last week's worth of MBS devaluations. In regards to reporting for the second quarter of 2013, this was basically one of the worst weeks for such an occurrence to happen. This is due to the fact AGNC's second quarter of 2013 ends on 6/30/2013. This will make the upcoming week extremely important in regards to mortgage interest rates and existing MBS price valuations. For AGNC's sake, hopefully a sharp reversal of mortgage interest rates and thus a material price appreciation on existing MBS valuations occurs. Otherwise, AGNC will report an extremely negative/suppressed book value figure for the second quarter of 2013 which will spook investors even more than they already are.
Side Note: The above analysis excludes any discussion of AGNC's TBA MBS portfolio or its derivative instrument holdings. In regards to calculating a precise book value estimate, these additional accounts need to be analyzed. Furthermore, for an exact book value, one must also analyze AGNC's remaining statement of operations accounts, all quarterly distributions made to shareholders, and all capital transactions. A future article will specifically address a detailed book value estimation for the second quarter of 2013. This article shows the material MBS price devaluations that have occurred during the week of 6/21/2013 when compared to the second quarter of 2013 (up till last week).
In light of the Fed Chairman's statement and comments during the Q + A session on 6/19/2013, a certain timeline and projections were provided to the public that signaled a more definitive "tapering" and ultimate elimination of the Fed's QE3 purchasing program. As such, extremely rapid mortgage interest rate "spikes" occurred. Therefore, dramatic existing MBS price declines ensued. These devaluations, within the latter half of last week, were so great that such a movement has not been seen for over ten years. From these devaluations, AGNC's fixed-rate agency MBS portfolio took a substantial hit for the week. Therefore, AGNC will be reporting an extremely weak second quarter of 2013 in regards to its unrealized loss on agency securities within its income statement. These ramifications will also be felt in regards to AGNC's book value as of 6/30/2013.
Throughout the article, with several tables as supporting proof, it was revealed AGNC has sustained huge devaluations (thus unrealized losses) within its entire fixed-rate agency MBS portfolio. This especially holds true in regards to last week's events. During last week alone, AGNC's MBS portfolio declined in value by an amount almost equal to its cumulative quarterly loss of the second quarter of 2013 prior to last week's declines. The timing of such a huge devaluation could not have come at a worse time. AGNC's second quarter of 2013 ends 6/30/2013. Therefore, AGNC's book value as of 6/30/2013 will be greatly impacted to the downside.
Unless a material reversal of mortgage interest rates (causing a material increase in MBS price valuations) occurs prior to 6/30/2013, AGNC will be reporting an extremely weak quarter in regards to asset valuations and thus book value. People may argue that the market is ahead of itself in regards to the extremely rapid rise in interest rates, but unless the market has a change of heart next week, the markets dictate the rules in regards to fair-market valuations.
However, it should be noted this projected extremely large unrealized loss for the second quarter of 2013 could easily be reversed in the third quarter of 2013 as interest rates flatten out or modestly reverse course if future economic indicators are less bullish and more bearish in nature. Remember, asset valuations (thus book values) change daily.
Final Side Note: People may argue a company's derivative strategy will "hedge" these MBS valuation losses. It should be noted a company's derivative strategies will not recuperate its asset valuation losses by 100%. There are underlying explicit costs associated with hedging to general. These implicit costs are expenses of having these hedges. These costs will never be recuperated. Also, as is the case in most hedging scenarios, the hedge only provides relief on SOME of the assets they are pledged against. Perfect, ideal hedging scenarios are few and far between. This is based on the numerous factors that go into a hedge's functional abilities and characteristics. Therefore, some asset valuation losses will be mitigated through hedging, but this will only be a partial offset. A more realistic hedge recuperation rate would be 50% of the devaluation loss (and this is on the higher end of the spectrum). Furthermore, AGNC currently has its TBA MBS problem in regards to its hedging strategy. This point alone could be discussed within an entire article's worth of discussion and analysis.
Full Disclosure on "Long" Position of AGNC: I have owned AGNC since early 2011. I have gradually increased my position in AGNC when certain pullbacks have occurred. I have also sold minor positions when I felt the stock was highly overpriced. I have taken both cash + reinvested dividends depending on the stock price of AGNC when the quarterly dividends were distributed.
The main focus of this specific article is to show readers the material MBS portfolio devaluations that have occurred during the week of 6/21/2013. I am "long" AGNC for the longer-term prospects of this specific company. This means I may just "hold" my position during this turbulent timeframe. It also means I may purchase additional shares when I feel the company is undervalued from a stock price vs. book value basis. I am not a high frequency trader, and usually look at the longer-term prospects of a particular company.
I believe there's a good chance AGNC will continue to report several future quarters that are "disappointing" if interest rates continue to sharply rise/existing MBS prices were to quickly decline further. However, I strongly do not believe this situation will occur. I feel the market has currently "over-panicked" thus causing overall mortgage interest rates to rise faster than they should have. These events have subsequently caused MBS valuations to be overly undervalued. In the coming months, I feel a stabilization of rates will occur and MBS price will appreciate on most coupon rates. Even if rates only gradually rise, this is not the worst possible outcome for the mREIT sector. Whenever there are "spikes" in interest rates, this usually spells trouble for most mREIT companies. As such, I am long AGNC in regards to its longer term fundamentals and prospects. This would entail a 1-3 year time horizon.
Even though I would not necessarily advise starting any initial positions within AGNC during this highly volatile period of time, I would not explicitly sell any positions as well. Most of the negative news for the mREIT sector has already been priced into the MBS and stock market. Again, this is just my personal opinion.