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I recently took to social media and lambasted talking heads who claim that mortgage real estate investment trusts (mREITs) are too difficult to understand. To me, it's not that hard to understand, and it won't be for you either. Some of my institutional money management friends said they have no place in a portfolio. Really? Just going to lump them in with penny stocks? No place? Well, everyone is entitled to their opinion. However, I disagree. I not only think mREITs are not that difficult to understand but I also believe that they serve a good purpose in tax favorable accounts such as IRAs and ESAs. Now, many of you are reading this and probably thinking "ok, but hasn't this sector been crushed?" The answer is yes, it has been. My followers who own American Capital Agency (AGNC) have been most concerned. Specifically, the concern rests with a declining share price (figure 1) and a reduction in historical dividends (table 1). I maintain that yes, in the short-term it's painful, but the reason we own these stocks is to collect income, our compound our investments. In that regard, I think they have a place in a portfolio, especially if you dollar cost average or pyramid down into the stocks and plan to hold for 10 to 30 years as a long-term investment.

Figure 1. Historical Share Price Of American Capital Agency in 2013

(click to enlarge)

Table 1. American Capital Agency's Common Stock Dividend History, Dividends Paid Since 2008.

Ex-Dividend Date

Dividend Paid Date

Dividend

6/30/2008

7/29/2008

$0.31

9/25/2008

10/10/2008

$1.00

12/29/2008

1/26/2009

$1.20

3/31/2009

4/27/2009

$0.85

6/30/2009

7/27/2009

$1.50

9/30/2009

10/27/2009

$1.40

12/29/2009

1/26/2010

$1.40

3/29/2010

4/28/2010

$1.40

6/28/2010

7/28/2010

$1.40

9/24/2010

10/27/2010

$1.40

12/29/2010

1/27/2011

$1.40

3/21/2011

4/27/2011

$1.40

6/21/2011

7/27/2011

$1.40

9/21/2011

10/27/2011

$1.40

12/20/2011

1/27/2012

$1.40

3/5/2012

4/27/2012

$1.25

6/19/2012

7/27/2012

$1.25

9/19/2012

10/26/2012

$1.25

12/24/2012

1/28/2013

$1.25

3/18/2013

4/26/2013

$1.25

6/26/2013

7/26/2013

$1.05

9/26/2013

10/28/2013

$0.80

I maintain that yes, in the short-term it's painful, but the reason we own these stocks is to collect income, or compound our investments. In that regard, I think they have a place in a portfolio, especially if you dollar cost average or pyramid down into the stocks and plan to hold for 10 to 30 years as a long-term investment. But, here is the kicker. Despite all of my in depth analyses, a lot of novice investors don't have a basic understanding of what AGNC does. So, this article is geared for you, the new investor or individual interested in learning about mREITs. mREIT veterans, this one may simply be a good, but entertaining review. Too many analyses are so complicated that new individuals, including a new recent follower, have reached out to ask simply, "how does AGNC make money, what are the risks and what's the Fed got to do with it?"

How Does AGNC Make Money?

At the most basic levels it really isn't that hard to understand how AGNC makes its money. AGNC pretty much borrows money and lends mortgage backed securities. So that takes us to the next question, what is a mortgage backed security? Well, mortgage backed securities are essentially debt obligations that represent claims to the cash flows from pools of mortgage loans. These can be residential or commercial in nature though AGNC tends to work primarily in the residential space, while its sister company American Capital Mortgage (MTGE) deals with commercial MBS. So if you want commercial exposure, you would be better off with MTGE. For residential, you would go with AGNC. If you want both, you might look for a hybrid REIT which does both. Ok, so back to making money. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity that turns them into securities. Now, what feeds into their profits? The interest rate that AGNC borrows at and the interest rate they lend at is called the interest rate spread or simply the spread. As I have stated many times before, this metric is absolutely key and is one that you must assess and keep your eye on when owning AGNC or any other mREIT. AGNC then profits from this spread, but does so how? Well they borrow at the 2 year Treasury rate and lend to the 10 year Treasury rate. Or, they borrow the 10 year and lend to the 30 year. All they are really doing is borrowing at a lower cost item and then lending at a higher rate, generating a spread and pocketing the difference. If necessary, the company can and often does increase their exposure and risk when conditions call for it. This is called leverage, which allows potential profits to be magnified. This is when they lend further out on the curve, maybe to 15, 20 or even 30 years from funds borrowed at the lowest rates. This leverage is risky but can lead to huge profits. AGNC often carries a moderate to moderately high amount of leverage.

What Really Impacts AGNC's Profit Potential?

The rate at which AGNC borrows is key. This is one reason to care about the Fed. Right now, they have a zero interest rate policy in place. This keeps shorter term interest rates between 0 and 0.3%, so AGNC can borrow money for almost nothing. This has been key to maintaining a favorable spread, borrowing at next to nothing, lending at some predetermined rate. Pressuring the spread has been Fed purchase programs which can keep the longer term interest rates low as they purchase longer term treasuries. Anything that changes the yield curve between the 2 year and 10 year or 10 and 30 year rates can cause either widening or flattening of the spread. We saw a spike in interest rates in shorter term debt from May to August (figure 2), which put massive pressure on the mREITs. Many of the spreads narrowed. This led to these stocks getting crushed.

Figure 2. Interest Rates On The Ten Year Treasury in 2013

(click to enlarge)

Occasionally the rates can be higher on shorter term debt than on longer term debt. This is a dangerous situation for AGNC and the only option is proper hedging of the portfolio, rebalancing the portfolio rapidly and/or taking on more risk. If they do not, AGNC will suffer losses. We also have to beware of rapidly changing rates. The rate rises from May to August were pretty rapid. If all interest rates move higher quickly mREITs simply cannot rebalance their holdings in a timely enough fashion. Many mortgage holders will look to refinance at lower rates or prepay their mortgage down. Refinances or prepays are both good and bad for AGNC. If a borrower refinances or prepays their mortgage, AGNC's mortgage backed securities held for that mortgage will be paid off and AGNC gets a lump sum payoff. (Note this can occur with MTGE as well for commercial real estate lending, it is not unique to AGNC or residential loans). Thus they have more money to lend, but they stop earning the interest on the loan, which can hurt revenues in the short term, potentially impact the bottom line as well.

Everyone Fears The Fed Taper

The Fed announces asset purchases, AGNC, MTGE and other companies get crushed. The Fed announces they may taper asset purchasing, and MTGE and AGNC get crushed again. What will happen when they actually do taper? The market may or may not overreact, but I for one will be glad when they are out of the asset buying picture so that stocks like AGNC and MTGE will no longer be hit by chatter over the next Fed move. For those just looking to get in, it is a pretty good time. You may get the chance to build a position at these low share prices. I have outlined the nuts and bolts of how AGNC operates. It is not hard to understand. There are some subtle nuances that differentiate mREITs. There are plenty of articles that I have written that go into specific detail about one or two topics associated with the mREITs I suggest consulting them for further reading. The stocks have been volatile thanks to the Fed, but they haven't really done anything different policy wise in the past 6 months. It's been business as usual. Much of the action has been a result of fear that they may do something. For now the Fed's accommodative stance remains in place because the economic data just isn't that strong. The Fed is not advocating for tapering of asset purchases ahead of stable economic news and/or meeting the economic goals laid out when the program was announced. So the fears of this issue that partially punished the mREITs are simply unfounded right now. Among the most important takeaways is that FOMC remains adamant that the low-rate situation, or the zero rate interest policy, will not change until the unemployment rate drops to 6.5%. This is not likely until late 2014 or 2015. The nomination of Janet Yellen indicates that the Dovish policies will continue, however, this is a discussion for a later article. For now, we have a 14% yielding stock with a stabilizing environment. It's time for those on the sidelines to consider stepping in and doing some buying.

Source: American Capital Agency: It's Not That Hard