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Summary

  • Unrealized gains and losses on the bulk of AGNC’s assets do not appear on the income statement.
  • Net interest income does not include all the expenses of interest rate swaps.
  • Non-GAAP based model is required to assess dividend sustainability.
  • Despite leverage, net interest spreads and book values in 4Q13 and 2013 being below last year’s levels, the model indicates the current dividend rate is sustainable.

In a prior article, I outlined a methodology for assessing the dividend sustainability of American Capital Agency Corp. (NASDAQ:AGNC), a Nasdaq-listed mortgage real estate investment trust ("mREIT") with a market capitalization of ~$7.9 billion and assets on the balance sheet as of 12/31/13 totaling ~$76 billion. The conclusion was that a quarterly dividend of $0.80 per common share is not sustainable based on AGNC's portfolio leverage and interest rate spreads as of 4Q13. I now apply the same methodology to and examine whether AGNC's reduced dividend (currently $0.65 per quarter) is sustainable in light of the latest available information (4Q13 data) on leverage and interest rate spreads.

The bulk of AGNC's assets consist of mortgage-backed securities ("MBS") and debentures issued by Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC), Ginnie Mae and the Federal Home Loan Bank (together, "Agency Securities"). These securities account for 86% of AGNC's asset portfolio as of 12/31/13 (85% as of the prior year-end). AGNC relies primarily on short-term borrowings to acquire Agency Securities with long-term maturities. The shape of yield curve, the spread between returns on assets owned and the interest paid on amounts borrowed to purchase these assets, and amount of leverage (the bulk of which is generated via the repurchase markets) are the key drivers of profitability.

AGNC's Agency Securities are typically classified for accounting purposes as "available-for-sale." They appear on the balance sheet at fair value, but unrealized gains and losses on these securities do not appear on the income statement. Instead, such gains and losses are reported on the balance sheet as a separate component of stockholders' equity. In addition, net interest income as measured by GAAP does not include all the expenses of interest rate swaps.

AGNC also engages in a form of off-balance sheet financing of agency MBS on a generic pool, or to-be-announced ("TBA"), basis. In TBA dollar roll transactions, AGNC purchases agency MBS paper for a forward settlement date. The difference between the price paid and the price of the same paper for settlement in the current month is referred to as the "price drop." The price drop is the economic equivalent of the net interest carry (interest income less implied financing cost). AGNC accounts for these positions as derivative instruments and recognizes dollar roll income in "other income (loss)" on its financial statements (i.e., not as interest expense).

In light of this, I look for a Non-GAAP based model that can provide insights as to what is happening to AGNC's bread and butter business of using short-term borrowings to acquire Agency Securities. This model and the relationship it shows between sustainable dividends and actual dividends paid is presented in Table 1 below:

(click to enlarge)

Table 1: Model for assessing sustainability of AGNC's dividend. Source: company 10-Q, 10-K, 8-K filings and author estimates

Although leverage, net interest spreads and book values in 4Q13 and 2013 are all below the levels in the corresponding prior year periods, sustainable coverage of dividends turned positive in 4Q13 after 5 consecutive quarters of below 1x coverage. This was made possible by the more than 50% reduction in quarterly dividends (from $1.25 to $0.65). The current dividend now seems to be aligned with what AGNC's basic business model can produce under 4Q13 conditions.

Source: Model For Assessing The Sustainability Of American Capital Agency Corp.'s Dividend