We have recently lowered our recommendation on American Capital Agency Corp. (AGNC), a leading real estate investment trust (REIT) that focuses on investments in mortgage pass-through securities and collateralized mortgage obligations (CMOs), from Outperform to Neutral as we anticipate it to perform in line with the broader market.
American Capital invests only in fixed-rate agency securities where payments are guaranteed by the U.S. government or government-owned entities, such as Fannie Mae (FNMA.OB), Freddie Mac (FMCC.OB) and Ginnie Mae. Specifically, American Capital invests in FMCC Gold certificates, FNMA certificates and Ginnie Mae certificates.
With the government takeover of Fannie and Freddie, American Capital’s securities now have an explicit government guarantee, which makes it a much more attractive prospect for investors. Additionally, the company’s portfolio of government-backed assets is relatively liquid and credit risk is limited.
Furthermore, American Capital purchases payer swaptions to protect against lower interest rates that might lead to early prepayment of the mortgages. This measure ultimately facilitates the company to continue making money by collecting premium and ensures a steady revenue stream.
However, the residential mortgage market in the U.S. has experienced defaults, credit losses and liquidity concerns in the recent past, which have reduced financial industry capital, leading to reduced liquidity for some institutions. These factors have impacted investor perception of the risk associated with real estate related assets, including agency securities and other high-quality RMBS (residential mortgage backed securities) assets.
As a result, values for RMBS assets, including some agency securities and other AAA-rated RMBS assets, have experienced a certain amount of volatility. Increased volatility and deterioration in the broader residential mortgage and RMBS markets may adversely affect the performance of American Capital in the future.
In addition, any decline in the value of the agency securities might cause its lenders to initiate margin calls, forcing it to pledge additional collateral. Consequently, the potential threat of a margin call could force American Capital to sell (either directly or through a foreclosure) its agency securities, which in turn might reduce its long-term profitability.