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On Monday I had the fortunate experience to interview Gary Kain. Mr. Kain is the President and Chief Investment Officer of American Capital Agency Corporation (NASDAQ:AGNC). American Capital Agency Corporation is a mortgage real estate investment trust (mREIT). American Capital Agency invests in only Government Sponsored Entity (GSE) mortgage backed securities (MBS), an agency-mREIT owns MBS which possess an implicit Federal guarantee. The stock currently pays a 21% dividend. The company has paid a quarterly $1.40-dividend, per share, for 9 consecutive quarters.

Gary provided an enormous amount of information during the course of the interview. He answered every question I posed to him. I do not have his breadth of knowledge. Please visit the latest SEC 10Q for any issues which need clarification.

I would like to share my interview thoughts in this article. First, I would like to sincerely thank Gary Kain for taking the time for the interview. His professional attitude and industry knowledge were very impressive and illuminating.


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Liquidity Risk

My first question concerned liquidity risk. I asked if the Euro sovereign-debt could carry over to American Capital Agency's 26 counter parties. The counter parties provide liquidity for repurchase (repo) agreements. Gary confirmed this was not the case. In fact, counter parties have "increased lines" for repo agreements. Gary discussed this aspect with an example. If a counter party had a $1.5 billion lending line to the company, in some cases that has been raised to $2 billion.

If there is a rise in the one-month repo rate, the increase is likely to be limited to 5 basis points. At present time, the one-month repo rate is approximately 25 basis points.

Prepayment Risk

This is the essential - and core aspect of the interview - area of focus. Gary reiterated this point on numerous accounts. He said, "In 3-6 months time, the focus will be on how we handled prepayment risk." American Capital Agency is clearly focused upon this issue. The company addressed this topic very clearly at the September 26th JMP Securities Financial Services and Real Estate Conference.

The company has focused upon owing GSE-MBS with the lowest prepayment risks. The GSE-MBS with the lowest prepayment risk include:

  1. GSE-MBS with low balances,
  2. GSE-MBS associated with the Federal Housing Finance Agency's (FHFA) Home Affordable Refinance Program (.pdf) (HARP).

The company, as of June 30th, has over 66% of its GSE-MBS portfolio invested in the two above categories. American Capital Agency was proactive in taking this stance prior to Federal intervention coming to page one of the Wall Street Journal. Gary reiterated during the course of the interview that AGNC's management and staff are focused upon maintaining or increasing American Capital Agency's book value per share. "We are not looking for any home runs in our book value", [but only to do our best to] "maintain or increase" [the book value per share].

If there is one key aspect this article should communicate is the impact of "prepayment risk".

Hedging Practices

I was curious to know if the company used "hedging" to only hedge its positions, or also to "speculate" on a high-probability event. Gary confirmed the company's hedging practices are designed to be agnostic towards the noise on the markets. His staff hedges the GSE-MBS to protect the book value per share. Gary wants to be able to walk into the office tomorrow and have a sound portfolio regardless if interest rates are "increasing or decreasing".

Gary commented, "we don't know how much is already priced in the markets. It's the same as with the stock market." My question resonated because I wanted to know if a high probability of "Operation Twist" (ie, the Fed selling short-term Treasury Bills and purchasing longer duration Treasury Bonds) was likely, would the company position themselves based upon this likelihood? The answer was "no". The focus is to be consistent and neutral on agency MBS price movement. Clearly, the company is focused upon protecting the book value and be a consistent performer.

Gary took the time and patience of Job to explain the "hypothetical yield sensitivity analysis" for prepayment risk based upon the Constant Prepayment Rate (CPR), which is the percentage of principal that is prepaid over a period of time on an annualized basis. A couple of notes to highlight the prepayment risk:

  • The highlighted "green" numbers reflect the percentage of prepayments in a given year,
  • The highlighted "yellow" numbers reflect the net interest rate spread,
  • The highlighted "salmon" numbers reflects the reflect on equity based upon an 8x leverage.

The key issue is Gary and American Capital have focused upon reducing the CPR a) to benefit the net yield spread, b) to benefit the return of equity, c) to benefit the book value per share, and d) to benefit the dividends for shareholders: "institutional and small". The company is 100% aligned with the goals of the common shareholder.

Benefits of Freddie Mac Experience

I asked Gary what benefits were gained by his extensive Federal Home Loan Mortgage Corporation (“Freddie Mac") work experience. There were some very intriguing responses on this issue.

  • Gary's Freddie Mac experience required managing a "40 to 50x leveraged portfolio". This is in stark contrast to a current 8x leverage rate. He gained a greater "respect for hedging" when dealing with a high leverage rate.
  • He learned how the GSE operates and thinks. Gary gained insight into the regulatory oversight as a GSE manager.
  • Historically, mREITs traded GSE adjustable rate mortgages (ARMs). Gary's Freddie Mac experience was, historically, with both ARMs and fixed rate mortgages. It wasn't until much later did the publicly traded mREIT industry move more to the the fixed rate mortgage segment.

Will the mREIT Industry Expand its Leverage Rate

Presently, the agency-mREIT leverage rate is approximately 7x to 8x. This is historically lower than prior leverage rates. Gary believed the move, in the future, will offer opportunities to increase leverage. Presently, there are GSE unknowns which must sort themselves out.

GSEs will be shrinking in market size over the next 7 years. The ability to increase leverage levels upward from a 7x-leverage rate to higher levels clearly is an opportunity for the agency-mREITs once there is stability amongst the Euro sovereign debt, SEC 60-day review period, Fed Operation Twist, Treasury programs, and Policy Risk - HARP. Gary's focus is ignoring the noise and recognizing what truly matters. Time will pass and well-prepared companies will be at the center of attention.

Backlog of mREIT IPOs

I wanted to know Gary's thoughts on the backlog of mREIT initial public offerings. The SEC is asking for feedback on a couple of issues:

    • The SEC, as of August 31st, is seeking "Public Comment on Asset-Backed Issuers and Mortgage-Related Pools Under Investment Company Act".
    • The SEC, as of August 31st, is seeking under a separate concept release, public comment on "interpretations of a provision in the Investment Company Act – Section 3(c)(5)(C) – that may be used by some companies engaged in the business of acquiring mortgages and mortgage-related instruments such as some REITs".

Agency mREITs provide a fluid buy and sell marketplace for the $10 trillion mREIT sector. There are, however, a few companies who are interested in entering this sector. It is important to note the difference between a non-agency mREIT and an agency mREIT. Agency mREITs own only GSE-MBS implicitly backed by the U.S. Federal government.

One of the companies who is interested is Pimco. Pimco's "Bill Gross" is almost synonymous with the word "bond". He has certainly gained a following over the years. Pimco would like to enter the mREIT sector, per its April 5th filing.

In full disclosure, Jeffrey Gundlach, chief executive of DoubleLine Capital LLC and a veteran of more than 20 years in the industry, said in August he was passing on the mREIT sector. Mr. Gunlach recently discussed his desire for absolute returns instead of political ambitions. Mr. Gunlach stated to the Wall Street Journal, "I'm too old to raise money then go around the world and apologize," he said. Time will tell who had the insights and knowledge to prepare accordingly. On the agency mREIT sector, my bet is with Gary and American Capital.

Gary said as the GSEs exit the market place over the coming 7 years, there will be ample room for new mREITs to enter into the $10 trillion market place. The annual GSE MBS exit will result in shrinkage amounts of "$150 million to $200 million per year".

Summary

American Capital Agency has very little exposure to GSE-MBS with "high prepayment risks". Management is cognizant of this risk and addressed the risks before Fed Chairman Bernanke came in with Operation Twist and CNBC had the topic as headline news.

I concluded the interview with complete confidence in Gary Kain's leadership and industry expertise. Gary was willing to discuss the challenges, opportunities, and unknowns. American Capital Agency has a leader to tackle any Federal government action, interest rate move, and prepayment risk in the best interests of shareholders.

I believe the interview provides insights on the rewards of owning AGNC stock. The company has produced industry-best returns. The company is aligned with achieving a solid book value per share, dealing with the political and Euro sovereign-debt issue, and provide outstanding absolute positive shareholder returns. What more could a common shareholder desire?

mREIT-Sector Peer Comparison

For background purposes, directly blow is a table showing the mREIT sector's financial performance. The chart assumes dividends are not reinvested. The dividends are assumed to be kept in cash.

Source: An Interview With American Capital's Gary Kain