American Capital Mortgage (MTGE) reported its results and held its conference call Wednesday and Thursday Oct. 26-27, shedding a lot of light on its activities so far and giving us a chance to form data-based expectations for the future.
The general situation is much as what I expected as I discussed in my previous article in advance of the earnings release: I suggested that the book value would be at least $19 a share and MTGE reported $19.96 net book value per share as of September 30, 2011. I suggested a rise in stock price, and the price in fact rose from about $16.50 a share to a little more than $18/share. It continues to sell at a discount to book value, though the discount has narrowed.
In general it seems to me that the biggest factor in the continuing undervaluation of MTGE, AGNC and other mortgage REITs is the difficulty in understanding their business and the ensuing negative worry premium. Since people have a hard time understanding what they do they worry about their future performance and are skittish when there is any change. So this makes these securities valued lower than their true value.
One of the biggest questions I had was why American Capital would open a fund to invest in non-agency mortgages when it was doing so well with agency mortgages in AGNC. Well, the answer is that so far it has bought mostly agency paper. 96% of its portfolio is agency-backed paper and only 4% is non-agency paper. This is very encouraging in that they did not rush to buy the more risky paper and they spoke clearly about the need for patience and discipline in finding the right non-agency paper. It is also worth noting that they hired a special expert for non-agency paper. Sometimes having an expert on-board makes people want to use his expertise, but MTGE seems to have resisted the temptation, and has bought only paper that truly has a better risk-adjusted return (using conservative assessments of risk) than the agency paper.
Interestingly, the MTGE website under "Our Business" only says that the aim is to produce "attractive risk-adjusted returns to our investors over the long-term." Although it does qualify this goal by saying that everything should be "properly financed and hedged," it does not speak about preservation of book value like the AGNC website which puts that goal up front. Nonetheless, during the conference call, the officers spoke convincingly about their commitment to protecting the book value of their fund, and it seems that they will try to be as careful with MTGE as they have been with AGNC (where book value has increased in 10 of 11 quarters since 2009). The need to protect the book value is included as one of its guiding principles in the presentation that accompanied the conference call.
Although management did not provide any guidance about the distribution, an analysis of the portfolio position at the end of the 3rd quarter, and comparing those to the respective figures of AGNC, can give us reasonable data-based expectations.
MTGE reported 7.8x leverage, and a 2.13% annualized net interest spread as of September 30. AGNC had 7.7x leverage and a 2.14% net interest spread over the entire quarter. Actually, their exit interest spreads showed a distinct advantage to MTGE as the latter exited with a 2.41% spread and AGNC exited with only a 1.94% spread.
Based largely on these numbers, AGNC reported $1.86 of taxable income and $1.39 net income, and they paid a dividend of $1.40. The annualized return based on the book value ($26.90) was 20.8%.
The numbers reported by MTGE for its third quarter refer to the stub period from its IPO to the end of the quarter. Since they were deploying all the funds in this period things were unstable and unreflective of what to expect in the next quarter. For example, they reported that the actual average leverage for the stub period was only 4.7x. Thus, I argue, a better data-based way of projecting minimum reasonable expectations for the fourth quarter performance of MTGE is by assuming that they will at least match the performance of AGNC. So far, where comparisons are possible, they have met or beat them, as we showed above.
So given that the leverage and the interest rate spread of MTGE is similar to that of AGNC, adjusting for the book value of MTGE ($19.96) we can expect it to pay a dividend of at least $1.04 next quarter.
There is one important factor that we have so far left out, and that is the prepayment rate. Having identified it as the only visible, significant risk factor in rate of return that cannot be hedged, the managers of AGNC have been carefully positioning their portfolio since at least last June to minimize prepayment risk. Their success at this task is shown by the fact that AGNC reported an 8% actual rate of prepayment compared to the overall actual rate that is much higher. AGNC has conservatively estimated the future prepayment rate of its portfolio at 13%.
The actual rate of prepayment in the portfolio of MTGE during the stub period was only 4%. During the part of October that was reported, its prepayment rate rose to 5.7%. Both figures are comfortable lower than even the AGNC rate. So by this measure as well, MTGE remains comparable to AGNC.
Of course, the dividend policy of MTGE is completely unknown. There are significant restraints because it is a REIT, but there is still a lot of room for variation. AGNC has paid a constant and steady $1.40 since Q3 of 2009 (9 quarters) but other funds vary their payouts much more. On the other hand, MTGE is presumably hoping for a higher rate of return than AGNC. So we therefore expect the Q4 dividend of MTGE to be no less than a dollar.
This is the expectation for Q4 of 2011. For the longer term, since MTGE has started off on the right foot as 96% agency backed paper and promised to be patient and disciplined in choosing non-agency securities, the record of AGNC can serve as a baseline expectation for MTGE. Since December 2008, AGNC has grown book value by 56%, from $17.20 to the current $26.90. At the same time it has paid a total of $14.95 per share in dividends. If MTGE does at least as good, it is a very attractive investment compared to most anything else that is available.