Investments in Fannie Mae and Freddie Mac, CMOs, mortgage pass-throughs is not exactly the holiday treat for the risk-averse. Annaly Capital Management (NLY) and American Capital Agency (AGNC) are two real estate investment firms that pay out their earnings through dividend distributions. With the former having a dividend yield of 14.9% and the latter having a dividend yield of 19.5%, the rewards are, admittedly, tempting. The Street currently rates shares of both companies around a "buy" (slightly preferring American Capital), but I find that risk outweighs reward in almost everything housing right now.
From a multiples perspective, both firms appear cheap. Annaly Capital trades just under book value while American Capital trades at 1.07x book value. For the last twelve months, the stocks have underperformed the market, falling by 10.7% and 1.9% respectively at the same time that the Dow Jones appreciated by 5.4%. At the same time, their betas are notably low and alleviate risk concerns for many investors.
At the JPMorgan SMid Cap Conference, AGNC's CIO, Gary Kain, went so far as to begin his speech by presenting an optimistic backdrop:
But really what I want to focus on today is related to the low interest-rate environment that we are in and it's really the prepayment picture because in the absence of any real change to this environment which we don't see happening in the near term, prepayments are really going to dominate performance in the REIT space and it's really going to be a key driver of our returns.
So with that I will try to jump right in because we have a lot to cover today. So, first of all the current market landscape is one where again interest rates are at basically record lows, mortgage rates are at record lows. Borrowers can take out of a 30 year fixed-rate mortgage around 4%; they can take out 15 year mortgages around 3% are very low 3%, ARM mortgages are around 3% as well maybe a little below. The other thing that's really important to keep in mind is that most of the borrowers who took out loans over the last two to three years, two years since 2009 are good credit borrowers that qualified under stricter underwriting and so guess what they can refinance.
The truth is that although interest rates are at an all time low, WACC is likely to rise. In particular, there exists substantial risk from US Dollar Funding, as European banks' demand for the greenback rises. This will raise LIBOR and make conditions adverse for mortgage securities. Thus, while the yield curve may be at a historical high and buoyed by a quicker-than-expected recovery, considerable leverage and rising shareholder equity is focusing investors more on the red flags.
Consensus estimates for AGNC's EPS are that it will decline by 31.1% to $5.44 in 2011 and then by 11.9% and 1.7% more in the following two years. Assuming that the multiple rises to 6.5x and a conservative 2012 EPS of $4.65, the stock only has 5.2%. Should the multiple hold steady and 2012 EPS turn out to be 2.9% below the consensus at $4.65, the downside is -30.4%.
Annaly Capital is in a similar position, as I describe here. With financial regulation on the rise and unemployment risks looming, mortgage prepayments become an increasingly greater concern. Consensus estimates for its EPS are that it will be basically flat over the next few years.