American Capital Agency (NASDAQ:AGNC) is a mortgage real estate investment trust (REIT). Rather than invest in hotels and office parks, American Capital Agency purchases residential mortgage securities. To avoid the credit risk that bankrupted Residential Capital, a former division of General Motors (NYSE:GM), and caused Wachovia to be acquired by Wells Fargo (NYSE:WFC), American Capital Agency primarily purchases securities guaranteed by one of the federal mortgage agencies.
The federal mortgage agencies: Fannie Mae, Freddie Mac and Ginnie Mae guarantee both the principal and interest payments of mortgagees. American Capital Agency then takes that payment stream and pays out the excess funds as dividends to investors (the US tax code requires that REITs pay out 90% of their income as dividends) or reinvests the capital in short-term investments. Recent dividend yields have topped 15%, but investors should understand more before simply deciding to feast on what appears to be an attractive yield.
American Capital Agency is a wholly owned subsidiary of the publicly traded private equity firm American Capital (NASDAQ:ACAS). Unlike a bank, American Capital Agency has no deposits. To generate the cash needed to purchase securities, the company engages in secured borrowing. Essentially, the company posts its securities as collateral and receives slightly less than the face amount in cash in return. The cash is then used to buy more securities. For the business model to work, the interest earned from the investments needs to cover both its borrowing costs plus generate a return (a dividend stream) that is attractive to investors.
The primary risk faced by American Capital Agency is the fluctuations in interest rates and the associated impact these changes have on the pre-payment rates of the mortgage securities it has invested in. To protect itself, American Capital Agency is an active hedger of interest rate risk. The company strives to reduce pre-payment risk by focusing on securities with inherent pre-payment protection. As the recession has led to widespread government intervention in the mortgage markets, American Capital Agency has benefited by purchasing HARP and HARP 2.0 securities (HARP stands for Home Affordable Refinance Program) backed by mortgages with relatively low balances (less than $125K) or high loan to value (LTV) ratios.
Low balance loans and high LTV loans are generally difficult to re-finance thus reducing the risk of pre-payments. In reality, these securities offset the lower pre-payments by having higher credit risk; however the U.S. government is assuming the credit risk through Fannie Mae and the other agencies. In the intermediate term, this careful security selection process may provide American Capital Agency a competitive advantage over other mortgage securities buyers. Not completely a free lunch, but a maybe an excellent blue plate special.
The Federal Reserve has indicated that it intends to keep short-term interest rates at minimal levels through 2014, which will impact the net interest income spread that REITs, such as American Capital Agency, can generate. Operating costs at financial companies are relatively fixed and as net interest income falls the impact on net income is magnified. American Capital Agency has felt the impact of these historically low rates on net income per share as seen in the table below:
Net Income per Common Share (basic and diluted)
Additionally, American Capital Agency has increased its leverage rates over the past year-and-a-half to maintain and grow income levels. The table below presents leverage ratios over the past five quarters:
(dollars in Millions)
Within the residential mortgage REIT space, Annaly Capital Management (NYSE:NLY) is the largest player by market capitalization with a recent value of nearly $16 billion. Annaly has a similar business model to American Capital Agency in that it purchases securities guaranteed by one of the federal mortgage agencies. Annaly maintains a relatively low leverage ratio at 6.96 times as of 12/31/11, whereas American Capital Agency maintained a higher leverage ratio of 7.9 times at 12/31/11.
I believe leverage is an indication of each company's view on how to manage the low interest environment. Annaly has taken more of a value approach and is waiting for the market to provide attractive risk returns and American Capital Agency has taken more of a growth strategy by increasing leverage to maintain dividend levels.
Large consumer banks such as U.S. Bancorp (NYSE:USB) and Wells Fargo are also active buyers of mortgage securities. Should the spread between treasury yields and mortgage rates widen, insurance companies such as MetLife (NYSE:MET) will be become more aggressive buyers likely shrinking the supply available to the mortgage REITs.
In my opinion, the best ratio for determining the value of a financial institution is price to book. With interest rates at rock bottom levels, it is hard to believe that mortgage REITs should trade much beyond a 1 to 1 price to book level. Using tangible book value as an initial valuation shows that the per share value as of 3/31/2012 was approximately $36.17 per share. The stock currently trades around $32.20 per share, which is a 10.9% discount from the Q1 2012 stated book value.
The trouble with price to book is that you need to adjust equity for intangibles and other equity reducing activities. The initial $36.17 valuation has to be adjusted down to capture the impact of American Capital Agency's unrealized losses from hedging practices of $108 million and to include the dilution of additional equity issuances since 3/31/2012. With these changes made, my estimated value per share is $28.70. This implies, given the company's current stock price, that it is trading at a premium of 12.2%.
The current dividend yield equals $5 per year. Determining the equity cost of a mortgage REIT is tricky, but as a rule of thumb I use the dividend yield. The current dividend yield was recently 15.56%. I believe that dividends may fall to $4.25 per year, which would reduce the yield to roughly 13.25%. I doubt that American Capital Agency will be able to grow dividends for the foreseeable future and I am estimating no more than a .5% growth rate in dividends in the long term. Under a simple dividend discount model, the value of the equity equates to $33.25 per share.
The value of American Capital Agency's portfolio of securities changes with interest rate movements. As rates continue to slide lower, the likelihood that existing homeowners refinance will increase. This phenomenon increases American Capital Agency's pre-payment risk.
As I have shown above, American Capital Agency has carefully selected securities that have natural barriers to pre-payments, yet they cannot totally eliminate this risk. If rates remain low it could become more difficult for American Capital Agency to generate a sufficient interest rate spread in its investment activities, requiring that the company purchase more and more assets to generate the same level of earnings.
In order to purchase more securities, it must take on more debt and hence lever up the balance sheet even higher than current levels. There is a natural limit as lenders will haircut the collateral reducing American Capital Agency's ability to borrow.
I believe that if investors are interested in owning a mortgage REIT, then Annaly remains a better choice than American Capital Agency. The dividend yield for American Capital Agency looks attractive, but I believe it will be cut severely if rates remain stuck at historically low levels. With the current premium to book value there is little value in owning the stock from a capital appreciation stance.
Each investor must determine his or her own margin of safety before purchasing a stock. For me, I would require no less than 15%. Using the mid-point of my $28.70 to $33.25 fair value range, this would imply a target entry price of $26.33.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.