American Capital Agency Corp (AGNC) has been featured numerous times on this site but one key thing that is skipped over is how AGNC makes its money. AGNC invests in agency mortgage-backed securities issued by one of the major government-sponsored entities (GSE) such as Fannie Mae and Freddie Mac as well as the government-owned Ginnie Mae. It also has some minor investments in other Collateralized Mortgage Obligations (CMO), US Treasuries and various derivatives (such as interest-rate swaps and total return swaps) for hedging purposes. Outside of the derivatives and CMO, the securities are government guaranteed so the principal risk has been removed. This means that these securities offer a fairly low rate of return. The average yield on the AGNC portfolio as of March 2012 was 3.91%. The question is then how does Agency turn this low coupon into a 15%+ dividend yield? This article will cover how AGNC is able to use approximately $9.8 billion in equity to invest in $88 billion in assets and deliver a very high return on equity.
How AGNC uses Leverage
The majority of AGNC's operations are financed via Repurchase Agreements (Repo). The Wikipedia article provides a good overview, but here is a small breakdown of how AGNC would employ this strategy.
1. Starting equity of $9b, buy $9b in securities.
2. "Repo" out the $9b and receive $8.55b in cash. Counterparties in a Repo transaction typically "haircut" the collateral they receive as a way of reducing risk. In the case of a default, there is a built in cushion in the collateral so the Counterparty could sell that security and recoup their lost cash. AGNC stated on its most recent 10-Q that the weighted average haircut was less than 5%.
3. Buy more Fannie/Freddie/Ginnie securities with the $8.55b and repeat this approximately 9 more times to get to $82.7b in assets. In theory, this could be done numerous times to reach a maximum of $180b.
4. Collect the 3.91% interest on these securities and pay out the Repo Rate of .37% (annualized to 1.48%) for a net interest rate of 2.43%. Seeing that AGNC employs 10x leverage, the resulting return on investment and high dividend yield are visible.
Risks of Leverage
Increasing the leverage on a portfolio magnifies the impact of gains and losses. The primary gains and losses that AGNC is susceptible to are interest rate risk (rates will suddenly go up), prepayment risk (mortgages pay-down sooner and they will have to reinvest in a lower yielding instrument) and spread risk (the market suddenly views agency securities as more risky versus US Treasuries and the prices on the securities fall). The major factor that matters is the interest rate risk. If the Fed were to announce a sudden increase in rates by 1%, AGNC's net interest income would drop by -16.5% and the portfolio NAV would suffer a -10.7% decline (as per their 10-Q). This income drop would be do to increase borrowing costs as the Repo Rate would jump up while the fixed-rate mortgages would stay the same. The NAV decline would be due to the lower coupon securities being worth less than a new security of similar risk with a higher coupon. Fortunately, the Federal Reserve has already stated that it will keep rates low until the end of 2014. Also, AGNC employs a variety of interest rate hedges (swaps, swaptions, forwards) to mitigate some of these risks.
One other risk that is briefly mentioned in the 10-Q, but needs to be addressed is the haircutting required for the collateral in repurchase agreements. AGNC states the average haircut is currently under 5%, but if this haircut was to be raised to 10%, AGNC would be at its theoretical maximum amount of leverage and be under increased pressure to fund operations. How/why would the haircut be raised? The US is likely to reach its debt ceiling again by the end of 2012 with some accounting quirks pushing it back to early 2013. If Congress and the President fight over this like they did in 2011, the US Sovereign rating could be further downgraded and Counterparties could react by increasing the haircut on securities and/or charging a much higher Repo Rate. This collapse in the net interest rate (going from 2.43 to a much lower rate) would cause AGNC's share price to tumble. One consolation to this risk is that Moody's has already stated they would most likely not change the US Debt Rating in 2012.
AGNC's management team is taking advantage of the low interest rate environment to produce a sizeable dividend yield for their shareholders. As long as interest rates movements are minor and the US debt ceiling debate is solved (or delayed for another year), AGNC should be able to continue with their current strategy. Some things to watch for include watching how REPO rates are trending as well as keeping an eye on Operation Twist. If the Fed continues the short-term selling to buy longer-term debt to keep housing rates down, AGNC's net interest spread will be compressed.