American Capital Agency: Making Money the Old-Fashioned Way

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 |  Includes: ACAS, AGNC
by: Jaded Consumer

American Capital Agency (NASDAQ:AGNC) is a REIT that doesn't actually own any real estate.

Although it enjoys favorable tax status so long as it pays sufficient profits as dividends, its investment portfolio exclusively contains agency-backed home mortgages. Since AGNC first opened for investment this April -- well after the subprime risks were known by American Capital Strategies (NASDAQ:ACAS), which supplies AGNC's management -- AGNC isn't sitting on a subprime time bomb, but acquired its assets with its management firm's full understanding of the type of market in which it was initiating its investments.

AGNC previously declared a 31¢ per share dividend for 2Q2008, a "stub" quarter in which it was invested only 27 days. Familiar with ACAS' dividend payment practices (remember, AGNC hasn't any employees, and obtains all its management from ACAS in exchange for a management fee), The Jaded Consumer confidently declared on the basis of the 31¢ dividend that AGNC had earned at least 31¢ in distributable profit. To drive home the kind of success AGNC is having, it seemed appropriate to report here for emphasis the extent of AGNC's actual profit in the stub quarter.

AGNC's profit from about 27 days' investment proved to be 37¢ per share. That's over a penny and a third per day per share. The annualized profit at that rate would be about $5.00 per share. For a stock trading below $20, that's not too bad, eh?

There's no assurance that AGNC's profits will be identical in every quarter; AGNC receives income, principal, and prepayments of principal, which means that without considering undistributed profit AGNC must routinely enter new investments to keep its capital deployed. Changing market conditions might improve the returns, or impair them. However, that undistributed $0.06 -- earned in less than a month -- definitely can add up. In fact, at that rate, it'd add up to just over $0.81/share in a year.

So, what about AGNC's annualized dividend? Assuming that the first 27 days' payout is about a month's profit, AGNC would have an annualized dividend of something like 3.24. But 27 days is shorter than any month. Looking at the dividend paid as 27/365 of an annual dividend and multiplying to get the whole 365-day dividend, AGNC would pay about $4.19 a share in dividends.

Mind you, I don't know exactly what ACAS will end up achieving for AGNC shareholders with respect to annual returns -- but ACAS has powerful reason to achieve the best there is to have. First, ACAS is a shareholder that wants dividends. Second, ACAS wants to grow its funds management business (and thus the assets in AGNC). AGNC offers shareholders something that most companies can't: assurance about the size of corporate overhead. Since AGNC hasn't any employees, and all its officers are supplied by ACAS in exchange for a known-in-advance management fee, shareholders understand the relationship between gross and net in a way few shareholders can.

AGNC makes money in an old fashioned, unsexy, but reliable way: it helps institutions rent their customers money. Solvent private parties acting to bear nonperformance risk for profit is an old tradition, older than insurance, with roots in capital-intensive international trade. AGNC doesn't need the risk or overhead of retail banking branches to profit from loans, though: ACAS offers AGNC the expertise ACAS' management developed in ACAS' own business. Risk is further reduced by limiting investment to securities backed by a United States government agency like the Government National Mortgage Association or a government-sponsored institution like the Federal National Mortgage Association or the Federal Home Loan Mortgage Association. Given Congress' recent vote to authorize borrowing to fund bailouts of the latter two if need arose, it's reasonable to conclude that the principal in AGNC's investments is secure. (This isn't the same as saying your investment in a publicly-traded security like AGNC is safe, particularly if you don't hold "forever" -- share prices can become irrational even in a business that's executing like a champ.)

The big regret I have about AGNC is not buying even more at $15. But, who knows? With financials continuing to be hated and bad information so easy to find, we could see it again!

Disclosure: Author holds long positions in AGNC and ACAS