All About Book Value? How It's Affecting Your Mortgage REIT

Includes: AGNC, MTGE, NLY, WMC
by: Quad 7 Capital

May has been a bad month for the mortgage real estate investment trusts (mREITS) and the entire sector has seen a sell-off after poor earnings from both American Capital Agency (NASDAQ:AGNC), Annaly Capital (NYSE:NLY). There was also disappointment reported from the hybrid mREIT American Capital Mortgage (NASDAQ:MTGE). Last week we saw a similarly depressing earnings announcement from an up and comer in the mREIT space, Western Asset Mortgage (NYSE:WMC). These earnings reports, their impact on book value, a reason to rally last week and finally where the stocks could go from here are discussed.

Brief review of earnings highlights

The AGNC earnings report was indeed worrisome as it registered its worst Q1 ever. For the first quarter, it reported a comprehensive loss per common share of $1.57. This included $0.64 net income per share with a $2.21 loss per common share in other comprehensive areas (such as unrealized losses on investments). AGNC also reported a $0.78 net income spread per share (that is, the income made after cost of borrowing, expenses and interest income). Its total economic return, which is calculated by taking the dividends paid plus the change in book value, was a loss of $1.46 per share, or 4.6% for the quarter. Much of the losses came from $837 million (about $2.20 per share) of unrealized losses on agency securities. AGNC had realized losses of $26 million related to the sale of agency securities. In addition, AGNC realized about $0.55 per share in losses related to the recognition of tax during the quarter.

The NLY earnings report was weaker than expected but the company remained profitable. NLY reported GAAP net income for the quarter of $870.3 million or $0.90 per average common share as compared to GAAP net income of $901.8 million or $0.92 per average common share for comparable 2012 quarter. The GAAP net income was reported as $700.5 million or $0.70 per share. The annualized yield on average interest-earning assets was 2.37% and the annualized cost of funds on average interest-bearing liabilities, including the net interest payments on interest rate swaps, was 1.46%, which resulted in an average interest rate spread of 0.91%.

The MTGE earnings report was less than stellar. The company reported a $0.56 per share of net loss. This resulted mainly from $1.66 per share in net unrealized losses on agency securities, partially offset by $0.64 per share in net unrealized gains on non-agency securities. It reported $0.62 per share of net spread income. It also reported a 2.3% economic loss on equity for the quarter, or 9.2% loss annualized. MTGE's average asset yield on its investment portfolio for the first quarter was 3.11%, compared to 3.08% for the fourth quarter.

The WMC earnings report was also was concerning as I had high hopes for them as well. The stock got. There was a lot to be desired, but also some bright spots. First off, WMC reported a net loss of $28.5 million, or $1.18 per share. Included in the net loss was $54.8 million of net unrealized loss on RMBS and other securities, $13.9 million of net realized loss on RMBS and other securities (including other loss on residential mortgage-backed securities of $2.3 million), and $15.4 million of net gain on derivative instruments and linked transactions. These unrealized losses were high, similar to AGNC's report. In Q1 WMC generated core earnings of $22.6 million, or $0.93 per basic and diluted share. Net interest income for the period was $28.6 million. WMC's weighted average yield on its portfolio was 3.04%

A rally in the last few sessions

The mREITs rallied in a big way late last week, particularly on Friday (May 17th) which begs the question, why? I believe the answer lies primarily in the belief that book value for the companies is higher now than reported at the end of Q1.

Book Values Dropped In Q1

All of these companies, AGNC, NLY, MTGE and WMC saw book values nosedive in the first quarter simply because of a decrease in the value of its portfolio of mortgage-backed securities. The AGNC book value dipped 9% to $28.93, down from $31.64 at the end of the 4th quarter. The reported book value for NLY was $15.19 down from $15.85, or a loss of 4.1%. The MTGE book value was down 5.8% from $25.74 to $24.25. WMC saw a decrease in book value from $21.67 to $19.42, or a loss of just over 10%.

The Dip is Likely a Buy Based on Q1 Anomalies; Current Book Value likely higher

AGNC President Gary Kain noted that interest rates dropped again in April and May, which could allow the company to acquire assets at attractive prices. He also noted that much of the action in the mREIT space in Q1 was due to a belief that the stronger economy would lead to an end to the Federal Reserve's quantitative easing. Much like Gary Kain WMC Chairman Gavin James really hammered home the point that market fears regarding the end of QE3 caused much of the negative sentiment. This is something that he, much like Gary Kain, doesn't believe will be happening in the near future.

The recent rebound of stock prices in the sector, which were beat down in the last few weeks is in my opinion due to the fact that investors realize book value is higher among these companies and that the Federal Reserve will not end quantitative easing any time soon. The action had been improving according to the discussions on the conference calls. WMC's Gavin James said:

"Due to the volatility that was seen in the mortgage market during the first quarter, our net book value declined approximately $0.10 to $19.42 per share, inclusive of our Q1 divided as of March 31, 2013. Quite simply, we saw the equivalent of a perfect storm in the mortgage market during the first quarter, given this past few weeks, we have put in place on our portfolio. In our view, this was the result of the market incorrectly servicing remarks from Chairman Bernanke and believing the QE3 will be coming to an end sooner than expected. It is believed this is only for a short period of time but it was enough to put downward pressure on asset prices and resulted in a declining net book value given the marks on the book value as of March 31, 2013".

AGNG's and MTGE's Gary Kain stated:

"Fears of an early Fed exit led to extension risk becoming the main focus of mortgage investors. This weakness in both TBAs and specified strove that declined in our book value. Importantly, these conditions appear to be reversing in Q2 and recent Fed statements have been considerably more balanced…. As such, as of month end, our book value had recovered a portion of the Q1 declines. We also believe the significant weakness in the prices of specified mortgages has created an excellent opportunity to add value-added product at attractive levels".

NLY capital also hinted at similar sentiment, using a story of shark attacks as symbolism of the fear in the market that QE3 would end, which hurt the markets.

"I want to share the following story, and I will call it, 'The Summer of the Shark'. On July 6, 2001 an eight year boy had his arm bitten off by a shark while wading offshore near Santa Rosa, Florida. Shortly afterwards a New Yorker vacationing in the Bahamas has had his legs severed in a shark attack. And on July 15, there was a third attack, this time on a surfer who was at the spot near where the first attack happened on the small boy, a media frenzy ensued culminating in a Time Magazine cover on July 30, titled 'Summer of the Shark'."

The story was huge and provided an interesting diversion to what was an otherwise slow news summer, but it was misleading, the media attention did not put the risk of shark attack into proper context. As it turns out, there wasn't any surge in shark attacks in 2001, it was just an average year. The number of attacks in 2001 76 was down from the previous year of 85. The number of shark attack fatalities dropped to 5 from 12 the previous year. And in Florida, which leads the nation in shark attacks in over the last half centuries you would have been 50 times more likely to die from lighting strikes as from a shark attack.

I tell this little story not to minimize the risk of shark attacks, but to remind everyone that there is always a risk of shark attack. As a matter of fact I am definitely afraid of sharks and yet I still swim in the ocean. The lesson of the summer of 2001, the "Summer of Sharks" is that fears rose with the level of media attention, even though there had been no actual change in the risks of shark attacks.

Mortgage REITs are going through their own "summer of the sharks". While CEO William Denahan didn't come out an state that this story was meant to symbolize the fears of quantitative easing ending, I think he told it to keep in mind that the risk has always been there, yet was hyped during the quarter, thus pressuring the industry and hurting book values.

Stocks of the mREITs rebounded last week

While I believe investors are realizing quantitative easing won't end until the Fed says it's over and I believe that actual book values are higher than what was stated at end of the first quarter, there may be other fundamental reasons, Some of the jump may also be a result of the aftereffects of a few bits of dour economic news, which caused Treasury bond prices to shoot up, dropping the yield. Lousy housing data a dip in consumer prices, and an unexpected uptick in jobless claims all conspired to push prices of treasury bonds upward, further quelling fears that quantitative easing would end any time soon. Note the recurring theme, all the evidence points to continued easing. Thus, the mREIT space is still an attractive place to be.

From their respective lows of last week, AGNC, NLY, MTGE and WMC finished the trading week up 3.9%, 4.0%, 5% and 5.1% respectively. The stocks currently trade at $29.65, $15.01, $23.86 and $20.53, respectively.


Reported book values dropped in Q1 for all of these mREITs. Much of this drop was due to a widespread fear in the market that quantitative easing would end sooner than expected because of a strengthening economy. However, management of the mREITs has informed us that business has definitely been improving into Q2. This improvement should help boost book value when we hear Q2 reports. It is quite likely from economic news the quantitative easing continues. It won't end until the Fed says "it's over." Taking a page from NLY CEO Denahan, the risk of a shark attack (QE3 ending) is always there. It has just been hyped up a bit during the first quarter, pressuring markets and book value. However, the risk of the shark attack is the same as before, and the companies will continue to execute their plans to profit. Given that book values are likely higher and that economic news supports the continuation of quantitative easing forever, investors are wading their way back into the mREIT waters, despite the risk of a shark attack. At this time, I maintain that mREITs are still a buy as they are likely trading at a discount to actual book value.

Disclosure: I am long AGNC, WMC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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