AGNC: Rising Mortgage Spread Signals Trouble For Agency REITs
Summary
- While agency mortgage REITs carry minimal credit risks, they carry immense exposure to the spread between mortgages and treasuries.
- This spread has been artificially suppressed by the Federal Reserve's immense mortgage-backed-security purchase program.
- The Fed's ability to keep the mortgage spread below its equilibrium level is fading despite continued purchase pressures.
- The coming end to the eviction moratorium or Federal Reserve tapering may create dislocations that catalyze a larger widening of the mortgage spread.
- As the mortgage spread normalizes, AGNC's book value may decline 20-40% - making for a short opportunity for those looking to hedge against downside risks.
Mortgage REITs have been in a highly volatile period since the beginning of 2020. During the COVID crash, most lost well over half of their value as widespread margin calls triggered fear of mass bankruptcies. Fortunately, the Federal Reserve stepped in with an aggressive mortgage-backed-security purchasing program which deterred this possibility. Most mREITs are now trading back at pre-COVID levels following a significant decline in mortgage rates despite an overall steepening of the yield curve.
With legislative and economic pressures shifting, it seems like a good time to take a close look at those mREITs which will likely be impacted. One great example is AGNC Investment Corp (NASDAQ:AGNC). It is a top-choice among yield-seeking investors and has very high exposure to the Federal Government's decisions since it focuses on agency securities. Overall, I believe this REIT and its peers are at a very high risk of declining the current environment.
Despite their strong performance, many mREITs have suffered drawdowns over the past month as the yield curve has reversed into a negative trend and the mortgage spread has widened. This is particularly true for agency/residentially-oriented mortgage REITs since they typically use the highest leverage. Generally, these mREITs use 7-12X leverage and buy low-yielding mortgage-backed securities, which are technically backed by Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC).
Of course, the events of 2007-2009 proved that these mortgage-backed securities are not necessarily risk-free since it is not guaranteed that the Federal Government will bail out Fannie Mae and Freddie Mac once again despite conservatorship status. This is something to keep in mind considering the Federal Housing Finance Agency has repeatedly dictated that Fannie Mae and Freddie Mac extend eviction moratoriums for the ~4% of homeowners who remain in forbearance.
While most homeowners are now paying their mortgages, last year's events proved that a significant portion of homeowners was hardly able to make payments. This risk may be exacerbated by skyrocketing home prices which has caused household debt obligations to rise dramatically. That said, the commercial mortgage market is in a more concerning condition as 14% of renters remain in arrears due to eviction moratoriums. Over time, this will add to stress within the mortgage finance market and likely create rapid dislocations once the moratorium is lifted (likely at the end of July).
The Spread Trouble of AGNC's Strategy
Agency mREITs, such as AGNC Investment Corp, operate under a straightforward strategy - borrow immense amounts at near-zero short-term rates and buy these hypothetically low-risk longer-term mortgage-backed securities. Thus, their income is directly tied to the spread between mortgage rates and the discount rate (currently 0-25 bps). This spread is highly correlated to the 10-2 yield curve, as you can see below:
AGNC and its peers decline in value from 2010 to 2019 as the falling yield curve caused dividends to be suppressed and mortgage prepayment rates to rise. Many believed this downdraft ended in 2020 as demand for long-term debt declined, causing spreads to rise to the benefit of mortgage REITs and banks.
In general, steeper yield curves benefit mortgage REITs. However, rapid increases in mortgage rates can put them in immense danger of bankruptcy due to their leverage. Currently, AGNC operates at ~8X leverage with over 80% of its portfolio in 30-year fixed agency mortgaged-backed securities. This makes AGNC intimately tied to the Federal Reserve, which has used its Q.E program to save these securities from declining in value. This is seen quite clearly below by the fact that the yield spread between 30-year mortgages and Treasuries collapsed as the Federal Reserve bought up mortgage-backed securities last year:
If it were not for the Federal Reserve's immense mortgage-purchasing program, the 30-year mortgage rate would likely be at least 1% or more above its current level. The Fed now owns over a third of the U.S mortgage market, though its continued purchasing efforts are no longer causing the mortgage-to-treasury yield spread to decline. This is extremely important since AGNC, like all mREITs, hedges against changes in Treasury yields and assumes the risk for changes in spreads. Thus, as long-term mortgage rates rise compared to long-term Treasury rates, AGNC's book value declines, and its leverage increases.
The spread between mortgage and Treasury rates has widened recently despite an acceleration in Federal Reserve purchases. This is indicative that the spread will continue to widen since the Fed's reigns of control have been loosened. AGNC seems to be aware of this issue as it may have been the impetus for their recent mixed-automatic shelf registration, which will allow the company to dilute stakeholders and raise cash. This decision caused AGNC to decline by around 10% thus far.
According to AGNC's last 10-K (pg 47.), a 50 bps increase in the spread between mortgage rates and Treasury rates would cause its tangible book value per share to decline ~24%. From the chart above, we can see this spread has risen around 35 bps over the past month from 55 to 90 bps. The spread usually is around 1.25, which means it should increase an additional 35 bps. Such a move is likely to occur as the Federal Reserve's impact on the market wanes, and the market returns to equilibrium.
I estimate this likelihood could cause AGNC's price per share to decline around 17% from current levels (assuming AGNC continues to trade close to its book value). Of course, the spread could rise to over 2%, as was seen last year, which would likely cause AGNC's book value per share to decline well over 50%% from here. I believe this outcome is very likely if the Federal Reserve ever decides to halt its mortgage-backed-security purchase program.
Of course, if concerns regarding Fannie and Freddie's ability to meet obligations return (which is possible given the coming eviction moratorium ending), then an even more significant jump in mortgage spreads could occur and potentially drive AGNC's book value to zero. Notably, the mere concern that this could happen is enough to cause a run on the MBS market, as was seen during March of 2020 and had caused AGNC to lose around half of its value rapidly.
Looking Forward
Investors who do not fully understand the complexities of the modern mortgage market (and its intimate ties to the Federal Government) may find themselves taking on far more risks than they currently believe. Reading comments and even some analysis regarding AGNC, it appears too many investors may take its lack of direct credit risk as implying it is a low-risk investment. Remember, low-risk investments can become very risky when immense leverage is used since small bouts of volatility are magnified tremendously.
Now, AGNC is less risky than many of its smaller peers, such as Orchid Island Capital (ORC) which uses even higher leverage. That said, I would place AGNC's risk level among the highest level within the stock market. The most significant problem with these mREITs is that their risk is extremely asymmetric. They go through long periods of high dividends and little volatility and occasionally experience large and sudden declines. To a certain extent, their performance can be compared to that of a martingale betting strategy which can generate consistent returns until inevitably collapsing.
A collapse in AGNC is not inevitable, though a significant drawdown from here is seemingly likely. AGNC is back at its pre-COVID valuation even though risks within the mortgage market are far higher. While we cannot truly see these risks until the eviction moratorium ends, we can be assured that it will create dislocations. This risk increases the longer the FHFA and Federal Reserve artificially support the market.
It is increasingly clear that the Federal Reserve must purchase even greater amounts of mortgage-backed securities to keep mortgage spreads from rising. They can no longer keep the spread down even with accelerated purchasing over the past three months. As the Fed moves closer to tapering (with an immense divide regarding mortgage-backed securities), there is a significant chance that the mortgage spread will quickly widen. I believe this is necessary to stop the property bubble from becoming an even more considerable systemic risk. Still, a widening of spreads will undoubtedly cause AGNC and similar companies to lose 20-40% of their book value. At the end of the day, the Federal Reserve probably cannot keep the mortgage market in permanent disequilibrium without creating undue risks elsewhere in the financial system.
A Short Opportunity
Overall, I believe it is prime time to take profits on AGNC and its peers. While the Federal Reserve may manage to "kick the can down the road" regarding the MBS market for some time, I believe it is inevitable that mortgage rates spike. I am bearish on AGNC, considering it has limited upside potential and high downside risks in the current environment. Indeed, the recent decision to raise cash and the coming end to the eviction moratorium may catalyze larger declines.
In my opinion, this makes for an attractive short opportunity for those looking to hedge against losses. Few are currently short AGNC, so it has a borrowing cost near zero. Its 8.5% dividend yield is a justifiable carry cost, considering another period of significant declines seems likely. It is also possible AGNC pops back up to $18+, though the company rarely deviates significantly from its book value. As such, dividend carry costs are the primary risk facing AGNC short-sellers today. However, as the mortgage spread widens, I firmly believe the decline in AGNC's book value will be larger than its annual dividend.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Short position through short-selling of the stock, or purchase of put options or similar derivatives in AGNC over the next 72 hours. 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.