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American Capital Agency: Making Money the Old-Fashioned Way

by: Jaded Consumer September 07, 2008 | about stocks: ACAS / AGNC    

Jaded Consumer

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American Capital Agency (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 (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

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This article has 7 comments:

  •  
    Sep 07 09:36 AM
    I'm long ACAS, but I think I'll watch AGNC for another quarter before making that decision. Sure does look good so far!
    Reply
  •  
    Sep 07 06:35 PM
    I think you need to read AGNC's 10-Q a bit more carefully. AGNC buys mortgage debt insured by government agencies yielding 5.5%, and somehow turns it into a return on equity of 25% to 30%? And you're not a little suspicious?

    How about the fact that AGNC is leveraged 8 to 1? How about the fact that the value of its investments declined by $ 26 million in 27 days, while its net income (excluding the value loss, which is only included in other comprehensive income on the balance sheet and hasn't hit the income statement yet) was only $ 5.5 million? AGNC didn't make a dime in the June quarter - it lost $ 20 million. At that rate its equity would be wiped out in a year.

    I like and own ACAS, but AGNC is crazy. Take a look at the risk footnote in the 10-Q. If interest rates rise by 1% (100 bp), net interest income is projected to drop 22% and the value of its portfolio is projected to drop by 4%. The 4% doesn't sound too bad until you remember the 8 to 1 leverage. A 4% drop in value on a $ 2.4 billion portfolio equates to $ 96 million loss, or about 35% of equity. And that's after considering AGNC's interest rate hedges. A 1% drop in interest rates would increase net interest income by 13% and increase the value of the portfolio by 2.4%. Something seems a bit strange, that a 1% drop in rates doesn't produce the same effect (in the other direction) as a 1% rise in rates.

    Anyway, AGNC seems to be a highly leveraged bet on a drop in interest rates, and probably will do ok if rates stay the same. But the risk in owning AGNC is a lot more than you indicate.
    Reply
  •  
    Sep 07 08:24 PM
    Looks like their model is the same as Annaly, Hatterras etc. The borrow short term to buy long term mortgages. This is a profitable business as long as the yeild curve is steep. The model will breakdown in a flat yeild curve or inverted yeild curve.

    Financial leverage of 8 X is actually not bad. It is much better than most banks. Leverage is needed to amplify the spread between short term interest they have to pay in order to buy MBS from the GSE's.
    Reply
  •  
    Sep 07 09:04 PM
    The reason this company did so well in the stub period is that it put its entire portfolio in place when GSE spreads are at their highest levels in history. They completed their IPO in May and immediately put all the money to work at an 8X leverage. It was the best of all possible worlds to start in. The spreads won't be so good after the just completed FNM/FRE bailout. They will do well until the portfolio runoff catches up with them. But after that they will have to prove their worth.
    Reply
  •  
    Sep 07 10:12 PM
    The value of their existing portfolio's should increase in the short term given the explicit backing of the govt. So there might be a short term trading opportunity.
    Reply
  •  
    Sep 08 12:31 AM
    AGNC is an interesting company. I'm a longtime Annaly investor, so I'll just highlight two apparent differences. First, AGNC is much, much smaller ($300MM market cap) and has bought its entire portfolio in the last few months. Second, and this is an important one, they've made a bet on prepayment speeds of higher coupon mortgages (basically, in most environments higher coupon mortgages refinance quickly, because borrowers can save money by doing so). There are some good reasons for this bet, but its worth understanding that it could go wrong. Basically, my reading is that the harder it is for consumers to refinance, the better AGNC's current strategy will do.
    Reply
  •  
    Sep 09 07:13 PM
    You can't suffer realized losses waiting for information on making a more confident buy decision. Whether AGNC has something strange in its revenue stream that produces unexpected lumpiness is something we will definitely have to wait to see. Being conservative is a way to avoid losing money, and avoiding losing money is a key to building more of it.
    Reply
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