AGNC: Mortgage Woes Create Opportunity

08/09/2013 8:00 am EST


Gerald Appel

Publisher, Systems & Forecasts

Mortgage REITs are undervalued after selling off during the past three months, observes Gerald and Marvin Appel, editors of Systems & Forecasts.

The bond market rout during May and June hit mortgage REITs especially hard, and mortgage REITs reported big second-quarter losses. During the quarter, American Capital Agency (AGNC) lost more than 26% in total return.

The context for this big loss was the jump in mortgage rates from 3.6% to 4.3% for conventional 30-year mortgages. Since mortgage REITs employ tremendous leverage, their losses were magnified.

AGNC lost 11.8% in book value in the quarter, down to $25.51 per share, which is 15% above the current share price of $22.20.

Allowing for additional book value losses in July as the result of further underlying bond losses, it still appears that AGNC now trades at a discount of approximately 10% to book value.

AGNC started the second quarter at a 10% premium to book value ($31.31 share price, $28.93 book value.)

By the way, AGNC reported leverage of 8.4 during the second quarter. That implies that an unhedged, leveraged portfolio of mortgage-backed securities would have lost 21%.

It would appear then, that hedging mitigated the potential losses by almost half. This is confirmed in the financial statements ($2.81 billion loss in the value of securities, $1.44 billion gain from derivatives.)

For the second quarter, net spread income (interest earned less borrowing costs, preferred dividends, and operating expenses) was $1.15, which is currently able to cover the quarterly dividend of $1.05.

I continue to recommend American Capital Agency because its earnings potential in the years ahead remains attractive.

Shareholders face the risk of further increases in mortgage rates, but for potential interest earnings of 20%, based on current net interest income, I believe that risk is worth taking.

The fact that AGNC started the second quarter at a large premium to book values, and is now at a big discount, reduces the risk of further outsized losses in the future.

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