After the carnage in the mortgage real estate investment trust (REIT) space over the past two months, is the worst over? For at least one mortgage REIT, the answer may be yes.
The first quarter was brutal
AGNC Investment Corp. (NASDAQ:AGNC) reported first-quarter earnings on Thursday, April 30, that demonstrated the pain in the mortgage REIT space. The company saw a 23% decline in book value to $13.62 a share, which is remarkable given that the company invests almost entirely in instruments the Fed has spent the last month supporting. Between the drop in book value and the $0.48 per share in dividends paid, the company delivered an economic loss of about 20% in the quarter.
AGNC shrunk its balance sheet aggressively, taking down assets from $113 billion at the end of 2019 to $85 billion as the holdings of agency mortgage-backed securities fell from $98.5 billion to $70.3 billion. Repurchase agreements fell from $89.2 billion to $66.5 billion. Shareholder’s equity fell from $11 billion to $9.8 billion. Finally, leverage (the ratio of debt to capital) was flat at 9.4 times. At the end of the quarter, liquidity comprised of cash and unencumbered assets stood at $3.5 billion, and the average age of the company’s repurchase agreements was 93 days.
Margin calls and the Fed
Since AGNC Investment is invested in securities that are guaranteed by the government and the Fed just spent billions supporting these securities, it is natural to ask: How did the company lose money? It should be pretty hard to do when you aren’t taking credit losses and the Fed is pulling out all the stops trying to help your portfolio.
Here is what happened. AGNC invests in what are called specified pools, which are securities that have some characteristic that makes the loans less likely to pre-pay. Mortgage-backed securities with such characteristics usually trade at a premium to similar securities. In other words, a newly issued mortgage-backed security comprised of Fannie Mae loans might trade at 104% of face value. A specified pool with the same coupon might trade at 105% of face value. Why would the specified pool be worth more? Lower expected prepayment speeds.
A prepayment occurs when the borrower pays off the loan early. Borrowers do this for one of two reasons — either they move, or they refinance. When interest rates fall, it makes people more likely to find it attractive to refinance their mortgages, which makes higher coupon mortgage-backed securities worth less. AGNC mainly holds specified pools made up of low-balance loans (typically under $150,000) which are less likely to refinance because the fees to refinance are higher as a percentage of the loan.
Before the COVID crisis, these pools traded at a premium to normal mortgage-backed securities. Over the past month, they converged with the generic mortgage-backed securities. In other words, the specified pool that was trading at 105% of face ended up trading at 104% of face. This convergence triggered margin calls and forced AGNC to unwind some of its positions at a loss in order to deliver cash to the broker-dealer.
Book value has increased since the end of the quarter
AGNC Investment noted that these problems have begun to reverse, and as of April 29, book value per share had recovered about 8% from March 31. In addition, the tightening of credit in the mortgage market has made refinances tougher to get and more expensive. The characteristics that made these specified pools attractive to begin with are about to make them even more attractive. Going forward, AGNC anticipates that these specified pools will generate mid-to-high teens returns on equity. AGNC still has some credit risk between some non-agency mortgages and credit risk transfer securities, but it is only about $1 billion, which is small compared to its $85 billion in assets.
At this stage of the game, AGNC Investment’s book value is probably around $14.70 per share given the 8% pickup since the end of March. AGNC pays a $0.12 per share monthly dividend that was $0.16 pre-COVID. That works out to be an 11.3% dividend yield. With the stock trading at a 13% discount to book value, AGNC has several catalysts to give shareholders a favorable return going forward.