Adding to American Capital Agency (AGNC)

Summary

• At 84% of book value, AGNC is trading near its historically low.
• Upside is collect 14% dividend and perhaps more with a pull to par. 
• Downside is controlled. There are many risks, but they are mostly uncorrelated. The biggest threat in the near term is book value decline due to rising rates and mortgage spreads. 
• Comparing the current environment to 2Q13 (the worst quarter in AGNC history), book value hits should be limited. 
• I added to my positions this past week.

Situation

American Capital Agency Corp (AGNC) is a mortgage REIT. It earns a spread by buying mortgage backed securities (MBS) with low cost funding, and then magnifying that spread with leverage. In the past few years this allowed AGNC to pay a consistently high dividend yield.

AGNC’s stock price has declined steadily the past 2 months, with price to book now at 84%, among the lowest in its history. My base case outlook is a 12% dividend in the next year, while a P/B recovery (less likely) would add 16% for a total return of 28%. But what is the downside, and the likelihood of that downside?

Many Risks, But Uncorrelated

AGNC is cheap for a reason. Many reasons actually. Among its many risks, the main three are: 1) book value hit due to rising rates and mortgage spreads, 2) flatter yield curve leading to spread compression and threaten the mREIT business model, 3) dividend sustainability with dollar rolls. The last point about dollar rolls is really a unique subset of spread compression. It is relatively obscure and deserves a separate discussion, but for now I want to focus on the first two risks.

The worst case would be a bear flattener, which is a combination of 1) and 2) - rising rates and compression spreads. Rising rates would hurt asset prices and decrease book value in the near term, while compressed spreads hurt P/B multiples by lowering future income. Theoretically, these can happen at the same time. For mortgage REITs though, these are conflicting risks that are unlikely to happen at the same point in time:

o Unlike other financial institutions that constantly have money coming and risk investing with lower spreads, a mortgage REIT’s exposure to spread compression mostly comes from mortgages prepayments, where investors have to re-investment into a lower spread environment. However, if rate/ mortgage basis are shocking upward, prepayments would likely to be muted.

o For AGNC, the most relevant rates are repo funding cost and MBS yields, where repo funding costs are unlikely to spike upward short of a banking crisis. High prepayments (both voluntary and involuntary) are unlikely in that scenario, given the current state of housing markets.

Since these risks are unlikely to happen at the same time, I will focus on the risk of rising rates and spreads hurting book value. This is the more immediate risk, and is also the one that hurt AGNC more historically.

Quantifying the Downside

Historically, AGNC’s worst performance came during 2Q13, when the stock dropped 31% in the quarter. About 2/3 of that price drop was simply due to market multiples. Price to book ratio flipped from a premium of 110% to a discount of <90%, which magnified a 12% decline in book value.




The ~12% in book value (both on a total and per share basis) was due to a confluence of multiple factors:

o A violent 63bps up move in 10yr UST, while mortgage yields were up more than rates.

o A collapse in specified pool pay-ups. AGNC owned prepayment protected MBS such as low loan balance and HARP loans. Normally, these trades a premium (“pay-ups”) to more generic MBS, but as rates go up and people are less worried about prepays, those premiums shrank dramatically.

Here’s an old 2Q13 presentation slide explaining the collapse in pay-ups. Note that the 30year, 4% coupon pay-up dropped from 3.28 in 1Q13, to 0.91 in 2Q13. A decline of 237bps!




As of now, many these factors are simply not present. Comparing the present situation to end of 1Q13 (the start of 2Q13 meltdown), AGNC already trades at ~15% discount to book value as opposed to a 10% premium. Yes, it’s very possible that rates may shock upward, but probably not as violently as in 2Q13 when talks of Fed “tapering” dominated news headlines. Finally, as the below table from Markit shows, specified pool pay-ups are nowhere near where they were in 1Q13, which could be greater than 3 points. As of January 2015, the higher pay ups are for 30 year low loan balance (LLB) pools with >4% coupon, and those are under 3% of AGNC’s portfolio.

Therefore I believe AGNC’s downside is limited - any book value deterioration from rate increases should be less than the 12% drop as seen in 2Q13, and thus well within the current 84% P/B buffer. I do not think P/B will drop much further because that would have to come from spread compression, which as I explained previously, is incompatible with a “rate up” scenario.

Finally, if all else fails management always have the option to do buybacks, as they have done before.

Risk Control and my Mortgage and Housing Portfolio

I mentioned my mortgage/housing portfolio a few months ago and here’s what it looks like now:

• Title insurance: FNF/FAF/STC
• Asset pools: AGNC/MTGE/ HLSS
• Origination and servicing: PFSI/WAC. A short put position in OCN that is fully hedged 
• Builders: UCP
• A tiny position in Freddie Preferred.

Combined, these are more than 20% of my portfolio. My housing exposure is actually more if I count Wells Fargo, Citibank…etc.

Since that last post, I have traded in and out of STC with incredible luck, and it looks like my patience in title insurers are now paying off. I’m not so lucky in OCN however. This one killed my returns this year. Analysts are bound to make wrong fundamental calls at some point, but you have to control your losses with sound portfolio management and this is where I failed. 

Getting Scalped by Gamma

Among the many lessons I learned (and paid for), a more interesting one is the negative convexity of shorting options. I got into OCN with short put positions thinking I can subsequently adjusted my net exposure up and down by going long/short stocks. That turns out to be naïve. A simplified example using fake numbers go like this.

Time 1

Stock trade at $34.
My long position: sold 100 shares of puts strike $35, this is now in the money so I’m net long.
My short position: short 100 shares of stocks.
Net exposure:  zero; I’m hedged right?  right?

Time 2

Stock spikes to $37.
My long position: now 0. That 100 shares of $35 puts is now out-of-the-money
My short position:  still short 100 shares of stocks.
Net exposure:  all the sudden I’m net short, when stock is making a run upward! I close my short stocks to bring net exposure down to 0.

Time 3 

Stock goes back down to $33.
My long position: Those sold puts struck at $35 went In-The-Money again.
My short exposure:  0. I closed my shorts in time 2
Net exposure: long 100 shares, but stock is plummeting.

So basically, that short put positions goes in and out of the money at the worst times. What I thought was a fully hedged position could turn into a net short exposure when stock is making a run upward; and vice versa, it turns to net long when stock is tanking.

People talk about “gamma scalping” by going long call option and shorting stock. With my set up I was short gamma and got scalped instead. 

Controlling Risk with Technical Analysis

FNF, and to some extent FAF, are core positions I plan to hold through the cycles. The rest however are not what most people would consider “quality” companies and my positions in them fluctuate greatly. When the fundamentals are shaky and information dissemination is sparse, I learned to use technicals to control my risk. That means buying things near some technical support level (ideally around 52 week or all-time lows), and cut my losses when they drop below that support level. Since that doesn’t always work (some of these stocks are known for taking a big gap downward), I further control risk by diversify my sector bets into multiple names, and look for cheap valuation (low P/Es or P/B multiples) 

Blending of Risk across Sub-sectors

Some of these sub-sectors offset each other with respect to specific risk factors. 

For example, my positions in title insurers could be hurt if mortgage transactions get lower. A partial hedge to that is a position in AGNC. This agency mortgage REIT benefits in that scenario because lower MBS issuance would drive its asset valuation higher. On the other hand, the mREITs have duration risks and could be hurt when rates go higher. The mortgage servicers provide some offset here with their MSR holdings. And so on. 

This is not an exact science because it’s hard to quantify the effect of various risk factors. Nevertheless, it’s good to think through what you’re trying to bet on and the risk you’re exposed to. For now, this portfolio is a bet on household formation, higher mortgage volumes, regulatory environment stabilizing, and various company specific factors such as operating efficiency, low valuation…etc.

Finally, I just started positions in PFSI and WAC this week. Those are for a separate post.