As we have encouraged readers since the peak in September 2012, the mortgage real estate investment trust (REIT) industry has myriad risks, and the marketing pitches indicating that their principal and interest payments are guaranteed by a US government sponsored entity (GSE) should not make investors feel safe. This dynamic has little bearing on the underlying trajectory of fundamentals and a mortgage REIT’s book value, the key valuation driver and the major impetus behind share price movements in the space.
During the second quarter (results released Monday), American Capital Agency (AGNC) failed at its principal objective to preserve net asset value, as book value plunged to $25.51 per share from $28.93 per share in the previous sequential quarter (a $3.42 move). The REIT reported a comprehensive loss of $2.37 for the period, as $4.61 in net income per common share was overwhelmed by nearly a $7 per share hit in other comprehensive losses (OCL)—net unrealized losses on investments marked-to-market. Other comprehensive losses (OCL) remain the key driver behind book value deterioration, something we had warned about before the mortgage REIT industry’s recent large share price decline. Investors that continue to argue for exposure to the group have thus far underestimated the mortgage REIT industry’s exposure to higher rates, which has only started to be addressed by management teams across the space (“our exposure to higher rates is [now] lower than it has been in past years” – AGNC CEO Gary Kain, second-quarter press release).
American Capital Agency’s management seemed pleased to have generated a positive economic return of 3.1% (dividends paid plus change in book value) over the past twelve months, but we reiterate that such performance is value-destructive and well below our estimate of the firm’s cost of capital. We expect a modest share-price bounce across the industry as a result of the quarterly performance, but only because reported book value is modestly above American Capital Agency’s current share price. Nonetheless, we think an ongoing discount is justified, and we reiterate our well-documented view that “the good times are over for the mortgage REITs.”