American Capital Fights Fed Exit Worry as Investors Flee
Gary Kain built American Capital Agency Corp. (AGNC) into the fastest growing real estate investment trust as the Federal Reserve pushed borrowing costs to record lows. Now he’s trying to persuade investors to stay with him as he navigates the central bank’s retreat.
American Capital has slumped 10 percent since May 2, the worst performance in a Bloomberg index of 34 companies that invest in mortgage bonds, after reporting an 8.6 percent drop in book value from the prior quarter. Annaly Capital Management Inc. (NLY), the only mortgage REIT bigger than American Capital, said its book value, a measure of its assets minus its liabilities, fell 4 percent.
“The issue isn’t if the Fed exits, it’s a question of whether they exit way earlier than expected,” Kain said in a telephone interview. “We feel like positions are in much better shape now than they were in the January-February time frame.”
Firms that buy government-backed home-loan bonds are under pressure as investors speculate the Fed will withdraw from buying $40 billion of mortgage securities each month as the economy shows signs of strengthening. American Capital, which increased assets over three years more than 20-fold to $100.5 billion at the end of 2012, plunged the most of mortgage REITs after targeting higher-priced bonds that would benefit from continued Fed intervention.
“The overall performance in the quarter, with decline in book value, was a wake-up call that even very good managers like Gary Kain with a great track record can’t bat a thousand all the time,” said Steven Delaney, an analyst at JMP Securities LLC in Atlanta.
Mortgage REITs have been among the biggest winners from government policies to resuscitate housing and stimulate the economy. The central bank’s policy of so-called quantitative easing, purchasing Treasury and mortgage bonds, has made it cheaper for REITs to borrow money to invest in the same government-backed mortgage bonds the Fed has targeted.
That’s helped drive a 67 percent gain in mortgage REIT stocks, including reinvested dividends, since the end of 2009, with American Capital more than doubling. Now, with the housing market rebounding and the unemployment rate declining in April to 7.5 percent from a peak of 10 percent in 2009, speculation has grown that the Fed will retreat earlier than anticipated.
San Francisco Fed President John Williams said yesterday the central bank may begin slowing the pace of its bond purchases as early as this summer, after three of the Fed’s regional bank presidents called for phasing out the purchases.
“This is the year you should start thinking about reducing exposure to the mortgage REITs,” said Daniel Furtado, an analyst at Jefferies Group LLC. “There’s a tremendous amount of price risk and the Fed has got its fingers all over everything.”
The Bloomberg index of mortgage REITs has declined 3.6 percent this month. American Capital, gained 0.4 percent to $29.65 today in New York.
Kain, the REIT’s president, joined Bethesda, Maryland-based American Capital in 2009 after 20 years at Freddie Mac. He said the firm is investing knowing that the Fed will disrupt markets even though he disagrees with the likelihood of a midyear exit.
“The expected path is tapering over the next few months and concluding around the end of the year,” Kain said in the interview. “Mortgages should perform reasonably well under those circumstances and they may do even better in that scenario.”
He told investors on a May 3 conference call that the company had already recovered a portion of the first quarter declines by the end of April, as economic reports signaled the Fed would keep its program in place for longer.
He added that the “significant weakness in the prices of specified mortgages has created an excellent opportunity to add value-added product at attractive levels.”
Those specified pools contain mortgages that are considered less likely to refinance, such as loans with low balances or those given to borrowers who had already gone through the Federal Home Affordable Refinance Program, or HARP, according to Merrill Ross, an analyst with Baltimore-based Wunderlich Securities Inc.
Mortgage bond investors monitor prepayment rates because they influence returns. Bondholders risk losses when buying debt for more than 100 cents on the dollar as the value can be erased when homeowners take out new mortgages too early to repay existing debt. As the government and Fed encouraged homeowners to refinance, those types of bonds became more attractive to firms like American Capital.
“They paid broker-dealers a premium for loans with characteristics they thought would perform better, and now those premiums are eroding because nobody else wants those bonds,” Ross said. If the Fed retreats from the market, “those specified pools aren’t as valuable because everything will slow down,” she said.
Kain said the firm has purchased more at the reduced prices because they can hedge the securities with derivatives so they’re attractive even if interest rates rise.
“This is not a market for even mortgage experts like ourselves to rely too heavily on any one opinion,” Kain said. “It’s a time for making sure you have reasonable long-run hedges in place and not go overboard in one direction or another.”
On Tuesday, he rang the opening bell of the Nasdaq Stock Market, a day after he bought 332,794 shares of the company, almost doubling his stake in the REIT. The purchase was scheduled, and Kain said he didn’t determine the timing.
While investors are concerned about the Fed’s reduction in bond purchases and the resulting risks they could create in the market, the central bank probably will be “extremely slow” in its withdrawal, said Michael Widner, an analyst at Keefe, Bruyette & Woods. “That spells an environment that actually gets better for the mortgage REITs before it gets worse.”
Even as Fed officials signal the scaling back of stimulus efforts, signs are emerging of a slowdown in growth. More Americans than projected filed claims for jobless benefits last week and manufacturing in the Philadelphia region unexpectedly shrank in May.
Options traders are the most bullish on American Capital in three years, according to data compiled by Bloomberg. The average dividend yield for mortgage REITs is 12.4 percent with American Capital’s at 16.9 percent. Those that invest in so-called agency debt are trading at 0.93 times their book value, Widner wrote in a May 15 report.
“We tend to see this kind of weakness in the group as a buying opportunity, he wrote. ‘‘Fears the Fed is materially closer to an exit are overdone, and when those fears are put to rest (at least for a while) we see the group and MBS prices bouncing back.’’
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