American Capital Slumps as Mortgage Strategy Backfires

American Capital Agency Corp., the second-largest real estate investment trust that buys mortgage debt, tumbled after reporting an 8.6 percent drop in its book value from the previous quarter.

The REIT slumped 7.4 percent to $30.66 as of 4:15 p.m. in New York, the largest daily drop since October 2009. The Bethesda, Maryland-based firm said in a statement yesterday that its book value, a measure of its assets minus its liabilities, declined $2.71 to $28.93 per share on March 31.

The company, led by Chief Investment Officer Gary Kain, may have suffered a bigger drop than peers because of a strategy of targeting securities with loans considered less likely to refinance, according to Jefferies Group LLC analysts. Those bonds had helped the REIT outperform last year.

“The surprising decline in book value from a company that has had a stellar track record in value generation is likely to be the key discussion point today with the stock,” Jefferies analysts including Daniel Furtado wrote today in a report. “Although we anticipate talk of AGNC losing their multiple premium due to this bad performance, at the end of the day, we expect AGNC will maintain a slight premium valuation,” they said, referring to American Capital Agency by its equity ticker.

Refinancing Risk

Investors pay more for certain government-backed mortgage bonds to avoid homeowner refinancing that can shrink returns on debt trading for more than face value by returning principal faster at par and curbing interest. The types of loans include those with low balances or borrowers who have already tapped the federal Home Affordable Refinance Program, or HARP.

The so-called pay-ups have dropped as investors focused more on the risk that the lives of mortgage securities will extend once interest rates rise, Kain said in the statement. The firm’s book value was also damaged by widening relative yields on generic securities amid concern the Federal Reserve could end its buying sooner than expected, he said.

“The Fed’s massive involvement in the mortgage market is clearly creating volatility,” Kain, who managed Freddie Mac’s investment portfolio before joining the REIT in 2009, said today on a conference call.

The U.S. central bank has been adding $40 billion of the securities a month to stimulate the economy, as well as reinvesting in the market with proceeds from existing holdings.

‘Considerably Worse’

Kain defended his firm’s bets on securities with refinancing protection, which he said performed “considerably worse than we anticipated” last quarter.

“Faster prepaying pools may be a little more stable in price but they’re not earning you much in many environments,” Kain said. Still, pay-ups would drop “materially” if rates went up 1 percentage point, he said.

The premiums on so-called specified pools have also declined as the Fed’s purchases of generic securities made it cheaper to finance investments in the debt through the so-called dollar roll market, Bank of America Corp. analysts including Satish Mansukhani wrote in an April 26 report.

At the same time, some types of refinancing protection may prove less valuable if the HARP program for Fannie Mae and Freddie Mac loans is expanded. This week, President Barack Obama nominated Representative Mel Watt to be director of the Federal Housing Finance Agency, the overseer of government-controlled firms. Rising home prices could also help expand refinancing.

Annaly Capital

Less than 5 percent of American Capital Agency’s portfolio would be impacted by a one-year extension of HARP’s eligibility date that allows homeowners to use it a second time, Kain said on the call.

Annaly Capital Management Inc., the biggest mortgage REIT with $125.5 billion of assets on March 31, said in a statement May 1 that its book value per share fell to $15.19, down from $15.85 on Dec. 31. American Capital Agency reported $93.4 billion of assets.

“While this quarter’s book value performance” at American Capital Agency “is likely to be one of the worst in the space, management has generated exceptional returns over the course of the last three years,” the Jefferies analysts wrote.

Some of the drops in pay-ups and widening in spreads on generic bonds have reversed this quarter as investors push back their expectations for the Fed’s retreat, Kain said on the call.

Premiums on Fannie Mae 4 percent bonds with the mortgages with loan-to-value ratios of more than 125 percent allowed by HARP have risen to 3.3 cents on the dollar, from as low as 2.2 cents in April and a record high 4.5 cents in December, according to Credit Suisse Group AG data. Pay-ups for similar bonds backed by the smallest loans have climbed to 4 cents, from 3.4 cents in March, though remain down from a record 4.9 cents in November.