Monday, June 23, 2008

American Capital Agency's First 27 Days

A little bit ago I posted on American Capital Strategies' (ACAS) spate of lousy media coverage and the fact the company seemed to be routinely drilled by folks who could make a good sound bite but didn't have much analytic depth.

One of the three profit streams I identified was ACAS' management fee revenues. A recently-raised pool of external funds, organized as a Real Estate Investment Trust (REIT) and designed to take advantage of fire sales in (and one must pay attention a little here to see that we're not talking about undercollateralized subprime debt) lately-underpriced government-backed mortgage securities, is American Capital Agency Corp. (AGNC). AGNC was launched last month at an IPO price of $20, though after underwriting discounts and the like AGNC ended up with a bit less.

This isn't the first time ACAS has been responsible for managing mortgage-backed securities. A trust full of commercial mortgage investments is one of ACAS' ongoing funds under management, and the assets backing it up have apparently been pretty solid, an apparent testament to ACAS' due diligence in selecting morgage investments: "The underlying commercial real estate assets in ACAS CRE CDO are performing well and have had zero losses." (Announcement here) As I've mentioned before, current FAS 157-compliant valuations of debt derivatives seems to give valuations that make little sense, even considering the illiquidity of the current assets. Lat time I quoted:
[A]t the end of the first quarter of 2008, the Company held an investment in a commercial real estate collateralized debt obligation (CRE CDO) which had been depreciated $209 million from its inception to date, including $160 million in the first quarter of 2008. The investment is currently producing approximately $8 million per quarter of cash flow but its current fair value determined in accordance with GAAP is $11 million due to a lack of liquidity in the financial markets for CDO investments which has caused investment spreads to widen. However, the Company anticipates realizing its $220 million investment on settlement or maturity based on its assumptions of future credit losses, which includes a recession over the life of the investment.
via ACAS' Form 10-Q filed May 6, 2008.
With valuations potentially this out of whack, what a time to buy, right? And that's the purpose of AGNC. I'll quote the press release, that AGNC was formed to invest "exclusively in agency pass-through securities and collateralized mortgage obligations for which the principal and interest payments are guaranteed by a U.S. Government agency or a U.S. Government-sponsored entity."

One commentator, discussing the risks facing AGNC, cited the fact four competitors were still trying to organize IPOs of REITS aimed at agency-backed paper. This is a negative risk factor impacting AGNC? This is, in fact, an endorsement of AGNC. The fact that AGNC and ACAS have the ability to make deals happen while others would like to be doing the deals tells a tale worth hearing: AGNC's already buying investments, while its competitors are still trying to get funded. The competitive advantage of being able to actually offer sellers cash now is hard to overstate when illiquid securities are at issue and firms looking to unload them face potential time constraints and want suddenly-unfashionable investments off their books. Another risk cited in the same news flash was the external management structure, which might be confusing for some potential buyers, but actually offers security to AGNC (officers won't be compensated by unlimited share grants, but by a fixed management percentage) while offering security to ACAS (which gets a management fee). As for the third cited risk -- the execution risk -- I think the numbers achieved in the first 27 days says quite a bit about the kind of execution ACAS' management subsidiary delivers for AGNC.

So, how has it done? The launch quarter has just yielded a dividend, just declared, of $0.31 per share based on assets invested some 27 days in the quarter's stub-end. ACAS, as both an investor in AGNC (ACAS bought 5 million AGNC shares in its IPO and up to another 2.5 million in a private placement, for an ownership fraction of up to 50%) and as the recipient of management fees, is a significant beneficiary of this return. Since the return reflects ACAS' funds management expertise, the results since launch last month would seem to make ACAS look pretty smart:
Since then, the Company has invested these net proceeds, along with proceeds from borrowings under repurchase agreements with 12 global financial institutions, in approximately $2.5 billion of agency securities. On average, the portfolio was deployed for approximately 27 days during the stub period. With the successful deployment of our capital, we are pleased to be in a position to declare our inaugural dividend of $0.31 per share and expect that this will be the first of many attractive dividends for our shareholders for years to come.
via PR Newswire
As a REIT, AGNC will be expected to distribute substantially all its income after expenses (i.e., after its management fees to ACAS) to shareholders to avoid income taxes. The fact that AGNC has 31¢ of distributable profit in its first 27 days of its investing existence portends well for its future. ACAS will get a couple million in revenue from the stub quarter, flowing through in dividends, before adding its management fees (which annually should also be several millions, and should grow as AGNC's assets attain pricing reflecting an abatement of the mortgage market scare, and the return to rational valuations). Rising operating revenues will make ACAS less dependent on potentially irregular capital gains for its total return, and will tend to put to ACAS management the hard question whether it will be rolling more undistributed revenue forward (and paying taxes on it) or whether it will raise ACAS' own dividend some more.

Decisions, decisions.

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