AGNC Back to 20?

The shares of American Capital Agency (AGNC), which I first wrote about when I was talking about the funds management business of American Capital (ACAS), closed Monday at their IPO price of $20. Apparently, the government bailout of Fannie Mae and Freddie Mae, guarantors of much of AGNC's asset base, has reassured investors that the >20% returns I wrote about last week don't indicate as much downside risk as previously feared.

Personally, I had relied on ACAS' success in commercial mortgage investment performance as an indicator that AGNC's mortgage investments would likely not require the support of a guarantor. Indeed, the FAS-157-compliant mortgage instrument valuations at ACAS suggest the possibility that AGNC could be buying vastly-underpriced investments: subprime home mortgages had become so hated that non-subprime commercial mortgage instruments still performing as expected and still producing revenues of $8 million per quarter were required to be listed as if worth a mere $11 million on ACAS' books. That's a return exceeding 70% per quarter. With an eye on bargains like that in performing non-home-mortgage investments, I hoped that ACAS would be able to build a portfolio of grossly-undervalued securities that would later become subject to price appreciation.

Granted, firms with an asset like ACAS' >70%-per-quarter commercial CDO aren't keen to part with them; even in distress, a firm needing cash would sooner part with something of more modest value, something less crazily mispriced. Still, the need for liquidity has surely put onto the market quite a lot of mortgage-backed debt assets (surely a factor in the pressure against their value). ACAS' experience with the pricing of complex debt instruments, and its familiarity from prior dealings with the parties dealing in these assets, gives AGNC an opportunity to buy from a position of relative expertise. ACAS, after all, hasn't been bitten by poorly-performing loans despite having commercial real property exposure. ACAS has demonstrated some expertise in performing effective due diligence in avoiding unnecessary capital risk in the mortgage area and elsewhere in its business. ACAS won't be chasing a 70% coupon mortgage instrument in the hope of winning the lottery if the thing doesn't bust, it'll be using its resources to identify and obtain attractive risk-adjusted returns.

Part of the way AGNC offers an attractive risk-adjusted return is to control risk: AGNC knows its expenses (it has no personnel of its own, so its overhead seems limited largely to the fixed 1.25% annual rate it pays ACAS), AGNC's investments are backed by the credit of the United States (Fannie Mae and Sallie Mae having been taken over by the federal government, which, say what you will, has the longest-running credit payment record on the planet), and AGNC knows its manager is using all its power to protect asset values because its manager (a) is compensated on the basis of those asset values and has no performance incentive payment to game from quarter to quarter, and (b) is a huge shareholder of AGNC and stands to lose more than anyone else if it fails to deliver on the investment. The other way to offer an attractive risk-adjusted return is to use leverage. Instead of offering a low yield and expecting investors to raise funds by borrowing to buy more shares with debt, AGNC raises funds at a much lower rate and allows investors to own the result of multiplying a several-percentage-point yield spread by over 8x leverage. The availability of leverage is based on good credit and creditors' solid view of AGNC's asset values. Intra-investment leverage allows investors to enjoy the benefit of leverage without the risk investor-level leverage might bring to a broader portfolio: if the worst possible case materialized at AGNC, no other investment need be impacted within an investor's portfolio.

AGNC heading back to 20 raises an interesting feature: AGNC trading above the last-posted NAV. Granted, the conversion of Fannie and Freddy guarantees into Treasury guarantees may have actually grown the NAV by improving the marketability of AGNC's investment assets. However, the ability to grow the business' power to fund good deals will only improve with a share price above NAV. Moreover, issuance above NAV -- if leveraged as prior investments and if given similarly high-quality due diligence -- will benefit existing shareholders by giving them a return based on even more invested (and leveraged) assets.