ACAS Launches MTGE IPO

[Note: This post was begun 8/3/11 and, due to distractions, not completed until it was noticed in a draft bin weeks later. Sorry about that.]

As previously discussed, ACAS is launching a REIT to invest in mortgage bundles. Unlike American Capital Agency (AGNC), American Capital Mortgage Investment Corp. (MTGE) will invest mortgage-related investments that aren't necessarily backed by the guarantee of a United States agency. Selling fewer shares than initially planned (8m rather than the planned 17.5m) on the first day of the recent market rout, ACAS maintained pricing at $20. In conjunction with the public offering, ACAS directly purchased a $40m block (2m shares) of MTGE for itself.

Despite a prediction that the investment was doomed to be a loser at issuance prices – based on comparisons with other recent mREITs rather than with ACAS' other mREIT – MTGE shares (which dropped with the whole market over the first two days) have recovered to $19 and above before MTGE even demonstrated any investment performance.

I had hoped to buy under $19, but my plan had been to make the purchase in a new account funded with money I hadn't received yet, and it looks like my window for a steal has closed. I suspect that MTGE will in many ways replay AGNC, with the exception that MTGE will not have access to the derivatives income that aided AGNC during the 2008 panic. This prediction is based on the assumption that non-Agency-backed mortgage securities will be less liquid, and thus will not have a ready derivatives market to use as a hedge.

The investment thesis in MTGE is surely a reflection of ACAS' broader investment thesis: illiquid investments are likely to be underpriced due to the inefficiency of the markets for illiquid hard-to-price investments, so ACAS will buy not to resell but to hold. To counter the risk of being stuck until maturity, I expect ACAS to do things like buy variable-rate mortgages. Without the government guarantee, I expect ACAS to be looking for – and finding – medium-grade mortgage packages at afwul-grade prices, with the intent to hold for the upside of the repayments the sellers are too impatient to bet on. I believe ACAS' experience pricing AGNC's portfolio has given it a good idea where the inefficiency is in the market, and given it a hunger to buy at dirt-cheap prices mortgage bundles that aren't nearly as bad as their pricing would imply.

On the other hand, MTGE isn't barred from investing in the exact same investments as AGNC. MTGE merely has the freedom to invest more flexibly.

Oh, and ACAS is paid by MTGE an advisory fee of 1.5% of MTGE's assets, not the 1.25% it is paid by AGNC. So maybe the MTGE issuance is less exciting than it looks: ACAS gives itself a 0.25% raise while broadening its freedom to invest funds beyond agency-backed securities. The 185m raised in the initial round of funding doesn't all become MTGE assets; the 8m shares actually in the IPO are subject to underwriting fees. Assets were reportedly expected to be something like $199m, meaning that ACAS' monthly advisory fee (1/12 of 1.5% of $199m) is approaching a quarter million dollars a month. By my own math, I expect $242,000 per month to be paid to ACAS, but there may be some assets in MTGE that weren't raised on IPO Day; the expected post-IPO assets are a bit above what I calculated based on the 80¢/sh underwriting fee disclosed here. Based on the greater advisory fee in MTGE, I expect ACAS to try to raise in MTGE funds it previously raised in AGNC. MTGE's performance – and its consequent price relative to NAV – will determine how successful that effort will be.

The other advantage to ACAS? With growing management fee income, ACAS' asset management subsidiary becomes more valuable. As a component of ACAS' NAV, the asset manager is as valuable as any profitable subsidiary.

You heard it here first: MTGE is just like AGNC, but allows ACAS to deploy funds into underpriced mortgage bundles that aren't backed by an agency (which is a factor potentially exacerbating pessimism and thus creating an exciting underpricing opportunity); because ACAS is paid more to hold funds in MTGE than in AGNC, expect ACAS to try to raise future funds in MTGE, where it will also have more investment flexibility.