American Capital Update

Shortly after American Capital Ltd. announced its quarterly results, so too did American Capital Agency Corp.

The important figure for ACAS – the NAV growth to $15.71 – is discussed in the article Why American Capital Is Buying American Capital. That article rebuts a thin work at The Motley Fool, which pitches ACAS share buybacks as a waste of shareholder funds. Its evidence? ACAS "can't afford" a dividend. Uh, it can afford share buybacks. The only difference is that shareholders aren't taxed on the NAV increases caused by below-NAV share buybacks, whereas they would be taxed on dividends. Were share price above NAV, the same funds would be directed into dividends under the recently continued (through 2013) dividend/buyback policy first announced last year. News the Fool apparently missed.

At American Capital Agency, NAV grew even more than the dividend over the quarter. Share price was more volatile, but that's of more import to traders than to investors. The key for investors is that the dividend remains safe while management reinvests further earnings with the added boost of some hidden tax deferral.

Meanwhile, American Capital Mortgage Investment Corp. announced its 1Q2012 results. As with AGNC, MTGE grew NAV in an amount exceeding the dividend it paid (net of the dividend payment, so it's like getting the dividend and having them reinvest it for you, both). Article to follow :-)

Hidden Tax Deferral at AGNC, MTGE

Just published at Seeking Alpha, the newest article from the Jaded Consumer looks at the effect on your taxes of all those share issuances ACAS is conducting at its managed funds AGNC and MTGE.

In a word: it's good news.

ACAS launches new Preferred at AGNC

Thanks to more clever management at ACAS, AGNC now has a preferred issue. Recalling that ACAS' fee is based on funds under management, the managers are unconcerned whether equity is raised in common or preferred issues. The $150m preferred issue will yield ACAS another $156,250 per month in management fees atop those already paid by AGNC, plus fees on the equity reinvested from income made on the issue.

And as described at Seeking Alpha ("Understanding American Capital Agency's New Preferred Issue"), there will definitely be something to reinvest after paying the preferred shareholders their 8% on the $25/sh in equity in each stub of preferred.

Why Issuing Shares Isn't All Bad For Shareholders

I've seen one too many articles describing accretive share issuance as "dilution". I wrote an article at Seeking Alpha (which gets more page hits than I did when I wrote about it here in 2011) in order to explain the difference between issuance that dilutes shareholder value, and issuance that accretes shareholder value.

I hope they get it.

I also hope ACAS maintains its issuance discipline in its managed funds. It's been wonderful and I'd rather not see a good thing spoiled.

Understanding ACAS' 2011 Results

Confused by the tax asset impact of Q4? Wondering whether a dividend makes sense, and when we'd see it again?

All this and more on "Understanding American Capital's 2011 Results".

Therein, we see American Capital's real NAV improvement (that is, recognizing that the "tax asset" isn't an income-producing asset and wasn't really even new in 2011 as it resulted from crash-era loss carryforwards), revisit the share buyback, and think about the effect of taxes as ACAS changes between a RIC and a C-corp (and maybe back?). We also weigh the impact of AGNC and MTGE on ACAS' per-share results, and suggest that income investors wanting ACAS' management expertise look to MTGE and AGNC until the tax treatment of potential dividends becomes clear.

Enjoy!

Foolish Return Analysis

A while back, the Jaded Consumer ran an article on The Motley Fool's seemingly opposing investing advice and the dizzying array of stock picks offered in its numerous paid newsletters. In it, The Motley Fool's method of comparing users' stock picks to the S&P 500 index performance was criticized in passing as mishandling dividends. The point of this post is to illustrate that comparisons on The Motley Fool between users' stock picks and the S&P 500 are absolutely rubbish when dividends are involved.

The Motley Fool's method of handling dividends is not to add their return to the capital return. This method would err by ignoring the tax inefficiency of dividends, which are taxed in the year paid while capital gains go untaxed until realized, and err further by utterly ignoring the time value of money – that is, the difference in value of having a dollar of liquid return today versus having it paid to you in three years. Instead, what The Motley Fool claims it does is much worse: it subtracts dividends from users' basis. Confusing things further, The Motley Fool avoids negative basis by applying an undisclosed method to avoid ever hitting zero. According to the site, "The adjustment will be a fractional deduction, and not a flat dollar reduction. This prevents the cost-basis from ever reaching zero." The method also prevents anything like accuracy, or even duplication by third parties.

For purposes of example, and to show the absurdity of The Motley Fool's method by looking at a dividend stock, The Jaded Consumer will look at American Capital Agency Corp. (AGNC), which has been written about here on numerous occasions (mostly because it is managed by ACAS, about which much is also written here).

Let's have a look at a user who picked AGNC as a "buy" at The Motley Fool. The "buy" pick for this user was made on Thursday, September 4, 2008 – a day in which AGNC traded between $18.25 and $18.69. To give The Motley Fool the best possible case of accuracy, we will assume that the user made the pick at the exact time of day needed to nail the day low of $18.25. Given today's closing price of $$28.11, the user would (if the user had made a real buy, and held) enjoy an unrealized (and untaxed!) gain of $9.86 – for a not-too-shabby 54%. (By comparison, the SPDR S&P 500 ETF Trust – designed to mimic the performance of the S&P 500 – which traded at a low of $123.96 on 9/4/08, closed at $129.15 today, thus yielding a rather lower return even after considering several years of its single-digit dividend yield.) Holding for all this time would have entitled a user to some dividends, the history of which is readily available from the NASDAQ web site. Holding from 9/4/08 through the 1/27/2012 payment date would have entitled an investor to a $1.00 dividend, a $1.20 dividend, a dividend of $0.85, a dividend of $1.50, and for the last ten quarters a dividend of $1.40 apiece. This totals $18.55, which (ignoring time-value-of-money considerations) would amount to 101.6% of a the hypothetical $18.25 purchase price. Adding the capital gains and dividend returns would yield at best (ignoring time value of money considerations) a gain of $28.41, or 155.6%.

Yet, the CAPS participant we're looking at, having given the thumbs-up and a 3-year investment horizon to ACAS on 9/4/08, is credited with having already bagged a whopping return of 212.93%, even though the results at The Motley Fool cannot yet reflect the 1/27/2012 dividend (which hasn't yet been paid and won't be owed a shareholder until the ex-dividend date passes):


The real mystery is the purported Start Price. AGNC never traded for $9, ever. And this user's happy return is not really greater than a total return of 300% (yet) as suggested by the 212+% gain claimed at The Motley Fool.

The Motley Fool CAPS system that produces these bogus returns is not the only place one can get confusing results. The Motley Fool has a portfolio-tracker that will help calculate an annualized return that can be compared to that of the S&P, but that tool ignores dividends altogether. An investment in AGNC over the last year doesn't look like it's enjoyed a double-digit return, it looks flat.

For a site dedicated to helping users understand investment returns, The Motley Fool has a few things to straighten out – particularly with respect to making sense of the return obtained from dividend investments.

AGNC Pummeled Today

TheStreet just today published that American Capital Agency Corp (AGNC) fell on high volume, but it doesn't seem to suggest why.

AGNC, which has a history of issuing shares above NAV to increase the equity behind its outstanding shares, announced on 10/26 that it would issue another 37m shares ("approximately" $1B gross proceeds), which comes to "approximately" just north of $27 per share. There's an over-allotment option for an additional 5.55m shares. Presumably, the proceeds received by AGNC net of fees and commissions will be "approximately" $27. The magic number to look at in evaluating this transaction isn't the trading price of the shares, but the net assets per share prior to the transaction. At the end of the third quarter of 2011, that NAV stood at $26.90 per share. Without knowing what "approximately" means, we can't know whether this is NAV-neutral, or actually raises NAV.

The fact that AGNC has maintained NAV despite worries about the twist suggests that its managers at ACAS are doing an appropriate job of managing rate-related risk. Or in the alternative: it suggests that worry about the twist failed to take into consideration the difference between the short-term rates available to financial institutions borrowing against federally-secured financial instruments, and the rates that were available to individual borrowers when they last refinanced their real-estate-backed mortgages. The spread AGNC needs to accomplish its work isn't the spread between 1-week and 10-year Treasuries, but the spread between the rate AGNC can get in the short term and the rate individual borrowers can get on their home loans.

Given the growth of this movement, it's clear the view isn't in favor of rapid decrease of home loans toward 0%. While the spread survives, so too does AGNC's business model.

With NAV seemingly free from dilution risk in the current issuance, and share prices remaining above NAV, AGNC doesn't seem to be moving in response to factors specific to the long-term prospects for the stock. The "issuance at ~$27.03" news is good for a short-term push toward $27.03, but AGNC has historically traded at a premium to NAV and – barring failure to perform in the manner so long justifying the premium – that premium is likely to return.

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.

AGNC's Offering Raises NAV

AGNC's newest offering of 28,000,000 shares has been priced to yield gross proceeds of "approximately $780 million." That means approximately $27.85 per share. Given that the last-reported NAV was $24.24, and the company's shares were just south of 65m outstanding, the issuance should result in a NAV north of $25.

Magic.

This isn't the first time existing shareholders have been blessed with a NAV boost like this. In the last quarter of 2010, the effect of issuance was 97¢ (see p.20 of the 4Q2010 presentation). Holy cow, right?

I think ACAS' management of AGNC has not only been brilliant for ACAS, but a terrific ride for shareholders of AGNC. (I told my mother to buy after the IPO at $20, then again about a year later at $15; the current quarterly dividend of $1.40 is going to do nicely for her as it continues to compound for her tax-deferred on a DRIP in her rollover IRA.)

And what does the issuance do for ACAS? Well, two things. First, 1.25% of $780,000 would be $9.75m in annual fees, but of course the gross proceeds aren't all turning into funds under management; the underwriters are getting paid from that gross. Still, adding a fee income of over $2m/quarter is nothing to sneeze at. It's about 0.7¢ per share per quarter of indefinite income, without requiring ACAS to deploy any more assets. The whole firm just got more valuable.

Dig it?

ACAS is now worth more, and so is AGNC. Who says you can't have a win-win deal on Wall Street?

ACAS Raises Monthly AGNC-based Revenues

ACAS' ability to grow revenue has been evidenced a bit more with its pricing of more AGNC shares earlier this week. AGNC shares were priced at $28, which is a premium to its NAV (which is closer to $23). This drove down AGNC's price from above $29, at least momentarily. You can track it here to see how it plays out over the longer term, but earlier issuances in the lower $20s didn't hold prices down or dilute value: they were at or above NAV and were neutral to accretive.

What's this mean for ACAS? In the immediate term, it means that its client AGNC is set to increase its assets by a net of $625,000,000. Since AGNC pays ACAS 1.25% of its assets as an annual management fee, and pays in monthly installments, this means that ACAS' monthly income is set to increase by over $650,000 (almost $2m/q), and its annual revenue is heading up by $7.8m. Not bad, considering the revenue is likely obtained on the same investment analysis infrastructure, and involves primarily ramping up deal sizes in an existing stream of transactions in a marketplace for government-backed securities that is so liquid that AGNC is able to use derivatives to hedge risk, and use repurchase agreements to finance purchases. Considering that ACAS' 3Q2010 pre-tax NOI was $59m, little projects to increase revenues $2m a quarter without committing any additional capital are pretty nifty. At 341m shares outstanding at the end of Q32010, the ACAS income boost from this issuance amounts to over half a penny a share per quarter in earnings. (The total AGNC management fee is more, and AGNC also pays ACAS dividends on, if I recall, 2.5m shares; the 5.7¢ per share is the impact of just this newest-priced issuance.)

In the long term, this suggests that ACAS' business as an asset manager isn't dead. As the marketplace begins to value asset management better, ACAS' ability to create cash by growing asset pools it doesn't own and which don't create any capital risk to ACAS (other than its risk as an owner of a couple million dividend-paying shares) should make for more ACAS shareholder value. The major placement of ACAS' "funds under management" box on the Q32010 investor fact sheet suggests that ACAS' management is really trying to draw attention to this, too. AGNC may be a nice source of dividends, and covers several salaries at ACAS, but perhaps its true value is to advertise to the world what ACAS can do as an asset manager.

In theory, the AGNC deal signals something else: when ACAS' management is able to show stable dividends, its performance supports a NAV premium. That is, after the liquidity panic and once the markets had begun normalizing, ACAS has been able to issue AGNC shares at and above NAV and AGNC shares have traded at and above NAV. The ability to issue half a billion bucks' worth of shares – and to do so over $4 above NAV – isn't some mystical property of AGNC but is a result of the management team provided by ACAS. Give ACAS a year to be stuck with taxable net income (*sob*) and its BDC obligation to issue dividends of 90% or more of that income will place ACAS back on the radar of dividend stocks (though it'll take a little while for people to view the income stream as stable; cutting the dividend burned people who just earlier the year of the cut had heard management say it never planned issuing a dividend it would have to lower).

So, what dividend will ACAS pay? Hard to say. The NAV of ACAS by that time will likely be different, though how different is still speculative. The number of $0-valued assets that turn out to be valuable will not be infinite. And the recovery (however it happens to materialize) will impact portfolio company revenues, which all turn up on ACAS' consolidated balance sheet. It's still speculative, but consider that ECAS' listed value (the FAS-157-compliant value) on ACAS' SEC filings is about 5/8 of its NAV, and as the market conditions for ACAS' NAV discount evaporation occur so too will conditions affecting the "fair value" and thus NAV discount of ECAS. That's hundreds of millions in assets right there, subjected to a double NAV discount (once in ECAS, then once in ACAS). What return is likely? What value will be "fair" in a year and a half? There's a lot to consider in terms of upside, and the existing NAV discount offers some insurance – particularly in light of the current trend toward increasing NAV. Despite that ACAS has had a wild ride up from its trading price nadir of $0.59 per share, its current price north of $8 leaves it over a dollar is NAV discount.

ACAS' report for the 2010 calendar year will be interesting reading, as it will embrace results from an enormously changing set of circumstances: ACAS entered 2010 in default of all its debt (due not from missed interest payments but to net asset covenant breach) and paying (timely, mind you) default-rate interest on a ten-figure debt, while paying its attorneys and its lenders' attorneys to haggle over ACAS' debt restructuring while maintaining a credible threat of bankruptcy to ensure that negotiations went its way (at a cost of tens of millions of dollars) ... and it exited 2010 with a nine-figure debt that was not in default and which had been lowered in interest rate to the most favorable rate available under its refinanced debt agreements due to prepayments (while ditching its crazy bankruptcy-related and debt-renegotiation-related legal overhead). Looking at the difference between the entry and the exit of 2010 should be quite an eye-opener. The first quarter of 2011 will be the first chance to see a whole quarter of what are presumably "normal" results for the refinanced ACAS.

As long as NAV and NOI continue to trend in the right direction, ACAS' future is headed toward mandatory dividends and toward the re-attraction of those who invest for dividends. Increasing the demand for the shares is a significant part of shucking ACAS' NAV discount, so the dividend issuance, while a drain on cash, is actually a boon to share price. (It's also the price of ACAS' nearly-tax-exempt status.)

My take on ACAS hasn't changed much, just ACAS' position in its turnaround. My lack of posting isn't from lack of interest in ACAS, but from extreme busy-ness in my "real work" that now involves lots of time at a client's site solving problems that don't leave me with the time I once had to think about ACAS as a break from work. I expect continued improvement with ACAS, and I also expect continued improvement in my free time as I transition from my "old work" to the new tasks I'm currently undertaking for my new (4Q2010) client.

Which client may be in a position to offer me a regular job, which could be interesting. Buying health insurance as a self-employed person is an adventure not for the faint of heart.

ACAS: Getting Something For Nothing

At the end of last year, ACAS' equity investment in Roadrunner Transportation Systems Inc. had a FAS-157-compliant "fair value" of $0. Shares of the company are being priced from $14 to $16 in a New York Stock Exchange IPO described in a recent SEC filing (this update first provided to the Jaded Consumer by this poster). With a share count of 7,000, this doesn't amount to much for ACAS directly. However, ACAS-managed funds hold over a million shares. Turning $0 assets into hard cash has to be a worthwhile move for ACAS' fee-based asset management service business.

One wonders how many $0 assets on ACAS' books are actually top-tier exchange listings about to happen?

On the debt front, ACAS is slated to be paid $20.5million for subordinated notes which at the end of 2009 had a "fair value" of $17.5m. The 18.5% notes were current at that time. As long as the deal remains pending, ACAS will presumably continue to enjoy the 18.5% interest payable on the $20.2 face value of the notes.

The fact that $0 assets are near-IPO holdings and below-face notes turn out to be about to be repaid early makes one wonder what ACAS' portfolio holds that the street doesn't know and can't price into the shares.

In other news, ACAS' publicly-traded REIT AGNC is issuing 6m new shares at $25.75, with an additional possible 900,000 shares available to cover over-allotments. Given AGNC's end-of-quarter net assets of $22.91 per share, the sale is accretive to shareholder value: AGNC can do the same deals with the same leverage strategy, but bigger – and with more money per share for revenue generation. This is a big win, because it is not only accretive to book value, but grows AGNC by more than 50%. The transaction, which is expected to close May 19, 2010, will net AGNC approximately $147m. On ACAS' management fee of 1.25% of net assets annually, payable monthly, this means ACAS' fee income has gone up overnight by $153,000 per month in cash, or $1.8375 million per year. (Getting the exact number of shares over time requires looking at each quarterly report, because AGNC has instituted a DRIP and realizes above-book sales of newly-issued shares at each dividend payment. Last quarter, that new DRIP equity totaled $62m.) Making larger transactions on the same overhead makes good sense for ACAS, and improves the net it keeps of its gross fee income.

AGNC offers a quick overview of its business, showing how it obtains its interest rate spread and explaining how much leverage it uses to obtain its results. ACAS' ability to grow its managed funds with AGNC's issuance, DRIP, and subsequent offerings shows ACAS still has some managed-funds business capability. ACAS' 2.5m shares of AGNC ensure AGNC owners that ACAS is taking the owners' interest seriously, as well. Making a percentage from someone else's equity is great, but making huge ROE on your own equity is a thing of beauty.

Let's hope for more $0 that turns out to be valuable :)

On AGNC's Dividend

An article recently suggested that AGNC's dividends were doomed because they were supported in part with capital gains. Since my own exposure to AGNC is modest, I'm not particularly keen to debate the merits of the prediction that AGNC's dividend might fall. A reader asked what The Jaded Consumer had to say on AGNC's dividend, so here it is: I don't know.

AGNC is capable of working with 10x leverage without violating its governing documents. Like a bank, AGNC makes money on interest spreads (the interest earned less the cost of borrowing, as multiplied by leverage). To ask whether AGNC can keep up its dividend is to ask whether AGNC can borrow more cheaply than it lends to such an extent that income stays up. AGNC has demonstrated creativity, though: when volatility went through the roof last year, AGNC shed leverage for protection and lost the ability to make money from multiplied interest spreads (at the end of 2008, leverage was 5.2x) -- but earned money from the volatility due to options activity (in effect, covered calls). Creative approaches to financial management in the face of changing conditions has enabled AGNC to earn money at a much better rate than onlookers might have guessed on the basis of interest rate spreads alone.

I don't dare predict AGNC's dividends -- any more than I'd try to predict specific interest rate spreads or prudent leverage levels -- but I offer the quality of AGNC's management (rented from ACAS), as evidenced over AGNC's history, as a counter-argument to the thesis that some particular indicator (like the appearance of capital gain in AGNC's income) proves that AGNC's dividend is doomed. Sure, capital gain in fixed instruments may be cyclical and therefore doomed to a finite life, but this doesn't mean AGNC can't make money in other ways. With government stepping in to guarantee the obligations of Fannie and Freddie (for example), increasing leverage beyond last year's levels may be more sensible.

Let's have a look at ACAS' management of AGNC, though: ACAS, like many other shareholders, have very much wanted high current dividends during the liquidity crisis of the last year. ACAS has benefited from AGNC-created liquidity, and if the train slows down for cyclical reasons it's of little harm to ACAS. My real question is whether AGNC can raise more capital at its current above-IPO prices. ACAS benefits from capital increase because its management fee is based on the size of funds under management. However, ACAS seems to make quite a bit more at the moment as a shareholder than as a manager.

(To those who worry about AGNC holding ARM-based assets: imagine AGNC holding fixed-mortgage assets in a climate of increasing interest rates, and ask whether holding ARMs is risky or is a hedge. Frankly, I believe home mortgage interest rates are already increasing and that having begun moving from fixed-rate holdings early in the year is a Good Thing™.)

The fact that ACAS has been able to generate outsized returns from AGNC could be dismissed as some kind of fluke, but I doubt success entirely an accident. ACAS may not be able to replicate indefinitely the crazy returns it's produced to date from AGNC, but this doesn't mean that market-beating returns are dead. The fact that AGNC's investment mandate has such rigid restrictions -- it's a REIT, for example, and invests in agency-backed mortgages (and obligations comprised of such mortgages) -- means that it will be subject to a host of limitations peculiar to those investments, constraining what ACAS can do to wring profit from it. However, creativity demonstrated thus far suggests ACAS can do quite a bit with AGNC under various conditions to create value. The only question is whether the value ACAS can wring from AGNC has peaked. Since the performance of agency backed mortgage investments isn't stable over time I'd expect ACAS to derive an unstable benefit from AGNC even if it continued to produce market-beating returns.

So, has the dividend peaked? Who knows. The question is whether market-beating returns have ceased, and the answer there is maybe not. And let's assume for a moment that the day comes that an investor becomes convinced the dividend must be decreased. Is this a reason to bail from AGNC? Only if you have someplace even more market-beating to put your money.

ACAS Raises More Cash

A recent comment asked for the Jaded Consumer's take on ACAS selling AGNC shares to Deutche Bank. Previously, not selling AGNC shares was defended here on the ground that if ACAS didn't need a one-time liquidity boost, and AGNC was producing a nice return for ACAS. Following the sale of 2.5 million shares to Deutche Bank, ACAS will retain 2.5 million of the 5.0 million it bought when AGNC was first capitalized. ACAS won't have entirely liquidated, but it will have sold some.

The first thing to ask is: what does ACAS get from the sale? No price was mentioned, but AGNC's basis in the shares was $20, the sale occurred at a time AGNC traded over $22, and the sale caused a price dip (the prior day's peak was over $23, but on the day the sale was announced it dipped below $22) that left the price above $21, so it's likely ACAS got at least its capital back out of the sale ($20). Given that two and a half million times $20 is $50m, it seems ACAS likely raised about $50m -- maybe a bit more if the private placement price was something close to market value instead of being discounted. Given ACAS' credit situation, it's quite possible selling AGNC to a major bank at a discount might be part of some larger transaction.

What does the sale mean?

• Institutional interest exists, at least near the size of $50m chunks, for ACAS' funds management
• ACAS can raise something like $50m again if it needs to (assuming AGNC's price keeps up) because ACAS has another 2.5m shares of AGNC -- and still keep receiving monthly managment fees in cash based on the whole of AGNC
  
• Institutional appetite for millions of shares of AGNC can also support subsequent offerings of new AGNC shares, increasing ACAS' funds under management and elevating its monthly management fee cash receipts

Additional new shares' issuance would be good for AGNC's liquidity and maybe its trading volume, which could help ACAS either to acquire meaningful positions when AGNC trades below NAV or to liquidate positions when significantly above NAV. Maybe the next time a big buyer appears, ACAS can have AGNC print the shares. On the other hand, if ACAS really needs cash ....

In the meantime, what can ACAS do with the money? ACAS is looking at an upcoming debt retirement, and another $50m won't hurt. ACAS also has distressed opportunities to pursue, and to the extent ACAS has the cash, there's no reason ACAS shouldn't make good deals. Deals entered at current (depressed) multiples will be great to exit down the road when multiples are higher.

The fact that ACAS had a strong reason not to sell AGNC last year doesn't mean that selling to meet a liquidity need -- a debt maturity -- isn't a good idea now. ACAS makes more on dividends from AGNC than it makes on management fees (a reason others should be happy to own it), but the benefit of retiring debt in an economic environment like this -- while ACAS is in default of debt covenants and needs both to fix its debt-to-equity ratio and to eliminate debt overhead.

The AGNC sale is positive in that it demonstrates ACAS has valuable assets, and that there is genuine appetite by real buyers to pay cash for those assets. Because AGNC is an ACAS-managed fund, it is also a vote of confidence in ACAS' forward management. Both things are good to see from a large bank with strong incentives to do due diligence on $50m investments.

AGNC Says Borrowing Getting Cheaper

AGNC recently declared its fourth consecutive dividend (the first of which was a partial-quarter result), while explaining that its cost of leverage has decreased -- suggesting a good future in its leveraged agency-backed portfolio of mortgage assets. AGNC's ACAS-supplied Chief Investment Officer stated this:

We've been able to take advantage of favorable market conditions to diversify away from 100% fixed rate MBS and construct a portfolio that we believe will better position us for today's dynamic market environment. As part of the portfolio adjustments, we were able to generate modest realized gains in the quarter to date.
-- Gary Kain

In other words, the portfolio now includes call options the company has written against its government-backed assets, and whenever AGNC gets called it realizes gains (else, it is not called and realizes the options premium). It's possible this effort to "diversify" means something else, but I haven't heard what that might be, so I conclude it's a signal that the success in the second half of last year to realize options premiums on respected portfolio content is continuing to be successful as the market remains concerned about asset quality and AGNC's government-backed portfolio continues to appear attractive to other investors.

I've heard complaints that AGNC's 1Q2009 85¢ dividend represents a "cut". Maybe, maybe not. First, although as a REIT AGNC must pay over 90% of earnings as dividends, AGNC need do this on an annual basis (and, like ACAS, is not obliged to do it on a quarterly basis). Keeping some retained earnings (we'll know more about whether this is the case when we see the 10-Q) is a much cheaper source of investment capital during the year than is borrowing the money (particularly during a credit crunch), and so long as AGNC is making a good return on its NAV, I'd as soon allow AGNC to retain realized earnings as long as it's allowed. Secondly, AGNC didn't have a 1Q2008 dividend to which to compare the recently-announced 1Q2009 85¢ dividend. The 2Q2009 dividend will be compared to a 31¢ partial-quarter dividend in 2Q2008, making comparison difficult. It's my hope that AGNC retains more of what it's allowed (to the extent it can still do so without paying taxes) so that we get the best return on AGNC-held funds.

I think the 4Q2008 dividend was likely a symptom of everyone wanting cash (you, me, and ACAS) during the panic, and AGNC's management consequently paying everything it was allowed to pay (or near it). Now that the panic is subsiding, I think retaining earnings is the more high-yield course for AGNC's shareholders and I applaud it. The news about improved leverage costs and the suggestion that additional business has longevity are all good data to hear.

I'm unsurprised that AGNC's shares are up 25¢ on the news.

I just wish I'd bought again when AGNC dipped below $15 in January ....

AGNC: High-Yield Income For Market Bears

After releasing its 3Q2008 quarterly results, and fielding questions in a conference call with analysts, American Capital Agency (AGNC) is now trading above net asset value. As described before, AGNC is a REIT that owns no real estate. AGNC, rather, makes money investing in government-backed home mortgage instruments. The relatively modest rates paid on home morgages doesn't support outsized returns without leverage; AGNC's portfolio being comprised solely of high-quality agency-backed securities, it is capable of supporting enough leverage that even modest spreads support high net returns. However, management made clear in the call that the industry is in "the midst of what we would call a 'deleveraging vortex'" and that a REIT levered 15x will look in this environment as overleveraged as a REIT levered 25x in prior days.

In order to get ahead of this delevering curve, AGNC has delevered.

During the third quarter, AGNC reduced its debt:equity ratio from 8.3:1 to 5.4:1, selectively reducing borrowings under agreements whose terms management thought least favorable. Since revenues from holding debt are a function of leverage and rate spreads, one reasonably asks whether AGNC's income will be torpedoed by its relatively conservative leverage. Volatility may make a high debt:equity ratio dangerous, but it creates other opportunities.

During the last quarter, a dramatic increase in volatility placed AGNC in the happy position to make money selling options. Because AGNC invests only in agency instruments, and not in complex hard-to-value CDOs or the like, the quality and transparency of its holdings enable it to negotiate options agreements with potential buyers. By writing (in effect) covered call options against a few hundred million dollars' worth of the portfolio, AGNC collected substantial premiums (because volatility increases options premiums, and AGNC was selling) with which to protect shareholders against portfolio valuation risk. In the event the options are exercised, AGNC will sell securities for cash at a price above the market value at the time the options were issued. Considering AGNC's view that the market for agency securities remains liquid, and that there are numerous opportunities to be had in a market that has become inefficient (e.g., fifteen and thirty year notes trading at the same price for the same yield), the possibility of becoming a shopper with cash isn't such a bad risk.

There is an annual limit to the fraction of non-real-estate income that a REIT can earn while maintaining its tax status, but management indicated on the call that it was managing options income with that limit in mind. Moreover, AGNC did not anticipate long-term opportunities to use options rather than debt to achieve its desired leverage; management expected to maintain conservative leverage, but to enjoy increased spreads, resulting in adequate returns without the need of leverage levels that seem risky in the current market. AGNC's management observed that federal government intervention has thus far only had the result of widening rate spreads. Consequently, AGNC takes the (pessimistic) view that the mortgage market will continue to suffer. AGNC's strategy to profit from the mortgage market seems to benefit from mispricing, high mortgage interest rates, and other features of an ill home mortgage industry.

AGNC invests in what management described during the call as the highest-quality fixed-income securities in the universe. Following the Freddie/Fannie bailout, all AGNC's investments are in effect agency securities, backed by the United States government for the timely payment of principal and interest.

As foreshadowed in an earlier post here, AGNC intends retaining some earnings (within the REIT distribution limits) in order to moderate volatility in the dividend. AGNC's net asset value has actually increased since June 30, from $17.45 to $17.85. Management stressed that as AGNC grows, its results should improve because many of its material costs are fixed -- accounting, compliance, etc. -- and that its financial tools are intended to handle a much larger portfolio. AGNC's seemingly comprehensible strategy, its government-backed portfolio, and its apparently rosy future have bouyed AGNC's shares above NAV, something that ACAS' other managed but publicly-traded fund (ECAS) hasn't achieved, and something ACAS itself lost within the last few quarters. I imagine AGNC issuing shares to capitalize on dislocations involving investements with a long-term horizon, improving its margins, and enhancing existing shareholders' total returns.

The fact that AGNC is trading above NAV and is cranking out large cash dividends is probably a very good sign for AGNC's manager, ACAS, which holds something near 50% of AGNC's common stock. ACAS' holdings -- 7.5 million shares -- provide both dividend income (on the order of $7.5 million per quarter) and management fees (1.25% of the net asset value, payable in monthly installments, on approximately $265 million would be nearly another million per quarter), and both stand to increase as AGNC grows in value and profitability. The dividends and management fees are slightly above the 4¢ per ACAS share estimated here previously. AGNC's results -- and its premium share price -- imply an understanding of the current market that has not been attributed thus far by the market, in the form of per-share pricing, to ACAS. Part fo the pricing difference is a result of ACAS' increased opacity (investors would have a hard time understanding the hundreds of businesses which drive ACAS' results, and since those companies don't have individually-disclosed financials, investors are left to worry that performance might be silently slipping as the economy is jolted by economic shocks), and part of it is a result of AGNC's simpler-looking investment portfolio (valuing agency-backed mortgages is less uncertain and less speculative than valuing illiquid and more individually distinctive private companies). The issue here is comprehensibility: especially in a market panic, people fear what they do not understand. People have run for the doors in ACAS, and it won't be clear until November 10 whether fear led to safety or to abandonment of a good investment. The repeatedly-recurring allegation that ACAS' numbers result from fictitious accounting should tend to lose credence as ACAS and its publicly-traded managed funds continue to produce taxable income and continue to pay outstanding dividends.

As in ACAS conference calls, passing emergency vehicle sirens could be heard intermittently in the background. I wonder if management is saving rent money by buying in a bad neighborhood, or if the ACAS offices are simply near a hospital. Malon Wilkus appeared briefly on the call with a prepared statement, but the water was clearly being carried by specialists in mortgage instruments and not Mr. Wilkus. Mr. Wilkus' statement was fairly generic:

Despite the turmoil experienced in the financial markets during the third quarter of 2008, AGNC was able to navigate the market and deliver strong results to our shareholders. Our relative value approach to investing in agency securities and prudent management of our balance sheet has allowed us to produce excellent results for our shareholders while reducing our overall leverage.
--Malon Wilkus, Oct. 29, 2008

By contrast, some detail was offered by AGNC's Chief Investment Officer Russ Jeffrey:

Given the turmoil within the financial system in the third quarter of 2008, AGNC felt it was prudent to proactively manage our balance sheet through opportunistic sales of agency securities, which lowered our leverage ratio to 5.4 times. Market volatility created the opportunity for AGNC to develop and execute an option strategy, which was accretive to both ROE and earnings per share while allowing us to further reduce our risk profile. Overall, we remain optimistic about our ability to navigate these markets while delivering an appropriate risk- adjusted return for our shareholders.
-- Russ Jeffrey, Oct. 29, 2008

The specific solution utilized by AGNC to create value during the recent volatility -- options -- would not have been available to AGNC were its portfolio comprised of less liquid investments, and it is almost certainly not the solution ACAS could itself have used. ACAS' individual vestments -- debt and equity interests in privately held companies -- are not liquid. However, ACAS has a portfolio of nearly three hundred companies, and at the time of the last conference call was in the process of selling twenty-two of them. The question for ACAS is essentially whether its ability to achieve exits in a challenging environment is as solid as management seemed confident in August; other sources of liquidity seem unlikely to bear fruit for ACAS in this environment. On November 10, we'll know.

As for ACAS' managed company AGNC, the result is in: deft leverage management and successful underwriting has allowed ACAS to achieve a solid result in crazy times. The market's answer is clear: AGNC is worth more than the sum of its assets. AGNC's opportunities seem especially rosy as credit dislocations and market mispricing continue to create opportunities to identify solid values. The solidity of these values isn't based solely on federal guarantees, but careful underwriting and financial modeling that so far have played out quite well.

AGNC's First Full Quarter Conference Call Scheduled

For those of you keen to learn about American Capital Agency's first full quarter -- and what a quarter for that to be, eh? -- it's been scheduled for October 29. Investors can follow it live at the AGNC web site.

During the last ACAS conference call -- that is, the conference call of the company managing AGNC -- managers indicated that AGNC was at that time providing the exact performance anticipated, yielding a return on equity north of 25%. I'm intereste to see what the recent market dislocations has wrought, and how interest rate spread changes are expected to impact AGNC's profits. Unless the spreads narrow, AGNC's government-guaranteed underlying investments should put it into a position to continue performing. The question is, how long as AGNC got under its current borrowing arrangements. Currently, AGNC is producing pretty good income for itself and for shareholders.

Since AGNC gets monthly payments of not only interest but principal and prepayments, AGNC is in a position to regularly recycle capital back into its business as the illiquidity problems make it difficult to market securitized home mortgage products. One advantage of easily-timed liquidity is that an illiquidity crisis seems easily avoided. Additionally, AGNC's ability to reinvest at current rates presumably will enable increasingly superior investment entries as the economy worsens, as instrument pricing will deteriorate (and reinvestment opportunities will improve) with confidence losses at a rate faster than the deterioration of instrument performance. In light of the govenment guarantees behind AGNC's underlying investments, this last point is more than a speculative bet.

The fact that the government-backed guarantors of AGNC's investments have recruited from the board of AGNC's manager ACAS to find a new Chairman of the Board of Freddie Mac suggests that AGNC's manager is a fairly good place to find expertise in the field in which AGNC invests. In an era in which knowledge is golden, ACAS may well be a gold mine -- and AGNC a well-positioned prospector.

American Capital Agency: Really Making Money

Jaded Consumer predicted of American Capital Agency (AGNC), following the 31¢ dividend it paid on the 27-day stub second quarter in which it initiated operations, that its full-quarter dividend looked set to exceed 90¢. Today, AGNC announced a quarterly dividend of $1.00 per share for its first full quarter of operations. At AGNC's IPO price of $20, this would yield an annual dividend return of 20% -- but AGNC hasn't closed at 20 since Monday, September 8. AGNC is likely to continue to exceed a 20% return even if it trades marginally above NAV.

AGNC's performance continues to be understated at Yahoo because it hasn't got twelve trailing months of performance, so AGNC's partial-year results are given as full-year results. The sale on AGNC should continue while AGNC continues to fly under the radar of investors using screening tools that aren't smart enough to notice AGNC's annualized results.

Whether AGNC remains mispriced after that is another question entirely.

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.

Making Money The Old Fashioned Way with AGNC

[Seeking Alpha made this an Editor's Pick. Enjoy!]

American Capital Agency (AGNC) is a REIT that doesn't actually own any real estate. Although it enjoys favorable tax status so long as it pays sufficient profits as dividends, its investment portfolio exclusively contains agency-backed home mortgages. Since AGNC first opened for investment this April -- well after the subprime risks were known by ACAS, which supplies AGNC's management -- AGNC isn't sitting on a subprime time bomb, but acquired its assets with its management firm's full understanding of the type of market in which it was initiating its investments.

AGNC previously declared a 31¢ per share dividend for 2Q2008, a "stub" quarter in which it was invested only 27 days. Familiar with ACAS' dividend payment practices (remember, AGNC hasn't any employees, and obtains all its management from ACAS in exchange for a management fee), The Jaded Consumer confidently declared on the basis of the 31¢ dividend that AGNC had earned at least 31¢ in distributable profit. To drive home the kind of success AGNC is having, it seemed appropriate to report here for emphasis the extent of AGNC's actual profit in the stub quarter.

AGNC's profit from about 27 days' investment proved to be 37¢ per share. That's over a penny and a third per day per share. The annualized profit at that rate would be about $5.00 per share. For a stock trading below $20, that's not too bad, eh?

There's no assurance that AGNC's profits will be identical in every quarter; AGNC receives income, principal, and prepayments of principal, which means that without considering undistributed profit AGNC must routinely enter new investments to keep its capital deployed. Changing market conditions might improve the returns, or impair them. However, that undistributed $0.06 -- earned in less than a month -- definitely can add up. In fact, at that rate, it'd add up to just over $0.81/share in a year.

So, what about AGNC's annualized dividend? Assuming that the first 27 days' payout is about a month's profit, AGNC would have an annualized dividend of something like 3.24. But 27 days is shorter than any month. Looking at the dividend paid as 27/365 of an annual dividend and multiplying to get the whole 365-day dividend, AGNC would pay about $4.19 a share in dividends.

Mind you, I don't know exactly what ACAS will end up achieving for AGNC shareholders with respect to annual returns -- but ACAS has powerful reason to achieve the best there is to have. First, ACAS is a shareholder that wants dividends. Second, ACAS wants to grow its funds management business (and thus the assets in AGNC). AGNC offers shareholders something that most companies can't: assurance about the size of corporate overhead. Since AGNC hasn't any employees, and all its officers are supplied by ACAS in exchange for a known-in-advance management fee, shareholders understand the relationship between gross and net in a way few shareholders can.

AGNC makes money in an old fashioned, unsexy, but reliable way: it helps institutions rent their customers money. Solvent private parties acting to bear nonperformance risk for profit is an old tradition, older than insurance, with roots in capital-intensive international trade. AGNC doesn't need the risk or overhead of retail banking branches to profit from loans, though: ACAS offers AGNC the expertise ACAS' management developed in ACAS' own business. Risk is further reduced by limiting investment to securities backed by a United States government agency like the Government National Mortgage Association or a government-sponsored institution like the Federal National Mortgage Association or the Federal Home Loan Mortgage Association. Given Congress' recent vote to authorize borrowing to fund bailouts of the latter two if need arose, it's reasonable to conclude that the principal in AGNC's investments is secure. (This isn't the same as saying your investment in a publicly-traded security like AGNC is safe, particularly if you don't hold "forever" -- share prices can become irrational even in a business that's executing like a champ.)

The big regret I have about AGNC is not buying even more at $15. But, who knows? With financials continuing to be hated and bad information so easy to find, we could see it again!

Investment Disinformation at Yahoo

Since the report here will change within a quarter, I've made a screen capture to show the kind of information Yahoo offers the unwary investment researcher:


American Capital Agency (AGNC), an American Capital Strategies (ACAS)-managed REIT investing solely in agency-backed home mortgage investments, receives income every month from payments made in connection with the underlying mortgages. Although AGNC pays management fees on a monthly basis, it pays dividends on a quarterly basis. AGNC, which was just launched in April, has had only one quarterly earnings period -- and it was a stub quarter in which it was invested some 27 days. After making 37¢ during the 27-day stub quarter, and paying a 31¢ dividend on that performance, AGNC looks like it's threatening to pay a dividend over $4 per year while reinvesting most of a dollar.

In short, the stock Yahoo lists as paying a dividend of $0.31 (1.6% of the listed price) per year has actually paid, since inception, over a penny and an eighth per share per day after every completed quarter. At that rate, and at the price Yahoo lists, one would peg AGNC as a stock paying a dividend exceeding 22%.

People who don't look closely at the numbers -- in particular, the denominators -- are going to get really poor information at times. People looking only at listings of high-dividend stocks without doing their homework on the likelihood that the stocks' dividends will be maintained.

The warning is this: Yahoo isn't a substitute for due diligence. Yahoo warns people not to base investment decisions on the "information" it prints:

All information provided "as is" for informational purposes only, not intended for trading purposes or advice.
from in the footer of Yahoo's entry on YHOO shares

Yahoo is, according to the same footer, merely parroting the "data" supplied to it by vendors. Yahoo's vendors themselves have better things to do that make sure they warn you when the amount of time involved isn't divisible into quarters (much less provide an adjusted calculation), or put an asterisk next to impressive dividend information to warn you the company has announced dividend cuts.

It's a pity that better information isn't as easily retrieved as at Yahoo, or at least better warnings for consumers about the limitations of particular pieces of information. There is an upside, though: the world is full of folks who aren't doing much homework, and are making stupid decisions that occasionally create serious deals.

When you find a company whose management and business you can really believe in, keep an eye out for bargains.