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Why Interest Rates Will Rise. Why AGNC Will Lose.

Conditions are optimal for American Capital Agency Corp. (AGNC) to produce profits; however, those conditions are temporary.  The people who operate AGNC  are Keynesians.  Some of the senior officers used to work for Fannie Mae and/or Freddie Mac.  You must believe in the Keynesian mantra to work at those two government-sponsored enterprises.  Interest rates will rise and destroy AGNC's profitability.  Read the article from Gary North for a detailed explanation of why interest rates will rise.  This is the Austrian economics perspective.  Ignore it at your own peril if you own AGNC or any other mortgage REIT.

Why Interest Rates Will Rise.

by Gary North

Recently by Gary North: Milton Friedman's Contraption

 

  

The world is on a Keynesian spending spree. Western central banks are inflating as never before in peacetime. Western governments are running massive budget deficits.

The European Union in 1997 established a Stability and Growth Pact, which set guidelines for fiscal policy: an annual deficit of no more than 3% of GDP and a total government-debt-to-GDP ratio of no more than 60%.

The West is far beyond both limits. In a March 20 speech by a senior IMF official, we read the following.

In advanced economies, reducing unemployment is a priority. At the same time, however, public debt is piling up to unprecedented heights, creating worries in many advanced countries about fiscal sustainability. In fact, IMF analysis indicates that advanced economy fiscal deficits will average about 7 percent of GDP in 2011, and the average public debt ratio will exceed 100 percent of GDP for the first time since the end of World War II.

As is increasingly obvious, such a fiscal trend simply is not sustainable. While expansionary fiscal policy actions helped to save the global economy from a far deeper downturn, the fiscal fallout of the crisis must be addressed before it begins to impede the recovery, and to create new risks. The central challenge is to avert a potential future fiscal crisis, while at the same time create jobs and support social cohesion.

He is a standard Keynesian economist. He stated without qualification that "expansionary fiscal policy actions helped to save the global economy from a far deeper downturn." He assumed that his listeners would agree with him. This has been the Keynesian party line ever since 1936. It is not questioned. But now the acceptance of the Keynesian party line has removed all resistance to fiscal deficits on an unprecedented peacetime level.

"The central challenge is to avert a potential future fiscal crisis, while at the same time create jobs and support social cohesion." This is like saying, "Governments need to pursue policies of black and white – no gray." According to Keynesians, the fiscal crisis can be overcome by economic growth. But governments still pursue massive deficits, and central banks inflate. No Keynesian is willing to say, "Enough is enough. The economy is now on a path to self-sustained recovery. It is time to implement an exit strategy for both the deficits and monetary expansion." On the contrary, they call for extending the deficits. They praise the central banks' willingness to buy the IOUs of national governments.

The speaker was straightforward in his assessment of what must be done. The problem is, there is no major political party that will do this.

The immediate fiscal task among the advanced countries is to credibly reduce deficits and debts to sustainable levels, while remaining consistent with achieving the economy's long-term growth potential and reducing unemployment. Achieving the fiscal adjustment alone is no small task: The reduction in advanced economies' cyclically adjusted primary budget balance that will be needed to bring debt ratios back to their pre-crisis levels within the next two decades is very large – averaging around 8 percent of GDP – although there is considerable variation across countries. Large gross financing requirements – averaging over 25 percent of GDP both this year and next – only add to the urgency of creating credible medium-term fiscal adjustment plans.

Urgency? What urgency? There is no sense of urgency. The deficits climb, the debt-to-GDP ratios climb, and politicians show no sign of being willing to reverse this.

Low interest rates have saved Western economies from suffering serious restraints on fiscal policy. This will not last much longer, he thinks.

This combination of rising debt but stable debt service payments is not likely to continue for long, however. Higher deficits and debts – together with normalizing economic growth – sooner or later will lead to higher interest rates. Evidence suggests that an increase in the debt-to-GDP ratio of 10 percentage points is associated with a rise in long-term interest rates of 30 to 50 basis points.

He identified the #1 problem: spiraling costs for government-funded medicine. The problem is, this is politically untouchable. He knows this. He failed to mention it. Instead, he merely described it.

To be credible, any advanced economy fiscal consolidation strategy must deal with the cost of entitlements that are a if not the key driver of long-term spending pressures. Of course, health care-related spending reforms will have to form a central part of any budget strategy. New projections by IMF staff show that for advanced economies, public spending on health care alone is expected to rise on average by 3 percent of GDP over the next two decades. Thus, for any budget consolidation plan to be credible, it must deal with the reality of rising health care costs. Inevitably, successful reforms in this area will include effective spending controls, but also bottom-up reforms that will improve the efficiency of health care provision.

Credibility is as credibility does. Western governments are doing nothing to bring these deficits under control. By this standard, the promises and assurances of politicians in the West are incredible.

This is the elephant in the living room. An IMF official at least mentioned its presence. He of course offered no suggestions as to how the elephant should be removed, or who will attempt to remove it. That is for politicians to decide.

Politicians have decided to let the elephant occupy the living room indefinitely.

Voters are unaware of the problem. They think that this elephant can be dealt with. But elephants must be fed, and their waste must be removed. By whom?

MEDICARE

Medicare for years has been running a deficit. This deficit has been funded by the general fund. The trustees expect this to continue. But they offer hope. The system will not be busted until 2029. By "solvent," they mean that the Trustees will not run out of nonmarketable IOUs to sell back each year from the Treasury, which has to come up with the money to buy these IOUs, year by year.

The trustees also make a major assumption. The legislation of 2010 will reduce Medicare costs, as promised. This was the Patient Protection and Affordable Care Act as amended by the Health Care and Education Reconciliation Act of 2010 (the "Affordable Care Act" or ACA).

Much of the projected improvement in Medicare finances is due to a provision of the ACA that reduces payment updates for most Medicare goods and services other than physicians services and drugs by measured total economy multifactor productivity growth, which is projected to increase at a 1.1 percent annual rate on average. This provision is premised on the assumption that productivity growth in the health care sector can match that in the economy overall, rather than lag behind as has been the case in the past. This report notes that achieving this objective for long periods of time may prove difficult, and will probably require that payment and health care delivery systems be made more efficient than they are currently.

Anyone who believes that passing that law is going to reduce Medicare costs probably also believes that the elephant in the living room will soon go away of his own accord. The trustees know better, so they covered their backsides: "This report notes that achieving this objective for long periods of time may prove difficult." May prove difficult! Indeed!

The handwriting is now on the wall, written in red ink. No one seems to notice. The king does not call for a modern-day Daniel to translate. The message is in a foreign tongue: digits. The king does not call in the accountants to translate, because he knows what they will say. The message is much the same as it was in Daniel's day: MENE, MENE, TEKEL UPHARSIN. TEKEL means the same: "You have been weighed in the balance and found wanting."

Any politician who openly says, "It's time to cut back on Medicare," will find himself out of a job after the next election. The insurance companies welcomed Medicare as a way to get high-risk oldsters off their rolls. They kick you off when you turn 65. They will not pay for anything that Medicare would pay for. You can stay on the rolls by paying high premiums, but you will not be paid.

There is no way to go back. The elephant will remain in the living room. He will grow. He will consume more. The pile of dropping will increase.

Everyone in high places knows how this will end: in default. No one is willing to say the form that the default will take.

Some think it will end in hyperinflation. But that does not end the program. It will still be there on the far side of T-bill repudiation.

Some think it will be the unwillingness of central banks to buy government debt. They will cease inflating That will cause Great Depression 2.

Some think the oldsters will finally be cut off and returned to their children for medical care. At today's Medicare costs, that will be $11,000 per year of added insurance fees, which private companies will refuse to insure for people with existing conditions.

Someone will pay to get the elephant out of the living room. The taxpayers will not bear the costs of Medicare indefinitely.

RE-THINKING KEYNES

John Maynard Keynes wrote in the depths of the worldwide depression. His most famous book was published in 1936: The General Theory of Employment, Interest and Money, soon captured the minds of younger economists. A decade later, Keynes died. At the time of his death, it was clear that his explanation of the Great Depression would become dominant.

In 1948, the first edition Paul Samuelson's Economics textbook appeared. It became the dominant textbook in the West. It was called neo-Keynesian. That is, it was only partially incoherent, unlike Keynes' General Theory, which is totally incoherent. (Skeptics who think I am exaggerating have either never read The General Theory or have spent years reading textbooks to prepare them to believe they understand The General Theory when they read it after they have received their Ph.Ds in economics.)

Keynes' publisher, Macmillan, had published Lionel Robbins' excellent book, The Great Depression, in 1934. It was short, readable, and theoretically accurate. It is online for free here.

In 1937, Macmillan published another book on the causes of the depression, Banking and the Business Cycle, by three economists. It is online for free here.

If these two books had carried the day in the economics profession, the West would be far richer today, if we assume that decisions made by private property owners are more efficient than decisions made by politicians and central bankers, none of whom can be held personally economically accountable for the outcome of their decisions. These two books were coherent, accurate, and committed to the free market. They are forgotten today. Were it not for the Mises Institute's program of online posting and physical reprinting of out-of-print books on free market, they would probably not be available.

The world's economists are allied to the politicians. They defend massive government deficits as necessary to avoid recessions and unemployment. But unemployment is higher than anything since the Great Depression. The policies have clearly failed. Nevertheless, apologists use the familiar argument from counter-factual history: the rate of unemployment would be much higher today if it had not been for the deficits and central bank inflation. This needs to be proven. They do not attempt to prove it.

The Keynesians have been given a free ride by non-Austrian School economists. While economists gripe about this or that minor technical detail about the deficits and the central bank inflation, there is no full-scale critique of these policies by mainstream economists. They have bet the farm on the positive outcome of the policies.

The rise of commodity prices testifies to a growing problem. Price inflation apart from energy and food has remained low. Energy and food prices are dismissed as irrelevant in the medium-term, because they are volatile. They go down, too. But when price categories do not go down, as these two have not ever since late 2008, the statisticians are supposed to incorporate them into their statistical model. Government statisticians are resisting this.

As the rise in prices forces a rise in interest rates, debt will become a major drain in consumer spending. Consumers respond to rising monthly expenditures by cutting back on borrowing. Governments do not. They call on the central bank to intervene and buy bonds with newly created money. This cannot go on much longer. The inflation premium in the bond market will increase.

Government is absorbing the savings of Americans. The sink holes that constitute the Federal government's constituencies will absorb the money that would otherwise have gone to finance businesses. Economic growth will slow. Then it will become contraction.

CONCLUSION

The IMF bureaucrat ended his speech with this.

In sum, there is no doubt that given the evolution of the recovery, countries are grappling with increasingly-complex and increasingly-diverse challenges. This is certainly true of fiscal policy. But to move toward a future of strong, sustainable, and balanced growth, these fiscal challenges need to be addressed urgently. The time for action is now.

Thank you for your attention.

The problem: no one in power is paying attention. The time for action is now, he said. Salaried economists have been saying this for years. But no one takes any action.

Government debts will increase until rates go up. Then lenders will still lend. Private capital will suffer. It will be crowded out at the governments' low rates.

The Federal Reserve System is buying most new Treasury debt today. The monetary base is rising. Monetary inflation is increasing. Price inflation is increasing. This is why interest rates will be going up.

If you are in debt for anything on a floating-rate basis, you are in trouble.

March 24, 2011

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2011 Gary North

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The Party is Almost Over For American Capital Agency Corp.

Mortgage REITs are among the highest dividend yielders. I have been warning for over a quarter about the end of the party for American Capital Agency Corp. (AGNC). Now others are taking notice.

http://www.fool.com/investing/dividends-income/2011/03/24/beginning-of-the-en...

AGNC has been above 100% dividend payout ratio for two quarters now. Others in the industry are beginning to make cuts. It's only a matter of time for AGNC.

There will be an opportunity to buy AGNC after the dividend cut and after the next Federal Reserve induced financial crash.

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Time For a PE Ratio History Lesson.

The S&P 500 index has had quite a run since its March 2009 bottom.  It hit bottom at 666 points on March 9th, 2009 and has powered 94.5% higher to 1,249 today.

http://bit.ly/SP5003yrs

I think it’s time to reexamine the S&P 500 PE ratio.  Are we closer to a market top or a market bottom?  The price to earnings ratio for the S&P 500 is currently 18 (http://www.decisionpoint.com/tac/Swenlin.html ).  It has been around or above 20 since 2003.  I don’t think that the market is anywhere near the value level.

Time for a little price to earnings ratio history lesson.  The following excerpt comes from the book Security Analysis (2nd Edition) pg. 536 and it is enlightening 71 years later.

* * * * * * *

In previous chapters various references have been made to Wall Street’s ideas on the relation of earnings to values.  A given common stock is generally considered to be worth a certain number of times its current earnings.  This number of times, or multiplier, depends partly on the prevailing psychology and partly on the nature and record of the enterprise.  Prior to the 1927-1929 bull market ten times earnings was the accepted standard of measurement.  More accurately speaking, it was the common point of departure for valuing common stocks, so that an issue would have to be considered exceptionally desirable to justify a higher ratio, and conversely.

            Beginning about 1927 the ten-times-earnings standard was superseded by a rather confusing set of new yardsticks.  On the one hand, there was a tendency to value common stocks in general more liberally than before.  This was summarized in a famous dictum of a financial leader implying that good stocks were worth fifteen times their earnings.1  There was also the tendency to make more sweeping distinctions in the valuations of different kinds of common stocks.  Companies in especially favored groups, e.g., public utilities and chain stores, in 1928-1929, sold at a very high multiple of current earnings, say, twenty-five to forty times.  This was true also of the “blue chip” issues, which comprised leading units in miscellaneous fields.  As pointed out before, these generous valuations were based upon the assumed continuance of the upward trend shown over a longer or shorter period in the past.  Subsequent to 1932 there developed a tendency for prices to rule higher in relation to earnings because of the sharp drop in long-term interest rates.

* * * * * * *

This chart confirms that there has been a change in investor valuation of common stocks over the years.  The bottoms of S&P 500 has been rising.  Too bad the chart cuts off in 2003.

Image001

  How low did the S&P 500 P/E ratio fall to during the Panic of 2008-2009?

It didn’t fall during the panic.  On the contrary, it skyrocketed because earnings were falling faster than stock prices.    It has settled in the 18-20 PE range since the end of 2009.  Dividend yields tend to be highest at market bottoms.  The last time the S&P 500 yielded over 6% was in 1982.  We are closer to the top of the market than the bottom.  If you are in the market, then you should make plans to get out before the next financial crisis.

Current price to earnings ratios of stock mentioned often on this blog:

American Capital Agency Corp. (AGNC) – 4.00

SafeBulkers Inc. (SB) – 4.98

SeaDrill (SDRL) – 13.70

Terra Nitrogen (TNH) – 13.51

AGNC and SafeBulkers are high dividend stocks in the value zone, but only SafeBulkers has earning power and a strong balance sheet.

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American Capital Agency Declares $1.40 First Quarter Dividend. Where is the money coming from?

American Capital Agency Corp. (AGNC) just declared another $1.40 quarterly dividend.  Where are they getting the money to cover this dividend?  They are not earning enough income to cover their dividend.  Here is an excerpt of what a wrote after AGNC released 4Q2010 earnings a few weeks ago:

·         American Capital Agency Corp. (AGNC) reports $1.26 net income per share, excluding $1.24 of other income (mostly the sale of agency securities and derivatives paying off).  AGNC’s earning power is less than their dividend payments.

·         They paid a $1.40 dividend for 4Q2010.  Their net income doesn’t cover the dividend.  Dividend payout ratio was 111% excluding the irregular income items.

They can continue issuing new shares to raise capital, but then the total dividend payment is bigger and they would have to lower the dividend rate per share.  This can't go on too many quarters longer.  The stock price is going to tumble when they cut their dividend and the management knows it.  They are kicking the can for as long as they can.

This high dividend stocks does not have enough earning power to sustain a $1.40 per share dividend and it has a weak balance sheet.

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American Capital Agency Declares $1.40 First Quarter Dividend
 
BETHESDA, Md., March 7, 2011 /PRNewswire/ -- American Capital Agency Corp. (Nasdaq: AGNC) ("AGNC" or the "Company") announced today that its Board of Directors has declared a cash dividend of $1.40 per share for the first quarter 2011.  The dividend is payable on April 27, 2011 to common shareholders of record as of March 23, 2011, with an ex-dividend date of March 21, 2011.
 
 

Bad News for Mortgage REIT AGNC. Housing Prices Headed Lower.

The financial press is reporting today that house prices are headed back down following the ill conceived government stimulus known as the “First Time Home Buyer” subsidy.

http://www.reuters.com/article/2011/02/22/us-usa-economy-confidence-idUSTRE71L3XL20110222

I believe these continued adverse developments in the broader residential mortgage market will negatively impact the earnings of high dividend stock American Capital Agency Corp. (AGNC).  The following risk excerpt from AGNC’s 2009 annual report states the risk quite succinctly:

Continued adverse developments in the broader residential mortgage market may adversely affect the value of the agency securities in which we invest.

In 2008 and 2009, the residential mortgage market in the United States experienced a variety of unprecedented difficulties and changed economic conditions, including defaults, credit losses and liquidity concerns. Many of these conditions are expected to continue in 2010. Certain commercial banks, investment banks and insurance companies announced extensive losses from exposure to the residential mortgage market.  These losses reduced financial industry capital, leading to reduced liquidity for some institutions. These factors have impacted investor perception of the risk associated with real estate related assets, including agency securities and other high-quality RMBS assets. As a result, values for RMBS assets, including some agency securities and other AAA-rated RMBS assets, have experienced a certain amount of volatility. Further increased volatility and deterioration in the broader residential mortgage and RMBS markets may adversely affect the

performance and market value of our agency securities.

We invest exclusively in agency securities and rely on our agency securities as collateral for our financings.  Any decline in their value, or perceived market uncertainty about their value, would likely make it difficult for us to obtain financing on favorable terms or at all, or maintain our compliance with terms of any financing arrangements already in place. The agency securities we invest in are classified for accounting purposes as available-for-sale. All assets classified as available-for-sale are reported at fair value, based on market prices from third-party sources, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders’ equity. As a result, a decline in fair values may reduce the book value of our assets.  Moreover, if the decline in fair value of an available-for-sale security is other-than-temporarily impaired, such

decline will reduce earnings. If market conditions result in a decline in the fair value of our agency securities, our financial position and results of operations could be adversely affected.

There really is a double-dip recession.  It never went away.  Federal Reserve counterfeiting and government stimulus just papered over the problems for many months.  The structural problems caused by fractional reserve banking and government deficit spending are not only present, but they have worsened.  Prices must drop to clear markets and to bring supply and demand into balance.

There is a glut of unemployed people, there is a glut of houses, and businesses are not hiring.  These facts are finally imposing reality on some people.  More people will default on their mortgage payments when housing prices decline.  They will join a growing number of strategic defaulters (people who could make their mortgage payments but chose not to).  This occurs because their loans exceed the dollar price of their homes and also due to the resentment against bankers who receive Federal Reserve and US government bailouts.

Look at this chart.  The trend is clearly down.  Keep this in mind as you watch the short video clip at the end of this article.

Image001

[D]ata showed single-family home prices fell in December, bringing them closer to the low seen in 2009.

The S&P/Case Shiller composite index of 20 metropolitan areas declined 0.4 percent in December from November on a seasonally adjusted basis, as expected.

For the year, prices fell 2.4 percent, slightly more than the 2.3 percent decline analysts had forecast.

While the composite held above its 2009 low, 11 cities hit their lowest levels since home prices peaked in 2006 and 2007, the report showed.

Unadjusted for seasonal impact, home prices fell 1 percent for the month, leaving them just 2.3 percent above their April 2009 troughs, S&P said.

VIDEO: House prices drop; Case-Shiller: 10 city index

Robert Shiller, Yale University Professor of [Keynesian] Economics, and David Blitzer, S&P 500 Index Committee chairman, discusses [housing price] declines in the 10 and 20 City Indices.

VIDEO http://on-msn.com/HousingDown

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AGNC Swaptions Explained. Beware of Counterparties.

This is the best explanation that I’ve read about American Capital Agency Corp’s (AGNC) swaptions.  They are important because AGNC made a chunk of their 4Q2010 earnings on swaptions.  The rest of the article lavished AGNC with praise.  I believe that AGNC will lose its ability to pay its hefty dividend when the next financial crisis hits.

Here is one definition of a swaption I found using the Google search term “define: swaption”

A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps.
en.wikipedia.org/wiki/Swaption

“American Capital Agency’s fourth quarter results were positively affected by non-recurring net realized and unrealized gains on its derivative instruments, and net realized gains on available-for-sale securities. The derivative instruments, such as to-be-announced (TBA) mortgage short positions and payer swaptions, are primarily utilized by the company to hedge increases in interest rates.”

The Wikipedia entry explains that there is counterparty risk to each swaption.  Keep counterparty risk in mind when you read about how AGNC made money in 4Q2010.  AGNC doesn’t disclose which banks it enters into swaptions contracts with.  Imagine what would have happened if they entered into swaption with AIG.  That would simply be trading interest rate risk with counterparty risk.

From the Wikipedia entry: “The swaption market is over-the-counter (OTC), i.e., not traded on any exchange. Legally, a swaption is an agreement between the two counterparties to exchange the required payments. The counterparties are exposed to each others' failure to make scheduled payments on the underlying swap, although this exposure is typically mitigated through the use of "collateral agreements" whereby margin is posted to cover the anticipated future exposure.”

“A payer swaption is a tool to enter into an interest rate swap where the buyer pays fixed rate and receives floating, thereby benefiting from interest rate rises. The initial cost of the swaption comes in the form of a premium, and this is the maximum amount the buyer can lose.”

“The participants in the swaption market are primarily large corporations, banks, financial institutions and hedge funds, who typically utilize swaptions to manage interest rate risk arising from their financing arrangements.”

“Agency lenders such as American Capital, which holds a mortgage portfolio, purchases payer swaptions to protect against lower interest rates that might lead to early prepayment of the mortgages. This measure ultimately facilitates the company to continue making money by collecting premium.”

Here is the link to the original article: http://www.dailymarkets.com/stock/2011/02/14/american-capital-agency-4q-rocks/

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AGNC reports $1.26 per share in net income in really small print. The headline was $2.50 per share net income

If you just read the earnings headline, then you are missing the whole story.  Here are a few noteworthy line in the AGNC press release:

·         American Capital Agency Corp. (AGNC) reports $1.26 net income per share, excluding $1.24 of other income (mostly the sale of agency securities and derivatives paying off).  AGNC’s earning power is less than their dividend payments.

·         They paid a $1.40 dividend for 4Q2010.  Their net income doesn’t cover the dividend.  Dividend payout ratio was 111% excluding the irregular income items.

·         Leverage increasing in the quarter.  Leverage for the year equaled 7.8x; leverage for the quarter 8.4x.  AGNC, like all banks, are borrowed short and lent long.  They have a horrible balance sheet.

·         “As of December 31st, 2010, the Company had repurchase agreements with 22 financial institutions.”  They are 22 financial institutions away from a debt rollover problem.  Their current liabilities (repurchase agreements) dwarf their current assets.  That creates a weak balance sheet dependent on other institutions.

Delusional quote from the company’s chief investment officer, Gary Kain:

            “As we look ahead,” continued Mr. Kain, “we believe that the economic and competitive landscape is very favorable for our industry.  The changes we are witnessing at the GSE’s, coupled with the prepayment environment that is likely to be more benign, should provide for an attractive backdrop for mortgage investors.  When you combine this with a very steep yield curve, and a Federal Reserve that is likely to keep short term funding rates low for an extended period of time, we continue to remain optimistic.”

The yield curve will not remain steep with short term rates low and longer term rates much higher.  The front end (the short term) rates will rise and eventually it will invert.  Inverted yield curves occur when short term rates are higher than long term rates.  An inverted yield curve usually signals a recession is coming.  In our case it will be the double-dip recession.  Ben Bernanke said that QE2 would  lower mid-term interest rates.  The opposite is happening.

Conclusion: AGNC lacks earning power and a strong balance sheet.  Mr. Kain is a delusional Keynesian.  He will be speaking on February 10th, 2011.  You can see so for yourself.

American Capital Agency Corp. (Nasdaq: AGNC) ("AGNC" or the "Company") announced today that Gary Kain, Chief Investment Officer, is scheduled to make a presentation at the Credit Suisse 12th Annual Financial Services Forum on Thursday, February 10, 2011 in Miami, FL. The AGNC presentation is scheduled to begin at 2:45pm ET. The presentation will be webcast live and archived for 90 days on the AGNC website at http://ir.agnc.com.

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Here is the press release from AGNC: http://bit.ly/AGNC_4Q2010_earnings

American Capital Agency Reports $2.50 Earnings Per Share and $24.24 Book Value Per Share

 

BETHESDA, Md., Feb. 8, 2011 /PRNewswire/ -- American Capital Agency Corp. ("AGNC" or the "Company") (Nasdaq: AGNC) today reported net income for the fourth quarter of 2010 of $138.1 million, or $2.50 per share, and book value of $24.24 per share.

FOURTH QUARTER 2010 FINANCIAL HIGHLIGHTS

·         $2.50 per share of net income

o    $1.26 per share, excluding $1.24 per share of other investment related income and excise tax

·         $1.64 per share of taxable income(1)

·         $1.40 per share fourth quarter dividend paid on January 27, 2011

·         $0.60 per share of undistributed taxable income as of December 31, 2010

o    Undistributed taxable income was $39 million as of December 31, 2010, essentially unchanged from September 30, 2010

·         $24.24 book value per share as of December 31, 2010

o    Increased from $23.43 per share as of September 30, 2010

o    Increased from $23.78 per share, pro forma, as of September 30, 2010 when adjusted for the follow-on equity offering that closed on October 1, 2010

·         42% annualized return on average stockholders' equity ("ROE") for the quarter(2)

OTHER FOURTH QUARTER HIGHLIGHTS

·         $13.5 billion portfolio value as of December 31, 2010

o    18%(3) constant prepayment rate ("CPR") for the fourth quarter of 2010

o    16% CPR in December 2010 (based on data released in January 2011)

·         7.8x(4) leverage as of December 31, 2010

o    8.4x average leverage for the quarter

·         2.58% annualized net interest rate spread for the quarter

·         $354 million of net proceeds raised from follow-on equity offerings during the quarter(5)

o    $227 million raised from a follow-on equity offering that settled on December 14

o    $127 million raised pursuant to a Controlled Equity Offering(SM) Sales Agreement

o    In January 2011 raised an additional $719 million from a subsequent follow-on equity offering

o    All equity raised was accretive to book value

2010 FULL YEAR FINANCIAL HIGHLIGHTS

·         $7.89 per share of net income

o    $4.50 per share, excluding $3.39 per share of other investment related income, amortization expense associated with the termination of interest rate swaps during 2009 and excise tax

o    34% ROE

·         $5.60 per share dividends declared

o    $6.76 per share of taxable income(6)

o    Undistributed taxable income increased from $22 million as of December 31, 2009 to $39 million as of December 31, 2010

·         $1.76 per share or 7.8% increase in book value

o    Increased from $22.48 as of December 31, 2009 to $24.24 per share as of December 31, 2010

·         33% economic return

o    Represents the combination of dividends paid plus book value appreciation over the year

·         29% total return to shareholders

o    Represents the combination of dividends paid or accrued plus share price appreciation over the year

“We are proud of the performance of AGNC in 2010, successfully navigating multiple challenges in our markets,” said Malon Wilkus, Chief Executive Officer of AGNC, “We delivered a 33% economic return to our shareholders in 2010, counting dividends paid plus book value appreciation and a 34% return on equity.  We accomplished this due to the outstanding insights of Gary Kain our Chief Investment Officer and the AGNC team whose focus on relative value within the agency market proved highly successful.  During the year, we also expanded the team, deepening and enhancing our overall capabilities.  We are excited about the opportunity to perform for our shareholders in 2011 and beyond.”

"2010 was an extremely volatile year," said Gary Kain, Chief Investment Officer of AGNC, "where every quarter had significant and unique challenges in the mortgage market.  Despite this difficult backdrop, we were able to produce strong returns for our shareholders each quarter, broaden our shareholder base, and meaningfully grow our company.  We paid $5.60 per share in dividends for the year and grew our book value per share by $1.76 from $22.48 as of December 31, 2009 to $24.24 as of December 31, 2010.  We view the combination of these two metrics as an essential part of shareholder value creation over the long term.  We are proud of these accomplishments and believe that our emphasis on asset selection coupled with our active approach to portfolio management was instrumental to this success."

"As we look ahead," continued Mr. Kain, "we believe that the economic and competitive landscape is very favorable for our industry. The changes we are witnessing at the GSE's, coupled with a prepayment environment that is likely to be more benign, should provide for an attractive backdrop for mortgage investors.  When you combine this with a very steep yield curve, and a Federal Reserve that is likely to keep short term funding rates low for an extended period of time, we continue to remain optimistic."

INVESTMENT PORTFOLIO

As of December 31, 2010, the Company's investment portfolio totaled $13.5 billion of agency securities, at fair value, comprised of $9.1 billion of fixed-rate agency securities, $3.9 billion of adjustable-rate agency securities ("ARMs") and $0.5 billion of collateralized mortgage obligations ("CMOs") backed by fixed and adjustable-rate agency securities(7).  As of December 31, 2010, AGNC's investment portfolio was comprised of 40% </=15-year fixed-rate securities, 6% 20-year fixed-rate securities, 22% 30-year fixed-rate securities(8), 29% adjustable-rate securities and 3% CMOs backed by fixed and adjustable-rate agency securities.  

ASSET YIELDS, COST OF FUNDS AND NET INTEREST RATE SPREAD

During the quarter, the annualized weighted average yield on the Company's average earning assets was 3.48% and its annualized average cost of funds was 0.90%, which resulted in a net interest rate spread of 2.58%, versus the third quarter of 2010 net interest rate spread of 2.21%.  As of December 31, 2010, the weighted average yield on the Company's earning assets was 3.31% and its weighted average cost of funds was 1.03%.  This resulted in a net interest rate spread of 2.28% as of December 31, 2010, an increase of 12 bps from the weighted average net interest rate spread as of September 30, 2010 of 2.16%.  

The weighted average cost basis of the investment portfolio was 104.9% (or 104.5% excluding interest-only strips) as of December 31, 2010. The amortization of premiums (net of any accretion of discounts) on the investment portfolio for the quarter was $33.2 million, or $0.60 per share.  The unamortized net premium as of December 31, 2010 was $626.3 million.

The Company's asset yields benefited from a decline in the Company's projected CPR for the remaining life of its investments and from purchases of higher yielding securities toward the end of the quarter as the Company invested capital from its December capital raise after interest rates increased. Premiums and discounts associated with purchases of agency securities are amortized or accreted into interest income over the estimated life of such securities using the effective yield method. Given the relatively high cost basis of the Company's mortgage assets, slower prepayment projections can have a meaningful positive impact on asset yields.  The Company's projected CPR for the remaining life of its investments as of December 31, 2010 was 12%. This reflects a decrease from 18% as of September 30, 2010.  The decrease in the Company's projected CPR is largely due to increases in interest rates coupled with new purchases of lower coupon securities near the end of the quarter. The actual CPR for the Company's portfolio held in the fourth quarter of 2010 was 18%, an increase from 15% during the third quarter of 2010.  The most recent prepayment speed for the Company's portfolio for the month of January 2011 was 12%.

The cost of funds at the end of the quarter reflects both a higher relative interest rate swap portfolio to borrowings at the end of the quarter compared to the average during the quarter, as well as a temporary increase in repurchase agreement financing rates extending over the end of the year.

LEVERAGE AND HEDGING ACTIVITIES

As of December 31, 2010, the Company's $13.5 billion investment portfolio was financed with $11.7 billion of repurchase agreements, $0.1 billion of other debt(9) and $1.6 billion of equity capital, resulting in a leverage ratio of 7.5x.  When adjusted for the net payable for agency securities not yet settled, the leverage ratio was 7.8x as of December 31, 2010.  Due in part to the equity raise the Company completed towards the end of the fourth quarter, the Company's leverage at the end of the quarter was lower than the average leverage for the quarter of 8.4x.

Of the $11.7 billion borrowed under repurchase agreements as of December 31, 2010, $3.3 billion had original maturities of 30 days or less, $5.7 billion had original maturities greater than 30 days and less than or equal to 60 days, $1.5 billion had original maturities greater than 60 days and less than or equal to 90 days and the remaining $1.2 billion had original maturities of 91 days or more.  As of December 31, 2010, the Company had repurchase agreements with 22 financial institutions.    

The Company's interest rate swap positions as of December 31, 2010 totaled $6.5 billion in notional amount at an average fixed pay rate of 1.61%, a weighted average receive rate of 0.26% and a weighted average maturity of 3.1 years.  During the quarter, the Company increased its swap position by $2.5 billion in conjunction with an increase in the portfolio size.  The new swap agreements entered into during the quarter have an average term of approximately 3.8 years and a weighted average fixed pay rate of 1.35%.

The Company also utilizes swaptions to help mitigate the Company's exposure to larger changes in interest rates.  During the quarter, the Company added $850 million of payer swaptions at a cost of $4.6 million. The Company also had $200 million of payer swaptions from a previous quarter expire during the fourth quarter.  As of December 31, 2010, the Company still had $850 million in payer swaptions outstanding at a market value of $16.8 million.      

As of December 31, 2010, 55% of the Company's repurchase agreement balance and other debt were hedged through interest rate swap agreements. If net unsettled purchases and sales of securities are incorporated, this percentage declines to 53%.  These percentages do not reflect the swaps underlying the swaptions noted above.

OTHER INCOME, NET

During the quarter, the Company produced $68.5 million in other income, net, or $1.24 per share.  Other income is comprised of $10.4 million of net realized gains on sales of agency securities, $20.6 million of net realized gains on derivative and trading securities and $37.5 million of net unrealized gains, including reversals of prior period unrealized gains and losses realized during the current quarter, on derivative and trading securities that are marked-to-market in current income.  

Sales of agency securities during the quarter were largely driven by actions taken by the Company in the ordinary course in response to changing relative values perceived by the Company.  

The net gains (realized and unrealized) on derivative and trading securities generally represent instruments that are used to supplement the Company's interest rate swaps (such as swaptions, short or long positions in "to-be-announced" mortgage securities (TBA's) and short or long positions in treasury securities); however, these are not in hedge relationships for accounting purposes and consequently are accounted for through current income as opposed to shareholders' equity.  The Company uses these supplemental hedges to reduce its exposure to interest rates, which, given the increase in interest rates experienced in December, resulted in the significant net derivative gains discussed above and helped to protect the Company's book value.

TAXABLE INCOME

For the quarter ended December 31, 2010, GAAP income exceeded taxable net income by $0.86 per share.  This was comprised of $0.18 per share of net temporary differences between GAAP and taxable income related to premium amortization and net realized gains, as well as $0.68 per share of net unrealized gains, net of prior period reversals, associated with derivatives marked-to-market in current income for GAAP purposes, but excluded from taxable income until realized or settled.

NET ASSET VALUE

As of December 31, 2010, the Company's net asset value per share was $24.24, or $0.81 higher than the September 30, 2010 net asset value per share of $23.43, or $0.46 higher than pro forma net asset value per share of $23.78, when adjusted for the follow on equity offering that settled on October 1, 2010.  

FOURTH QUARTER 2010 DIVIDEND DECLARATION

On December 17, 2010, the Board of Directors of the Company declared a fourth quarter 2010 dividend of $1.40 per share payable to stockholders of record as of December 31, 2010, which was paid on January 27, 2011. Since its May 2008 initial public offering, the Company has paid or declared a total of $364.0 million in dividends, or $13.26 per share.  After adjusting for the fourth quarter 2010 accrued dividend, the Company had approximately $39 million of undistributed taxable income as of December 31, 2010, essentially unchanged from September 30, 2010. Undistributed taxable income per share as of December 31, 2010 was $0.60 per share.  

The Company has also announced the tax characteristics of its 2010 distributions. The Company's 2010 distributions of $5.60 per share consisted of $4.93 per share of ordinary income and $0.67 per share of long-term capital gains for federal income tax purposes. AGNC stockholders should receive an IRS Form 1099-DIV containing this information from their brokers, transfer agents or other institutions. For additional detail please visit the Company's Investor Relations website at www.AGNC.com.

(1) Based on the weighted average shares outstanding for the quarter.  Please refer to the section on the use of Non-GAAP financial information

(2) Annualized ROE based on net income and average monthly stockholders' equity for the q

These charts show the continuation of the housing crisis. This spells trouble for REITs.

The information in these charts below can't be good for high dividend mortgage REIT stocks like American Capital Agency Corp. (AGNC).  Make sure you read the five important points at the end of the charts.
 
I believe that Fannie Mae, Freddie Mac, and Ginnie Mae pick up the tab (pay off the mortgage) when homeowners with these mortgages walk away from their loans.  This results in an acceleration of prepayments to owners of government backed agency securities like AGNC.  Prepayments can also occur from refinancing.  AGNC does not like prepayments.  It hurts their profits.
 
This excerpt from AGNC's 2009 annual report explains prepayments for those of you who have never heard of them:
 

Agency securities differ from other forms of traditional debt securities, which normally provide for periodic payments of interest in fixed amounts with principal payments at maturity or on specified call dates. Instead, agency securities provide for a monthly payment, which may consist of both interest and principal. In effect, these payments are a “pass-through” of the monthly interest and scheduled and unscheduled principal payments (referred to as “prepayments”) made by the individual borrower on the mortgage loans, net of any fees paid to the issuer, servicer or guarantor of the securities.

 

The investment characteristics of agency securities differ from those of traditional fixed-income securities. The major differences include the payment of interest and principal on the securities on a more frequent schedule, as described above, and the possibility that principal may be prepaid at par at any time due to prepayments on the underlying mortgage loans. These differences can result in significantly greater price and yield volatility than is the case with traditional fixed-income securities.

 

Various factors affect the rate at which mortgage prepayments occur, including changes in the level and directional trends in housing prices, interest rates, general economic conditions, defaults on the underlying mortgages, the age of the mortgage loan, the location of the property and other social and demographic conditions. Generally, prepayments on agency securities increase during periods of falling mortgage interest rates and decrease during periods of rising mortgage interest rates. However, this may not always be the case. We may reinvest principal repayments at a yield that is higher or lower than the yield on the repaid investment, thus affecting our net interest income by altering the average yield on our assets.

 

When interest rates are declining, the value of agency securities with prepayment options may not increase as much as other fixed income securities. The rate of prepayments on underlying mortgages will affect the price and volatility of agency securities and may have the effect of shortening or extending the duration of the security beyond what was anticipated at the time of purchase. When interest rates rise, our holdings of agency securities may experience reduced returns if the owners of the underlying mortgages pay off their mortgages slower than anticipated. This is generally referred to as extension risk. 

New Credit Suisse Recast Chart

 
Credit Suisse has released an updated version of their popular Mortgage Reset & Recast Chart.

Here is the new one:

9085247 New Credit Suisse Recast Chart

Here is last year’s chart:

CreditSuisseResetMarch09 1024x721 New Credit Suisse Recast Chart

And, here is the original:

IMFresets New Credit Suisse Recast Chart

There are some thoughts to consider:

  1. There are about 2.5 years of huge resets and recasting ahead.  Because the foreclosure pipeline is already so backlogged, people who stop making payments during this stretch could easily end up waiting another 1-2 years before their homes are actually foreclosed upon.  Even without all of the foreclosures still to come from unemployment, it is easy to see this foreclosure crisis being with us well into 2014-2015.
  2. Because mortgage interest rates are low, “resets” are less of a problem right now. Today, “recasts” are the real threat.  A recast refers to the changing of payment options for Option-Arm loans.  Many borrowers bought the biggest home they could “afford”, using minimum payments to qualify. When the minimum payment option disappears, their monthly expense will “recast” to a substantially-higher amount, regardless of what interest rates do.
  3. Most Option-Arm loans were concentrated in higher-income areas and generally used to buy more expensive homes.  Banks that are holding lots of these on their books, like Wells Fargo, have been fairly proactive in modifying these loans now, while long term rates are low.  It will be interesting to watch, however, if many of these high-end borrowers will walk away from their mortgages as high-end prices continue to fall.
  4. Though rates are currently low, you can see how sensitive the market would be to rate hikes.  The Fed’s MBS repurchase program, the Euro, Greece, Spain, China’s Treasury holdings…all of these factors will likely weigh on mortgage rates in the coming years and have profound effects on our overall economy.
  5. Note the volume of Agency, Alt-A, and Prime loans that will be resetting over the next few years.  These were generally to more qualified buyers with good credit.  If this crowd begins to feel that walking away from their mortgages is socially acceptable, then the housing market will suffer substantially.

Link to original article: http://bayarearealestatetrends.com/2010/03/new-credit-suisse-recast-chart/

 

Don't believe the REIT dividend stablity hype.

Image002

Don’t believe the hype that REIT’s dividends are any more stable than government bonds.  REITs like American Capital Agency Inc. (AGNC) are benefiting temporarily from abnormally low interest rates caused by massive Federal Reserve money printing.  Interest rates have nowhere to go but upward.  It is just a matter of time until bond investors wake up, smell the smoke, and start running for the exits.  Don’t get trampled.

The market participants can see all the money printing.  They will demand an inflation premium for the bonds they are prepared to purchase.  This means that they demand higher interest rates.  Higher interest rates will squeeze AGNC’s profits.  They will be forced to cut their dividend drastically.  Just understand the risks of owning AGNC shares.  Their dividends are enormous right now.  That is mighty tempting.  Don’t let your AGNC shares exceed 5% of your high dividend stock portfolio.

Subscribe today at www.myhighdividendstocks.com/feed to discover high dividend stocks with earning power and strong balance sheets.  AGNC’s earning power is very precarious.

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SOURCE: The Bedford Report

 

Jan 31, 2011 11:25 ET

REITs Remain the Top Destination for Dividend Investors

The Bedford Report Provides Analyst Research on Annaly Capital & American Capital Agency

NEW YORK, NY--(Marketwire - January 31, 2011) - In the past year Real Estate Investment Trusts (REITs) have been one of the most popular investments in the financial sector. Since the start of 2010, the Vanguard REIT ETF has surged more than 30 percent while the overall financial sector has been relatively neutral. REITs' ability to generate this significant capital appreciation is one of the industry's main allures, as most investors flock to REITs for their hefty dividends and stability. In fact, most of the success of the industry in the last year can be attributed to low interest rates. When interest rates get this low the return on dividends can far exceed that of bonds. The Bedford Report examines the outlook for diversified REITs and provides research reports on Annaly Capital Management, Inc. (NYSE: NLY) and American Capital Agency Corporation (NASDAQ: AGNC). Access to the full company reports can be found at:

www.bedfordreport.com/2011-01-NLY

www.bedfordreport.com/2011-01-AGNC

The Vanguard REIT index had been stagnant for most of January, however it surged last week as investors bought up a number of the fund's top components on speculation of a wave of M&A activity in the industry.

M&A speculation in the REIT sector increased after ProLogis confirmed it is in talks with rival AMB Property about a possible merger. The two industrial REIT giants have a combined market cap of $13.9B, and are considering an "all-stock, at-market transaction, based upon the unaffected trading prices of the two companies' stock prior to media reports of a possible merger."

The Bedford Report releases regular market updates on REITs so investors can stay ahead of the crowd and make the best investment decisions to maximize their returns. Take a few minutes to register with us free at www.bedfordreport.com and get exclusive access to our numerous analyst reports and industry newsletters.

Companies such as American Capital Agency and Annaly earn their money on the spread between low-interest short-term borrowing and purchasing high-interest long-term securities, which leads to solid profits given the current conditions. Federal Reserve Chairman Ben Bernanke says that he is prepared to keep rates in the range of 0 - 0.25 percent for an extended period if the unemployment numbers don't drop significantly.

Solid profits for a REIT keep those dividend payments stable. Presently, American Capital pays an annual dividend of 5.60 for yield of about 19.60%. Annaly, meanwhile, pays an annual dividend of 2.56 for a yield of 14.40%. While high yielding dividend paying stocks are appealing, be forewarned that companies can cut, slash, or suspend dividends at any time, often without notice.

Link to original article: http://www.marketwire.com/press-release/REITs-Remain-the-Top-Destination-for-Dividend-Investors-1387799.htm

AGNC Will Report 4Q2010 Earnings on February 8th

American Capital Agency Corp. (AGNC) will report 4th quarter 2010 earnings after the US markets close on February 8th, 2011. The company said earlier this month that earnings would exceed $1.20 per share. Unnamed analysts expect earnings of $1.29 per share. AGNC also reported that they would pay another dividend of $1.40 per share. Expect a dividend cut in an upcoming quarter because their dividend payout ratio exceeds 100% and has exceeded it for more than one quarter.

I think this confirms the fact that AGNC does not have the earning power to sustain a $1.40 per share dividend. Be sure to subscribe to www.myhighdividendstocks.com/feed to receive more AGNC analysis delivered to your reader once their quarterly report is available.

Disclosure: I don't own AGNC.

Here is the link to the press release: http://finance.yahoo.com/news/AGNC-Will-Report-Q4-2010-prnews-3553937482.html...

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