Seeking Alpha contributor sees no risk with buying AGNC. He is blind.

Seeking Alpha contributor Mike Maher wrote a positive article on American Capital Agency Corp. (AGNC) on June 23rd, 2011.  He claims that each new equity offering is an opportunity to buy AGNC because a month later the stock will have climbed higher above the old price that exisited before the drop.  Where have we heard this before?  Does the phrase “house prices always go up” ring a bell in your mind?  The two year chart of AGNC does conform to Mr. Maher’s observations, but that doesn’t mean that there is no risk of AGNC going down from its current level.  Text from Mr. Maher’s article appear indented below.

Mr. Maher wrote:

Wednesday’s close of trading brings a familiar press release for holders of American Capital Agency (AGNC): news of a secondary offering. The firm originally announced it was selling an additional 36 million shares, with an overallotment option for another 5.4 million shares. Later, AGNC said it had sold 43.2 million shares, raising approximately $1.2 billion. Underwriters have the right to purchase 6.48 million shares to cover overallotments. Proceeds will be used to purchase more securities and for general corporate purchases. Shares are only dropping about 2%, perhaps signaling that the market was expecting another offering.

He got this right, “These massive offerings are the only way the firm can grow rapidly…”  The executives of AGNC are compensated for the amount of equity (book value per share).   All of a sudden the massive equity offerings make sense.  Here is the applicable risk factor from the 2010 annual report.  Read it for yourself.

Our Manager’s management fee is based on the amount of our Equity and is payable regardless of our performance.

Our Manager is entitled to receive a monthly management fee from us that is based on the amount of our Equity (as defined in our management agreement), regardless of the performance of our investment portfolio. For example, we would pay our Manager a management fee for a specific period even if we experienced a net loss during the same period. The amount of the monthly management fee is equal to one twelfth of 1.25% of our Equity and therefore is only increased by increases in our Equity. Increases to our Equity would be primarily from equity offerings, which could result in a conflict of interest between our manager and our stockholders with respect to the timing and terms of our equity offerings. Our Manager’s entitlement to substantial nonperformance-based compensation may reduce its incentive to devote sufficient time and effort to seeking investments that provide attractive risk-adjusted returns for our investment portfolio. This in turn could harm our ability to make distributions to our stockholders and the market price of our common stock.

As I wrote in March, AGNC is making these offerings a habit and this is the 5th offering since last September. The previous article shows each of the earlier offerings has been an opportunity, with shares being higher a month after the news. This offering should prove to be the same. These massive offerings are the only way the firm can grow rapidly and it seems like investors should get used to them. Since shares currently trade above book value, which was last reported as $25.96 at the end of March, it makes sense to use the strong stock price to raise more money and expand the business. The fact that AGNC is able to continually tap the equity markets and still see shares run up to new highs into the dividend is a testament both to the management of the firm and to investors’ interest in the massive dividend, currently at $1.40 per quarter. While it would be nice to see this dividend rising as new shares are offered and the business expands, it’s hard to complain about a 19% yield without sounding greedy. Management has proven itself to be an excellent operator, so I trust in both their ability and their judgment.

AGNC’s book value will crumble when short term interest rates rise faster than long term interest rates.  I have written why interest rates will rise here:

The management of AGNC freely admits that higher interest rates may adversely affect their book value or their net interest income.  They use the weasel word “may” because they think their active management will be able hedge rising interest rate with swaptions and other financial devices.

Because we invest in fixed-rate securities, an increase in interest rates on our borrowings may adversely affect our book value or our net interest income.

Increases in interest rates may negatively affect the market value of our agency securities. Any fixed-rate securities we invest in generally will be more negatively affected by these increases than adjustable-rate securities. In accordance with GAAP, we are required to reduce our stockholders’ equity, or book value, by the amount of any decrease in the fair value of our agency securities that are classified as available-for-sale.  Reductions in stockholders’ equity could decrease the amounts we may borrow to purchase additional agency securities, which may restrict our ability to increase our net income.  Furthermore, if our funding costs are rising while our interest income is fixed, our net interest income will contract and could become negative.

The shares are not dropping as much as they have in the past on the news of the offering, at $28.32 after hours, down $0.50 from the close of trading Wednesday. This makes a quick trade in the name less attractive, since there will be less ground for shares to make up after the offering. Expect heavy volume Thursday, but each of the last four offerings have been opportunities to get into the name at a discount and I see no reason this offering is any different. As long as the dividend is not cut and book value continues to climb, AGNC is a buy and these offerings are opportunities.

Disclosure: I am long AGNC.

True, he sees no reason to not buy AGNC’s recent drop in price.  But I do.  If you want to really understand the risks associated with AGNC and other mortgage REITs, then read some of my past articles on AGNC:

Disclosure: I do not own AGNC.  I don’t plan on owning AGNC because of its potential dividend cut, poor earning power, and weak balance sheet.

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Link to original Seeking Alpha article:

Published in: on June 28, 2011 at 7:03 pm  Leave a Comment  

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