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Over current months, there was a pointy decline throughout monetary markets within the face of rising recession indicators. This development has accelerated in current weeks as practically all belongings, together with shares and bonds, have skilled fast declines. Whereas virtually all fairness sectors have declined, know-how and, extra lately, financials are faring worst.

The housing and mortgage markets are thrilling right this moment since they traversed from a robust growth to a bust over a really brief interval. When the Federal Reserve started to buy mortgage-backed securities two years in the past, mortgage charges declined to excessive lows and triggered the housing market to soar. Conversely, when these purchases ended, mortgage charges soared, inflicting the housing market to gradual. Mortgage lenders, particularly mortgage REITs, are dealing with excessive declines.

A yr in the past, when many have been fawning mortgage REITs for his or her excessive yields, I used to be one of many few analysts to sign the alarm bells. This view is especially associated to agency-oriented mREITs reminiscent of (NASDAQ:AGNC) as detailed in “AGNC: Rising Mortgage Unfold Indicators Hassle For Company REITs.” Most mREITs with important company mortgage-backed-security belongings or “MBS” carry excessive publicity to the “mortgage unfold” or the distinction between a mortgage and Treasury rates of interest. My view on the time was that because the Federal Reserve started to gradual and finish MBS purchases, mortgage charges would spike and trigger the unfold to return to regular ranges, inflicting AGNC’s e-book worth to say no by “20-40%.”

Since then, the mortgage unfold has normalized, and AGNC’s value has declined by 40%. AGNC is now on the finish of my earlier goal vary. Nonetheless, the general state of affairs has shifted as the acute spike in vitality prices and mortgage charges are pushing the economic system right into a recession. Based mostly on an ample provide of current information relating to each banks and the property market, a technical recession is my base case outlook, with a big slowdown not unlikely. Undoubtedly, this makes a troublesome state of affairs worse for AGNC is the mortgage-backed-security market has a behavior of freezing when danger notion rises. In my opinion, this may increasingly doubtlessly trigger AGNC and its friends to expertise a wave of pressured asset gross sales.

AGNC’s NAV Volatility Is Rising With Charges

Like most MBS-oriented mREITs, AGNC’s enterprise mannequin is comparatively easy – purchase low-yielding mortgage-backed securities and amplify their yield through the use of important leverage. As of Q1, the overwhelming majority of AGNC’s portfolio (over 90%) was made up of 30-year fastened residential company mortgage-backed-securities. These are giant swimming pools of conventional long-term fixed-rate mortgages assured by housing businesses reminiscent of Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). Fannie and Freddie make up the distinction if debtors don’t meet funds.

This assure offers company MBS belongings low credit score danger, that means their yields are sometimes not far above that of the U.S. Treasury. Nonetheless, contemplating Fannie and Freddie would not have an awesome monitor document within the occasion of broad housing market declines (see 2008), the distinction in yields between mortgages and Treasuries tends to widen as danger grows. Whereas greater mortgage charges may enhance AGNC’s earnings in the long run, it could additionally trigger its e-book worth to break down within the brief time period because of its 7.8X leverage on tangible web e-book worth. See the shut inverse relationship beneath:

AGNC tangible book value and 30 year mortgage rate - 30 year treasure rate
Knowledge by YCharts

On the finish of the final quarter, AGNC had a tangible e-book worth of $13.21. At the moment, the bottom 30-year fastened mortgage charge was round 4.67%, whereas the 30-year U.S. Treasury charge was 2.44%. The distinction between the 2, the mortgage unfold, was 2.23%. Within the firm’s final quarterly submitting, they reported a mortgage charge unfold sensitivity and rate of interest sensitivity proven beneath:

interest rate sensitivity and spread sensitivity

AGNC Q1 2022 Curiosity Price Sensitivity Tables (AGNC Q1 2022 10-Q)

A 50 bps (half %) rise within the mortgage unfold is predicted to trigger AGNC’s e-book worth to say no by roughly 30%. Notably, the mortgage unfold had widened dramatically by ~30 bps over the week earlier than the tip of Q1 and by ~50 bps from March Fifteenth-Thirty first. Because it might take time for AGNC’s MBS belongings and plenty of rate of interest hedges to re-value, the corporate’s reported e-book worth might not have totally thought-about the current shock.

Nonetheless, as of the final information, the bottom 30-year mortgage charge was a lot greater at 5.23%, with the Treasury charge presently (as of writing) at 3.37%. The unfold between the 2 is barely decrease at 1.86%, doubtlessly benefiting AGNC’s e-book worth. Nonetheless, mortgage charges are printed on a weekly foundation whereas Treasuries are each day, and this week’s large decline within the company MBS ETF (MBB) implies the unfold has risen sharply greater. See beneath:

iShares MBS ETF price and 30 year mortgage rate
Knowledge by YCharts

The mortgage charge information can also be lagging since it’s not primarily based on reside market costs, as is the MBS ETF. Nonetheless, given the connection between the MBS ETF (MBB) and mortgage charges, I estimate this week’s 30-year base mortgage charge is probably going nearer to five.7% right this moment and doubtlessly barely greater. This will increase the estimated unfold to 2.33% (5.7% minus 3.37%). A current survey additionally suggests mortgage charges of round 5.7% to five.8%.

General, there was a slight improve within the MBS unfold from the tip of Q1 to right this moment as of the time of writing. That time is necessary for the reason that market is extraordinarily unstable right this moment, and as each mortgage charges and Treasuries rise, their potential each day change does as nicely. Currently, we’re seeing important fast 15-30 bps rises and declines within the mortgage unfold, which implies that AGNC’s web asset worth is probably going swinging by 5-15% on any given week.

For the reason that finish of Q1, Treasury charges have risen by round 1%, doubtlessly pushing AGNC’s e-book worth round 8% decrease (given its -5.5% B.V. publicity to a 75 bps improve in Treasury charges). However, mortgage spreads are doubtless round 10-20 bps greater than when AGNC valued its portfolio, implying a further ~15% in e-book worth. The mixed 23% anticipated decline brings AGNC’s estimated NAV per share to $10.17 (23% beneath $13.21), virtually precisely the place the inventory is right this moment.

AGNC Greatest Prevented – MBS Liquidity Considerations

Based mostly on my charge estimates, AGNC could also be buying and selling virtually exactly at its present estimated web asset worth per share. The corporate additionally has a 13.5% yield, and so long as Fannie and Freddie can proceed to make ends meet, a few of that earnings ought to stay. After all, AGNC is borrowing below short-term repurchase agreements, which carried a borrowing charge of 0.37% final quarter. Right this moment, after the current Fed hikes, that borrowing charge is round 1.5% to 1.75%, so AGNC’s revenue margins are below stress. Over the approaching months, I count on this issue to lead to a dividend minimize, notably contemplating the Fed funds charge could also be round 3.5% to 4% by year-end.

Contemplating the anticipated decline in AGNC’s revenue margin and its important and rising NAV volatility, I imagine the inventory is finest averted. In 2020, because the spiraling financial outlook led to sharp declines in market liquidity, MBS belongings plummeted in worth. Just about all MBS mREITs are topic to tight covenants because of their excessive leverage, inflicting many to expertise a pointy wave in margin calls throughout March of 2020.

Most mREITs, together with AGNC, have barely decreased leverage ranges, however the potential for a repeat situation appears to be rising by the day. Final week, the MBS market went ‘no-bid’ because the excessive CPI information triggered the market to unwind. Whereas not solely associated, I exploit the floating charge ETF (FLOT) as an indicator of economic market liquidity. That fund has plummeted at a comparatively excessive tempo over the previous week and a half – indicating banks and different giant traders are dashing for liquidity.

In my opinion, this creates a cloth likelihood that the mortgage-backed-securities market might quickly see a bigger shock. In contrast to in 2020, because of inflation, the Federal Reserve will be unable to shortly rush in to save lots of the market. In my opinion, if it weren’t for the Fed’s large $2T MBS shopping for program, most mREITs, together with AGNC, wouldn’t be solvent right this moment. Certainly, such actions from the Fed might have solely delayed the inevitable and even worsened the difficulty by inflicting house costs to inflate artificially (as a result of excessive drop in mortgage charges throughout MBS Q.E.).

General, I’m bearish on AGNC and imagine it’s a very dangerous guess in right this moment’s unstable market. The mortgage unfold is now barely above its long-term ranges, so my bearish thesis on AGNC from final yr has now performed out. If house costs start to tumble (which I count on) as unemployment rises (which it could be), then there will probably be an unlimited potential pressure on these businesses. Current rule adjustments make it so taxpayers can’t simply bail out the businesses. Contemplating they carry ~$6T in obligations with a leverage of 140 to 1. In my opinion, the potential repeat failure of those establishments is probably probably the most outstanding potential damaging catalyst for AGNC, and its peer Annaly (NLY), going ahead.

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