American Capital Agency Corp.: Returning to Normalcy?

American Capital Agency's (NASDAQ: AGNC  ) first quarter earnings should leave shareholders pleased. The company reported comprehensive income of $1.18 per share, easily covering its $0.65 quarterly dividend.

The first quarter of 2014 was one of its best in recent memory. The company benefited from lower volatility in the mortgage markets, which allowed it to recognize gains on its portfolio of mortgage-backed securities.

Here are 3 noteworthy developments in the first quarter:

1. "True" taxable income of $0.76 per share
American Capital Agency reported estimated taxable income of $0.47 per share in the first quarter. However, this number needs adjusting to include the $0.29 in capital gains and dollar roll income that wouldn't appear in taxable income figures, due to previous loss carryforwards.

After adjustments, American Capital Agency would have taxable income of $0.76 per share, again exceeding its $0.65 quarterly dividend. After several dividend cuts, shareholders should be happy to see American Capital Agency once again earning its dividend.

2. Its speculative investments paid off
The fourth quarter conference call revealed American Capital Agency was making a big bet on its peers. The cash flow statement showed $197 million in purchases of other mREITs, which we know now to be Hatteras Financial Corp. (NYSE: HTS  ) , among others.

By the end of the fourth quarter, American Capital Agency had already recognized a gain on its investments in other mREITs, valuing them at $237 million.

This quarter, we find that American Capital Agency's buying spree didn't stop at the end of the fourth quarter. The press release shows $352 million in mortgage REIT equities, on which American Capital Agency recognized $49 million in capital gains and dividends. This is not trivial by any stretch; the gains provided $0.14 per share that can be returned to shareholders, assisting in American Capital Agency's dividend coverage.

3. A healthy income statement
Last quarter, American Capital Agency posted a gain on its hedges, but a loss from other comprehensive income, largely from declines in its portfolio value.

This quarter, however, the opposite proved true. American Capital Agency would lose $378 million on its hedges, but generate $521 million from unrealized gains in its mortgage-backed securities, alongside another $291 million in net interest income.

The extent to which lower forward volatility helped American Capital Agency cannot be overstated. Its first quarter presentation shows that MBSes traded higher in almost every duration and yield available.

It seems backwards that at the same time the Federal Reserve is tapering, the mortgage markets would become less volatile. The Fed is purchasing mortgage-backed securities at a rate of $25 billion per month, down from $40 billion per month last year.

That $15 billion change in monthly demand would be troublesome if it weren't for fewer mortgages hitting the market. The Mortgage Bankers Association estimates have shown a consistent trend in declining originations over the past 6 quarters:

The trade group now estimates that 2014 will bring $1.12 trillion in new originations, down from $1.755 trillion in estimated volume in 2013.

That decline of $635 billion more than offsets the Fed's declining demand for mortgages, suggesting that even if the Fed pulls out of the market entirely, existing buyers -- mREITs, banks, insurance companies, etc. -- can digest volumes at current interest rates.  

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