The brunt of the COVID-19 financial crisis has largely been borne by mortgage real estate investment trusts (REITs), which use borrowed money and purchase a portfolio of mortgage-backed securities. No stock has managed to escape the carnage. On April 8, AGNC Investment Corp. (NASDAQ:AGNC) cut its dividend and gave an update on the portfolio.
A dividend cut and a decline in book value
AGNC cut its monthly dividend from $0.16 a share to $0.12 and lowered its book value estimate from $17.66 a share to $13.60 as of the end of March. Since almost all of AGNC's portfolio is in agency paper (that is, guaranteed by the government), this is somewhat surprising. AGNC attributed this to a decline in the value of some of its specified pools, which it believes will reverse over time.
Specified pools are mortgage-backed securities with attributes that make them less likely to prepay. To give two examples: Loans with low balances (say $100,000 or so) are less likely to prepay because the fees involved with refinancing make up a larger percentage of the loan value, which discourages serial refinancings. AGNC also has specified pools with loans originated in New York, where the state charges a 1% tax on all refinance transactions; that also discourages refinancings. The upshot for investors is that they can hang on to their above-market-rate bonds for longer than usual. For example, a specified pool of loans paying 4% might be expected to last six years, while an ordinary MBS paying 4% might last only five. As a result, the value of the mortgage-backed security is generally higher than a similar MBS in the market.
The CARES Act may actually benefit AGNC, albeit in a backhanded way
CEO Gary Kain said AGNC's dividend reduction "provides the company greater flexibility to take advantage of attractive investment opportunities presented by the current environment and to reinvest earnings in excess of our dividend back into our business over time." Kain added that the dislocations in the mortgage market will make the prepayment speeds for these pools materially lower than what otherwise may be expected.
He may be spot-on with his assessment as credit tightens in the mortgage market. JPMorgan Chase just announced that it will no longer originate loans with credit scores under 700 and down payments smaller than 20%, with a few limited exceptions. The CARES Act, which requires servicers to grant forbearance requests to anyone who asks for them, is having the unintended consequence of tightening credit. If refinances fall or get restricted by the market, those specified pools become more valuable.
The safest stock in the sector
Going forward, AGNC intends to use the capital from the reduced dividend to pick up investments at attractive prices. AGNC said in its press release that it was able to retain almost all of its portfolio during the crisis, which most mortgage REITs have not been able to do. Most have been forced to sell assets at fire-sale prices to meet margin calls.
AGNC Investment is trading at a 10% discount to book value, has a 12% dividend yield, and has a catalyst for increasing book value as the primary mortgage market tightens up and expected prepayment speeds fall. AGNC has de minimis credit exposure, except to counterparties. While the pain in the mortgage REIT sector may not be quite over yet, AGNC Investment is the safest stock in the sector.