Wall Street isn't happy with American Capital Agency's (NASDAQ:AGNC) third-quarter results, sending the stock down more than 8% in a single trading day.

Clearly, investors are expressing their dissatisfaction with the earnings report, which many believe will foretell yet another dividend cut.

What's so wrong with American Capital Agency?
There were a number of negative trends in American Capital Agency's report, including:

  • Further erosion in the company's net interest spread which plunged from 1.49% to 1.2% quarter to quarter. The spread is the difference between its borrowing costs and its investment returns.
  • Declining returns on equity from net interest income. This quarter, American Capital Agency posted an annualized net spread income return on equity of 10.31%.
  • The potential for another dividend cut. American Capital Agency earned only $0.58 in income per share from the net interest spread, while paying out a current dividend of $0.80 per share.

Making sense of the third quarter
The third quarter will likely hit all mortgage real estate investment trusts harder than investors expect. Through Sept. 30, mortgage rates soared, pushing down the value of existing mortgage-backed securities and driving down mREIT book values.

During the period, American Capital Agency repositioned its portfolio as expected, but it didn't seem to latch on to higher interest rates. The company increased its investments in 15-year mortgages to 52% of the portfolio from 42% of the portfolio, which reduced its potential spread income.

A chart from the company's presentation shows the portfolio composition changes, which began in the second quarter:

Source: Slide 11 of American Capital Agency's 3rd Quarter Presentation

A quarter for rebuilding
American Capital Agency is doubling down on higher rates. By moving into 15-year mortgages, it can reduce its book value exposure to rising interest rates at the cost of its net interest spread. While that's good for defending book value, it isn't good for protecting the dividend.

At this point, investors should expect yet another cut to American Capital Agency's dividend. Earning just $0.58 per share in net interest income, it will quickly exhaust the remaining $0.57 per share in undistributed earnings in just three quarters, holding all else equal.

However, to management's credit, American Capital Agency now has a portfolio that can sustain an eventual end to the Federal Reserve's quantitative easing.

When the Fed slows or stops purchases of mortgage-backed securities, long-term interest rates will rise while short-term borrowing costs for mREITs should stay flat. The central bank hasn't indicated any interest in allowing the short-term Fed funds rate to rise, which is key to keeping American Capital Agency's borrowing costs lower than its returns on mortgage-backed securities.

American Capital Agency is now in a holding period. All signs point to management's willingness to keep 15-year mortgages at the core of its portfolio and to sacrifice interest income until the Federal Reserve gives the signal it will allow long-term rates to rise. When that happens, American Capital Agency can move back to higher-yielding 30-year assets to capitalize on a bigger net interest spread to protect the $0.80 quarterly dividend.