Mortgage REITs have had a tumultuous year as interest rate volatility has risen dramatically. Mortgage rates have increased from decade lows to decade highs while the Treasury market has faced immense yield curve flattening. Some mortgage REITs have fared better than others. Those with lower leverage or higher-yielding assets have generally outperformed as their interest-rate effect on book value has been lower. Some, such as Orchid Island Capital (ORC), which I recently covered in “Orchid Island Capital: Insolvency Risks Grow As Fed Considers MBS Sales,” have seen substantial losses due to the combination of high leverage and minimal hedging activity.
One interesting and popular mortgage REIT is AGNC Investment Corp. (NASDAQ:AGNC). I was among the few to signal a solid bearish sentiment on the stock last year in “AGNC: Rising Mortgage Spread Signals Trouble For Agency REITs.” More recently, I warned that AGNC might face additional losses if the mortgage-backed security market declines in liquidity. Over the past two months, markets as a whole have rallied from their June lows, and inflation and interest rate sentiment has normalized. However, since the Fed’s Jackson Hole meeting last week, it has become more apparent that the Federal Reserve is likely to take a more aggressive approach to slow inflation. This news has triggered another wave of declines, causing AGNC to fall around ~6-7%.
With agency mortgage-backed-security ETFs such as (MBB) retracing toward June lows, I believe the MBS market may face a stutter in liquidity. While there are no plans to sell bonds outright, the Federal Reserve is planning to accelerate its MBS tapering rate dramatically this month. Additionally, while mortgage rates are much higher, they are not exceptionally high compared to inflation. Overall, I believe this situation points to material risk for AGNC. Though it is better protected than Orchid Island, the company may continue to face losses if MBS spreads widen.
AGNC and MBS Spreads
AGNC is a mortgage REIT that owns agency-backed mortgage-backed securities at moderately high leverage to boost yields. The company owns almost entirely 30-year fixed-rate MBS assets. These assets hypothetically have no credit risk since they are backed by government-sponsored entities such as Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). As we will see, this is a particular risk factor for AGNC, as the poor solvency of these entities may cause the market to question their ability to guarantee mortgages in the event of a widespread property market slowdown.
The chief risk to AGNC today is MBS spreads or the difference between mortgage rates and Treasury bonds. AGNC’s book value declines quite dramatically as the company has no hedge directly against mortgage-backed securities as this figure grows. Unlike more partially-hedged Orchid Island, AGNC does have significant hedges against the Treasury market. Its current sensitivity estimates are shown below:
As you can see, a significant upward move in Treasury rates would only slightly impact AGNC’s book value due to its hedging activity. In my view, this protection is beneficial today since Treasury rates are showing signs of rising, particularly toward the long end of the curve. However, a 50 bps increase in the spread between MBS rates and Treasury rates is expected to lower AGNC’s book value by a significant 31%. Over time, a higher spread will increase AGNC’s cash flow, which will take years, while a spread shock can take days.
MBS spreads are toward the high level of their historical range. The current average 30-year fixed mortgage rate is 2.3% higher than the current 30-year Treasury rate. This level nearly matches the peak spread during the 2008 mortgage market crisis. See below:
On the one hand, this spread level could benefit AGNC if the high historical range indicates a coming reversal. The historical pattern would indicate MBS spreads should contract from today’s level, boosting AGNC’s book value. If the difference were to return to a “normal” level of 1.5% (70 bps lower), AGNC’s book value could quickly rise by 40%+ based on its current sensitivity.
However, we must consider why MBS spreads are as high as they are to determine better if its trend will reverse. Over the past two years, there have been extreme in-flows into the MBS market on behalf of the Federal Reserve and commercial banks. Today, both entities are net sellers of mortgage-backed securities, while there are few buyers. There is no precedent to this extreme situation, meaning MBS spreads could widen more dramatically, given the weakness in MBS demand.
There is a relatively straightforward decline in the MBS ETF MBB following the end of the Fed’s Q.E. and reversal in commercial bank MBS portfolio growth. Additionally, the above chart regarding mortgage spreads uses lagged weekly data and does not show the movement in mortgage rates following the Jackson hole slump. As you can see below, MBB has crashed quite dramatically over the past week, indicating a significant increase in mortgage rates:
While we can not know the specific mortgage spread today, it is likely trending toward the higher end of its recent range. Also, Treasury bonds have sold off, so AGNC’s hedges may provide some protection.
For the spread to continue, there must be a loss of confidence regarding the MBS market. We know the property market is slowing down as home affordability reaches record lows and existing home sales plummet. Unless inflation continues to rise, I expect home prices to decline. Additionally, personal saving rates are faltering as real wages fall, indicating a potential rise in mortgage delinquencies. With a 90X debt-to-equity ratio, I do not believe Freddie Mac can genuinely guarantee a faltering mortgage market. If more market participants share this view, MBS assets may decline much lower as rates adjust to a loss of supposed protection. For now, most do not share this sentiment, but with liquidity faltering, such risks may come to light.
The Bottom Line
If you believe the MBS market is fundamentally sound, then AGNC may not be a bad bet. The stock has a 12% yield, has reduced its leverage, and may see its book value soar if MBS spreads revert toward normal levels. For these reasons, I would no longer bet against AGNC since it has moderate upside potential.
That said, I continue to believe AGNC’s downside risk outweighs this positive potential, given the unprecedented and extreme situation in the mortgage-backed security market. MBS assets will need many billions in monthly in-flows to offset increased balance-sheet run-off from the Fed. Additionally, U.S. commercial banks have become net-sellers of MBS assets.
The U.S. property market is slowing after two stellar years (driven by trillions in Fed MBS purchases), and I highly doubt GSEs can meet obligations in the case of a widespread market slowdown. It is a common misconception that MBS securities (besides Ginnie Mae’s) have no credit risk as the government is under no obligation to save a GSE from default. I also doubt the U.S. government will necessarily bail out these GSEs as they had in 2008, as this action did not fix the mortgage market’s risks but seemingly prolonged (and arguably worsened) them. In my view, this risk is the most significant bearish factor facing AGNC and may cause it to face another wave lower over the coming months.