What Will Happen to American Capital Agency in 2012?

With 2012 just getting started, it's worth it to take a peek at our investments to see what's working and what's not.

That's what we aim to do today, as we pull out the instant replay and consider the year that was at American Capital (NAS: AGNC) .

A few Foolish facts about American Capital

Sources: Yahoo! Finance and S&P Capital IQ.

What's next?
Residential mortgage REITs like American Capital have hit a bonanza over the past few years, as ultra-low interest rates have juiced their yields by pushing down their cost of capital.

But low interest rates also make mortgage refinancing more attractive for borrowers. REITs generally don't like it when homeowners prepay their mortgages, because it reduces the income they can collect.

So far, prepayment hasn't been a major issue for the housing industry, as refinancing levels have remained relatively subdued despite low rates, since banks have been reluctant to make new loans. However, all that might be changing as the Department of Housing and the Fed have been taking steps recently to help households reduce their debt and cultivate the nascent economic recovery.

You can get a decent sense of how risky a mortgage REIT portfolio is by looking at what proportion of its mortgage-backed securities is guaranteed by government agencies. Generally speaking, the lower the number, the riskier and more creative management is being in its portfolio selection.

Source: Yahoo! Finance and S&P Capital IQ as of most recent quarterly data.

Like Annaly and Armour, American Capital Agency buys Fannie- and Freddie-guaranteed securities that tend to have low prepayment speeds -- but also lower yields. Naturally, reforms encouraging refinancing would hit them the hardest.

Chimera and Invesco have more open mandates to buy non-agency, commercial, and other riskier securities in addition to the agency-guaranteed ones their peers buy. Since their portfolios could theoretically turn on a dime, I provided ranges for their prepayment speeds.

Many REITs have reassured investors that the most recent Department of Housing changes won't have a huge affect on their business, citing statistics on the relatively tiny portion of their portfolio that is exposed to the rule change. However, it's important to remember that with household debt and slow refinancing being two of the biggest drags on the economy, we could see further changes. American Capital is becoming concerned with the possibility of rising prepayment rates, so it's raised its prepayment projections to 13%.

The second thing American Capital investors need to watch out for in 2012 is the possibility of lower long-term interest rates. If the investors become more pessimistic about the economy or the Fed decides to push long-term rates down further, high-leverage/narrow-margin REITs like American Capital and Armour would likely be the most sensitive.

Steady as she goes
Given the company's high leverage and relatively plain-vanilla portfolio, how American Capital fares in 2012 will depend on market conditions, especially interest and prepayment rates. Though some warning signs may be on the horizon for the industry, the new year is looking to be another profitable one.

I think American Capital has got what it takes to succeed in the new year, but our analysts have selected a different stock that they believe is poised for tremendous growth in 2012. Find out which company in our new free report: "The Motley Fool's Top Stock for 2012." Thousands have already requested access and it'll only be available for a limited time. Simply click here -- it's free.

At the time thisarticle was published Ilan Moscovitz doesn't own shares of any company mentioned. The Motley Fool owns shares of Annaly Capital Management and American Capital Investment. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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