American Capital Agency Learns an Important Lesson

American Capital Agency Learns an Important Lesson

Earnings season has been especially tumultuous for mortgage REITs, and share prices have suffered as earnings per share losses and declining book values spook investors.

As American Capital Agency announced earnings on Monday, however, the stock price of CIO Gary Kain's mREIT rose, as did those of practically all others, despite a loss of $2.37 per share and a dip in book value of 11.8% from the first quarter.

When American Capital Mortgage , the hybrid mREIT also managed by Kain, reported a second-quarter loss of $0.94 per share on Tuesday -- as well as a 6.7% drop in book value -- its stock rose even more than it had earlier in the day.

Gary Kain saved the day
Considering how investors reacted when CYS Investments and Hatteras Financial reported second-quarter losses earlier this month, this rally is quite remarkable. Book values at both these mREITs plunged by approximately 20% from the previous quarter, and CYS lost over 4% on the day, while Hatteras tumbled by 10% one week later, after its own earnings announcement.

So, why are investors so blithe about the sector now? I think Gary Kain is to be credited on that score, as I believe it was his machinations that brought about this revival. Mr. Kain was able to turn investors' frowns upside down after learning an important lesson: When your trust is the first to report book value dings in a given year, make darn sure that you look better than your peers in the next quarter -- even if losses are unavoidable.

First-quarter massacre put damage control front-and-center
American Capital Agency's $1.57 per share loss and 8.6% dip in book value in Q1 was a surprise, and Kain was quick to point out that the rise in long-term interest rates, combined with a secondary stock offering, took a big toll. Kain noted that things were looking better for the second quarter, however.

Kain and company obviously got busy making things better, knowing full well that announcing a steeper plunge in book value for the second quarter was not an optimal situation. As the trust's officers relate in the earnings conference call, risk management became paramount.

Management described a three-pronged portfolio adjustment meant to ameliorate rising interest rate risks. Noting that 30-year, 3% coupon mortgage-backed securities took a huge hit in value over the past few months, the team has reduced that part of the portfolio from 20% to 14% of the total. Since interest rates moved upwards, management sold $6 billion of its 4% coupon specified pools, which represented the highest pay-up risk.

Lastly, the company invested more heavily in 15-year, lower coupon MBSes, changing the portfolio percentage in that regard from 34% at the end of the first quarter, to 42% by the end of June. In addition, management increased hedging to its highest historical level -- 100% -- and dumped shorter-term swaps in favor of those with a longer duration.

A successful defense
Kain claims that the trust is better protected from the risk of rising interest rates now than it has been in years. The hard work seems to have paid off. Compared to the book value slumps experienced by CYS and Hatteras, American Capital Agency's looks tame. Even adding the first quarter's 8.6% fall in book value to the Q2 percentage brings the total to just about 20% or so -- the same rate of book value declines recently reported by the two other trusts.

The hedge portfolio gained around $5.50 per share in value during the second quarter, Kain said, and "performed as intended." Compare these comments to those of CYS chief Kevin E. Grant, who admitted that his company's hedging program didn't pan out all that well.

While mortgage rates have dropped a bit from the first half of July, the trajectory is definitely upward. The rest of the summer may be quiet, but things should heat up again as the Federal Reserve's September meeting approaches. This time, when interest rates jump, American Capital Agency will be ready.

Dividend stocks can make you rich. It's as simple as that. Over the long term, the compounding effect of the quarterly payouts, as well as their growth, adds up faster than most investors imagine. With mortgage REITs cutting dividends, however, you may want to play the field a little, until things settle down again. Luckily for you, our analysts sat down to identify the absolute best of the best when it comes to rock-solid dividend stocks, drawing up a list in this free report of the only nine that fit the bill. To discover the identities of these companies before the rest of the market catches on, you can download this valuable free report by simply clicking here now.

The article American Capital Agency Learns an Important Lesson originally appeared on

Fool contributor Amanda Alix has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.

Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

Originally published