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Annaly, AGNC: Where's the Bottom?

NEW YORK ( TheStreet) -- American Capital Agency (AGNC - Get Report) and Annaly Capital Management (NLY - Get Report) have been among the hardest-hit financial stocks in recent weeks though much of the selling appears to be driven by fears about the future rather than negative news.

That's not to say that fears are unwarranted. It only means that for those capable of figuring out what these companies hold in their investment portfolios and what the impact of different interest rate scenarios will be, the reward will be substantial.

AGNC and Annaly borrow short-term to buy longer-dated mortgage-backed securities. When rates go up, it harms their businesses. That's because borrowing costs go up quickly while the longer-dated mortgage-backs on their balance sheets decline in value.

Since the start of May, AGNC shares have lost 34.15% vs. a decline of 23.89% for Annaly. AGNC shares closed at $21.93 in the shortened trading session Wednesday ahead of the July 4th holiday. Annaly shares closed at $12.13 Wednesday. They were each down more than 6% shortly after the market opened Friday as rates moved higher on the back of strong June payroll numbers.

Sellside analysts initially rushed to defend these companies as they sold off, but they have become quiet of late.

Sterne Agee analyst Henry Coffey calculated AGNC's book value at roughly $27.75 in a June 11 research note. "We have factored into this analysis an ~1% decline in MBS value, an additional 0.5% decline to account for any sell-off in pay-ups and other factors. This decline in value should be offset in part by swaps and hedges. The stock is oversold in our view and a 'snap-back trade' closer to our price target over time is likely, unless rates suddenly snap higher or the GSEs extend HARP to include 2010 cohorts."

Coffey's price target is $27.50. Rates did suddenly snap higher after he published that note. They have since moderated, however. One way to see this activity is by looking at this Bloomberg MBS index. The higher the index, the more valuable the securities in AGNC and Annaly's portfolios ought to be. This is complicated by the fact that these companies hedge their portfolios against rising rates, and that hedging is an inexact science that has blown up in the faces of many sophisticated companies.

Forgetting about hedging, however, the Bloomberg MBS Index was at 113.93 when Coffey wrote his note. It fell to 111.56 on June 24. Its latest reading is 112.96, though it will surely move lower Friday due to the strong June payroll data. That rebound in the MBS index, however, has not been reflected in shares of Annaly and AGNC, which have continued to sell off.

This inconsistency -- the rebound in the MBS index not reflected in the shares of Annaly or AGNC -- makes them tempting gambles. What is less clear is how effective their hedging is, or what is happening to their cost of financing. And, of course, one never knows where rates are headed. Analysts at CRT Capital Markets have generally argued they are headed lower over the short term, though they seemed a bit surprised by Thursday's June payroll report and are now predicting the Fed will begin tapering its $85 billion in monthly bond purchases in September -- probably by $15 billion to $20 billion.

I wouldn't expect AGNC or Annaly to snap back until next week at the earliest.

-- Written by Dan Freed in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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