Annaly Capital Management is Like Gold, For Now ($NLY)

It seems like leveraged agency MBS REITs (NLY and AGNC for example) are being pitched as the next "sure thing" investment for the next decade. They are publicly traded real estate investment trusts that invest in agency mortgage-backed securities guaranteed by government housing agencies' Fannie Mae, Freddie Mac and Ginnie Mae, and pay out 90% of their income as dividends to investors. Annaly Capital Management (NLY) currently yields 13.24% annualized and has a 5-year net dividend growth rate of 24% (via Bloomberg.com key statistics). It looks like Annaly's balance sheet is levered 8 to 1 (total assets of 128 billion over $16 billion of equity) and has a debt/equity ratio of 6 to 1 (see quotes from the 8K below).

I'm not going to dig into NLY's financials in detail since I'm not a professional mortgage REIT analyst or MBS portfolio manager, but it seems odd to me how these companies can sustain a dividend payout between 13%-20% (via leverage) with the 30-year fixed rate mortgage near record lows (3.66%) and heightened pre-payment risk. I understand that mortgage portfolio managers can sell off agency MBS for gains, or manipulate their cash flows with interest rate swaps in a rising interest rate environment (which use the TBTF banks as counterparties that could end up blowing up the system again)! Or hold adjustable-rate agency MBS, which is 7% of Annaly's portfolio. But how long can these portfolio managers running $118 billion of agency MBS on mostly borrowed money game a market that is 100% manipulated by the Federal Reserve and backed by government intervention and failed, broke housing agencies? What if deflation sends the 30-year mortgage rate even lower, or the yield curve goes to zero or even inverts in various scenarios?

If interested, here is more information on Annaly's holdings from its Q2 8K filing (here is the 10Q):

"For the quarter ended June 30, 2012, the annualized yield on average interest-earning assets was 3.04% and the annualized cost of funds on average interest-bearing liabilities, including the net interest payments on interest rate swaps, was 1.50%, which resulted in an average interest rate spread of 1.54%. This was a 91 basis point decrease from the 2.45% annualized interest rate spread for the quarter ended June 30, 2011, and a 17 basis point decrease from the 1.71% average interest rate spread for the quarter ended March 31, 2012. At June 30, 2012, the weighted average yield on investment securities was 3.17% and the weighted average cost of funds on borrowings, including the net interest payments on interest rate swaps, was 1.58%, which resulted in an interest rate spread of 1.59%. Beginning with the quarter ended June 30, 2011, net interest payments on interest rate swaps, reflected in the consolidated statements of comprehensive income as realized gains (losses) on interest rate swaps, are included in the summary table presentation of cost of funds and interest rate spread. This change does not affect GAAP or taxable net income, shareholders’ equity, cash flows or earnings per share. Leverage at June 30, 2012, June 30, 2011, and March 31, 2012 was 6.0:1, 5.7:1 and 5.8:1, respectively.

Fixed-rate mortgage-backed securities and Agency debentures comprised 92% of the Company’s portfolio at June 30, 2012. The balance of the mortgage-backed securities and Agency debentures was comprised of 7% adjustable-rate mortgage-backed securities and Agency debentures and 1% LIBOR floating-rate collateralized mortgage obligations. At June 30, 2012, the Company had entered into interest rate swaps with a notional amount of $46.2 billion, or 41% of the Company’s Agency mortgage-backed securities and debentures. Changes in the unrealized gains or losses on the interest rate swaps are reflected in the Company’s consolidated statements of comprehensive income. The purpose of the interest rate swaps is to mitigate the risk of rising interest rates that affect the Company’s cost of funds. Since the Company receives a floating rate on the notional amount of the swaps, the intended effect of the swaps is to lock in a spread relative to the cost of financing. As of June 30, 2012, the swap portfolio had a weighted average pay rate of 2.29%, a weighted average receive rate of 0.30% and weighted average years to maturity of 4.91 years. As of June 30, 2012, substantially all of the Company’s Investment Securities were Fannie Mae, Freddie Mac and Ginnie Mae mortgage-backed securities and debentures.

“Market conditions continue to warrant a conservative approach to our portfolio,” said Wellington Denahan-Norris, Annaly’s Vice Chairman, Chief Investment Officer and Chief Operating Officer. “We continue to strengthen and extend the tenor of our liabilities while maintaining leverage at a relatively low level. After taking into account the effect of interest rate swaps, our portfolio of mortgage-backed securities and Agency debentures was comprised of 42% floating-rate, 7% adjustable-rate and 51% fixed-rate assets.”

And here is info on Annaly's pre-payment rate and weighted average purchase price of agency MBS and debentures:

"The Constant Prepayment Rate for the quarters ended June 30, 2012, June 30, 2011, and March 31, 2012 was 19%, 11% and 19%, respectively. The weighted average purchase price of the Company’s Agency mortgage-backed securities and debentures at June 30, 2012, June 30, 2011 and March 31, 2012 was 103.2%, 102.1% and 102.9%, respectively. The net amortization of premiums and accretion of discounts on Agency mortgage-backed securities and debentures for the quarters ended June 30, 2012, June 30, 2011, and March 31, 2012 was $302.8 million, $126.5 million, and $280.3 million, respectively. The total net premium and discount balance at June 30, 2012, June 30, 2011, and March 31, 2012, was $4.5 billion, $3.0 billion, and $3.8 billion, respectively."

This brings me to a chart I found interesting. Look at the 12 year chart of NLY against Gold. NLY has rallied with gold ever since gold's secular bull market began in 2000 (NLY +503% and GOLD +554%). And this comes after the housing and mortgage fraud crash and bailouts. I even think NLY was yielding 15-20% even before the housing bubble burst, right? So NLY is almost beating out the ultimate real, safe haven asset! And this comes after the Fed expanded its balance sheet by trillions of dollars and the National debt grew by $6 trillion after the bailouts in 2008, which is about to hit the new $16.4 trillion debt limit very soon. So how long can this relationship seriously last for? Or will they both go down in tandem together if interest rates get volatile? This does not seem like a normal relationship. Any thoughts on this?


Annaly Capital Management vs. Gold since 2000 (source: StockCharts.com)



30-year Fixed Rate Mortgage Average (St. Louis Fed)



And here is the 2-10 year Treasury yield spread against NLY. The spread has been tightening. Hmm, seems like a big gap is forming as well. These companies borrow short and lend long to generate interest income like a bank. Or they sell off mortgage securities for a profit or loss. And then there are unrealized gains and losses. For example, Annaly lost money on derivatives (interest rate swaps) and on "interest only" agency mortgage-backed securities during the quarter. Update: as noted by the company above, their collateralized mortgage obligations (CMO's) are tied to LIBOR, which are 1% of their portfolio. So this company is loaded with interest rate, hedging, and even policy risk. Here's a good post to read at Seeking Alpha: Annaly Capital: A Bond Fund In Disguise (January 2012).

Here's more on Annaly's unrealized gains and losses during the quarter:

"Without the effect of the unrealized gains or losses on interest rate swaps and Agency interest-only mortgage-backed securities, net income for the quarter ended June 30, 2012, was $546.2 million or $0.55 per average common share as compared to $587.5 million or $0.71 per average common share for the quarter ended June 30, 2011."
"During the quarter ended June 30, 2012, the Company disposed of $6.4 billion of Agency mortgage-backed securities and debentures, resulting in a realized gain of $94.8 million."


NLY vs 2-10 Year Treasury Yield Spread (StockCharts.com - direct link)



Here is more analysis and news on Annaly around the web. Seems like Annaly articles are all over Seeking Alpha. This REIT is held by the largest asset managers and probably in a bunch of retail funds. BlackRock Institutional Trust Company, BlackRock Fund Advisors, Vanguard Group, Bank of New York Mellon, Allianz, State Street, Artisan, etc.

Mortgage REIT Chimera Climbs After Details On Restatement (Bloomberg)

Annaly Capital disposes of $6.4 billion in mortgage bonds (Housing Wire)

Annaly Capital Management's CEO Discusses Q2 2012 Results - Earnings Call Transcript (SeekingAlpha)

Annaly Capital Slashed to “Underperform” at Wells Fargo; Sees Several Headwinds (NLY) (Dividend.com)

FBR Downgrades NLY, Mortgage REIT ETF Down (Barron's Income Investing)

Why Annaly Capital's Dividend Will Keep Shrinking (SeekingAlpha)

Annaly Capital And The Residential mREIT Gang: Just The Facts (SeekingAlpha)

Annaly Beats Estimates, Excluding Unrealized Losses, As Spreads Continue To Narrow (SeekingAlpha)

Annaly's 13% Yield: A Safe Bet? (SeekingAlpha)

A Closer Look At Annaly Capital Management's Cash Flows (SeekingAlpha)

Fannie Mae’s Still No Ginnie After Bailout Fix: Credit Markets (Businessweek)

TEXT-Fitch: rising delinquency rates pose looming threat for FHA (Reuters)

FHA's 30x leverage on mortgages is creating a new "subprime" market (Sober Look)

US Treasury shrinking the GSEs, capping taxpayer support (Sober Look)


Disclosure: I do not own NLY

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