Description

Annaly Capital management (NLY) is the largest mortgage REIT and, as such, makes its money by owning a leveraged portfolio of mortgage bonds. NLY’s strategy has been to focus on GSE debt, minimizing the credit risk in their portfolio. This fact, plus prudent portfolio management allowed NLY to stay in business during the crises while other mortgage REITS were not so fortunate.

If you think interest rates are going to shoot sky high, or you think that we are on the cusp of an outbreak of high inflation or financial instability, then it should be obvious that a leveraged pool of bonds, derivatives and counterparty risk (NLY has all three) is not of interest to you.

In my opinion, the bet you’re making in owning NLY is that we have a healthy financial environment (regarding counterparty risk and repo liquidity), and a term structure where mortgage rates are neither dramatically high, nor dramatically low, relative to current short rates. NLY has been compared to a thrift bank, without physical retail locations and, I would add, also without credit risk.

I believe the fed also has an interest in a healthy financial environment and affordable mortgage rates, and also has a significant (though not total) ability to influence these markets, as it did when it addressed the repo market illiquidity during the crisis.

NLY generally trades as a multiple of its book value. In the past, when there have been attractive investment opportunities, NLY has issued equity above 1.05x book value (non-dilutive). Therefore, for certain periods NLY has generated strong dividend income, grown its assets significantly and traded around bv (or a discount to bv).  I expect NLY’s investment return will be generated mainly from its distribution. Changes in bv will also drive the stock price. I wouldn’t expect the multiple to expand significantly beyond 1x book.

NLY is complex, leveraged and opaque. NLY uses a variety of derivatives to manage its interest rate risk, diversifying across fixed, variable and floating structures as well as using interest rate collars, caps and/or floors. There is a significant amount of information in the 10k/q, but NLY intentionally does not tell you enough to recreate its exposure on a spreadsheet, if you were so inclined. NLY discloses sensitivity to a parallel shift in the yield curve at certain thresholds, but again – this is a peephole into the kind of understanding you would like to have. I can understand how this opacity and complexity is unsettling as an analyst. I would point out that this concern would be multiplied when considering any of the large banks, as at least with NLY, they are (mainly) in one business and have roughly no credit risk.

Mortgage REITs tend to react negatively when the yield curve steepens and this is what has recently been happening as mortgage spreads have widened and the 10 year yield has been rising to north of 2.50% as I write this. Last quarter, BV was $15.19. JPM estimates that current tangible book value is $13.00 – $13.25.

As I’ve read Bill Gross and Jeff Gundlach explain, the 10 year treasury has generally been priced to reflect nominal GDP. So currently 2013 inflation estimates are around 1% (depending on the index) and real GDP estimates are somewhere between 1-2%. The 10 year has moved from a yield of 1.6% in 12/2012 to north of 2.5% as I write this. This has been a major contributor to the decline in bv at NLY. I’m not making a call that the 10 year is dramatically underpriced, but I think in the current economic environment the downside (in price) of the 10 year treasury is significantly reduced from the levels we recently experienced in the first quarter of 2013.

Depending on the month, you will hear critics complaining about any number of risks that happen to be driving the mortgage market and REIT portfolios. In 2012 and early 2013, the prevailing concern was that the fed was buying such a large portion of the GSE debt issuance and creating stiff competition for NLY and other mortgage REITS. This drove interest rates down, compressing NIMs, and raised concerns over refi risk (for debt that NLY owned that was trading above par - .i.e. yielding a higher rate than could be obtained from the borrower refinancing). Now that mortgage rates have had a significant move higher, the current concern is that the prices of mortgage debt have gone down and NAVs will have taken a hit. This concern dominates, despite the fact that NLY is running with historically low leverage (6.6:1 currently a/o 3/31), and for new investments NIMs are now dramatically more attractive. I’m not suggesting that these concerns are not valid. I’m just suggesting that we don’t know the future path of rates and as long as the market functions normally and rates do not have extreme moves, I think NLY will provide attractive returns over time.

NLY can invest up to 25% of its assets in non GSE debt and since spreads in this core area were so tight (prior to this recent move) NLY has taken steps to grow their non GSE portion of its portfolio. It recently acquired Crexus (CXS), which owns a leveraged pool of CMBS. Given that CXS had about $1b in assets vs. NLY assets of $125b the impact is not dramatic but the strategic direction should be noted.

Anyone considering this investment should have, at a minimum, a general understanding of the inherent negative convexity of mortgage debt. By this I mean simply, that if you own a mortgage that yields 4% and rates go down to 3%, then it’s more likely that the borrower will refinance and you’ll lose that 4% yielding asset, and gain the associated reinvestment risk. Likewise if rate go from 4% to 5% then you are much more likely to be stuck holding the 4% debt, rather than being able to reinvest at 5%.

The following is off the top of my head and should not be considered a substitute for reading the “risk factors” section in NLY’s most recent 10k:

NLY may have a timing mismatch between its cost of borrowing and lending, increased haircuts on repo transactions may require NLY to sell assets and/or reduce leverage, NLY has subsidiaries and if any subs lose access to liquidity then NLY may provide support, unanticipated future government interference in the mortgage market could impair or enhance NLY’s portfolio, any changes or compliance with REIT rules, changes in the yield curve, GSE legislation, mortgage market legislation, counterparty risk, prepayment rates, leverage, liquidity, credit risk on non GSE assets (or GSE assets, for that matter), future equity dilution, and change from current exemption from being considered an “investment company”.

Since NLY is trading around bv, the downside scenario may be limited for some of the risks highlighted above but that cannot be assured.

Disclosure: The author, his family, and funds the author manages and/or is associated with may or may not have a position in any of the securities mentioned in this write-up. Any of the aforementioned may trade in and out and around any of the securities mentioned without notifying you. The analysis presented is the author’s own and is believed to be accurate. Do your own diligence. This write-up constitutes analysis and/or market commentary and is not an investment recommendation and as such, should not be used in isolation to make an investment decision. The author undertakes no obligation to update this report based on any future events or information. Estimates are subject to numerous assumptions, risks and uncertainties which change over time.

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