Annaly Mortgage Mgmt (short) NLY S
June 13, 2003 - 6:09pm EST by
fizz808
2003 2004
Price: 20.18 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,900 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT
Borrow Cost: NA

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Description

Annaly (short sale idea) is a mortgage REIT that invests primarily in ARMS and fixed rate mortgages (among others) and finances these purchases in the wholesale money market. Their leverage (assets to equity) is currently around 12:1. As a REIT, NLY pays out at least 90% of taxable income in dividends. The current dividend yield (based on MRQ annualized) is 11.9%.

Over the past several years, NLY has benefited greatly from the declining interest rate environment. Just as a theoretical example, consider a mortgage REIT holding a portfolio consisting entirely of standard ARMs that re-price 1x per year: 1/12 of the assets re-price every month. If interest rates are falling and company has all short term (let’s say 1 month LIBOR liabilities) COF drops immediately, while assets will take a full year to catch up. Financing costs drop faster than assets re-price. In declining interest rates this creates a bubble of profitability. Of course the opposite effect hits them when interest rates start to rise.

Even more helpful to NLY has been the steepening (until recently) yield curve over the past few years. Obviously the steeper the yield curve, the more spread is available for the NLY profit model.

Here’s a look at the yield curve at four points in time within the past year:


6/13/02 3/13/03 5/13/03 6/13/03
3 Mos 1.89% 1.26% 1.32% 1.09%
2 Yr 3.44% 1.89% 1.66% 1.24%
5 Yr 4.70% 3.19% 2.87% 2.34%
10 Yr 5.45% 4.20% 3.94% 3.43%
30 Yr 6.03% 5.08% 4.89% 4.43%

The long end of the yield curve has dropped fairly dramatically over the past year. The 3 mos. (which best approximates NLY’s cost of funds) has dropped 80 bps in the past year and only 17 bps in the past 3 months. The 5 year, on the other hand, has dropped 236 bps in the past year and 85 bps in the past 3 months. Annaly’s average spread in the first quarter was approximately 154 bps. It’s difficult to determine exactly how much the spread has compressed since then (we don’t have the precise securities in their portfolio and we don’t know what they’ve been buying or selling since then) but it’s certainly clear that the spread has compressed significantly. Also consider that the Refi index is at all time highs: prepayments speeds have increased dramatically—more and more of NLY’s high interest rate mortgages are pre-paying and the proceeds are invested at lower spreads.

Annaly can (and will) offset some of the spread compression by selling MBS at a gain. In the first quarter this year, income from gain on sale was $11m vs. $3.4m in 1Q 2002. And as of 3/31/03 NLY had an additional $91m of unrealized gains in their MBS portfolio. However, these gains will eventually disappear (either through rising rates or gain on sale) and the underlying long term business is inherently less profitable in this environment.

Other reasons for concern:

Investors tend to overpay for high yielding investments, especially in this volatile equity market, low interest rate environment.

NLY is just borrowing money, buying mortgages (borrowing short, lending long). Why should they continue to earn 20%+ ROEs for that? I am skeptical that management has the “unique expertise” in managing, predicting interest rates (or buying mortgage securities) that they claim to have. Assets have mushroomed over past several quarters, from $1bn to $12bn! Any advantage they had in finding mis-priced securities has to be much more difficult to utilize now…

Although 1/3 of the portfolio is in fixed rate mortgages, 1/3 is in ARMs, and 1/3 is in floating, company claims to be well hedged against interest rate increases. Approximately 80% of liabilities are variable rate. Average time to re-price of assets is less than 18 months; less than 3 months for liabilities. Rising interest rates certainly present some risk to their portfolio.

Also, as Fed starts to raise interest rates (after period of declining or stable rates) there is usually a rush of prepayments and refinancing. This hurts NLY (price of assets fall) just when their spreads are getting squeezed. Theoretically could be wiped out if value of assets plummets by more than BV.

Trading at 1.72x book ($1.9bn market value on $1.1bn book value). 72 points over BV and 12:1 leverage implies that market is paying 72/12 = 6 points “extra” to own these mortgage securities through NLY. Does that premium make sense?

Downside:

- Interest rates stay low and yield curve steepens again

- $2.40 dividend (11.9% dividend yield) = expensive short (on the other hand this tends to scare shorts away which is one of the reasons the price might be “artificially” high)

- NLY can temporarily offset compression in spread by gains on sale

- Does market already anticipate a dividend cut? And even if the dividend is cut in half, NLY still yielding 6% at current stock price. How much would the price drop?"

Catalyst

NLY will announce the 2nd quarter dividend sometime on or around June 20th. I believe that management will be forced to cut the dividend given the current outlook for NLY’s profitability going forward.
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    Description

    Annaly (short sale idea) is a mortgage REIT that invests primarily in ARMS and fixed rate mortgages (among others) and finances these purchases in the wholesale money market. Their leverage (assets to equity) is currently around 12:1. As a REIT, NLY pays out at least 90% of taxable income in dividends. The current dividend yield (based on MRQ annualized) is 11.9%.

    Over the past several years, NLY has benefited greatly from the declining interest rate environment. Just as a theoretical example, consider a mortgage REIT holding a portfolio consisting entirely of standard ARMs that re-price 1x per year: 1/12 of the assets re-price every month. If interest rates are falling and company has all short term (let’s say 1 month LIBOR liabilities) COF drops immediately, while assets will take a full year to catch up. Financing costs drop faster than assets re-price. In declining interest rates this creates a bubble of profitability. Of course the opposite effect hits them when interest rates start to rise.

    Even more helpful to NLY has been the steepening (until recently) yield curve over the past few years. Obviously the steeper the yield curve, the more spread is available for the NLY profit model.

    Here’s a look at the yield curve at four points in time within the past year:


    6/13/02 3/13/03 5/13/03 6/13/03
    3 Mos 1.89% 1.26% 1.32% 1.09%
    2 Yr 3.44% 1.89% 1.66% 1.24%
    5 Yr 4.70% 3.19% 2.87% 2.34%
    10 Yr 5.45% 4.20% 3.94% 3.43%
    30 Yr 6.03% 5.08% 4.89% 4.43%

    The long end of the yield curve has dropped fairly dramatically over the past year. The 3 mos. (which best approximates NLY’s cost of funds) has dropped 80 bps in the past year and only 17 bps in the past 3 months. The 5 year, on the other hand, has dropped 236 bps in the past year and 85 bps in the past 3 months. Annaly’s average spread in the first quarter was approximately 154 bps. It’s difficult to determine exactly how much the spread has compressed since then (we don’t have the precise securities in their portfolio and we don’t know what they’ve been buying or selling since then) but it’s certainly clear that the spread has compressed significantly. Also consider that the Refi index is at all time highs: prepayments speeds have increased dramatically—more and more of NLY’s high interest rate mortgages are pre-paying and the proceeds are invested at lower spreads.

    Annaly can (and will) offset some of the spread compression by selling MBS at a gain. In the first quarter this year, income from gain on sale was $11m vs. $3.4m in 1Q 2002. And as of 3/31/03 NLY had an additional $91m of unrealized gains in their MBS portfolio. However, these gains will eventually disappear (either through rising rates or gain on sale) and the underlying long term business is inherently less profitable in this environment.

    Other reasons for concern:

    Investors tend to overpay for high yielding investments, especially in this volatile equity market, low interest rate environment.

    NLY is just borrowing money, buying mortgages (borrowing short, lending long). Why should they continue to earn 20%+ ROEs for that? I am skeptical that management has the “unique expertise” in managing, predicting interest rates (or buying mortgage securities) that they claim to have. Assets have mushroomed over past several quarters, from $1bn to $12bn! Any advantage they had in finding mis-priced securities has to be much more difficult to utilize now…

    Although 1/3 of the portfolio is in fixed rate mortgages, 1/3 is in ARMs, and 1/3 is in floating, company claims to be well hedged against interest rate increases. Approximately 80% of liabilities are variable rate. Average time to re-price of assets is less than 18 months; less than 3 months for liabilities. Rising interest rates certainly present some risk to their portfolio.

    Also, as Fed starts to raise interest rates (after period of declining or stable rates) there is usually a rush of prepayments and refinancing. This hurts NLY (price of assets fall) just when their spreads are getting squeezed. Theoretically could be wiped out if value of assets plummets by more than BV.

    Trading at 1.72x book ($1.9bn market value on $1.1bn book value). 72 points over BV and 12:1 leverage implies that market is paying 72/12 = 6 points “extra” to own these mortgage securities through NLY. Does that premium make sense?

    Downside:

    - Interest rates stay low and yield curve steepens again

    - $2.40 dividend (11.9% dividend yield) = expensive short (on the other hand this tends to scare shorts away which is one of the reasons the price might be “artificially” high)

    - NLY can temporarily offset compression in spread by gains on sale

    - Does market already anticipate a dividend cut? And even if the dividend is cut in half, NLY still yielding 6% at current stock price. How much would the price drop?"

    Catalyst

    NLY will announce the 2nd quarter dividend sometime on or around June 20th. I believe that management will be forced to cut the dividend given the current outlook for NLY’s profitability going forward.

    Messages


    SubjectLong or Short?
    Entry06/13/2003 07:22 PM
    Memberjohn771
    I'll rate this a 7 if it's a Short and 3 if it's a Long.

    Several other points supporting a short position:

    1) Most of the portfolio is agency securities. If there's some kind of systemic risk then NLY's heavily leveraged portfolio could get wiped out.

    2) A similar REIT (CMO) is managed by smart money at Fortress Investments. CMO insiders have been aggressively selling off their large holdings.

    3) NLY senior management salaries are based on shareholder equity. Management has a clear financial incentive to increase the share count even if it would depress the share price. NLY just filed a $750MM shelf registration.

    4) NLY is a REIT and therefore its dividends remain fully taxable. It has become relatively less attractive to income oriented investors.

    SubjectROE
    Entry06/14/2003 06:56 AM
    Memberbowd57

    Hi, fizz --

    > NLY is just borrowing money, buying mortgages (borrowing short, lending long). Why should they continue to earn 20%+ ROEs for that?

    Well,

    >

    SubjectROE
    Entry06/14/2003 07:04 AM
    Memberbowd57

    Hi, Fizz --

    Sorry for the mis-post.

    > NLY is just borrowing money, buying mortgages (borrowing short, lending long). Why should they continue to earn 20%+ ROEs for that?

    Well,

    > Their leverage (assets to equity) is currently around 12:1.

    there you go.

    I'd agree that paying 1.72x book for a bunch of agencies isn't a great idea. But as you point out, it could be an expensive short. I'm also not seeing any insider sales. What do you think the chances are of NLY blowing up anytime soon?

    Doesn't Grant's love these guys?

    Yours,
    Bowd

    SubjectA short
    Entry06/15/2003 07:31 AM
    Membersparky371
    I'm assuming this is a short idea, and thanks for the writeup. We're already short this for all the reasons you and John771 make so well. I have written Jim Grant and Bill Fleckenstein for comment, since they have strongly promoted this stock. Jeremy Diamond is a former editor, I believe, of maybe Grant's Asia, so am not sure Grant will ever go negative. FWIW, I got absolutely no response from either, and neither has commented in columns or the GIO. Let us know for sure that this is a short, so, as with John, I can rate it appropriately. Thank you for the info.

    SubjectGrant
    Entry06/15/2003 09:29 AM
    Memberroark304
    One of the samples Grant puts up on his website happens to include last October's bullish Annaly / Mortgage REIT piece, so you take a look even if you're not a subscriber.

    http://www.grantspub.com/samples/g20n19.pdf


    Subjectthis is a SHORT idea in case t
    Entry06/15/2003 10:07 PM
    Memberfizz808
    this is a SHORT idea in case that's not clear

    SubjectTiming
    Entry06/16/2003 08:52 AM
    Memberdavid101
    Fizz,

    At some point, NLY and many other businesses tied to real estate transactions are going to run into the interest rate hike wall, and the key questions for shorting NLY are:

    1. When do you think interest rates be raised and how high do rates have to go in order to impact NLY?

    2. What is the cost of shorting of a 12% annual dividend under the new tax laws?

    It seems that Greenspan has curried favor with Bush, and he seems willing to maintain the status quo through next year's election. Even if the economy recovers, Greenspan may be cautious in raising interest rates because a rapid rise in rates could seriously derail the economy. You need to be fairly certain that interest rates are going up, and going up soon, in order to justify the cost of shorting NLY.

    David

    SubjectTiming
    Entry06/16/2003 09:35 AM
    Memberfizz808
    David:

    i agree with you that short term interest rates moving up sharply would be very bad for NLY. however, i don't know when this will happen and it's not the only way that NLY gets hurt. long rates coming down is also bad for NLY (as i describe in my write-up) because spread gets squeezed. that is happening right now and i'm fairly certain NLY earnings will be significantly lower and dividend will be cut. i also happen to believe that the NLY busines model is "too good to be true" and that theoretically they should not be able to continue earning 20+% roe's just buying mortgages. if it's really that easy then maybe we should all quit our jobs and start a mortgage REIT.

    As for the dividend, i certainly agree that a 12% yield is painful on the short side. however, since NLY is a REIT the dividend would not be eligible for the new 15% tax rate and therefore the cost to carry the short position should be 12%. i also think it's a relatively "safe" short position in that the short interest is very low and i doubt anything will move the stock up significantly. lastly, you shouldn't have to hold the position for more than a quarter or two to see my thesis come to fruition...

    SubjectTiming
    Entry06/16/2003 12:56 PM
    Membersparky371
    Fizz,
    Glad you clarified it so i could rate it appropriately.

    Given that NLY appears to want to do a massive secondary, will that influence their divvie hold/cut decision on/around Jun20th? On one hand, they'll wanna keep the stock up for the secondary; on the other, cutting the divvie after the secondary invites litigation. Thanks for a great idea.

    Subjectsparky - secondary?
    Entry06/16/2003 08:08 PM
    Memberkevin155
    Why do you think the co wants to do a secondary?
    Has mgmt said this lately?

    Didnt they just do a secondary in April?

    SubjectPR Jun10th
    Entry06/17/2003 09:23 AM
    Membersparky371
    Reuters
    UPDATE - Annaly Mortgage files $750 mln stock shelf
    Tuesday June 10, 4:07 pm ET


    (Adds background, stock price)
    WASHINGTON, June 10 (Reuters) - Annaly Mortgage Management Inc. (NYSE:NLY - News) filed with the Securities and Exchange Commission (News - Websites) to periodically sell up to $750 million in common and preferred stock.

    The New York-based company, which manages a portfolio of investment securities, including mortgage pass-through certificates, said it plans to use the proceeds from the shelf offering for buying mortgage-backed securities.

    Its shares were down 11 cents at $19.51 in late afternoon trading on the New York Stock Exchange (News - Websites). They have been as high as $21.50 and as low as $14 in the past 52 weeks.

    Under a shelf registration, a company may sell securities in one or more separate offerings with the size, price and terms to be determined at the time of sale.



    SubjectI agree that the curve flatten
    Entry06/17/2003 07:49 PM
    Membersunny329
    I agree that the curve flattening is an issue for many financial institutions. Consider that over the last 20 years, the average spread between the 10 yr bond and 3 month libor has been 112 bp. it currently stands at 220.55, or about 100 bp too wide off the median.

    While I think the NLY is interesting, my favorite short on this theme is IFIN. Some of you are probably familiar, but it is a trust & custody bank that engages in the same interest rate bet as NLY to generate earnings far in excess of what its traditional business should earn. IFIN, however, has no dividend and trades at 4x book. It also excessively issues options and capitalizes lots of costs.

    Subjectfizz-- did not mean to take
    Entry06/17/2003 07:52 PM
    Membersunny329
    fizz--

    did not mean to take away from the NLY short as i think it is very interesting. to get a sense of what margin one can earn safely in this business (by safely i mean without exposing a company to massive extension risk), consider that Freddie Mac has the best funding around and the same assets (MBS) as NLY and IFIN. FRE's net interest margin was 0.80% compared to 1.54% for Annaly and 2.34% for IFIN. Same business, different appetites for risk--

    SubjectSunny
    Entry06/18/2003 07:18 AM
    Membersparky371
    Sunny,
    I'll look at IFIN too, but what I like about NLY is that there is a lot of retail longs who are buying for yield, not realizing that if the divvy is cut, the stock price can go down hard too. They'll panic out. I gotta figure best case is that mgmt trims the divvy the bare minimum and hopes for a minor mult. expansion. I wonder what the large holders will do. They may just hold, since in this environ., even a 9-10% yld may look good; or, they may race for the exits hoping to beat an anticipated rush.....

    Subjectsparky - sorry for the dumb qu
    Entry06/18/2003 10:33 PM
    Memberkevin155
    I hadnt seen the PR and my question was just me being lazy.

    Subjectkevin
    Entry06/20/2003 07:49 AM
    Membersparky371
    Been there, done that.

    Anyone have any thoughts on the 60ct divvie decl?? My take is this is an attempt to buy time and get the secondary off or see what happens with rates/refis; but, then again, I'm a raging cynic.....

    Subject60c dividend
    Entry06/20/2003 09:55 AM
    Memberfizz808
    NLY declared 60c 2nd Q dividend yesterday. i think the only way for them to actually earn the 60c in the 2Q is through large gain on sales. this is not sustainable and will reduce future income. we'll have to wait for the 2nd Q earnings release to see the details. but it looks like we may have to wait another quarter to see the thesis play out.

    SubjectEarnings Report
    Entry07/29/2003 03:45 PM
    Memberjohn771
    Seems pretty poor.

    Any thoughts on the attractiveness of NLY's portfolio in the current market?

    SubjectWhat about LUM?
    Entry07/22/2004 12:46 PM
    Memberround291
    Fizz -

    You rightly had decent success with this short as, at the time of the write-up, NLY was trading at a healthy premium to book.

    Have you looked at Luminent? It's a straight forward leveraged investor in ARM's (both fully adjustable and those still in the teaser period) that trades at a discount to book. Financing is provided by a consortium of seventeen investment banks (many of whom underwrote the IPO and secondary) and is structured as repurchase agreements (short term collateralized loans). It's as plain vanilla as you can get, with the exception of a Eurodollar future based hedge strategy (which, by the way, seems to make sense to me).

    As ARMs are essentially thirty year amortizing one year mortgages, I'd rather hold them in a rising short rate environment than the fixed rate stuff.

    Curious on your take or on the feedback of others.
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