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.