Annaly: Getting Lulled Into A False Sense Of Security

| About: Annaly Capital (NLY)

The fiscal cliff has been averted for now, and all is wonderful, or is it? We are finally seeing some green days in the mREIT sector. Annaly Capital (NYSE:NLY) has jumped about 3.5% in less than 2 days, and I have noticed some positive articles referencing the 13% dividend yield. If that dividend was safe, it absolutely would be something I would once again consider owning.

The problem I see is the potential for investors to be lulled into a false sense of security with just a few up days. It is not unusual for individual investors to feel positive about stocks when share prices are up. The same thing goes for that feeling of gloom and doom when share prices drop for a few days. It is human nature I suppose.

I will simply state that nothing has changed for NLY and the issues it faced last week have not changed at all. I believe selling into strength could be the appropriate strategy in this sector right now.

The Fed Is Still Calling The Shots

Congress has finally decided to kick the can down the road on cost-cutting issues for our nation, but has decided to keep the capital gains and dividend income tax rates at very acceptable levels. It has also decided to keep the Federal income tax rates the same for folks earning under $400k per year ($450k for married couples filing jointly). Positive news, and certainly better than it could have been.

I would remind investors that dividends received from all REITs are not treated as ordinary dividends. Investors receive the dividends from Annaly, and other REITs, as ordinary income. That means that nothing has changed unless you earn over $400k-$450k per year. Then you WILL pay more on dividends received from these investments, including Annaly.

Keep in mind that the Fed is still in the "way" as well.

  • $40 billion in MBS each and every month, open ended.
  • $45 billion in Treasuries purchased each and every month, open ended.
  • An ongoing attempt to push long-term rates down further, until the employment rate is less than 6.5% and inflation stays under 2.5%.
  • A goal to stimulate the housing sector to have anyone and everyone with an FHA mortgage, to refinance at ever declining mortgage rates.
  • The intention to accelerate all quantitative easing if the economy continues to struggle.

With the Federal Reserve basically calling the shots in these areas, the potential for profits are greatly diminished for NLY and other companies in the agency backed MBS sector. Diminished profitability will mean more dividend cuts in the near to medium term from what I can tell. If dividends are cut then total returns on an already risk-oriented sector to begin with, could mean that the share price will continue the downward trend we have seen since the Fed announced the latest actions.

As the share price drops, there could be a "doom loop" effect where investors will seek other opportunities to replace at least a portion of the dividends lost, as well as a more stable investment, with less risk to total value.

There are many investors who firmly believe that since the share price of Annaly has been selling at a discount to book value, that now is the time to begin buying the stock or adding to positions held, to dollar cost average.

I believe that this approach could cost investors money as long as the Fed is in the way.

This chart makes it rather simple to see the direction. Some would argue that the mortgage rates have leveled off and there is some stability of late. That is true, but as so perfectly stated in this article by fellow SA author Tim Plaehn, investors should not get very comfortable:

The main point of this article is that investors should take little comfort in 3.5% mortgage rate. The prices and yields of agency MBS continue to be squeezed by the market hunger for these bonds and the Fed's QE3 massive buying of agency MBS. Currently, 3.5% mortgages probably produces sub-2% MBS yields.

The second point is that net interest income and the resulting dividend rates could easily end up at half the rates paid in early and mid-2012. The mREIT companies have made it clear that business is tough by switching to share buybacks....

The Oval Office Might Be Jumping In As Well

I wrote this article recently, referencing the trial balloon recently sent up by our Administration, as this Seeking Alpha Market Current reported:

Wednesday, December 26, 7:10 AM The Obama Administration considers expanding its mortgage-refinance program to include those loans not held by the GSE's. Fannie and Freddie back just 50% of the nation's mortgages, leaving a big chunk of the 10.8M underwater mortgage loans not qualified for the HAMP. What happened to weaning the nation off of public mortgage finance?

The bottom line here is that our administration is not thrilled with the level of participation in its previous "schemes," such as MHAP, HARP, HAMP and HAMP II. If it is going to extend these programs further, it is another uncertainty for the entire sector, including the non-agency backed mortgage REITs.

An argument can be made that it might even be a net positive for the non-agency mortgage REIT sector, but the jury is still out and we have no idea of any of the details, or even if anything will even occur.

What we do know is that the Oval Office is not happy about homeowners who are still underwater with their mortgages versus their home values, and has shown its intent to encourage all homeowners with mortgages to refinance.

If the Government can move that process along with even stronger programs, where will that leave the entire mREIT sector? In my opinion, it leaves Annaly and the rest, in the world of uncertainty.

My Opinion

The world of uncertainty is not where I want my own investment dollars parked. Since equities are fraught with all sorts of risks anyway, why go into something that we already know has greater risks than the potential rewards?

As long as the Fed is in the way, and potentially the Oval Office, I will sit and watch the circus go by for now.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.