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After a pretty crummy third quarter and a full fourth quarter of the Fed's QE mortgage-backed securities buying, I expected worse results than Annaly Capital Management (NYSE:NLY) actually reported for the 2012 fourth quarter. That said, there still remain a host of negatives facing Annaly and any leveraged agency mortgage REIT.

The Positive News

The nuts and bolts of an agency mortgage REIT business are a complicated affair. However, I think just a couple of items out of any earnings report can give investors a fair idea how the quarter worked out and what are the trends continuing from previous quarters. Here are the positive news numbers:

  • The adjusted net income of $469 million or 46 cents per share was a touch better than the third quarter's $450 million / 45 cents per share. The adjusted net is enough to cover the most recent 45 cent dividend and the up-tick is a minor reversal in a two-year long down trend.
  • The annualized interest rate spread for the quarter of 0.95% was just 7 basis points lower than the 1.02% reported in the third quarter. The quarter-end spread of 1.20% was down just 4 basis points from the previous quarter. These are much better results than the 52 basis point drop in the spread from 2012 Q2 to 2012 Q3.
  • During the quarter Annaly Capital repurchased almost 28 million shares for $397 million. This works out to an average purchase price of $14.28 per share. From the balance sheet, I get a book value - shareholder equity divided by shares out - of $16.81.

The Negative News

In spite of Annaly Capital's ability to keep things level in the fourth quarter, there still are some strong headwinds for the agency mortgage REITs. The biggest issue is the practice of selling securities held for investment and using the profits to prop up the dividend. For the fourth quarter, Annaly reported gains from the sale of securities of $122 million. These gains represent over 25% of the adjusted net income and thus a quarter of the quarterly dividend.

For the full year 2012, Annaly Capital had gains from the sales of securities of $440 million. These profits account for almost one full quarter's dividend so it could be said that Annaly earned 3 out of 4 of the 2012 dividends from its basic businesses of earning interest spreads and providing management services.

In the environment of falling interest rates and rising MBS prices it was probably a prudent thing to lock in capital gains before mortgage prepayments sucked them away leaving nada. The question arises as to what will replace that $400 million of earnings if interest rates start to increase and bond prices decline.

  • Shareholder equity declined from 17.1 billion to $15.9 billion during the fourth quarter, or about $1.20 per share.

Another New Paradigm

No not really new, the outlook remains the same, if slightly tempered for agency mREITs like Annaly Capital. The new year has started off with mortgage and MBS rates increasing, which will eventually allow the rate spread to spread - assuming short rates stay at or near zero - but the capital gains that have supported dividends for the last handful of quarters will not be as abundant.

When the Fed announced QE infinity back in September, I thought the MBS rates would fall to the point that possibly one or more of the mREITs would run out of enough spread to cover the expenses. That does not seem like it will happen. Only a black swan type of event will budge short rates off the floor, so at this point, I am comfortable with Annaly Capital being able to hold a 100 basis points spread over the next few quarters and possibly throughout the year. The problem is that spread is enough to justify a 30 to 35 cent quarterly dividend, not 45 cents and a $1.80 per year. Annaly shareholders can expect to earn $1.20 to $1.50 in 2013. I expect the share price to stay in the $12 to $15 range for the rest of the year.

NLY Chart

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Source: Annaly Capital's Q4 Results Show Decline Rate Slowing