Annaly Capital Management: Is Excellent Performance a Thing of the Past?

Annaly Capital Management, Inc. (NLY) is a medium-sized investment fund that invests in mortgage-backed securities. While this sounds risky, it is not, at least not the way NLY manages the business. The company invests almost exclusively in MBS guaranteed by Fannie Mae (FNM), Freddy Mac (FRE) and Ginnie Mae. Now that these monsters have been taken over by the government, most of NLY’s assets effectively carry a U.S. government guaranty.

NLY runs its business as a REIT and thus pays no taxes on its earnings. Each quarter it pays most of its earnings out in dividends. NLY’s assets are funded by repurchase agreements and equity capital. Leverage is about 7/1. Through this leverage the company turns a net yield on the portfolio that has been running at about 2% into an ROE of approximately 14%, which is nothing short of a fantastic performance, compared to most other companies.

For management purposes NLY tracks a measure it calls core earnings, rather than net income. (This is yet another example of how far GAAP accounting has strayed from economic reality – more and more conservative companies are having to resort to these non-GAAP measures in order to report a more meaningful earnings figure.) Core earnings consists of net income excluding impairment losses, gains and losses on the sale of securities, gains and losses on the termination of interest-rate swaps, and unrealized gains and losses on swaps. The company recently stopped using hedge accounting for swaps, again because the rigidity of the accounting rules were throwing off results that did not fully reflect the economics of the business, resulting in a lot of extra bookkeeping costs.

At year-end 2008 NLY had total assets of $57.6b. During the quarter it produced core earnings of $262m, or $0.47 per common share. In the same quarter a year ago the company earned $0.37 per share and in Q3 2008 it had core earnings of $0.61 per share. (Since its business is not seasonal, it makes sense to track earnings from one calendar quarter to the next rather than from one quarter to the same quarter a year ago.)

Annaly runs a barbell strategy in its asset management. On the one hand, much of the portfolio consists of floating rate assets, on which a reliable spread is earned no matter where interest rates go. However, part of its portfolio is fixed rate, so earnings on that portion of the portfolio are more volatile, or, better said, earnings on the portion of the fixed rate portfolio that is not hedged by interest-rate swaps is volatile. Credit risk is not a feature of the company's business, since all the assets are guaranteed by federal agencies, but prepayment risk is. However, NLY has been at this game a long time, and knows more than most about how to manage prepayment risks.

Dividends declared in the fourth quarter were $0.50 per share, which produces an annualized yield of 13% on the recent $15 share price. These dividends are down a bit from Q3 ($0.55 per share), reflecting the fact that earnings have fallen a bit since the earlier quarter.

NLY is a very transparent company that gets high marks for its openness. It has an interesting website that provides a high level of disclosure about its business http://www.annaly.com/ and it runs a very efficient operation. G&A expenses were only 0.13% of average assets during 2008.

One aspect of the quality of disclosure is the useful chart presented in the press release announcing Q4 results (Call Transcript). In it one sees some clouds forming, however. Not only have quarterly earnings declined somewhat, from $0.61 in Q3 to $0.47 in Q4, but the spread between the yield on the portfolio and the costs of funds is trending lower. The average spread on the portfolio shrank from 2.08% to 1.71% from one quarter to the next giving rise to the falloff in quarterly earnings.

The more recent trend represented by the spread at the end of the two quarters is more worrying. This spread was 1.68% at the end of Q3 but only 0.95% at the end of Q4. Also of some concern is the fact that the Fed started buying MBS only in January, so the yield-reducing effect of their presence has not been fully felt yet.

So expectations for 2009 should be more modest than the excellent performance posted during 2008. It could be that the 13% yields enjoyed recently are a thing of the past. Investors should keep tabs on the next dividend announcement, expected in March, along with the announcement for first quarter earnings that will be made a month later.

Disclosure: Positions held in AHL, HUM, JPM, ITU, TNE, GFA

Comments

[BearClaw:]

The quarter end spread was still being dragged down from the spike in LIBOR in Oct...now that rates are~1% ,if not lower, their spread should return to 2%+ once they roll their repos in Jan.

Feb 17 10:37 AM

[Leonard the...:]

Agree with BearClaw and I think HTS looks like an even better buy at the current level.

As such I have been buying.

Feb 18 01:25 PM

[gizzer:]

It may be better to make projections based on the more recent [Jan & Feb 2009] Libor figures. It is unlikely the Libor numbers of 2008 will be repeated in the near future.

Feb 18 01:26 PM

[William Arm...:]

I did not make any projections for libor. I simply noted that the spread between the rate at which NLY borrows and the rate they earn on their assets had narrowed sharply during the last quarter of 2008. The spread was 1.61% at the beginning of the quarter and only 0.95% at the end. That means that NLY began Q1 09 earning a spread 40% LESS than the spread that they started the previous quarter at. That does not bode well for earnings this quarter.

Feb 18 11:59 PM

[olrick:]

Good points on both sides, but let's not lose the big picture. Here's a financial stock actually making money, and dealing in government guaranteed paper to do it. Maybe their spreads are narrower this quarter, but they are not bankrupt, taken over, being bailed out or flitting around in the company jets...what's not to love?

Feb 19 08:41 AM

[jessducky:]

the writer writes well but seems not to understand the stock. he includes a link to the call transcript but apparently didnt read it or he would have understood that the increase in cost was a spike, not a trend, that will roll off in the next qtr. Eventually spreads will narrow but the book value of the MBS's will increase, and NLY trades off of book value.


On Feb 17 10:37 AM BearClaw wrote:

> The quarter end spread was still being dragged down from the spike
> in LIBOR in Oct...now that rates are~1% ,if not lower, their spread
> should return to 2%+ once they roll their repos in Jan.

Feb 22 08:48 PM

[Greener Pas...:]

There are definitely two camps going here. Please keep your comments coming. I'm new to this and it's interesting to see the debate, and it will be interesting to see how it plays out.

Mar 04 08:03 PM