For quite some time, one of the biggest hurdles faced by Annaly Capital (NLY), as well as the other agency backed mREITs, was all of the refinancing and pre-payments of existing FHA mortgages. Whether it was due to foreclosure or government policy (HARP, HAMP, etc.), any of the securities held by NLY would be paid off, and the income flow would diminish, even though the company's cash reserves would increase as well as its book value.
Then NLY would re-enter the MBS market, as usual, but the spreads would be narrower due to the lowered rates inflicted by Fed policies, and there would be less profits coming in from that end of the business as well.
With no income coming from the prepaid mortgages, and lower profits due to a narrower yield curve spread, the spiral would be downward - both in share price as well as dividends, as we have seen over the last year.
I suppose one can compare it to a retail store that sells all inventory, has no profits or revenues coming in, and then must pay much more for new inventory and must charge LESS to sell the new inventory. I believe you can understand the situation.
Times Have Changed, A Little
There are still headwinds of course, one being the narrowed spread in the yield curve. This will still make it difficult to consistently increase profits. The other headwinds would be that of rapidly rising interest rates. Since Annaly would be holding instruments at lower rates, it would be very difficult to turn those over, or sell them, to replace them with higher rate instruments.
What has happened is that even though the Fed is playing in NLY's sandbox, by buying the same mortgage backed securities to the tune of $40 billion per month each and every month, it has had little impact on refinancing of existing mortgages.
Even though the Fed continues to buy longer-term Treasuries, the impact on the yields has been minimal for the last 6-9 months. What all of this means is that NLY has a more stable environment to work within. In effect, some of the major risks have abated for now.
In the latest testimony Ben Bernanke has given to congress, he reiterated that the Fed has no immediate intentions of ending its zero interest rate policy, or the $85 billion being spent on Treasuries and MBS each and every month.
Contrary to the noise we had heard from some fed officials, Bernanke has reiterated the Fed's position rather strongly. As I noted in this article, directly from the testimony:
With unemployment well above normal levels and inflation subdued, progress toward the Federal Reserve's mandated objectives of maximum employment and price stability has required a highly accommodative monetary policy ... The December postmeeting statement indicated that the current exceptionally low range for the federal funds rate "will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored ... Last September the FOMC announced that it would purchase agency mortgage-backed securities at a pace of $40 billion per month, and in December the Committee stated that, in addition, beginning in January it would purchase longer-term Treasury securities at an initial pace of $45 billion per month.4 These additional purchases of longer-term Treasury securities replace the purchases we were conducting under our now-completed maturity extension program, which lengthened the maturity of our securities portfolio without increasing its size. The FOMC has indicated that it will continue purchases until it observes a substantial improvement in the outlook for the labor market in a context of price stability.......As I noted, inflation is currently subdued, and inflation expectations appear well anchored; neither the FOMC nor private forecasters are projecting the development of significant inflation pressures.
It seems very likely that the easy money era is not dead. It is also not having much of an impact, which helps NLY, and other agency mREITs. Take a look at this report from the Mortgage Bankers Association.
The Refinance Index decreased 3 percent from the previous week. The seasonally adjusted Purchase Index decreased 5 percent from one week earlier and is at its lowest level since the week ending December 28, 2012. The unadjusted Purchase Index decreased 2 percent compared with the previous week and was 14 percent higher than the same week one year ago.
The re-finance "well" seems to be drying up, and the delinquency rates are dropping (as well as foreclosure rates). Take a look at a chart from this report:
Also from the Mortgage Bankers Association:
The delinquency rate for mortgage loans on one-to-four-unit residential properties fell to a seasonally adjusted rate of 7.09 percent of all loans outstanding at the end of the fourth quarter of 2012, the lowest level since 2008, a decrease of 31 basis points from the previous quarter, and down 49 basis points from one year ago, according to the Mortgage Bankers Association's (MBA) National Delinquency Survey, released today at MBA's National Servicing Conference and Expo in Dallas, Texas.
While delinquency rates typically increase between the third and fourth quarters of the year, even the non-seasonally adjusted delinquency rate dropped 13 basis points to 7.51 percent this quarter from 7.64 percent last quarter.
The delinquency rate includes loans that are at least one payment past due but does not include loans in the process of foreclosure. The percentage of loans on which foreclosure actions were started during the fourth quarter was 0.70 percent, the lowest level since the second quarter of 2007, down 20 basis points from last quarter and down 29 basis points from one year ago. The percentage of loans in the foreclosure process at the end of the fourth quarter was 3.74 percent, the lowest level since the fourth quarter of 2008, down 33 basis points from the third quarter and 64 basis points lower than one year ago.
The serious delinquency rate, the percentage of loans 90 days or more past due or in the process of foreclosure, was 6.78 percent, a decrease of 25 basis points from last quarter, and a decrease of 95 basis points from the fourth quarter of 2011.
"We are seeing large improvements in mortgage performance nationally and in almost every state. The 30 day delinquency rate decreased 21 basis points to its lowest level since mid-2007. With fewer new delinquencies, the foreclosure start rate and foreclosure inventory rates continue to fall and are at their lowest levels since 2007 and 2008 respectively," said Jay Brinkmann, MBA's Chief Economist and Senior Vice President of Research.
As investors in this sector, we should always be monitoring any of the changes in the mortgage landscape that can affect the shares of our holdings. Whether the changes are positive or negative. In the above cited examples of the current environment, the affects are positive for shareholders of Annaly Capital, in my opinion.
The Current Interest Rate Environment
With all of the Fed policies in place, mortgage rates have actually ticked up a bit, as well as the spread between the 2 and 10-year Treasury yields. To me, this looks like a very stable environment for NLY to work within.
With a stable interest rate environment, lower pre-payment risks, and "better" mortgages going forward, I believe that we just might see a more stable dividend from NLY in the months ahead. That does not mean that we will not see another dividend cut next quarter, or even the quarter after that. What I do believe is that the cuts could be less, and after that, remain stable (I am not ready to predict dividend increases however).
At the current yield of about 12.5%, even if the yield were to drop a full percentage point, shareholders will have a better environment to buy and hold shares of NLY while receiving a very strong income stream.
Obviously I believe I have laid out a solid bull case for owning shares of Annaly Capital. I have always liked their conservative approach and the way management has navigated virtually all interest rate environments.
With the recent indicators I have noted above, I believe that NLY's conservative approach, plus the anticipated purchase of CreXus (CXS), which would widen NLY's business model, leads me to believe that owning shares of NLY right now, will benefit any dividend income seeking portfolio.
Please understand that these are only my opinions, and you should not buy or sell any security based on this, or any other opinion. Do your own research and due diligence, as well as consulting with an expert in this field, prior to making any decisions.
Disclosure: I am long NLY.