Annaly's Continuing Metamorphosis

| About: Annaly Capital (NLY)

Last week, Annaly Capital Management Inc. (NYSE:NLY) filed a proposal with the Securities and Exchange Commission regarding a potential modification to its structure so that it would be managed by a new entity composed of the same people that presently run the mortgage REIT. This new proposed entity would be named Annaly Management Company. The decision on whether to make the change will be put to a shareholder vote at Annaly's annual meeting on May 23.

Annaly, the largest mortgage REIT, has made some trailblazing moves within the agency mREIT industry, but this is not one of them. This structural change would make the REIT more like many of its competitors, such as American Capital Agency Corp. (NASDAQ:AGNC), the second largest mortgage REIT, and Invesco Mortgage Capital Inc. (NYSE:IVR), a large hybrid mortgage REIT.

One of the more notable changes that this structure will put in place is that Annaly will not have to disclose individual executive compensation. Instead, the total cost of employee payroll and other administrative expenses would merely be disclosed as a line item. The company drew some criticism in the past for executive compensation. The mortgage REIT manages a sizable portfolio of over $130 billion in federal agency guaranteed residential mortgage-backed securities and related paper, and one would expect that compensation would be substantial, but in 2011 it paid its then Chairman and CEO, Michael Farrell, more than any domestic bank CEO earned. In late 2012, Farrell died and Wellington J. Denahan took over as the company's Chairman and CEO (she, like Farrell, was a founder of Annaly). Denahan earned $25.8 million last year.

Under the proposal, Annaly Management Company would be paid a management fee of 1.05 percent of shareholder equity, which the company estimates would have resulted in saving the company $48 million last year, if already utilized.

Annaly was historically not only the largest mREIT, but also one of the more conservative REITs that invested solely within the agency-backed mortgage paper space. Though always employing leverage, Annaly generally maintains a lower leverage rate than most of its peers. More recently, Annaly has begun to make changes to its normal course of business that indicates it believes the industry is poised for a shake-up in the coming quarters.

Annaly's first unorthodox move came last October, when the company announced a $1.5 billion share repurchase plan over a 12-month period. This was a noticeably different and quite contrary move compared to the standard serial secondary stock offerings made by most mortgage REITs. Prepayments and high dividend payouts usually compel mortgage REITs to go to the market and sell additional shares in order to raise funds and expand their operation. This move indicated that Annaly was not interested in such expansion in the near term.

For several quarters prior to Annaly's share repurchase plan announcement, interest rates declined and most mortgage REITs sustained declining spreads and rising prepayment rates. This made it difficult for mREITs to maintain dividend rates, without buying riskier securities and/or instituting higher leverage rates. Annaly reduced its dividend in five of the last seven quarters, though last week it did report that it will maintain its $0.45 payout from Q4 of 2012 for its Q1 2013 dividend.

More recently, Annaly also announced its plans to acquire the portion of Crexus Investment Corp. (NYSE:CXS) that it did not already own for about $872 million. Annaly already owned 12.4 percent of Crexus, which is managed by FIDAC, a wholly owned subsidiary of Annaly. The commercial mortgage backed securities (or "CMBSs") that compose Crexus's portfolio generally carry higher yields than agency-backed RMBSs because they are not considered default-proof, while the agency-backing of Annaly's traditionally held RMBSs is considered essentially default-proof.

While many non-agency-backed RMBSs and CMBSs fell apart due to the popping of the subprime real estate bubble, agency-backed RMBS investors survived the crisis because of that backing, and subsequently recognized capital appreciation as interest rates declined. Now, due to the historically low interest rates at which government debt trades, agency-backed debt is looking riskier and yielding less. As a result, Annaly has opted to diversify out of its bread-and-butter holdings. At the time Annaly made its initial bid for Crexus, Denahan commented that:

"While we remain committed to the Agency market, given the current environment, we believe it is prudent to diversify a portion of our investment portfolio. Therefore, we may allocate up to 25% of our shareholders' equity to real estate assets other than Agency mortgage-backed securities."

It is also entirely possible and rather likely that Annaly will not only add CMBSs to its portfolio, but also include non-agency RMBSs within its holdings. Though still merely speculation, there appears a growing likelihood that Annaly will eventually seek to absorb Chimera (NYSE:CIM), a non-agency mREIT in which Annaly also owns an interest and that is also managed by FIDAC, much like it is now doing with Crexus. Chimera also holds a decent amount of agency RMBSs like those that Annaly traditionally exclusively held.

Chimera has been plagued with accounting and SEC filing issues for the last several quarters. This March, Chimera finally filed its 2011 annual report and is still yet to provide its 2012 filings. Much of Chimera's accounting problem originated from its ownership of non-agency RMBS paper that existed before 2008, and which initially traded with exceptionally high credit ratings before being downgraded to junk. The company's repackaging and selling portions of those downgraded securities further complicated Chimera's accounting.

If Chimera can soon produce its remaining truant filings, it may be Annaly's next acquisition target. Part of the reason Chimera appears such a probable acquisition target for Annaly is that it may be a conflict of interests for Annaly to strategically expand into non-agency RMBSs while also managing an external portfolio of them. Annaly's CFO and Treasurer, Kathryn Fagan, commented on its relationship with Crexus and Chimera during the company's last conference call, noting that:

"Annaly's participation has been as an equity owner in those companies, and part of the reason for the Crexus transaction is that we do need to remove some of the conflicts I guess, of being able to expand those positions on our own balance sheet while we have these public companies out there that we manage."

Even if such a purchase were to occur, it would likely not happen until Annaly completes its acquisition of Crexus and Chimera files its reports. It is likely that Annaly's annual meeting on May 23 will likely occur in advance of any further acquisition attempts or other attempted changes by Annaly. Nonetheless, it does appear that Annaly will continue to modify its strategy and holdings during 2013.

Disclosure: I am long NLY, CIM. 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.