The 2013 first quarter was tough on the holdings and book values of the mortgage REIT companies when market fears led to a declines in agency mortgage-backed security values. Annaly Capital Management (NLY) took advantage of the lower prices to swap out low-yield MBS for some better paying securities. However, in my opinion it will be tough for Annaly Capital and the other mREIT companies to maintain their dividend levels over the next few quarters.
Upgrading the Portfolio
During the first quarter earnings conference call, Chairman and CEO Wellington J. Denahan stated that during the first quarter Annaly sold $17 billion in mortgage assets and booked a $182 million gain. More importantly, the sold assets had a book yield of 1.27%. As a result, the end of quarter average yield on the portfolio was 2.72% compared to a weighted average of 2.37% for the full quarter.
I am not sure how much of the sales proceed have been reinvested to date. At the end of the quarter the balance sheet listed $108.3 billion of agency MBS at the end of the quarter, compared to holdings of $125.6 billion at the end of 2012. Quarter-end values of owned reverse repo agreements and agency debentures were $4.3 billion higher compared to the end of last year and the income statement showed about $870 million of non-realized portfolio losses. Overall, total assets declined by $8 billion for the quarter.
Selling off the low-yield MBS should allow Annaly Capital to show a higher net interest spread for the second quarter and it will be interesting to see if capital goes into more agency MBS with better yields or if the company is holding back to go hard into commercial mortgage lending when the CreXus acquisition is complete later in May.
Still Living on Realized Portfolio Gains
Over the last year or so, I have been pointing out that the mortgage REITs have to a great extent been supporting current dividend levels by selling securities at a profit and paying a portion of the dividends out of realized gains. The problem with this approach is that when rates start to rise, bond prices will fall and there will be no gains to hold up the dividend until capital can be reinvested at the new higher rates to earn enough net interest spread to cover the dividend.
For the 2013 first quarter Annaly reported adjusted net income of $464 million. I like the adjusted net number because it excludes the highly volatile unrealized gains or losses on interest rate swaps and Agency interest-only mortgage-backed securities. Common share dividends payable for the quarter totaled $426 million, so the adjusted net handily covered the distribution. However, realized gains from securities sales and included in the net income were $182 million or almost 40% of the net income for the quarter.
For the 2012 fourth quarter, the adjusted net income was $465.1 million, putting the first quarter of this year at basically the same level. However in the final quarter of 2012, realized gains from the sale of securities accounted for $115 million of adjusted net income or 25%.
Annaly Capital should show a higher net interest spread for the second quarter and the CreXus acquisition is expected to be accretive to per share earnings. Both are positives for the dividend. However, CreXus will only be in the fold for two-thirds of the quarter and net interest is currently generated by a smaller portfolio. Annaly would need to leverage up the portfolio to boost net interest earnings compared to the first quarter.
I would not be surprised to see another dividend cut for Q2, possibly down to 40 cents per share. Annaly Capital continues to position itself for long term survival and growth, but the current agency MBS market makes it nearly impossible to sustain the current dividend without realized gains from selling securities. With rates volatile to flat, those gains are going to be harder to book and include in the net quarterly income.