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Annaly Capital (NYSE:NLY) is now down 22% since the start of May. Those losses will take about two years of dividends at the current price of $12.50 to recoup. Assuming the share price and dividend stay fixed, we still have a juicy 12.8% yield, but capital losses have been dramatic. Further, the dividend has been cut time and again. Most recently, the latest payment has been reduced to $0.40. But NLY is not alone. My favorite mortgage real estate investment trust (mREIT), American Capital Agency (NASDAQ:AGNC) recently announced its next quarterly distribution, which was cut by 16% to $1.05, and as such, only results in a forward annual yield of 18.2%. This is based on the current price of AGNC at the time of this writing, which is $23.00. While holders of NLY have been clipped for 22%, holders of AGNC are looking at a 30% haircut. And it has not been just my two favorite mREITs that have been crushed. What about my third largest mREIT holding, Western Asset Mortgage (NYSE:WMC)? It is pretty much equally as beaten down, now trading at $17.00, down some 27% since May 2013. How about my position in the hybrid mREIT, American Capital Mortgage Investment (NASDAQ:MTGE)? It can be had for just $18.00 when it was $23.00 weeks ago. With the immense pressure on mREIT share prices, I really need to question whether NLY can survive the storm and discuss what to do with this stock. At the end of the day, is NLY down and out, or is it just getting started?

So What's With The Relentless Selling?

For a time, the price of NLY was dictated by its earnings and dividends. Interest rates, while playing an underlying role, were less volatile. However, as I predicted, the FOMC meeting, and more importantly the comments by Ben Bernanke, spiked interest rates which weighed heavily on the mREITs and on the broader markets as a whole. As I write we are heading for the fourth straight down session on exceptional volatility. Why? Well, Bernanke's comments were pretty reasonable, but the market reaction has been less than sensible. Last week's FOMC meeting, in the eyes of large money managers, was the most important one so far for the near-term action in mREITS as we got some clarity as to when tapering of the Fed's purchasing would occur. We learned that tapering will be as early as 2013, but most likely in 2014. The timing will be heavily data-dependent but the Fed will indeed taper mortgage asset purchases and other balance sheet expansion if the data is strong. The irrational thing about the market's reaction was that we all knew this was coming. We knew that buying could not go on indefinitely. The markets reacted as if they were expecting Bernanke to announce an unending purchasing program. Here we are four days later, trying to hit some sort of floor where buying can pick up.

The Key Statement Affecting mREITs

In the post meeting speech, Mr. Bernanke also stated that the Fed would not sell their mortgage backed securities (MBS), but likely let them mature. This statement alone led to my screens flashing red. The statement led to a sharp decline in mREITs moments later, as if Bernanke announced he would sell every last MBS they owned (there by driving their value down). While the meeting minutes will not be released until for another few weeks, the fixed income markets have sold off on Mr. Bernanke's post-meeting talk resulting in a spike in rates. As soon as the speech was completed, interest rates jumped immediately. We are currently looking at a ten year treasury that is yielding 2.6% while a thirty year mortgage is being quoted over 5%. While the rise in interest rates was a topic of discussion for the FOMC, it must certainly be an increasing topic of importance and may dominate the July meeting. Despite what housing bulls may argue, rates rising this fast will likely crush mortgage applications. On the bright side, the rising long-term rates, coupled with low borrowing rates for NLY, suggests that this selloff could be a buying opportunity. While MBS values have been decimated, which will hurt book value, NLY can now take advantage of a widening interest rate spread to reposition its holdings moving forward. Further, unlike my largest mREIT holding AGNC, NLY has another way to make money in this market.

What NLY Has That AGNC Doesn't

As you may be aware, I have encouraged mREIT investors to consider diversifying into hybrid mREITs (such as MTGE), which are companies that have exposure to both residential MBS and commercial-backed mortgage securities. NLY has always been heavily invested in residential MBS. However, given the market climate, management has recognized that the commercial real estate market has yet to pick up steam compared to the residential market. The one thing NLY has that AGNC does not, which makes me believe in owning this stock for the long-term regardless of the headline risk and short-term volatility, is that the company has recently completed the purchase of CreXus (NYSE:CXS). This purchase is critical because it will offer NLY massive diversification advantages. CreXus acquires, manages and finances, directly or through its subsidiaries, commercial mortgage loans and other commercial real estate debt, commercial real property, commercial mortgage-backed securities and other commercial and residential real estate-related assets. Also, NLY is renaming the company to Annaly Commercial Real Estate Group following the closing of the merger. This purchase will allow NLY to diversify its investment portfolio and when commercial real estate mortgage picks up, it will help future earnings growth. Chief Executive and Chair of the Board Wellington Denahan said of the acquisition during the last conference call:

"The CreXus's acquisition is accretive to the Annaly dividend and represents a meaningful step in the evolution of Annaly's capital allocation strategy, one that will enable us to take advantage of a broader spectrum of investments. Since the announcement of this acquisition in November, we have continued to build out our commercial expertise and we remain confident that CreXus' capabilities and growth may be significantly enhanced when coupled with Annaly's broader capital base."

It is not a secret that the commercial real estate market has lagged the residential real estate market. Being focused on residential MBS concentrates risk, thus an added layer of diversification is wise. With evidence that the US economy is on the rebound, it is likely the commercial mortgage market will be a significant source of revenue moving forward. Thus, NLY has wisely taken steps so that it will not be down and out for long, and can emerge from the ashes of this firesale much stronger.

My Recent Moves in NLY

I was not pleased with the dividend cut even though I expected it. However, the stock is currently yielding 12.8%. With its diversification in the commercial markets and its solid management team in the residential business, I think NLY is incredibly attractive for the long-term investor right now. I recently chose to expand my mREIT threshold in my portfolio by double, to allow myself to take advantage of the bargain prices mREITs. I added to my NLY position today (6/22/13) at $12.25.

My Recommendation Going Forward

We must be cautious of a flattening of the yield curve, but for now this curve is widening. In the last few sessions, it has leveled off a bit, but the trend is in place. The slowing of the interest rate spread widening could reduce the pressure that has been on MBS prices which have hurt NLY's stock. Despite the markets' overreaction to the Bernanke speech I actually think the confirmation from the Fed that it will continue its asset purchases for the foreseeable future is good for NLY as it repositions its residential MBS portfolio. As a long-term investor, I think it is prudent to buy stocks that are on sale so long as the management team is strong and the underlying business model is intact. The latter has been called into question by many, but I argue that NLY has been in business well before quantitative easing ever began, and was profitable when interest rates were much higher. Further, the move into commercial assets is wise as it offers another diverse source of revenue. The exceptional volatility in NLY and its competitors has led to incredible long-term buying opportunities for investors as the high dividends, which will always fluctuate over time, can be reinvested to compound one's investment over time. The best course of action is to add to holdings during times of fear, and to always take advantage of buying stock in these companies when they trade at a discount to their net asset book values. Trading around the core position (buying when the stock gets unfairly punished and selling when the stock gets ahead of itself) and reinvesting those dividends over many years, is the secret to winning in the long-term at this game.

Source: Annaly Capital: Down And Out Or Just Getting Started?