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Amid continued volatility in the interest rates, due to the confusion surrounding the final unwinding of QE3 by Fed, mortgage REITs suffered the most. The entire sector nosedived on fears of significant book value declines, particularly within the mortgage REITs that invested in Agency-only MBS. Among them, Annaly Capital Management (NLY) was considered the most favorable. Investors and analysts who were bullish on Annaly Capital were left astonished when it reported better-than-expected earnings for the second quarter.

Let's review Annaly's second quarter performance and see what growth potentials it has to offer in the coming quarters.

Earnings beat

Annaly Capital Management's second quarter performance was largely marked as better-than-expected. It reported EPS of $0.47per share, which remained $0.15 per share ahead of expectation. EPS was in line with the prior quarter's figure. The reported EPS also remains above its previously announced dividend rate of $0.4 per share.

Risk to future dividends persist

The earnings beat was attributed to a better-than-expected gain on sale of assets. During the quarter, Annaly Capital realized $0.16 per share in gain on sale of $14.8 billion worth of mortgage backed securities. After adjusting for the one-time item, EPS comes out to be $0.31 per share, below the announced dividend rate. Annaly has been supporting its dividends from gain on sale for quite some time now. However, the recent selloff in mortgages should yield lower gains going forward, creating pressure on the company's future dividends.

During the quarter, interest rate spread expanded 7 bps as yield on assets increased 14 bps, partially offset by 7 bps hike in funding costs. During the quarter, the company's book value plunged 14%. Compared to the reported book value decline, as of June 31 2013, Annaly was trading at 17.3% discount to its first quarter book value. This means the reported book value erosion of 14% is much less than the erosion expected by the market.

Risk to book value persist

Given the volatility in interest rates, mortgage REITs need to defensively position their investment portfolios in order to provide further cushion to book values. However, the investment portfolio of Annaly Capital doesn't seem be defensively positioned as previously imagined. Annaly's book value still seems to be susceptible to large declines if rates sell off or spreads widen further. Compared to this, many mREITs have reduced their duration gaps to protect against future book value erosion.

According to the latest financial disclosures, a 50 bps increase in interest rates would decrease its book value by nearly 9% while an additional 15 bps spread widening would yield nearly 5% book value decline. While book value would benefit from a rate rally, the chances of this are minimal at best.

Conclusion

In the earnings call, the management stated its belief that there is still room for the spreads to widen and indicated that they are actively trying to reduce potential risk to book value. However, since the company's dividends are also under pressure, the company will be attempting to balance risk mitigation efforts with their ability to support the current dividend rate. Given the blurred future, I would stay away from Annaly Capital Management until the rates stabilize.

Source: Annaly Capital: Risk To Future Dividend And Book Value Persist

Additional disclosure: Equity Whisper is a team of analysts. This article was written by our Financials analyst. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.