Jim Cramer Is Just Plain Wrong About Annaly

| About: Annaly Capital (NLY)

Jim Cramer is wrong. I disagree with him entirely, at least on his recent bearish call on Annaly Capital Management (NYSE:NLY). Basically, the call was somewhat benign during his lightning round of his show Mad Money. When asked about NLY at current levels, he stated:

"I say no. It is too difficult to understand in this taper, no taper environment."

Much of the headlines and action thereafter were predicated on the belief that "NLY is too difficult to understand." I'll admit, the mortgage real estate investment trust (mREIT) sector can really be confusing to many investors who own shares in the sector. However, unlike all of my prior articles on NLY, which have focused specifically on performance, or dividend sustainability or long-term performance of NLY, in this article I want to come right out and say NLY is not too difficult to understand, regardless of what Jim Cramer says or what the Fed says. I want you to understand NLY, a stock that I have been recommending after the recent rout it has seen in its share price, so I would like to focus this article on how mREITs, like NLY and its competitors make money. Bottom line, it's not too difficult Mr. Cramer.

So Just How Does The Company Make Money?

It's not that hard to understand how NLY, or most other mREITs operate. First and foremost, the companies often borrow and lend mortgage backed securities (MBSs). What are MBSs? MBSs are essentially debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property, but can be commercial as well. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization. Now, what feeds into their profits? The interest rate that NLY borrows at and the interest rate they lend at is called the spread. This metric is absolutely key and is one that you must assess when choosing an mREIT. I have written about it frequently. So where does NLY make its money? Well yes, from the spread, but how specifically? Generally, NLY has a pretty conservative business model and tends to borrow between the 2 year Treasury, and lend to the 10 year Treasury. So basically they borrow at a lower cost item lend at a higher rate, generating a spread and pocketing the difference. Then there is leverage, which allows potential profits to be magnified. This is when they lend further out on the curve, maybe to 15, 20 or even 30 years. This leverage is risky but can lead to huge profits. Although they leverage, NLY being somewhat conservative tends to have a lower amount of leverage than most mREITs.

How Can NLY Make More Profits Or Lose Money?

There are very basic things you need to be aware of. Forget about taper no taper madness. What you do care about with the Fed is that they have a zero interest rate policy in place. This keeps shorter term interest rates between 0 and 0.3%, so NLY will always be able to borrow cheap money. This has been key to maintaining a favorable spread. Pressuring the spread has been Fed purchase programs which can keep the longer term interest rates low as they purchase longer term treasuries. Anything that changes the yield curve between the 2 year and 10 year or 10 and 30 year rates can cause either widening or flattening of the spread. We saw a spike in interest rates in shorter term debt from May to August, which put massive pressure on the mREITs. Many of the spreads narrowed. This led to these stocks getting crushed. Occasionally sometimes the rates can be higher on shorter term debt than on longer term debt. This is a dangerous situation for NLY. The only option is proper hedging of the portfolio, rebalancing the portfolio rapidly and/or taking on more risk. If they do not, NLY will suffer losses. This situation occurred in 2005 for about 18 months, when the yields were really close on short and long-term debt. Revisit some of my old articles and you will find the dividend history. Notice that the dividend was hammered in 2005 and 2006, as a direct result of this yield curve compression. I alluded to the rate rises from May to August. That was pretty rapid. If all interest rates move higher quickly mREITs simply cannot rebalance their MBS holdings in a timely enough fashion. Many mortgage holders will look to refinance at lower rates or prepay their mortgage down. Refinances or prepays are a catch-22. If a borrower refinances or prepays their mortgage, NLY's MBS they hold for that mortgage is paid off and NLY gets a lump sum payoff. Thus they have more money to lend, but they stop earning the interest on the loan, which can hurt revenues in the short term.

Don't Fear The Fed

Forget what Cramer says. His call knocked NLY down 2.3% yesterday (Friday 10/4). You now have the nuts and bolts of how mREITs like NLY operate. They are not overly complicated to understand. There are some subtle nuances that differentiate mREITs. NLY does a great job in the 10-Qs outlining where all of their investments lie, and discuss subsequent market risks. I suggest consulting these for more detailed readings about how NLY is making money. But unlike Cramer, you don't need to stay away because you don't understand. The business model hasn't changed. The stocks have been volatile thanks to the Fed, but they haven't really done anything different policy wise in the past 6 months. It's been business as usual. Much of the action has been a result of fear that they may do something.

But my work has indicated that NLY can stand on its own two feet. They had two transitional quarters and being a shareholder has been painful. I began accumulating and completing a position on the way down. During this time, a lot of criticisms I received were surrounding the Fed and how devastating its exit will be. Let me be clear: With Ben Bernanke's comments in Boston over the summer following and FOMC meeting minute release, and then the no taper September announcement, it is clear most members advocate for an extension of the Fed's current economic stimulus program. Their accommodative stance remains in place because the economic data just isn't that strong.

The Fed is not advocating for tapering of asset purchases ahead of stable economic news and/or meeting the economic goals laid out when the program was announced. So the fears of this issue that partially punished the mREITs are simply unfounded right now. Among the most important takeaways is that FOMC remains adamant that the low-rate situation, or the zero rate interest policy, will not change until the unemployment rate drops to 6.5%. This is not likely until late 2014 or 2015. Furthermore, Ben Bernanke said that the current unemployment rate of 7.6% might be overstating the "health of the labor market," and as such "highly accommodative monetary policy for the foreseeable future is what's needed."

Disclosure: I am long NLY. 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.