Since bottoming out in the third quarter of 2005, Annaly Capital Management (NLY) has shown continuous improvement in operating results, rebuilding both its book value and its net interest spread after suffering through a prolonged period of flat and/or inverted yield curves. However, all good things must come to end, and it is with this sentiment in mind that I question if NLY's good fortunes are through. Here are three reasons that I believe NLY no longer has the wind at its back:
- Net interest spreads have peaked. Annaly reported that interest rate spreads of 2.40% at December 31, 2009, which exactly where spreads stood at September 30, 2009. NLY's cost of funds dropped by only 4 bps during the quarter, suggesting that the company's swap book has slowed its roll into lower rates. With mortgage rates remaining at record lows, the yield on NLY's asset book has continued its slow decline into the 4.5% range.
- Regulatory and accounting considerations have increased the likelihood that Fannie and Freddie will repurchase the seriously delinquent loans in agency-backed MBS pools. These "buy-outs" by the GSEs will effectively increase prepayment rate for investors in agency-backed securities, which increases the rate at which the original purchase premium on these securities is expensed against income. Increases in amortization premium expense will directly impact NLY's core earnings, the best available measure for gauging the company's dividend.
- The Federal Reserve is winding down its Agency MBS purchase program in the first quarter of this year. The decrease in buyer demand for agency MBS will put downward pressure on MBS prices. Because the Fed's purchase program exclusively involves fixed-rate MBS and Annaly's MBS book is 75% fixed-rate securities, the reduction in NLY's book value will be more significant than the reduction of the book value of its competitors.
Regardless of the headwinds now facing it, Annaly remains a bellweather of the agency-backed mortgage REIT sector. The company is much better diversified than in the past when it has faced negative macroeconomic trends and currently sports much lower leverage. As a result, Annaly may be able to mitigate future reduction of in its net interest margins by increasing its leverage.
I believe that Annaly will maintain the $0.75/share dividend for the next two to three quarters, but that book value will begin to erode in the second quarter of 2010. As the price-to-book ratio widens beyond historical norms, the stock will begin a slow decline in the second half of 2010 before settling in the $15/share range in early 2011.
Disclosure: Author does not hold a position in NLY.