The bulk of the assets owned by Annaly Capital Management, Inc. (NYSE:NLY) consist of mortgage-backed securities and debentures issued by Fannie Mae, Freddie Mac or the Federal Home Loan Banks (together, "Investment Securities"). These securities account for 95% of NLY's asset portfolio as of 6/30/14. NLY relies primarily on short-term borrowings to acquire Investment Securities with long-term maturities. The shape of yield curve, the spread between returns on assets owned and the interest paid on amounts borrowed to purchase these assets, and amount of leverage (the bulk of which is generated via the repurchase markets) are the key drivers of profitability.
NLY's Investment Securities are classified for accounting purposes as "available-for-sale." They appear on the balance sheet at fair value, but unrealized gains and losses on these securities do not appear on the income statement. Instead, such gains and losses are reported on the balance sheet as a separate component of stockholders' equity. In addition, net interest income as measured by GAAP does not include all the expenses of interest rate swaps. The portion classified as "Realized gains (losses) on interest rate swaps" appears below the net income line, buried in the statement of comprehensive income.
Management therefore uses a non-GAAP definition of net interest income. This is referred to as "economic net interest income" and is derived by deducting economic interest expense from interest income. The exact manner in which economic net interest income is determined is detailed in a prior article.
A simple model describing NLY's bread and butter business of using short-term borrowings to acquire Investment Securities is presented in Table 1 below. Economic net interest income is used as a proxy for net interest spread (line 4 of the table). The model can be used to assess whether NLY's dividends are sustainable and whether there is reason to be optimistic about a prospective dividend increase. Applying this model to NLY's recent quarterly and trailing twelve months ("TTM") results generates the following output:
Encouragingly, in the latest TTM period and in 2 of the last 3 sustainable coverage of dividends moved into positive territory (i.e., above the 1x threshold).
The improved performance has been driven by several factors. In 4 of the last 5 quarters net interest rate spreads increased (the exception is 1Q14). That, coupled with dividend reductions (line 13), produced positive coverage in 4Q13, for the first time after 8 consecutive quarters of below 1x coverage. In 1Q14, the combination of a decline in net interest spread and lower leverage returned NLY to negative (i.e., below 1x) coverage (line 14).
The current dividend again seems to be aligned with what NLY's basic business model can produce. The good news is that the return to positive coverage in 2Q14 was achieved without increasing leverage and was almost entirely driven by the better net interest spread. I believe it is prudent for management to see if this continues for another 1 or 2 quarters. If it does, the long trend of declining or flat dividends (the last increase was over 3 years ago, in 2Q11) may finally be broken. The model also provides investors an order of magnitude with respect to the amount of a possible dividend increase.
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