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With a dividend yield of more than 14%, it is hard not to be interested in Annaly Capital (NYSE:NLY), the largest mortgage REIT. The last five headlines of Seeking Alpha articles about the company--all positive--demonstrate that it is a popular stock among buy side analysts and contributors to Seeking Alpha.

Annaly Yield vs. the S&P 500
The S&P 500 (NYSEARCA:SPY) has a dividend yield of a little over 2%, meaning Annaly's dividend is more than 600% higher. What is the catch with Annaly's huge dividend? What could go wrong? This article, and the next one in the series, which is forthcoming, aim to examine that question by taking a look at the company's financial statements and figuring out how Annaly makes money.

The article refers to the company's latest quarterly filing with the SEC, available here (pdf). As with some of my other articles, we are looking at the big picture so numbers may be rounded more than would be appropriate in a thorough analysis, to simplify the math.

Fair Warning & Disclosure: The author is a real estate investor, not a trained stock market analyst. The analysis in this article was done based strictly on the financial statements without any external support from the company and without referring to any sell-side analyst coverage of the company. I am interested in Annaly because I manage a portfolio of real estate loans...a miniature version of a mortgage REIT, but with virtually no leverage. This perspective may allow me to analyze Annaly a little differently than the average analyst, hopefully providing a different perspective on its business than the usual one.

Annaly's Balance Sheet
Annaly lists assets of $101 billion, including $97 billion of "Agency Mortgage Backed Securities." These are bonds issued by Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC), and Ginnie Mae, mostly backed by home loans. Fannie and Freddie are government owned today (and losing a lot of money). There is a stong likelihood the government will keep pumping money into the agencies before they would let owners of Fannie and Freddie bonds take any losses.

Note: "Strong likelihood" is not the same as an absolute guarantee. Hence the difference in yield between Agency bonds of Fannie and Freddie, vs. treasury bonds with the same maturity.

On the liability side, Annaly shows $78 billion of "Repurchase Agreements"--loans to Annaly secured by the agency bonds that it owns. Another $5 billion is listed as "Payable for Investments Purchased." Together, these two items total $83 billion. So of $97 billion of bonds held, Annaly is borrowing about 86% of the money and has actually put up cash for something like the other 14% (actually, a little less, since there are some other liabilities that we are ignoring in this analysis).

Let's pause here to calculate one more thing, which will become important later. If we look at the ratio of Annaly's debt to equity, we get 86%/14%=about 6 times.

Annaly's Income Statement
Annaly received interest on its portfolio of Agency bonds in the latest quarter of about $950 million. Annualizing that number, we can estimate interest income of $3.8 billion. Comparing the interest income of $3.8 billion and the balance sheet entry of $97 billion of such bonds, we can estimate Annaly is earning about 3.9% on its portfolio of bonds. Page 11 of the quarterly report of Annaly shows how the Company is earning this yield--about a quarter of the agency bonds owned have a maturity of more than five years, while the lion's share of the balance is securities with a maturity of 1-5 years.

Meanwhile interest expense on the loans to purchase most of those bonds was about $100 million. Annualizing this number, we get $400 million. Comparing this expense with the principal amount of Annaly's loans of $83 billion, we can see the effective borrowing costs is about 0.5%-a very low borrowing cost. Page 13 of the annual report states that the weighted average maturity of these loans to Annaly is 130 days.

Tying it All Together
Annaly earns a 3.9% interest rate on its investments, and borrows money at an effective rate of 0.5% (on the borrowings secured by those investments). The "spread" between these two numbers is 3.4%.

As we calculated previously, Annaly has leverage of about 6 times. Therefore, this "spread" is magnified by a factor of about 6, resulting in a return on equity (before operating expenses) of something like 3.4% x 6 = about 20%. Let's call this number the "cash-on-cash return" after accounting for leverage, but before accounting for operating expenses.

Of course, Annaly does have operating expenses. General and administrative expenses were $57 million in the latest quarter, or about $228 million on an annualized basis. The top two officers of the company each earned about $24 million last year, and the CFO earned another $9 million or so. Annaly also appears to spend some money on hedging various risks in its portfolio, which is presumably one of its larger expenses.

When various expenses are taken out, Annaly can afford to pay shareholders a 14+% dividend. So, if Annaly were a fund rather than a public company, the operating costs and management fees would eat up about 6% of the maximum possible return of 20%, which is the approximate return that investors would receive if operating costs and management fees were zero, and all the cash flow were paid out to investors.

In the next article, we will examine the risks facing investors in Annaly Capital, referring back to the underlying analysis in this article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: How Risky Is Annaly Capital?