Annaly Capital: Risks Have Been Reduced Thanks To Recent Events

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 |  About: Annaly Capital Management, Inc. (NLY)
by: Mardo Iknadiossian

Although recent market turmoil may have scared away investors from stocks that rely on debt markets, Annaly Capital (NYSE:NLY) was an exception, and it had a right to be so. In fact, in this environment, Annaly may provide higher returns due to decreased costs. To demonstrate my point, I will summarize Annaly's business model, its risks and how it hedges against them. I will also discuss its management practices, past returns and future outlook.

Business Model

Annaly Capital is a mortgage REIT. Its main business is buying long-term mortgage-backed securities financed by short-term loans. Its profits come from the spread between the interest income it receives from the mortgage-backed securities and the interest it pays for the short-term loans.

Risks

  • Borrowing ability and cost
    • Volatile debt markets create uncertainty, resulting in lower liquidity, which increases borrowing costs, thus diminishing the spread that Annaly needs to generate income.
  • Book value of securities
    • Negative perceptions of the global economy and general volatility in mortgage-backed securities markets may decrease the value of such securities. This causes Annaly to lose book value; it also drives up costs of borrowing since Annaly uses these securities as collateral for its short-term loans.
      The hereunder chart shows the effects of changes in interest rates on the portfolio value and interest income of Annaly from the latest 10-Q report.
      Change in Interest Rate Projected Percentage Change in Economic Net Interest Income Projected Percentage Change in Portfolio Value, with Effect of Interest Rate Swaps
      -75 Basis Points 8.86% 0.75%
      -50 Basis Points 5.88% 0.57%
      -25 Basis Points 2.72% 0.32%
      Base Interest Rate - -
      +25 Basis Points -1.74% -0.40%
      +50 Basis Points -4.14% -0.96%
      +75 Basis Points -6.87% -1.58%
      Click to enlarge
  • Potential Winding down of Fannie Mae and Freddie Mac
    • The type of mortgages that Annaly purchases is agency mortgage-backed securities. These mortgages are guaranteed against default by government-backed agencies such as Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), giving them an implicit rating of AAA. This guarantee protects Annaly from delinquencies, and allows it to obtain favorable financing terms. Any change in the structure of these agencies will adversely affect mortgage-backed securities markets causing volatility in security valuations and financing costs.
  • Prepayment Risk
    • Annaly is adversely affected when loans are refinanced or prepaid. This risk increases as interest rates go down.

Hedges

Annaly Capital has taken steps to mitigate its risks by diversifying its financing sources and income base by implementing the barbell strategy to protect its book value and by purchasing types of securities that reduce the risk of prepayments.

  • Financing
    • By using AAA rated agency-backed mortgages as collateral, Annaly gets attractive terms on its short-term loans.
    • AAA high quality mortgages are easily converted to cash, reducing risk of meeting margin calls.
    • Annaly has diversified its sources of lending by maintaining credit relationships with many high quality lenders and utilizing self-imposed limits on the amount borrowed from any one lender.
    • Interest rate swaps and other derivatives are used for protection against sudden rise in interest rates.
  • Book Value
    • Barbell strategy
      • Annaly owns two different types of mortgage-backed securities: fixed-rate and adjustable rate mortgages. Fixed rate mortgages rise in value when interest rates drop and fall in value when interest rates rise. The opposite is true for adjustable rate mortgages. This strategy helps in maintaining a stable book value in different interest rate environments. 89% of the portfolio is made up of fixed-rate securities and 11% is adjustable as of June 30th, 2011.
  • Prepayment
    • Annaly can hedge prepayment risks by buying planned amortization CMOs. Such CMOs divide a pool of mortgage loans into multiple tranches that allow for shifting of prepayment risks from slower paying tranches to faster-paying ones.
    • It can also reduce such risk by purchasing securities at a discount rather than at a premium. This way the amortized costs of the premium do not have to be realized at once during prepayment.
    • Also, it is important to note that Fannie Mae and Freddie Mac's mortgage repurchase programs are largely over, thus reducing risks of prepayment.
      • The average prepayment speed of Annaly’s securities for the quarter ending June 30, 2011 dropped to 11% from 32% of the same quarter last year.
  • Subsidiaries
    • Annaly has forayed into other fields of finance to diversify its sources of revenue. Currently, it operates 7 subsidiaries with intentions of creating more. For example, it has increased its management of third party fixed income securities, which is expected to generate annual fees of $75 million this year.

Management

Having been through both rising and falling interest rate environments, Annaly's management has gained the experience and know how to take the necessary steps to protect the company and allow it to thrive. For example, due to market volatility, management has reduced leverage to 5.7:1 (as of June 30, 2011) from 6.7:1 (Dec. 2010) by raising capital through equity sales and cutting liability. The equity sales will allow Annaly to purchase more mortgages in the future increasing income as management intends to maintain a ratio of debt-to-equity of between 8:1 and 12:1 when market conditions stabilize.

The management occasionally publishes papers on a variety of topics providing insightful commentary on market conditions and future outlook. These notes can help investors assess the risks in owning Annaly stock. The papers can be found here.

Returns

By paying regular dividends, Annaly has provided tremendous returns for its investors while maintaining a more or less constant share price over the years.

Below is a chart displaying the astronomical returns compared to different market indexes:

click to enlarge

Click to enlarge

Future Outlook

Recent events have reduced the risks associated with Annaly. Due to market volatility and Ben Bernanke's comments regarding interest rates, treasuries have rallied, driving interest rates to record lows. The continued weakness in the housing market and the economy in general have reduced the chances of a major change in Fannie Mae's and Freddie Mac's structure, easing concerns about the stability of mortgage-backed securities markets.

Prepayment risks are lowered because Fannie and Freddie's repurchase program is ending soon. These facts, coupled with the steps that Annaly has taken to protect it from such risks and improve its liquidity, makes holding its stock less concerning, and may even be more rewarding.

Disclosure: I am long NLY.