The Fed recently announced the implementation of Operation Twist. Over the course of the year until June 2012 they will sell around $400 billion of short-term treasuries and use the proceeds to purchase 6 to 30 year treasuries. This will further lower the yields of long-term treasuries, narrowing the spread between short-term and long-term interest rates.
Mortgage REITs depend on this spread to make their income. They buy long-term mortgage-backed securities financed by short-term loans; their profit is the difference between the interest rate received from the long-term mortgage-backed security and the interest paid for the short-term loan. When the difference between those two tightens, their profits decrease.
Annaly Capital is well positioned to maintain a healthy level of its profits during Operation Twist because of the long lives of its mortgage-backed securities in its portfolio.
Portfolio Value & Yield
According to their most recent 10-Q, about 90% of Annaly's portfolio is made up of fixed rate mortgages that go up in price when interest rates go down. Only about four percent of those fixed rate mortgages mature within a year or less, 1.3% mature between one and three years, and the remaining 95% have a maturation time of three years or more. The chart below shows the composition of the portfolio in nominal terms as of June 30, 2011:
Within 3 months
More than 1 Year to 3 Years
3 years and Over
The following chart shows the weighted-average life of mortgages that takes into account prepayment rates: Weighted-Average Life Fair Value Less than one year $780,883.00 Greater than one year and less than five years $71,716,641.00 Greater than or equal to five years $24,275,924.00
Less than one year
Greater than one year and less than five years
Greater than or equal to five years
As we can see most of the mortgages are expected to have a life of a year or longer, so Annaly does not have to worry about purchasing new mortgage-backed securities with lower yields, allowing it to maintain the yield of its portfolio and continue to pay out more or less the same amount of dividends it has in recent quarters. As mentioned above these calculations hinge on the prepayment rate.
The company can take many steps to reduce prepayment risk. One move would be to purchase mortgage-backed securities at a discount rather than at a premium. The most recent 10-Q states, however, that the aggregate premium exceeds the aggregate discount of Annaly's mortgage-backed securities. This is a cause for concern, but for the quarter ending June 30, 2011 the prepayment rate averaged 11%, a significant decrease from the prepayment rate of 32% for the quarter ending June 30, 2010. This lack of refinancing in the face of lower interest rates can be explained by the higher standards and lack of willingness among banks to lend due of the terrible housing and job markets. Of course this could all change if the federal government decides to implement a policy to support underwater mortgage owners refinance.
With a portfolio of fixed-rate mortgage-backed securities that rise in value as interest rates fall, and with most of the mortgages expected to have a life of greater than a year, Annaly Capital should be able to weather the storm created by Operation Twist. This assumption seems to be the ongoing sentiment as the stock has shown some resilience in spite of declining markets. Holding other factors constant, such as the issue of REIT tax qualifications and government intervention to support underwater homeowners refinance, Annaly Capital's stock is a hold.
Disclosure: I am long NLY.