Annaly Capital 10-K: Good Mortgage Good REIT Primer

Mar.26.07 | About: Annaly Capital (NLY)

As a companion to my previous discussion of the mortgage market, investors may want to take a look at the recently issued 10-K for Annaly Capital Management (NYSE:NLY).

With CEO Michael Farrell at the helm, the firm remains one of the best managed and well-capitalized mortgage real estate investment trusts, and its 10-K provides a good overview of the operations of this class of specialty REITs. Many of you may be familiar with its shares' precipitous rise and fall in the last 3-4 years amidst a Greenspan ease and later increase in short term interest rates. However, the company has likely turned the corner and created a foundation to achieve steady, long-term success for shareholders.

Mortgage REITs [MREITs] raise capital by issuing stock to the public or by borrowing money, which they invest in mortgage-related bonds and other assets. By exploiting the spread between the rates paid on their borrowings and the interest received from those bonds/assets ("net interest"), these REITs can make large dividend payouts to investors. However, in a time of rising rates, this strategy can backfire - rates on debt increase faster than interest paid on their holdings, the spread contracts, and they must decrease their dividends.

Because investors purchase MREITs for their payouts, REITs stock prices fall. Moreover, because higher rates also devalue existing fixed-rate bonds issued at lower coupon yields, the typically fixed-rate bond portfolio held by MREITs also declines in worth (known as declining "book" value), adding to the dividend-induced decrease in their stock. As the chart below demonstrates the steep drop in share price in a time of rising interest rates.

Annaly's 10-K explains much of this activity for investors, and the firm remains one of the exceptional MREIT operators for its risk management. The stock dropped sharply in the last 18 months as the Fed initiated a series of rate increases, forcing the firm to lower its payout and reshuffle its holdings. However, its fortunes may have begun to change.

As Herb Greenberg discusses, NLY raised $675 million in a stock offering a few weeks ago, and long-time CEO Farrell and his team will likely allocate that cash to now cheaper mortgage assets in a somewhat distressed environment.

Farrell and other execs possess considerable holdings in the firm, aligning their interests with common shareholders and likely signaling their confidence in the firm's strategy. Barron's (sub. req.) also highlights NLY this weekend, as investor Sy Jacobs notes that, unlike sub-prime mortgage lenders such as Novastar (NFI) and Fremont, (FMT) whose asset quality may still be overestimated, Farrell accurately predicted the current fallout from poor underwriting standards and oversight during the last 36 months and built a strong portfolio with little, if any, real credit risk. The types of investments made by NLY have been included in the 10-K.

In stable or declining interest rate environments, mortgage REITs typically perform well. Although mortgage holders may refinance, prepaying their mortgage and forcing bondholders to find a new place to invest at lower rates, the spread between borrowing rates and mortgage rates usually widens, allowing MREITs to make more on interest than they pay on borrowings.

While I do not expect inflation or rates to decline quickly, NLY's recent equity offering and resulting balance sheet strength will enable it to make opportunistic investments without incurring additional debt and likely allow the firm to steadily increase its dividend (currently 5.4%).

Whether the economy begins to slow, rates decline, or the Fed remains neutral hoping to stem additional inflationary pressures, NLY shareholders will likely be rewarded.

NLY 2-yr chart: