Annaly Capital Management And FHFA Ruling

| About: Annaly Capital (NLY)

Summary

Investors can check for the impacts of the FHFA ruling (excluding captive insurers from the FHLB system) with a quick look through the 10-Q.

I’ll demonstrate how to look through Annaly Capital Management’s filing and find the impact on earnings.

The ratio of repurchase agreements to advances indicates the relative impact on earnings.

The same technique can be used across other mREITs.

I will also share my rough findings for ORC, CYS, and DX.

The entire mREIT industry has been in upheaval throughout the day, throughout the week, and throughout the last month and a half. Annaly Capital Management (NYSE:NLY) is no exception and it is time to provide some coverage on the biggest mREIT and several factors that are slamming both them and their peers. I already published my "thoughts on mREITs" piece for the week. It has a great discussion of the implications of the FHFA (Federal Housing Finance Agency) ruling that kicked mREITs out of the FHLB (Federal Home Loan Banking) system.

If you run into any terms in this piece that are confusing, I would encourage you to check out my guide to the terms.

Annaly Capital Management and the FHFA Ruling

The first thing I want to touch on here is the impact specifically for NLY from this ruling. This part of the analysis applies directly to NLY. The techniques can be used to search for implications for other mREITs.

To determine how much impact the ruling would have on NLY, I pulled up their 2015 Q3 10-Q. The document is 80 pages, which may seem entirely overwhelming. Since I spent countless hours each week analyzing mREITs, I want a faster way to check for impacts. The way the FHFA ruling impacted mREITs was by excluding captive insurers from the FHLB system. The mREITs would use these subsidiaries to get access to a better (lower cost) source of funding. Specifically, FHLB debt was materially superior to using repo financing. I would estimate (very rough estimate here) that they were looking to shave 5 to 20 basis points off the cost of debt for each dollar of debt transferred to FHLB funding rather than repo funding.

FHLB funding is referred to as "advances". Given the information stated so far (excluding my rough estimate) we now have a few ways to check for the impact. We hit CTRL + F (the find command) and want to test searching for the following terms:

"Captive Insurer" (or simply "captive insur" so that "captive insurance" would also show up)

"FHFA"

"FHLB"

"Advances"

If you perform this test on NLY, you'll see that there is no mention of a captive insurer. There are also no hits for FHFA. However, when you get to FHLB you'll get a hit.

Specifically, on page 28 you'll find the following section:

Click to enlarge

I added the red and green markings to make it very clear which area investors should be looking at. The information in the table is not what we are looking for. The text in the green box has confirmed that NLY is using FHLB funding as part of their financing.

From the green box we know that NLY incorporates this cost as one part of the category: "other secured financing". That is all we needed to know to switch the search term and start looking for:

"Other secured financing"

The first hit is on page 43 for footnote 3 to a table. The footnote indicates that the value listed incorporates several numbers, one of which is the cost of the servicer advances. However, it includes far too many variables within one number, so it would be a long path to try to back into the right number. This would be a last resort.

The next hit is on page 48 and is even less useful.

The third hit on the other hand has precisely the information we wanted:

Click to enlarge

The highlighted text shows where the find command triggered. The red box demonstrates the value of repurchase agreements and the interest expense on those agreements. The green box demonstrates the max value of the advances and the interest expense on them by giving us the value of the category that contains them. The value is $270 million compared to around $48.6 billion (note the B) in repo agreements. This indicates that while NLY had access to the FHLB system, they were not running a material portion of their financing through that system yet.

Implications

Since NLY was not doing much to utilize this membership yet, their previously reported earnings would not be showing any boosts from the membership. The ruling effectively removed one method that NLY might have used to boost earnings in future periods, but it wouldn't directly drive their cost of funds higher from previous quarters.

Repeating This Technique

Investors can use the same technique I just demonstrated for NLY to check on any mREITs they are interested in. Writing this article on how to check took substantially more time than the initial process of checking.

Some mREITs That You Could Use This On

I keep a table listing the mREITs I'm covering or intending to cover. I have not checked the statements for every mREIT to determine how much this ruling would impact their cost of funds relative to their costs over the previous quarters.

Annaly Capital Management

American Capital Agency Corp

(NASDAQ:AGNC)

ARMOUR Residential REIT

(NYSE:ARR)

Capstead Mortgage Corporation

(NYSE:CMO)

CYS Investments

(NYSE:CYS)

Dynex Capital

(NYSE:DX)

Long DX

Javelin Mortgage Investment

(NYSE:JMI)

New York Mortgage Trust

(NASDAQ:NYMT)

Orchid Island Capital

(NYSE:ORC)

Two Harbors Investment Corp

(NYSE:TWO)

Western Asset Mortgage Capital Corp.

(NYSE:WMC)

MFA Financial

(NYSE:MFA)

Ellington Residential Mortgage REIT

(NYSE:EARN)

Arlington Asset Investment Corporation

(NYSE:AI)

Technically Corporation

ZAIS Financial

(NYSE:ZFC)

Apollo Residential Mortgage

(NYSE:AMTG)

Anworth Mortgage Asset Corporation

(NYSE:ANH)

American Capital Mortgage Investment

(NASDAQ:MTGE)

Cherry Hill Mortgage Investment

(NYSE:CHMI)

Resource Capital Corporation

(NYSE:RSO)

Starwood Property Trust

(NYSE:STWD)

Blackstone Mortgage Trust

(NYSE:BXMT)

Chimera Investment Corporation

(NYSE:CIM)

New Residential Investment Corp.

(NYSE:NRZ)

Click to enlarge

I did check on ORC and didn't see any evidence of a captive insurer being listed there. I also looked into CYS Investments and know they have a captive insurer. They had a material amount of financing running through the subsidiary. I estimated the increase to their cost of funds relative to the third quarter that would be a direct result of this ruling was about 1.5 cents per quarter. I did a very extensive piece on CYS over the weekend.

My personal holding in Dynex Capital should be impacted as well, though I haven't finished running numbers. At current market prices I have no interest in selling, so the importance of knowing the exact numbers is diminished.

Dynex Capital owns a captive insurer subsidiary named "Mackinaw Insurance Company, LLC". That company is a member of the FHLB of Indianapolis.

Shopping

I'm in the process of transferring some cash into my brokerage accounts to create more opportunities for shopping. Of course, my favorite thing to buy is stocks and the fierce selling in the mREIT sector should be creating some very compelling investments.

If investors are going to focus on the principles of buying securities materially below fair value, then the best place to be shopping in the sector is in the smaller names. The larger ones are tracked by bigger funds and will usually be fairly close on comparative value relative to each other. The smaller ones can deviate dramatically.

I am already long DX. I might buy shares in any mREIT listed in this article at any point if I believe the shares are deviating too substantially from comparable values. Given the volatility (some mREITs were down by double digits this morning), I don't see a solid way to predict what I would want to buy 72 hours in advance.

Expect Some Dividend Cuts

It'll take a great deal of research as I try to find the dividend impacts for each mREIT. The quick statement I can make today is that many mREITs should be looking at a possibility of cutting dividends in 2016 unless there is some improvement in the interest rate environment. The enormous dividend yields you see listed on screeners should be disregarded.

Disclosure: I am/we are long DX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.