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This is Part 2 of a series of articles in which we are going through the Annaly Capital Management (NLY) annual report, and highlighting points that might be important to prospective investors. We have been comparing this company to American Capital Agency (AGNC).

The annual report for Annaly is linked here, for those who wish to follow along, and the annual report for AGNC is linked here.

Last time, we studied the growth, cash flow, and leverage of these two companies and came to the conclusion that of the two, NLY is bigger but slower growing (its revenues contracted in the fourth quarter), but had a higher net margin. AGNC, despite being smaller, had the better cash position, as of year end, and had done a better job in its financing activities.

Now, let us look at the income statement of NLY, which is on page F-3:

(click to enlarge images)

Here is a summary of NLY's activity:

$M
Net Income 3099
Gain from Sale of MBS 206
Net Unrealized Gains on Int Only MBS -106
Realized gain on swaps -882
Unrealized gain on swaps -1815
Unrealized gain on AFS securities 2036
Unrealized Loss on Swaps 14
Sum 2552

This does not include the negative $200M of "Reclassification Adjustment".

Now, let's check it for AGNC (page 66):

Here is a summary of AGNC's activity:

$M
Net Income 824
Gain from Sale of Agency Securities 472
Net gain on Derivative Instruments -446
Unrealized gain on AFS securities 1029
Unrealized Gain on Derivative Inst -650
Sum 1229

Here is why all of this is important: Both of these companies are aggressive traders. NLY had approximately $2B in dividend payments last year, and AGNC $660M. Both need the success of their derivative activity to sustain their dividend where it is.

Is it not clear that notwithstanding anything that can happen to the "unrealized" portion of all of this that AGNC had the better year?

Can you attribute this to NLY having a "bad year?" Let us look at 2010:

NLY

$M
Net Income 2254
Gain from Sale of MBS 182
Net Unrealized Gains on Int Only MBS 0
Realized gain on swaps -735
Unrealized gain on swaps -318
Unrealized gain on AFS securities -639
Unrealized Loss on Interest Rate Swaps 94
Sum 838

Once again this excludes the $181M "reclassification loss."

AGNC

$M
Net Income 176
Gain from Sale of MBS 92
Net gain on Derivative Instruments 38
Unrealized gain on AFS securities -64
Unrealized Gain on Derivative Inst -23
Sum 219

NLY's realized and unrealized non-operational activity totaling about $2.7B in 2011 is very close to 80% of their net income. For AGNC the $400M interest rate swap activity above the line is 50% of their net income.

It was pointed out by one of the participants in the discussion thread of Part 1 that NLY had a net $206M gain on sale of agency-backed securities, and AGNC had in excess of $472M, nearly twice as much for a company half the size.

So what are we to make of this? The questions on everybody's mind should be:

1. Can either of these two companies continue to sustain their dividend, given the current level of magnitude of derivative trading that they have going on in the company?

2. To what extent is this ability to pay the dividend related to the success, or lack of, of this derivative trading?

3. Are you more likely to have dividend security in NLY, compared to AGNC, given both the levels and relative success of the two companies in these non-operational activities, and also given the relative cash positions that we discussed earlier?

I will leave it for further discussion. We still have a few more things to check.

Continue to Part 3 >>

Source: The Annaly Capital Management Annual Report Dissected, Part 2