The Annaly Capital Management Annual Report Dissected, Part 3

Apr.23.12 | About: Annaly Capital (NLY)

<< Return to Part 2

We have a few more areas of interest in our ongoing comparison between Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC), two of the mortgage REITs that are in focus at the current time because of their high dividend rates.

If the reader would like to follow along, the NLY annual report is linked here and the AGNC annual report is linked here.

The interest rate spread is the difference between the coupon value of the mortgage and the interest cost. It was pointed out in the previous discussion that NLY has an advantage from the standpoint of gross margin, interest income minus interest expense.

This table pretty much tells the story for NLY; it is on page 41 of the report:

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We noted previously some of the problems that were encountered in the marketplace in second half of last year. The average NLY interest rate spread for the entire year was 2.09%, but for the fourth quarter, it was actually lower, 1.78%. Also, it declined for the last three quarters of the year, from a high of 2.45% in the second quarter.

For AGNC this data is on page 39:

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AGNC did not post its quarterly spread data. The interest rate spread was 2.3% for 2011.

So why was the interest rate spread higher for AGNC than for NLY? The average yield for NLY was actually higher, at 3.7% than it was for AGNC at 3.18%. However, the borrowing cost for NLY, which includes its hedging activity, was 1.61% versus 0.89%. NLY's hedging strategy shows up in this number.

So, the two conclusions are: The interest rate spread was higher for AGNC than it was for NLY, spreads got smaller as the year went on, and the main difference was because of NLY's hedging strategy, which caused higher borrowing costs.

The portfolio maturity distribution is the time at which the mortgages that are in the portfolio of the two companies are due to reset. For NLY this information is on page 57.

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This table reflects the statement we made in a previous article that 95% of the portfolio of NLY is agency-backed securities, and practically all of them have a maturity of over three years.

For AGNC there was not a table like that but the following quote appears on Page 46:

The actual maturities of agency MBS are generally shorter than stated contractual maturities primarily as a result of prepayments of principal of the underlying mortgages. The stated contractual final maturity of the mortgage loans underlying our 47 agency MBS portfolio ranges up to 40 years, but the expected maturity is subject to change based on the actual and expected future prepayments of the underlying loans. As of December 31, 2011 and 2010, the weighted average final contractual maturity of our agency MBS portfolio was 23 and 22 years, respectively.

So the data on the maturity distribution of the mortgage loans of these two companies are incomplete. However both companies do disclose the CPR, or constant prepayment rate, which is the rate at which the mortgages in their portfolio are paid off early, causing the company to have to go out and find new mortgages. At the moment, new mortgages have a lower coupon value for both of these companies because interest rates went down.

For NLY this rate is posted on Page 41:

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For AGNC this information is provided on page 48:

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So these data are logically consistent at least, although to be totally scientific about it we are missing the exact distribution of the mortgage maturities. What we do know is that the prepayment rate for NLY is 50% higher right now than it is for AGNC. This may be due to the higher coupon rate on NLY's loans, or it may be due to shorter maturities on NLY's portfolio, which is what I conjectured the other day. We do not have enough information to determine this definitively.

What are we to conclude from this?

We know that despite the higher coupon rates, and despite showing a higher interest rate margin on its income statement, the interest rate spread for NLY is smaller because of its hedging "insurance." This is consistent with what we found in Part 2 of this series.

We also know that NLY's portfolio is turning over at a faster rate. In a period like now where the current interest rate is low, it means their average coupon rate is going to fall. AGNC's portfolio turnover is not as high.

At this point we have enough information to take a look at the future.

Continue to Part 4 >>

Disclosure: I am long AGNC, ARR, CYS, IVR, TWO. I exited CIM just before the last dividend.