The last article I wrote on Annaly Capital Management (NLY) for Seeking Alpha was slammed for not answering the right questions. In this article, I have tried to do just that, because the commenter brought up some valid and interesting concerns that I have researched and commented on here.
Question: "What is the current Prepayment Rate and Where is it Going?"
CPR from Page 41 of NLY 10K:The following table presents the CPR experienced on our Agency mortgage-backed securities portfolio, on an annualized basis, for the quarterly periods presented.
Quarter Ended CPR
- December 31, 2011 22 %
- September 30, 2011 18 %
- June 30, 2011 11 %
- March 31, 2011 17 %
In Annaly's Most Recent Press Release they state:
"From a historical perspective prepayments are tame relative to prevailing interest rates. Chart 3 illustrates historical prepayment speeds on mortgages with 100 basis points of rate incentive. The time series adds 100 bps to the 30-year Fannie Mae Current Coupon (which represents where current mortgages are being originated) and looks at the prepayment rate for mortgages at that rate level. For example, in March 2012 the current coupon was approximately 3%, and the prepayment speed on 4% mortgages was 22.1%. In contrast, in July 2003 the current coupon was approximately 6% and the prepayment speed on 7% coupons was 67.1%. What should be obvious from Chart 3 is that interest rates have never been lower and speeds on collateral with substantial rate incentive have rarely been slower, certainly prior to the credit crisis."
From the 10K Page F-12:
| December 31, 2011 | Freddie Mac | Fannie Mae | Ginnie Mae | Total Mortgage- Backed Securities | ||||||||||||
| (dollars in thousands) | ||||||||||||||||
| Agency mortgage-backed Securities, par value | $ | 34,395,542 | $ | 63,066,372 | $ | 500,968 | $ | 97,962,882 | ||||||||
| Unamortized discount | (9,874 | ) | (13,632 | ) | (399 | ) | (23,905 | ) | ||||||||
| Unamortized premium | 1,139,881 | 2,205,138 | 15,949 | 3,360,968 | ||||||||||||
| Amortized cost | 35,525,549 | 65,257,878 | 516,518 | 101,299,945 | ||||||||||||
| Gross unrealized gains | 973,476 | 2,081,282 | 31,474 | 3,086,232 | ||||||||||||
| Gross unrealized losses | (15,243 | ) | (118,871 | ) | (1,008 | ) | (135,122 | ) | ||||||||
| Estimated fair value | $ | 36,483,782 | $ | 67,220,289 | $ | 546,984 | $ | 104,251,055 | ||||||||
If CPR does continue to rise toward historical levels, or the 2003 levels mentioned above the Unamortized premium will trend toward the Par Value. A 65% reduction in the Unamortized Premium would be a $2.17 billion write down or $2.48/share of book value.
This does not take into account loss of revenue from having cash instead of a paying mortgage.
If we look back at the period mentioned above of July 2003 the dividend did drop from $0.60 to $0.28 for two quarters, then rose to $0.47 and $0.50.
This information comes directly from Annaly, so they are aware that a higher rate of prepayments are likely and should manage accordingly.
Question: What is NLY's exposure to HAMP eligible mortgages if FHFA goes for principle forgiveness-which treasury has recently tripled funding for?
HAMP Effect
The goal of HAMP is to get those that qualify to pay 31% of the borrowers pretax monthly income. To achieve the 31% level a loan servicer must take a number of steps to adjust the monthly mortgage payment. "These steps include:
- Capitalize delinquent interest and escrow payments.
- If necessary, apply principal reduction to a portion of the principal balance. This step is applied only if the current loan to value (LTV) ratio is greater than 115%. Borrowers who are eligible for HAMP but whose loan-to-value ratio is equal to or less than 115% are not eligible for principal reduction.
- If necessary, reduce the interest rate to as low as 2.000%.
- If necessary, extend the term of the loan to 40 years.
- If necessary, forbear (defer) a portion of the principal as a balloon payment and waive the interest on the deferred amount. The balloon payment is due with the final payment of the loan."
75 billion in HAMP government funding + 25 billion bank settlement funding(assuming it is all used) =100 Billion in HAMP.
IF all the HAMP funding is deployed (it has been a miserable failure so far) and IF Annaly has an equal share of HAMP eligible mortgages, Then the absolute worst case scenario to NLY is $3.86 Billion (100 Billion/2,700 Billion x 104.25 Billion) or $4.41/Share
Question: Who are Ed DeMarco and Elijah Cummings?
Other info affecting HAMP and NLY is the drama playing out between these two men: Ed DeMarco and Elijah Cummings. Keep an eye on how this progresses as it will affect the significance of HAMP and principal reduction on Fannie Mae- and Freddie Mac-backed mortgages.
These are serious issues that could significantly impact shareholder value and income in the coming months. However, I do believe NLY management is aware of these issues and are taking steps to address them. The current rate environment is still favorable for initiating new MBS positions and I expect NLY to manage their way out of this current cycle.
I am invested with a long term time horizon (15 to 20 years) so I am going to stick with NLY and reinvest my dividends to get the compound interest working for me.
