Annaly: REIT Panic Ahead

| About: Annaly Capital (NLY)

One person that did very well last year was the CEO of Annaly Capital Management (NYSE:NLY), Mike Farrell. His take home pay was $35 million, according to Bloomberg. Bloomberg noted that Farrell made more than the CEO's of the six largest U.S. banks last year. Not surprisingly, stockholders will want to know if Mr. Farrell earned all that money or not.

The market definitely does not think that Mr. Farrell earned his money, judging by the stock performance on May 9. Annaly's stock had earnings per share of just 49 cents. It also had a dividend yield of 55 cents a share. The share price on that day closed at $16.66, which was up slightly.

Yet people that bought into Annaly early might think that Mr. Farrell is worth the money. Bloomberg estimated that Annaly's returns have totaled 580% since its IPO. Bloomberg also estimated that the company's return for 2012 was a healthy 5.6%. Farrell's pay is apparently tied to the size and performance of Annaly.

Some of the experts that Bloomberg asked about Mr. Farrell and his business were less than thrilled with him. Doug Dachille, the CEO of First Principles Capital Management LLC and former head of proprietary trading at JP Morgan, said the kind of mortgage-backed securities that Annaly specializes in poses systematic risk. He called the securities' financing structure poor because they are subject to daily margin calls.

Annaly was seeking more capital on May 8. The company announced a new public offering of convertible senior notes. The offering is supposed to be worth $750 million and will close on May 14. Each of the notes will be convertible in 52.7969 shares of Annaly's common stock per $1,000 principal amount of notes. The stock conversion price mentioned in the Annaly press release for the offering is $18.94, which is actually higher than the price Annaly stock was selling for on May 9, 2012.

This press release seems to confirm that Mr. Dachille's concerns about Annaly are right. If there's a margin call on this stock, it's headed for a fall, and fast. There's no way the stock prices can justify the kind of financing deals that Mr. Farrell and his team seem to be putting together.

So how does Annaly stack up against some of the other REITs out there? Well, it certainly is not doing as well as American Capital Agency (NASDAQ:AGNC), which had an earnings per share of $6.69 and a dividend of $5 on May 9, 2012. Since AGNC is regarded as Annaly's closest competitor, I have to wonder what sort of criteria Mr. Farrell's compensation is based upon. It certainly is not returns to the shareholders.

Cypress Sharpridge, or CYS Investments (NYSE:CYS), paid its stockholders a 50 cent a share dividend on April 18. Since CYS's shares are about $3 cheaper than Annaly's, it might be a better deal for those interested in REITs.

REITS Could Be the Dominant Force in the Mortgage Industry

REITS, like Chimera Investment (NYSE:CIM), Two Harbors Investment (NYSE:TWO), and Annaly, are now more important to the mortgage industry than big banks such as Citigroup (NYSE:C), Wells Fargo (NYSE:WFC), and JPMorgan Chase (NYSE:JPM). That's the conclusion of Motley Fool analyst David Caplinger, who estimated that profits at those companies have grown seven fold since 2005. He also thinks that such companies have tripled in size in a little under three years.

Using data from S&P Capital IQ, Caplinger estimated that ARMOUR Residential (NYSE:ARR) is the fastest-growing mortgage REIT, increasing in size at an astonishing rate of 5,025% since December 2008. The growth rate at Two Harbors and the American Capital Agency were also more than double that at Annaly. Two Harbors' assets increased in value by 4,225% and American Capital's assets grew by 1,811% since December 2008 by Caplinger's estimates.

Annaly's growth was actually fairly modest when compared to its main competitors. It has only increased in size by 649% since December 2005, although. Although it should be noted that Annaly is a lot larger than the others, with $120.3 billion in assets compared to Armour's $12.8 billion.

One reason why Annaly's growth is smaller is that smaller competitors such as Chimera are taking business away from it. Interestingly enough, American Capital seems to be approaching Annaly in size. That could indicate that the industry leader is beginning to fumble. In the long term, that could lead to a fall in stock value, particularly when investors get wind of Mr. Farrell's big payday at a time when his company seems to be losing its' edge.

Mr. Caplinger's interesting analysis is not all good news for mortgage REIT investors. Like a number of other analysts, he points out what could be the ticking time bomb underneath the entire mortgage REIT boom:, interest rates.

The engine driving growth in the mortgage industry is short-term interest rates.

Low short-term interest rates give companies like Two Harbors a large spread between what they pay for money and what they lend it out at. This, in turn, generates the high profits that they can pay out to shareholders and creditors.

That means that any increase in the interest rates, or indication that the Federal Reserve is about to raise interest rates, could send these stocks falling. Even if an interest rate change turns out to be nothing about rumors, a company like Annaly could be seriously damaged.

Like a number of other observers, Caplinger thinks that these companies are so unstable that they could constitute another mortgage bubble. He thinks that this could occur if the large spread between what they pay for money and what they pay out disappears. In other words, he thinks that they could quickly become over ledged just as the big mortgage companies did back in 2007.

This is just speculation, but just the mention of the possibility could send these stocks falling. After all, investors today seem more skittish and gun shy than they were just a few years ago. It should also be noted that part of the reason why these stocks have done so well is that they've flown under the radar.

The media, politicians, and regulators have paid little or no attention to them, so they've been allowed to flourish. Speculation like Mr. Caplinger's and news of Mr. Farrell's big payday could change that. After all, it is an election year, and overpaid corporate executives make a great whipping boy.

It should also be noted that some investors could think Mr. Farrell knows something we don't and start selling. Such a panic is all it would take to bring down over inflated REIT stocks. At the same time, it could benefit other mortgage REITs such as Redwood Trust (NYSE:RWT) and American Capital. Investors might simply move their money into them, betting that the industry will survive, but Annaly might not.

So, how much attention should investors pay to commentators like Mr. Caplinger and Mr. Dachille? My answer would be some. They are raising some valid concerns, but Caplinger in particular pointed out the potential of mortgage REITs' potential. The real effects of such comments will be how investors take them. So far, they haven't listened and there has not been a rush to sell.

The biggest potential downside that mortgage REIT stocks face right now is panic. If people start believing commentators, they could start selling, particularly if they conclude that insiders like Mr. Farrell are cashing in and getting out before the fall.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.