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By Kathleen Martin

We are at an important juncture in the REIT market. Rather, we are at an important juncture in the market for companies that trade in mortgage backed paper. Annaly (NYSE:NLY), Chimera (NYSE:CIM) which is owned by Annaly, Crexus (NYSE:CXS) which specializes in commercially backed paper and is also owned by Annaly and American Capital Agency (NASDAQ:AGNC) are companies that pass profits made on the trading of mortgage backed securities to the REIT holders in the form of income distributions.

These companies do not own actual properties, the trade in the mortgages that back property ownership. They are currently not classified as Investment Corporations and enjoy the tax favored status as REITs as they distribute 90% or more of their net earnings to shareholders. What has become important is the timing of the paper held by these REITs. As talk of recovery becomes more confident in domestic markets, the current returns offered to shareholders of Annaly and like REITs will be compromised if short term interest rates rise. I know that the Federal Reserve has said they are keeping rates low until 2014. I am semi confident this will remain in effect. The issues before these companies are how they can re-adjust trading programs to be prepared for the inevitable rise in rates, whether their current status as REITs will continue and the continued availability of Agency guaranteed paper.

Annaly is the largest mortgage securities REIT, second in line is American Capital Agency. The REIT industry plays an important role in the mortgage securities market. It provides great returns to shareholders as long as rates remain low. Annaly and American Capital Agency buy only Agency guaranteed debt speculating on interest rates and the pace of homeowner refinancing. They also have affiliates (Chimera) that mix those bonds with securities that are not Agency guaranteed. MFA Investment (NYSE:MFA) and Two Harbors Investment (NYSE:TWO) have the same kind of guaranteed and non guaranteed holdings. Along with Chimera these companies have accounted for about 40% of sales of mortgage backed paper in 2012.

Looking at the company's debt versus its cash position, if this were any other kind of company, it might cause some concern. The risk in the amount of borrowing that REITs use is high because the borrowing is short term and subject to daily margin calls which could result in sharp sell-offs of assets when values decline. REITs that trade Agency mortgage paper buy this home or commercial loan paper with borrowed money that costs almost nothing to carry, as long as rates remain low. Any raise in short term rates will see borrowing costs increase and that could be problematic as there will likely be no increase in revenue to match the borrowing costs.

In the first quarter 2012 Annaly's yield on interest earning assets was 3.23%, the cost of carrying the debt was 1.52%. The interest rate spread was 1.71% a decrease from the 2.17% spread in the same quarter 2011. At the end of the first quarter, the company used interest rate swaps of approximately 40% of its portfolio to lessen the risk of rising interest rates that impact the company's borrowing costs. In anticipation of a shift in the interest rate environment, at the end of the first quarter 2012, the company's portfolios of Agency paper had 41% floating rate, 8% adjustable rate and 51% fixed rate assets. Adjustable and floating rate mortgages allow for increased yields without increasing the cost of borrowing. The terms of these adjustable and floating rate mortgages range anywhere from 18 months to five years.

REITs are not subject to the Investment Company Act, which limits leverage. This exemption is being considered for change by the SEC but nothing has been decided yet. Most Agency REITs leverage between six and nine times, as opposed to non Agency REITs that borrow between one and three times equity. New growth in the non-Agency market securities has the SEC examining whether REITs should retain their ability to use unlimited leverage. Seeing as overleveraging was one of the main contributors to the economic collapse, companies like Annaly and all of its peers will face watermarks for determining regulatory oversight currently only given to banks is necessary.

Unlike banks and insurers REITs have no primary regulators. The Financial Stability Oversight Council a board of regulators which includes the Treasury and SEC are faced with deciding which non-banks need closer supervision because their collapse could cause massive market upheaval. FSOC will start with tests including whether firms have in excess of $50 billion in assets, study short term funding leverage, ties to important entities, internal governance and transparency. The government wants to stop covering default risk on most new mortgages. It is likely that any kind of reform will result in less Agency guaranteed paper being available, which could again increase borrowing costs.

Since its IPO in 1997, Annaly has provided over 580% returns. Mortgage REITs have been able to raise capital because they have been delivering stellar returns. Annaly has offered several million in preferred shares this year and has a shelf offering for 125 million common shares at $16.16 for the remainder of 2012. The CEO, Mike Farrell's compensation has climbed to $35 million since 2007 when it was $12.5 million. His compensation is tied to book value, which increases as Annaly sells shares. It is hard to argue with the performance of the company vis-a-vis Mr. Farrell's performance. At the very least, it can be viewed that he has been compensated well because the company has performed well. It would be a whole different discussion if the company had not performed and he was still drawing an increasing amount for compensation.

Annaly issued an update on the health of its CEO, Michael Farrell, stating that he has completed treatment and his cancer is in remission. Mr. Farrell believes there are risks of slow economic growth, uncertainty in Europe and the future of domestic monetary policy that will affect business. He is confident that management adheres to a conservative operating methodology that will prepare Annaly's holdings for this environment and will be gauged to a range of outcomes.

All factors that are providing success to Annaly are still in place, low borrowing costs, consistent yields on Agency bonds and low levels of home loan payments. According the Fed, these factors are not going away until 2014, when REITs can adjust to the environment at that time. Any adjustments may be difficult if any of these factors change as REITs don't have anything in reserve as they have to pay out 90% of net income to keep tax free status. The fallout from rate increases will be dependent on the amount of time it takes the rates to increase. Higher long term yields will boost margins on new investments causing the prices of existing holdings to drop, damaging the REITs book value which is used as a compensation guideline and to value stock. The challenge is to handle transition from one interest rate environment to another.

I think that the dividend of the stock is still a compelling reason to be in it. I have said it before, it will face downward pressure going into ex-dividend periods and small lifts after selling programs have completed and shorts are covered. This stock is a yield play not a growth play. The last half of 2012 going into 2013 will determine how Annaly and its management will handle any precipitous rise in rates or any changes in the macro-economic environment at home and abroad. Annaly has managed some very rough waters in the past, at present, there is no reason to believe it will not continue to do so. The deciding factors for investors really are the company's continued treatment as a REIT and how its business may be affected by a new regulatory environment.

Source: Annaly's Monster 13.2% Yield Is Safe For Now