Annaly: How mREITs Make Money And The Case For A Dividend Increase

| About: Annaly Capital (NLY)

Much has been written about the mREIT sector here on Seeking Alpha over the course of the last few years. It is a sector that confuses many investors who own shares in the sector, as well as those who do not. I am not an advocate of investing in anything that you cannot understand at least at a very basic level, so I would like to focus this article on how mREITs make money, and why I believe we might see a dividend INCREASE in Annaly Capital (NYSE:NLY), in this upcoming quarter.

First, let me state that this is my opinion based on the most fundamental facts that I personally use to determine whether or not I even want to hold shares of Annaly (or any other mREIT for that matter).

The Basic Ways Annaly Makes Money

The mysterious world of mREITs can be broken down into the most basic elements without all of the confusing phrases and "strange" nicknames by just briefly outlining how an mREIT makes money.

  • An mREIT borrows and lends "mortgage backed securities" (MBS).
  • The interest rate that NLY borrows at and the interest rate they lend at, is called the "spread".
  • Annaly has a conservative business model and tends to borrow between the 2 year Treasury, and lend to the 10 year Treasury.
  • There are times when they go "off the charts" and lend further out on the curve, out to 30 years. This is called leverage, but Annaly keeps the percentage of that business lower, and tends to be more conservative than their largest competitor, American Capital (NASDAQ:AGNC).
  • The difference between the 2 year Treasury rate and the 10 year rate is the percentage that is considered profit.
  • When that "spread" between the 2 and 10 year rate is compressed, profits can be lower. When the "spreads" widen, profits can be higher.

These are the basic ways that ALL mREITs work. There are wrinkles and tweaks that each company uses to bring as much profit in as possible, but if you can understand the BASICS, you can easily keep an eye on your investment.

For a tad more detail to support these facts, read this article written about 2 months ago.

What Factors Will Impact mREITs Profits

Once again, cutting away the confusion, let me outline the nuts and bolts on how all mREITs are negatively affected.

  • Pre-payments or refinancing of mortgages (or foreclosures). If a borrower refinances or pre pays their mortgage, mREITs have less income coming in. The MBS they hold is paid off and the mREIT, like NLY, gets a lump sum payoff and they stop earning the interest on the loan. (Remember, when NLY gets a chunk of money, they now have more cash on hand and their book value increases, but much like an investor taking a profit in a dividend paying stock, they do not "earn" money until that cash is redeployed)
  • Government intervention such as HARP, HAMP, and Operation Twist. What these programs attempt to do, is to keep the longer term interest rates artificially low, by having the Fed buy the 10 year treasuries (and 30 year). It works to a small degree but thus far the impact on that "spread" has been no more than 10-20 basis points. Yes, they compress the "spread", but since the Fed ALSO has a "zero interest rate policy" (ZIRP) in place, the 2 year Treasury yield is also artificially "locked" in at between 0-.25%. That fact alone allows mREITs to continue making money in spite of a low interest rate environment.
  • If the yield curve between the 2 year and 10 year rates are flattened for any reason such as a quick rise in short term rates, then mREITs are in "trouble". If the rates INVERT, meaning the 2 year rate is HIGHER than the 10 year rate, then mREITs will either have to take on more risk, or suffer losses. Annaly has navigated these scenarios between 2005-2007 when the 2 and 10 year Treasury rates were both around 5.50%.
  • If all interest rates move higher quickly, Annaly (and all other mREITs) will not be able to "unload" their MBS's quickly enough and be stuck with the "rush" to the exits by mortgage holders frantically refinancing at lower rates and the mREITs business will suffer greatly if not mortally. Since Annaly plays a more conservative "game", they are less apt to be "killed" but dividends will suffer if not disappear, and even though the company will be flush with cash, there will be no place to put the money to work, easily.

Again, there are a few other issues that get in the way of the bottom line here, but if you grasp the idea that these are the way all mREITs can make money and lose money, then you are more knowledgeable than 99.999% of their shareholders. I myself do not know every single twist and turn either, but I do know the basics, and they have allowed me to keep an eye on my investments and make a somewhat intelligent investing decision.

For a further understanding of the risks of mREITs, I especially like this article, written about a year or so ago, but basically nails everything. I encourage everyone to read it.

Now For The Good News In My Opinion!

Now that your eyes have glazed over, or you're fast asleep, here is your wake up call. I think that Annaly could offer a dividend increase this coming quarter.

The only way I will look at it, is with this chart:

What I would like to point out is first the $.55/share dividend paid out over the last several quarters, including the one announced on 6/26. If you look at the chart, you can see that the 10 year note was under 1.60% (1.57% actually). The "spread" was at 1.28%.

Now since that time, beginning in mid July, we have seen an increase in 10 year note, currently at 1.67%, with a recent high of about 1.83% just last week. We also can see the "spread" at 1.42% currently, with a high of 1.54% made last week as well.

IF this pattern remains the same, then we could see a higher "spread" for this quarter than for the last. Based on the Government rules, a REIT MUST pay out at least 90% of their earnings to shareholders in the form of dividends, to maintain the REIT tax exempt status.

With one more month to go before Annaly announces its dividend, the trend seems to be in favor of perhaps an $.01-$.02/share increase. The "spread" has increased from a low of 1.28% to a high of 1.54% or a difference of .26%.

Taking a mid-point average for the volatility of the "spread", I come up with an increase of .13%, which of course will allow NLY to increase the dividend on the surface, without my knowing the rest of the equation.

A penny or two might not be that amazing, but when we consider that just about everyone has been talking about dividend CUTS in this sector, IF I am correct in my theory, then Annaly will AT LEAST be maintaining its dividend, or just might be able to pop them up a drop or two.

My Opinion

I have no way of knowing whether I am right in my assumption here or not. Time will tell.

I hope this article can elicit many comments either pro or con the dividend question. After all, the reason we own Annaly, or any other mREIT stock, is for the dividends!

Disclosure: I am long NLY, AGNC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.