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Part I: Prices Incorporate Risk

Given the lack of yield available elsewhere, there are a good number of seniors buying into Annaly Capital (NYSE:NLY) and other mortgage REITs like American Capital Agency (NASDAQ:AGNC). The income stream available in NLY is hard to find elsewhere in the market, especially when considering the last few years of total return stability in the stock. But is the investment safe for seniors who must preserve capital first and foremost?

Company & Ticker

Dividend Yield

Chimera (NYSE:CIM)

14.7%

American Capital Agency

14.6%

Two Harbors Investment (NYSE:TWO)

14.0%

CYS Investments (NYSE:CYS)

14.1%

Annaly Capital

12.8%

Hatteras Financial (NYSE:HTS)

12.6%

MFA Financial (NYSE:MFA)

11.3%

Crexus Investment (NYSE:CXS)

10.6%

A Lesson on Value

This will not be a new revelation to anyone who has the wisdom that comes with gray hairs. When something seems too good to be true, it usually is. Most of the time, a low stock price, like for a penny stock, is that way for a reason. A low P/E or price-to-book value, or a fat dividend yield represents value priced for risk. A penny stock is not as cheap as it is because it is going to go up 10,000% like we would like to calculate it might. It's cheap because there's not enough demand for the shares to drive the price higher, and that could be for various fundamental reasons, including too many shares. A P/E ratio or other valuation metric below historical record or that of relative comparables does not necessarily mean a stock is going to revert to its mean valuation or to the industry standard. It can also mean that a company is facing serious issues, like say Bank of America (NYSE:BAC) or Research in Motion (RIMM). Sometimes a cheap valuation just keeps getting cheaper if a company's goods or services are being rendered obsolete. And a really fat dividend yield is not often a gift from God, but reflects real risk in one way or another. If the dividend yields of the mortgage REITs were risk free, they would measure closer to that of Treasury Bills.

Mortgage REIT advocates, and especially fans of Annaly , can point to the last couple years of price stability to make a case to potential buyers. As you can see by the chart here, NLY's price has traded within a very tight range since late 2009. If that price stability were something that could be guaranteed along with the company's dividend payments, then indeed, you would have something special here.

Chart forAnnaly Capital Management, Inc.

Chart by Yahoo Finance

Unfortunately, it is not guaranteed, and neither is the dividend payout amount, and thus the yield. If NLY and the other mREITs were truly such great deals, then more capital would be flowing into them, driving the stock prices higher and cutting into the dividend yields in the process. No arbitrage opportunity lasts very long in the mostly efficient stock market. Therefore, there must be important risk factors at play in the mortgage REITs today.

First, we must understand how Annaly does business. Based on its own description in the company's 10K Annual Report: Annaly Capital owns, manages, and finances a portfolio of real estate related investments, including mortgage pass-through certificates, collateralized mortgage obligations (CMOs), agency callable debentures, and other securities representing interests in or obligations backed by pools of mortgage loans. Annaly's principal business objective is to generate net income for distribution to stockholders from the spread between the interest income on its interest earning assets and the cost of borrowings to finance the acquisition of interest earning assets and from dividends received from its subsidiaries. The company's wholly-owned subsidiaries offer diversified real estate, asset management and other financial services.

You only have to look as far as the 10K Annual Report of one of these companies to understand what the risks are. The company invests mostly in "high quality mortgage-backed securities and short-term investments". We all know by now that "high quality mortgage-backed securities" proved to be an oxymoron as the financial crisis unfolded a few years back. Likewise, the credibility of Standard & Poor's, a subsidiary of McGraw-Hill (MHP), and Moody's (NYSE:MCO) came into serious question in the process. We would hope the rating agencies are doing a better job these days, but who could be sure.

The "Risk Factors" section of the 10K report offers some pretty specific details about risk, and it's worth a read before making any equity investment, especially for seniors who can least afford to risk their personal wealth. It's best to at least know the knowable risks, to limit your chances of being blindsided. Just as the company outlines, if any of the risks in this section are realized, the company and its stock could be materially adversely affected. Companies are required to file this information with the SEC for the benefit of investors, and it also limits their legal risk to shareholder lawsuits. Most importantly, it serves the purpose of forewarning investors of bad case scenarios. You'll find Annaly's risk factors on page 17 of its annual report. The section is extensive in this case, first outlining risks related to adverse events in mortgage finance and credit markets and then risks related to the company's business itself. In Part II of this already long report, we'll analyze those risks for you in detail.

Source: Are Annaly Capital And mREITs Right For Seniors?