Annaly Capital Management: Epitome of Low Risk, High Reward 31 comments
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Stabilizing home prices and unfreezing the mortgage market is the paramount focus of US policy makers. The first significant step in this process occurred with the passage of the Housing bill and the US government now explicitly guaranteeing Freddie Mac (FRE) and Fannie Mae (FNM) backed mortgage securities (also known as Agency MBS or Agency debt) and effectively nationalizing more than 50% of the US mortgage market. What this also means is that Agency MBS are now equivalent to Treasuries in terms of risk profile, which implies that the yield spread between Agency MBS and Treasuries of similar maturity should be close to zero.
As shown in the chart below the current spread is almost 160 basis points which must and will close in short order to a more typical 50 basis points, or if rationality prevails to zero, since for the first time in history the government's guarantee is explicit rather than implicit.
Enter Annaly Capital Management (NYSE:NLY) with a business model that is stupid-simple: borrow money at short term rates, use it to buy Agency MBS and pocket the yield spread. There is zero credit risk in Annaly's portfolio which consists almost exclusively of Agency-backed paper - guaranteed (explicitly as of last weekend) in full by the US government. Annaly's profitability is governed only by the spread between short term borrowing costs and the yield on the Agency debt.
This spread measured across Annaly's portfolio (of varying maturity agency debt), as of June 30, 2008, was 2% which when applied to its $60B portfolio resulted in earnings of $300M for that quarter, which annualizes to a P/E of less than 6 at the current market price of $15. Annaly is structured as a REIT which mean 90% of its earnings must be paid out as dividends which they were - $0.55 per share for the quarter ending Jun 30, 08, which translates to a yield of close to 15%.
The quarter in question was probably the most challenging in the history of MBS REITs with doubts about the government's backing of Freddie and Fannie (and therefore for Agency debt) deflating the assets (Agency debt) on Annaly's balance sheet requiring de-leveraging which (if the government hadn't stepped in with an explicit guarantee) could have led to a terminal, negative feedback loop of further asset price deflation begetting further de-leveraging (which is is exactly what happened to Thornburg Mortgage (TMA)).
If Annaly does absolutely nothing and just waits for the market to adjust to the now safe outlook for Agency debt, Annaly's yield will come down to more typical levels of 10% which means the stock price will rise by 50% to $21/share (assuming current dividend level is maintained).
This by itself creates a compelling investment opportunity, but there is more, much more. With all the uncertainty out of the way, Agency debt will be bid higher bringing it close to parity with Treasuries of similar maturity. This means a few things to Annaly's business:
- if leverage applied on the current equity of $7.2b is increased from the current (extremely conservative) 7.1:1 to a more typical level of 11:1 (where it was a year ago) it will allow the purchase of another $25 billion worth of Agency debt
- the value of the existing Agency debt on Annaly's balance sheet will rise with resultant mark-to-market gains creating even more borrowing power. A 10% Mark-to-market gain on a $60B portfolio will result in a $6B increase in equity which when levered 11:1 can be used to purchase another $66B worth of MBS
- as the risk of a credit freeze fades, the 1.5 Billion in cash sitting on the balance sheet as of Jun 30, 08 can be deployed and even if only $1 billion of this is used, another $12 billion (again at a 11:1 lever) of Agency MBS can be purchased.
In total, more than $100 billion of Agency debt can be purchased without raising a single dollar in capital. Of course, as Agency yields fall in line with Treasury yields the spread captured (between short term borrowing and Agency debt) on all new debt purchases will be narrower than the unusually high 2% earned on the existing portfolio in the last quarter. Note that the spread on the existing portfolio i.e. already purchased MBS will stay at 2% unless short term borrowing costs increase.
Assuming Annaly levers up close to the extent to which it safely can, and purchases say, another $100 billion of MBS over the next few quarters, the resultant earnings and dividends (annualized) based on different levels of (average) captured spread for the entire $161.5B portfolio (existing $61.5B + $100B new) is shown below.
click to enlarge
Also shown is the share price required to support a 10% yield for the dividend/share range of $1.55 to $6.20 shown above. Given that the spread capture is currently 200 basis points and historically has never been lower than 50 basis points, we can expect the average yield capture over the next few quarters to be between 100 and 150 basis points. Bear in mind that a rapid tightening by the Fed is unlikely to happen anytime given the current state of the economy.
Put another way, if Annaly levers up to the extent described above, a fair value for Annaly's shares over the next few quarters should be between $31 and $46.54 depending on the spread captured. If however, Annaly levers up much less (or more slowly) and instead of $100B purchases only $50B worth of new debt, the expected share prices corresponding to the 100 to 150 basis point range of spread capture will be between $21.42 and $32.13 as shown in the table below.
Net-net look for hugely positive earnings surprises, increasing dividends and a strongly appreciating stock price over the next few quarters.
For those interested in more detail, the latest quarter (ending Jun 30, 2008) earnings release can be viewed here.
Disclosure: Long NLY
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This article has 31 comments:
1) that with the US government explicitly backing Agency bonds (which has never happened before) the spread between Agency and Treasury bonds will fluctuate in a much narrower range than ever before. So its not about reversion to a mean that was established in the pre-explicit-guarantee period. Annaly has successfully navigated the high volatility and widening spread environment and can now look forward to calmer waters with the explicit government guarantee for agency paper.
2) that the current economic malaise is too pervasive for the Fed to raise short term rates aggressively anytime soon - which would otherwise seriously crimp Annaly' spread capture and profitability.
These guys know what hey're doing and they are the best in the biz. They are running a bank investment portfolio without the hazrds of having the rest of the bank.
Their disclosure is extremely transparent and they only messed up once-- back in 2003, when the yield curve flattened/inverted and hit them.
You can also investigate their preferreds which offer nice yields but lack liquidity.
Annaly is a pure time arbitrage play. For tax purposes, Annaly is classified as a REIT. Despite this tax classification, Annaly, unlike other mortgage REITs, does not own any actual commercial or residential real estate. Annaly borrows via short-term loans (usually lasting only thirty days) and uses the money to buy mortgages that are packaged and guaranteed by Government Sponsored Entities (GSE's) like Fannie Mae. These mortgages earn the company interest. At the end of the thirty days, Annaly will borrow again to pay off the previous loan. Because the short term interest rates that Annaly pays to borrow money are typically lower than the long-term rates it earns on Mortgage-Backed Securities, it makes a narrow profit. It amplifies these narrow profits thru leverage. Annaly is currently levered around 9 times equity.
Annaly depends on being able to continuously access the capital markets, particularly since nearly all of its debt is short-term repurchase agreements. Thus Annaly is susceptible to market confidence/ counter party confidence issues as illustrated by the collapse of Bear, Thornburg, Carlyle etc. The implosion if it comes can occur at stunning speed.
Annaly is exposed to two ends of the yield curve--liabilities at the short end and assets at the long end. This strategy makes Annaly dependent not only on the level of interest rates, but also on the shape of the yield curve.
The yield curve is currently steep - thus generating strong tail winds for Annaly. However in a flat or inverted yield curve situation (and if the FED starts raising rates) strong head winds can result forcing Annaly to liquidate its portfolio at below book. This can wipe out equity PDQ. Start unwinding your position if and when the FED starts raising rates ...a keep a close eye on the yeild curve.
On Charlie's question regarding how the 10% markup was computed - yes the fall in yield implies a proportionate increase in the bond price. For example if we assume an agency yield of 6%, a 9% drop in yield to 5.46% (i.e. by 54 basis points) implies the bond price is up by 10%.
The basic fact is that the GSEs are insolvent, and there are plenty of ways to add liquidity to the mortgage market short of a _complete_ GSE bondholder bailout.
Again, who says that GSE debt will be completely paid? Maybe the Treasury will buy the GSE debt at 92 cents on the dollar? Such a scenario would send NLY stock to 0.
You seem to think that Congress is going to decide the best use of taxpayer funds during a recession is going to be sending taxpayer funds to the Chinese Government, NLY investors, and Bill Gross. Maybe that will happen, but personally I would not put my own money on that bet.
"GSE debt is held by financial institutions around the world. Its continued strength is important to maintaining confidence and stability in our financial system and our financial markets. Therefore we must take steps to address the current situation as we move to a stronger regulatory structure."
So, yes the above does not make the specifics of the guarantee explicit, but the agency debt market is trading as if the implicit guarantee that existed (untested) in the past has been diminished in some way - instead of trading in a fashion that reflects the fact that the US Treasury has stepped in with legislation that reinforces their commitment to back this debt i.e to redeem the debt at 100 cents on the dollar - not 99.5, 99 or 98 since the latter is an extremely slippery slope with no backstop and cannot even be construed as a verbal backing.
Therein lies the opportunity - eventually the market will realize (and reflect in pricing) the fact that the guarantee is more explicit than it has ever been in the past which means narrower spreads to treasuries than ever in the past. That is the only assumption being made and regardless of the propriety or fairness of Paulson's approach, is where I think we are today.
But a forced trade of current GSE debt for explicitly guaranteed debt at 92 or 94 cents on the dollar would only cause major pain to _leveraged_ holders of GSE debt. Like NLY.
You guys think the 14% div on NLY is a free lunch. You are sorely wrong. Repairing bridges, health care for the uninsured, repairing the military after Iraq, or free money for the mostly rich and/or foreign GSE bondholders? No way, not in this political environment.
By the way, the housing bill allows the GSEs to continue to fritter away their money in dividends. That is cash that won't be available for bondholders later on. There was a proposal to stop the GSE dividends, but it was killed.
Also, we are looking at a deficit next year well north of $600 billion, and higher if the FDIC needs a capital infusion. It had $48 billion when the year started, and IndyMac's failure alone is going to wipe out $4 to $10 billion of that. WaMu's impending failure will be several times larger.
NLY is a trip to a casino, and the substantial odds of a 100% loss on the stock in the next 12-18 months just don't justify the extra 11% dividend you get above CD rates. If you want to gamble, there are plenty of bets with much better risk/reward than this.
Not to mention the other concerns raised here about an increase in short-term rates.
On Aug 04 11:53 AM Greg Weston wrote:
> Of course it would be a huge shock to the financial system if GSE
> debt were suddenly worth 0 and there is not way the gov will let
> that happen, but that is not the question here.
>
> But a forced trade of current GSE debt for explicitly guaranteed
> debt at 92 or 94 cents on the dollar would only cause major pain
> to _leveraged_ holders of GSE debt. Like NLY.
>
> You guys think the 14% div on NLY is a free lunch. You are sorely
> wrong. Repairing bridges, health care for the uninsured, repairing
> the military after Iraq, or free money for the mostly rich and/or
> foreign GSE bondholders? No way, not in this political environment.
>
>
> By the way, the housing bill allows the GSEs to continue to fritter
> away their money in dividends. That is cash that won't be available
> for bondholders later on. There was a proposal to stop the GSE dividends,
> but it was killed.
>
> Also, we are looking at a deficit next year well north of $600 billion,
> and higher if the FDIC needs a capital infusion. It had $48 billion
> when the year started, and IndyMac's failure alone is going to wipe
> out $4 to $10 billion of that. WaMu's impending failure will be several
> times larger.
>
> NLY is a trip to a casino, and the substantial odds of a 100% loss
> on the stock in the next 12-18 months just don't justify the extra
> 11% dividend you get above CD rates. If you want to gamble, there
> are plenty of bets with much better risk/reward than this.
>
> Not to mention the other concerns raised here about an increase in
> short-term rates.
On Aug 04 05:05 PM Charlie_Bott le wrote:
> JAZ, what about my question on the relationship between the yield
> and the mark to market of the assets? What are your assumptions
> on the duration or the portfolio?
The nature of the distribution could include:
Return of Capital - lowers your basis
Interest - personal tax rates
Dividends - Right now, 5-15%; in 2 years 39.6%
Cap gain - Same as above.
You have little control over the classification of these streams when you get your K-1 document. So consider too that stocks like this and other high distribution stocks should or could be liquidated perhaps as soon as November 3rd, depending on who wins the elections, but since the tax changes in 2010 will require proactive legislation, it makes the older Clinton era rates pretty much a lock.
Best to all.
Basic bond math tells you that change in value of portfolio approximates change in yield times duration of the portfolio.
It seems that you are overestimating the upside and underestimating the downside, given that (i) the entire agrument for the upside rests on this and you do not have enough information (and perhaps knowledge) to ascertain it with any precision, and (ii) you incorrectly stated that the government has provided an explicit guarantee on the agency debt.
The artcile subtracts from the sum of human knowledge, I suggest you do the right thing and ask to remove it as itis technically incorrect on key aspects.
On Aug 10 04:00 PM Stuart, Atlanta, Ga wrote:
> Would these observations apply equally to Anworth and Capstead?
Anybody who thinks that the US Gov can walk away from the GSE debt without 100% repayment is crazy. Yes, the people who are leveraged into the GSE will get bailed out. Deal with it. Nothing's been 'fair' so far, why expect the system to become 'fair' all of a sudden?
But, the bail out of leveraged investors will only be on the tail coats of the bigger objective which is to keep foreign entities financing our current account deficit. If the Fed paid back even only 99c on the dollar, the credibility would be ruined and interest rates on treasuries would shoot up dramatically as all the foreign countries (and sovereign wealth funds) would start to question the concept of "the risk free rate of return". If you undermine the notion of a 'risk-free-rate of return', you seriously damage the entire notion of modern finance. Then all bets are off, and you really are talking about the 'financial apocalypse'
So yes, your bridges won't get built, health care will continue to suck, the infrastructure will continue to crumble, because in the end it will be far worse for the country to default on debt that was 'implicit', then made 'explicit' than to worry a building new bridges.
Another words, the US Gov in meeting its larger economic and strategic objectives will also have the nice side benefit of 'bailing' out the leveraged GSE buyers as well.
It seems like the risk to NLY is really the shape of the yield curve and the fact that in the future, the spread won't be as much as in the past if Agency Debt starts trading at the same rate as treasuries.
That's the only reason. Period.