Part II: Deciphering Annaly's Risk Factors
In the first part of this report we considered why the dividend yields of Annaly Capital Management (NLY) and other mortgage REITs are so attractive. We noted that value incorporates risk, and said that a low valuation does not necessarily represent a great opportunity but almost always reflects real risk. In the case of the dividend yields of the mREITs, we said there must be significant risk or else these securities would offer rates closer to the risk-free Treasury Bill. The recent dividend yields of popular mREITs are listed here. You can see their appeal.
Company & Ticker
Recent Dividend Yield
American Capital Agency (AGNC)
Two Harbors Investment (TWO)
CYS Investments (CYS)
Hatteras Financial (HTS)
MFA Financial (MFA)
Crexus Investment (CXS)
Through this follow up report, we determined to more thoroughly review the risks that Annaly notes within its 10K Annual Report filed with the Securities and Exchange Commission (SEC). It's an arduous task, but one we think is worth it before an investor puts his hard earned capital at risk. Many of these same risks apply across the spectrum of Mortgage REITs, including those listed above, and so are important for all investors in mREITs.
The risks listed are comprehensive, and yet may miss a factor that later comes to play in the return on investment in these securities. At the same time, the risks listed may include issues that are highly unlikely to unfold. But, if you are aware of the risks, then as they potentially become heightened, you are more likely to recognize an intensifying threat against your capital investment. So let's now begin the comprehensive analysis of Annaly's and mortgage REIT risks.
Annaly's 10K Risk Factors Analyzed:
Annaly spends a good portion of its risk discussion on the risk in mortgage-backed securities generally. We should all be well-enough aware of those risks today, versus how off-guard market participants were as the financial crisis unfolded a few years back.
Risks to Mortgage Backed Securities (MBS) Generally
Annaly notes that economic conditions and other factors can drive adverse financial market conditions, which can lead to deleveraging in the global financial system. Such deleveraging can drive the forced sale of large quantities of mortgage-related and other financial assets. Unfortunately, today, we do face adverse economic conditions, despite the Federal Reserve's efforts.
Also, "other" factors including geopolitical, which is noted in Annaly's discussion, can hamper the securities which Annaly owns. To this I note the events unfolding in the Middle East, Africa and Asia, and the military presence near Iran's shores. Such factors can remove liquidity from financial markets and affect both supply and demand for financial derivatives. The tie should be noted by those investors who see a high probability of a geopolitical event of significance. Still, it's important that I note my view that unless foreign conflict reaches American shores or otherwise hampers American investors or business (like through higher gas or energy prices), then the housing market and this industry might be insulated.
Annaly reminds us that in the summer of 2007, many traditional mortgage investors suffered severe losses in their residential mortgage portfolios, and some major market participants even failed. Those failures significantly dried up liquidity for mortgage related assets, affecting their terms and the availability of new funding. If such events were to recur, the value and performance of the company's investment assets could diminish. Also, Annaly might find it difficult to raise the funds it uses to purchase those securities if capital resource terms were to tighten. Volatility within the mortgage market might also make it harder for Annaly and its peers to raise funds to buy mortgage assets. Also, the accounting for mortgage assets, priced at fair market value, could impair the company's book value and further harm its ability to raise funds and even impair earnings if persistent.
Government efforts to help Americans through the current crisis, including mortgage modification programs, threaten the value of the assets Annaly owns and could own. Changes in the requirements to qualify for mortgage modification with Fannie Mae (FNMA.OB), Freddie Mac (FMCC.OB) and Ginnie Mae impact the assets Annaly invests in. The programs may also involve, among other things, the modification of mortgage loans to reduce the principal amount of the loans or the rate of interest payable on the loans, or to extend the payment terms of the loans. These prospective programs and their risks are certainly one reason why NLY and others are generating such high yields.
Furthermore, the Federal Reserve in its efforts could overshoot and actually do damage to the interest rate environment. Annaly mentions this issue vaguely, but I have my own strong concerns about dilution of fiat currency and potential inflation. If the rates at which Annaly raises capital increase, its profit margins could be hampered in future asset stakes and in its more recent acquisitions of lower paying assets. And even if the Fed achieves its goal and establishes a flat yield curve, prepayment rates could increase, narrowing NLY's net interest margin.
Annaly operates in a highly competitive marketplace, and one in which the Federal Reserve has become a new and important competitor. QE3 appears to be a threat to the mREIT competitive environment. I think that was visible in the first two days trading of NLY after the latest FOMC policy announcements.
The company also notes risks tied to the European financial crisis. We recently said Europe's debt crisis has been effectively resolved. Take note that I'm referring to the financial crisis, not the economic crisis, which is ongoing. Risks to European banks and their U.S. lending subsidiaries threaten Annaly because the mREIT borrows from them. Thus, the issue poses a threat to the financing of mREIT operations generally, because if sources of capital are removed, the degree of rate spread exploitation achievable is reduced.
Risks Specific to Annaly
Interest Rate Risk
There is some overlap between this section and the section just discussed, and so I've cut out much of the discussion that would be repetitive. The first and key risk noted by Annaly is that tied to interest rate changes. Annaly notes that changes to the interest rates it pays for capital and interest earned from investments will impact its net interest margin and profitability. For instance, its income earning assets are often limited by rate caps on adjustable rate instruments and by fixed rates on others. However, the company's borrowing costs are not capped. Thus, in a period of rising rates, especially rapidly so, a mismatch could occur and impair profitability. Also, if short-term rates were to rise, the company's borrowing costs would increase, possibly out of line with its long-term duration investments. Obviously, higher interest rates would also decrease the value of investments held with fixed rate streams.
Annaly bears risk to prepayments of mortgages when it owns them at a premium, however, when it has acquired a mortgage security at discount, it benefits from the prepayment of mortgages. The company has several ways to hedge against prepayment risk, but it might not be perfectly hedged at a time when/if prepayments occur in bulk, perhaps due to government impetus.
Lender Related Risks
If a major lender were to fail, it could affect the company's ability to secure funding capital and adversely affect the availability of funds for other investors as well. Such an event could raise the cost of funding for the company. Furthermore, if a major market participant were to fail, it could affect the marketability of all fixed income securities, which could reduce the value of the securities Annaly holds (as seen in the recent past). Lack of funding could also force the company to sell assets at less than optimal value. Also, relations with counterparties in the financial services industry, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds, and other institutional clients are extensive. Many of the company's transactions expose it to credit risk in the event of default of its counterparty or client.
The company notes many risks because of leverage. It is greatly because of the leverage it employs that Annaly is able to return so well to investors. But there's risk in leverage, as we should all know by now. The company's leverage magnifies all of the rate risks we've already listed. It also means Annaly's lenders could issue margin calls on collateral if the company's fixed income securities decline in value, possibly on rate increase. Banks could require the company put down more collateral or even foreclose on collateral if Annaly cannot meet its margin call. Forced liquidations could cause the company to fail to meet its REIT requirements, and put its tax status at risk. This is discussed in detail further on. In addition, the company may not be able to achieve its optimal leverage ratios, which could hamper its returns. Also, its short-term borrowings are greatly in repurchase agreements, so changes to the spreads between those and other short-term rates could affect the company's profitability. Also, if counterparties to repurchase agreements default on their obligations, the company could lose money.
Annaly employs hedging strategies to limit its risk, but those same strategies also create their own relative set of risks. The REIT's policies permit it to enter into interest rate swaps, caps and floors and other derivative transactions to help Annaly mitigate its interest rate and prepayment risks. It may be difficult or impossible for the company to perfectly match its risks with its hedges (or it could fail to due to error), and so it may incur losses on its derivative financial instruments at times. The company's hedging instruments may perform differently than anticipated and result in imperfect hedges and losses. Hedging transactions are also costly, and increase in cost in times of their greatest need. Counterparty risks are created through the use of hedging instruments, and so there is risk of counterparty default.
Annaly's investment strategy may involve credit risk. The REIT may incur losses if there are payment defaults under its investment securities. Even though NLY's agency mortgage-backed securities and agency debentures acquired thus far have been "AAA," pursuant to its capital investment policy, Annaly has the ability to acquire securities of lower credit quality. If the company acquires securities of lower credit quality, it could incur losses if there are defaults under those securities or if the rating agencies downgrade the credit quality of those securities.
Dividend Payment Risk
There is no floor dividend payment to which Annaly has committed, therefore, there is risk that Annaly could pay much less than expected by investors today. The company's dividends depend on its earnings, financial condition, maintenance of its REIT status and such other factors as the board of directors may deem relevant from time to time. Annaly's dividend could be limited by the amount of and yield paid by mortgage backed securities it acquires in a competitive marketplace. GAAP financial results differ from taxable income results, so that what is represented in GAAP may not reflect what can and will be paid out, which is dictated by taxable income results.
Special Tax Risks
Annaly faces significant tax risks. If Annaly were to fail to qualify as a REIT at some future date, the tax consequences would be substantial. The company does not control all the factors that weigh on its REIT status. Also, even a technical or inadvertent mistake could jeopardize its tax status. Furthermore, the rules could change, which might make it difficult or impossible for Annaly to qualify as a REIT.
If Annaly lost its REIT status, it could not recover it for four years, and during that time, would be required to pay federal income tax at regular corporate rates. It would no longer be required to make distributions to shareholders, and the value of its stock would likely be significantly impacted. There are many ways a mortgage REIT could lose its tax status, and many of the factors involved are market or otherwise driven and out of the company's control. Such factors are affected by the values of securities held, borrowings, stock ownership and other issues beyond full control and so at special risk. Because of the company's risk tied to the rules limiting ownership of its shares and its REIT tax status, it could be forced to issue shares diluting current owners.
Annaly faces special regulatory risks. For instance, if it were to lose its Investment Company Act exemption it would be adversely affected. If Annaly were to fail to qualify for this exemption, its ability to use leverage would be substantially reduced, and it would be unable to conduct business as it currently does.
On August 31, 2011, the SEC issued a concept release titled "Companies Engaged in the Business of Acquiring Mortgages and Mortgage Related Instruments." Under the concept release, the SEC is reviewing interpretive issues, and requesting comments on whether it should revisit whether Agency Whole Pool Certificates may be treated as interest in real estate (and presumably Qualifying Real Estate Assets) and whether companies, such as Annaly, whose primary business consists of investing in Agency Whole Pool Certificates, are the type of entities that Congress intended to be encompassed by the exclusion.
If the SEC determines that any of these securities are not Qualifying Real Estate Assets or real estate related assets, adopts a contrary interpretation with respect to Agency Whole Pool Certificates or otherwise believes Annaly does not satisfy the exemption, it could be required to restructure its activities or sell certain of its assets. The net effect of these factors would be to lower net interest income. If Annaly were to fail to qualify for exemption from registration as an investment company, its ability to use leverage would be substantially reduced, and it would not be able to conduct business as it has. Annaly's business would thus be materially and adversely affected if it failed to qualify for this exemption. In addition, simply complying with proposed and recently enacted changes in securities laws have increased Annaly's cost of operations and threaten to raise costs further.
Finally, Annaly notes that computer hacking attacks against the financial services sector have increased substantially. The company relies on its systems, and warns that successful attacks to its systems could substantially harm its business and results of operation.
The risks to any company's operations are many, and they will never be short in the risk notation found within a company's filings with the SEC. It's because these notations help to mitigate legal risks should the security incur losses for investors who find issue, place blame and seek retribution. Still, it's important to read through the risk notations of the stocks you own or contemplate owning. As you work through the arduous task, compare it to the research you put in before you buy a high ticket item like a car or a home. Your capital is at risk, and so doing your homework is in your best interest.
Annaly and the mortgage REITs have some unique risks that investors should be aware of. Those risks, detailed in this report, are important and certainly weigh heavily in the returns paid by these firms. You never get reward without risk, and so the greater the potential reward in an efficient market like this one, the greater the risk. Be aware of them for your own good. Thus, I would advise seniors to limit their exposure to these types of securities and apply sound diversification strategies for the whole of their portfolio. In future articles, I'll discuss specific risks that are showing up in plain sight today and affecting the trading of mortgage REIT shares. Follow my column to be kept in the loop of my publishing.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.