Avoiding Annaly Capital

| About: Annaly Capital (NLY)
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Mortgage market guru Jeffrey Gundlach of Doubleline Capital is telling investors to avoid real estate investment trusts that investment in mortgage backed securities as homeowners continue to refinance mortgages to lock in lower rates. There is an old mantra on Wall Street that says “don’t fight the fed.” I think Gundlach is spot on in his view in that the current administration and Federal Reserve are doing everything in their power to help homeowners secure lower cost mortgages to allow people to stay in their homes.
Gundlach who sold his mortgage REITS a few months ago believes that the recent dividend declines experienced is just the beginning as dividend cuts will continue into the quarters ahead. Mortgage REIT giant, Annaly Capital Management (NYSE:NLY) reduced its dividend to $0.57 from $0.60 in Q311 and $0.65 in Q211. According to Gundlach, the trusts are lowering payouts because prepayments are increasing on government-backed securities, most of which are carried by REITs above 100 cents on the dollar. Mortgage REITs acquired higher coupon securities at above par, thus carry risk of prepayments. Investors can see the declining underlying trends in the Company’s filings and press releases.
Interest rates on 30-year loans averaged 4.08 percent last week, the lowest on record, according to surveys by the Washington-based Mortgage Bankers Association, as monetary policy by the Federal Reserve and Europe's debt crisis restrains benchmark yields that guide consumer borrowing costs.
Mortgage REIT investors should focus on constant prepayment rates (CPR) to monitor the health and dividend potential for mortgage REITs. The constant prepayment rate (“CPR”) reflects the percentage of principal that is prepaid over a period of time on an annualized basis.
Investors have been attracted to the stock due to its strong dividend yield but investors should be cautious that yields may fall if refinancings increase.
Understanding the Risks
As CPRs increase, the company will have to invest in securities with lower coupons which will hurt earnings. Mortgage REITs are highly levered investment vehicles which employ significant leverage to generate yields. Mortgage REITs have had difficulty as an asset class and have been prone to noteworthy failures. Conservative investors should be aware of the risks and examine the underlying business model and not just the attractive dividend yields. While I think rates will remain low, market volatility and a banking crisis can impact liquidity and thus funding costs through increased haircuts. During the 2008 / 2009 meltdown a number of mortgage REITs went bust including: Carlyle Capital, Thornburg Mortgage, New Century Financial.
With a seasoned veteran moving away from the space due to risk to prepayment rates I believe it is prudent to move to the sideline with mortgage REITs including Annaly.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.