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.
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