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Annaly Capital Management (NLY)Stock (Financial Services Industry, Mortgage Investment Industry, Real Estate Industry)
 Annaly Capital Management, Inc. (NYSE:NLY) is a unique real estate investment trust focused on the government sponsored mortgage-backed securities market. Annaly makes money by trading a portfolio of Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNM), and Federal Home Loan Mortgage Corportation (FRE) securities and derivatives. These three government agencies securitize groups of mortgages and then sell them as low-risk bonds similar to treasury bonds because they have the implicit support of the federal government. The company holds just over $54 billion in these securities. Through its advisory subsidiary, Annaly has $15.4 billion under management. 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 garanteed 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. Because Annaly invests only in mortgages guaranteed by GSE's and, implicitly, the U.S. federal government, it is less exposed to fluctuations in the mortgage market (such as the economic crisis precipitated by the collapse of subprime lending) than changes in the yield curve. Annaly's business depends on its ability to manage interest rate spreads - if short term interest rates increased suddenly, Annaly's costs to borrow money would go up, potentially wiping out it profits.
[edit] Business Financials[edit] Breakdown of Segments[edit] AnnalyAnnaly Capital's basic business model is to raise capital and invest in government-sponsored real estate backed securities (REBS). NLY profits when the return on its investment in the REBS exceeds the interest it pays on the money it borrows to invest in the REBS. Per its investment agreement with shareholders, Annaly is allowed to invest up to 25% of its assets in non-AAA equivalent securities. However, as of March 2008 they only owned government sponsored REBS. These bond-like instruments are similar to Treasury Securities in that they are (effectively) backed by the full faith and credit of the U.S. Government (i.e.- they are risk free). However, while the Ginnie Mae securities are still explicitly guaranteed as the GNMA is still owned and operated by the Federal Government, Freddie Mac and Fannie Mae securities were spun off to the public but are still SPONSORED by the government (More on this concept here). This means that although they have implicit AAA ratings on their MEBS, they do not have the stronger, EXPLICIT backing off the full faith and credit of the U.S. Government. Nonetheless, there is wide speculation that the government would intervene in any way possible to prevent these companies, which constitute a major part of our financial system, from not fulfilling their guarantees to pay back defaulted mortgages.[1] Annaly borrows money to purchase REBS and their derivatives, and the difference between the interest on this debt and the interest and price appreciation of the bonds is the profit. These margins are slim, but Annaly uses massive leverage (8.7:1, for every $1 of cash, it borrowed $8.70 to invest) to pump up the return.[2] The only exposure is to the interest rates on the debt. Annaly has structured its portfolio in such a way that its fixed rate exposure benefits greatly from a decreased Federal Funds Rate. What that means to you is that when Ben Bernanke lowers interests rates, Annaly's portfolio is more valuable and profitable because its margins increase. Taking that one step further, rate cut=bigger earnings and dividend. [edit] FIDACFixed Income Discount Advisory Company is the asset management arm of Annaly Capital. This segment makes profits by receiving fees from third parties to implement Annaly's strategies with outside capital. This adds additional revenue without risking any Annaly or shareholder capital. The subsidiary has a publicly listed closed end fund with First Trust (FHI) , FMY. This fund allows any investor to have access to one of Annaly's strategy. They then proceed to collect a risk free management fee from the fund's returns. FIDAC also collects a fee by acting as the advisor to Chimera Investment Corporation (CIM). This subsidiary is relatively small, as it only generates about 5% of profits. However, it represents a constant risk free stream of income.[3]
[edit] Income Statement Analysis
[edit] Portfolio AnalysisDespite the worsening conditions of most asset managers balance sheets, Annaly has posted significant growth across every metric. The effect of rate cuts materialized in the decreased 4th quarter capital cost. This causes the interest spread to widen even further. Additionally, it is beneficial for shareholders to have Annaly both buying and borrowing more as long as they effectively manage the interest spread. This was certainly the case over the last four quarters. Additionally, Annaly is trying to improve this spread by borrowing directly or issuing commercial paper to avoid paying financial intermediaries.[5]
[edit] Key Trends and Forces[edit] Falling Interest Rates Will Increase ProfitsThe most important determinant in valuing Annaly's portfolio and profitability are interest rates. These rates determine the borrowing cost of Annaly's securities, and the margin that the firm earns on its investments. The spreads between borrowing cost and returns on securities - the yield curve - is Annaly's profit. Because of the current make up of the portfolio, decreased interest rates benefit Annaly, while higher interest rates will squeeze margins. [6] This comes from the weighting of its holdings/borrowings with regard to rate adjustments. Over 71% of Annaly’s investment holdings have a fixed rate with an average yield of 5.80%.[7] However, its borrowing is based more on adjustable rates, and so the firm depends on these rates to stay below 5.80% in order to earn profit. To get a picture of the timing of rate adjustments, one should look at the weighted average term to next rate adjustment. This tells how often the interest rates on securities will be revised to market rates. For Annaly’s investment holdings, the weighted average term to next rate adjustment was 39 months. For its borrowings, there was a weighted average term to next rate adjustment of just under 8 months.[8] This essentially creates a “lag.” The lag is on the side of the investments. So if rates are going up, the borrowing costs will reflect it faster than the return on investment and Annaly will be adversely affected. In a period of falling rates, as we are experiencing now, the borrowing costs will fall much faster than the return on investment, and Annaly will profit in the interim. [edit] Rising Interest Rates Will Cut Into Annaly’s MarginsIf the U.S. economy begins growing at a pace that requires interest rate increases, or inflation spins out of control, Annaly will have to pay more out in interest to its lenders. This was the case in 2004-2006. As rates continued to go up, Annaly’s margins fell. This is a result of the aforementioned lag in resetting of investments vs. borrowings. This is not static, though. The weighting of the portfolio is determined by Annaly’s management. Management has clearly articulated that their strategy was based on the belief in short term rate decreases. If the market environment turns to one that is unfavorable to Annaly, management will have to take serious action to correct the weighting of the portfolio. [edit] Index Rates Affect AnnalyMost of the commentary above has centered on the federal funds rate because this is the number one driver of where market interest rates are heading. But there are much more relevant market rates in term of direct impact on NLY's portfolio that offer greater insight into where Annaly’s margins are heading. As explained above, it is an inverse relationship. Thus, if the LIBOR Index is falling, Annaly’s profit margins are increasing.
[edit] Free Flowing Credit Markets Are EssentialAs we are seeing now, a teetering economy with lower rates to spur growth but free flowing capital markets is the ideal mix for NLY. The main reason that Annaly relies on U.S. economic health is ease of capital. There must be access to low cost financing to create leverage. As Fed Chairman Ben Bernanke cuts rates, it will ensure that Annaly has access to low cost financing. The threat to Annaly lied in the freezing of U.S. credit markets, but this crisis has been avoided for now. [edit] Subprime LendingAs hard as it is to believe, since it is a mortgage REIT, Annaly has largely avoided the subprime mess. The composition of its portfolio, along with well managed interest rate exposure, has allowed Annaly to do dodge this bullet. Additionally, Annaly is making record profits indirectly through this mess. The subprime mess has caused a major shock to U.S. credit markets. This has caused the Federal Reserve to step in and lower rates to ensure proper flow. The lowering of rates allows Annaly to borrow at a lower cost, and values their current index-based holdings at a higher value. Thus, subprime has benefited Annaly immensely [9]. [edit] Explanation of Current Price Volatility[edit] Perfect Storm of Downward PressureOn March 6th, three significant events put extreme downward pressure on Annaly's stock. After the dust had settled, Annaly closed the day down 18% to 15.81. It would fall an additional 7.8% over the next two days and close at 14.58 on March 10. In a matter of three days, the stock had given up all of the gains posted during the rate cuts of September-February. [edit] Analyst DowngradesDuring the aforementioned period of rate cuts, several brokers had Annaly on their strong buy list. One of these companies, KBW had Annaly on their "Best Ideas" list. On the morning of March 6, a KBW analyst removed Annaly from this list. His reasoning was that Annaly was going to put less capital to work in its business model because it may need extra liquidity for increased margin requirements. With less capital at work, the analyst lowered his EPS guidance for 2008 from $2.91 to $2.41.[10] As the slide continued the next few days, analysts at FBR and JMP Group both reiterated their ratings, but lowered their price targets to reflect this new potential development. It is important to stress here that nothing changed in Annaly's fundamentals. Rather, it was the concern that the margin requirements of its lenders might be increased. [edit] The Jim Cramer FactorRegardless of what one thinks of Jim Cramer, he carries significant influence over the equity markets. In 2007, Cramer paraded Annaly around as his favorite financial stock. He claimed that it was not at risk due to subprime lending and was actually poised to profit from it (see explanation above). "I thought Annaly would be the exception," said Cramer, "but I was horribly wrong."[11] His decision to recommend a sell to his viewers (and sell half of the shares he personally owns) was made out of fear and concern for liquidity and margin problems. [edit] Fannie/Freddie FearsSince Annaly deals only in agency REBS, Fannie Mae and Freddie Mac constitute two of the three channels for revenue. These two companies have been viewed as somewhat of a safehouse for mortgage backed securities. This is a combination of their government agency status and the fact that they only deal in safer conforming loans.[12] When the two reported a combined 4th quarter 07 loss of nearly $6 billion, investors began to worry about these so-called "safe" agency mortgages.[13] Despite the fact that interest rate indices were falling with Fed intervention, mortgage rate spreads were widening. Additionally, both companies reported increased delinquency rates in their portfolios. Freddie and Fannie loans were now seeing their premiums erased in secondary market trading of their packaged loans. This new fear of the possibility that agency REBS were no longer "risk free" put Annaly's entire business model up for doubt. If their agency REBS could lose value, was the leverage and interest rate risk justified?
[edit] Are These Agency Mortgage-Backed Securities Risk Free?What is going on with Freddie Mac and Fannie Mae? Despite market fears and concerns, the government released a statement on March 11 regarding their financial positions. This statement was seen as a sign of relief and assurance that their guarantees were still worthwhile. The stock prices of both companies and mortgage REITs rebounded on two major points:
[edit] Was the Market Irrational?One of the great Keynesian principles of investing is that despite the market's propensity to form rational and efficient equilibriums, it can remain irrational longer than you can be solvent. This was the case with the $4 billion hedge fund LTCM's collapse. Fox-Pitt, Kelton analyst Matthew Howlett called the sell-off "overdone and based on illogical conclusions being reached about the business model, in conjunction with the well-publicized meltdown in the non-agency space and funding issues with at least one private-agency REIT."[16]
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