Election Implications for Annaly’s Mortgages

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Of the myriad of potential impacts that the U.S. Presidential election will have on the global economy, the very role the government will play in financial matters should be of particular concern. In a statement released by Annaly Capital Management (NYSE: NLY), the company said that it fears a win by President Obama could mean more “meddling” by regulators and legislators. Given the $5.2 trillion size of the government mortgage-backed mortgage securities (MBS) market, the resulting policies promoted by the victor has the potential to carry significant economic repercussions.

The Model

The business model used by Annaly – and peers including American Capital Agency (NASDAQ: AGNC) and Capstead Mortgage (NYSE: CMO) – involves the company taking loans from the money market and then buying higher-yielding MBS. The company earns the spread between the MBS interest and the short-term interest that must be paid on the loans that form the source of capital. In Annaly’s case, the company focuses on agency MBS, meaning that the future roles of both Fannie Mae and Freddie Mac are of importance.

This model allows and requires the companies to pay the bulk of their income to investors in the form of dividends. Annaly currently carries a dividend yield of 12.6% relative to American Capital Agency at 15.4% and Capstead at 11.7%. While there are subtle differences from company to company, the basic model is the same. It has proved quite successful over the past several years, so shareholders are particularly interested in where things may go from here.

Issues Up for Change

Depending of the results of the election, there are several issues that will either stay on the same course or be subject to dramatic change. Some of these include the leadership of both Fannie Mae and Freddie Mac, the level of involvement of the Federal Reserve, the continuation of perpetual quantitative easing and how much regulation will be supported. Annaly’s CEO said “The way I see it is if Obama wins, then we potentially see more policy meddling.” Of course, should Governor Romney prevail, there is no guarantee that existing policies will change quickly. The news, therefore, is very much about expectations rather than immediate shifts.

Also of concern is the so-called fiscal cliff that is currently being faced on various issues. Sequestration, for example – the means by which certain sweeping and automatic spending cuts will go into effect due to a failure of the two parties to agree on reasonable cuts – is still looming. Experts generally believe that a compromise will more easily be reached under Romney, but this is largely driven by the President’s public remarks to date. If we accept that many may have been campaign-related, it is hard to get a fix on how things will unfold.

The Obama Case

One of the critical factors that influence MBS investing is prepayment risk. This is the risk that a homeowner will pay off the loan early in order to refinance at a more attractive rate, leaving the lender – the MBS holder – to replace the bond, frequently at less attractive rates. Since the income earned by Annaly is derived from this rate, prepayment risk must be considered. One of the offshoot consequences of many refinancing plans currently championed by the Obama administration is that prepayments have slowed because homeowners are being bailed out. This factor aside, the impact of the current administration's artificially low rates is bearish for Annaly.

The Trade

At this point, it is too late to trade purely based on election predictions, but watching the results should give you a strong indication of where the company may trade soon and into the future. Clearly Annaly prefers a Romney win, so you should be prepared for the stock to react accordingly. If the stock does sell-off, it may represent a buying opportunity if enough other factors line up.

Interested in Additional Analysis?

Annaly Capital Management has a history of paying huge dividends to shareholders, made possible by borrowing at cheap short term rates and investing in longer term mortgage securities. But there are some things investors absolutely must know about Annaly’s business before buying the stock. In this brand new premium research report on the company, a Fool analyst runs through the dynamics of Annaly’s business, as well as the future opportunities and pitfalls of their strategy. Click here now to claim your copy.

Mr. Ehrman has no positions in the stocks mentioned above. The Motley Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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