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Annaly’s Strategy Expansion

Douglas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There are typically two appropriate responses when a company makes a major shift in its central strategy, particularly when that company is in the business of managing money. The first is to recognize it as a necessary part of a changing environment and praise management for its ability to dynamically adapt to new conditions. The second is to see it as a serious warning sign and quietly find the exit as quickly as possible. In the case of Annaly Capital Management (NYSE: NLY), while a certain level of increased scrutiny is prudent as the company embarks on some critical strategy shifts, the company’s reaction to the political and monetary landscape should be seen as bullish.

The Existing Strategy

Annaly is an mREIT than operates in the residential mortgage-backed securities (MBS) space, specifically focusing on agency MBS. This focus has provided the company with a certain additional measure of safety because agency MBS are guaranteed by government sponsored agencies including Fannie Mae and Feddie Mac. To generate profits, the company borrows money as cheaply as possible in the short-term money market – focusing on overnight repos and corporate paper – and then uses the borrowed funds to buy or initiate positions in the longer-term MBS it favors. Annaly derives a profit by earning the spread between what it can earn on the bonds and its lower cost of capital.

The Market

Agency mREITs have come under increasing pressure as a result of the Federal Reserve’s continuing policy of quantitative easing. Under the current round of QE, the Fed is targeting agency MBS at a rate of $40 billion in bond buying per month. When coupled with the prevailing artificially low interest rates and the fact that “Helicopter” Ben Bernanke has seemingly abandoned the inflation component of the Fed’s dual mandate, conditions for mREITs, especially agency mREITs, have been poor.

The impact of the Fed’s actions is to accelerate prepayments on those bonds that Annaly relies for income. When borrowers refinance their mortgages, the bonds that the company owns begin to shrink. That capital must then be reinvested, but, because rates have remained so low, the available credit spread has been shrinking. Where Annaly was earning a 1.71% spread in the first quarter of this year, by the third quarter the company is only able to construct a 1.02% spread.

To put this in perspective, the spreads earned by American Capital Agency (NASDAQ: AGNC), one of Annaly’s principle competitors in the agency space, have fallen from 2.31% in the first quarter to 1.43% by the third. American Capital Agency has been able to achieve somewhat higher spreads as a result of its hedging activity, but the entire industry faces the same challenges. These companies, which are sought after for their very high dividends, have largely maintained their yields because of falling stock prices. As the pressure remains on, their ability to pay such handsome returns may be in jeopardy.

The Shakeup

In a press release issued on November 12 by Annaly, CEO Wellington Denahan outlined the company’s vision for its strategy shift:

Since our inception in 1997, Annaly has maintained the capacity to diversify its asset base to include real estate related assets in addition to Agency mortgage-backed securities if we determined that compelling other long-term investment opportunities exist relative to the Agency market. While we remain committed to the Agency market, given the current environment, we believe it is prudent to diversify a portion of our investment portfolio. Therefore, we may allocate up to 25% of our shareholders’ equity to real estate assets other than Agency mortgage-backed securities.

A significant step in this process was the company’s announcement, contained in the same press release, of its bid to acquire the rest of Crexus Investment Corp. (NYSE: CXS.DL). Annaly already owns roughly 12% of the commercial real estate focused mREIT and plays a large role in its management. By diversifying into this space, the company hopes to recapture some of the yield that it has seen deteriorate over the last several quarters.

The commercial real estate sector offers higher yields than the agency space, but also has less protection. During the real estate crisis, despite the suffering of the agencies themselves, agency MBS stood up far better than other sectors. Given the economic and political climate, however, the decision to diversify is likely a good and necessary decision.

The Trade

While major strategy shifts can, at times, be seen as red flags for a company, failure to react to major structural changes in the market place can be devastating to companies and their shareholders as well. Given the stance of the Fed, and the apparent certainty that current policies are permanent for the foreseeable future, Annaly’s decision to adapt is proper. While I will be anxious to see how its bid for Crexus develops, I like the stock on this news as a positive catalyst.

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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