Annaly Capital: The Good, the Bad, and the Unknown

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Last week was extremely tough for mREITS in general, and Annaly Capital Management (NYSE: NLY) in particular. The 10-year Treasury yield was up another 22 basis points in Friday trading, exceeding the 2.7%.level. This equates to a jump of 8.5% in the yield. Normally, such a move can take months, if not years. But today's economy is on steroids. Everything happens at a furious pace.

Whether rising interest rates are a sign of systemic health or an arrow aimed at the heart of an over-leveraged society remains an open question. But what's certain is that shares of Annaly, and other rivals such as Chimera Investment (NYSE: CIM) and American Capital Agency (NASDAQ: AGNC), have reached new 52-week lows, as a result of this interest rate swing. 

The business model

Annaly is a mortgage real estate investment trust. As such, the company owns, manages, and finances a portfolio of real-estate related investments. If it sounds boring to you...that's okay. Because Annaly elected to be taxed as a REIT, it's obligated to pay 90% of its net income back to its shareholders in the form of dividends. Now it's getting more interesting.

The business model of Annaly and other rivals such as is fairly simple. They borrow money at low interest rates (thanks to the Federal Reserve) and invest it at a higher interest rate in government-guaranteed mortgages from Fannie Mae and Freddie Mac. The difference between the rates they pay to borrow and the ones they collect from investments is called the "interest-rate spread." Annaly, for instance, has an interest rate spread of 2%. At six times leverage -- or six times more debt than equity -- that's roughly a 12% return on its money. And that's what allows it to pay out such hefty dividends.

The good

Higher interest rates could be a blessing for mREITs because fewer homeowners have an incentive to refinance. A recent report stated that the spike in interest rates has led to a decline of more than 15% in refinance application volume. This is good news because it diminishes one of the industry's greatest fears -- the fear of refinancing.

You see, when people prepay their mortgages, mREITS are forced to take them off their books, and instead, settle for a lower, newer mortgage. What this finding indicates is that people will continue making payments on existing loans, so the "inventory" that Annaly and others currently have will continue to produce income rather than be taken off the table.

The bad

But, higher rates eventually erode the book value, which is the most important for mREITS. Chimera, for example, is now falling apart. The company has failed to file year end and quarterly statements since December 2011, and it's now on the verge of being de-listed from trading. Although it has continued to pay dividends throughout 2012, in November it paid a dividend of $0.09, of which $0.06 was a distribution of capital.

Distributions of capital are usually done by companies that are winding up operations or closing out divisions. So, it's very probable that it's game over for Chimera. And American Capital Agency hasn't escaped the bad news either. According to management's recent presentation, book value was around $26.44. With the share price currently hovering above $20, American Capital trades at a 23% discount to book value. In Annaly's case, book value is estimated at $15.2. At the current share price of $11.50, shares are trading at a steep 25% discount to book. 

It's important to keep in mind that book value is essentially the value of the assets on a company's balance sheet. With mREITs, it's not just an accounting number. It's the actual liquidation value of the business. This means that both Annaly and American could sell their book of mortgages on the market today for around 33% more than its quote on the books. 

The unknown

The main problem with the current "Fed tapering" environment is that the scale and timing is highly unknown. Now, mREITS use hedging instruments at all times, but the scale of interest rate moves is unprecedented. Put simply, no one can hedge against a daily interest rate spike of 8.5%, such as the one witnessed last Friday. If you consistently hedge against all risks, you will end up paying the majority of your earnings to hedging instruments. That's why, uncertainty is really the worst enemy of the mREIT sector. 

Looking ahead

Strange times often bring about lucrative opportunities. I believe that although the sector as a whole is highly volatile, buying shares of mREITS at discounts of more than 20% to book value will turn out to be a good idea. Invest accordingly. 

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Shmulik Karpf has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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