Annaly Downgrade: Too Early in the Cycle?

Shares of Annaly Capital (NLY) are slipping in early trade this morning after JPMorgan analyst Andrew Wessel downgraded the real estate investment trust on valuation.

Wessel downgraded the stock to "Neutral" from "Overweight," and said the stock has recovered to a fair value over the last few months. Wessel thinks the Federal Reserve is going to raise interest rates later this year, which would increase Annaly's expenses and reduce its profits.

Fair enough. But Annaly withstood seven straight quarter-point increases in the federal funds rate during 2004-2005 before the dividend was materially impacted. Furthermore, Annaly is quite efficient at using 2-year swaps to lock in its funding costs, so the mere threat of future rate increases will have no near-term impact on the Company's results.

If one thinks of Annaly's cycle of results as a U-shaped curve, then perhaps we've hit the top of the curve and will be coasting downward for the next few quarters. However, there is still a long way to go before Annaly hits the ground -- and plenty of time to enjoy juicy dividends before the tightening ends the ride.

At $16/share, Annaly's forward dividend yield will approach 12%. Investors with an eye towards income versus capital appreciation might be interested in coasting down with Annaly in the near-term.

Agency mREITs Turn In Strong Q1

Both Annaly Capital (NLY) and MFA Mortgage (MFA) reported solid first quarter results today, with Annaly's earnings looking particularly strong.

Annaly's core EPS of $0.51/share was in-line with estimates, and spreads improved by an impressive 58 bps on a sequential basis to 1.46%. Leverage remained at 8.1:1, however, which seems slightly aggressive. However, with no exposure to non-agency assets and no apparent painful margin calls, the 8.1:1 ratio appears reasonably comfortable.

Annaly's strong results are rooted in the Company's significant investment in fixed-rate assets several months ago. Repo financing had a weighted average cost of just 4.18% during the quarter and 3.85% at period-end. With funding becoming cheaper on the heels of yet another Fed rate cut, Annaly can look forward to several more quarters of wide spreads and flush earnings.

Annaly's book value at 3/31/08 was $13.38, so the stock is trading at 1.3x the after-hours closing price of $17.25. This valuation is on the lower end of Annaly's historical trading price, suggesting that the stock could have more room to run.

MFA also had a strong quarter, though GAAP earnings were tarnished by a $25 million loss on the sale of assets and a $91 million loss on swap terminations. Core earnings, however, came in at $0.20/share after backing out the capital losses from the asset sales and swap terminations. That $0.20/share is a good approximation of MFA's taxable income and lends support to the $0.18/share dividend. MFA declined to disclose REIT taxable income in its 10-Q.

Despite trading at just 1.1x book value, MFA still remains exposed to margin calls and markdowns on its portfolio of non-agency securities. Unlike Annaly, MFA does have some exposure to non-agency assets and consequently had to lower its leverage to 7:1 during Q1 2008. The de-levering will limit MFA's earnings power going forward. MFA's spread improved by just 25 bps to 0.90% sequentially, also hampering meaningful growth in taxable income.

Annaly Selloff is Overdone

Annaly Capital Management (NLY), the bellweather for the publicly-traded agency mREITs has suffered a serious setback in its stock price after private agency investor Carlyle Capital was margin called to the point of bankruptcy this morning. The Carlyle situation, which was brought by historically wide spreads between Treasury bonds and agency-backed securities, rattled investors who thought GSE-sponsored securities were immune from the credit crisis. Even long-time Annaly bull, Jim Cramer, dumped his buy rating on the stock last week and sold out of the position.

But is Annaly really that much at risk? The Company's leverage was 8.7 to 1 at December 31, 2007, and Annaly completed a $1 billion equity offering shortly after year-end. With respect to repurchase agreements, the Company did not have an amount at risk greater than 10% of the equity of the Company with any counterparties as of December 31, 2007, indicating that Annaly has a diverse array of counterparties for its repurchase agreements, so there is little risk that one nervous counterparty could deliver a fateful margin call. Through December 31, 2007, NLY did not have any margin calls on its repurchase agreements that it was not able to satisfy with either cash or additional pledged collateral.

The credit markets are volatile and unpredictable, as shown by the Thornburg Mortgage situation. However, I believe Annaly is too far up the food chain and has sufficient liquidity to fall victim to the credit crunch. If Annaly's securities become illiquid, then Fannie and Freddie are both at risk. The government cannot allow this to happen for fear of a complete systemic economic meltdown. With a dividend yield of 14% and a stock price that's just 1.06x book value, Annaly is delivering solid risk-adjusted returns. It's well worth rolling the dice on.

Liquidity Fears and Repo Flu Infect Agency mREITs

Bloomberg is reporting that agency mortgage-backed bond spreads have reached their highest levels since 1986. Meanwhile, Reuters is reporting that Dutch-listed affiliate of private equity firm Carlyle Group said it received margin calls totaling more than $37 million from seven financing parties on Wednesday and was unable to meet the demands for extra collateral to cover its market positions for four of them. This branch of Carlyle invests in agency RMBS.

This news has spread fear and doubt to the agency mREITs today, who are all off sharply in early morning trade. All the agency mREITs have thus far been virtually unaffected by the credit crunch, as their paper is implicitly guaranteed by the GSEs and has remained liquid throughout the credit freeze. However, as buyers remain on strike and the credit crunch continues to travel up the mortgage security food chain, investors are nervous that even the agency mREITs may receive significant margin calls under the terms of their repurchase agreements. Should spreads widen to the point where margin calls go out to the agency mREITs, the effect would be devastating, since this group of mREITs typically does not utilize term-financing. Their entire portfolios are funded by repo agreements and warehouse lines.

Should the crisis deepen to the point that GSE-backed paper is subject to forced sales, even Fannie and Freddie could be seriously crippled by the downward mark-to-market spiral that would result.

Earnings Roundup - Monday Edition

Editor's note: This week will be very heavy with earnings announcements in the mREIT universe. Each day this week, I plan to do an earnings roundup to at least provide some coverage for each company reporting.

Thornburg Mortgage (TMA) reported fourth-quarter GAAP diluted EPS of $0.33, well above the consensus estimates of $0.27. Thornburg has completed a restructuring of its balance sheet and expects to be able to begin growing and financing the portfolio in 2008. The Company saw significant improvement in net interest margins and spoke positively of being able to create agency securities if the conforming loan limits are raised.

Annaly Capital (NLY) reported fourth-quarter "core" EPS of $0.37, in-line with the consensus estimates of $0.37. Annaly benefited from gains on MBS sales during the period, from net interest margin expansion, and from continuing with its accretive equity offerings.

Agency mREITs Soar on Fed Panic

The Fed's panic-driven emergency 75 basis points sent the agency mREITs soaring, up 3.5% to 5.0% as last check. Annaly Capital (NLY) in particular looks to benefit as it holds a large portion of fixed-rate securities in its portfolio.

Meanwhile, Anworth Mortgage (ANH) had the good fortune of announcing a very timely 11 million common stock offering, which will raise about $90 million in net proceeds. Shares surged despite the news of the offering because the Fed rate action, so Anworth will benefit from attractive pricing for this issuance.

Chimera Prepares to Come Public

Chimera Investment Corp. (CIM), a new mortgage REIT, filed another amendment to its registration statement this morning, pricing the offering at approximately $15/share, which would give the Company an initial market cap of around $500 million. Chimera will be managed by FIDAC, a wholly-owned subsidiary of Annaly Capital (NLY). Annaly will also own 9.8% of Chimera.

Chimera's investment portfolio is expected to be composed of purchased residential mortgage loans that have been originated by select high-quality originators, including the retail lending operations of leading commercial banks, and non-Agency RMBS. This is in contrast to Annaly’s strategy, which concentrates on Agency RMBS.

Chimera's IPO will be an interesting litmus test on a couple of different fronts:

1. Can Annaly's personnel manage investments in private-label RMBS, CMBS, and CDOs?
2. Will the market be receptive to a new mortgage REIT in this environment?

Chimera's investment strategy will be very similar to that of Luminent Mortgage Capital (LUM), which crashed back in August after defaulting on repurchase agreements. Although Annaly has been very successful in managing interest-rate risk, its management has not been tested with respect to credit risk.

Fed Comment Undercuts Agency Investors

The Federal Reserve slashed its key fed funds rate by another 25 basis points Wednesday, but thoughts that the Fed may be done easing triggered a significant selloff among the agency RMBS investors.

"The committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth," the FOMC statement says. "The committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth."

That statement sparked selling in Annaly Capital (NLY), MFA Mortgage (MFA), Capstead Mortgage (CMO), and Anworth Mortgage (ANH). The agency investor group is all liability-sensitive, meaning that the impact of the change in its assets is smaller than the impact of the change in its liabilities after a change in prevailing interest rates. A liability sensitive entity’s economic value of equity decreases when prevailing rates rise or increase when prevailing rates fall. If the Fed stops lowering interest rates, these mREITs will have limited success investing long and borrowing short because the net interest spread available will not be as wide as they would like for it to be.

Annaly Posts In-Line Q3 Results

Annaly Capital Management (NLY) posted third quarter results that were largely in line with the Street's expectations. GAAP earnings were $0.33/share, which included $3.8 million in gains on sales of MBS and $2.0 million in gains on related swap terminations. After backing out those one-time gains, Annaly's adjusted GAAP EPS is roughly $0.31/share, two cents ahead of analyst estimates.

Although Annaly does not disclose taxable income, its operating earnings excluding FIDAC represent a reasonable proxy for REIT taxable income - about $0.28/share, leaving Annaly with a small amount of undistributed taxable income to roll into the fourth quarter. Look for a fourth quarter dividend of $0.30/share, assuming Annaly can fully deploy its early Q4 capital raise by year-end.

Annaly's book value rose to $12.11/share (excluding the liquidation preference effect of the preferred and the pro-forma effect of the accretive Q4 offering). At a closing price of $17.05/share, Annaly is trading at 1.4x book value, in-line with peer Capstead Mortgage. However, NLY has taken on significantly more interest-rate risk than Capstead by having 71% of its portfolio in fixed-rate securities. Annaly has hedged about half of that risk with swaps, clearly betting on a falling interest rate environment. We'll know as soon as Wednesday whether Annaly has made the correct bet.

Annaly's Secondary Is Not That Exciting

Here's a classic example of a misunderstanding in mortgage REIT land. I came across this article on Seeking Alpha. I don't mean to pick on the author, as his misunderstanding is fairly common.

In the article, the author discusses Annaly's recent secondary offering that should close this week. He's particularly excited because "Annaly’s capital raise is a brilliant move here, as it gives the company a huge chunk of cash to buy distressed mortgage backed securities."

Right, except that Annaly's entire portfolio consists of GSE-sponsored MBS, which have remained relatively liquid and maintained their pricing visibility throughout the current credit crunch. These securities aren't distressed at all. Annaly is simply taking advantage of the fact that they are trading at about 1.5x book value right now, so any offering they complete is immediately accretive to book value.

It's probably a good time for Annaly to raise additional capital, but it's not the opportunity of a lifetime that so many market participants are thinking. Annaly will simply take the proceeds, plow it into fixed-rate agency RMBS, and keep on hoping for more interest rate cuts to improve their liability-sensitive position.