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Annaly Capital Destruction



August 28, 2011 – Comments (13) | RELATED TICKERS: NLY

"Annaly Capital" is a phrase tripping off many lips.  So is "Capital Destruction."

What have they to do with each other? Look.  We can argue over whether a stock share is the same as an REIT share or different.  (They're different.)  We can argue over whether an REIT payout is the same as a dividend, or different.  (They're different; the REIT is obligated to payout 90% of its income, and the tax treatment for the recipient is different.) But that doesn't matter.  You can buy a share of NLY at your favorite brokerage and receive periodic payments after doing so.

But NLY isn't a business.  It isn't about making sure gross revenues exceed costs of sales every quarter.  NLY is an investment firm - it takes capital, your capital, dear stakeholder; and leverages it up to purchase all kinds of mortgage-backed obligations.

A 16% dividend looks promising.  Heck, I wish I had a savings account that paid 16%.  But here's the difference: you can withdraw your money from a savings account.  If something goes wrong - like the Bernank raises rates, or there's a wave of mortgage defaults, or one of Annaly's big counterparties collapses or restructures in bankruptcy - the dividend goes away very quickly.  Maybe only 1% of Annaly's assets would have to go into default for the dividend to go away entirely.

"Well, OK.  If that happens, I'll just sell my shares," you say.  That's right.  Everyone who holds NLY thinks that.  That's why the market price of Annaly dropped 19% in 5 minutes last month.  Some piece of news spooked the people who hold NLY and have a sell order wired up to Google News with no human intervention, and 19% of the value of the share came off in 5 minutes.  At a dividend rate of 16%, that's more than a year of dividends gone.  In 5 minutes. This time, the stock price rebounded, because the rumor wasn't true.  If we do have a "catastrophe," like Big Ben raising the Fed Funds rate to 0.5% from its current position, the price will not rebound.  It'll stay down.  And now the dividend is gone.  And all the dumb money will be holding non-dividend-paying shares of NLY at a significantly depressed price. 

"But wait, I've got a stop-loss order in."  You prepared for it to execute at a market price 50% less than where your stop trigger is set?  When New Century and NovaStar went belly up in Feb 07, it happened in milliseconds. 

"But my stop-limit.."  Won't execute. 

"But I'm still confident in Annaly because I don't believe there's another financial crisis is going to come down the pike, and if it does I'm prepared to stop receiving the dividend AND lose most of my capital immediately!"

OK, NLY investor.  If you got that far - if you can open your mouth and recite the last paragraph verbatim, and really mean it and believe it - then I bless you.  You can hold your NLY shares.

The rest of you?  You haven't thought it through; and you should sell all your NLY shares while you still can.  Props to Dumortier for trying to point this out: 

13 Comments – Post Your Own

#1) On August 28, 2011 at 4:58 PM, AltData (31.90) wrote:

Something funky going on with the link you provided for alex's article; 18% Dividend Yield I Don't Want To Earn

I think that one will work.

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#2) On August 28, 2011 at 4:59 PM, vgaymer (34.33) wrote:

your link to Alex's article doesn't work for me, but you bring out some good points. 

I usually shy away from reits and partnerships because of their complexity despite their high yields(and I loooove sustainable high yields) especially if their not hard-asset reits.

  I do have a small position in a limited partnership

(disclosure long PSE).




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#3) On August 28, 2011 at 6:18 PM, rd80 (95.88) wrote:

Good summary of some of the risks that go with NLY and mortgage REITs in general.

One correction, NLY does NOT purchase "all kinds of mortgage-backed obligations" - it purchases agency backed MBS, primarily Fannie and Freddie paper.  By sticking to agency backed paper, default risk is off the table as long as Treasury continues standing behind Frannie.

The biggest positive for mortgage REITs is Bernanke's recent announcement that the Fed plans to hold short term rates very low for the next two years - see Jim Royal's piece for more.  I also touched on it when the Fed was just talking 'extended period.'

For what would happen if short-term rates went up by .5%, I took a look at an Annaly competitor, Hatteras Financial (HTS) because I own shares in that one.  For the quarter ended in June, HTS' cost of funds was a little over 1%, so a half-percent increase in short rates would be about a 50% increase in interest expenses if nothing else changed. That would drop the quarterly net interest income from $77.6 mil to about $60 mil and knock something like 20 - 25 cents off the $1 dividend.  That doesn't consider the fact that HTS - and I assume NLY - hedge part of the repo agreements used for funding.

It's harder to say how hard the stock price would be hit.  It almost certainly would go down, but these things typically don't trade at a big premium to book value and the market rates for the mortgage paper, not short term rates, would determine book value of the assets. Based on recent volatility, a 20%+ drop on a bump in short term rates is easily possible.

I absolutely agree with you that anyone holding a mortgage REIT thinking it's a high-yield replacement for a savings account should take a close look at the risks involved.  HTS fact sheet gives a nice summary of its risks and those risks should generally apply to any mortgage REIT investing in agency paper.

Disclosure:  As mentioned, long HTS.




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#4) On August 28, 2011 at 6:46 PM, motleyanimal (38.64) wrote:

Woooo, why are you guys such a downer today?

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#5) On August 28, 2011 at 8:43 PM, ikkyu2 (98.05) wrote:

Because it's my birthday.

Thanks for fixing my link, blesto. 

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#6) On August 28, 2011 at 8:48 PM, ikkyu2 (98.05) wrote:

As far as what you said, Russ - and I appreciate your input today and always - but:

Go check out FNM's and FRE's charters.  Nowhere does it state their liabilities are guaranteed and backed by the full faith and credit of the US Government.  Both of them would be considered insolvent today by any rational accounting method and I don't know about you, but I have not been particularly impressed by our current Congress' willingness to spend more taxpayer money fixing broken financials.

As far as the Fed, the Bernank was saying the same thing in 06 and the actual first rate hike came as a surprise to many.  No way do I believe we still have 0-0.25% FF rate in Jan 2013.  What is true about fiscal policy maneuvers is that they only work to the extent that the market has not already priced them in.  If expectations about future events are perfectly informed, the rate hike makes no difference at all and the Fed is hamstrung.  They have to get you thinking that they're going to do one thing before they do another.

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#7) On August 29, 2011 at 1:35 AM, awallejr (39.57) wrote:

Personally I like AGNC, but all these mortgage REITS are interest rate sensitive. As RD80 said, Bernanke just set the table for at least two years. 

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#8) On August 29, 2011 at 3:55 PM, rfaramir (28.71) wrote:

"as long as Treasury continues standing behind Frannie"

That's the key phrase. With a coming change in the next election toward fiscal sanity, Treasury will be hard put to continue the fraud of backing these insolvent agencies. But if your time frame is only looking ahead until the end of next year, these look like tempting gambles.

Personally, I don't think that there will be a large enough revolution of responsibility to really move the dial in the right direction, so you might get lucky when the can is kicked further down the road by the next regime as well. But I wouldn't bet on it, especially not long term.

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#9) On August 29, 2011 at 9:21 PM, rd80 (95.88) wrote:

if your time frame is only looking ahead until the end of next year, these look like tempting gambles

I'll be surprised if I'm still holding HTS when we're toasting the end of 2012.

@ikkyu2 - Thanks, it's important to never get so passionate about an investment that opposing views are shut out.  Opinions that line up with mine won't keep me from doing something stupid. 
There's nothing in Frannie's charters about a gov't backstop.  However, Treasury is on record providing an explicit backstop - and one of the risks with a mortgage REIT is it doesn't take anything more than the stroke of a pen or maybe just a press conference to undo that backstop.

HTS isn't one of my bigger positions, I understand (or at least think I understand) the risks and think it's a decent risk/reward picture.  At this point, I've held it for about 2-1/2 years, have recouped about a quarter of the investment in dividends and the current share price gives me a small unrealized cap gain - partly because of an add a few weeks ago on a silly price dive following the S&P debt downgrade. 

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#10) On August 29, 2011 at 10:28 PM, ikkyu2 (98.05) wrote:

Agree that T de facto has to take care of FNM's liabilities, one way or another.  I think once that's stated, you gotta ask, does it get taken care of the way Merrill's did - forced onto the balance sheet of a bigger bank and made good eventually (we think); or does it get taken care of the way Lehman's liabilities did (shredded, and then the teetering counterparties too well-connected to fail get bailed out?)  Or like GMAC?  Or some other way?

At this point I don't think we know, but I do think there won't be much ink spilt on the WSJ op-ed page crying for the plight of NLY shareholders at that time. 

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#11) On August 31, 2011 at 2:25 AM, icanpickm (96.77) wrote:

Ikkyu2, I am glad I found you.  I added you to my fav's so I can read your stuff.  I have to take the other side of this one however. I have owned NLY  right though 2008 and have listened to all the calls.  While I certainly wouldn't put all my money in it, but I am convinced that Mike Ferrel and his team are smarter than anyone realizes.  They have delivered this consistent return right on through since their IPO in 1998.  Sure if the financial system collasps again, we may have some trouble, but these guys are really conservative with their leverage and often forgo higher returns for less leverage.  Mike was one of the first guys I heard warning of the problems in Europe (in 2009) and he was warnng people about the sub prime collapse very early.   I would encourage you to read all his letters.  I am staying with him and NLY, although I may buy some puts because I have a feeling Obama is going to roll out the fanny/freddie refi plan in a couple weeks.  That could hit them a bit short term.  

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#12) On September 03, 2011 at 8:52 PM, ikkyu2 (98.05) wrote:

You are smarter than the market, then, "icanpickm," because the market is putting a hell of a risk premium on NLY. 

There is no "hitting NLY a bit" or "having some trouble" with NLY.  Within seconds of the market learning that NLY is having anything like a problem, the stock will lose 90% of its value. 

I appreciate your compliments.  Come back in 2 years and tell me how much capital loss you sustained in NLY, "icanpickm," and then we'll have a real conversation.

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#13) On October 18, 2013 at 4:19 PM, ikkyu2 (98.05) wrote:

So, on Aug 28, 2011, I told icanpickm that he would not be singing the same tune about NLY 2 years from the date of the post. At that time the price of NLY was $17.60 or close to it, and the most recent quarterly dividend was $0.65.

Today the price of NLY is 11.87 and the most recent quarterly dividend has been $0.35.  I am considering that prediction closed as 'correct'.

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