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TheDumbMoney (58.51)

This Will Not End Well

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17

February 21, 2012 – Comments (57) | RELATED TICKERS: TWO , NLY

Folks, the fad for (highly-levereged, and oft-equity-diluting) mortgage REITs, which has been driven by yield-starvation elsewhere, will not end positively.  Something is hinky here.  Maybe it ends a year or three or five years from now.  But whenever it ends, it will not end well I think.

57 Comments – Post Your Own

#1) On February 21, 2012 at 8:19 PM, awallejr (77.67) wrote:

Well I don't know about that. People just have to be mindful of interest rates when owning these stocks. I own a few hundred shares of AGNC.  The stock announced a dividend cut and the price went higher so go figure heheh (from 1.40 to 1.25 per quarter).  So far I received about 40 pct of my cost back.  Should Bernanke actually keep interest rates to zero thru 2014 and AGNC keep it's dividend at $1.25 I will get all my money back and then some.

As for equity raising, you see that plenty in this sector, BDCs and MLPs.  They aren't necessarily dilutive (unless a bad decision is made with the use of the proceeds), and can be quickly accretive.  So often times you see the price of the stocks drop on announcement and slowly drift higher (assuming a good underlining company).

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#2) On February 22, 2012 at 10:13 AM, Valyooo (99.47) wrote:

Can you please explain your concern?  The secondaries are not dilutive, they usually sell the new shares above market value.  The rates are good for a while, and the mREITs are government backed.  I admit I am a little ignorant to REITs, but AGNC is one of my best real life picks ever.

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#3) On February 22, 2012 at 12:56 PM, ikkyu2 (99.14) wrote:

I think people really underestimate how quickly a total loss of all capital value can wipe out all those years of yield.  I keep harping on this - the last time we had prolonged low rate environment, Novastar and New Century Capital were being bruited about the same way Annaly, Hatteras and some of the others are, with ridiculous sky-high REIT yields and people straight-facedly stating that home prices would be going up forever from here and that there was no risk at all.

When Novastar and New Century failed just after making their Dec 2006 dividend payments, they lost 96% of their capital value in literally a few seconds of trading on the market.  There is no difference between now and then, except that instead of saying "It can't happen" people are saying "It can't happen again."

Holding these stocks is playing chicken with the Fed, nothing more.  If you do not swerve at the right moment you will be wiped out. 

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#4) On February 22, 2012 at 2:12 PM, awallejr (77.67) wrote:

Except the ones you mentioned were their holdings 100% backed by the Federal Government?  AGNC only deals with those.  What you could see down the road is a lowering of the dividend should interest rates rise and the spreads narrow.  Doesn't mean these companies go belly up.  Enjoy the ride and once yield starts dropping regularly, switch out to something else.  These are not buy, hold and forget companies.  You do have to monitor them.

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#5) On February 22, 2012 at 5:30 PM, TMFAleph1 (95.32) wrote:

 It appears you're not as dumb as your name suggests, after all ;-)

Owning mortgage REIT shares is like selling small delta puts. The Sharpe ratio of the trade looks great until it explodes and takes all of your capital with it.

Many investors appear to believe that Annaly's dividend is risk-free (to name just one of these companies.) I know this because I've written about it before and I've read the comments from Annaly shareholders.

(By the way, Valyooo, mREITs certainly aren't government backed!)

Let me be very clear: If you are earning a 15% yield in an environment in which 10-year Treasuries yield 2%, it's NOTbecause everyone else is too foolish to line their pockets with it or because no-one else has spotted it. If you believe that, you're the fool. The 13% risk premium is just that -- a premium you're earning in exchange for taking risk. It's a very generous premium and my operating assumption is that the risk is commensurate with that. I would require a very convincing explanation to believe otherwise.

On July 11, 2011, I wrote:

"Investors should be aware that American Capital (and Annaly) are exactly the sort of stocks that could inflict maximum pain on shareholders if the U.S. fails to extend its debt ceiling in time and enters into technical default -- or if the credit markets were to seize up for any reason."

And this is what happened on July 29, as reported in the WSJ:

"At the height of the debt-ceiling uncertainty on Friday, a handful of mortgage real-estate investment trusts suffered a mini flash crash. Shares of Annaly Capital Management plummeted 19% in a few minutes in the morning, and American Capital Agency fell 22% before recovering the lost ground. The two REITs invest in government-backed mortgage securities using huge amounts of short-term debt."

In the current environment, owning shares in a company whose entire business model relies on the ability to tap repo markets doesn't look very prudent to me. 

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#6) On February 22, 2012 at 6:11 PM, awallejr (77.67) wrote:

At the height of the debt-ceiling uncertainty on Friday, a handful of mortgage real-estate investment trusts suffered a mini flash crash. Shares of Annaly Capital Management plummeted 19% in a few minutes in the morning, and American Capital Agency fell 22% before recovering the lost ground. The two REITs invest in government-backed mortgage securities using huge amounts of short-term debt."

And there was your lost opportunity.  Almost everyone knew the debt ceiling would be raised at the last minute.  NLY plays with less leverage than most.  AGNC is a bit more aggressive but not insanely so.  With NLY you could have bought it way back in 1998 for $6 and have made about $25 in dividends. AGNC had the misfortune of IOPing in May of 2008, but it has paid dividends every single quarter even thru the crash.

I don't see anything "wrong" with their business model since that is what their business is.  Interest rates will dictate distributions, but these companies can still remain profitable

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#7) On February 22, 2012 at 6:14 PM, awallejr (77.67) wrote:

IPOing ;p

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#8) On February 22, 2012 at 6:26 PM, TMFAleph1 (95.32) wrote:

Almost everyone knew the debt ceiling would be raised at the last minute.

Not NLY and AGNC shareholders, apparently.

I don't see anything "wrong" with their business model since that is what their business is. 

I fail to see your argument here: By virtue of the fact that it is a business model, there can be nothing wrong with it? 

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#9) On February 22, 2012 at 6:38 PM, awallejr (77.67) wrote:

Not NLY and AGNC shareholders, apparently

Algorithmic panic.  Seriously there was a great buying opportunity same as with the flash crash.  To suggest a momentary computer panic over the really doubtful chance the US would default on its debt as a reason to not invest in these companies is just silly in my opinion. 

I fail to see your argument here: By virtue of the fact that it is a business model, there can be nothing wrong with it? 

No, their business model is their business which has so far returned substantial profits to their shareholders.  Whether it is prudent to you or not really is irrelevant.  With great rewards come risk.  I would suggest TBills as an alternative for you but you seem to think they might be defaulted on ;p

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#10) On February 22, 2012 at 7:17 PM, TMFAleph1 (95.32) wrote:

To suggest a momentary computer panic over the really doubtful chance the US would default on its debt as a reason to not invest in these companies is just silly in my opinion.

That is a misunderstanding of the risks involved in owning these shares. The U.S. doesn't need to default for these companies to fail, just as Italy and Spain didn't need to default for MF Global to go bankrupt as a result of its European sovereign repo-to-maturity transactions.

No, their business model is their business which has so far returned substantial profits to their shareholders.

The fact that it has so far returned substantial profits to their shareholders doesn't mean the shares are a good risk-reward proposition. As I wrote above, the Sharpe ratio of the trade looks great until it blows up and takes all your capital with it. Long-Term Capital Management earned "substantial profits" for its limited partners for several years running before it collapsed.

With great rewards come risk.  

That's exactly my point. It's very clear that most mREIT shareholders believe that the only risk they are incurring is that of the company cutting its dividend -- that's a fundamental misunderstanding of their "investment". You need look no further than this thread -- some shareholders even believe that the mREITs are government-backed!

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#11) On February 22, 2012 at 7:46 PM, TheDumbMoney (58.51) wrote:

Valyoo,

Ah, repeated equity raises above the then-appraised market value!  Great then.  While also running 7x to 10x leverage.  Oh by the way, are the management fees collected on the equity base, or on the asset base?....  And what does this say about management incentives?  (Leading questions.)

Not necessarily talking about your REIT, note.  This was originally more of a general comment, as is this follow-up. 

Also, certain of these companies are playing an interest rate spread game using short term debt to fund long-term obligations: that's why if credit markets seize up they're screwed, a-la-Lehman.  And then there's potential accounting-markage and counter-party risk....

I do worry I'm missing some sort of larger secular bull story, something along the lines of:  they'll make a ton of money by buying distressed MBS or distressed commercial real estate now and it will pay huge dividends for twenty years.  I have not done enough research to know if that is the story on some of them. 

There just seem to be a lot of issues here.  And as one of my fave fool writers/analysis, TMFAleph1 aka TMFMarathonMan aka TMFBullnBear pointed out, a lot of investors seem just to think about the risk of a dividend cut. 

You, frankly, I'm not as worried about.  You are a heathen technician!  You are not a true believer in anything related to the owning of stocks.  And I also think it's possible these things continue to do well for some time, at least until 2014 anyway.  I would note however that AGNC has on the Fool.com chart anyway basically been a market perform for the last two years, though I think that chart does not calculate the impact of dividends on comparative return.

All best,

DTAF

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#12) On February 22, 2012 at 9:18 PM, awallejr (77.67) wrote:

 TMFAleph1

I think you misunderstood Valyoo, I suspect he was referring to the assets AGNC invests in, which are guaranteed by the US, not the shares of stock of the company.

But in your initial reply you simply made 2 reasons why AGNC and NLY are dangerous.

1.  There is a theoretical possibility that the US will default on its guarantees; and

2.  You don't think their business model is prudent.

Fine.  Don't buy the stock.  I personally can't imagine any President, Democrat or Republican who ever would allow defaults under their watch.  And the business model so far has  created tremendous returns to the shareholders so far.  Of course past performance is no guarantee of future results, but these 2 companies have more than paid for themselves since their IPOs.  The only thing is you can't count on the same distributions each year since they can fluctuate.  But that doesn't make them bad investments.

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#13) On February 22, 2012 at 9:31 PM, awallejr (77.67) wrote:

that's why if credit markets seize up they're screwed, a-la-Lehman.  And then there's potential accounting-markage and counter-party risk....

Yeah but Dtaf, if that happened pretty much anything you invested in (except maybe precious metals) will crash.  That scenario isn't just a small sector concern, that is a system wide concern that nearly brought our entire financial structure down to its knees, but for the quick action of Paulsen and Bernanke.

You don't get 17% return on capital in a 0% interest rate environment without acknowledging the risk.  But the risk to these 2 companies is not in their crashing and having their assets failing to zero.  The risk is that the distributions are not set in stone since they are function of the spread between asset yields and funding costs.

Bernanke pretty much put the possibility of interest rate hikes in 2015 at the earliest.  That is not a guarantee since anything could happen in the future.  Nor does that mean he would start jacking up interest rates in 2015 since there may be no need to.  The point is these companies play the spread, they dish out 90% of their income to the sharehoilders and they are interest rate sensitive which could impact future distributions.  That's it. 

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#14) On February 22, 2012 at 10:28 PM, TMFAleph1 (95.32) wrote:

But in your initial reply you simply made 2 reasons why AGNC and NLY are dangerous: 1.  There is a theoretical possibility that the US will default on its guarantees...

I personally can't imagine any President, Democrat or Republican who ever would allow defaults under their watch.

Please re-read my previous post -- that is not one of the reasons I gave. In fact, I was explict in making the point that "the U.S. doesn't need to default for these companies to fail, just as Italy and Spain didn't need to default for MF Global to go bankrupt as a result of its European sovereign repo-to-maturity transactions."

The only thing is you can't count on the same distributions each year since they can fluctuate.  But that doesn't make them bad investments.

Did you read my previous post? That is exactly the error many mREIT investors are making: Not being able to count on the same distributions each year ISN'T "the only thing."

As I wrote above: " It's very clear that most mREIT shareholders believe that the only risk they are incurring is that of the company cutting its dividend -- that's a fundamental misunderstanding of their "investment".

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#15) On February 22, 2012 at 10:36 PM, TMFAleph1 (95.32) wrote:

The risk is that the distributions are not set in stone since they are function of the spread between asset yields and funding costs.

If that were the only risk, it's extremely improbable that these shares would yield 16.5% (in the case of AGNC). 

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#16) On February 22, 2012 at 10:51 PM, awallejr (77.67) wrote:

Yet no one ever gives a realistic reason otherwise.  All I read is generic dangers.  They only invest in US Gov't backed assets.  I don't want to hear about Spain, or Italy or even Greece.  The US is not those countries.  S&P downgraded the US and what happened?  Everyone bought TBills.

They are yielding 16.5% because people don't think the return is sustainable, not because people think it will go BK (because then they would be yielding a heck of a lot more).

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#17) On February 22, 2012 at 11:20 PM, awallejr (77.67) wrote:

And to take this further.  These companies are really very simple. They play the spread between asset yields (US Gov't backed ones) and funding costs. What other fundamental misunderstanding is there?  The model is straight forward.

Stop scaring people.  I heard this back in 2009 when I was telling people to buy buy buy and describing back then that it was a "generational" opportunity long before Cramer took that phrase. And every time the market rises I still hear the warnings by the bears that a crash is impending.  Finally Roubini capitulated by taking the whole "second dip recession" off the table.  And I got Alstry to capitulate and even GMX.

Investing is all about risk taking.  You get a smaller return the less the perceived risk. But the risk with NLY and AGNC is ONLY about future distributions, NOT because they may blow up somehow because Long Term Captial Management did.

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#18) On February 22, 2012 at 11:51 PM, TMFAleph1 (95.32) wrote:

I don't want to hear about Spain, or Italy or even Greece.  The US is not those countries.  S&P downgraded the US and what happened?

Again, you're missing the point. I didn't bring up MF Global's disastrous sovereign repo trade to compare the creditworthiness of the U.S. to that of Italy or Spain. The reason MF Global blew up was not due to default risk or credit risk, it was due to funding and liquidity risk.

Stop focusing the assets (agency bonds) for a moment and concentrate on the liabilities instead. The bonds in mREITs' inventories are financed through short-term repos which need to be rolled over frequently. In this environment, that cannot be considered a stable source of financing -- it can literally dry up from one day to the next. If you don't understand this, you shouldn't be invested in mREITs shares.

These companies are really very simple. They play the spread between asset yields (US Gov't backed ones) and funding costs 

These companies may be "really very simple", but it's really very clear that you don't understand them. 

You get a smaller return the less the perceived risk. But the risk with NLY and AGNC is ONLY about future distributions 

If that were the only risk, everyone and their mother would want to earn mid-teen yields this way and those yields would quickly disappear.

I'll let you ponder the likelihood that you are among an elite group of investors that has spotted this opportunity to earn mid-teen to high-teen yields by incurring only the risk that the distribution will be reduced. There is a saying about someone who sits down at a poker table and isn't able to figure out who the sucker is. I recommend you try to avoid playing that role as an investor.

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#19) On February 23, 2012 at 2:11 AM, TMFAleph1 (95.32) wrote:

You get a smaller return the less the perceived risk. But the risk with NLY and AGNC is ONLY about future distributions.

Use your head. With 12-mo T-bills yielding 15bps and 2-yr T-notes yielding 30bps, do you really believe that mREIT investors require an annual premium of sixteen percentage points just to compensate them for the "risk" of not being to earn the same fat yield the following year?

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#20) On February 23, 2012 at 9:22 AM, awallejr (77.67) wrote:

In this environment, that cannot be considered a stable source of financing -- it can literally dry up from one day to the next.

And have you been following what Bernanke has been doing these last few years? The economy is flush with liquidity.

I'll let you ponder the likelihood that you are among an elite group of investors that has spotted this opportunity to earn mid-teen to high-teen yields by incurring only the risk that the distribution will be reduced. There is a saying about someone who sits down at a poker table and isn't able to figure out who the sucker is. I recommend you try to avoid playing that role as an investor.

There is nothing to ponder.  I accept the risk in return for higher rewards.  But all you are doing is using scare tactics to keep people out of these investments.  I can do that to literally any company.  Create a scenario that could cause any company to go under and say "there don't invest in it."

And that is EXACTLY what you are doing here.  And I am sorry if I had listened to all the negative Nancy's in 2009 I would have made a wopping .3 % from my bank account.

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#21) On February 23, 2012 at 11:31 AM, TheDumbMoney (58.51) wrote:

Hi awallejr,

You said:  "Yeah but Dtaf, if that happened pretty much anything you invested in (except maybe precious metals) will crash."

Respectfully, I think this is just not true.  Many of these REITs would go bankrupt, not being large enough to merit bailouts.  By contrast, my investments in excellent dividend-paying (and dividend-growing) and other companies that have so-called "fortress" balance sheets would do just fine.  E.g., MSFT, AAPL WMT, JNJ.  They might suffer large drops in their presently-appraised value (which is all any day's stock price is), but it would be temporary (i.e., a 0-5 year event), and not a so-called "permanent impairment of capital."  Do not confuse a major credit crunch (which incompetent anti-interventionist politicians might still allow to happen) with the end of civilization.  Civilization survived the Great Depression, as did JNJ and PG.  TWO would not have.

I certainly try not to be a negative nancy.  I was buying hand-over-fist from about 10/2008 through 2/2009.  But I picked up Intel for $13/share, MSFT for $20, MCD for $45, KO for $50, XOM for sub-$60, PM for $38, etc., companies that I think I can now hold, if not forever, certainly for a long time.  And of course I made mistakes, too, and there are more-cyclical names like CAT and BA that I wish I had bought and held.  But Reits generally lack any major competitive advantage as against other Reits, or over the long term generally. 

Unlike TMF Aleph1 maybe, I don't really have any inherent beef with them.  It is just not something I want to own, because it is not something I am confident I don't really need to worry about over a five-year period.  I fully acknowledge you and others may make tons of money off of them for a few years.  I fully acknowledge you may know exactly when to sell.  But I doubt it.  And I certainly will not and do not.  Everybody thinks they'll know when to sell.  I prefer not to play a game where I need to worry much about when to sell.  This does not mean I hold all of my picks forever, and it doesn't mean I never sell.  And it doesn't mean I never speculate at all. 

What prompted this original blog post was an idiotic article on CNN Money or some such site, talking about how "sophisticated" market players were really excited about REITS, and only talking about the yield.  Pretty much anything "sophisticated" market participants are into, as reported by third-tier financial reporters on generalist websites, is something I want to stay well away from.  This same aversion has prompted my near two-year-long reevaluation of dividend stocks in general, as I can only read so many articles about how many hedge funds have bought MSFT and XOM and PM (after I bought them) before I start thinking that's maybe not the best place to put new money (even though I still think MSFT is undervalued at anything below $35/share).  But in that case, it's a matter of possible over-valuation, rather than the piling into investment entities of totally questionable long-term value, which in my perception are feasting off of a temporary dislocation.

Note: I'm not an expert on REITS.  But seriously, look at how some of the managers are compensated on these things.

Anyway, thanks for commenting.

All best,

DTAF

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#22) On February 23, 2012 at 1:22 PM, TMFAleph1 (95.32) wrote:

 I accept the risk in return for higher rewards.

What "risk" are you talking about? Ceasing to earn 16.5% annually on your capital alone is not commensurate with equity risk. Even a company's preferred shares -- which pay a dividend that is at the company's discretion -- carry principal risk. You do realize that common equity is below, not above, debt in the capital structure, don't you? Unless you understand these notions, you shouldn't be investing in equities, period.

But all you are doing is using scare tactics to keep people out of these investments.   

Be reasonable. What possible interest could I have in keeping people out of these shares? I'm perfectly happy for people to own mREITs, I just happen to think investors are better off when they understand the risks associated with it. That isn't your case right now.

As such, I highly recommend you read the 'Risk Factors' section of AGNC's latest 10-K. If I'm using scare tactics to keep people from owning their shares, then it seems that the company is using the very same scare tactics. You'll find the following passage on page 21 of their 2011 10-K (my emphasis):

"Furthermore, because we rely primarily on short-term borrowings, our ability to achieve our investment objectives depends not only on our ability to borrow money in sufficient amounts and on favorable terms, but also on our ability to renew or replace on a continuous basis our maturing short-term borrowings. If we are not able to renew or replace maturing borrowings, we may have to sell some or all of our assets, possibly under adverse market conditions."

I can do that to literally any company.

With respect, not every company is leveraged 8x with short-term repo funding. 

I'm going to have to stop here. There is no arguing with you, as it appears that you are unable or unwilling to perform a rational, comprehensive assessment of the risks inherent in mREITs.

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#23) On February 23, 2012 at 1:29 PM, TMFAleph1 (95.32) wrote:

 Pretty much anything "sophisticated" market participants are into, as reported by third-tier financial reporters on generalist websites, is something I want to stay well away from.

That is a sound attitude, without a doubt. 

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#24) On February 23, 2012 at 2:11 PM, awallejr (77.67) wrote:

Well DTAF normally I like your blogs.  But this one I submit you shouldn't have made because all you said was you think mreits are going to crash because you feel it.  And that was it. 

Since things are pretty quiet on this board lately I felt compelled to reply and point out that there are some companies that have positioned themselves well in steering through the interest rate curves, along with hamp impacts, higher short term and lower long term yields such as  NLY and AGNC.

I also pointed out that these companies only invest in Federally insured paper.  The only way those crash is if the US Gov't defaults. Is it possible? Yes.  Is it probable? NO.

With the case of NLY it has a 15 year history.  It has paid varying quarterly distributions throughout.  It's management has guided this company through 2 recessions, one being very dangerous.  AGNC, however has a shorter history, hence why I only have a few hundred shares.  But it too managed to survive this last recession and still pay out.

Personally I suggest you don't invest in these companies since by your own admission you don't understand them.  Rule of thumb is if you don't understand what the company does move on to one that you do understand.

I will respond to Aleph1 below, which will be my last, because he/she is more snarky.

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#25) On February 23, 2012 at 2:34 PM, awallejr (77.67) wrote:

 TMFAleph1

With the Ad Hominem attacks aside, I honestly believe you do not know much about NLY and AGNC.  Here's a good read on AGNC. It is their last cc

http://us.rd.yahoo.com/finance/external/trsa/SIG=13pvhg1jt/*http://seekingalpha.com/article/348231-american-capital-agency-s-ceo-discusses-q4-2011-results-earnings-call-transcript?source=yahoo

Of course you risk principal, but you will wind up doing so as a result of a declining rate of distribution not on defaults on their assets.  I don't accept your premise that the US Gov't will default on its obligations. I think that so remote as not to be a worthwile threat.  You will note in that cc link AGNC rates its book value at $27.71.  So it isn't trading that much higher.

I do find it amusing that you decide to finally discuss something nongeneric by quoting a section out of its 10Q.  Of course they are compelled to say that, because it could happen.  Every company warns about that because no one can predict the future.  IBM does it.  Apple does it.

When the thesis for holding an investment changes one should re-evaluate whether to close an investment or not.

Right now these 2 companies are profitable and they are handling the yield curve changes well.

Had you blogged about company specifics that would have been fine.  But re-read your reply #5.  Basically you surmised they would explode and you supported further with a computer generated panic crash, which you at least acknowledged the drops were retraced.  So I take you to task.  And you have yet to give me company specific reasons why these 2 stocks will crash and burn.

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#26) On February 23, 2012 at 2:50 PM, TMFAleph1 (95.32) wrote:

I don't accept your premise that the US Gov't will default on its obligations.

How many times do I have to write it?! Please read the following line more than once before even considering posting again.

A U.S. GOVERNMENT DEFAULT IS NOT MY PREMISE. 

This is completely pointless. You still don't understand the risk I've been trying to highlight.

Every company warns about that because no one can predict the future.  IBM does it.  Apple does it. 

Please go read IBM and Apple's 10-K -- they are not subject to this same risk. You really picked the absolute worst example in Apple -- they've got roughly $100 billion in cash. The repo markets can shut down for the next ten years and it will have zero impact on Apple. AGNC and NLY, on the other hand, wouldn't survive ten days without a functioning repo market.

I'm really wasting my time here. 

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#27) On February 23, 2012 at 3:29 PM, awallejr (77.67) wrote:

You've given no company specifics aside from prognosticating on the company's inability to engage in short term borrowing which might compel them to sell assets at a loss.  And I had already responded to that and will repeat here:  Ben Bernanke.

And my IBM, APPLE comment  was about warnings.  Every 10k for every company has them.  Their lawyers make them do so.

If you are trying to convince me that you understand NLY and AGNC and their managment, you are wasting your time.  I have asked you several times for company specifics as to why these companies will explode like you said.  And you have yet to give me any.

Real people own these stocks. Certainly some of your readers do like Valyoo (though he should do more DD if he has a high exposure).  So when you start trashing them give good reasons, not conclusory generic comments like they will explode if they can't get short-term borrowing.  And Apple will crash if another kid comes up with better products in his garage.

 

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#28) On February 27, 2012 at 5:44 PM, TMFAleph1 (95.32) wrote:

U.S. Treasury investigating repo market stress, Reuters, Feb. 27

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#29) On February 27, 2012 at 6:52 PM, awallejr (77.67) wrote:

Interesting, I wonder if there actually might be improper behavior. But as long as this comment in 5 doesn't come to fruition I think NLY and AGNC should still work as an investment:

"Investors should be aware that American Capital (and Annaly) are exactly the sort of stocks that could inflict maximum pain on shareholders if the U.S. fails to extend its debt ceiling in time and enters into technical default

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#30) On February 27, 2012 at 8:13 PM, TMFAleph1 (95.32) wrote:

Hopeless...

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#31) On February 27, 2012 at 8:14 PM, TMFAleph1 (95.32) wrote:

...and helpless.

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#32) On February 27, 2012 at 8:50 PM, Mega (99.97) wrote:

awallejr wrote: "And I had already responded to that and will repeat here:  Ben Bernanke."

Bernanke was chairman of the Fed in 2008 and was fully committed to preventing credit market panic.  Yet, many companies that relied on short term funding collapsed including Bear and Lehman.  Might want to rethink your thesis.

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#33) On February 27, 2012 at 8:58 PM, Mega (99.97) wrote:

And keep in mind that Bear and Lehman were bond-focused investment banks.  Their assets mainly consisted of government bonds, corporate bonds and MBS.  Sounds safe, right?  Not when you leverage them with short term financing.

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#34) On February 27, 2012 at 10:05 PM, HighVoltage627 (< 20) wrote:

I guess I should start with a disclosure: I’m long NLY.

 

I have a question for the mREIT detractors.  Your argument seems to be that a liquidity crisis could end up blowing up the mREIT’s.  We just went through the largest credit crisis in living memory, second only to the great depression.  These firms flourished.  So my question is if the Great Recession didn’t do it, what would?

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#35) On February 27, 2012 at 10:40 PM, Mega (99.97) wrote:

1. Liquidity crisis combined with a debt ceiling deadline.

2. Liquidity crisis combined with a rumor of FNMA and FRE restructuring. Does not need to be true.

3. "Bond vigilantes" pushing up yield on US government debt more aggressively than Bernanke is willing to keep it down.  Particularly if the right wing applies political pressure to the Fed over the next few years.

I'm not as negative on mREITs as Aleph and DTAF.  In all likelihood they will produce good returns for the next 2 years and then lower returns, just like bulls are expecting.  But I think they have "black swan" tail risk that I don't want to take.

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#36) On February 28, 2012 at 12:48 AM, TMFAleph1 (95.32) wrote:

I'm not a detractor of mREITs, I'm a detractor of investors who don't understand the risks associated with a stock they already own. Here are some of the bizarre notions I have come across in this thread alone:

- If an mREIT invests only in agency bonds, investors can't suffer a total loss of capital;

- The only scenario under which NLY and AGNC investors can suffer a massive capital loss is that of a U.S. government default;

- The only risk to mREIT investors worth mentioning is that of a decrease in the distributions;

- All companies spell out risk factors in their 10-K reports, therefore all risk factors must be equally likely and have an equal potential impact on share values

etc...

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#37) On February 28, 2012 at 12:48 AM, TMFAleph1 (95.32) wrote:

I'm not a detractor of mREITs, I'm a detractor of investors who don't understand the risks associated with a stock they already own. Here are some of the bizarre notions I have come across in this thread alone:

- If an mREIT invests only in agency bonds, investors can't suffer a total loss of capital;

- The only scenario under which NLY and AGNC investors can suffer a massive capital loss is that of a U.S. government default;

- The only risk to mREIT investors worth mentioning is that of a decrease in the distributions;

- All companies spell out risk factors in their 10-K reports, therefore all risk factors must be equally likely and have an equal potential impact on share values

etc...

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#38) On February 28, 2012 at 1:23 AM, awallejr (77.67) wrote:

Might want to rethink your thesis.

No need to since time has proven otherwise.  NLY has been profitable for 15 years and thru the worse financial crisis during our lifetime.  AGNC had also paid distiributions during the same period.  Describe to me what other realistic scenario beyond the whole Post-Lehman crisis that you can see as something reasonable to happen in the foreseeable future?

Of course if there is a total liquidity freeze these companies will be affected just like GE could or GS or even T. Under that reasoning don't invest in anything but gold bullion.

 

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#39) On February 28, 2012 at 1:40 AM, awallejr (77.67) wrote:

I'm not a detractor of mREITs, I'm a detractor of investors who don't understand the risks associated with a stock they already own

Well Alex we are beating a deadhorse with a stick now, but I keep referring you back to your very first blog and quoted your argument which I reprinted in #29, despite your subsequent denial by this: A U.S. GOVERNMENT DEFAULT IS NOT MY PREMISE.  It was and you said so. 

Subsequently you argued another potential danger could be if they could not engage in short term borrowing which could trigger forcing these companies to sell assets at a loss.  I responded, and I will continue to respond: Bernanke.  What in the last 3 years makes you think he won't continue to insure that there is plentiful liquidity in the marketplace?  Can this change down the road with say another Fed Chariman?  Yes but then the thesis would be re-evaluated. 

Throw all the theoretical black swans you want.  I can do the same with ANY other company as well. 

The person who is hopeless is you.  You hate these investments, fine, move on.  I've heard the same fear-mongering in 2009, 2010, 2011 and now 2012.  Go view all my stock suggestions I made during those years.  Had you listened to me you made good money.  Had I listened to the fear mongerers my cash would be under a matress.

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#40) On February 28, 2012 at 1:46 AM, awallejr (77.67) wrote:

 HighVoltage627

So my question is if the Great Recession didn’t do it, what would?

It is all theoretical with them High.  You hang on to your NLY.  They have a good management team, something people seem to ignore. 

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#41) On February 28, 2012 at 10:18 AM, TMFAleph1 (95.32) wrote:

It is all theoretical with them High.

All risks are theoretical until they occur.

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#42) On February 28, 2012 at 10:23 AM, TMFAleph1 (95.32) wrote:

 I responded, and I will continue to respond: Bernanke.  What in the last 3 years makes you think he won't continue to insure that there is plentiful liquidity in the marketplace?

Don't confuse 'Bernanke will use his toolkit to maintain functional financial markets' with 'Bernanke personally guarantees that none of the mREITs will fail under his watch.' 

 

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#43) On February 28, 2012 at 12:23 PM, awallejr (77.67) wrote:

Sheesh Alex, we are now kicking the dead horse.  It becomes a question of probabilities.  Your 2 main knocks on NLY and AGNC were the theoretical possibility of a US default (yes you said that as I quoted from #5) and a possiblity of having a liquidity crisis with short term borrowing.

I will acknowledge that those are possible.  I have argued however, that at the current state of affairs they are improbable.  I have also argued that management of NLY and AGNC have handled one of the greatest recessions and financial crisis in history. Either you believe in them or you don't. End of discussion.  You don't want to invest here, fine.  Others do and have made nice profits especially if they have been long term holders.  Agree to disagree and move on.

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#44) On February 28, 2012 at 1:06 PM, TMFAleph1 (95.32) wrote:

I will acknowledge that those are possible.

It took a while, but we got there in the end.

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#45) On February 28, 2012 at 1:50 PM, TheDumbMoney (58.51) wrote:

Hi all,

Wow this thread sure has been active during my absence from it. 

A few notes:

1)  I would not say I'm quite as negative as TMFAleph1 is, megashort.  

2)  General: I have no beef with NLY in particular, not having analyzed it thoroughly.

3)  To awallejr I would just say this:  all I have ever inteded to say here is that every awful, unsustainable trend starts with a valid and sometimes even an excellent thesis, but which ultimately gets carried beyond its original parameters, and also gets implemented by many who either are never told or do not understand the caveats to the thesis.  That and, "don't these yields just seem 'too good to be true'"?  That's all I'm saying.  If you believe you understand all of the risks, and you believe in management, and you have a clear sell strategy in place, that's fine, go wild. 

All best,

DTAF 

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#46) On February 28, 2012 at 2:03 PM, awallejr (77.67) wrote:

It took a while, but we got there in the end

I never said they weren't possible since as the old saying goes ANYTHING is possible.  Now if you will acknowledge that they aren't "probable" currently then we have an accord ;)

and DTAF, anytime you have high yields you should ask the question "are they too good to be true?"

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#47) On February 28, 2012 at 6:05 PM, TheDumbMoney (58.51) wrote:

awallejr, is that a question or an assertion?  Anyway, I think it's a truism.  Which is why when I see a yield over 7% or 10%, or even 15%, and I see multiple such yields in a single sector, I become particularly suspicious.

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#48) On February 28, 2012 at 7:53 PM, awallejr (77.67) wrote:

Was treating it as a truism.  But that being said you really can hit homeruns by sorting through the company"s hurdles.  Afterall you had monstrous yields end of 2008 early 2009. Stocks were being dumped mainly as a result of the massive deleveraging and redemptions that were taking place.  You could have thrown a dart at all the MLPs, BDCs, Reits and hit major homeruns.  For years I was advising people to check them out. A more recent one I blogged here:

http://caps.fool.com/Blogs/gmxr-preferred/701427

At the time it had a monstrous  30% yield.  But doing some digging and a little speculating it became a homerun. When I see high yields I see potential opportunity.  But researching the company is the key more than anything else.

 

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#49) On February 28, 2012 at 7:59 PM, TMFAleph1 (95.32) wrote:

I never said they weren't possible since as the old saying goes ANYTHING is possible.  Now if you will acknowledge that they aren't "probable" currently then we have an accord ;)

We are probably closer than it may appear. I do not say Annaly is certain to collapse (although I do think the nature of the business model means that the probability of that event has an asymptotic limit of 1 if you push your time horizon out far enough), my point is simply that many shareholders have not clearly thought through all the ways in which these companies can fail (at least that is the impression I get from comments.)

Furthermore, many of those who have thought them through are treating "improbable" as if it were the same thing as "impossible."

Finally, I submit to you that the risk of a significant (but not total) capital loss is itself significant. Unless shareholders believe they have uncovered an extraordinary arbitrage that the rest of the market has missed -- and I see absolutely no reason to believe this -- they should acknowledge that in a zero-rate environment, earning mid- to high-teen yields on a business with no barriers to entry can only be achieved by bearing substantial risk.

Many shareholders have been lulled by the size of the yield and the relative stability of mREIT share values. All told, I don't know for certain if you are one of the shareholders I have described above, but some of your responses certainly look a bit suspect.

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#50) On February 28, 2012 at 9:26 PM, awallejr (77.67) wrote:

If you look at the history of NLY you will see that the company has traded mostly in a narrow range between $10-$20.  It is not a company to own for capital gains.  Its allure is its distributions.  As I said earlier you could have bought the stock for $6 back in 1998 and earned over $25 dollars in distributions.  That is a hell of a return even if the company went belly up tomorrow.

I stated right off the bat that these stocks need to be monitored.  I deal in perceived probabilities, acknowledging reasonable possibilities.  The management of NLY in my opinion is top notch.  There is no denying NLY's sucess to date.  That doesn't mean things can't change in the future.  But I don't see anything at the company level that suggests it will explode.  At best a lowering of distributions because of the shrinking yield gap and early repayments as a result of refinancings.

Ok enough said on this for me.  Good luck NLY and AGNC longs.

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#51) On March 26, 2012 at 5:32 PM, TMFAleph1 (95.32) wrote:

In response to the article I wrote on mREITS, I received the following from a professional investor and CFA charterholder:

"Came across your excellent piece about mREITs dividends.

I believe all investors should have a clear understanding of their investments. mREITs are exceedingly complex investments to analyze and unless shareholders are comfortable with such topics as prepayment risk/CPR, repo financing and duration, they should avoid the sector. Company updates are regularly peppered with such terms as interest rate spread, margin requirements, swaptions, undistributed taxable income, “comprehensive income,” and “economic return.” If a potential investor can’t make it past page three of the management presentation without diving for a bond analysis textbook, this may not be a good place for their money. I would highly recommend that any existing or potential investor review a management presentation from AGNC or NLY as an example.

Unlike a firm that sells a well-understood product or service where the capital structure is only one part of the analysis; for an mREIT the capital structure is virtually the entire risk. While many mREITs invest in agency paper, this only reduces one aspect of risk. The returns are enhanced to by significant amounts of leverage so the yield curve can impart a dramatic (or devastating), impact on returns. The company’s hedging strategy-if employed-can reduce risk, but requires a great degree of sophistication. Additionally, while the implied government guarantee of Freddie and Fannie helps with one risk sector, other government programs enacted (HARP) or proposed will likely significantly impact mREITs. The political risk is not to be dismissed, nor is it easily evaluated.

I have professional experience with REITs of all types as well as MBS and CMBS. I currently have positions in AGNC and NLY as I believe they have some of the better management teams and think they are an interesting short-term play, but feel those positions require virtually daily monitoring. These are not “undiscovered investments” as AGNC alone has a $6b market cap. Investors of all stripes have looked at these companies and determined that the risks justify the yield."

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#52) On March 27, 2012 at 1:46 AM, awallejr (77.67) wrote:

Sounds like the person you are quoting is saying things I said.  I told DTAF, for example, to avoid these stocks if he didn't understand the business.  I also said it becomes an issue of trust in the management of the companies involved, namely NLY and AGNC, and that they need continual monitoring. 

As per your quote: I currently have positions in AGNC and NLY as I believe they have some of the better management teams and think they are an interesting short-term play, but feel those positions require virtually daily monitoring. These are not “undiscovered investments” as AGNC alone has a $6b market cap. Investors of all stripes have looked at these companies and determined that the risks justify the yield."

I don't know why you wish to continue such a crusade against these companies.

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#53) On June 22, 2012 at 5:44 PM, TMFAleph1 (95.32) wrote:

“It’s a double whammy and a little unsettling for the repo market to no longer have SOMA lending as a backstop,” said Michael Cloherty, head of US interest rate strategy at RBC Capital Markets.

'Operation Twist' threat to bond trading, Financial Times, Jun. 21, 2012

"As a reminder, there has been abnormally low liquidity, reflected in offer-to-cover ratios, in the recent auctions for some of the Treasuries that the Fed purchases as part of the program. Other strategists have also pointed out that the Fed has a dwindling supply of sub-three-year Treasuries to sell, which among other things might exacerbate future strains in repo markets."

RBC: Problems with extending Twist... not fixed by extending Twist, FT Alphaville, Jun. 22, 2012

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#54) On July 21, 2012 at 11:36 PM, profit77 (< 20) wrote:

TMF Aleph1

I will probably only post one time. I have spent a long time reading all your posts arguing with the other guy. He shut you up for almost 3 months, and then you return like a fungus with more scare tactics. Why don't you go away and come back in 5 years and say I was wrong if AGNC outperforms the market, or I was right if indeed it blows up. You have warned everyone here about the risks. Keep telling everyone you know who invests to stay away from AGNC, as a matter of fact keep it up here. You know what they say if everyone is a buyer, no one is left to convert. AGNC shareholders need you. Keep up the good work.

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#55) On October 15, 2012 at 4:57 PM, TheDumbMoney (58.51) wrote:

Here is the Reit index for this year; note the post-QE3 slide.

http://www.finviz.com/publish/101512/REMc1dl1220.png

Here is a post about it: 

http://blogs.barrons.com/incomeinvesting/2012/10/15/reits-annaly-agnc-continue-to-slide/

More specifically, note that NLY just reduced its dividend, again, because of reduced profits to feed through.  Now down to $0.50.  Appointing new management, including a new co-CEO.

Time will see how this eventually plays out, but in my view there is no such thing as a free lunch, ladies and gentlemen.  It doesn't take a lot of stock price depreciation to wipe out the impact of your dividends.  When I wrote this post on 2/21/2012 NLY was at $16.60.  If you bought then you have received $1.60 in dividends, but the stock is down to $15.57, after another 2.93% drop today.  So you really have only made $0.57, and the dividend is dropping and (at least now) the trend is down.

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#56) On October 15, 2012 at 10:06 PM, rd80 (97.08) wrote:

Woo hoo, a hot debate on mREITs.

I sold out of my Hatteras Financial position about a year ago and have no regrets.  My reasons for selling were some of the risks TMFAleph1 is commenting on.  Specifically:

Interest rate spread - either short term rates going up (very unlikely as long as the Fed pins them to zero) or mortgage rates coming down - a primary goal of QE3.

Prepayment risk - this doesn't get enough attention.  As rates have come down, people refinance and the mREITs are faced with return of capital that must be reinvested in the lower yielding stuff on the market, and soon they'll be competing for the paper with a Fed hell bent on bidding those prices up.  And, if they paid a premium for the refinanced paper - a likely scenario - they can face losses since the refi pays back at par value.

Default risk wasn't an issue with HTS since it held agency backed mortgages.  Same with NLY.

Funding risk is there, but given all the money sloshing around the credit markets, I don't see the money that funds the repo agreements drying up any time soon.

One other risk is a crowded exit door at the first hint of a Fed rate hike.  No hard analysis behind this, but my speculation is a lot of mREIT holders are watching the Fed with fingers on the trigger to sell at the first signs of tightening.  Could be a lot of sellers and few buyers in that scenario.

I'm not good at, and won't attempt to make, predictions when or if mREITs might be hit hard by these risks, but they were risks I was no longer willing to accept last year.  To some extent, the mREITs have been seeing elevated levels of prepayment for some time now. 

FWIW, I have a CAPS pick on NLY that started in late June '11.  By CAPS accounting, over that 16 months or so NLY has returned 2% with reinvested dividends and has trailed the SPY by nearly 11 points.

From the comments I've read, I think the posters on this thread do understand the risks associated with mREITs.  I hope the investments work out well for those holding them and I don't expect to be rejoining the ranks of mREIT holders any time soon.

Fool on!

Russ

Disclosure: no position in any security mentioned.

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#57) On October 15, 2012 at 10:42 PM, rd80 (97.08) wrote:

Oops.  Hot debate, and a fairly old one. 

Note to self.  Check post dates.

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