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No. of Recommendations: 20
ANNALY 3Q/2008

I have three goals in submitting a write-up: clarifying my own thinking, hoping to educate or at least provoke thinking in others and generating constructive criticism of my thinking process and decision making. So fire away.

“Be greedy when others are fearful”
“There is chaos under heaven and the situation is excellent”
“Who dares, wins”

Regular followers of Annaly can jump down to the UPDATE, newcomers to the Board may or may not find the summary below worthwhile.

The company’s website instructive newcomers well at I learned basic vocabulary about Treasuries from I keep the Investopedia website open during conference calls.

Read this link and pay attention to the PDF yield curve showing “the spread”:


Mike Farrell established Annaly Mortgage Management in 1997 after a long career on Wall Street as a bond trader. The name changed to Annaly Capital Management on August 2, 2006. As a REIT, Annaly passes through earnings untaxed to its stockholders in the form of dividends. NLY’s wholly owned subsidiary, the Fixed Incomes Discount Investment Advisor Company (FIDAC), purchased for $40m in 2004, is a taxable REIT subsidiary and thus taxable as a domestic C corporation. FIDAC while executing a strategy similar to Annaly, generates income from fees, not levering a spread.

Annaly has two revenue streams: exploiting the spread and generating management fees.

Annaly exploits the spread between interest income on investment activities and the cost of borrowing to finance acquisition of those investments. Annaly borrows money at short-term rates to buy securities with longer terms and therefore (most of the time) higher yields. The heart of the business model, then, is to lever this spread to maximize profit during the majority of the time when the spread favors Annaly but minimize the chances of forced unfavorable selling or bankruptcy when the spread is flat or negative, all the while selling as much new equity as possible when terms are favorable (usu. related to price to book ratio).

Annaly deals largely in the business of mortgage backed securities (MBS). These MBS consist of mortgage pass-through certificates, collateralized mortgage obligations and agency callable debitures. All of Annaly’s MBS’s are agency backed. The “receivership” of the Agencies in 2008 seems to mean that the ability of the American people to pay taxes guarantees Annaly’s MBS’s!

The spread drives Annaly’s cash production generating net interest income. There will also be gains or losses from the sales of MBS’s, a little bit from trading (for example, selling fixed interest assets when interest rates have gone down) and the much smaller (but always positive) income stream from capital management projects like FIDAC. That’s it.

The refinements are the following:

. 1) “Barbell strategy” (from the company website), constructs an MBS “portfolio that performs well in a wide variety of interest rate environments. We use the "barbell" metaphor to describe the hedging process that occurs when, in general, a portion of our portfolio will outperform in times of rising rates, while a different portion will outperform in times of falling rates. The two portions of the portfolio- the ends of the barbell- thereby complement each other to maintain current income while minimizing NAV volatility as rates go up or down. What allows us to do this without using any derivatives is the unique characteristics of mortgage-backed securities. In our composition, at one end of the barbell we have ARMs and floating rate securities. These securities tend to outperform when interest rates rise because their yields will increase as interest rates rise due to the adjustable nature of the coupons associated with them. On the other end of the barbell we have the fixed rate securities. These securities generally experience capital gains when interest rates are falling and these gains help to offset the lower yields associated with falling interest rates.”

2) Annaly typically buys MBS at a premium (average is 102), which provides shorter dates to maturity for a given yield. MBS that are purchased at a premium will yield less when paid off early (an activity that generates the constant prepayment rate, or CPR, which is a drag on profits).

3) Annaly sells equity – a lot of equity – with the last five quarter share growth (descending) being 540,189,101, 538,546,666, 468,380,797, 401,822,703, and 330,509,203. a billion shares are authorized.

4) Annaly levers equity in the range of 8 to 12:1. Leverages works both ways for Annaly as elsewhere in the world. Unfavorable interest rates changes or decreasing mark to market value of the MBS’s can force unfavorable selling.

The company has not engaged in any formal hedging to date, although the 10-K does not preclude this practice to protect against variations in interest rates (interest rate swaps). Annaly pledges not to use hedging as a speculative tool. The company does perform some practical hedging by trying to have some adjustable rate mortgages (aligning investment and borrowing), diversified revenue stream with FIDAC and only investing in areas in which they believe that they understand well. Annaly makes a point that the lack of off-balance sheet derivatives gives them a transparent statement.

The constant prepayment rate (CRP) will rise during times of high refinancing rates (dropping interest rates), which causes pre-payment and loss of income to Annaly due to the premium nature of Annaly’s MBS purchasing. The current constant prepayment ratio (CPR) was 11% 3Q/2008, 42% in 2006, 27% 2004 and 2005. Rising interest rates or tight credit cause this refinancing to drop and losses would therefore decline in this area.

Annaly has a certain required capital base with two major components - first, they must maintain a current aggregate over collateralization amount (HAIRCUT) for their current MBS. That amount is determined by lender based on the risk and liquidity of the MBS, with FNM/GNM being 3% and certain private issuers ranging as high as 20%. The current average weighted haircut level is 3.95%. In addition, Annaly also maintains an excess capital cushion that is self-imposed in case the actual value of the MBS declines. This excess capital cushion is determined by Annaly managers for each MBS and is a key quality measurement of Annaly management.

Annaly pays a premium to acquire investments with a higher interest rate return. The premium is amortized over the life of the MBS. Fully 98% of Annaly’s MBS were bought at a premium. However, Annaly must calculate its equity at mark-to-market and therefore equity is subject to variation in interest rates.

General and administrative expenses as a percentage of average assets were 0.17%, 0.16% and 0.18% for the quarters ended September 30, 2008, September 30, 2007, and June 30, 2008, respectively. Options are minimal at 5m outstanding and the REIT requirement means that with constant payout of capital, options only dilute book so far.


The spread drives Annaly’s profits. For the quarter ended September 30, 2008, the annualized yield on average earning assets was 5.62% and the annualized cost of funds on the average repurchase balance was 3.54%, which results in an interest rate spread of 2.08%. The company sold $4.8b realizing a loss of $1.1m. The dividend was 55 cents per share.

Fixed-rate securities comprised 65% of the Company's portfolio at September 30, 2008. The balance of the portfolio was comprised of 27% adjustable-rate mortgages and 8% LIBOR floating-rate collateralized mortgage obligations. At September 30, 2008, the Company had entered into interest rate swaps on a notional amount of $18.4 billion, or 33% of the portfolio. The Company's swaps are designated as cash flow hedges against the benchmark interest rate risk associated with the Company's borrowings. The purpose of the swaps is to mitigate the risk of rising interest rates that affect the Company's cost of funds. Since the Company will be receiving a floating rate on the notional amount of the swaps, the effect of the swaps is to lock in a spread relative to the cost of financing.

Leverage was at 7.2 to 1. Concretely, that is $59b assets and $52b liabilities . The vast majority of assets are Level 2. At September 30, 2008, September 30, 2007, and June 30, 2008, the Company had a common stock book value per share of $12.70, $11.36 and $13.03, respectively.

The CRP was 11%.

The company has 540m shares out, and also has $108m Series B cumulative convertible preferred stock at 4.4m out and Preferred A 7.875% shares at 7,412,500 shares issued.

Net interest income was $352m and net income $302m after some trading, sales and management fees are thrown in.

Annaly has expanded in other ways than applying more leverage to more equity.

FIDAC was a first step; At September 30, 2008, FIDAC, Annaly's wholly-owned registered investment advisor, had under management approximately $2.4 billion in net assets and $10.5 billion in gross assets, as compared to $2.5 billion in net assets and $13.9 billion in gross assets at September 30, 2007 and $2.7 billion in net assets and $11.8 billion in gross assets at June 30, 2008. For the quarter ended September 30, 2008, FIDAC earned investment advisory and service fees, net of fees paid to distributors, of $7.4 million, as compared to $4.4 million for the quarter ended September 30, 2007 and $6.0 million for the quarter ended June 30, 2008.

On June 27, 2006, the Company made a majority equity investment in an affiliated investment fund which is now wholly owned by the Company. The Company acquired approximately 3.6 million shares of common stock of Chimera Investment Corporation ("Chimera") for approximately $54.3 million on November 21, 2007. Chimera is a publicly traded, specialty finance company that invests in residential mortgage loans, residential mortgage-backed securities, real estate related securities and various other asset classes. Chimera is externally managed by FIDAC and has elected and intends to qualify to be taxed as a REIT for federal income tax purposes.

Annaly has also established Ranger Capital Management to operate as a broker/dealer Ranger's business objectives include operating as a sales agent for investment products managed by Annaly's subsidiaries, engaging in securities lending, facilitating matched book operations and providing market data products. Ranger, organized as a taxable REIT subsidiary of Annaly, is expected to begin operations in December 2008.

Annaly acquired Merganser Capital Management 11/3/2008 as a wholly-owned taxable REIT subsidiary. Terms not disclosed. Has $4.6b AUM.

Currently, Annaly trades around $14 a share, paying out about $2 per year for a yield of 14%. You don’t get a high yield on Wall Street for nothing and the cost of Annaly is the guarantee that there will be rough spots in earnings. Currently, the stock price reflects that the spread is at Annaly’s back and that the market has been assured that Agency MBS are money good. Given that interest rates are cyclical, eventually the spread will narrow, Annaly’s profits will drop like a rock and the stock price will follow.

Ultimately, either you like Farrell or you don’t. One can only drill down into the 10-Q so far before you realize that you don’t have the data granularity or knowledge to make a judgment on the quality of repurchase agreements, interest rate swaps, equity issuance etc.

I have NLY only in my IRA and on DRIP. I actually like several energy companies better than NLY right now since I think that their stock prices have over-pendulumed in reaction to dropping oil prices. I’m not selling NLY, though, since the yield is acceptably high, I like the management and have a comfort level associated with the business. I would move heavily into NLY precisely during those times when a tight spread has dropped the stock price to close to book value.

For a more optimistic analysis, see:

From the 10-Q

Projected % Change in:

Interest Rate Net Interest Income InterestRateSwaps

-75 Basis Points 10.97% 1.43%
-50 Basis Points 6.75% 1.36%
-25 Basis Points 2.87% 1.18%
Base Interest Rate - -
+25 Basis Points (3.92%) 0.53%
+50 Basis Points (8.00%) 0.04%
+75 Basis Points (12.07%) (0.55%)
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