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Annaly Falling Knives/ IV: Stocks I am Interested in/REIT/ Dividend Income/Annaly Boards presentation:

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”

The stock price of Annaly Mortgage has dropped 25% over the past 3 months chasing the company's yield that in turn has followed the rise in interest rates and the shrinkage of the spread between short term and long-term interest rates. The media has nothing but negative pieces on mREITs and even that lover of yield and dogs, Dr Ed, warns against investing in mREITs.

Must be time for a closer look.

I have cribbed substantially from earlier write-ups on Annaly

The company's website is also instructive at and I learned basic vocabulary about Treasuries from (essential to have some of the jargon under one's belt before listening to Farrell talk – makes me empathize with my patient's glazed look when I start talking about “imaging modalities” and “long term outcomes”…)

Mike Farrell established Annaly in 1997 after a long career on Wall Street as a bond trader. Mr. Farrell is well respected and an impressive and knowledgeable speaker. I would encourage anyone interested in the company to listen to his conference calls ( and to visits on Squawkbox and, yes, even Mad Money ( – and available on the company website).

Annaly qualifies as a REIT and therefore is able to pass through earnings untaxed to its stockholder 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 (I incorrectly stated in one of the write up[s above that FIDAC's growth would be limited by its REIT tax status – this is not true – see most recent 10-Q, page 10.) FIDAC is growing overseas – Canada, London – and, while executing a strategy that is the same as Annaly, generates income from fees, not results. Annaly is self advised and self managed. Farrell keeps administrative expenses absurdly low; the company employs all of 30 people.

Annaly has two major revenue streams: trading mortgage-backed securities (MBS) and generating management fees from FIDAC.

Income from the MBS business comes from the spread between interest income on investment activities and the cost of borrowing to finance acquisition of those investments. Basically, Annaly borrows money short term to buy securities with longer terms and therefore (most of the time) higher yields. As part of the “barbell strategy” (see company website), which means that Annaly has income streams that will not move in the same direction all at once with variations in the spread and absolute interest rates, 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).

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: that is, although the MBS are not rated, they are AAA “implied” since the MBS come through FNM, GNM and FHLMC. This means that Annaly takes no risk that the originator of the mortgage will not be able to pay the interest and principle of the mortgage.

Annaly feels that the current “problems” at FNM do not affect its business (

As of the last 10-K, 62% of the MSB consist of adjustable rate pass through certificates, 29% are fixed rates, pass through and 9% are collateralized mortgage obligations (CMO) floaters

Pass through means that the principle and interest payments are passed onto Annaly from the mortgager through the selling agency. Adjustable rate means that as interest rates fluctuate, so shall the interest rates on the mortgage. Fixed rate mean that the rate will not fluctuate. As interest rates go down, a fixed rate will become more valuable and can be sold. CMO is debt backed by mortgages.

How the spread is affected: rate adjustments are frequent. There is a lag between borrowing rates and investment rates – at Annaly the average borrowing rate is adjusted every 84 DAYS and the investment rate every 24 MONTHS (from the last conference call). This is a potential problem spot when interest rates go up.

Annaly also makes money from selling assets when market conditions are favorable (that is, selling fixed interest assets when interest rates have gone down). The company discussed potential effect of changes in the prime interest rate (

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.

Here are their views on derivatives:

In addition, their current income is adversely affected by the constant prepayment rate (CRP) during a time of high refinancing 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) has decreased from 42% last year to 27% 2004 and has remained at that level in 2005. If interest rates were to go up, this refinancing should drop and losses would therefore decline in this area. Annaly also attempts to buy securities that will provide a profit over a large range of interest rates.

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 liquidity is determined by ability to turn non-cash assets into cash: thus, cash on hand and unused borrowing capacity determines liquidity.

Annaly increased equity by issuing common stock in 2004. On 1/20/2004, the company sold 20,700,000 shares and raised $363 million. In 3/1/2004 4.2 million preferred shares raised $103 million then in 10/2004 sold another 3.1 million shares preferred shares for $74.5 million. They also issued 2.2 million shares to FIDAC shareholders at value of $18.40, the 12/31/2003 closing price. Finally, 2 million shares were issued through the Equity Shelf Program netting $37 million and 57K options were exercised and 127,000 shares were purchased through the DRIP for 2.3 million. There was an increase in the number of shares from 2003 to 2004 of 25,188,904 raising $476 million in equity. At a debt to equity ratio of 10:1 this increased equity thus enables the company to borrow almost 5 billion dollars more and the potential for generating 30% or so more net income in net interest income.

Annaly is trying to achieve cost efficiencies through a facility sharing agreement with FIDAC. They will also seek to lower their effective borrowing rate by seeking direct funding from collateralized lenders and may try to use commercial paper and medium note programs.

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. Farrell stressed that he would not be “reaching” for a better return or attempting to smooth return by taking on riskier investments (he will not go to less than AAA implied securities).

Annaly uses a lot of leverage. Typically, debt to equity is in the range of 8 to 12:1 - which only makes sense since the company makes money from the gap between borrowing and lending. They note that if interest rates change or the value of their MBS' decline, margins may be called and they may be forced to sell MBS' in an unfavorable market (in other words, at a loss). The company has an excellent page on discussing leverage on their website. In the recent conference call, Farrell stressed that the company would not “reach” for return by taking on more leverage than he thinks is prudent. Their ratio is currently 10.1/1.

Executive compensation: Farrell got paid $2.4 million in 2004 and gets 5 paid weeks of vacation a year. The Board can increase but not decrease his salary. He is also eligible for a bonus of 0.25% of the book value of the company at the end of the year. His severance package is worth over $6 million (nice parachute). The other executives have similar packages going down to $300,000 a year.

Stock options - as of 6/2005 there were 122m shares issued. The company may grant its executives stock options numbering up to the higher of 500,000 shares or 9.5% of the total numbers of shares outstanding. As of 3/2005, they had issued 1,645,721 shares at a weighted average of $15.66 and there are therefore 9,874,264 shares potentially up for options.

I don't like this much of the company's float involved in options, but with perhaps options play perhaps not the same implications as a non-REIT company - given that the company pays out most of its taxable income every year, the potential for the stock price rise much higher is limited - the potential for growth is not zero but is much more attenuated compared to a company that can retain income (and invest that income wisely!).

FIDAC: merger was completed at the close of business June 4, 2004 and the consolidated cash flows and operations sheets reflect this closing date. Former FIDAC shareholders may receive up to $50 million of NLY stock from 2005-2007 if FIDAC attains certain performance targets.

The total cost of the FIDAC purchase cannot be calculated until the final stock shares are issued for performance in 2007. However, up the point of the most recent 10-K, I calculated that FIDAC cost $2.2 million X 18.40 = $40.5 million plus up to $8 million in additional admin costs (does not look to me like FIDAC merger costs were broken out but please correct if I am wrong) for $48 million and has returned $12.5 million in 6 months for a run rate for $24 million. The NAV was $42.8 million of which $15 million was customer relations and $22 million was “goodwill”. Customer relations are calculated to have an indefinite life and are not amortized while goodwill shall be. So FIDAC should pay for itself over 3-4 years, neglecting continued increased admin costs minus supposed economies of scale and the effect of performance offsetting issuance of up to $50 million of new shares.

The Numbers
I will include my numbers from the 10-K in the discussion below and then discuss more recent developments

Key pages for discussion of numbers in the 10K are 34 to 46 (of the PDF corresponding to pp28-39 of the 10-K) and then the F supplement.

Year Net income/share Total ROE
2004 $2.04 $248.6 million 16%
2003 $1.95 $180 million 16%
2002 $2.68 $219 million 22%

The company paid out $1.98 per common share in 2004 as compared to $1.95 in 2003 and $2.67 in 2002.

The rise in net income for 2004 over 2003 reflected an increasing asset base and positive interest spread plus the addition of $12.5 million from FIDAC fees after the merger in 6/2004. FIDAC charges 10-15 basis points of gross AUM with AUM (gross) being about $15 billion generating net fees of $9.7 million. The FIDAC merger also increased administrative fees for 2004. The ROE reflects the difference in the spread in 2002 that was 2.12%, 2003 at 1.23% and in 2004 1.51% balanced against increased income from FIDAC, increased admin expenses from the FIDAC merger.

The interest spread went from 1.23% in 2003 to 1.51% in 2004. There was a decrease in income generated by the sale of MBS (these would be MBS sold when interest rates went down) from $40.9 million in 2003 to $5.2 million in 2004.

The largest expense by far is the cost of borrowed funds. In 2004 this was $270 million compared to interest income that was $532 million. In 2004 the average weighted value of borrowed funds was $15 billion.

ROA = 1.1% 2005, 1.2%. 2004 1.3% 2003

Annaly notes that the decrease in dividend payout taxes has decreased the advantage REIT's have over C corporations.

Share dilution is not usually desirable, but if a dollar of equity can be leveraged into $10 with a ROE of 15% = $11.50, there is money to be made (economic value added). The run rate for the $363 million raised in 2004 through offerings thus comes out to $54 million in income at ROE of 15%. While shares are diluted 25% (from 96 m to 120 m) income appears to gain. I tried to isolate the effect of the added equity and shares by taking the 2003 equity and shares of 1,149 million and 96 million, respectively with a ROE of 15% and got $1.79 per share, then added only the $363 to the 2003 equity for 1,512 million equity and did ROE of 15% divided by 120 million shares to get $1.89 per share. Annaly issued 1.2m shares from shelf in 2Q/2005 to raise $23m (In retrospect, some damned good timing)

Written in early 2005 ultimately much depends on the quality of Annaly's management to properly assess risk and reward for their MBS purchase decisions. I would think that the REIT requirements of payout would provide a hard floor for the stock price. In fact, if earnings drop this year due to a decrease in the interest rate gap, I for one look to buy as much as I can, anticipating there is a strong chance that the future will bring more favorable conditions to this well run company. Interest rates are cyclical.

Okay, so now we are in 8/2005, Annaly's stock has taken a big hit. Annaly made it onto the Income Investor list in 2003, does it qualify as a Falling Knife or maybe…. even… an Inside Value pick?

I say yes.

So what happened in the last three months?

Narrowing of the borrowing to interest-bearing spread (60 basis points on the last 10-Q compared to 118 basis points the previous quarter) as a result of flattening of the yield curve without a drop in the CPR (in fact, CPR went from 25 to 27% Q/Q) without a substantial increase in assets led to a drop in net income and thus the dividend happened (from 48 cents in 2q/2004 to 36 cents in 2q/2005). ROAE dropped to 11.3% while return on equity per unit leverage is 1.1%

You don't get 10% on Wall Street for nothing and the cost of Annaly is a beta of 0.2. This a stock that requires long range thinking. Farrell noted (when I say Farrell noted, I mean he said during a conference call or one of the appearances in the media that are available on the company website) that if one had bought NLY in 1997, the dividends would have paid for the stock in five years and all the dividends from the stock thereafter were free money (and he didn't mean reinvesting the dividends either).

Interest rates, interest rates spreads and economic growth are cyclical. One makes money buying at the bottom. Annaly essentially has constructed a bond ladder that will provide new capital as its legacy purchases mature – the average age of which is 24 months for variable rate and 29 months for fixed rate – so Annaly's currently maturing securities are from 2003. The average age of the short-term borrowing is 81 days (from the last conference call) down from 94 days the previous quarter.

Where's the value? Annaly's book value in 6/2005 was $12.43, which is STILL .62 cents greater than first quarter 2005, and the stock price is $14.8 right now. However, the book value is calculated on a mark-to-market basis – and Annaly is carrying a unrealized loss as a result. The key is that mark to market is fairyland for Annaly – they deal only in AAA MBS's – remember they pay premium for their MBS - so their book value on historical values is actually $13.61. FIDAC, income that in no direct way depends on interest rates or spread, kicked out in the first six months of 2005 10cents per share net income ($4.7m + $7.5m) and note the 75% Q/Q increase in income from FIDAC. Let's say that FIDAC's income doesn't grow at all the second half of 2005 – we are still looking at $27m for the year or 22 cents per share. So you've got a stock that traditionally pays out 10% currently trading for 1.09x historical book with a section of the business (FIDAC) that essentially HAS no book but contributes a conservative 22 cents per share per year run by a great mind, a guy that you want to have your back and in the worst interest rate scenario possible (rising rates, narrowing spread and rising CPR). And the current yield is about 10% (run rate of 36 cents x 4 divided by 14.8).

I like it. Tell me why you don't.

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