Friday, August 24, 2007

Annaly doesn't look so bad to me...

Annaly Capital Management's portfolio strategy is strong enough to pull the ears off a gundar. What their stock is inherently worth, that's something else.

Anyway, Annaly is relatively unique among public REITs. Their entire portfolio is agency-backed MBS. No credit risk at all. There are many private REITs that follow a similar strategy. Here is basically how it works

The REIT starts with capital of say, $10 million. Annaly is obviously much bigger, but I'll use simple numbers for simple math. Anyway, they borrow another $90 million short-term, then buy a $100 million portfolio of shorter-term MBS and CMOs, all GSE backed so all AAA/Aaa rated. I'm using 10/1, but I know various leverage is used by various firms. I think Annaly moves between 8 and 12x. The 10/1 might be done in the repo market, where the haircut on agency MBS is usually pretty light, or some other credit facility. A decent sized REIT is going to do enough trading where they can negotiate pretty good terms with dealers, at least that used to be true prior to recent problems. More on that in a minute.

Repo rates with MBS collateral are usually within a couple beeps of LIBOR. They are basically trying to put together a portfolio that can generate income in excess of their borrowing costs. Pretty simple, eh?

There are two basic risks the agency MBS REIT is taking. First is term risk. The REIT is usually borrowing at terms of 1 month. But their assets are mostly fixed rate, and even though the REIT is always getting principal cash flow from the portfolio, if short-term rates rise significantly its possible for the borrowing rate to exceed the interest rate on the portfolio. REITs can try to mitigate this risk one of two ways. Either they can buy shorter-duration MBS, like CMOs, balloons, hybrid ARMs or straight ARMs. Or they can buy hedges. Both are costly, however, and hedging MBS is difficult because of the optionality.

Which is a perfect segue way into the second risk, which is option risk. MBS have inherent options, as the borrower can refinance at any time without penalty. Before I talked about how interest rates rising would be a problem, and so it would follow that interest rates falling would be beneficial. Not really though, because as soon as rates fall, borrowers all refinance and pay off their loans. So because of the option risk, the problems inherent with rates rising are much worse than the benefit of rates falling. We call that negative convexity.

If you think about the two risks for a while, you'll realize there are two kinds of markets which are problematic for the agency MBS REIT. One is an inverted curve. Obviously if you are trying to play a simple carry game, you want a steep curve if at all possible. Second is a volatile interest rate market. We're not talking about up and down 20bps here. We're talking about 1994/1999/2003 type markets, where borrowing costs and investment rates fluctuate constantly. If rates fall then rapidly rise, you wind up with large numbers of refinancings which get reinvested at lower rates, only to see the REIT suffer through higher borrowing costs when rates rise again.

Despite all this, leveraged MBS portfolios have been successful for a long time. Not just REITs, but various types of banks and hedge funds play this same game.

All leveraged investors are going through a tough time right now, however. Lenders to leveraged investors are becoming more strict about the haircuts they allow. Since a lot of agency MBS buyers are also alt-A and sub-prime buyers, dealers are particularly leery of MBS as collateral for repo. They assume you have sub-prime in your portfolio someplace.

This is resulting in REITs and other leverage managers selling large amounts of agency MBS, particularly hybrid-ARMs. Of course, there is nothing wrong with the securities, merely an alteration in the credit standards. Of course, at the same time REITs are trying to sell, dealer desks are choking on inventory, with many sitting on ugly losses in sub-prime MBS. So dealers are not putting strong bids on the bonds for sale. This has caused agency MBS to widen substantially.

But other than credit standards, conditions are improving for the leveraged MBS strategy. First of all, wider spreads on MBS mean more interest in their portfolios. Second, the curve is finally got some slope to it, and with the Fed set to ease, LIBOR rates are probably going to decline. Finally, the optionality of MBS is actually declining as well. The spread between Treasury and mortgage borrowing rates is widening, meaning that mortgage borrowers are further away from a refi opportunity despite the mild rally in Treasury rates.

Plus borrowers who put less than 20% down initially will have a hard time refinancing any time soon, unless rates drop dramatically. It used to be that these borrowers had to pay mortgage insurance, but recently people have gotten second mortgages instead. Going forward, banks are going to be less willing to offer the second mortgage, and where they do, the rate will probably be higher. So the borrower will have to come up with the 20% in order to do the refinancing, or else pay higher costs. And given that HPA is likely to be weak for a few years, borrowers won't be able to rely on price appreciation to get to the 20%. They'll have to actually come up with the cash. Now if you didn't have the cash when you bought the place, the odds of you having the cash a year or two later are pretty low.

All that adds up to the optionality being less for MBS than was true just a year or two ago. MBS should become easier to hedge, and the negative convexity problem is abated.

Now, what does that mean for Annaly stock? I don't want to be in the position of making stock recommendations, because I don't follow the trading patters for Annaly, or any other stock, professionally. I can say, however, that Annaly's core strategy is solid, and conditions for their portfolio's future performance are improving. This rosy outlook may or may not be priced into their stock currently. I don't f'ing know.

Fair Disclosure: I don't own any mortgage REIT stocks. I do own MBS through client portfolios. And I think MBS are crappin' sweet!


James I. Hymas said...

A timely post!

You may wish to add "haircut" to the glossary.

Dave M. said...

If their core strategy is solid, then I can't help but wonder why the stock crashed from 20 to 11 in only 4 months in 2005.

TDDG said...

I will add haircut, but basically its the amount you have to put up when you want to leverage a bond. If the haircut is 10%, you get 10% leverage.

Dave: Because the yield curve was inverting. Their dividend dropped to like 10c. But now things are improving.

Smurfy said...

Are commercial banks also playing the yield curve game -- borrowing short term and lending longer term at a higher rate? If so, is a bsaket of commercial bank stocks just as effective of a bet that the yield curve will steepen as Annaly and its peers?

Thanks for a great and insightful blog, I check everyday if there updates here.


DC said...

I have been searching for and reading various blogs hoping to find suitable ones to link to in my blog. I especially have come to like yours. I was wondering if you would like to exchange links.


Dave M. said...

Dear tddg, Investor's Business Daily has reported this...

"The market gained momentum in the afternoon amid reports that the Fed eased collateral rules, allowing banks to expand the use of commercial paper when borrowing from the Fed's discount window.""

and this...

""Also, reports surfaced that the Fed agreed this week to change regulations to assist Citigroup (C) and Bank of America. (BAC) The pair can now lift their lending to their brokerage units.""

Uh-oh, red flag time. Are we really, really going to regret the repeal of Glass-Steagal?

the cds trader said...

vrey interesting post. Annaly (NLY) is a stock I've had an eye on for over a year to buy for my personal portfolio...seems like a very well run company, although obviously has been operating in a tough market this year. I might just pull the trigger this week and buy a little following this if it falls, be warned, i'll be back to complain :)

Anonymous said...

I'm fairly familiar with this stock and wanted to make a few points. TDDG's analysis was spot on, in terms of credit and interest rate risk of NLY. However, one should be wary to load up on this stock at this juncture because 1) at the current price, your yield is only 6.7%. They won't pay out 4Q dividend until December so you won't be getting forward dividend guidance until then, plus they are not known to pay special dividend in 4Q, so don't expect the current dividends to be underestimated like some other REITS (e.g. RWT), 2) it is not a sure bet that the Feds will cut rates in September, so if rates remain the same, we can see a return to some liquidity and credit instability, which may affect NLY price like it did a few weeks ago, despite its limited credit risk and 3) this firm is highly levered and despite the fact that 99% of their collateral are highly liquid, changes in repo level (e.g. rates & hair cut) can nonetheless lead to a hit to their equity, very similar to TMA (too a lesser extent). NLY is more of a wait and see stock right now and should be trading sideways for the next few weeks.

TDDG said...


Off the top of my head, I'd say that NLY is a more direct play on curve shape than a big bank. Now the stock of a small bank might be pretty close. NLY's core strategy is not much different than your classic savings and loan bank.


Thanks for the kind words. I'll check out the site.

Dave M.:

I'd wager that most Fed economists would like to see less regulation of banks, not more. That being said, I think the deal the Fed made with Citi is temporary. The Fed values (correctly) the market maker role that the big brokers play in the bond market.

CDS Trader/Anon:

Let me be clear that I don't follow NLY professionally, but I do know a lot about how a leveraged MBS portfolio works. So when I say the prospects are good for their portfolio, I mean their portfolio.

My quick take on NLY's current stock price is that some level of improvement in dividend is priced in. I'd say that leveraged MBS investors expect something like 9-12% IRRs, so with a dividend yield of ~7%, its clear that current shareholders are expecting some level of improvement. Maybe NLY gets a liquidity premium over a hedge fund, but then again, maybe investors are demanding more yield out of leveraged investments than they used to.

gab said...

I have a problem buying the stock of any company that looks like it could be pronounced "anally."

Just sayin'...