Another Monster Quarter for Annaly Capital

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Need a good scare this Halloween? Annaly Capital's (NYSE: NLY  ) business model will make you shudder. It buys loads of mortgage-backed securities, leverages up to the gills, and pockets the difference. Sound familiar? It's not too different from the strategy that sent Bear Stearns and Lehman Brothers to the graveyard.

Ha! Time to bail on this looming disaster? Nah. Annaly sets itself apart with one very important factor that's keeping this baby afloat: it only buys government-insured Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) securities. Since those securities are guaranteed by the full faith and credit of the government, the risk of default is about as close to zero as it gets.

The sweet, sweet taste of fear                                 
Luckily for Annaly, global markets will hear nothing of the sort, and have been dumping Fannie and Freddie securities in droves. That selling -- rational or not -- has blown up Annaly's "spread" -- the difference between what it pays on its leverage and what it takes in from the securities -- resulting in a flood of profits that's fueling a ridiculous 16% dividend yield.

Annaly booked $302 million, or $0.55 per share in net income during the third quarter, 66% above the $0.33 per share earned in the same period last year. The aforementioned interest spread surged to over 2%, more than three times last year's 0.67%.

Common dividends came out to $0.55 per share, more than double last year's $0.26 per share. Annualize it out, and you get a dividend yield of over 16%. Pretty sweet.

Looking ahead
There's one big question everyone wants to know about Annaly: Is it too good to be true? The easy answer is, yeah, it probably is. One thing is for sure, spreads will eventually tighten, and the amount of profit Annaly's been able to squeeze out of mortgage-backed securities will subside. If there's one thing we do know about today's market madness, it's that it'll eventually end ... we just don't know when.

Nonetheless, with a 16% yield, there's sizeable room for a drop in earnings that would still render Annaly a lucrative investment. Even if earnings and dividends reverted back to where they were last year, investors would be sitting on an 8% yield with minimal risk. Analysts expect it to earn $2.59 in 2009 -- a figure that, if held true, will be making investors mighty happy at today's prices.

For related Foolishness:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Annaly Capital Management is a Motley Fool Income Investor recommendation. The Fool has a disclosure policy.

Read/Post Comments (4) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 31, 2008, at 6:26 AM, texalope7 wrote:

    If spreads tighten, the value of their holdings will increase. This should result in a rise in stock price(assuming rationality in the market, an assumption in itself).

  • Report this Comment On October 31, 2008, at 11:29 AM, markmti wrote:

    You got this one wrong. NLY health has as much to do with the 'price' of the MBS which they own as the guaranteed payments. It also has much do do with the health of the repo and warehouse counterparties and the LIBOR based rates they charge.

    NLY is leveraged to the hilt - you are correct. Nearly ALL of the $60 billion in GSE backed MBS were purchased at higher prices that they are worth today. That means NLY has margin management challenges that can be hedged away but with the Agency MBS market under such duress, foreign central banks selling all they can before Paulson leaves, spreads at all time highs vs Treasuries and .gov refusing to give an explicit guaranty, NLY better become a broker/dealer ast with access to the window or they will be bankrupt.

    If they owned the securities outright, its a totally different story. NLY is a hero or zero and their fate depends upon them becoming a legit broker/dealer with the full ability to warehouse $60 billion in securities. If the credit market take a turn for the worse or there is a hiccup with getting their final approval, their creditors will call the collateral - I can promise you that Deutsche and Credit Suisse would feel much better having the MBS on their balance sheet vs NLY's. The leveraged M-REIT is a broken business model.

  • Report this Comment On October 31, 2008, at 1:19 PM, cmfhousel wrote:


    Thanks for your comments. I just wanted to add that Fred and Fann do in fact have an explicit guarantee:

  • Report this Comment On November 01, 2008, at 11:10 AM, vladimus wrote:

    1. NLY exposure to European Libor rates may be linked more to the US governement's low rates, where mortgages are tied to Libor rates, the low US rates presure Libor to drop. I am not sure that NLY exposure is only to Libor, if at all directly.

    2. It is more likely that the $2.20 dividend yearly will be increased to $2.40 per share, from 55 cents to 60 cents.

    3. The pattern seems stonger for the next two quarters, as markets stablize, NLY still negotiates its payout increases. Thus, NLY climb recently and its projection to $17.60 as funds reestablish a core position this next month, following the election, the quarter's end, and its public report on earnings;hence, its payouts.

    tom columbus

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