Annaly Keeps Charging Ahead

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Mortgages. Leverage. Profits.

That's the story of Annaly Capital (NYSE: NLY). It scares the bejeezus out of plenty, thanks to its outward resemblance to Wall Street's folly. In some respects, it should. But subtle differences in this company's business model make it sustainable -- and still hugely profitable.

Its GAAP net income for the third quarter came in at $285 million, or $0.51 per share, compared with $302 million, or $0.55 per share, in the same period last year. Using a metric the company calls "core earnings," a non-GAAP but more inclusive measure of profitability, earnings were $413 million, or $0.75 per share.

Quarterly dividends were $0.69 per share. Annualize that out and throw it over today's opening share price, and you get a 16.5% yield. That's why people love this stock.

So what makes it different from Wall Street's idiocy? Unlike the insane private mortgage-backed products companies like Citigroup (NYSE: C) and Bank of America (NYSE: BAC) got tangled up in, Annaly invests almost exclusively in Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) securities, where interest and principal are guaranteed by taxpayers. That leaves but one risk: Interest-rate fluctuations that backfire on leverage.

Right now, companies can borrow in short-term markets for basically nothing, and invest in long-term securities yielding a lot more than nothing. It's called a steep yield curve, and it has been a godsend for companies like Goldman Sachs (NYSE: GS), JPMorgan Chase (NYSE: JPM), and Annaly Capital.

But reversing the monetary policy implemented over the past year could -- no, will -- mean spectacular interest-rate shifts in the years ahead. Those shifts could be far more violent than anyone anticipates, quickly boomeranging Annaly's cash flow. When the cost of short-term liabilities increases while you're locked into fixed-rate long-term assets, bad things happen. Just ask Bear Stearns. Or Lehman Brothers.

This, in fact, explains Annaly's huge dividend yield: Many investors don't think it's sustainable.

Management, though, can effectively hedge interest-rate risk. It can do this by holding just the right combination of fixed and floating-rate securities, whereby one offsets the other depending on the interest-rate climate. Can is the key word there -- and there's no guarantee that management will execute flawlessly. So far, it has done a spectacular job. Whether it can keep it up holds 100% of the answer to Annaly's future success.

For now, profits are both great and real. Annaly is a fantastic story that has been kind for those willing to take the plunge. But this story isn't without risks, and investors would be wise to keep that in mind before thinking they're getting a completely safe 16% yield.