Does Annaly Have Hidden Credit Risk?

Annaly Capital Management (NYSE: NLY  ) is an incredibly popular stock. It pays a double-digit dividend yield, invests largely in riskless agency-backed mortgage securities, and is led by a CEO whom many consider an industry sage. It's even included in fellow Fool Dan Dzombak's high-yield dividend portfolio, which is beating the S&P 500 by almost 8 percentage points -- though it is one of the portfolio's worst performers.

While Annaly's shares are off since the beginning of last year, Fool analyst Jim Royal believes the mortgage REIT giant should be able to weather the storm without cutting its 14% dividend yield. I'm not as certain. In fact, I see a number of threats looming on Annaly's horizon. And although they may not be terminal or immediate, I do believe they will eventually cause the company's shareholders a non-negligible amount of pain.

What follows, in turn, is the second in a series of articles on what I believe are Annaly's biggest problems. To access the first in this series, click here.

The world of REITs
Real estate investment trusts come in a variety of shapes and sizes. Some, like Equity Residential, invest in multifamily properties. Some, like Health Care REIT, invest in health-care properties. Some, like Crexus Investment, invest in commercial property more generally. And some, like Annaly, invest primarily in residential real estate either directly or indirectly via residential mortgage-backed securities. The following table illustrates this variety.

Company

Investment Focus

Dividend Yield

Add to My Watchlist

Boston Properties Office properties in Boston, Washington, D.C., San Francisco, and Princeton, N.J. 2.2% Add
CYS Investments Residential real estate 15.3% Add
HCP Healthcare real estate including senior housing and medical offices, among other things 4.8% Add
Host Hotels Hotels 1.3% Add
Prologis Industrial distribution facilities and retail properties 3.8% Add
Simon Property Group Regional malls, premium outlets, community/lifestyle centers, etc. 2.8% Add

Source: Yahoo! Finance.

In terms of mortgage REITs, you can break it down another level. In one camp, you have companies like Annaly, American Capital Agency (Nasdaq: AGNC  ) , and Armour Residential (NYSE: ARR  ) , all of which claim to invest exclusively in mortgage-backed securities that are guaranteed by a governmental agency like Fannie Mae, Freddie Mac, or Ginnie Mae. In the other camp, you have companies like Chimera Investments (NYSE: CIM  ) and Invesco (NYSE: IVR  ) , both of which hold a sizable portion of their portfolio in non-guaranteed mortgage-backed securities.

Company

Agency Securities as % of Total Mortgage-Backed Securities

Dividend Yield

Add to My Watchlist

Annaly 100% 14% Add
American Capital Agency 100% 19.9% Add
Armour Residential 100% 18.3% Add
Invesco 71% 18.6% Add
Chimera 47% 16.7% Add

Source: Yahoo! Finance and S&P Capital IQ as of most recent quarterly data.

The distinction between these camps boils down to risk. Companies that invest in agency-backed securities are exposed primarily to interest-rate risk -- in this case, the risk that short-term interest rates will rise relative to long-term interest rates. Companies that invest in non-agency mortgage-backed securities, on the other hand, are exposed additionally to credit risk -- the risk that the underlying mortgages will go into default. It's generally fair to say, in turn, that companies in the latter category are riskier than those in the former.

Annaly's hidden risk
With these factors in mind, one would assume that Annaly exposes investors to less risk than many other REITs, as it claims to only invest in agency-backed securities -- Armour Residential and American Capital Agency excepted. The flaw in this logic, however, is that Annaly has derivative credit exposure through equity investments in Chimera and Crexus -- both of which hold a non-negligible portion of their portfolios in non-guaranteed securities. According to Annaly's most recent quarterly filing, it owns 45 million shares of Chimera and 9.5 million shares of Crexus. And as Fool analyst Anand Chokkavelu noted in his column on the worst mortgage REITs of 2011, both of these companies performed abysmally last year, offering negative dividend-adjusted returns of 25% and 10%, respectively. As a result, Annaly is carrying a $55 million unrealized loss on its books related to its investments in these companies.

It should be noted, moreover, that Annaly derives significant fee income from both of these companies as well. In the first three quarters of 2011, Annaly's wholly owned subsidiary FIDAC received $7.4 million and $39.2 million in management fees from Crexus and Chimera, respectively. These fees would be jeopardized in the event that either or both of these companies faltered -- which isn't totally out of the question if Chimera's recent share price performance is any indication.

Foolish bottom line
While Annaly's size allows it to absorb investment losses like those discussed above -- the losses account for less than 5% of its net income -- it nevertheless diverts income that would otherwise go to shareholders. And on top of that, it exposes its shareholders to a type of risk that isn't obvious at first glance. It's for these reasons that I prefer dividend stocks like the ones disclosed in our recently released free report "Secure Your Future with 11 Rock-Solid Dividend Stocks." While Annaly's dividend yield is admittedly huge, I don't think you can rely on it in the same way that you can rely on the stocks identified in this free report. To access the report while it's still available, click here now.

Fool contributor John Maxfield does not have a financial position in any of the companies mentioned in this article. The Motley Fool owns shares of Chimera Investment and Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (15)

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 January 18, 2012, at 3:52 PM, vaderblue wrote:

    Nly is a popular stock alright. I am long with

    Annally till interest rates start to climb and then we must wait and see how mortgage reits adjust

    to a new climate of our economy.

    Thanks for the exposure.

    it's all a wait and see game and as long as they can manage those dividends above 10% I am OK.

  • Report this Comment On January 18, 2012, at 5:23 PM, jonkai wrote:

    ------------

    Annaly has derivative credit exposure through equity investments in Chimera and Crexus

    ---------------

    this is incorrect and misleading, NLY has "INVESTMENTS" in chimera and crexus, if either or both of those investments failed, NLY would only lose the investment, and it isn't even that big of an investment, THAT IS WHY they are separate companies in the first place.... Hello????

    and a $55 million dollar lose is nothing compared to the $Billions it makes a year....IN CORE EARNINGS......geesh........ ONTOP of the $3.5 billion it has in cash on it's books....

    it is not even in the same league as the interest rate swaps it also carries on it's books in losses... and the important part is that they are UNrealized losses for a reason, interest rate swaps are like insurance, you hope you don't have to use them for profits....

    any of that ringing any bells or whistles in your head?

  • Report this Comment On January 18, 2012, at 5:27 PM, jonkai wrote:

    just to show you what league that $55 million in unrealized losses is... here is a side note from the earnings report....

    "During the quarter ended September 30, 2011, the Company disposed of $3.9 billion of mortgage-backed securities and agency debentures, resulting in a realized gain of $91.7 million"

    that is a single quarter, where your made up $55 million is spread out over multiple years.... talk about doing your homework and doing it in the wrong class, located in the wrong country....

  • Report this Comment On January 19, 2012, at 12:14 AM, techy46 wrote:

    NLY's biggest risk is that the general market will keep going up and people will liquidate NLY positions between x-dividends to play other appreciation positions.

  • Report this Comment On January 21, 2012, at 10:44 PM, Regarded49 wrote:

    NLY will continue to pay its dividend, and its' PPS is relatively meaningless over the course of 6 years at 14%....cost basis will be zero....if its cut in half, well hold it for 10-12 years.....cost basis...zero....and keep cashing those checks.

    This is a ridiculous article with an inaccurate premise....it should be removed.

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