3 Things You Need to Know About Annaly Capital's Big Earnings News

Annaly Capital (NYSE: NLY  ) reported adjusted earnings per share of $0.54 for the fourth quarter, down a bit from $0.65 last quarter, or $0.60 in last year's fourth quarter.

Here are three things you need to know:

1. Profit spreads are down
The Fed has been working harder to target and lower long-term interest rates to boost the economy by buying long-term treasuries and, most recently, announcing that it expects low rates through 2014. While low short-term rates are great for mortgage REITs like Annaly because they drive down funding costs, falling long-term rates hit income. The difference between the two representing profits is known as the interest rate spread, and it's been falling:

Interest Rate Spread, 2011

Q1

Q2

Q3

Q4

Annaly Capital 2.17% 2.45% 2.08% 1.71%

Sources: Capital IQ and company press release.

This has been the case not just for Annaly, but industrywide, regardless of strategy or makeup, from American Capital Agency (Nasdaq: AGNC  ) to tiny Armour Residential (NYSE: ARR  ) , from non-agency RMBS specialist Chimera (NYSE: CIM  ) to CMBS-dabbler Invesco (NYSE: IVR  ) .

Now, it's important to keep these values in perspective. From 2005 to 2007 Annaly was looking at spreads well below 1%, and the environment is still a great one for all of these REITs. But the fourth-quarter decline was dramatic. REIT investors shouldn't ignore it.

2. Leverage is down
Over the past year, Annaly's leverage has fallen from 6.7 to 5.4, suggesting the company wants to play it safer. Consider how it stacks up alongside some of its agency peers:

Company

Leverage Ratio

Annaly Capital 5.4
American Capital Agency 7.9
Armour Residential 10*

Sources: Capital IQ and company press releases. *Estimated.

Annaly-managed Chimera also reduced its risk profile in 2011, so this didn't come out of the blue. Annaly's management suggested in its quarterly conference call that the reason for the change was that "quality rates of return have diminished dramatically" and that there's an added risk during an election year that the administration will pull out all the stops to try to help homeowners and the economy, which could potentially reduce profits for mortgage-backed-security holders. Which brings us to the final thing you need to know...

3. Prepayments are steady
Annaly's constant prepayment rate rose to 22% from 18% last quarter, but is down from 23% at the end of 2010. Mortgage holders generally don't like high prepayment rates, because they reduce interest income. We'll find out in the first two quarters of 2012 to what extent the administration's prior attempts to help homeowners refinance affect REITs, but most REITs have said they don't expect to be much affected. Keep in mind that with so many homes underwater and banks hesitant to extend credit, prepayment rates are lower than you'd expect them to be for such low interest rates. So despite their increasingly conservative leverage stance, Annaly predicted "more of the same."

The Foolish bottom line
All in all, it was another predictably good quarter for Annaly. With favorable interest rates and prepayment rates basically locked in, we can expect that to continue. But I'll be keeping an eye on those declining interest rates' spreads and leverage, since they suggest that Annaly's massive dividend may not stay quite as massive as many may expect.

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Ilan Moscovitz doesn't own shares of any company mentioned. The Motley Fool owns shares of Annaly Capital Management and Chimera Investment. 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.


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