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Why Annaly Could Underperform in 2013

If you invest in mortgage REITs, there's one metric you should get comfortable with.

It's known as the "constant prepayment rate" and can be found by searching the text of any mREIT's quarterly or annual financial filing -- to access these, go to the SEC's EDGAR database, enter the company name or ticker symbol, select the relevant filing (either the 10-Q or 10-K), and then do a textual search for the acronym "CPR."

This metric is important is because it measures the proportion of an mREIT's portfolio that's prepaid every year and must accordingly be replaced by new mortgages and/or mortgage-backed securities. It's particularly important in an environment of declining interest rates like the present, as every mortgage that's prepaid is replaced by one with a lower effective yield.

(As a side note, for the purposes of this article, when I refer to interest rates, I'm referring exclusively to the rates on mortgages and MBSes.)

With this in mind, the CPR can be used to forecast a particular mREIT's future interest rate spread relative to its peers. You can think of this in terms of a Punnett Square -- I apologize to anyone with bad memories from high school biology class.

Source: Image created by author.

As you can see, if interest rates are declining, holding all else equal, it's in an mREIT's favor to have a low CPR, as that will increase its interest rate spread compared to peers with higher CPRs. On the other hand, if interest rates are increasing, then it's better to have a high CPR -- though, it's important to note here that prepayment rates and interest rates are themselves correlated.

It should be no surprise, in turn, to see that mREITs with relatively low CPRs like ARMOUR Residential (NYSE: ARR  ) and American Capital Agency (NASDAQ: AGNC  ) have done significantly better over the last year than those with relatively high CPRs like Annaly Capital Management (NYSE: NLY  ) and CYS Investments (NYSE: CYS  ) . As you can see below, the latter two currently sport significantly higher interest rate spreads than the former two.

Source: S&P's Capital IQ.

And lest you think that shareholders are immune from the pernicious effects of a low CPR, here's how comparable investments in these five companies have performed this year.

NLY Total Return Price Chart

NLY Total Return Price data by YCharts.

While far from perfect, you'd be excused for discerning a pattern here. Namely, mREITs with lower CPRs like ARMOUR and American Capital have handily outperformed those with higher CPRs like Annaly and CYS.

it's all coming together now
Given this, and to now focus on Annaly, it's probably clear why the mREIT pioneer has decided to acquire CXS Investments (UNKNOWN: CXS.DL.DL  ) , a higher-yielding commercial REIT that operates under the Annaly family of companies. What better way is there to increase your interest rate spread in the face of a high CPR and declining interest rates than to simply buy a higher yielding portfolio? None that I can think of.

But from the shareholders' perspective, there are two problems with this approach. First, the size of CXS' portfolio pales in comparison to Annaly's. As a result, the acquisition, while positive depending on the amount of goodwill that comes along with it, won't be inordinately accretive to Annaly's interest rate spread. And second, beyond the dividend, the benefit of investing in Annaly has always been its commitment to agency MBSes, which carry effectively no credit risk. CXS' portfolio isn't similarly insured.

With these factors in mind, as well as a host of economic issues that are beyond our current scope, investors would be well-advised to watch their investments in Annaly closely over the next year, as both the company's profitability and risk profile may look very different at the end of the next year as compared to today.

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  • Report this Comment On December 13, 2012, at 4:11 PM, jonkai3 wrote:


    Namely, mREITs with lower CPRs like ARMOUR and American Capital have handily outperformed those with higher CPRs like Annaly and CYS.


    you made one fatal mistake, it is the CHANGE in CPR rates that effect earnings and dividend numbers...

    and AGNC's CHANGE in CPR rate has been far larger than NLY's...

    and if you actually did look into the SEC filings, you'll notice a HUGE change in AGNC's earnings, while NLY's has been much slower to change.

    what this means is that your theory about 2013 is most likely extremely off... and you are using a rear view mirror to peer into that future.

  • Report this Comment On December 13, 2012, at 4:34 PM, jonkai3 wrote:


    But from the shareholders' perspective, there are two problems with this approach. First, the size of CXS' portfolio pales in comparison to Annaly's. As a result, the acquisition, while positive depending on the amount of goodwill that comes along with it, won't be inordinately accretive to Annaly's interest rate spread.


    this too is off base, Commercial paper does not need the same leverage as Agency paper, meaning $1-$2 of Commercial paper is equal to $7 of Agency paper...

    meaning that $1 billion, can be equivalent to buying $7 billion, in terms of the interest it brings in....

    once more for every $1 billion NLY buys of commercial paper, they can retire $7 billion of their portfolio AND the associated CPR rate and Swap hedging that go along with it... along with a large change in leverage ratio....

    7% a quarter starts to add up ....

    and the Swap expenses are NLY's main expense, which they self regulate.

    also CXS themselves identified $1 billion more Commercial paper they wanted to buy but didn't have the money to do it... NLY has the money to do it... that is 14% of their portfolio...

    this along with retiring 10% of NLY's stock easily covers the $10 billion they are getting back in principal payments a quarter, a few quarters of 10% of their portfolio and we are talking 25% of their portfolio.... which is exactly what NLY said they were going to do.

    in even more words, they could if they so chose to do so, RAISE the dividend, mainly because there is a huge change in their swap expenses CPR rates and leverage ratios, and they have complete control of those expenses. they are not forced to buy this swap hedging... and with 25% of their portfolio not needing this hedging... well large numbers start pouring out of such situations... now they will in some way hedge this 25% of their portfolio, but the costs wont be near what they are for Agency paper...

    we are talking a very different 2013 for NLY, i don't know what the rest of the all AGencies are going to do, but we know exactly what NLY is going to do...

    10% of their shareholder stock is going to be bought back, (and at these prices they probably should do 10% more on that)

    and 25% of their portfolio will be commercial paper....

    2013 will be very interesting, but one thing is for certain, NLY will try to return about 12% in actual real earnings to it's shareholders during 2013..

    in 2013, 12% is going to look mighty tempting when the company doing it was able to do it in this rate environment.

    they are so flush with confidence that they actually spent $25 billion dollars since january buying 3 year protection for it's portfolio... protection that didn't even exist a couple years ago... once more the prices are so good that NLY couldn't pass them up...

    mind you they didn't have to take on these extra expenses, but they felt they were making enough to be able to do it.

    that means that they can make the earnings what ever they want in the future, simply by what they buy in their hedging...

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