The Surprising Reason Annaly Capital Management, Inc. Could Have a Good Year

After one of the worst year's in recent memory for mortgage REITs, there's at least one reason to believe that 2014 will turn out to be much better for Annaly Capital Management (NYSE: NLY  ) and its brethren.

If you'll recall, the problem last year revolved around the Federal Reserve's decision to begin tapering its monthly purchases of mortgage-backed securities.

By decreasing demand for these instruments, the move pushed MBS prices down. Because MBS prices and yields are inversely related, the latter went up. And because MBS yields are the primary determinant of mortgage rates, these headed higher as well.

When all was said and done, here's what happened to the interest rate on conforming 30-year fixed-rate mortgages:

As you may already be aware, these trends devastated balance sheets throughout the mREIT space, as the value of investment portfolios across the industry plummeted when MBS prices dropped. Since the end of 2012, for instance, Annaly's book value per share has fallen by 23.5%, triggering a similar spiral in the price of its stock.

With this in mind, it's tempting to conclude that the Fed's recent decision to further reduce its monthly MBS purchases will only exacerbate the problem. But a deeper look at the issue suggests this may turn out to be wrong.

According to Annaly's head of agency trading, David Finkelstein, the dynamics of the MBS marketplace have evolved over the past year. While a lot of attention has been paid to the demand side of the equation, thanks largely to the central bank, there's been an equally robust impact on supply.

As mortgage rates soared, the desire and ability to buy a house or refinance a mortgage dove precipitously. And because fewer mortgages mean fewer MBS, it follows that the MBS supply has contracted -- or, at the very least, that any additional supply to hit the market will be more than offset by the Fed's diminished purchasing program. As Finkelstein explained on Annaly's most recent earnings call:

I think when we look at what actual net supply or growth of the agency MBS market will be this year, most estimates have it ranging from about $100 billion to $150 billion in net supply. The Fed, even with the taper, will absorb that much supply in the first four to five months of this year. So the technicals for the year are certainly on the positive side.

The net result of this is twofold. In the first case, if true, it will staunch the decline in book values throughout the industry. This alone would be a welcome surprise to many investors in the space.

Beyond this, it might give a company like Annaly a chance to opportunistically releverage its balance sheet. At the end of last year, Annaly was levered only five to one, its lowest level in years. This leaves the company with "tremendous buying power to augment forward earnings," says CEO Wellington Denahan-Norris.

Does this mean that an end to the mREIT industry's agony is in sight? While the answer will only be obvious in hindsight, it's getting safer to assume that companies like Annaly may soon be headed in the right direction again if they haven't already set off on that journey.

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