If you take one look at mortgage real estate investment trust (mREIT) Annaly Capital Management (NLY -0.35%), the first thing that will stick out is the company's jaw-dropping dividend yield of more than 16%. You'll be hard-pressed to find higher passive-income opportunities than this.

But the rule of thumb is that if things look too good to be true, then they probably are. Annaly is a case in point: It has had a tough year in the face of rising interest and mortgage rates, and the stock has plummeted whether you look at it this year or over the past five years.

But the Federal Reserve now seems to have done the bulk of its interest rate increases, and inflation seems to be cooling. Is the worst over for Annaly heading into 2023?

Will book value continue to diminish?

To be classified as a REIT and receive special tax advantages, these companies must pay out 90% of their annual taxable income in dividends. Dividends are paid out from earnings and excess capital. A problem for Annaly and all mortgage REITs this year is that its equity, or book value, has been eroding as mortgage rates have climbed.

The bulk of Annaly's assets are agency mortgage-backed securities (MBSes). Even though these bonds are backed by the U.S. government, a lot of them are underwater right now as mortgage spreads -- the difference between the yield on a 30-year fixed-rate mortgage and the yield on the U.S. 10-year Treasury bill -- have widened to crisis-era levels this year.

30 Year Mortgage Rate Chart

30 Year Mortgage Rate data by YCharts

Bonds have an inverse relationship with yields, which means as yields rise the value of the bond goes down. These are just unrealized gains and losses, which can be recouped if rates fall or the bonds are held to maturity.

But these losses do get marked to market and affect book value in the present. This year, as mortgage rates have surged, Annaly has taken billions of unrealized losses and seen its book value fall from $33.55 a share at the end of the third quarter of 2021 to less than $20 at the end of the third quarter.

Earnings have struggled as well

While unrealized losses hurt book value, Annaly's earnings have struggled amid higher funding costs, which have increased with the Fed's interest rate hikes. Remember, the bulk of the Fed's rate increases didn't start until the second half of the year, which is why third-quarter results at the company look very different from those of the second quarter.

The cost of Annaly's interest-bearing liabilities, or its funding sources, skyrocketed in the third quarter to 2.38%, up from 1.12% in the second quarter. Meanwhile, the yield on Annaly's interest-earning assets actually declined to 3.47% in the quarter, even though the company added roughly $7.4 billion of agency MBSs in Q3, which should have higher yields.

Ultimately, the company saw its margin decline from 2.64% in Q2 to 1.42% in Q3 and it reported a net loss of $274 million, or $0.70 per share, which also will diminish book value.

But the main value in mREITs is their ability to cover and pay their high dividends, and this ability can be better examined through a metric called earnings available for distribution (EAD). Here Annaly adjusts earnings to account for things such as unrealized losses from its bond holdings, any hedging on interest rates management did through derivatives in the quarter, and mortgage servicing rights amortization.

After all the adjustments, which include other components as well, EAD came out to $1.06 per share, more than enough to cover Annaly's $0.88 quarterly dividend. Still, the EAD is $0.16 lower than in Q2 and the lowest EAD the company has reported in a year.

Is the worst behind Annaly?

We know the fourth quarter has been tough because mortgage rates continued to rise into November. Annaly Chief Executive Officer David Finkelstein said on the company's most recent earnings call on Oct. 27 that book value had fallen another 6% to 7% in the quarter.

In addition, the Fed has undertaken another 1.25 percentage points of rate increases in Q4, which means funding costs have also probably risen as well, although investors can hope the company's yield on its interest-earning assets has risen more this quarter. Finkelstein said he expects the company to generate EAD in the fourth quarter right around the current dividend level of $0.88, which would be a significant decline from Q3.

But on the plus side, mortgage spreads have begun to tighten recently, which may help Annaly's bond portfolio a little bit, and recent data suggests that inflation is moderating. That could mean the Fed is close to finishing its campaign of rate increases.

Once funding costs stop rising so fast, the company should be able to bring on higher-yielding MBSs and begin to widen its margin and increase book value. Still, there are a lot of external factors affecting the mortgage market right now, such as falling home values and the Fed's unwinding of its balance sheet, which is loaded with MBS. That could contribute to falling values of mortgage-backed securities.

The worst may be done after this quarter, but I'll want to see Q4 earnings and hear management's comments first. If you're interested in generating some passive income, however, and understand the dividend could be cut, then it might be worth a small position right now.