Benign Yield Curve Environment Helps Annaly

Annaly Capital Management (NYSE:NLY) shareholders can breathe a sigh of relief, as the company's fourth-quarter results didn't include any major red flags or dividend cuts.

As a residential mortgage real estate investment trust, Annaly -- along with competitors Thornburg Mortgage (NYSE:TMA), Impac Mortgage Holdings (NYSE:IMH), Newcastle Investment (NYSE:NCT), and Redwood Trust (NYSE:RWT) -- tries to earn a spread between the mortgage-backed securities (MBS) it invests in and its cost of funds. In other words, it's like a closed-end mortgage-backed security fund, except its management tries to turbocharge returns through the use of substantial leverage. At the end of 2006, Annaly levered each dollar of equity 10.4 times, compared to 9 times at the end of last year. Due to leverage, Annaly is able to invest in MBS yielding an average 5.64% but earn a 7%-8% return on equity.

For the fourth quarter, core earnings (which exclude impairment charges and gains/losses on security sales) increased to $52 million from $12 million last year. For the year, core earnings increased to $142 million from $127 million. Last year, the company was caught flat-footed by the yield curve and sold $3 billion worth of MBS at a $53.2 million loss.

The stable yield curve was a boon this quarter, and the company's average yield on earnings assets improved to 5.64%, earning it a 49-basis-point spread over its 5.15% cost of funds -- up significantly from last year's 9-basis-point spread thanks to portfolio repositioning.

Constant prepayment rates (CPR) lowered to 15% from 28%. Mortgage borrowers have the option of prepaying; they often do this when interest rates fall. When a borrower prepays, the mortgage lender (Annaly, in this case) gets his money exactly when he doesn't want it: when interest rates are lowered. Plus, at the end of the year, Annaly paid an average 50-basis-point premium to buy its MBS -- this premium isn't earned back via interest rate spreads if the borrower prepays too soon. Thus, the lowered CPR is a good thing.

At year-end, Annaly had a book value of $11.52 per share and raised its dividend to $0.19 from $0.14 in the third quarter, giving it a 1.2 price-to-book multiple and a 5.3% run-rate dividend yield. Investors eyeing Annaly, however, will need to decide whether the credit and prepay risk they would be taking, including the book value premium they'd be paying, is justified by Annaly's dividend yield and management's ability to create future shareholder value.

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Annaly Capital Management is a Motley Fool Income Investor recommendation. Find more dividend superstars with a free 30-day trial of James Early's low-risk, high-reward newsletter service.

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. The Motley Fool has a disclosure policy.