Following my analysis of Motley Fool Income Investor selection Annaly Capital Management (NYSE:NLY) a few weeks back, I was able to persuade the folks at Annaly to give me a Q&A with their chairman, CEO, and president: Michael Farrell.
Joe Magyer: First of all, allow me to thank you for taking the time to answer a few questions for our readers today, many of whom, myself included, are Annaly shareholders.
For those who are new to or unfamiliar with Annaly, could you provide a brief overview of the company and its business model?
Michael Farrell: In its purest form, Annaly is an asset manager that takes the fundamental operations of a financial services firm -- the creation of net interest income -- and optimizes it from a tax perspective by electing to operate as a real estate investment trust [REIT]. Banks take their deposits, pay a rate for them, and lever up their balance sheet of loans at higher rates. Annaly does the same thing, except its loans are AAA[-rated] securities and its deposits are formed in the repurchase market.
Joe Magyer: Annaly, along with fellow mortgage REIT Anworth Mortgage (NYSE:ANH), was recently highlighted in Barron's by investment manager Sy Jacobs as being a solid play on the residential mortgage market. Can you explain to our readers what differentiates Annaly from other mortgage REITs in terms of strategy and your approach to credit risk?
Michael Farrell: Annaly uses a unique investment strategy that we servicemark as our Annaly MBS Barbell Strategy. It is a combination of fixed-rate, floating-rate, and adjustable-rate securities that allows us to navigate the moves in interest rates over time. We do not originate loans, and we think that the Barbell provides better cash flow characteristics than just concentrating on one category of the market, like adjustable-rate securities. This unique Barbell strategy has helped us outperform in difficult markets.
Joe Magyer: Does Annaly own any Alt-A or subprime loans directly or through structured finance products like collateralized debt obligations [CDOs] or residential mortgage-backed securities [RMBS]?
Michael Farrell: Annaly only owns U.S. government-insured paper, some of which are full faith and credit -- like GNMA [Ginnie Mae], and some are implied guarantees like FNMA [Fannie Mae] and FHLMC [Freddie Mac]. We believe that the nearly 40 years of this market have demonstrated that these are the premier asset-backed securities in the market. These securities are viewed as AAA by the investing public and are not general obligations of the agencies. They are supported by real, uneven cash flows from middle-class borrowers throughout the United States. The effect of these cash flows flow through the government agencies, the banking system, and onto our balance sheet, then become dividends.
Joe Magyer: Based on a recent white paper penned by your colleague Jeremy Diamond, Annaly's managing director of investor relations, I get the impression that Annaly believes short-term rates have almost nowhere to move but down. How is Annaly preparing to profit from such a move?
Michael Farrell: In our discussions with the markets via media releases, press releases, and commentary, we have been quite concerned about the current situation for almost three years. Since, as a REIT, we pay out 100% of our taxable earnings, we stayed away from the market during 2003 to 2005, preferring to limit our exposure to the excesses of the poor underwriting standards that the low interest rate environment enabled. In 2006, we felt confident that this discipline was recognized by the broader market and we began to access capital again as investors began to become concerned about credit quality and the equities of homebuilders and lenders began to reflect our view. As a result of the steps we took starting in 2003, we now had the ability to raise money when the rest of our competitors cannot. This is an important thing to understand about Annaly's current success.
Joe Magyer: How far along do you think we are in the "slow-motion train wreck" that is the subprime and housing mess?
Michael Farrell: I am very concerned that it is really in the early stages of being recognized for what it is -- a debt bubble that will have global ramifications for consumers, corporations, and governments. As I've said before, this is not a pretty picture for our country, but it is leading to a good environment for Annaly and FIDAC, our registered investment advisor. We intend to be opportunistic for our investors.
Joe Magyer: Annaly has raised its quarterly dividend for five consecutive quarters. What has made it possible for Annaly to raise its profits in the face of an inverted yield curve?
Michael Farrell: One of things that I think we have been able to communicate successfully to the markets is that there are many yield curves -- the Treasury yield curve and the mortgage yield curve are just two examples. In 2003, the markets believed that the yield curve was steep, with low front-end rates versus higher long rates. Under that theory, Annaly should have been raising lots of capital. Our analysis of that period was that while the Treasury yield curve was steep, the mortgage yield curve was actually inverted -- mostly because of the ability of borrowers to refinance into generational low interest rates. We declined capital raises during that period and as a result, when we returned to the markets in 2006, we were able to demonstrate to investors the value that was embedded in our structure.
Joe Magyer: You've used preferred stock as a means of raising capital in the past. Is that a route you would be open to in the future?
Michael Farrell: Yes, but only when it serves the best long-term interests of the common-share holders.
Joe Magyer: Outside of shortly after when you went public in the late 1990s, Annaly has consistently traded in a range of 1.1 to 1.5 times its book value. Why does Annaly's stock trade at a premium to its book value and, generally speaking, what metrics does management use to assess the fair value of your shares?
Michael Farrell: I think it's because of our financial services mindset, which allows us to be a very scalable business model. This in turn helps to keep expenses low and give investors professional access to a multi-trillion-dollar asset class that needs to be constantly monitored and managed. Fair value for our shares is determined by the markets, and as a result, we only act in the best interests of our shareholders. Sometimes, like 2003, it will mean staying away from the markets.
Joe Magyer: How much does your estimate of the fair value for your shares influence your decision-making process regarding raising capital through the equity markets?
Michael Farrell: Since we pay out all of our net earnings, we can only grow the company by sequential access to capital [issuing additional equity]. It is a valuable management discipline that makes us focus on the long-term interests of the shareholders. Every capital raise that we have done has been accretive both in terms of earnings and book value as a result.
That's a wrap
The knowledge and professionalism of the folks at Annaly gave this shareholder a great deal of confidence in the company's leadership. While I certainly hope to catch up with Mr. Farrell and other dividend-dishing CEOs in the future, I expect that next week we'll be back to our regularly scheduled dividend-focused programming.
Until then, you may want to check out the service that first introduced me to Annaly, Motley Fool Income Investor, which offers a free 30-day trial. You can also check out last week's version of "The Weekly Dividend" or a couple of Foolish dividend-focused articles from the past week:
Foolish editor Joe Magyer's desk is covered in 20-ounce Diet Coke caps, textbooks, CFA study guides, and Girl Scout cookies. Joe owns shares in Annaly. Joe's holdings and CAPS profile are always available for your viewing pleasure. Fannie Mae is an Inside Value recommendation. The Motley Fool has an unyielding disclosure policy.
