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We're living and investing in a tough economy, to say the least: high unemployment, possible deflation, and slow-to-moderate economic growth are the order of the day. It's not exactly the environment that many investors relish, but it's a beautiful one for Annaly Capital (NYSE: NLY).

Fast facts on Annaly Capital

Market Capitalization

$10.6 billion

Industry

real estate investment trusts

Revenue (TTM)

$1.3 billion

Earnings (TTM)

$1.1 billion

Debt/Equity Ratio

6:1

Price/Book Value

1.01

Dividend Yield

15.6%

Source: Capital IQ, a division of Standard & Poor's. TTM is trailing 12 months.

Annaly uses short-term financing to buy longer-term mortgage-backed securities and other debt, largely issued by Fannie Mae and Freddie Mac. Annaly's profit is the difference between the two, which is known as its interest rate spread. As a real estate investment trust, Annaly gains favorable tax treatment, but must distribute at least 90% of its earnings to shareholders in the form of dividends.

Annaly and its huge yield could make a great investment or a useful hedge for this economy.

Why Annaly makes sense today
When unemployment is high and inflation low, the Federal Reserve lowers interest rates to stimulate the economy. The Fed is currently targeting short-term rates of 0%-0.25% -- pretty much the lowest possible.

But with the economy in such awful shape, even that may not be enough to substantially reduce unemployment or boost inflation on its own. Though there have been some stirrings, the Fed hasn't announced yet other initiatives, and "deficit hawks" in Congress succeeded in scaling back or delaying stimulus measures.

What this means is that the same economic conditions that led to the Fed keeping rates this low are likely to persist. Federal Reserve estimates, which show unemployment remaining above 7% and inflation only rising to some 1.25% by 2012, led the board to commit once again to keeping interest rates low for "an extended period."

Why is this great for Annaly? When the Fed lowers the overnight interest rate at which banks lend to each other, the interest rates for other overnight and short-term loans also decline -- usually much more so than long-term interest rates. This means higher profits for Annaly, because it uses short-term financing to buy longer-term mortgage-backed securities.

Take a look at how declining Fed rates (green) drag down Annaly's borrowing costs (red) much more than they reduce Annaly's interest yield (blue). The expanded area between the red and blue lines represents Annaly's profit:


Source: Company filings and the Federal Reserve Bank of New York.

This is essentially the same phenomenon that's responsible for the recent explosive profits at bond trading desks for Goldman Sachs (NYSE: GS), JPMorgan (NYSE: JPM), Bank of America (NYSE: BAC), and Morgan Stanley (NYSE: MS).

While traders at these companies enjoy significant advantages, we're talking about black boxes that could carry enormous risk, the rewards of which go largely to star traders -- traditionally about 50%. Annaly, on the other hand, spends just 12% of its revenue on all administrative and salary expenses combined, leaving a greater portion of the spoils for shareholders.

What else there is to like
In such an economy, it's easy to see how homeowners might default on the mortgages backing most of Annaly's assets. Mortgage-backed securities were responsible for the blowups at a number of companies at the heart of the financial crisis. However, Annaly's portfolio is reasonably conservative and high quality -- at least 75% must be short term, be of top ratings quality, or be guaranteed by Fannie or Freddie, and therefore implicitly, by the U.S. government. Annaly's creditors know this, which is partly how it's able to keep financing costs low. (American Capital (Nasdaq: ACAS)-managed American Capital Agency (Nasdaq: AGNC) follows a similar model, but its history is shorter.)

There are few competitive advantages in Annaly's industry, so a management team with the ability to navigate changing interest rates and allocate capital effectively is critical. Michael Farrell, Annaly's CEO and chairman, has been with the company since he founded it in 1997. Through the years, the company has held up well through different interest rate environments.

Because Annaly is required to pay most of its earnings as a dividend, growth is often funded with new share issuances. You want to see more shares issued when the stock is expensive relative to book value, something Annaly's management has also done very well over the past decade.

What could go wrong?
Well, for starters:

1. Interest rates. A Fed short-term rate hike would crimp Annaly's profitability and could reduce its book value, but that's unlikely to happen for some time, and Annaly is partially hedged.

Perhaps the more likely risk is falling long-term rates. The Fed could get creative and begin buying up long-term debt again. Deflation fears or a flight to quality could prompt investors to buy up long-term Treasury notes. Both would probably hurt Annaly's profitability.

2. An end to the Fannie/Freddie gravy train. The House Financial Services Committee has already begun hearings on how to reform Fannie Mae and Freddie Mac. If Annaly isn't able to count on an implicit government guarantee for future mortgage-backed securities, its lenders could get cold feet and demand much higher rates. Annaly's costs would go up, and it could even be forced to find a new business model.

But as my Foolish colleague Matt Koppenheffer so aptly described it, reforming Fannie and Freddie is like defusing a massive nuclear weapon. It's a complicated, dangerous, and time-consuming process. We don't know if and how badly reform will hurt Annaly's future profitability, but the stock is trading for no more than book value today. And in the meantime, we can enjoy that fat dividend.

Foolish takeaway
It's not always easy to find good stocks for a lousy economy. But this interest rate environment does wonders for Annaly's profitability and dividend, and the stock is pretty cheap. Annaly could yield some nice returns or make a good hedge in a tough economy.

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At the time of publication, Fool editor Ilan Moscovitz doesn't own shares of any company mentioned. The Motley Fool has a disclosure policy.