In early August, the Securities and Exchange Commission reviewed Annaly Capital Management's (NYSE:NLY) fillings with the Commission from 2013. While this isn't always the case, the review lead to several questions regarding some of Annaly's reported results.
As the chief U.S. advocate for protecting investors, the SEC's comments and concerns are significant and worth understanding. However, because the four letters sent back and forth between Annaly and the SEC are cluttered with complex terms and general gobbledygook, I'll break it down into four simple takeaways.
4. Mortgage REITs are complicated... for everyone
What the SEC said: "[Y]ou paid dividends of $1.6 million and had net cash used in operating activities of $12.9 million ... please discuss the source(s) of these distributions ... as this disparity raises concerns about the sustainability of distributions into the future."
Dividend stability is a hot topic with Annaly, and the question seems to suggest the company is distributing too much cash and that the dividend appears unsustainable.
For most companies this would make perfect sense. However, as a mortgage real estate investment trust, Annaly is not like most companies. Rather, the company pays out 90% of its taxable income to shareholders. Instead of the dividend coming from cash it really comes from their earnings. So if you try to evaluate Annaly like any other company you will end up with some wonky results.
3. Growing commercial equity position
SEC: "Please tell us how you determined it was not necessary to provide ... your commercial real estate debt."
Annaly acquired CreXus Investment in January 2013 with the intention of creating a triple-net lease portfolio -- owning physical real estate leased to businesses. This was a radical change considering the company invested exclusively in residential housing debt for more than a decade.
The question refers to why Annaly has not disclosed more about these assets. To which CFO Glen Votek explained that since commercial assets make up only 2% of Annaly's total assets they aren't an important enough part of the business to disclose.
More important, he added, "As [Annaly] intends to increase the size and proportion of the commercial real estate business, the Company will provide the schedule in future 10-K filings."
Despite Annaly's past suggestions, I've questioned whether the company truly intends to shift away from its core strategy and make owning physical properties more than just a sideshow. This comment suggests that remains the intent.
2. Average debt matters
SEC: "Please tell us how you determined it was not necessary to continue to disclose ... average amount of repurchase and reverse repurchase transactions"
Repurchase agreements are a type of collateralized borrowing Annaly uses to fund its investments. But, like any debt, the more you have the more potential risk and reward. The question suggests that because Annaly's filings are only snapshots in time, rather than an average, it is possible the company is taking on enormous amounts of debt and then cutting back at the end of a quarter. Essentially, this would mean Annaly is masking its operations to appear safer.
This is not the case, as Annaly reports both quarter-end and average borrowing -- just not exactly the way the SEC would like.
The point being made is still important. For instance, Annaly had $67 billion in liabilities at the end of 2013. Average liabilities for the year, however, totaled $91 billion. These are extraordinarily different amounts of risk, and examining both numbers gives investors more insight into how Annaly is managing their portfolio over time.
1. Liquidity can be deceiving
SEC: "Please tell us how you determined these items were liquid assets ... how you determined it was appropriate to include any pledged investment securities within your liquid assets."
At the end of the second quarter, Annaly considered 96% of assets to be liquid. Which by its definition means they can be "readily converted into cash." At a glance, this makes Annaly's liquidity position look stellar, and I would assume the company would have little trouble paying off debt.
However, with the vast majority of its assets being used as collateral, the SEC wanted to know whether Annaly can really consider these assets liquid.
As it turns out, 88% of Annaly's assets are being used as collateral. This means only 12% of assets are truly liquid, or "unencumbered." Although this paints a dramatically different picture than what Annaly claimed, it's roughly in line with peers such as American Capital Agency. However, if this number begins to significantly click down, it could be a warning sign that Annaly isn't properly managing risk.
What does it all mean?
There are a a number of small and interesting takeaways here. Most important is that Annaly seems in good standing with the SEC, and none of the questions suggest any serious problems with its filings. This might be a fairly low bar, but it's miserable for companies that can't clear it.