Make no mistake about it: Annaly Capital (NYSE:NLY) is concerned.
Consider the statement from CEO Wellington Denahan-Norris in the company's quarterly earnings release:
The active involvement of policymakers in the mortgage market, particularly the Federal Reserve's latest, open-ended, large scale asset purchase program, has introduced unique challenges for all investors. These policy decisions will have consequences in a wide range of markets, not just Agency mortgage-backed securities. We continue to pursue a conservative stance in these conditions, as we assess relative value opportunities across asset classes, on both sides of our balance sheet and throughout our business.
Now, if you can picture Denahan-Norris saying the "introduced unique challenges" bit in a seething tone through clenched teeth, then you're probably on the right track.
Indeed, the Fed's policies have not been kind to mortgage REITs. Annaly's interest rate spread fell to 1.24% by the end of the third quarter, which was down from 1.96% the year before. This isn't particular to Annaly -- American Capital Agency's (NASDAQ:AGNC) Q3 average spread was 1.42%, versus 2.14% in the year-prior quarter.
There's no real hope on the horizon, either, in terms of a more comfortable rate environment. The Fed is aggressively pursuing its quantitative easing ends, and unless there's some drastic, unexpected turnaround in employment or inflation indicators, it seems very likely that this push will continue for the foreseeable future.
And this has put CreXus (NYSE: CXS) shareholders in a tough position.
Let's make a deal
With Annaly's freshly announced proposal to buy CreXus outright for cash, CreXus shareholders could soon find themselves with a pile of cash that needs to be reinvested. Perhaps the most obvious first place to look -- as the title of this article implies -- is Annaly.
For those investors with a "see a big dividend, buy a big dividend" strategy -- a strategy which, by the way, is not recommended -- the switch from CreXus to Annaly is a no-brainer since Annaly actually sports a heftier yield. Management is another easy consideration since CreXus was already managed by FIDAC, Annaly's wholly owned investment advisor. In fact, if you click over to CreXus' "management perspective," you get a commentary with Annaly's logo plastered at the top.
But strategically, and from a portfolio perspective, the move from CreXus to Annaly is considerable. Even if it does complete the acquisition of CreXus, Annaly's bottom line will be hugely weighted toward its current assets since it finished Q3 with $142 billion in assets to CreXus' less-than-$1 billion. And the nature of the portfolios are extremely different, with Annaly's focused on agency-backed securities ($130 billion worth) while CreXus' is focused on direct mortgage lending and even some direct real-estate investments.
As far as risk profile, there are pros and cons to each. Investors moving from CreXus to Annaly are going from a basically unlevered balance sheet to one that's notably levered through largely short-term repo borrowing. Jumping in on Annaly also exposes CreXus investors to the rate risk that Annaly is trying to address through this deal. Of course, on the flip side, CreXus' portfolio is heavily weighted toward mezzanine commercial mortgage loans -- not exactly a port-in-the-storm asset flavor.
Considering all of this, I can't blame Annaly for wanting to swallow CreXus -- in the current environment I see it as a much more attractive portfolio. Even over the longer term, if I had to pick one, there's a lot to like about CreXus' approach of filling the funding gaps left where banks are still hesitant on the lending front. So should current CreXus investors make the switch if the deal goes through? They shouldn't dismiss it out of hand, but it's well worth exploring other available options.