If you own shares in Annaly Capital Management (NYSE:NLY), then now is a good time to decide whether you should continue to do so.
It's impossible to deny that Annaly has been on a phenomenal run since the onset of the financial crisis. The interest rate spread it relies on to make money nearly quadrupled in the years between 2006 and 2010. This led the pioneer of the mortgage REIT business model to more than triple its dividend payout. And while the S&P 500 has returned an anemic 3% since the end of 2007, Annaly's shareholders have seen their investment grow by an impressive 76% once dividends are included.
Yet a growing chorus of evidence now suggests that this run is ending. Founder and widely respected chairman and chief executive officer Michael A.J. Farrell recently passed away, long-term interest rates are contracting, and the company is now taking steps to abandon its strategic focus on agency mortgage-backed securities -- that is, securities issued by either Fannie Mae or Freddie Mac, and thus presumptively guaranteed by the federal government.
How QE3 is crippling mREITs
The biggest hit to Annaly and other mREITs came from the Federal Reserve's decision to initiate a third round of so-called quantitative easing. Under the program announced this past September, the Fed is purchasing $40 billion in agency mortgage-backed securities a month until the outlook for the labor market improves "substantially." This is notably in addition to the still-ongoing Operation Twist, under which the Fed is extending the average maturity of its balance sheet by selling short-term and buying long-term securities. Between these two programs, then, it's estimated that the Fed is buying anywhere between $40 billion and $85 billion, or the lion's share, of new agency MBSes every month.
While analysts and commentators, myself included, speculated that this would have a disproportionately negative impact on mREITS that specialize in agency MBSes like Annaly and American Capital Agency (NASDAQ:AGNC), it's fair to say that few of us foresaw the magnitude. In its most recent earnings report, Annaly's yield on earning assets fell by a staggering 50 basis points down to 2.54%. And its average interest rate spread for the quarter dropped to 1.02%, the lowest point since the fourth quarter of 2007, when its cost of funds was more than three times higher.
To provide some context for this, there have been two monetary programs enacted since the end of 2008 that zero in on agency MBSes. In the fourth quarter of 2008, the Fed announced a $500 billion MBS purchase program that lasted until the first quarter of 2010. And picking up where the Fed left off, in the first quarter of 2010, both Fannie Mae and Freddie Mac announced similar policies. For its part, Fannie Mae said that it would purchase up to 200,000 delinquent loans it had packaged into MBSes. In both cases, however, the impact on Annaly's portfolio was much more muted than in the third quarter of this year, reducing its yield on earning assets by only 12 and 6 basis points, respectively, compared to the 50 basis-point decrease just reported.
Adding insult to injury is the fact that things are bound to get worse. As I noted above, the Fed has publicly acknowledged that its purchases of agency MBSes will continue until the labor market improves "substantially," which could take years. In addition, due in large part to Annaly's success over the last few years, a number of new mREITs have entered the market. As my colleague Matt Koppenheffer noted, CYS Investments (NYSE:CYS) was started in 2006, Chimera (NYSE:CIM) and Two Harbors (NYSE:TWO) in 2007, and American Capital Agency and ARMOUR Residential (NYSE:ARR) in 2008. This crowding has not surprisingly sent agency MBS prices racing higher and their yields concomitantly lower.
What are Annaly's options?
Now, despite these dynamics, Annaly isn't necessarily up a creek without a paddle. One tactic it could use to combat the declining yield on earning assets, and thus juice its return on equity, would be to increase leverage. Prior to the financial crisis, when its average interest rate spread hovered around 0.5%, Annaly leveraged its portfolio by 10 or more to one. Nowadays, it's leveraged by six to one. It should be noted, however, that doing so tends to drive down book value per share and would only exacerbate the already crowded nature of the market for agency MBSes.
A second tactic Annaly could use is to diversify into higher-yielding securities. And, in fact, this is precisely what it's doing with its proposed acquisition of Crexus (NYSE:CXS.DL), a REIT that's focused on commercial real estate and sports a double-digit yield on earning assets. In the press release announcing the deal, Annaly's CEO noted (emphasis added):
Since our inception in 1997, Annaly has maintained the capacity to diversify its asset base to include real estate related assets in addition to Agency mortgage-backed securities if we determined that compelling other long-term investment opportunities exist relative to the Agency market. While we remain committed to the Agency market, given the current environment, we believe it is prudent to diversify a portion of our investment portfolio. Therefore, we may allocate up to 25% of our shareholders' equity to real estate assets other than Agency mortgage-backed securities.
From the typical shareholder's perspective, however, this strategy too isn't without drawbacks. One of the reasons income investors love Annaly is that its singular focus on agency MBSes shields them from credit risk, the most potent threat to most financial companies. This fact isn't lost on Annaly. Take this 2007 statement from Michael Farrell:
Since inception, our focus on agency mortgage-backed securities has been a core tenet of [our] philosophy. Because of the actual and implied triple-A rating of these securities, we take virtually no credit risk. Instead, it allows investors in Annaly to judge our performance and potential performance based on our ability to manage interest rate risk. We believe this choice has served our investors well over time and, given the current state of both the credit cycle and the interest rate cycle, leaves us strategically well-positioned for the current environment.
Make no mistake about it: In turn, if Annaly pursues this course further -- through, say, an acquisition of Chimera -- you're looking at an entirely different beast from a risk perspective.
The Foolish bottom line
I'll be the first to admit that I'm not a big fan of Annaly. That said, there's no question it's been good to shareholders over the last few years, outperforming the broader market by leaps and bounds. But Annaly is now at a crossroads. If it chooses to do nothing, then its dividend payout will invariably and markedly decline. And if it chooses to act by diversifying into other asset classes, then it exposes both itself and its shareholders to a new, and potentially more toxic category of risk.
To get a better grasp of how to balance the risks and opportunities facing Annaly, I strongly urge you to download our in-depth report on the company. To access your own copy instantly, simply click here now.
John Maxfield has no positions in the stocks mentioned above. The Motley Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.