Will the Fiscal Cliff Hammer Annaly?

Annaly Capital (NLY -0.32%) has been one of many companies that's been whipsawed by fiscal cliff negotiations. And the hits just keep on coming.

Not content with the two-day rally that had taken the major indexes to their highest levels in two months, representatives of both parties spooked the market Wednesday with more rhetoric  about the impending fiscal cliff. The remarks, while not a surprise, were sufficient to remove the small measure of optimism that had driven stocks higher to start the week, causing the S&P 500 to decline by 0.76%. It is against this backdrop that such mREITs as Annaly traded steadily higher throughout the session, even after it announced another 10% cut to its quarterly dividend. The fiscal cliff has some unique ramifications for mREITs that you should consider before committing capital to these high-yielding options.

The fiscal cliff
The fiscal cliff refers to a series of both tax hikes and spending cuts that are set to take effect in 2013 if a deal is not reached in Congress. Most economists, including those in the Congressional Budget Office, believe that if the economy is allowed to go over the cliff unchecked, a new recession that could cost as many as 2 million jobs will ensue . While there are a wide variety of fiscal issues at stake in the fiscal cliff, there are three primary categories to be considered: the expiration of various tax-relief initiatives, the onset of sequestration measures, and the pending debt-ceiling issue .

As early as January, a wide array of tax-relief measures will expire. These include the so-called Bush tax cuts (including the tax-advantaged treatment of dividend income), the end of the payroll tax holiday, and the end of extended unemployment benefits. The sequestration cuts refer to mandatory cuts that are scheduled to take effect as a result of the fact that Congress was unable to agree to spending cuts in previous negotiations.

Finally, adding to the tension of the entire situation is the fact that the debt ceiling is likely to be reached at or near the end of December. The last time Congress addressed this -- roughly a year ago -- the economic consequences were serious, including the first downgrade to U.S. debt ever. At current levels, the extraordinary measures power granted the Treasury  to maintain U.S. fiscal integrity is expected to be exhausted within the first part of the year.

Over the cliff
Understanding that the broad expectation if the economy is allowed to go over the fiscal cliff is another recession, it is useful to understand both some of the macroeconomic impacts and how these will consequently affect Annaly.

A slumping economy and struggling housing market would be troublesome for Annaly's portfolio of mortgage-backed securities, though the extent of the impact may be tough to predict from where we sit today. However, what seems reasonable to expect is that the supply of new MBS will continue to be limited if the economy goes off the cliff because fewer people will be taking out mortgages to purchase homes (barring changes in refinancing activity). The competing forces on the value of existing MBS may net out to a small directional impact, but the lack of new supply will make things hard on Annaly moving forward.

On the other side of the fiscal cliff, however, is the fact that the tax advantage for dividends is set to expire. As things currently stand, dividends are taxed at 15%. At the bottom of the cliff, dividend income will be taxed as ordinary income.

This is advantageous for Annaly -- and other mREITs such as American Capital Agency (AGNC -0.11%) and Chimera Investment (CIM -0.48%) -- because mREIT "dividends" are currently treated as distributions for tax purposes. This means that these payments are already taxed as ordinary income. The net impact, then, of going over the cliff is that mREIT dividends will become more attractive on a relative basis. This is true because the effective income -- the amount you get to keep after taxes -- will be have an even greater spread to other dividend investments.

Disaster averted
If the boys and girls in Washington decide to play nice -- and remember the lesson behind our parents' question: "If your friend jumped off a cliff, would you?" -- another recession may be avoided. This does not, unfortunately, end the danger. The debt ceiling must still be addressed and the runaway spending that has occurred for the past several years must be brought into check. As we learned the last time we played chicken with the debt ceiling, U.S. debt is not infallible; maintaining our credit rating is important for the healthy operation of the global economy.

If the fiscal cliff is avoided by simply delaying any decision, and postponing the consequences of both the fiscal changes and the debt ceiling, at some point, U.S. credit will begin to suffer as it did the first time the debt ceiling was pushed into the future rather than addressed. Too significant a loss of confidence could lead to rapidly rising rates in order to attract capital. This is a particularly bad scenario for Annaly. As rates start to rise, shorter-term rates (where Annaly gets its investment capital through borrowing) may climb faster than longer-term rates (where Annaly deploys the capital it borrows). This may create a near-term squeeze on any new investments that the company may wish to make.

On the other hand, if Congress can come to some middle ground that neither leaves the problem for another day nor completely ignores the very real debt problem being faced in this country, perhaps Annaly and the economy as a whole may begin to recover. While I remain skeptical that Congress will adopt such a reasonable approach, it remains an option. Until these issues are addressed, the stock must be considered a somewhat speculative play.