|Shares Out. (in M):||800||P/E||0.0x||6.7x|
|Market Cap (in $M):||14,240||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||0||EBIT||0||0|
Annaly, which trades for around $17.70/share, is an Agency mortgage REIT and a fairly straight forward business. Annaly basically invests in government guaranteed (or implicitly guaranteed) mortgage securities ("risk free" investments from a credit standpoint). Annaly primarily finances the purchase of these "Agency" mortgage securities via a combination of issuing equity and borrowing from Wall Street banks. It is currently leveraged about 6.5:1. If you think of this in the context of a bank, which is basically what Annaly is, the leverage is low. To provide context, a typical commercial bank leveraged 10:1 or more. However, banks have better financing structures as most of their leverage comes from deposits and Federal Home Loan Bank lending, neither of which is particularly finicky. It also has a fee based asset management business that invests in a similar manner.
Annaly on the other hand relies primarily on Wall Street repo desks for its debt financing. As anyone using its financing in 2008 can attest to, Wall Street dealers can be quite finicky. Offsetting Annaly's more risky financing source is its low-risk asset mix: nearly 100% Agency mortgage securities (meaning securities issued by Fannie or Freddie as well as securities issued by Ginnie Mae). Fannie and Freddie have implicit government guarantees (closer to explicit today while they're in conservatorship, but still not explicit) while Ginnie has an explicit government guarantee. These are assets that Wall Street is willing to lend 20:1 or more against, so Annaly has plenty of financial flexibility.
In essence, by purchasing Agency securities Annaly's entire business is really to safely and cheaply finance low-risk residential mortgage loans. The implication of that is that Annaly's business model is akin to a low risk, branchless, customerless savings and loan. It has a clean balance sheet and dry powder on the investment side given its relatively low leverage relative to what's allowable. Even with its below average leverage, due to the historically wide spread between the mortgages Annaly is buying and its cost of financing, Annaly is generating a return on equity of about 17.5-18%.
Annaly is trading over book value (book is probably about $16/share as of Dec. 31, before adjusting for the likely 65-70c dividend that will have accrued). Therefore a purchaser of Annaly is buying a very low risk, low cost bank that can grow and shrink with the market opportunity for approximately 6.7x earnings (17.5% ROE * $15.25 book = $2.67/share in earnings). Further, due to its REIT status, we see those earnings passed directly on to us in the form of dividends. In today's environment, I expect Annaly to yield close to $2.67/share or 15.5%-16% (adjusted for the next dividend). In my eyes, this is a much lower risk profile than most high yield bonds yet over 2x the yield, even given the premium to book. It is very competitive with the best managed banks in the world.
How Annaly Makes Money Today:
As I mentioned, Annaly is like a wholesale bank with virtually zero credit risk on its assets. It entered Q42010 levered ~6.4:1. Given how much the curve has steepened since then, to be conservative, I'm assuming Annaly has taken its leverage back to 6:1. Thus, the math of their run-rate earnings stream based on today's assets and funding costs is as follows:
Estimated Average Earning Assets Yield: 4.35%
Estimated Blended Cost of Funding: 2.00%
2.35% spread x 6.0 turns of leverage + 4.35% x 1.0 turn of equity = 18.35% ROE (before expenses)
G&A ~ 0.9%
Estimated Run-rate ROE = 17.45%
Given Annaly trades at 1.1x book, that 17.45% run-rate ROE would translate to a 15.8% yield, all else being equal.
I believe a 15%+ coupon in today's world that does not require substantial risk is out of whack with where everything else in the world is priced. This anomaly is driven by current US monetary policy that aims to keep the short end of the curve incredibly easy for the foreseeable future. As I mentioned, the above analysis assumes that because the yield curve has steepened so much over the past few months that Annaly has reduced leverage back down toward 6:1. If leverage has remained 6.5:1, then the above ROE is more like 19.5% (run rate). This excludes any fee income from Annaly's asset management businesses.
It is not possible to know what Annaly will earn on its equity over the next several years, but I can tell you that with the curve as steep as it is (basically record steep in 2s/10s), the company is poised to crush it without needing to employ a dangerous balance sheet. If the curve were to normalize or even flatten, I'd be comfortable owning my Annaly - I believe Annaly is built to last. In addition to being battle tested over the last fifteen years, management is conservative by nature and maintain what I believe to be prudent leverage both in amount and structure.
Annaly has basically had the same management in place since its formation in early 1997. Their history has been characterized by foresight and thoughtful fund raising (issuing shares above book, such as they have done recently). In combination with incubating a few other REITs and business lines over its history, this habit of issuing shares above replacement cost has led to a modestly positive trend in book value per share over time.
Before going onto the risks of owning Annaly, I believe it's worth noting that Annaly's management is fantastic (albeit fully paid). They have been skeptics of the housing market, skeptics of counterparty risk, they manage interest rate and inflation risk aggressively by mixing fixed and floating rate investments, and they are conservative as to how much leverage they employ and how it's structured. They are considered the class of the Agency investment industry. They are also substantial owners of Annaly shares.
The primary risks facing Annaly are three-fold: 1) its lenders pull repo financing forcing Annaly into run-off; 2) mortgage losses are so great that the Federal government allows Fannie and Freddie to truly fail and does not guarantee their securitized obligations; and 3) the curve inverts and stays that way for a long, long time. I think all three risks are unusually low. Let's address each:
1) "Here comes the Repo Man" risk: Regarding repo financing risk, Annaly has dealt with this in a variety of ways. 1) they have no repo counterparty that represents more than 10% of Annaly's financing (so it's a diverse, albeit correlated, lending base); 2) the assets Annaly owns are considered incredibly high quality; and 3) they have built in a margin for Wall Street's mood changes by running with leverage well below allowable levels. Repo would almost certainly not disappear completely for Annaly's assets (though it got close in Fall 2008), but it could become less available meaning that Annaly's allowable leverage would decline. Given that Annaly is already substantially below the allowable leverage limit, allowable leverage would have to decline substantially before forcing Annaly to sell any of these assets. If Wall Street pulls repo on agency mortgages, we have reached something substantially similar to the depths of the 2008/2009 liquidity crisis. I believe in this world, a reasonably likely scenario is the Fed fills the breach to provide this financing via a new Federal Reserve facility. However, even without that, Annaly would likely go into run-off rather than blow-up.
2) "Oh Federal Overlords, why have you forsaken me" risk: As to the risk of the GSE's losing their government "guarantee", the Federal Reserve and the Treasury have both stated that supporting Agency obligations and providing liquidity to those markets is one of their top priorities (and have obviously acted accordingly). They view Fannie, Freddie, and Ginnie as key tools to keeping the housing debacle from going nuclear. Further, I absolutely cannot see the Obama administration cutting ties from existing Fannie and Freddie securities (nor can I see them letting Fannie and Freddie even stop wrapping new bonds without replacing them with some functional equivalent). The elimination of government guaranteed conforming mortgages would be the end of the U.S. housing market as we know it and I say that eyes wide open to the horror show going on in housing. Imagine what we've seen but two times worse. Further, pulling that guarantee would initially negatively impact existing middle income homeowner families who are the primary end customers of Fannie and Freddie subsidized loans, a politically unpalatable outcome. Finally, I think it would call into question the Treasury's "commitment" to paying off its explicit creditors, because to walk from Fannie and Freddie would be to forsake what many bond market participants consider a sacred vow and would be perceived as a last ditch effort to preserve the Treasury's ability to tap debt markets. This would likely precipitate the endgame for the current U.S. hegemony or, at least, for dollar reserve status. As a reminder, in order to qualify for an Agency mortgage, you have to actually make a down payment and document your income (crazy, I know) and thus the performance of Agency borrowers is far superior to subprime and Alt A (recognizing Ginnie is different). So even if the guarantee were to be officially killed, I believe Annaly's management team is best in class and will largely avoid most of the problem vintages (2005-2007), though certainly they'd risk meaningful losses. My best guess is you'd basically earn your way out to a book value or greater liquidation over time.
3) "Invert, Always Invert" Risk: Large and extended curve inversion risk - Annaly has easily handled prior flat/inverted periods (most recently 2005/06). I'm not at all concerned about a mild inversion. It would certainly take profitability down substantially, but it would not be remotely lethal. However, if we enter an inflationary Armageddon where Son of Volcker takes the short end into the double digit realm fast and without warning (or We The People completely lose control of the curve and Mr. Market plays the involuntary role of Son of Volcker), Annaly's funding costs will rise substantially, potentially obliterating its spread income. Fortunately, Annaly hedges about 35% of their non-equity funding from floating into fixed (which, in combination with approximately 15% of their investment asset being in floating or adjustable rate securities, gives about 50% of the portfolio reasonable interest rate protection, though the asset side is on a passed lag). I think with 2.5 - 3.0 turns of leverage subject to this risk, it is highly manageable even in an extreme inversion. In that environment, the reinvestment opportunity would also be increasingly attractive.
|Entry||02/03/2011 05:49 PM|
Well, if you do that in your own portfolio, you expose yourself to several different risks than Annaly (though, to be clear, you could also attempt to recreate Annaly's portfolio), including open ended risk, whereas within Annaly, you have limited risk to your capital in the REIT units.
As an aside, we have the exact flattener on that you referenced (2s/10s) due to its steepness but also two unusual characteristics that it has today: 1) near boundary conditions on the short side; and 2) positive carry.
I basically think Annaly at 1.1x book is a reasonable way to go after exactly the opportunity you described. At less than book it would be even better, but I think an owner will do well from my write-up's price.
|Subject||Interest rate risk|
|Entry||02/04/2011 06:28 PM|
Given that about 75% of the mortgages they hold are fixed-rate, won't the dividend get whacked when borrowing costs rise? They can compensate somewhat by increasing the balance sheet but it depends upon how much leverage the repo lenders are comfortable within the current environment.
|Subject||RE: Interest rate risk|
|Entry||02/07/2011 02:14 PM|
Thanks for reading my write up. "It depends" is my short answer.
So, 75% of the mortgages are fixed-rate, but they've also swapped a portion of the funding costs from floating to fixed, such that the impact (depending on where the curve moves) of a move up in rates only impacts half the portfolio. The spread is "locked" for lack of a better word on the other 50% (recognizing there is basis risk).
On the 50% that is not locked, that relates to about three turns of debt. Let's assume a reasonable stress scenario where the funding costs on those three turns rise to match the asset return, such that they receive 0% NIM on those assets.
2.35 * 3.0 turns of leverage + 0 * 3.0 turns of leverage + 4.35% * 1.0 = 11.4% ROE (before expenses)
11.4% - 90 bps of G&A = 10.5% ROE
At 1.1x book, that translates to a 9.5% yield, that I would expect would begin to migrate back up as they reinvest at a positive spread. Also, it wouldn't shock me to see them put another turn of leverage on in that world, offsetting some of the impact, but I wouldn't underwrite that outcome.
So, the longer answer is "probably": the dividend would probably be cut, "depending" on how much rates rise, how quickly it happens, whether Annaly changes its current cap structure, and whether the curve flattens, steepens, or moves in parallel. I think generally, given the somewhat low leverage today, we are more protected than Annaly's own average from the carnage a curve invesrion could wreak. but certainly it's there. I tried to be explicit in my third risk bullet that this is a risk, but that it's somewhat mitigated by their balance sheet positioning today.
My guess is, over time, we're able to clip 12-15% on this investment, base case. A broader band of 9 - 17% is certainly not out of the question. But from my perspective, that's not a bad range of likely outcomes. Of course, if you're a forced seller at any point, you can do much worse (and have option value to do much better if the P/B rose a lot), but from a lont-term hold perspective, I view this as an exercise in generally safe double digit coupon clipping.