High Yields at Annaly Capital
Richard Sloan
Summary of Business Strategy
Invest in high quality mortgage backed securities (MBS)
Generate income by leveraging the spread between the interest earned on MBS portfolio and cost of borrowing on repo market
Structured as a real estate investment trust (REIT), avoiding federal income tax on distributed income
Key Success Factors
Expertise in evaluating and managing MBS portfolio Invest primarily in Agency MBS that carry an implied AAA credit
rating Utilize leverage to increase potential returns to stockholders Structure borrowings to have interest rate adjustments that
correspond to MBS portfolio Minimize prepayment risk through diversified portfolio Minimize interest rate risk through hedging in derivatives Opportunistic issuance of equity and debt to exploit market
opportunities
Key Risks
Prepayment risk (e.g., interest rates fall, MBS paid off early, have to reinvest in lower yielding MBS)
Interest rate risk (e.g., interest rates rise, borrowing costs increase, but still invested in lower yielding MBS)
Credit risk (e.g., U.S. government decides not to support Fannie Mae and Freddie Mac)
Volatile market conditions/contraction in liquidity for MBS
Yield Curve in 2011
= 2011
Interest Rates in 2011
10 Year T-Note
5 Year T-Note
Why Did Annaly’s Income Decline in 2011?
Large unrealized losses on interest rate hedges as interest rates fall
Underlying Economic Performance
Main difference between net income and comprehensive income is unrealized gains on MBS portfolio due to drop in interest rates
Note that Annaly hedges against the effects of such interest rate changes, booking a $1,815,107 unrealized loss to net income on its interest rate swaps (see previous slide)
The unrealized loss on the interest rate swaps is approximately offset by the unrealized gain on the MBS portfolio, making comprehensive income a better measure of underlying performance
Dupont Analysis(click for computations)
Advanced Dupont Analysis
Inputs 2011Effective Tax Rate 14.68%Net Financing Expense 426,689Net Operating Income 2,615,496Net Financial Obligations 76,978,466Net Operating Assets 89,614,149
AnaysisRNOA 2.92%Net Borrowing Cost 0.55%Leverage 6.09Spread 2.36%ROE 17.32%ROE (check) 17.32%
Reconciliation of Spread and Leverage
Annaly Us Primary Explanation
RNOA 3.70 2.92 Annaly uses only interest income, while we net out operating costs
- Borrowing Cost
1.61 0.55 We use only interest expense, while Annaly includes realized losses on interest rate swaps
= Spread 2.09 2.36
Leverage 5.4; 6.7 6.09 Annaly defines equity as fair value of investment portfolio less book value of collateralized borrowings
Major reason for decline in 2011 cash from operations
The major difference is an approximately $10 billion decline in the net proceeds on repurchase agreements with Broker-Dealer
Since repurchase agreements are a form of financing, this is not a cause for concern, but simply indicates that Annaly chose not to raise capital using this channel in 2011
Evaluation of Investment Opportunity
Annaly has identified a profitable ‘trade’ and hedged key risks, so 10-15% return is likely locked in for the duration of the current portfolio
But market conditions are likely to change and competition is likely to drive down spreads on MBS
Can view high recent returns as a ‘premium’ for managing risks associated with MBS through turbulent times