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Annaly Reversing Slump as Denahan Tries to Dodge Fed: Mortgages

By Heather Perlberg
February 19, 2013 4:45 PM EST
Fed efforts to push down borrowing costs have been dented this year by improvements in the economy and improvements in dealing with Europe’s sovereign debt crisis.
Photographer: Andrew Harrer/Bloomberg
Fed efforts to push down borrowing costs have been dented this year by improvements in the economy and improvements in dealing with Europe’s sovereign debt crisis.

Annaly Capital Management Inc. (NLY) is clawing back from its worst quarterly performance in more than 7 years as the largest real estate investment trust that buys mortgage debt seeks to sidestep the U.S. Federal Reserve’s interference in credit markets.

Chief Executive Officer Wellington Denahan is buying Crexus Investment Corp. (CXS), a commercial mortgage investor, increased the firm’s use of borrowed money after Fed Chairman Ben S. Bernanke said in September he would keep acquiring home-loan bonds to push down home loan costs, and repurchased shares. She assumed the top job in October as Annaly’s former head and her co- founder Michael Farrell was dying from cancer.

“Annaly is not taking the Fed head on; they are making an end run around,” said Merrill Ross, an analyst with Baltimore- based Wunderlich Securities Inc.

The firm, which largely buys government-backed residential securities and oversees about $133 billion of assets, lost 17 percent in the fourth quarter, leading the decline of a Bloomberg index of 32 REITs, as Fed efforts to stimulate the economy narrowed bond yields, made it easier for more Americans to prepay mortgages and raised investor concern that REITs would need to cut dividends.

Those concerns have faded as the economic recovery gains momentum, pushing up bond yields that guide mortgage rates. While Annaly has risen 8 percent this year, it’s still trailing the 11 percent gain for the overall index as competitors also diversify investments.

‘Strategic Shift’

“There is a strategic shift happening at many of these companies so their pricing isn’t being dictated by the Fed buying bonds,” Ross said. “They are looking to less competitively bid assets, like commercial mortgage backed securities and private label securitizations.”

Annaly, which already owned 12.4 percent of Crexus, said in January it agreed to buy the rest for about $872 million. The firm also repurchased shares and limited selling in its portfolio by increasing the amount of borrowed capital from 6 times to 6.5 times last quarter, according to Bank of America Corp. (BAC) analysts.

”The Crexus transaction is a bigger step to more aggressively broaden our business,” Denahan said in an e-mail. “In the past 12 months, we’ve lowered our cost of capital dramatically through the issuance of preferred equity and convertible debt, extended the duration of our borrowings, and repurchased common stock at accretive levels for our shareholders.”

Industry Negative

While Annaly’s decision to diversify “makes perfect sense,” said Daniel Furtado, an analyst at Jefferies & Co. in San Francisco, “it’s a negative indictment on the industry,” and signals this could be a difficult business for a long time and Annaly is trying to get ahead of that.

“It’s like the Yankees saying they are going to diversify out of baseball,” Furtado said. “They’ve been through a housing boom and bust, the technology bubble, an inverted yield curve and very high prepayment rates which are horrible for this business, and in all those challenges they’ve never felt the need to diversify away from the pure agency strategy.”

Annaly (NLY) has returned more than 600 percent to shareholders since its 1997 initial public offering, outpacing gains of about 108 percent for the Standard & Poor’s 500 index. The company rose 0.3 percent to $15.21 in New York and is yielding about 11.8 percent.

Denahan, who served as the company’s vice chairman, chief operating officer and chief investment officer before rising to CEO, has faced a series of challenges in her latest role.

Selling Accelerated

Investor selling of mortgage REITs accelerated after the Fed in September started acquiring $40 billion of mortgage bonds a month to boost the economy. The prospect that more homeowners would refinance fueled concern the companies would be forced to write off the premiums they paid for bonds faster and reinvest at lesser yields. That in turn, raised the likelihood Annaly and others would need to cut their dividends.

Issuance of home-loan securities backed by Fannie Mae, Freddie Mac or U.S.-owned Ginnie Mae, which are financing about 90 percent of new lending, totaled $1.7 trillion last year. The Fed bought about $500 billion in 2012, driving rates on typical new mortgages to record lows and helping drive the housing rebound.

“The Fed’s buying has just replaced the Fannie/Freddie dominating presence of the past,” Denahan said in the e-mail.

Fed efforts to push down borrowing costs have been dented this year by improvements in the economy and improvements in dealing with Europe’s sovereign debt crisis. Yields on Fannie Mae-guaranteed debt trading closest to face value have risen to 2.63 percent from a record low 1.68 percent on Sept. 26, according to Bloomberg data.

Slowing Prepayments

The policy concerns that caused REIT stocks to sell off aggressively last year have faded, and rising rates, last week holding steady at a five-month high, are slowing prepayments and benefiting the companies, according to Furtado.

The average 30-year mortgage rate was 3.53 percent last week, unchanged from the previous week and the highest level since September, McLean, Virginia-based Freddie Mac said in a statement.

“The worst for the REITs should be behind us,” said Michael Widner, an analyst at Baltimore-based Stifel Nicolaus & Co.

Even when the Fed pushed down rates, firms including American Capital Agency Corp. (AGNC) also demonstrated “they are willing to be very opportunistic about taking incremental yield anywhere they can find it,” he said.

Financing Opportunities

American Capital, the second-largest mortgage REIT, has gained 13 percent this year. The company has taken advantage of favorable financing opportunities and repurchased stock in November when the firm’s shares traded at a significant discount, chief executive officer Gary Kain said during a conference call with investors this month.

Renewed investor demand has also spurred companies including American Capital Mortgage Investment Corp. (MTGE) and Armour Residential REIT Inc. (ARR) to announce $1.7 billion in new equity offerings this year, according to a Feb. 14 Bank of America Corp. report.

Additional equity raising by companies “would create a timely source of demand for mortgage-backed securities in an environment where banks remain on the sidelines waiting for rates to stabilize,” Credit Suisse Group AG analysts led by Mahesh Swaminathan wrote in a report last week.

Easing End

While momentum for REITs may be picking up again, the companies will probably reduce their use of borrowed money sometime later in the year as they start positioning for the end of the Fed’s so-called quantitative-easing stimulus strategy, Morgan Stanley analysts led by Vipul Jain wrote in a report last week.

“We are still penciling in an aggregate decline for REIT holdings this year,” Jain wrote.

Annaly will have limited net purchases of agency RMBS going forward, even though spreads have widened on the margin from depressed levels in the fourth quarter, Ross of Wunderlich said. It’s acquisition of Crexus will also see an end to the company buying back shares as more attractive opportunities open up in commercial mortgages, she wrote in a Feb. 8 note.

“The firm is likely to avoid head-on confrontation with the large scale asset programs of the Fed,” Ross said.

To contact the reporter on this story: Heather Perlberg in New York at hperlberg@bloomberg.net

To contact the editor responsible for this story: Rob Urban at robprag@bloomberg.net

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