Annaly (NLY): Mortgage-backed buy

By Jack Adamo, editor Insiders Plus

I’m adding a third position to Annaly Mortgage Management (NYSE: NLY). We seldom do this; I think we’ve only had three positions in a stock twice in our history. However, Annaly is performing very well, as my update later will show, and the market is warming to it.

Investors are expecting the Fed to stop buying mortgage-backed securities, which would lessen competition for them, giving NLY a chance to get them at better prices.

I’m skeptical that will happen. I think the Fed will change its mind and stay in the MBS market. If that happens, the stock might take a hit. But if I’m wrong and the Fed really does back out of the MBS market, Annaly could have a very nice run and be one of few stocks anywhere doing well.

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We’re being fairly aggressive here, considering the recent climate.If you’re feeling timid, I certainly wouldn’t call you a coward for being tentative here, but if I can get quality companies that are leaders in their industries, I’m willing to take a little chance on them.

Meanwhile, Annaly Mortgage reported Q4 Core Earnings of $0.79 per share shareholders as compared to $261.8 million or $0.47. On a GAAP basis, net income for the quarter was $729.3 million or $1.31 per share, compared to a net loss of $507.0 million or $0.95 per average share last year.

The core earnings exclude things like variations in rate swaps, plus gains and losses on securities sold. The earnings ex-items are more relevant and very satisfactory indeed. On a Core Earnings basis, the company provided an annualized return on average equity of 18.5%. On a GAAP basis, it was around 30%.

Leverage at December 31, 2009, was 5.7:1 compared to 6.4:1 at December 31, 2008, and 6.0:1 at September 30, 2009. That means the company delivered better earnings, while taking less risk. Leverage is less than half of that in commercial banks considered well-capitalized by the Fed’s criteria. All of the company’s investment securities were Fannie Mae, Freddie Mac and Ginnie Mae Mortgage, which have explicit government guarantees now.

After taking into account the effect of interest rate swaps, at December 31, 2009, the MBS portfolio was comprised of 39% floating-rate, 21% adjustable-rate and 40% fixed-rate assets. Since the company’s cost of funds is variable, a lower level of fixed-rate assets is safer. The level is a little higher than it was last quarter, but is still comfortable, especially since the company reduced its leverage.

The constant prepayment rate was 19% during the fourth quarter of 2009, as compared to 10% during the fourth quarter of 2008, and 21% during the third quarter of 2009. The weighted average cost basis of the company’s investment securities was 101.5 at Dec. 31, 2009. 

The prepayment rate is the proportion of loans that paid off their balances early, presumably, to refinance at a lower rate. That average cost basis above par of 100 represents the company’s exposure to write-offs if its mortgages are prepaid. As you can see, that 1.5% risk is much lower than the return the company is earning.

The risk of prepayment is minimal in my opinion. Given credit conditions, it is unlikely rates will go lower. The stock’s book value at year end was $16.95 per share, so it’s selling at just 6% over book value. Cheap indeed.

This remains one of my favorite companies. Management is one of the savviest and most forthright I’ve encountered.

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