The Risk To Annaly

I believe that Annaly Capital Management is attractively valued as it currently trades below book value. However, there are risks due to prepayments. Prepayments rise when people refinance their homes. Recently, we have seen a wave of refinances due to record low rates. If President Obama institutes a refinance program that allows underwater homeowners to refinance, prepayments are likely to rise much further. From the WSJ:
Some homeowners are beginning to refinance their residential mortgages faster than expected in response to falling long-term interest rates, causing a chunk of the $5 trillion in mortgage-backed securities to slump in secondary markets.

Prepayments on 30-year fixed-rate loans, the return of principal when a loan is refinanced or withdrawn from the MBS, jumped nearly 30% last month, Fannie Mae and Freddie Mac said late Thursday. That was well above forecasts of a 20% rise, though was focused on newer loans with lower interest rates to borrowers with better credit, according to strategists at Morgan Stanley and Credit Suisse.

The risk to Annaly is that bonds they are holding that trade above par will be redeemed at par. From the Annaly 10-K

An increase in prepayment rates may adversely affect our profitability.

...when borrowers prepay their mortgage loans at rates that are faster-than-expected, this results in prepayments on mortgage-backed securities that are faster than expected.  These faster than expected prepayments may adversely affect our profitability.

...While we seek to minimize prepayment risk to the extent practical, in selecting investments we must balance prepayment risk against other risks and the potential returns of each investment.  No strategy can completely insulate us from prepayment risk.

I believe the discount to book value gives one  a margin of safety in Annaly. I currently don't own the shares but would likely repurchase the shares if they dipped to last week's lows. I look forward to hearing more about Annaly's prepayment risk on the earnings conference call.

8 comments:

Anonymous said...

I would not touch them asymmetric risk /reward 1. refinance risk with the potential for gov action.  2. SEC risk making passive reits governed by the 1940 investment act (no 6x leverage). 3. Repo risk for funding crisis as no doubt they have exposure to french banks, investment banks etc 4. Premium amortization will increase on refi's and lower reinvestment risk 5.  Curve flattening
Why play a company that has no business model just because its below book when almost every bank and life insurance company is?

Monday links: ROL not ROI | Abnormal Returns said...

[...] The risk of mortgage refinancing for the mortgage REITs.  (Capital Observer) [...]

Tsachy Mishal said...

A few things
1) This companies book value is indisputable. Who knows what the banks/brokers hold?
2) The SEC is not looking at REITs holding agency securities rather synthetic products. Does not effect Annaly
3) If agency securities cant be repo'd every bank in the World has gone under
4) Curve flattening might lower the yield but why should one be able to buy agency securities below book regardless?

Tsachy Mishal said...

A few things
1) This companies book value is indisputable. Who knows what the banks/brokers hold?
2) The SEC is not looking at REITs holding agency securities rather synthetic products. Does not effect Annaly
3) If agency securities cant be repo'd every bank in the World has gone under

4) Curve flattening might lower the yield but why should one be able to buy agency securities below book regardless?

Anonymous said...

1.  I don't disagree on mortgage reits book value but only in the sense that "trading below book value" means they are cheap, or that represents an attractive entry point for a company that has not business model and basically is arbing the yield curve.
2.  As I understand it the SEC is looking at three things one of which is derivatives however another is the exemption from 3 (c) 5 (c) regarding leverage.  I think worse case NLY, AGNC and the others are grandfathered in but this is a risk that if enacted would effectively end the company's existence.
3.  Its not about if agency mbs can't be repod its about increasing haircuts from 5% to say 7-10% and what that would do to the passive reits.  First it would hit book value aka equity and they would have to post more equity (I believe this is what happened to IVR) then collateral and also there would be an unwind.  If you talk to NLY or anyone else its not the whole portfolio that is repo'd it is a portion of it so maybe 20% of the portfolio has leverage at 15x versus 85% with lower leverage.  They would not be able to post enough equity and thus would have to unwind some MBS.

Tsachy Mishal said...

I think the chances that the repo market gets so bad that Annaly is effected is remote. They are not highly levered and it did not happen in 08'. Nothing is safe if that happens.

Tsachy Mishal said...

Give me a 10% discount to book and Ill take my chances

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