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Annaly Capital Management, Inc. Message Board

  • bdinner bdinner Feb 25, 2010 5:06 PM Flag

    Graff's downside - part 1 of 2

    there is significant downside risk to NLY - I am significantly reducing my holdings of both NLY and MFA. I think these issues are known by the institutional investors and this is what has kept the price from rising more. But, when the next conference call and BVs come apparent I seriously think there will be a meaningful correction.
    Bill


    The most near-term issue is the potential impact of the recent announcement by Fannie Mae (FNM) and Freddie Mac (FRE) that they will be repurchasing all seriously delinquent loans out of their guarantee pools. Freddie will be doing this all at once on March 1. Fannie will phase it in over the next few months. Neither reports its delinquencies on a pool-by-pool basis, but it isn't hard to guess where most buyouts will occur -- in "affordability" mortgages, such as interest-only, adjustable-rate and hybrid-ARM pools.

    Prior to the announcement, most such outstanding pools were trading with dollar prices of $104-106. We can't tell to what extent, exactly, Annaly is holding such pools, but in its last annual report, the company said it had 21% of assets in adjustable-rate securities. I would suspect it also has a slug of fixed-rate interest-only paper. But even at just 21%, multiplied by 5.7 times leverage, the company has 119.7% of equity capital invested in GSE affordability mortgages. Hybrid-ARM paper is trading down 2% after the buyout announcement, so on that alone, the book value of Annaly's equity should decline by about 2.2%.

    The next major problem with this buyout announcement is it radically changes the duration of all higher-coupon MBS. A generic Fannie Mae 30-year 6.5% has been paying a CPR (constant prepayment rate) of about 20 over the last 12 months (implying that about 20% of the mortgage is being prepaid on an annual basis). Bear in mind that the borrowers within a 6.5% coupon MBS actually have a 7% mortgage rate, so that borrower has had an interest-rate incentive to refinance for a while now, but hasn't.

    Why not? Most likely, the borrower is either delinquent now or under water, so more likely to go delinquent in future. Thus, it is estimated that the CPR on high-coupon MBS will skyrocket for one month but then remain elevated because of subsequent delinquencies. Say the CPR goes from 20 to 30, which is in line with Street estimates, on a 6.5% MBS, the average life falls from 4.25 years to 2.78 years. Even at a more modest CPR of 25, the average life is 3.38, just about one year shorter. The math is similar for hybrid-ARM mortgages.

    This is problematic for two reasons. First, it means Annaly is suddenly over-hedged. It had hedges based on a 4.25-year cash flow that just became a three-ish-year cash flow. The bad news gets worse when you consider that four-year interest rate swap rates have fallen from 2.58% as of end December to 2.21% now. Falling rates mean rising prices, and Annaly is short as part of its hedge. So, the hedge is going against it at the same time as the value of its long portfolio is falling.

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