You can make money just like NLY, so for illustrative purposes, here is how it could be done: Assume that JP Investor sells a $100,000, 30-year, 5 percent mortgage to NLY. NLY invests $20,000 of its own money and arranges a six-month, $80,000 loan from the Fed at 2 percent. The 5 percent mortgage pays NLY $5,000 in interest, NLY pays the Fed $1,600 in interest and the spread between the two ($3,400) is income to NLY, which is a l7 per cent gain. Now NLY after paying overhead pays a dividend to shareholds at 15.5%. This is easy way to see how NLY makes money.
Now another way for shareholders to increase income is to buy shares of NLY but rather than paying cash, you borrow on margin half of the needed funds to buy 1000 shares of NLY.
Lets say for illustration a 1,000 shares of NLY pays a dividend of $2,720, while interest of 5 percent on the borrowed half of NLY 1000 shares is $8,750 and it will cost you $438. So the difference between your interest income ($2,720) and your interest costs ($438) is $2,282. And on an investment of $8,750, that’s almost a 26 percent annual return. That’s a bankable and guaranteed return as long as you can borrow money at 5 percent and as long as NLY pays a dividend of $2.72 per share. This is called leverage, and holy moly, it certainly beats buying 1,000 shares of NLY for cash and earning a middling l5.5 percent. This is an example that was published back around mid 2011. Now lets say a large number of investors made this very same kind of decision when they bought NLY. IMO, I think this did happen and now those people are receiving margin calls requiring them to sell NLY to cover their loans. I submit that this activity has happened, likely in the last two weeks thus those of us Long NLY are seeing continued pressure on the stock.
Fannie, Freddie wind-down will cause upheaval
As Annaly management notes in its 10-K, the idea to unwind Fannie and Freddie was first floated by the Treasury Department in early 2011, in a white paper regarding housing finance reform. As an entity that invests primarily in mortgage-backed securities backed by these government-sponsored entities, any change in the status of these behemoths would have an impact on Annaly and other pure-agency mREITs, such as American Capital Agency and Armour Residential .
Lately, the changes to those GSEs have been accelerated. Just this week, Edward DeMarco, the acting director of the Federal Housing Finance Agency decreed that the two must work together to create a new, joint company that will securitize home loans for a fee. This new entity could end up being either public or private, depending upon which way the political winds blow.
Since the two GSEs currently insure about 90% of all home loans being written, shutting them down, no matter how slowly, will cause issues for mREITs. As Annaly points out, market uncertainty pursuant to this process can easily cause market jitters that could decrease the value of the company's holdings. Not a good thing, of course, since it is these very securities that Annaly, American Capital Agency, and Armour use to secure financing with which to invest further.
I think most people are selling out of the "unknown". That meaning how much book value is going to disappear once the impact of the rapid rise in mortgage rates is reflected in the unrealized loss column. While this does NOT impact TAXABLE income (which is what the dividend is paid from) it DOES affect the stock price dramatically since the price normally tracks fairly closely to book value. The stock has lost about $4 Billion in market cap since May so the market is clearly expecting substantial book value loss as NLY is forced to write down the value of the MBS portfolio from the recent dramatic increase in mortgage rates. Impossible to know the outcome until earnings are released since there are multiple hedges to mitigate the impact, different coupon securities decline more than others due to rate increases etc.
The flip side is interest income should increase from the higher rates so the dividend should be reasonably safe but again impossible to know until the results are in.
Margin calls are undoubtedly part of the reason for the decline but the sudden rise in rates and the havoc it plays on MBS values in the portfolio is driving the selling in my opinion. Until rates stabilize ( I have a hard time seeing them going much higher and feel most of it is a knee-jerk reaction to the Fed "tapering") the share price will remain under pressure. Uncertainty is the rule of the day and that breeds selling.
If the Fed would make a clear statement of when they plan to actually reduce bond purchase that would help also - right now everyone is trying to outguess them and the jobs report convinced a lot of people that the taper would begin sooner rather than later. That's what led to the big spike in mortgage rates and precipitated the big selling day for NLY and AGNC on Friday.
You do have a good point. But what worries me is the possibility of NLY itself going bankrupt because of all their margin purchases. And as they keep lowering their dividends, stock price drops even more, creating a vicious circle. But, if you really believe that NLY will not go out of business, then perhaps another way to play this is to buy lots of call options. It is another way to buy NLY at the cheap. If NLY goes back up to say around 15-17 within the next two years, your call options will become much appreciate to a much higher price than what you paid for. Any thoughts?
According to Yahoo, NLY Jan. 2015 15 calls are between .34 and .36. Let's say you bought 100 contracts at .35 for a total of $3500. If (and that's a big if) NLY rises to say 16, your options would be worth upwards of $150,000. Of course, time plays an important role in option's pricing. All feed backs are welcomed.