The Fed would antagonize not only the Administration by raising the short rate a little (which is all that they could do in a weak economy), with the Pres hoping to have jobs increasing going into the election, but would also antagonize the far Right that wants rates higher than anything the Fed might do now to ward off inflation.
The Fed will hold the rates as low as they can, which is the current low level.
Merrill predicts the long rate coming down a little (increases NLY BV with reduced spread) til about mid year, and then rising as the gen economy shows mild recovery (increased spread as the Fed holds rates low).
The Jefferies analyst must be completely ignorant of Fed behavior concerning Presidential elections, or more likely working a devious agenda.
Jack, Jeffries cited the spread as the reason. However, this is nothing but a coin toss. Either short terms rates go up or they don't. Jeffries says they will, Merrill says they will not.
Heads or tails.
Personally, I think it is waaaaay to early to boost short rates. This is just January optimism. There's yet another unemployment report around the corner, and reality will revisit us.
And the elephant in the room: banks are holding a massive amount of foreclosed properties.
Jefferies downgraded to Hold today (no explanation provided) and reset target to $15 (again no explanation provided). This target and rating are inconsistent with the bulk of other rating, but the fact is they all analysts have an ax to grind and none are trustworthy more than once a day, if that frequently.
I am waiting on the AGNC shares bought at $28 to hit the market, and then it might become available around m$28 and a few cents.
Picking up on our discussion the other day, I see where there is an article on NLY on Seeking Alpha. The author comments on some of the points you raised above:
Annaly Capital Management
Annaly only invests in relatively risk-free assets that are guaranteed by Fannie Mae (FNMA.OB) and Freddie Mac (FMCC.OB). These agency backed mortgages make up nearly 93% of all of Annaly’s assets. Annaly’s earnings should be relatively stable given their near-guaranteed nature. Annaly uses borrowed money to purchase these mortgage assets. There is one problem: in an environment of rising rates, it will be likely that short term rates are going to rise faster than long terms rates and the yield curve will flatten. This means Annaly’s margins could be squeezed. Annaly’s management team has adopted a policy of using interest rate swaps and other derivatives to manage this interest rate risk to preserve cash-flows, as well as the value of their portfolios. In the event of a 0.75% increase in short-term rates, Annaly’s portfolio income is estimated to decrease 6.78%, and the value of the portfolio is expected to drop 0.84%.
A 6.78% drop in income from current holdings as well as the potential for a decreasing spread on future investments suggests that Annaly’s yield will eventually drop due to increasing rates - that is, unless they can increase leverage ratios to make up the difference. Increasing leverage ratios due to rising interest rates would only be a good idea if accompanied by a healthier economy and a healthier housing market. Also, Annaly is already levered 8.61:1 (they report 6.3:1). This is a high ratio, but given that their income is relatively stable and carries an implicit (and now explicit) government guarantee, that may not necessarily be bad or unsustainable. It does, however, limit how much they can increase leverage ratios to make up for income.
Your comments show you understand the mechanics as well as I do, as a non-professional for REIT mortgage investing.
But in answer to your question about why the NLY share price would drop with a decreased spread, even though NLY could moderate the decrease with additional leveraging (and also they do hedging, as does Linn), there is a very important general market behavior to be expected that we all know about, but tend to ignore or forget.
Technically, the market is not well described by linear math, but instead well described by nonlinear dynamics, in which each behavior serves as a feedback mechanism into the system and inescapably magnifies small movements (that may be logically appropriate to the triggering event, such as a 1/4 point increase in the short rate) into a cascading avalanche. A simple physical model is offered by the experience of placing a microphone too close to speakers, so that the sound going into the mic comes out amplified by the speakers, then back into the mic until the system blows up.
Market reactions to rumors or real events always feed iteratively on their own effects, thus exaggerating the rational importance of the triggers. The use of computers in modern trading that trades off of small tic trends further amplifies what used to be mere human over-reaction. It's generally believed that the Flash Crash was triggered by a computer trading amplification of a small trading system report error.
There is that good old saying about not fighting the tape, and another one that the market can behave irrationally much longer than you can expect to be reasonable. So, if one were not on margin, and not actively trading, then you can likely ride thru the cycles in interest rates for the long term, and in an IRA compound dividends to great wealth. But otherwise, you get out, before the "crazy" huiman traders and computer model-driven trading cause over-rereaction, typically more on the down side (fear and margin calls) than on the upside (that experiences profit taking on rises).
Thanks for taking the time to write out such a descriptive note. I admit, even though I knew about the mark to market situation, I was not familiar with the short term borrowing base explanation your provided. Thanks for the eduaction. I was particularly caught by your statement at the end of the mid paragraph:
"Thus, the short term efffect of rising rates is to decrease earnings, earnings potential, and the dividend payout. Down goes the price, and up goes the nominal yield."
I dont know whether the drop in dividend payout correlates to the increase in nominal yield (as one or both could happen); however, the statement begs for a followup question given my experience with LINE:
OK, so do you think the PPS of NLY may fall in the short term in reaction to an increase in rates, but NLY can keep paying the high current distributions based on their ability to leverage with short term borrowing? In that case, the nominal yield would ratchet up and the question becomes whether NLY's PPS will recover when rates stabilize at a higher level (a rate that NLY adjusts its business model to)?
I know this is a long winded discussion, but I would love to find out whether NLY might offer a repeat of the LINE story between spring 2008 and spring 2011. For example, and as I said before, I followed Linn several years ago buying around $20 before it fell to $13 in October. At that point I somewhat boldly (for me) more than doubled-down because the nominal payout was then 17% and I expected the hedges to allow Linn to hold its 2.52 payout and "gravitate back" to the higher price. As luck would have it, this is precisely what happend.
From your note, it sounds like IF NLY's short term borrowing potential can allow NLY to keep the current payout alive at a nominally higher payout ratio, then the same "price dip" experience in Linn may play out similarly in NLY? Sound right? If so, it is not bad to hold on through the trough vs selling (and/or to double down if the payout shoots above 20% as could happen here if the price dips to $12.50 and they hold the $2.56 distribution).
Indeed, the situation might present a great opportunity like the October 2008 Linn story.
Is this a realistic possibility, or am I dreaming?
thanks again. Lex
No "master" I, or I would be at my beach home in the Bahamas instead of cold Vegas.
Investments that pay out a high proportion of income are considered to be low grade, because they do not retain the cash to carry them thru down turns in the economy, their sector, and their own specific business. As their risk is above average, then so musrt their yeild be above average to compensate for that higher risk.
NLY is actually a bit tricky as an investment. Ii invests in Fed backed, fixed rate, high rated mortgage pools, so that provides lower risk for payer default. But as with any long term bond or bond like investment, when long rates go up, the market reduces the trading value; it marks to market on the lower value, and shows a paper loss, (similar paper accounting hit on Linn too when commodity spot pricing goes higher than its hedge values). If held to maturity, there is no real loss, but it looks bad (witness on the NLY yahoo board today a host of posts displaying total ignorance of this accounting procedure, but claiming to see and understand that NLY showed a loss in their last earnings report, and you can bet a bunch of these folks cleverly shorted from ignorance).
Generally, the short rate can move up faster in an inflationary environment than the long rates, so short term borrowing that NLY uses to leverage its equity starts to lose the srate spread that creates profits. Since book value is also going down with higher long rates, NLT borrowing capacity is crimpted, making it harder to make up for the lower spread by borrowing short to catch the available (albeit smaller) rate spread. Thus, the short term efffect of rising rates is to decrease earnings, earnings potential, and the dividend payout. Down goes the price, and up goes the nominal yield.
However, as mentioned in the BoF A upgrade, NLY is using a historically low (fdor them) amount of leverage, so that it expects to have borrowing capacity, even with lowered book value, to lever up when the rate spread narrows to compensate for the smaller profit spread. Also, the long term mortgages also get sold, and as high grade, the principlke is returned without the loss that mark to market accounting had (falsely) registered. THe returned capital is reinvested at a "healthy" spread, and life goes on for NLY.
THe issue for traders and relatively short term investors is what is the timing for the Fed to be raising the short rates. My guess based on the politics of the Fed is that we will not see any increase until the next administration is in office, and not then if the housing market has not shown recovery; with the large overhang of inventory and scarcity of mew jos and moving, and insecurity for many job holders, I think the Fed is trapped into holding the short rates very low for at least three years, and perhaps much longer.
Best of luck.
MSN, I have no email address for you, but mine is displayed in my yahoo ID.
Jack: I see your notes on NLY and that is another holding of mine as well.
I have a question that I would like to hear a "seasoned investor's" response to related to NLY. Why do you think the investment community gets so excited, in a negative way, about the impact of interest rates rising upon NLY's business? I understand how NLY's business works with yield spreads, but "for crying out loud" NLY's payout is in the 15% range and if its earnings got cut in half, it would still be one of the highest dividend players/payors around. So why all the excitement?
Several years ago when I started following LInn, before the PIPE overhang issue was worked through, I kept reading how, over the long term, LINE would gravitate to a 8% distribution payout price (about twice the rate of a regular dividend payor because of the ordinary income treatment on distributions). Why doesnt the price of NLY gravitate to a similar point?
Would love to hear your reactions. I trust I have a feel for a few remarks you will make, but want to hear them unfettered from the master.....
Your jaundiced perspective about NLY's earnings potential in the current economic environment is contradicted starkly by the BofA/Merrill analysis released after NLY's recent equity sale:
" NLY could increase leverage to raise returns
We forecast that NLY will pay $2.60 in dividends in 2011, generating a 20%
return for investors based on our $18.50 P.O. We are raising our ’11e Core EPS
to $2.60 from $2.45 to reflect wider spreads on new investments and greater
expected leverage. The steep curve has created a favorable investment
environment in NLY’s target assets, in our view, and we expect the company to
be able to generate returns approaching 20% on new investments. NLY’s 6.3x
D/E ratio is low relative to historical standards and its peers. We believe that its
conservative use of leverage provides it with the opportunity to protect its
earnings by increasing leverage if investment returns tighten. "
As between your perspective and Merrill's, although I am reluctant to place any trust in Merrill (with higher confidence after the equity sale was completed), I think they have a better grasp of NLY's perforance prospects.
Curious why you keep writing about NLY when you say your objective is trading, but NLY is too boring of a trade?
As I said, it needs to be discussed in due time. YOu can't price mortages at the same price as 10 year treasuries. While we are quite there, it is getting closer and closer and that was never the intention of the free market in MBS system. It has to be addressed. The risks should be distinguisable, but okay if NLY is writing about it, there is something there to think about anyway. I didn't say it was going away tomorrow. I would much rather play in the non-agency MREITs anyway, IVR, as an example. Even AGNC carries some non-agency RMBS and other paper. NLY is too close to the government model in my opinion and now it is too large. Let's see the earnings and have the debate later. Right now, I won't touch NLY. I won't buy any of it until I see the earnings report.