Annaly (NLY) took a big step last week toward becoming an ETF all by itself.
Under replacement CEO Wellington Denahan-Norris (formerly Chief Investment Officer and then co-CEO as Mike Farrell fought his cancer), Annaly decided to bid for all the shares of its commercial mortgage REIT, CreXus (CXS). They already owned a majority share, and already provided a significant piece of Crexus’ financing, so the exposure hasn’t really changed much for the monster (over $140 billion in assets) Agency MBS REIT, Annaly.
It makes economic sense for a mortgage REIT to buy its stock whenever it trades significantly below book value, since that increases the yield for existing shareholders and supports the stock price. The negative is that it decreases the capital supporting the portfolio. In this case, the $840 million price tag for the commercial mortgage REIT is less than NLY gets in principal paydown every month from its Agency MBS portfolio.
While making the argument that it’s only pennies for the mostly-Agency NLY holds water, the announcement that NLY will allocate up to 25% of its equity toward non-Agency paper means a major strategic shift is underway.
Along that line, in spite of the generally negative tone in the market, the shares of Annaly’s other non-Agency mREIT Chimera (CIM) took a healthy jump higher, and followed through on Friday’s rise nicely, with more than a 7% jump in price today. For those unfamiliar with the CIM portfolio and strategy, I recommend a post from a couple of years ago that describes how this non-Agency (private label) residential mortgage securities REIT operates.
Given the questions raised about Chimera’s true value and complexity of its subordinated, structured, private label MBS, it makes sense that Annaly’s obvious preference would be to buy CIM’s $10 billion in assets if they want to bet on that market.
The Upside and the Downside
On the upside, NLY will now have some built-in diversification benefit among the (highly correlated) segments of the mortgage market. I would characterize their new path as becoming a stand-alone mREIT ETF.
The downside is that we will most likely have even less transparency from NLY. For example, it will take some doing to figure out exactly how much capital is allocated to each sector if the company tells us only how many assets fall into each category, and not what borrowing arrangements they have in place to finance them.
The market cap of the three companies (NLY, CIM and CXS) is $14.5 billion, $2.8 billion, and $950 million, respectively. Should the three be combined by selling off MBS in NLY, or letting natural runoff take effect to raise cash for the purchase, we can see that the target of 25% or a bit less of capital dedicated to the non-Agency MBS, that can be achieved by simply merging the three as they stand now.
After a potential merging of the portfolios, NLY will continue to be the largest player in the market, though Gary Kain’s AGNC has hit the secondary issuance window so often that it now has over $100 billion in Agency MBS assets, and market cap just over $10 billion.
Right now, NLY has $14.5 billion market cap (a decent proxy for equity capital at today’s price-to-book ratios) supporting $141 billion in MBS. That’s a back-of-the-envelope ratio of $10 in assets for each dollar of equity. Over in CIM, the $2.8 billion market capitalization is associated with just under $10 billion in assets, for an approximate ratio of 4 to 1. CreXus has even less leverage, though in future it may be able to finance at higher ratios. For now, we’ll assume 2 to 1, since we can’t see inside the intercompany lending CSX is using right now. So there you have it… a merged entity would look like it was well over 90% Agency (government-guaranteed) paper if you looked at assets, but its equity would be allocated more like 75/25.
Given the lack of liquidity in the underlying holdings of CSX and CIM, we could expect the new NLY to be a simple bet on the sector more than an investment in a given strategy by the management team.
So that’s why I will think of NLY as a mini-ETF once this change is complete.