Becoming an ETF

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.

hh

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3 Responses to Becoming an ETF

  1. Just to let you know I read it. Don’t even have CIM on screener anymore.

  2. Dan Berman says:

    Howard, would love to know if there are any MReits you think are worthwhile right now. The experts
    at Value Forum seem mostly negative, though a few like DX or MITT or AGNC or AMTG. Myself I’ve sold
    most of my MReits, but I have a fair amount of MReit preferreds paying 7.5 to 8%

    • hhill51 says:

      The preferred stocks won’t have even a whisper of risk to their dividends until 2015 or 2016, given what’s up with the Fed. The commons have their current issues with spreads being squeezed, and the BIG issue of extension and capital hits once the long end of the curve heads back toward 6%, a virtual certainty at some point in the next Presidential cycle, assuming the economic recovery continues. Kondratyev wave theory says it should, for what that’s worth.

      I like the ones with better management teams, so in non-Agency, the cream of the crop is Angelo Gordon, while Kain’s team seems to best at the Agency MBS game. They do play it for trading profits, but with several years now of showing they can get out of the way when trouble develops, they are doing well. On the other hand, they’ve now got $100 billion, so that has the supertanker steering problem. It’s time to take a closer look at their hedges. Maybe I’ll try to ask on the next conference call, or one of the Street analysts that follows this blog can ask…. the way I’d put the question is to ask how heavily they have invested in gamma and vega in the 5-into-10 swaptions. Put into ordinary investor English, what I’d want to know is the face amount vs. portfolio of options to execute pay-fix/receive LIBOR swaps for the five-year periods beginning in 2016 and out through 2018 (and therefore running to 2021 through 2023).

      The big problem with today’s MBS market is that it will extend like a mother once the intermediate or long end of the curve goes up, and durations will double (or more)…. that means even correctly delta hedged portfolios (those that match funding through swaps with maturities as long as the MBS average lives) will be grossly underhedged in the out years once the move starts.

      The “small” problem with today’s MBS market is that the Fed is buying so many bonds, so spreads are squeezed. That’s what they’re all dealing with now, and they basically don’t have enough extra spread coming in to deal with bigger, longer problems.

      But when rates go up, here’s where a long memory kicks in. People get it that the mortgage prepayment option is a call option on interest rates. But if rates fly upward and people have 3.5% 30-year fixed-rate mortgages, they will figure out how to sell their houses without prepaying the mortgages, as they did in the early 80’s and late 70’s. That’s an interest rate put. The effect on a portfolio of MBS will be to extend them out to 15 years average life from the current assumed five to seven years. Yikes.

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