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Annaly Capital Management, Inc. (NLY): How Will the Upcoming Fed Meeting Impact REITs?

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Annaly Capital (NLY)Fed Chairman Ben Bernanke is scheduled to meet with his fellow policymakers soon to consider whether or not they should continue with quantitative easing. The results of their deliberations could have a profound impact on the mortgage REIT industry and the largest mortgage REIT Annaly Capital Management, Inc. (NYSE:NLY) . The debate on when to end bond purchases is continuing, but the U.S. labor market has not yet shown any signs of the significant gains the Fed would like to see before ending the program. While unemployment continues to hover around 7.8%, where it has been since the beginning of 2009, the Federal Open Market Committee does not envisage an immediate threat from inflation, which currently stands at 1.4%.

At least two district bank presidents who support the record quantitative easing have voting rights this year, while six Fed officials have shown their willingness in allowing the bank to continue easing.  It is therefore likely that the Fed Chairman can count on the FOMC to support the current programs of buying $40 billion in mortgage backed securities and $45 billion in treasuries every month.  The U.S. Agency mortgage REITs have been hit by the third round of QE 3, and the squeeze is likely to continue.

At the end of the third quarter, Annaly’s portfolio was made up of 93% fixed rate mortgage backed securities, while the remainder was adjustable rate securities. The average maturity of the company’s securities was 4.93 years, while the conditional prepayment rate increased from 19% to 20% at the end of the third quarter.  Because of the quantitative easing program, Annaly saw a 52 basis point decline in its annualized interest rate spread year over year and, as a result, it was forced to slash its quarterly dividends by 10% to $0.45 per common share.

Meanwhile, Annaly has been reiterated by TheStreet Ratings as a buy with a ratings score of B-. The firm’s impressive growth in net income, attractive valuations, strong cash flow from operations, and growth in earnings per share are seen to outweigh the fact that the company’s stock has shown lackluster performance.  The analyst points out that net income growth from the corresponding quarter of the previous year is well in excess of that of the S&P 500 and the Real Estate Investment Trust (REIT) industry. The net income increased by 124.4% when compared to the same quarter one year prior, rising from -$921.81 million to $224.76 million.  Net operating cash flow has significantly increased by 115.73% to $3,597.99 million when compared to the same quarter last year, which is well in excess of the industry average cash flow growth rate of 13.48%.

Lets take a quick look at the positive and negative factors that are likely to affect fourth-quarter performance as well as the outlook for 2013. All mREITs are currently experiencing a number of problems, of which the biggest is the third round of quantitative easing by the Fed. Although the increased demand in the mortgage backed securities market has had a positive effect of increasing the value of the securities held by Annaly, it has also had the negative effect of squeezing the interest spread on its portfolio.

This has been particularly harsh on mortgage REITs with high constant prepayment rates, and as a result Annaly has the highest CPR and the lowest interest rate spread compared to its peers.  The company has taken steps to counter these problems by reducing the cost of funds, which has been achieved by the issue of preferred shares and the restructuring of its liabilities for a longer duration.  It also proposes to diversify by acquiring Crexus Investment Corp (NYSE:CXS), a REIT that focuses on commercial property and has a higher yield on its portfolio.

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