How Risky Is Annaly Capital Management, Inc. Really?

By Markets Fool.com

If you are looking for a safe dividend stock, you shouldn't even think about investing in Annaly Capital Management or American Capital Agency , right? At least that seems to be the conventional wisdom: Mortgage REITs and their high yields are just too risky for the average investor.

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I am not convinced.

Since the first mortgage REITs started popping up in 1969, plenty have failed. But few of those failures had a higher profile than the bankruptcy of Thornburg Mortgage in 2009. Today, I'll dig into its downfall to see whether it can help paint a clearer picture of just how risky both Annaly and American Capital Agency really are.

No protection from defaults
Back in 2006, Thornburg Mortgage was considered among the best mortgage REITs. Unlike wild risk takers investing in subprime mortgages -- low-quality loans to borrowers with iffy credit -- Thornburg stuck to high-quality assets.

But Thornburg had a fatal flaw. Consider that because Annaly and American Capital Agency buy securities packaged by Fannie Mae and Freddie Mac, their assets are protected against defaults. This means that if borrowers miss or stop making payments on their loans, Fannie and Freddie are on the hook to cover the difference. Thornburg's assets were of a different variety, and did not benefit from this protection.

When the mortgage market started melting down in late 2007, despite their loans being high-quality, Thornburg started taking serious losses.

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High leverage
Thornburg's issues were compounded by its obscene use of leverage.

Think of it like a mortgage on a house. How much money you put down is your equity, and the size of the mortgage is your debt. The ratio of the two is your leverage. In late 2007, Thornburg had almost 20 times as much debt as it did equity. For some perspective, that's is like putting 5% down on a house. Although this not unheard of for a homeowner, it is very risky for a multibillion-dollar company.

Leverage is used to amplify returns, but it has the unpleasant side effect of magnifying losses. So, although Thornburg's assets did not see high levels of defaults, by maintaining high levels of debt its losses were much more severe.

Today, Annaly is holding five and a half times as much debt as equity, and American Capital Agency has seven times. Which, in terms of risk, is not even in the same ballpark as Thornburg's.

Not enough liquidity
Here's an example to consider: Imagine you go to a pawn shop for a loan. As collateral, you give the store owner a gold watch which will be returned to you when the loan is paid back. A week later the store owner realizes that the gold watch is actually a plastic watch painted gold. So, he does what anyone would do, he calls your loan and forces you to replace the collateral.

The actual process is less ridiculous than described, but not all that different for mortgage REITs. They use collateral to secure short-term loans. However, if that collateral loses value, lenders have the right to issue margin calls which forces companies to cover the lost value.The final nail in Thornburg's coffin came when the company started receiving more margin calls than it could possibly cover.

Through March 2008, Thornburg had received $1.8 billion worth of margin calls but was only able to cover $1.2 billion. The reason for this was twofold: First, Thornburg simply didn't have enough available cash or unpledged assets -- assets that can be readily sold -- to cover its losses. Second, because the U.S. economy was in the middle of a mortgage crisis, even the assets it could sell were difficult to unload.

Thornburg's margin calls continued to pile up and, like quicksand, the company sunk deeper and deeper into trouble until they filed for bankruptcy in May 2009.

Annaly and American Capital Agency's assets lose value when interest rates rise, so margin calls are not out of the question. However, if you control for each company's total liabilities, Annaly and American Capital Agency are currently holding five times more cash and unpledged assets than Thornburg held at the end of 2007.

Also, whether it's their protection from defaults or whether there is simply a bigger market for them, Annaly and American Capital Agency's assets have proven to be more liquid and easier to sell during times of distress. In fact, Annaly's securities actually increased in value during the financial crisis.

Not so risky after all?
The combination of holding safe assets, limiting risk by keeping leverage in check, and maintaining a high level of liquid assets, in my opinion, makes Annaly and American Capital Agencytwo of the most reliable high-yield investments.

This is not suggesting, by any means, that either company is risk free. Every company and industry has its own unique risks. The idea that these companies could fail on a whim, or that their business models have too many holes for the average investor to feel confident about, I don't think holds up.

The article How Risky Is Annaly Capital Management, Inc. Really? originally appeared on Fool.com.

Dave Koppenheffer has no position in any stocks mentioned, and he has never tried to pawn a fake gold watch. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.