An Analysis of Annalys First-Quarter Earnings

With the release of Annaly Capital Management's first-quarter results, it's becoming exceedingly clear that the pain in the mortgage REIT space is going from bad to worse.

Annaly's bottom lineThe nation's largest publicly traded mortgage REIT reported on Wednesday that it generated a $476.5 million net loss last quarter, compared with a loss of $203.4 million in the same period last year. On a per-share basis, that equates to quarterly losses of $0.52 and $0.23, respectively.

"We, along with the rest of the markets, are patiently waiting for the Federal Reserve to adjust policy accommodation sometime this year," said Annaly's chairman and CEO Wellington J. Denahan. "We fully expect increases in volatility and look forward to the opportunities it will bring."

Truth be told, the results weren't as bad as they may initially seem, because a number of accounting peculiarities can often lead GAAP earnings to be unrepresentative of a mortgage REIT's actual performance. To reflect this situation, the industry looks instead to so-called "core earnings," which exclude a variety of debits and credits to the income statement that don't bear on a mortgage REIT's fundamental performance.

Using core earnings as a benchmark, Annaly had income of $254.1 million in the quarter, compared with $239.7 million in the same quarter last year. This approach cast's the company's latest quarter in a more favorable light, both because it better reflects Annaly's earnings potential, and also because of the positive year-over-year comparison.

Industry headwinds are taking a tollThat's not to say Annaly, and companies like it, aren't struggling against multiple economic headwinds that have made the sector much less profitable.

In the first case, to Denahan's point, Annaly seems to have positioned its hedging portfolio in anticipation of rising interest rates. Doing so is necessary because higher rates will translate into lower values for the tens of billions of dollars' worth of fixed-income securities the mortgage REIT holds in its portfolio.

But the downside of this strategy is that hedging against higher rates is expensive when rates don't increase as anticipated. In Annaly's case, it reported a $850.9 million loss on its interest-rate swaps through the first three months of the year. While that performance was an improvement over last quarter, in which it realized more than a more $1 billion loss on its interest-rate hedges, these are nevertheless the primary culprits underlying Annaly's considerable GAAP loss.

Also weighing on Annaly's bottom line was its decision to offload assets during the quarter. It started the quarter with $88 billion in assets on its balance sheet. By the end of the quarter, this figure had dropped by $9 billion to settle at $79 billion. The net result is that it generated considerably less net interest income than it did either last quarter or in the first quarter of 2014.

The reduction in assets furthered Annaly's strategy of not only preparing for higher interest rates by rotating out of $12 billion worth of its bread-and-butter agency mortgage-backed securities, which are unusually susceptible to movements in interest rates, but also to diversify into the commercial real estate space through the purchase of $1.5 billion in commercial debt instruments.

To add insult to injury, moreover, Annaly earned markedly less on the assets it retained. The average yield on its interest-earning assets dropped by 74 basis points over the past 12 months to settle at a mere 2.47% compared to 3.21% in the same quarter last year.

It remains to be seen whether Annaly's latest moves will be as prescient as its tactics during the financial crisis, which transformed the company from a backwater investment fund into a market-beating stock. Can it fight against the considerable headwinds facing it? Or are its best days long since over? Only time will tell.

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