By Phillip Britt

Steep yield curve, investment mix prepares Annaly Mortgage Management for changing rates

The rising interest rate environment that economists expect to continue for at least the foreseeable future should improve the yields for investors in Annaly Mortgage Management, Inc. (NYSE: NLY), according to the company and analysts. However, any narrowing of interest rate spreads could threaten those yields. Federal Reserve Chairman Alan Greenspan has said in several speeches and testimonies that he favors gradual interest rate increases, which is in line with the 25-basis point bumps instituted at the end of June and in early August.

ANNALY MORTGAGE MANAGEMENT, INC.

HEADQUARTERS: 1211 Avenue of the Americas, Suite 2902 New York, NY 10036 PHONE: 888-8ANNALY WEB SITE: www.annaly.com PRESIDENT, CHAIRMAN & CEO: Michael A.J. Farrell VICE CHAIRMAN & CHIEF INVESTMENT OFFICER: Wellington Denahan CFO & TREASURER: Kathryn Fagan TICKER SYMBOL: NLY 52-WEEK HIGH: $21.28 (7/16/2003) 52-WEEK LOW: $15.56 (10/21/2003) CLOSING PRICE 2003: $18.40 CORE MARKETS: Mortgage-backed securities

Annaly, a mortgage REIT, follows a strategy of raising money in the public market to invest in REIT-eligible assets. Rather than the physical properties owned by an equity REIT, Annaly's assets are residential mortgage-backed securities—ownership interests in pools of mortgage loans made by financial institutions (savings and loans, commercial banks and mortgage bankers). The originating financial institution either holds the loans on its own book—collecting monthly principal and interest payments from the homeowners—or repackages and sells them as mortgage-backed securities to investors like Annaly.

Annaly purchases its securities from Fannie Mae, Ginnie Mae or Freddie Mac. All of the securities carry actual or implied AAA ratings, according to Annaly. There are no derivatives, interest rate swaps, currency swaps, or total return swaps in its portfolio, which Annaly officials say protects its investors from sharp changes in valuations.

Raising the Bar

Coming off one of the lowest mortgage rate environments in some 40 years, interest rates started inching up in the spring of 2004, and were expected to continue to rise along with higher bond interest rates and escalating short-term rates from the Federal Reserve. Though Fed increases don't relate directly to rate increases on long-term, fixed-rate mortgages, the two do tend to move in the same direction. Typically, the federal funds rate rises after the 10-year bond rate does, according to Michael A.J. Farrell, Annaly founder, chairman, president and chief executive officer.

Annaly expects to navigate successfully through the rising interest rate environment due to its strategy of holding a mix of adjustable, floating and fixed-rate mortgage-backed securities, says Jeremy "Jay" Diamond, Annaly executive vice president. The majority of its portfolio is in short and long-duration securities, with a smaller portion comprising mid-duration securities (e.g., adjustable-rate mortgages that are fixed for the first five years).

"A rising rate environment is not necessarily a bad thing," Diamond says. "It means quicker upward adjustments of shorter-duration assets leading, in turn, to higher yields. By keeping short-duration, high-quality assets, we can manage through the coming interest rate environment."

Annaly's income is derived from the interest rate spread; that is, the average interest rate earned on its assets less the average interest rate paid on its liabilities. The wider the spread, the higher the income will be. The spread tends to be wider when there's a sharply rising yield curve, the difference between long-term and short-term rates.

Farrell says the government wants a steep yield curve to meet deep federal budget deficits; so he expects the steep yield curve to remain in place for a while.

"This is not a good environment for our country; it is, however, the landscape in which we are going to drive our business going forward," Farrell says. "Nominal interest rates may change, but as long as deficits are on the horizon, the shape of the yield curve will remain relatively steep."

Like It's 1999

"We use leverage because it can help increase returns. If the asset earns more money than the interest payments on the debt, we can make more than we could if we did not borrow to buy the asset." —MICHAEL FARRELL

Helping to strengthen Annaly's expectations of success in the current market, Diamond points to 1999, the last time there was a Fed tightening cycle and rising interest rates.

In 1999, the federal funds rate began the year at 4.75 percent and ended the year at 5.5 percent. The 10-year rate began the year at 4.65 percent and ended the year at 6.44 percent. During that time, Annaly's return on equity improved, Diamond says.

As long as long-term rates stay ahead of short-term rates, Annaly can benefit from the interest rate spread. But any time the Fed increases short-term rates, there's a relative tightening of the yield curve, meaning the cost of funds for Annaly increases without a relative increase in revenues (until long-term rates go up again), says Merrill Ross, research director for Friedman, Billings, Ramsey & Co.

"With mortgage-backed securities, one of the ways that you lose yield is with high prepayment rates," Farrell says. "The bane of the mortgage industry for the past couple of years has been the high amortization expense [due to the refinancing-driven prepayments]."

James Ackor, analyst with RBC Capital Markets, says rising short-term rates will lead directly to higher borrowing costs, but the impact of higher borrowing costs should be more than offset over the near-term by the positive impact of rising long-term rates.

"As long-term interest rates rise, prepayment speeds on the company's mortgage securities should slow, which will result in reduced premium amortization," Ackor says. "Reduced premium amortization will lead directly to higher net yields on the company's securities. We expect spread compression in the second quarter of 2004 due to a spike in premium amortization. In the third quarter, we expect reduced premium amortization to more than offset higher borrowing costs, resulting in spread expansion. If short-term rates continue to rise, however, borrowing costs will continue to rise, which could lead to more spread compression in 2005."

High prepayments were the norm over the past two years as homeowners enjoyed the lowest mortgage rates in some 40 years, leading to record refinancings. With rates rising, the Mortgage Bankers Association expects refinancings to decline sharply in 2004, with no pickup predicted until rates decline again.

Leverage Boosts Investment Power

"Annaly expects to navigate successfully through the rising interest rate environment due to its strategy of holding a mix of adjustable, floating and fixed-rate mortgage-backed securities." —JEREMY "JAY" DIAMOND

Annaly uses money it raises through stock sales or private placements as collateral to borrow funds for investment. However, Ross cautions that Annaly's leveraging model, borrowing on an 8-to-1 to 12-to-1 basis, could subject the company to calls by lenders for additional collateral if the underlying securities decline in value.

"We use leverage because it can help increase returns," Farrell says. "If the asset earns more money than the interest payments on the debt, we can make more than we could if we did not borrow to buy the asset."

For example, Annaly could raise $1 million through its dividend reinvestment program. The company would borrow another $9 million and pay an interest rate of 2 percent on the loan. Annaly takes that whole $10 million and buys securities that pay an interest rate of 4 percent.

Farrell doesn't see much risk in the leveraging model because the securities carry an implied AAA rating from the government-sponsored entities (GSEs). If borrowers default on the loans, the GSEs are still at risk for non-repayment, not the holders of the mortgage-backed securities, Farrell says.

Ross also cautions that an unexpected rise in short-term interest rates or decline in long-term interest rates could cause compression in earnings and a reduction in book value. However, Farrell and most economists don't see a near-term threat of long-term rates declining, particularly with the Fed expected to raise interest rates through the rest of the year. Indications are that bond rates will also continue the trend up.

At the end of the first quarter of 2004, Annaly had $18.3 billion invested in mortgage-backed securities, with two-thirds of the coupons slated to reset in less than a year with higher interest rates, Diamond explains. With the higher rates, Annaly will earn higher returns, which should mean higher dividends for investors, he says.

Yet if rates go too high, Annaly's dividend yield compared to other investments may not seem so attractive, Ross says.

The company's latest dividend was 50 cents per share, payable on April 28. Farrell says he's "comfortable" with an annual dividend of $2.20, meaning a higher dividend for the next three quarters. Research analysts at RBC Capital Markets and Friedman, Billings, Ramsey say the annual dividend may exceed $2.20 by a couple of cents per share.

Annaly-zing History

That would put Annaly's dividend near its all-time high of 68 cents a share during the final three quarters of 2002. Annaly was initially funded in a 144A private placement in February 1997 and made its initial public offering in October 1997. The company's growth has been fueled by the $1.5 billion Annaly raised through five stock offerings since its private placement.

Since paying its first dividend as a publicly traded company in October 1997, the dividends have ranged from 18 cents per share—the first dividend—to 68 cents per share in the final three quarters of 2002. The price of the stock rose above $10 at the beginning of 2001, reaching $20 a share by the middle of 2002. Since then, it's traded between $15 and $20 per share.

Recently the stock price has dipped on the heels of the Fed's actions because investors tend to have a more bearish outlook as rates rise, Ross says.

However, share price growth is not what Annaly investors are primarily looking for, it's the dividend that attracts investors to the company's stock, Diamond says. He adds that the company's shareholders are split evenly between institutional and retail investors.

UPSIDE-DOWNSIDE Samplings of what analysts are saying about Annaly Mortgage Management, Inc. Merrill Lynch Rating: NEUTRAL (7/28/04) 12-Month Projected Target Price: $16.20 "Annaly’s divident will continue to be sensitive to moves in interest rates; simplistically a flatter yield curve tends to be negative for returns, while drops in long-term interest rates sufficient to generate refinancing activity is also detrimental. Conversely, the steep yield curve of the last few years has been helpful for returns, so a more moderate move in Fed-driven rate increases will tend to help the company." Friedman, Billings, Ramsey & Co. Rating: MARKET PERFORM (6/23/04) 12-Month Projected Target Price: $17.50 "Although prepayment speeds may slow, funding costs will encroach on spread. Annaly’s average time to reset on the funding side was less than four months at March 31, 2004; so the Fed’s move that has been widely anticipated in the market will roll through the balance sheet and income statement relatively quickly." Piper Jaffray & Co. Rating: OUTPERFORM (7/19/04) 12-month Projected Target Price: $22.00 "We believe Annaly’s historically proven ability to generate consistent attractive returns, even in the most challenging environments, is due to its strong mortgage portfolio and interest rate risk management skills, as well as its industry-leading operating efficiency ratio." RBC Capital Markets Rating: SECTOR PERFORM (6/22/04) 12-month Projected Target Price: $18.00 "We continue to view shares of Annaly as attractively valued for income-oriented investors. ...Despite the threat of rising short-term interest rates, the yield curve remains historically steep, which provides an excellent backdrop for incremental investments. ... That said, we recognize that rising short-term interest rates will eat into the company’s earnings capacity in late 2004, early 2005 and beyond."

Farrell says the institutional/retail investor ratio is ideal for Annaly because the institutional holders tend to be more concerned with capital gains, whereas Annaly's retail investors covet the dividend. So rather than buying and selling securities for quick, short-term income, Annaly management buys and holds securities for long terms, sometimes until maturity.

"It's an extremely passive strategy," Farrell says. "This is not a stock for capital gains. We offer competitive returns." The dividend typically offers a double-digit yield if based on the future quarters (current dividend, plus expected dividends of next three quarters) rather than on the current dividend added to the dividends of the trailing three quarters, according to Farrell. He bases his yield calculation on dividends for June 2004, and projected dividends for September 2004 and the next two quarters, rather than the typical analyst's yield that looks at historical (already paid) dividends.

"We want to hit singles and doubles for our investors," Diamond says. "We leave the home runs for other people."

The double-digit dividend yield may leave some investors feeling like they're getting more than singles and doubles. That's because bonds, Treasuries and other dividend-driven investments typically yield far less.

One of the reasons that Annaly's dividend yield is so high, Farrell says, is that the market discounts the price because the dividend isn't set. The lower the price, the higher the yield, says Farrell, adding that the only other vehicle offering such high dividend yields are higher risk foreign securities.

New Revenue Stream

In June 2004, Annaly completed an acquisition it hopes will be another avenue to boost shareholder returns. Annaly acquired Fixed Income Discount Advisory Co. (FIDAC), a fixed-income management company specializing in mortgage-backed and Treasury securities. A registered investment adviser, New York-based FIDAC currently manages offshore and on-shore private investment funds distributed globally as well as separate accounts for high net worth individuals, municipal funds and school endowments.

Annaly will continue to operate as a self-managed and self-advised REIT, and FIDAC will operate as Annaly's wholly-owned taxable REIT subsidiary. The two companies have always been very closely related. They've shared management teams, including Farrell and other top Annaly executives.

The FIDAC acquisition made more sense now than it had previously, Farrell says, due to recent tax treaty modifications with certain European nations and Japan. With the new treaties, overseas investors are subject to 15 percent withholding for investments in U.S. REITs, compared to the previous 30 percent, Farrell says.

While the transaction is a relatively small one (FIDAC is only about 7 percent of Annaly's total assets), it is expected to be accretive to Annaly's earnings, according to Farrell. Ross says that the FIDAC acquisition will provide Annaly with some additional revenue now and should have a smoothing effect on the company's income over time because FIDAC's revenues aren't subject to the ups and downs of the mortgage market.

Robert P. Napoli, senior research analyst for Piper Jaffray & Co., calls the acquisition "an additional catalyst" for Annaly because FIDAC offers "a much higher multiple and ROE business which we believe could return about 10 percent of total earnings."

With the acquisition in place and its investment strategy well established, Ross expects Annaly to continue to meet its goal of providing a yield that exceeds 10-year bond yield by 350 basis points to 500 basis points for at least the next couple of years. Ross stipulates that could prove difficult if the Fed gets very aggressive in increasing short-term interest rates. However, given recent indicators, it appears the Fed will follow its plans for gradual interest rate increases, which bodes well for Annaly and its shareholders.