Annaly Capital Management Q4 Reports $658 M Loss

On Tuesday, Annaly Capital Management reported a fourth-quarter net loss of $658 million thanks principally to the mortgage REIT's strategy of hedging its exposure to higher interest rates. The results confirmed what many analysts already knew -- namely, that the final three months of 2014 would offer no shelter to the embattled mortgage REIT space.

The problem isn't so much with Annaly itself, though its hedging strategy certainly hasn't paid off thus far; the issue instead is with the prevailing interest rate environment.

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It's important to remember that mortgage REITs make money by arbitraging interest rates. They borrow at low short-term rates, typically in the so-called "repo" market, and then invest the funds in higher-yielding long-term mortgage-backed securities.

This is a great business model under two conditions -- first, when there is a large spread between low short-term and high long-term rates, which allows mortgage REITs to essentially print money. We saw this happen during and immediately after the financial crisis, when companies such as Annaly and others reported record earnings.

The second condition is when long-term interest rates are falling. Because mortgage-backed securities are fixed-rate instruments, their value is inversely related to interest rates. When interest rates go up, the value of these securities goes down. When interest rates go down, the value of these securities goes up. That's why companies like Annaly hedge their portfolios against interest rate increases.

You can see these forces at work in Annaly's fourth-quarter results. Starting at the top, it earned $514 million in net interest income from arbitraging interest rates. But it then took a $1.1 billion loss in its hedging portfolio, suggesting that Annaly is positioned for the uptick in long-term rates that analysts have been predicting now for over a year.

Finally, because long-term interest rates fell last quarter, with the benchmark 10-year Treasury dropping from 2.4% down to 2.2%, Annaly's portfolio of mortgage-backed securities gained $1.2 billion in value over the three-month stretch. However, this isn't reflected in Annaly's GAAP earnings because the securities weren't actually sold, which would trigger a realizable "gain" for the purposes of accounting.

The net result is that Annaly's core earnings, which exclude unrealized gains and losses on interest rate swaps and mortgage-backed securities, came in at $299 million, or $0.30 per share of common stock. This isn't good or bad. Rather, what's important is that it's enough to cover Annaly's dividend payment, which, not coincidentally, is also currently set at $0.30 per share.

The critical question going forward is whether Annaly's longer-term strategy of keeping leverage, and thus profitability, low for the time being, as well as hedging aggressively in anticipation of a rising rate environment, will ultimately pay off. If rates do go up this year, then it will. If they don't, then it won't.