The 3 Biggest Risks To Annaly Capital Management

What's important to appreciate, however, is that dividend yields are generally proportional to risk -- the higher the yield, the higher the risk, and vice versa.

What specific risks should Annaly's investors be concerned about? In my opinion -- absent patent mismanagement, which, of course, can never be ruled out -- there are three.

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1. Interest rate risk
Mortgage REITs make money by arbitraging interest rates. They borrow money at low short-term rates and then invest the proceeds at higher long-term rates, principally by buying mortgage-backed securities.

At the end of last year, for example, $71.7 billion of Annaly's assets, or 92%, had a maturity schedule in excess of three years. Meanwhile, $40.7 billion of its liabilities, or 61%, were scheduled to come due within three months.

Under normal situations, this doesn't create a problem, as short-term interest rates are typically lower than long-term rates. But sometimes they aren't. And it's this threat that is the source of Annaly's interest rate risk.

2. Prepayment risk
To people not steeped in the sometimes paradoxical world of finance, the concept of prepayment risk can come across as counterintuitive. In short, this is the risk that borrowers will pay off their mortgages before the loans actually come due.

This is great from the perspective of credit risk, as a paid off mortgage can't default. But from the perspective of profitability, prepayment is horrible. This is because prepayments have a tendency to increase in volume when interest rates fall. And when interest rates fall, it's less profitable for mortgage REITs like Annaly to reinvest the prepaid funds.

Here's how Annaly described this in its latest annual report:

Declines in interest rates are generally accompanied by increased prepayments of mortgage loans, which in turn results in a prepayment of the related mortgage-backed securities. An increase in prepayments could result in the reinvestment of the proceeds we receive from such prepayments into lower yielding assets.

3. Liquidity risk
If you had to identify the single biggest menace to the typical leveraged financial company, it would be liquidity risk. This is the risk that creditors decide en masse to stop renewing a fund's lines of credit. When this happens, which it intermittently does, leveraged funds must scramble to find alternative ways to finance their operations.

It was this very thing that triggered the financial crisis of 2008-09. Bear Stearns didn't fail because it was insolvent -- though it certainly may have ended up that way if it hadn't been bailed out by the nation's biggest bank -- it failed because its creditors stopped funding its operations. And the same was true of Lehman Brothers.

In Annaly's case, to be fair, this isn't as big of a threat. This follows from the fact that the lion's share of Annaly's collateral -- namely, agency mortgage-backed securities -- is backed by the full faith and credit of the United States government, and is thus unassailable. However, as Annaly continues to expand into non-insured commercial real estate, the threat of illiquidity will grow.