Annaly Has a Credibility Problem


The executives at Annaly Capital Management have a serious problem on their hands. Over the last few years, they've become accustomed to unconscionably large compensation packages. In 2011, its top two executives made $35 million each. And while that figure was somewhat moderated last year, it still came in at $25.8 million.

Up until now, they've justified these exorbitant figures by citing the company's compensation policy, under which the majority of pay is tied to performance -- or so they say it is, but I'm getting ahead of myself. The problem is that this gravy train appears to be nearing its final stop. And as you can imagine, Annaly's executives aren't ready to disembark.

To prolong their journey without raising the suspicion of shareholders, they've devised a truly ingenious approach. They're asking Annaly's investors to vote in favor of a seemingly innocuous proposal at this year's shareholder meeting which would change the company's management structure, from one that's internally managed by Annaly's executives, to one that's externally managed by a company owned by the very same people.

The benefits of the proposed structure to Annaly's executives are twofold. First, as I discussed here, the new structure would no longer require them to disclose how much they're getting paid. This would save them the obvious inconvenience of trying to justify the unjustifiable. And second, as I discuss below, it's arguably the only way Annaly's executives can indeed prolong their ride on that oh-so-glorious gravy train.

To understand why this is so, it's necessary to delve into the details of Annaly's compensation policy, where pay is a function of a predetermined base salary and an incentive-laden bonus. Because the former is a comparatively negligible portion of overall compensation, the lion's share comes in the form of the latter. In 2011, for example, Annaly's then-CEO Michael Farrell earned a base salary of $3 million and a bonus of $32 million.

A structure like this is neither uncommon nor problematic in and of itself. In fact, it's probably the norm at most large financial companies, and I'd even go so far as to say that it's a desirable setup as long as the bonus amount is tethered to an appropriate performance metric.

But it's here where Annaly goes astray. To quote the company's most recent proxy statement: "Any bonus we pay our executives is calculated based on our book value." It then goes on to note that because "REIT regulations require us to pay at least 90% of our earnings to stockholders as dividends ... we cannot grow our ... book value by reinvesting our earnings. Rather, our growth in book value is dependent on sequential access to the capital markets" (emphasis added). What it means is that Annaly's executives can only maximize their bonuses if the company issues copious amounts of new stock.

So what's the problem with this? The main issue is that it doesn't directly incentivize superior performance. If this was the objective, the bonus would be tied to, say, maximizing earnings or minimizing prepayment risk. In this regard, the current setup is analogous to compensating a head coach in the National Football League for sales of his team's merchandise. Sure, merchandise sales increase if his team wins, but is this really the best way to incentivize superior coaching results?

In fact, tying bonuses to book value may actually provide a perverse incentive. The fastest way for a mortgage REIT to grow book value is to minimize leverage at the same time that it's issuing new shares, as a larger proportion of the incoming capital will remain in the equity section of the balance sheet. Yet, limiting leverage for this reason is antithetical to a REIT's fiduciary duty to existing shareholders, who want the leverage ratio to be predicated on nothing more than risk and return. This is particularly true when it comes to agency mortgage REITs like Annaly, which are largely shielded from credit risk and can thus more safely take on leverage.

An additional problem with this bonus structure is that it's unsustainable. It should be self-evident that Annaly, or any company for that matter, can only issue so many new shares of stock before the market has had its fill. This wasn't a problem before the financial crisis, when Annaly was one of the only mortgage REITs in town. Since then, however, there's been a veritable stampede into the space, with a multitude of new funds setting up shop over the last few years and competing for capital in the public markets. As I discussed here, for instance, the second and third largest mortgage REITs, American Capital Agency and ARMOUR Residential , weren't founded until 2008.

When you consider Annaly's management proposal in this context, its timing doesn't appear to be coincidental. Nor does it appear to be driven by an altruistic desire among a handful of overpaid executives to save shareholders some scratch. Consider this: At the end of last year, Annaly repurchased stock for essentially the first time in its history -- the only other time they had done so was in 1999 when they bought back a negligible $900,000 worth. They did so last year because Annaly was trading for less than tangible book value, which makes it difficult to justify issuing new shares given the dilutive effect on existing shareholders.

I trust you see where I'm going with this. If Annaly can't issue new shares, how will it grow book value? And if it can't grow book value, how will its executives get their exorbitant bonuses? Obviously, they won't. That is, unless they can concoct a new compensation structure outside the purview of its shareholders' prying eyes. And that's precisely what the management proposal allows it to do. As I discussed here and Bloomberg reporter Jody Shenn covered here, by externalizing management to the very same people that are internally running it now, Annaly will no longer have to disclose how, or how much, each of its top executives are getting paid.

So, when Annaly says that its management proposal is being offered to save money, I would encourage its shareholders to consider the possibility that they're actually doing it to pad their own pockets. And it's for this reason I'd urge anybody who holds this stock to think long and hard about how they plan to vote at the upcoming shareholder meeting.

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