3 Reasons to Sell Annaly Capital Management

Let me be clear from the outset: Annaly Capital Management  is one of my least favorite publicly traded companies.

It's run by executives who condone nepotismobfuscate their compensation structure to the detriment of shareholders, and have recently taken steps to effectively eliminate accountability and transparency of their actions. In my opinion, this is not a company that's run for the benefit of its shareholders, but rather to pad the pockets of its executives and their family members.

Now that we've gotten that out of the way (and I encourage you to read the articles linked to in the preceding paragraph), let's get down to business. If you're a shareholder of Annaly Capital Management and are wondering whether to sell your stake, then let me give you three reasons why that might be a good idea.

1. It's a bad time to be a mortgage REIT
There's no denying that Annaly had an impressive run during the financial crisis. But there's every reason to believe that this run is over -- or, at the very least, that the risk/reward proposition no longer tilts in favor of holding Annaly's stock.

As a mortgage real estate investment trust, Annaly's principal line of business is interest rate arbitrage; it buys long-term mortgage backed securities using short-term leverage and earns money from the interest rate spread between the two. This model became exceptionally profitable in 2008 after the Federal Reserve dropped short-term rates to near zero. You can see the impact on Annaly's spread in the chart below.

The bad news is that this trend has since reversed itself. Earlier this year, the spread between Annaly's yield on earning assets and its cost of funds fell to 98 basis points, or 0.98%. While this is still wider than the spread from 2005 through 2007, there's a big difference -- its yield on earning assets is dangerously low, at 2.82%.

The concern here is that Annaly's cost of funds, because it's based on short-term lending, could increase at a faster pace than its yield on earning assets, which derives from long-term rates. This doesn't seem likely over the short term, as the Fed has said it won't raise the Fed Funds rate, from which other short-term rates derive, until the unemployment rate is below 6.5%. Over the longer term, however, it doesn't take a wild imagination to envision a scenario in which this would be the case. This hypothetical scenario, in fact, was precisely what first set in motion the forces that ultimately culminated in the savings and loan crisis of the 1980s.

To think that something similar couldn't happen to highly concentrated funds like Annaly -- and, for that matter, its biggest competitors American Capital Agency  and ARMOUR Residential  -- is an affront to both history and the realities of interest rate cycles.

2. New management structure
I alluded to this point in the introduction, but it's worth digging into further. At this year's shareholder meeting, Annaly convinced investors to vote in favor of a proposal that outsourced the responsibility to manage the company to an external company that's privately owned by Annaly's current set of managers. The net result is that Annaly's executives no longer work for Annaly, but rather for this newly created private company.

The official explanation for the move was that the new structure would result in "significant shareholder benefits" in the form of more than $200 million in savings over the next five years. As Annaly CEO Wellington Denahan-Norris said at the time, "We believe that converting to an externally managed company and capping compensation expense as a fixed percentage of equity while we diversify our strategies will result in significant cost savings going forward."

This sounds great; who could argue with saving upward of $40 million a year? The problem is that I don't believe it's genuine. Analysts have long chided Annaly for egregiously overpaying its executives. To cite only one example, in 2011 co-founder and then-chief executive Michael Farrell was paid $35 million, dwarfing the compensation of the CEOs of the six largest banks in the country -- many of which, mind you, are more than 10 times Annaly's size. It's worth noting, moreover, that co-founder and now-CEO Denahan-Norris made the same amount that year.

"While such figures would cause little reaction if attributed to a hedge fund manager, they can be a source of comment and consternation when earned by an officer of a publicly held financial services company in this post financial crisis environment," an analyst cited by Bloomberg's Jodi Shenn wrote in a research note.

The point being, if Annaly's executives were really interested in saving shareholders money, one would think they'd cut their own salaries. It's for this reason that I tend to agree with Shenn's opinion that the actual "motivation for the change was probably that it means the pay of individual executives will no longer be disclosed."

Along these same lines, it also likely means that Annaly will no longer have to disclose the millions in dollars that it, at least at one time, paid to family members of Annaly's executives and board members to run its publicly traded portfolio company, Chimera Investment That entity has found itself in the crosshairs of both the SEC and the NYSE for an alleged accounting error -- I emphasize the word "alleged" both because it's still an ongoing matter and because the highly beneficial skew makes one suspicious that it may not have been an error after all.

3. Institutional investors aren't smitten
Go through any of the top publicly traded companies in the country and you can't help but notice that institutional investors make up the lion's share of their investors. They own 75% of JPMorgan Chase, 87% of Target, 63% of Intel, 61% of Apple, 64% of Caterpillar, and so on. Among industry giants, in other words, it's rare that individual investors own more than 50% of the outstanding common stock.

Given this, who do you think owns the majority of Annaly's common stock? Sophisticated institutional investors who have connections throughout the financial world and are paid to stay abreast of the latest developments at the companies they're invested in? Or do you suppose that individual investors are the primary owners? If you guessed the latter, you'd be right. According to S&P's Capital IQ, roughly 53% of Annaly's common stock is owned by the public at large.

While we should be careful about drawing too firm of a conclusion based on this alone, one can't help but acknowledge that it fits the pattern of facts that I highlighted above.

Foolish takeaway
At this point, if I've done my job, you're seriously questioning the prudence of owning shares of Annaly Capital Management. And, in my humble opinion, that's the right conclusion to draw.

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The article 3 Reasons to Sell Annaly Capital Management originally appeared on Fool.com.

John Maxfield has no position in any stocks mentioned, and neither does The Motley Fool. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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