Annaly seeks to diversify as Fed's bond buying squeezes business model

Nov 29 (Reuters) - Annaly Capital Management Inc pioneered the mortgage REIT business in late 1990s, and became an instant hit with investors who enjoyed generous dividend payouts.

Now its business model, and those big dividends, are under threat from the Federal Reserve's latest round of bond buying, forcing the company to diversify by making an $840 million bid for the remainder of CreXus Investment Corp.

And with its cash hoard of $2.26 billion it may not stop there, analysts said.

Annaly typically borrows short term at low rates and buys mortgage-backed securities (MBS) guaranteed by agencies such as Fannie Mae and Freddie Mac that make up more than 90 percent of its portfolio.

However, the third round of quantitative easing initiated by the Fed in September to mop up $40 billion of agency mortgage backed securities every month is flattening the yield curve, compressing the company's interest rate spreads.

"What has been the best dividend game in the town is getting squeezed," Stifel Nicolaus analyst Michael Widner said.

The decision to buy the 88 percent of CreXus that it does not already own is an acknowledgment by Annaly that it needs other lines of business to create attractive risk-adjusted returns, FBR analyst Gabe Poggi said in a note to clients.

CreXus invests mainly in commercial mortgage loans and commercial mortgage-backed securities.

"The company's proposed acquisition of CXS is an admittance by NLY that its current agency MBS model cannot work in the current environment from a risk/reward perspective," Poggi said.

Annaly shares, trading at a three-year low, have fallen about 17 percent since Sept. 13, when the Fed announced its decision to buy mortgage-backed securities.

Annaly's strategy to diversify into other asset classes and its steadily falling investment income may make the stock less attractive to investors.

The company, which has a $130 billion agency mortgage-backed securities (MBS) portfolio, plans to allocate up to 25 percent of shareholders' equity to other assets.

Of 20 analysts covering the stock, 11 rate it a hold, five have a buy or strong buy, and the rest rate it a sell or strong sell, according to Thomson Reuters Starmine.

"In terms of returns or economic returns or core income, they face material pressures, and their earnings and dividends are coming down further," Macquarie Capital analyst Jasper Burch told Reuters.

Annaly reported core-spread earnings, excluding one-time gains from MBS sales, of 30 cents per share in the third quarter, well below the 50-cent dividend it paid.

The company's interest rate spread, its key profit driver, fell by a whopping 52 basis point to 1.02 percent from the prior quarter and its net interest income shrank nearly 20 percent.

The annualized dividend yield on Annaly's stock for the quarter ended Sept. 30 was 11.88 percent, based on the closing price of $16.84, compared with 14.43 percent, a year earlier.

CHIMERA A POSSIBLE TARGET

"The active involvement of policymakers in the mortgage market, particularly the Federal Reserve's latest, open-ended, large-scale asset purchase program, has introduced unique challenges for all investors," CEO Wellington Denahan-Norris said in the company's earnings release on Nov. 5.

Annaly has a market value of about $14.4 billion, well ahead of its closest rival, American Capital Agency Corp, which has a market capitalization of about $10.8 billion.

As Annaly seeks to diversify, some analysts think Chimera Investment Corp, in which Annaly already owns a 4.4 percent stake, could be its next target.

"The easiest asset class for them is residential, non-agency RMBS (residential mortgage-backed securities) and their next target could be Chimera Investment Corp, which is similar to CreXus but harder to acquire as the former has regulatory issues," Macquarie's Burch said.

Chimera, which has a market value of about $2.7 billion, is externally managed by Annaly unit Fixed Income Discount Advisory Company (FIDAC), a unit of Annaly.

However, Chimera is still working through the toxic assets it accumulated during the sub-prime boom and is in the process of restating its results for the last four years.

The company faces delisting from the New York Stock Exchange if it does not file its restated results before a Jan. 15 deadline.

"The issue right now for Chimera is that they have not published signed off financials in almost a year," said Stifel Nicolaus's Widner.

"So they certainly need to get the accounting issues straightened out at Chimera first and if they get that done then (a bid is) a possibility."