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Buy 1,000 shares but be on guard

Dear Mr. Berko: How do companies like Annaly Capital Management pay a dividend of 15.5 percent when mortgages are yielding 5 percent? Would you recommend that I buy 1,000 shares?

I can afford moderate risks if you think Annaly isn’t too risky. It’s hard to believe that this company pays so much and sells for $l7 a share. – E.W., Moline, Ill.

Dear E.W.: Annaly Capital Mortgage (NLY, 52-week high of $18.99 as of Dec. 18) pays a dividend of $2.72. So a 100-share purchase at $1,750 (includes a commission of $8.95) would give you an annual income of $2,720, an outrageous l5.5 percent yield. And holy guacamole, I’d be buying NLY till Ulysses came home if I thought the dividend was safe.

It ain’t!

NLY is a REIT with a multibillion-dollar portfolio of mortgage-backed securities, including pass-throughs, CMOs and adjustable-rate, floating-rate and fixed-rate mortgages. The mortgages are guaranteed by government agencies and rated AAA by Moody’s, Fitch and Standard & Poor’s, the most inept rating agencies in the world.

NLY’s objective is to generate income for its shareholders from the spread between the interest income on its mortgages and the borrowing cost to purchase those mortgages. NLY also owns several subsidiaries and advisory services, a brokerage clearinghouse and an asset-management platform for fixed-income institutional clients. And the earnings from these subsidiaries also accrue to the shareholders.

You can make money just like NLY. So, for illustrative purposes, here is how it’s done:

Assume that JP-Mug-you sells a $100,000, 30-year, 5 percent mortgage to NLY. NLY invests $20,000 of its own money and arranges a six-month, $80,000 loan from the Fed at 2 percent. The 5 percent mortgage pays NLY $5,000 in interest, NLY pays the Fed $1,600 in interest and the spread between the two, $3,400, is income to NLY, which is a l7 percent return. So after salaries, rent and other expenses, NLY pays shareholders a dandy dividend of 15.5 percent.

You’re not connected enough to borrow money at 2 percent nor do you have enough pull with the Fed to leverage 80 percent of your purchase. But you can borrow money from your broker (margin) at 5 percent, and you can leverage 50 percent of your purchase from that broker. So consider buying 1,000 shares of NLY, which will cost you $17,500. And if you margin this purchase, you must deposit 50 percent of cost or $8,750.

Now, 1,000 shares of NLY pay a dividend of $2,720, while interest of 5 percent on the borrowed $8,750 will cost you $438. So the difference between your interest income, $2,720, and your interest costs, $438, is $2,282. And on an investment of $8,750, that’s almost a 26 percent annual return.

That’s a bankable and guaranteed return as long as you can borrow money at 5 percent and as long as NLY pays a dividend of $2.72 per share. This is called leverage, and holy moly, it certainly beats buying 1,000 shares of NLY for cash and earning a middling l5.5 percent.

According to Credit Suisse, NLY has a book value of $18.18 – about 70 cents more than the stock value – because its mortgages have increased in value. And according to Credit Suisse, the European crisis plus the Fed’s second economic stimulus plan make it likely that rates will remain near zero into next year.

According to JMP Securities, the earnings outlook for NLY and other mortgage REITs appear to be solid. However, the voices in the back of my head may not be real, but they often pose interesting questions, such as “What happens if the Fed raises short-term interest rates?” or “Will I be sufficiently vigilant to sell NLY before the Fed raises rates?” or “What will happen to NLY’s stock value if management reduces the dividend?” or “What will happen to short-term rates if small-business loan demand picks up?” or “What will happen to interest rates if the economy begins to inflate?”

I don’t object to a purchase of 1,000 NLY if you place an open stop with a DNR (do not reduce) at $16.50. This limits your principle loss to $1,000.

Please address your financial questions to Malcolm Berko, P.O. Box 8303, Largo, FL 33775 or e-mail him at mjberko@yahoo.com.

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