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Hello.
This is a business case study.
My name is Doctor Michael
McDonald and today we're
going to be talking about
interest rates and asset prices,
specifically in the case of
Annaly Capital Management.
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Annaly Capital Management is
a real estate mortgage company
trading in the United States.
The firm trades in
the US stock markers
under the ticker symbol NLY.
The basic business for the company
involves securitized real estate
investments.
In particular, the firm
generally buys and holds
securitized mortgage assets.
This can be collateralized
mortgage obligations.
It can be collateralized
loan obligations.
Any sort of paper
backed by real estate.
This paper throws off a particular
interest rate or a yield,
based on the underlying assets.
Now, to fund those purchases, the
company uses its equity of course,
but they also want to amp
up their return on equity.
So to do that, they generally
borrow at short-term interest rates
from the marketplace, and
then use that additional cash
to buy further long maturity
securities under a normal interest
rate curve, that is where
short-term interest rates are lower
than long-term interest rates.
This creates a yield spread
between their short-term paper
that they owe money on, and the
long-term assets that they hold.
Now of course, to the extent that
the firm can also borrow, or is
considered safer than the
assets that they're buying,
then they'll be able to
borrow at lower rates
and they can lend that money
out through the purchase
of these securities at higher
rates, which also creates a spread.
So as a result, the
firm has a nice cushion
in terms of what they're paying
versus what they owe on spreads
at any given point in time.
However, this use
of shorter term debt
is a significant source
of funding definitely
increases the firm's risk.
In particular, the question
becomes, what are the risks
inherent in this strategy?
For Annaly, they're taking
on significant exposure
to the risk of rising
interest rates.
As we're going to
see in today's talk,
that risk can be quite significant,
and can in fact wipe out
all of the firm's
profit in a given year
if interest rates move
against the company.
