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Extended-form Case Study

Interest rates and asset prices: Annaly Capital Management

Published on May 11, 2015   27 min

Other Talks in the Series: Hot Topics

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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.
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Interest rates and asset prices: Annaly Capital Management

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