For Investors, This REIT Is a Refuge From the Storm

As the market shows every sign of going to hell in a handbasket following the bad news from Intel, here are some thoughts about a relatively safer place to hide out.

On Tuesday, I wrote about the famous John P. Meriwether and his new hedge fund. Thursday's column is about a less risky, less expensive way to get the 15% to 20% average annual returns Meriwether is promising. And, dare I say it, these guys did not blow up in 1998 like Meriwether's Long Term Capital Management.

The name of the company is Annaly Mortgage Management(NLY). It's organized as a real estate investment trust . As you may recall, a REIT does not pay corporate income taxes on the money paid out as dividends to shareholders. Since there's no "double taxation," a REIT like this tends to pay out all of its earnings. Annaly pays a dividend of between 25 and 35 cents a quarter, which works out to a dividend yield of about 13%.

Annaly, which went public in October 1997, has raised $136 million. The company leverages that money about 12 times and buys AAA-rated mortgage-backed securities, which are bonds backed by mortgage payments. About one-third of the portfolio is in fixed interest-rate instruments and two-thirds in variable-rate mortgage bonds.

The CEO is Mike Farrell, a talented and experienced bond trader. Farrell and his team have performed admirably since October 1997, which has been a terrible trading environment. In 1998, when Russia and Long Term Capital blew up, so did many mortgage REITs. Their problems? They owned low-rated bonds or had loaded up on variable-rate mortgages. Those were both terrible calls. First, because suddenly no one wanted to risk owning bonds that might default. And second, because the Federal Reserve instantly lowered interest rates, which caused a rush of prepayments by homeowners with variable interest rates -- and that killed the income stream to those REITs. Many REITs lost 50% of their unit price.

Annaly was off 14% in 1998. It did not blow up because it had not loaded up on variable-rate mortgages and low-quality bonds. In 1999, it returned 22.8% and so far this year it has earned investors an 18.7% annualized return. Remarkably, it has achieved this as the Fed was raising short-term interest rates -- which raises Annaly's borrowing costs -- and when long-term interest rates were going down, which tends to cap the income on the company's long-dated mortgage bonds. They could do better if, as expected, the Fed simply stops raising rates, or perhaps cuts them.

Annaly's 2000 performance most likely will beat that of Meriwether's new fund, which was up only 7.8% through July, according to hedge-fund sources. And Annaly never uses more than 12-1 leverage. The new, improved Meriwether partnership employs leverage as high as 18 times.

Lastly, Annaly does not charge investors the 2% of assets under management plus 20% of the profits that Meriwether does.

I am not saying this is a sure bet. But I am saying that this REIT is run by experienced traders with a prudent approach to the bond market. In my view, that sure beats Long Term Capital. And for the next few months, Annaly may outperform Intel, too

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