Photo John Emerson

Michael A. J. Farrell leads Annaly's consistent investment performance

By Allen Kenney

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AGE: 56 FAMILY: Married, four children, one grandchild HOBBIES: Charities; coaching youth sports programs; fishing LAST BOOK READ: Last Book Read: “The Panic of 1907: Lessons Learned from the Market’s Perfect Storm” by Robert F. Bruner and Sean D. Carr. FAVORITE SPORTS TEAM: New York Yankees FAVORITE VACATION SPOT: Any beach PROFESSIONAL ACTIVITIES: Board of governors of NAREIT; Director of the U.S. Dollar Floating Rate Fund; Trustee of the Oratory Preparatory School in Summit, New Jersey; Frequently featured on CNBC and in financial publications for his views on interest rates, credit markets and the economy.

Annaly Capital Management Inc. (NYSE: NLY) proudly bears the family crest of founder and CEO Michael A.J. Farrell on its corporate logo, including the Latin motto Prodesse Non Nocere: “proceed without fear.”

It probably came as little surprise to those who know him well when Farrell decided to forge ahead with founding his own REIT in February 1997 after more than 20 years of experience in the real estate industry. Likewise, while more than 90 percent of the REIT market consists of equity REITs, Farrell opted for his fledgling company to join the minority of mortgage REITs.

Yet, although Farrell’s apparent adherence to his family motto might paint him as the dive-in-headfirst type, he cites the value of patience as the greatest lesson he has learned throughout his professional career. When he talks about the value his company offers its shareholders, measured consistency—not spectacular flashes of performance—is key.

“Annaly is the name of the ancestral home of the Farrell clan, a leading family in Ireland during medieval times,” Farrell says. “The crest is intended to symbolize the commitment that the Annaly team has to its shareholders, reinforced by years of consistent investment performance.”

In December 2007, Annaly announced a 30 percent dividend hike to 34 cents per share, its eighth straight quarterly increase. Meanwhile, the company has garnered praise from Wall Street analysts recently for deftly navigating through 2007’s credit market turmoil. A month before Annaly’s dividend increase, popular financial guru Jim Cramer, host of CNBC’s “Mad Money,” told his viewers that Farrell’s management is “about as good as it gets.”

Recently, Annaly launched Chimera Investment Company (NYSE: CIM), a separately listed REIT designed to take advantage of what Farrell considers an enticing credit market in 2008. Farrell sat down recently with Portfolio to discuss his management niche and style.

Portfolio: When people think of REITs, they think of companies that develop, manage, and buy and sell real estate. Annaly focuses on something somewhat different. Please tell us a little bit more about Annaly’s core business.

Farrell: Annaly’s core business is to invest in residential mortgage-backed securities (RMBS), which represent interests in cash flows from pools of mortgages. We focus on mortgages in which the principal and interest is guaranteed either directly by the federal government or by a related agency, such as Fannie Mae or Freddie Mac. These cash flows represent loans made to borrowers throughout the United States, collateralized by their homes. Because of the underwriting guidelines and guarantee of Fannie Mae and Freddie Mac, we believe our business involves virtually no credit risk. Properly acquired with a long-term investment structure, our income qualifies our company as a REIT.

Portfolio: What attracted you to mortgage-backed securities?

Farrell: I first became involved in mortgage-backed securities in the late 1970s. At that time, the market was much different then it is today. There were effective floating rate forward contracts and fixed rate forward contracts. As interest rates spiraled upwards, it caused relatively large dislocations, as dealers tried to cope with the end of a period of relatively low volatility to a period of extreme volatility. This was not unlike what is going on today in the fixed income markets.

The broker-dealer I worked for at that time was affected by the volatile markets, and I was assigned to play a leading role in reorganizing its operations and trading exposure. From that experience with volatile markets, I developed a base of knowledge that grew over time as my career progressed to different levels of front-office business development.

Portfolio: Can you explain Annaly’s “barbell” investment strategy as it relates to asset acquisitions?

Farrell: The general theory behind our MBS BarbellSM is to limit credit exposure and manage interest rate exposure. Annaly manages interest rate risk, and our unique style of taking a long-term view on investing is guided by adherence to the “barbell.” This approach refers to the creation of a composite portfolio of adjustable-rate, floating-rate and fixed-rate coupons. We have found that this combination—when properly and consistently managed—will create very valuable income streams for our investors over time. The floating rate and adjustable rate securities, which represent approximately two-thirds of the portfolio, tend to outperform when rates are rising since their coupons reset upwards.

At the same time, the fixed rate portion, approximately one-third of the portfolio, will generally experience capital gains and outperform when rates are falling since they are locked into a higher coupon.

Portfolio: One of 2007’s biggest stories in the real estate community was the subprime mortgage crisis and subsequent “credit crunch.” What kind of impact, if any, did this have on Annaly? What kind of challenges did this present?

Farrell: We have always been on the sidelines when it has come to subprime. People familiar with the Annaly story know that we spent several years resisting the temptation of using more credit risk to enhance our business results. We were under a lot of pressure from investors to migrate away from our focus on high-quality assets, which were yielding a lower return in comparison to subprime mortgages. We were able to successfully communicate our message to investors and did not drift away from our core style and operations. This has been very beneficial to Annaly’s investors so far, and we believe that will continue in the future.

Portfolio: Did you implement any special strategies to deal with the difficult market fluctuations of 2007? What are you doing to “weather the storm” at present?

Farrell: In any storm, you batten down the hatches and strengthen your balance sheet. Because our experience and business operations gave us a view by which to understand what was happening in the markets after 2001, we took what we thought were the appropriate steps to navigate the storm.

That process began in 2002 as the Fed continued lowering rates, reaching a generational low of 1 percent in June 2003. During this time, homeowners refinanced their mortgages at a record rate. This began to change when the Fed started raising rates in June 2004. After that, the slow drip of 17 consecutive 25 basis point rate hikes continued until June 2006.

As this five-year cycle began to play out, portfolio adjustments and re-balancing actions were taken to prepare the portfolio for the next phase of the cycle. The steps we took then, including selling underperforming assets and replacing them with higher-returning ones, have allowed us to look ahead to 2008 with a lot of wind at our backs.

Portfolio: How do you see the mortgage-backed securities market shaping up in 2008? What kind of opportunities do you think will be available?

Farrell: The U.S. housing markets are going to be challenged for several years ahead. By the end of the first quarter of 2008, the mortgage-backed securities markets will have priced in much of the reality to come. This does not mean that the consumer markets are on their way to repair, just the capital markets, which always look forward.

The biggest, but most volatile, opportunities ahead in 2008 are in credit. We expressed this view by launching a separately capitalized, separately listed REIT on the New York Stock Exchange, Chimera Investment Company. Annaly has a 9.8 percent investment stake in this company, and it is managed by Annaly’s wholly-owned subsidiary, Fixed Income Discount Advisory Company (FIDAC).

Portfolio: Could you tell us a little more about Chimera? What are the company’s objectives? Additionally, how is this company different from Annaly?

Farrell: Chimera’s objective is to provide attractive risk-adjusted returns to our investors over the long-term, primarily through dividends and secondarily through capital appreciation. Chimera intends to achieve this objective by investing in a broad class of financial assets, including prime and Alt-A residential mortgage loans and residential mortgage-backed securities.

Chimera’s investment strategy is to take advantage of opportunities in the current interest rate and credit environment and adjusting asset allocations depending on market conditions. Generally, we believe Chimera will perform using these various asset classes as interest rate and credit cycles change over time.