Annaly Capital Management Inc (NLY) 2010 Q3 法說會逐字稿

Good morning and welcome, ladies and gentlemen, to the third-quarter earnings call for Annaly Capital Management. At this time, I would like to inform you that this conference is being recorded and that all participants are in the listen-only mode. At the request of the Company, we will open the conference up for questions and answers after the presentation.

This earnings call may contain certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements which are based on various assumptions, some of which are beyond our control, may be identified by reference to a future period or periods or by the use of forward-looking terminology such as may, will, believe, expect, anticipate, continued or similar terms or variations on those terms or the negative of those terms. Actual results could differ materially from those set forth in forward-looking statements due to a variety of factors including, but not limited to, changes in interest rates, changes in the yield curve, changes in prepayment rates, the availability of mortgage-backed securities for purchase, the availability of financing, and if available, the terms of any financing, changes in the market value of our assets, changes in business conditions and the general economy, changes in governmental regulations affecting your business, our ability to maintain our classification as a REIT for federal income tax purposes, risks associated with the broker/dealer business of our subsidiary, risks associated with the investment advisory business of our subsidiaries, including the removal by clients of assets they manage, their regulatory refinement and competition in investment advisory business.

For a discussion of the risks and uncertainties which could cause actual results to differ from those contained in the forward-looking statements, see Risk Factors in our most recent Annual Report on Form 10K and all subsequent Quarterly Reports on Form 10-Q. We do not undertake and specifically disclaim any obligation to publicly release the results of any revisions which may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated expense or circumstances after the date of such statements.

I will now turn the conference over to Mr. Michael Farrell, Chairman, CEO, and President of Annaly Capital Management. Please go ahead, sir.

Thank you. Good morning, everyone, and welcome to the third-quarter 2010 earnings call for Annaly Capital Management. I am Mike Farrell and joining me today are Wellington Denahan-Norris, Kathryn Fagan, Jay Diamond, and Nick Singh.

As is our custom, I will begin the call with some prepared remarks after which we will take your questions. I would like to remind everyone to visit our website at Annaly.com where we will be posting my remarks including full-color graphs as well as a short companion video that we prepared. In the video, I expand on some of the ideas I'll be talking about today and offer some additional thoughts on housing finance reform.

The title today is Swimming Back To The Titanic. As we contemplate the evolving policy of efforts of late 2010, I am reminded of a curious anecdote from the sinking of the Titanic.

One part of the legacy of that disaster are the eyewitness accounts of some passengers having survived the initial moments of the sinking actually swimming back to the doomed ship's stern as it bobbed dangerously on edge. The analogy is apropos as I try to make sense of policy attempts to return to an economy that, as powerful as it was, was flawed and sinking.

I believe the economy of the United States isn't going to look anything like the one that has existed for the past 50 years. An economy driven by a population boom, unparalleled access to credit, and an increased [weighting] towards consumers and a consumption that the rest of the world was more than happy to satisfy through high bracket business activities and indulgent trade policies. The move to free floating currencies that began at [Bretton Woods] was completed by Richard Nixon in 1971, and it also contributed.

Yes, the world was complicit in this arrangement as central bankers, finance ministers and trade representatives from poor and rich countries alike, capitalist and former communist countries, design policies and products around this huge buying binge as the baby boomers got their first Christmas Club savings account, their first student loans, their first Diners Club to establish credit, their first car loans to enjoy their newfound mobility, their first mortgages to buy houses and apartments, and so on.

At its peak, the US and the world feasted on the growth and appetite of this breathtakingly large demographic cohort who dominated the pie chart of GDP rankings. The American consumer not only accounted for 70% of US gross domestic product, but also 20% of global GDP.

The intent of this current policy effort is to re-energize the consumer-based economy that was. Given the real income growth that has been flat for 20 years, this policy is also intended to entice borrowing at ultralow rates and disincentivize savings.

It is my belief that this game is over. The pie chart of future GDP market share will be more driven towards corporate consumption and production, which has much more competitive and slimmer margins than consumer business does.

In other words, the new round of [quantitive easing] will be less effective at re-energizing growth because we are chasing down a path that doesn't exist anymore.

As a demographic group, the boomers are in full retrenchment, all headed in the same direction. They are downsizing, consuming less, and dealing with the macro assault on incomes in the form of lower investment returns, shrinking entitlements, higher taxes and fees.

Overlaid on this is a likely reversal of access to credit as banks respond to new forms of financial regulation which, ultimately, will only mean one thing. Higher interest rates for consumers down the road. If we accept the fact that US consumers would be downsizing regardless of the crisis, what should we do? When I'm in Washington, I'm often asked what my policy solution would be.

And my reply is simple and straightforward. From a policy perspective it would be more prudent to invest in a strategy of converting our energy complex away from petroleum. At the very least, it will redirect hundreds of billions of dollars that leave the US every year to foreign sources and keep it here.

Consider the graph that is outlined on our website outlining the trade balance of the United States since the end of 1992. Based on the configuration in that chart, one's first reaction would be to assume that the growing and persistent trade gap should be blamed on the crush of Chinese imports. After all, are we not shipping all of our capital over to China in return for low-cost T-shirts, telephones, televisions and toys?

As it turns out, the answer is no. The current political season has turned China and its currency and trade policies into a bipartisan distraction. There is plenty of blame to go around including ourselves. But the problem is not that simple and it cannot be discussed without taking a deep hard look at our energy policies.

The following graph, a version which we first noticed on the blog Calculated Risk, shows the trade deficit excluding oil and petroleum products. Again that graph can be found on our website. It profiles the imbalances that have been developed due to our inability to harness our resources around independent energy policies, tax incentives and strategic national planning.

These statistics speak volumes. As issues of debt globally, the United States should be more concerned about what the Middle East will do with its allocations of petrodollars, rather than China.

Our lack of legislative direction is leaving the Central Bank with a limited set of options. The Federal Reserve is not buying securities to propel the private economy forward. It is debatable whether Q2 will do much more than help asset prices.

Reluctantly, it is becoming the balance sheet of last resort to fund the national budget deficit. It is running out of bullets. Legislators have to take the gloves off and get to work. No thoughtful American should expect that this will be pretty or easy.

I believe a reallocation of resources towards investment in energy will stem the flow of dollar reserves away from the imbalances in the trade deficit back to our local economy, [taking a sentence] out of foreign energy tax policy and redirect them towards domestic initiatives. Try a broad-based approach by scattering the incentives across natural gas, nuclear and solar options.

Imagine the impact on households from lower energy costs generated by domestic sources. Imagine running our cities and businesses at half the run rate for energy that municipal and corporate budgets now consume. Imagine not having to spend the limited resources we have on cleaning up the waste product of today's energy delivery system. Imagine reclaiming the opportunity costs of sending our troops into combat to secure and defend foreign resources that allow us to turn on the lights every day.

Instead of swimming back to the Titanic, let's go build a bigger, safer, better ship.

This concludes my prepared remarks. Thanks again for turning in to our call today, and once again please visit our website, Annaly.com. Operator, we will now take questions.

(Operator Instructions). Steve DeLaney with JMP Securities.

Good morning, Mike and everyone. You know, I think the big question about this policy, we won't know for a long time whether it will work or not work. The various -- whether it is dead or anybody else, we sure as hell know it is creating lots of volatility in the near term.

Yes. I agree. I mean just look what has happened between the yield curve between June 30 and September 30. It is very telling.

No question. I was hoping maybe Wellington could comment on this. Obviously third quarter was an unusual period mortgage valuations as people were trying to figure out what cash flows were going to be and we had both. We had rates going on and we had what I call this nuclear refi idea out there.

I was just wondering, Wellington, you had a big drop in the value of your MBS portfolio and I guess it is about $1.00 a share. But if you -- do you -- as you look at the quarter in hindsight, was it this sort of unusual fear about prepays that caused that?

And can you comment on the degree to which that fear has subsided and maybe the market is more rational, and what benefit that may have had to your portfolio value as we've moved past September 30?

Well, the one thing I would like to remind everybody is that mortgages are what we call negatively [came back]. And unlike traditional fixed income assets, the lower rates go doesn't mean the higher your dollar prices are going to get there.

Your options are with a mortgage you can either monetize some of the gains that are given by the market, via the market, or you can wait for a par -- pre-pay, essentially selling some of your assets. Now the market prices that stuff in. So mortgages will always under perform the Treasury market. And I think anybody who is kidding themselves that we have ever dealt with a market like we are seeing today is sadly mistaken.

You know, with rates where they are, with this threat of I think is ill-advised policy with [QE2] potentially looming. You know, you look across the spectrum of all investable dollars that you could make in the fixed income market, and I don't care where it is, you have a lower return environment that you are looking at.

Now mortgages had to contend with a lot of noise, a lot of reality. And so, I think the snapshot that we take at quarter end reflects a lot of that. And what I tend to do -- well, the way that I look at this is as we go through a quarter it's history, and now we have to always be looking forward and what is happening in the forward market.

And so at these level (sic) of interest rates, you have a lot of things happening that you've never had before and there was always the risk that your mortgages would under perform your swap. And I think the quarter reflects that.

So as things continue to evolve and change, and whether expectations meet what ultimately becomes reality out of QE2 remains to be seen and markets continue to move around and we continue -- I mean, I like to put it all into perspective that irrespective of where book came in and where mortgages performed, the Company still is delivering way above market returns in a zero bound interest rate environment.

And I hope investors don't lose sight of that.

No. I think that is at the end of the day, this volatility is in price, asset prices is something we are going to have to live with until we all see where we are going down the road. But it does appear that some of that fear built into the market. I mean, the higher coupon, the 5% to 5.5% looks like they picked up as much as a point since the end of September and with relatively flat swap rates. So there seems to be a little more stability if you will in the market's expectations. But thank you.

No. Because there has certainly been somewhat of a rebound in the mortgage position.

Thanks a lot.

Jason Arnold with RBC Capital Markets.

Good morning, everyone. To your points earlier, Mike, I'm not sure if I remember a point in time in the past in my conversations with investors that there has been such a broad range of interest-rate expectations. For me, it seems like somewhere in the sub 2% range for the 10-year. Some are north of 4% here over the near term.

And I guess I'm just curious for your perspective on rates and kind of how you go about managing that portfolio in this environment?

Well, I think that the perspective that we would assign a portfolio, especially the way it has been configured, is that it's never been cheaper to short the Treasury market. And I think that we would add our voices to the other voices in the market of professional bond managers who are erring on the side of caution as it regards what policy outcomes are going to come out of the current applications towards growth and what we're trying to save here.

But from that perspective, I think that there's two aspects that I expect to happen. One is I think that American corporations are extremely well-positioned, much more so than the government is positioned for the current economy. They've built up a lot of cash on their balance sheet. Corporate credit is extremely strong. You are seeing corporate issuances at the long end of the curve that are reminiscent of the 100-year Disney bond that was done in the 1990s.

For instance, you had a 50-year bond issued by Goldman Sachs the other day with a 6% or 7% handle on it. You had a Mexican bond that was done 100-year bond at 6%. You have Greek bonds trading at around 9%. You have Irish bonds trading around 10%. Countries that are truly in default.

So my range of interest rates for the Treasury are that I think it is going to be range-bound based off of this bid from the Federal Reserve, somewhere in the 2% to 3% range, that the front end is going to stay relatively well anchored at these levels until it becomes overwhelmed by supply, if the economy does not recover from these steps. And even if you are on the bull side of the argument and believe that we are coming out of the repression as I like to call this, then you would have to argue that interest rates are going to rise pretty dramatically from this point forward.

So one of the aspects of negative convexity, as Steve discussed with Welly, I would add that the following bullet point. That negative convexity in a rising interest-rate environment will only show up in good portfolio performance when that begins to occur and spread product.

And as I pointed out in the comments that were in the release, that there is a huge opportunity still between zero bound distance rates on the front end and the carry trade. How you deploy that capital and what you do with it should drive not one quarter's operations but should drive one quarter century's operations.

So we need to be extremely delicate here about the way that we view that interest-rate spread. I think the 10-year will be range bound between just 2% and 3%. But as I've said on other calls I think that spread product is going to widen out against it.

Makes sense. Thank you. And then just one other quick one. On swaps, I know you typically don't like to talk about the details of the strategy, but the recent moves in the swap portfolio suggests to me that you may have replaced some of the roll off in recent quarters with perhaps some modestly longer tenor swaps. Is that a fair assessment?

And I guess I think most of us understand these [markets] are temporary and will reverse over time, but just any color here would be helpful.

So, we continue to take advantage of what the market is offering. You know, as Mike mentioned earlier, it has never been cheaper to short the Treasury market and that is the way we do it via swap market. And we will continue to assess the tenor of the swaps in respect to the tenor of the mortgages.

Yes, I would say we have been pretty opportunistic all along, Jason. I would point towards the convertible deal that we did in the spring where as an unrated company we raised five-year money at 4% which was right on top of the U.S. Treasury 30-year at the time, extending our access to cheaper and lower cost of capital.

You know, I think that even though these rates of return are obviously achievable in these structures, right? We have plenty of gains in the portfolio that we are part of the opportunistic and only shave off the edge here as people deal with the vagaries of the different valuations and mortgages. Clearly, one thing that I would point out in this quarter's return is that core earnings basically bounced around at $0.60 or so for the past three quarters, and that stability and the ability to have sustainability going forward is certainly something that we are prepared for in a rising interest rate environment, given the steps that we have taken here.

The Company is mature, it's larger, it has a lot of diverse operations underneath it that are supplementing and adding value. I would point to Welly's investment in Chimera during 2009, 2008. Those kinds of choices about valuation across the curve, I think, are going to pay off and continue to pay off very well.

Just as a note, we wired out between these three companies, Annaly, CreXus, and Chimera, almost $800 million in dividends yesterday. So those checks are clearing. They feel pretty good.

I just want to let everybody know we actually would certainly look forward to higher interest rates. As a mortgage investor, these zero ballots interest rates are not the most optimal.

Yet the spreads, if you look at spreads relative to LIBOR or seven-year or five-year swaps, you are still at historical wides.

Makes sense. Thank you so much for the color. I appreciate it.

Henry Coffey with Sterne, Agee.

Good morning, everyone, and thanks for taking my question. When you look -- obviously you hold your swaps at fair value. I was wondering is there anything that would prevent you from, in essence, breaking the old contracts, absorbing the loss which you've already booked and then resetting the bar with current market? Have you seen that --?

We will always consider what is the best relative value for the shareholders.

Is there a non-economic impediment to doing that or is that --?

Again, we would just weigh our options at the time. But currently, the swap book continues to roll into the new environment. So you know, we will -- we've structured it so that we try and have it be as well-matched with the mortgage positions.

Is there anything we can derive from your comments on the rate environment? You seem pretty cautious which is probably the right thing to be doing right now. But (multiple speakers) where are you going to let leverage go? We are looking at, we've got a pretty clear snapshot of what your spreads are supposed to likely to look like from the data that you've supplied us.

I guess the open question then, in terms of what you earn, would be your appetite for leverage?

There's still, again, we are -- I like to remind everybody that we are delivering very attractive above market returns at these low leverage levels. Mike just mentioned you could get a 100-year Mexican bond for 6% or you can buy Annaly at 15% to 17% depending on the day.

I don't see any reason why we should be stretching beyond that.

I think that there are -- there are definitely opportunities for people to take significant amounts of risk relative to the perceived spread that is out there between funding on short duration and what would appear to be longer dated assets. But as a mortgage investor, that started in 1979 and lived through 1980 and 1987 and lived through 1997 through 2010, I can tell you that when this reverses, there will be no bell ringing. It will be Greek-like and that you will walk in one day and there will be a macro change taking place in interest rates, that those insurance policies will not be available for at those prices at that time.

So if you look at the return on average equity that we created in this quarter at 15 point something percent, that's above the long-term track record of the Company average of about 13.5%, using the least amount of leverage that we have ever used in our history, on the most amount of shares outstanding, and putting out the most amount of free cash flow that we've ever generated.

I think that is a great position to be in. Whether you are a deflationist or an inflationist, it doesn't matter.

However, as I would point out, we are not running this Company for one quarter's operations. We are running this Company for a quarter-century kind of views.

No, this is very helpful and obviously we all appreciate your experience, particularly in these kinds of markets. So thank you.

Don Fandetti with Citigroup.

I was curious how the capital raise earlier in the quarter played into this movement in your assets? And then also, did you see any change in how the repo desk viewed your collateral at all?

Collateral is well bid for, just to get the simple question out of the way. It is extremely liquid. There is a lot of cash around, and certainly through our cap, I think we have access to greater amounts of capital and cash flow and financing than we've ever had in our history.

I am extremely comfortable with that aspect of our business and it has also given us the ability to extend out on the curve and take advantage of wholesale versus retail haircuts, which would be extremely sustainable against any kind of reversal in rates from this point of view, whether you are a growth guy or a negative guy.

In terms of the capital raised, it was accretive to -- obviously to everybody now as they can look back in the quarter. It was accretive to both book end to earnings of around 3% is about my guess as to what that number looks like, which is consistent. I think the thing that most people should be aware of is that in other capital raises, we typically were very efficient at building up a position and then making it more liquid during the course of the capital raise.

And in this case and a negative duration environment, I would say that you want to be more cautious as you deploy that capital over the coming quarter.

And John, I just want to remind everybody once again spreads are pick your benchmark from our business model perspective, whether it's LIBOR or swaps (sic). The spreads are still at historical wide.

I don't think anybody for certain knows what the ultimate outcome is going to be. So if you are looking at our business and just figuring out whether you want to put more money to work in this environment, you still -- we could be Japan or we could be the United States in the '80s. Right now it looks like we're closer to being Japan.

So at 211 basis points when, historically, we have been inside of that, I think it is still a very attractive prospect for capital to be deployed. And we do have, even outside of capital raises, we have a tremendous amount of capital that comes in every single month via the prepayment market. So we are constantly putting money to work in this market.

Thank you.

Daniel Furtado with Jefferies.

Good morning, everybody, and thank you for the time. I was trying to get a handle on this movement in the swap mark. I appreciate that it may or may not be temporary, depending on what forward rates do.

But how do we think about the capital in terms of counterparty capital and what I'm trying to figure out here is just how do I think about if these swaps move back, what kind of cash flow that opens up. You know, that could be reapplied towards the portfolio.

We have a tremendous amount of liquidity, just given our leverage level. So we will have a positive impact on that liquidity, but like I say we are sitting in a pretty good position from a liquidity perspective. And so, the draw down from that is not very material.

So it would be like $0.25 on the dollar of movement type of immateriality?

Yes. I would say it's potentially even less than that.

Okay. And then I guess the other thing I'm trying to understand here is the swap book. Obviously, it's higher fixed pay rate than most of the space because you guys are the most established REIT and have been around the longest and this legacy swap book. At this level of fixed pay, call it 3.5%, does it mean that you have to necessarily run less swap than you would like to in order to keep cost of funds in a range that continues to generate the spreads you want to see?

Not necessarily. I mean, I think, you know, the mortgage market has exhibited negative duration most recently which would argue for -- you know, you don't need to run as much swap as you actually are. But there are a lot of things you can do within the curve to secure yourself against interest-rate moves without it being an overly costly drag on the portfolio.

Again, I mean I don't want people to lose sight of the fact that we clock in, even with legacy swaps 211 basis points in this market with a pretty good hedge position. You know the unfortunate thing about this most recent reported quarter is that people -- I think everybody got a clear sight on the potential negative duration or the effects of negative duration in the mortgage market.

Right. Thank you. And then my final thing -- my final question is, if we look at the delta in the fixed pay side. Again not to harp on the swap book, but I kind of think it is the theme for this quarter. If we look at the movement from fixed pay between 3Q '09 and 3Q '10, I think it is down about 45 basis points or so. Is it safe to assume we could run that that -- the K in a linear fashion for modeling purposes?

Probably not.

You should really you that you should really come in and spend some time with us. I appreciate where you're going with that thought and you should come in and spend some time with Kathryn and some of our risk managers to make sure you get a better understanding of how that model prices out. We would be happy to -- we would be happy to sponsor you for a day here and drill down on some of the Q&A there without necessarily exposing you to the kinds of things that we look at proprietary.

Understood. Thanks. I will take you up on the offer.

Jim Ballan with Lazard Capital Markets.

I wanted to ask about the turnover of the portfolio. It looks like there has been a significant pickup in the turnover of the portfolio and in taking gains over the past few quarters. Can you talk qualitatively around the strategic thought process behind that? I know, Wellington, you mentioned a little bit but maybe just give us a little more color on that? And should we expect this sort of continued higher turnover rate going forward?

You know, with a mortgage position, you can either take what the market gives you in value. And by virtue of what that market is giving you, you can have taken away in pre-payments and what I mean by that is rates drop. That prepayment option becomes much more valuable to the borrower. And there are people that have differing views on that in the market which is the nice thing about the market.

And so you can either monetize the difference in views or you can wait and get -- you could essentially sell your asset at par, or you can sell your asset in the market at what we think is a level that is unsustainable, relative to the pre-payment horizons.

Right. I think it is safe to say, Jim, that the way that we view things is not necessarily the way that other players in the market would view it, whether they are financial institutions, hedge funds or REITs.

And the great thing about mortgages is that the valuation of the option to prepay is driven by whether or not you take a short- or long-term perspective. Or as in some cases, like I would point out in the banking sector, whether you are driven from a regulatory point of view to fund mortgages that look non-economic to us and, on behalf of the shareholders, when we see that bid come into the market that makes these assets look non-economic from our point of view, given our perspective and our viewpoints -- which I think we have been extremely clear over the life of the Company explaining to people -- then we are supposed to monetize that for the shareholders.

Add to that point, the only way you can deal with that, obviously, you cannot bring it inside the REIT and keep it -- you know, tax loss going forward or tax gain going forward, you need to pay it out in the quarter or in the year that you take those results. So there's obviously a great deal of confusion in the mortgage market right now, and it's closing a lot of volatility as the first caller pointed out, Steve Delaney, in where people are valuing mortgages. And it is that uncertainty that is giving us the ability to be very opportunistic on behalf of the shareholders.

Now that said, the REIT structure is not a total rate of return structure. That is going to drive that with capital gains. In fact, I would argue and I think I have argued pretty effectively in the past that that is not the gain that you are investing in of a large public company to do. That is something that is best handled in a private structure and certainly in the REIT laws.

You have to be careful, very careful about how much capital gain as you blend in over time into the portfolio. Because you don't want to be de-REITed and you don't want to lose that very powerful tax advantage which I think we enjoy and others enjoy in this space, by overturning the portfolio too, too far.

That is always another business risk that people should enjoy. Otherwise, we capitalize everything today, sending cash and wait for the United States to blow up if you are listening to me.

We are in the business of managing those cash flows. That's the beauty and the curse that Welly's got to deal with, and I would say at 211 basis points, we are probably somewhere in the 90 basis point over our historical average spread over the life of the Company since 1997. And it has created an over 500% return which there aren't too many other companies that can say that or prove it against whatever else it is.

We looked at it this morning versus gold, versus Goldman Sachs, Berkshire Hathaway, the S&P. Yes, we are not Google, we are not Facebook, but that is not what you are paying us to do.

Right. I mean, is it a fair statement to say that given the 211 basis points today that there is an opportunity to take back in today and extend the timing that you can have -- that you can lock in that type of a spread? I mean, is that a good way to think about it?

I like the way you're thinking.

Great. Thanks a lot.

Stephen Mead with Anchor Capital.

Good morning. Can you shed some light on the issue of the CPR rate and there are a couple of questions.

CPR is driven by sort of what you buy or what mortgages you buy. The other thing that lurks in the background is what is happening in terms of the credit experience and whether we are going to run into another period where Fannie Mae and Freddie Mac accelerate the purchase of bad loans. Can you comment on those two things?

And then a little bit of some of your feelings about CPR going forward?

Yes, no. If housing continues to go down, I would expect -- if that was the only thing that was happening and rates to stay where they are, I would say that the refi ability of the general borrower is somewhat diminished.

And yes, there is an impact getting here, your first statement on a 20 CPR as something that you paid [$1.01] for is different than 20 CPR as something that you paid [$1.05] for. So the level of coupons is impacted, relative to the premium that you pay, even though the number is the same rate. So it does have a tremendous amount of bearing on what your reported experience is.

As far as delinquencies or potential problems starting to well up in the agency's books again, I don't think that we would necessarily see the kind of concentration that we saw in Q1, Q2 of this year in their buyout program. My hope is and we expect that they continue to work these things through in a more normalized fashion.

I mean, they did put out a statement with respect to a lot of the Robo-Signer and some of the affidavit issues. They go through four points and the last point is is, if everything is in order avoids delay on foreclosure. So you know get this stuff run through the system and it would be a prepayment slough. And so, we could be experiencing some of that in these numbers right now.

You know, my -- I think the mortgage market is not the thought that you are going to see another holding back where they are advancing insurance, and then all of a sudden you are going to see these massive buy outs.

Steve, can I just expand on the policy side of that for a second? You know we were spending an inordinate amount of time down in Washington making sure that we were in touch with and sitting on top of this. Actually, Jay Diamond is the guy who is on the foot. (technical difficulties) for us.

A couple of observations that I would point out. One is, is that according to our numbers, our best guess right now, we are headed towards 40% of the cohort in Fannie, Freddie, and FHA is underwater.

So one of the aspects of voluntary pre-pay is being automatically taken away. And I think we have argued pretty effectively over the past couple of quarters at least, and maybe longer, that the problem in assets is not about necessarily debt side of it right now or rate structure. If you can't finance yourself out of this problem with a 3% mortgage at this point, then you really -- you probably can't be refinanced out of it. Good, bad, or indifferent, whether you sign the docs legally or illegally or put in a false report on your W-2 when you did the loan.

So it's not about rate structure. Nothing is going to be saved by bringing down interest rates any further. It is about equity and it is certainly the pre-pays that are being put through the agencies.

First off, the people who are running the agencies today are not the caretaker people who were in there in the transition from when they went into [conservative shift] during the Bush administration. These are very good mortgage people. They deserve our respect. They are in the middle of a tremendous amount of paper flow, putting assets back into the banking system. There is a lifetime put when you originate a mortgage into the system. As the bank back out defending Freddie if anything is wrong with that document are the life of the loan, Fannie and Freddie have the right to put it back to you.

So I think the war that you're seeing today which is just unbelievable from this observer's point of view of the Federal Reserve, going after someone that they regulated and that they forced to buy Countrywide over documentations in reps and warranties, is just an unbelievable uncertainty that will continue to keep these spreads at extremely attractive levels for a long time to come, I believe. It is a question of entry point from our prepay point of view and that doesn't mean that you necessarily want to acquire them with a dollar price of $1.08.

So we don't think that the agencies are going to be pushing a lot of stuff back out into the investment pool. We think that it is pretty clear now that people looking for legal recourse against the banking system. And that legal recourse is going to wind up being an uncertainty in terms of the major banks for some period to come. And certainly they are building up the reserves on their legal fees, etc., to have to fight the battle. So it certainly appears as though there's not a settlement going to happen here.

All right. Thanks.

Ken Bruce with BofA Merrill Lynch.

Good morning. I will take from your prepared remarks that you expect this to be a very low growth type environment. Is that a correct portrayal?

Yes, I would add the caveat on there as a macro -- a macro point of view -- is that there are two aspects that we need to be aware of. One is energy and the other one is healthcare.

If we have breakthroughs in either one of those two sectors, then I think that you could see interest rates reverse very quickly and growth pick up very quickly. Not only in the United States but across the world. But I think the United States will be most impacted on it.

I always like to say, and I'm not sure if I've said this to you, but somewhere in the United States there are two kids that are one beer away from figuring out the energy complex. And they will do it and the next thing you know we'll all be running around on electric cars or whatever the solar cars or whatever they sell the hybrid -- the new hybrid is.

And the second thing is in healthcare there is definitely all sorts of foundational roots being planted right now to get rid of some of the long-term scourges that are such a drain on the healthcare system like cancer or Alzheimer's. And I think somewhere in one of these labs, most likely in the United States, but maybe in another country, you are going to see some sort of gene therapy breakthrough or stem cell breakthrough where the next thing you know you'll be taking an aspirin and you will be worrying just about how to replace your knees and your hips.

So from my point of view those are the two caveats that I threw out there. But other than that, I would agree low flat growth is probably the way to go from an investment point of view.

I mean, and also just based on the 40% of Fannie and Freddie as being in a negative equity situation, that we are really looking at a situation where this rate environment is not likely to change, unless there's a big pullback from the dollar, I'd suspect you might say. And that turnover within these mortgage portfolios aside from maybe the small cohort that's been turned over here a few times probably in the last couple of years are going to be basically not prepaying very quickly in the broader universe. So not the worst kind of prepayment environment to be operating through. Is that correct?

I would agree. And I think that if you look at the regulatory and supervisory environment that is being developed across the globe, one of the things that we've been preparing for in our business model is to embrace higher amounts of scrutiny from a regulatory point of view and compliance.

That is why we started our cap and that's what we've done some of the things that we've done in terms of launching the other vehicles that are here. But I would say that if you look at FASB 166 and 167, if you look at Basel 3 and you speak to the officers that are running those companies, especially as it regards Basel 3, that credit tightening across the globe is a very real thing. We expect those ratios, those Tier 1 ratios in the case of the Swiss to be in the middle teens requirements as opposed to US which is at around 7% or 8%.

So that is a global grab for credit and the balance of all those other regulations are driving business directly into structures like Annaly, Chimera, and CreXus. We are uniquely positioned to be the riskholder and it is our view that that is a huge business opportunity across all of the mortgage arena for us.

So in a low growth arena with potentially inflationary outcomes at the end of it, where you want to be is where Wellington and the team here have navigated the portfolio and still created a 15% return on average equity against that balance with some volatility in book. But if anyone thinks that book value at the major financial institution is easy to be calculated, then they don't really understand the issues and the problems that are faced inside of the valuation techniques today.

Well, at least your book value is clean. You can -- you understand it.

Thank you.

I guess the -- I'm going to -- I don't want to put words in your mouth, but I guess I would probably characterize your hedging strategy as one taking advantage of effectively just the very low rate environment in this case. Because, really, from the perspective you just laid out, the concern around rising rates is probably not in the next couple of years. It is going to be something much further out.

So your positioning today is just a fraction of maybe the fact that keeping some swaps is attractive, and you don't want to kind of pass that by. But the reality is there's not going to be much in terms of that coming back to you any time soon, it would seem.

That is a nice way of saying that we always could be wrong.

We actually always -- we always want to withhold the opportunity to be wrong in our business.

That's right.

Yes.

Look, it would be the easiest thing in the world today to be running this at 20-to-1 debt to equity. But I think that my experience, and having watched a lot of people carried out in body bags, teaches me that that's not really quite as easy as many people might think it is to do.

All right. Okay, well, you know good performance in a very tough market. I think you should be commended for that and thank you for your comments, as always.

[Jasper Burke] from Macquarie.

Hello, it's Matt Howlett. Thanks for taking my question. Mike, in the scenario where the Fed does resume the DMBS purchase program and potentially takes down yields and spreads tighter and it still remains a strong bid from the banks, do you see a scenario where you could possibly sell it in more assets and take leverage down further what is already at historically low levels? I mean, is there any room for that? If you just feel that things are going to widen out at some point and you might as well just sell into the bid and wait. Kind of like what you did in [CHSM 3] and kind of wait for a better entry point?

Let me -- can I just explore that question with you a little bit?

Sure.

Why do you think that the Fed will buy more mortgages?

Well, I still think they want to take down mortgage rates and feel that they are still in this area that lower mortgage rates some people will still spur refinancing despite your opinion that people who have already refinanced have already taken advantage of it. I still think that they feel a sub 4% mortgage rate is where they want to keep things.

Well, they're there. Right I mean [3.5s are trading at 101].

The good news is when they were buying mortgages were actually cheaper.

Yes, exactly. It didn't have the effect that they wanted it to have. I believe that that was their goal. If you think about the size and dimension of the programs that have taken place, and I would refer back to the second-quarter earnings call for this is that if we are looking for the Fed to tighten interest rates in some sectors, I would say between the Fed's activity or lack of activity in the mortgage market, the Treasury steps that they've taken in terms of in reducing their exposure in the market and, lastly, the legislative exploration of all of the support for tax credits, etc., the market already has tightened. And the characteristics of that market are that spreads have essentially flattened out and it's at exceptionally wide levels as a result.

You know, it is potentially -- it is a potential problem if the Fed comes in and continues to buy, let's say, another $0.5 trillion worth of mortgages. I don't think that that is the problem. There's plenty of bid out there for mortgages. We are competing with it every day. We see a lot of flow. There is plenty of money that is available for it, which is different than what they were faced with when it was [250] off and no one would buy a mortgage back in 2008 during the winter.

Today you see the effect of all of the liquidity that has been pushed in a specially from the private sector as a result. But I do think that the long-term consequences of doing that simply speak to (technical difficulties) and the world is managing itself towards much lower rates of return in general. Right?

Right.

And I would argue that if you are creating a 20% total rate of return and promising that to your investors in a zero bound interest-rate environment where the Fed is being interventionist, then you are being dishonest with your investors.

Right.

Because you are putting risks into your portfolio that clearly you do not understand, and you haven't existed through.

Right.

So you know, I'm sure that there is plenty of opportunity to do that. I can tell you that we could be at that number in about four hours if Welly decided to do that. But I think that history and experience have taught us that when you are navigating at the low end of the tide, you better be very careful about how you navigate through that reef.

Right. Fair enough. I mean, but just on the Fed scenario I just worry that they don't have to worry about [hedged] interest rates are going to put on their balance sheet, not hedge. Whether or not they would potentially take the relative value component out of the MBS market and tighten things to a point where it just doesn't make sense to bid against them, if you will. And rather than to sell it to them, take the gains which you clearly have the ability to produce. And --.

There is no question that we would to do what's is best for the shareholders at that point.

Okay, good.

If they are going to drive book up to $18 and we are going to basically liquefy and pay that out to our shareholders, there's been worse outcomes in investment history.

Right. Exactly. And then no one has asked yet just on FIDAX, you made -- you hired some personnel, I think, for the Bank of Ireland. And it looks like you are going to start possibly a BBC or something. Maybe you can elaborate what is going on inside of FIDAX or taxable sub?

You know I have to stick with exactly what is out there. In the public markets, yes, we did hire a team in the [middle markets] lending. We think very highly of these guys. We found that their information and their knowledge inside of the markets that are out there in that size market, especially, are tremendously -- tremendous contributions to the way we think about investments in general. And certainly would help us sculpt the nature of this call off of the investment decisions that are going to emerge over time in that market. Yes.

Great. We will look forward to more news on that. Thank you.

Bose George with KBW.

I just wanted to follow up on the prepayment issue. But I was wondering was there any lingering impact from the GSC buy outs in July? And also on a monthly basis was -- did you see any changes month on month over month on pre-payments?

No, I mean, we should be experiencing it. And we probably have experienced it through our entire life as a mortgage investor, you know, delinquency buy outs. During July, August, we didn't necessarily get any indication that there was above-market experience in that sector of the prepayment contribution.

So I just think with the level of rates and you know, the Fed and the Treasury hell-bent on trying to get everybody to take out some more debt and to refi down, you are going to see that experience. But then, ultimately going forward it is not about rate. I think it is largely not been about rate all along to get the housing market we started.

It is about price and people don't have a down payment. The world is trying to go back to sound underwriting. And that's the problem that everybody is facing.

So pre-payment landscape, I think you are going to continue to see fairly robust, given the level of rates and at some point the diminishing returns with every 10 basis points, I think, is going to start to evidence itself in pre-payments going forward.

Okay. Great. That makes sense. And then just a question on something I think you guys used to disclose in the past. Just the percentage of your fixed-rate portfolio that CMOs is, is that -- I didn't see that number.

No. We do not have those numbers disclosed.

Okay so that's not something that you would want to disclose?

No. We generally don't.

Okay. Thanks.

Stephen Laws with Deutsche Bank.

Thanks for taking my call. Just a quick question. A lot of things have been covered, and I appreciate that. Wellington, can you maybe discuss how the advantages and disadvantages maybe of managing a portfolio the size it is now as Annaly has. As recently as, I guess two years ago, it was only just over $50 billion. So can you maybe talk about any advantages or disadvantages you have now especially on the heels of Mike's comments about carefully managing the portfolio here when the tide is out?

I don't care what size you are dealing with. Everybody is dealing with the same market and the same pricing in the market. So for anybody who thinks that there's the ability to get tremendous value if you only bought smaller pieces is mistaken.

So the advantages and disadvantages of size, I think we have a tremendous advantage that we get shown so many things. I think the Feds demonstrated for us earlier in the year that you can buy $20 billion a week. They haven't been doing that and yet mortgages continue to move higher.

So as far as being able to put the money to work, you can always put money to work. It's all a matter of the broader market and what returns look like and like I mentioned earlier, spreads are at historical wides, relative to LIBOR and the swap market.

So from that perspective, it is a very attractive market. And you can look at the dollar prices in the market and say you wish you didn't have to deal with these dollar prices, but they are a reality. And they are a reality for everybody. I don't care if you are buying one bond or 10 billion. It is a reality for everybody.

So you know, with respect to the challenges of size, I don't think I think even in the repo markets there is a tremendous amount of liquidity and if we wanted to double the size of the portfolio we could do it. So it's not an issue. At some point, it may become an issue, but right now it is not an issue.

Great. And then, you mentioned repo. Can you talk about counterparties, a lot of liquidity there? I know your leverage is low but are you seeing more entrance in there and talk maybe about where haircuts are now in the (multiple speakers) --?

No. Everybody is very impressive. All our collateral is very well bid and we can go out pretty far out on the curve if we wanted to. The repo markets there is -- I mean, I like to remind everybody that the Fed injected $1.2 trillion of printed money into the system. And it is sloshing around. And we are a beneficiary of that. There is no question.

And the banking system is, they are beneficiaries of these spreads as well. And so, you have a tremendous amount of liquidity out there.

Great. Thanks for taking my questions.

I will now turn the conference back to Mr. Farrell.

Well, I want to thank you all for being with us here today. We, as usual, have our stuff on the website. So if you want to review it, please take a moment to do so, Annaly.com. We look forward to speaking to you again in the first quarter. Thank you.

Ladies and gentlemen, if you wish to access the replay for this call, you may do so by dialing 866-286-8010 or 617-801-6888 with an ID number of 533-79330. This concludes our conference for today. Thank you all for participating and have a nice day. All parties may now disconnect.