Annaly Capital Management Inc (NLY) 2010 Q4 法說會逐字稿

Good morning, and welcome to the fourth quarter earnings call for Annaly Capital Management Inc. At this time I would like to inform you that this conference is being recorded, and that all participants are in a listen-only mode. (Operator Instructions). 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 the 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, believes, expects, anticipates, continue, or similar terms or variations on these terms, or the method of these 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 effecting our business, our ability to maintain our process case as a REIT for better income tax purposes. Risks associated with a broker deal business of our subsidiary, risks associated with the investment advisor business of our subsidiary, including the removal by clients of assets they manage, their regulatory requirements, and competition in the investment advisory business.

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

I will now turn the call over to Mr. Michael Farrell, Chairman, Chief Executive Officer, and President. Please proceed sir.

Thank you Amy. Good morning everyone, and thank you for coming to Annaly's fourth quarter earnings call. I am Mike Farrell and today joining me are Wellington Denahan-Norris, our Chief Investment Officer and Vice Chairman, our Chief Operating Officer, Kathryn Fagan, our Chief Financial Officer, and Nick Singh, our General Counsel. To begin our call this morning I will prepare some remarks, after which we will take your questions. As has become customs we have paired video companion to the remarks which I expand on today's theme. This video piece as well as the full text of my remarks can be found on our website at www.Annaly.com.

Today's piece is entitled A Father's Question. In May 1986 as I sat at my dying father's bedside trying to make sure he was as comfortable, lucid and pain-free as possible, we talked about a lot of things, life, experiences, family, Wheel of Fortune, he had a thing for Vanna White, and my career choices. An uncomplicated man, a World War II veteran, a construction worker, a trade worker, an immigrant father of seven, he asked me one night in a hushed Irish rogue, tell me once again what it is you exactly do. A Wall Street mortgage trader at the time, I babbled out some incoherent answer about the capital markets, mortgage securities and trading positions. I am sure that my answer just added to the fog that the medications had created for him.

Today in a very different time, I will try to answer that question again, but this time as it relates to Annaly which was not even a twinkle in my eye in 1986. Annaly was conceived in 1992 as the solution to a business problem. How to optimize the operations of a private leveraged investment strategy that Wellington and I were managing for high network individuals, and provided the liquidity, transparency, scale and depth of both the equity and the debt markets. The prospective drafting session began a weekend in my attic office, and promptly ran into four years of trying to navigate the process of bringing the idea public.

We began with a small private placement in February of 1997, and took the Company public on October 8th 1997 with a market capitalization of approximately $125 million. Since that day Annaly has become the largest pure play public market financier of residential mortgages. The last sentence is important to understand. If asked the question today, what is it Annaly exactly does, that is the answer.

Annaly organizes capital formation for residential housing market. Investors both domestic and international entrust us with their capital to purchase securities that have US mortgages as their underling collateral. Presently Annaly has a market capitalization of about $12.5 billion, and together with the companies and funds managed by our investment advisors, we collectively manage total assets of roughly about $100 billion, mostly mortgages. Because of our ability to finance this amount of mortgages, we estimate that we have in essence financed a shelter for about 750,000 American families, or more succinctly about 2 million American citizens.

Just with the proceeds of our last capital raise and attendant financing, we will have provided capital for approximately 50,000 to 60,000 residential mortgages. The circular nature of our REIT tax collection is such that the residential mortgages that we fund turn Annaly into an economic engine. Since our IPO, we have generated a total rate of return of our investors of almost 590% through December 31st, 2010, most of which comes back to you in the form of distributions of dividend income. This above market income-based return has generated economic activity in our shareholder base, whether it is for reinvestment or consumption or paying for life's necessities.

Over the holidays I received an e-mail from a shareholder in Florida, who had been out driving that day and passed a convertible with vanity license plate that read, Annaly thanks. Over the years I have received pictures of similarly marked boats, and other toys in our Investor Relations mailbox. Investors write to us to relate how their Annaly dividend pays for their children's education. The most emotional moment for me personally was at a recent Annual Shareholder Meeting in New York, where a shareholder stood up during the question-and-answer session and publicly thanked the management team for providing him with the income to provide for his ailing mother in a nursing facility. Since 1997, we have declared $5.5 billion in cold hard cash for payments to our shareholders, through quarter after quarter of operating conditions that were never steady, never standard, and never predictable.

Once those dividends are distributed the income tax code takes over. Generally taxed at ordinary income tax rates, a large portion of our gross dividend payment becomes part of the local, state and federal tax coffers. The tax revenue is recirculated through municipal operations, federal projects, and government employment at many levels. Using an estimated top marginal Federal and state tax rate of 45% as a benchmark, that means that our shareholders via the dividend checks have remitted approximately $2.5 billion in tax receipts back into the system since the IPO. In a recent statement by the Board of Governors of the Federal Reserve System, the Fed announced it too had become an economic engine, thanks in large part to its portfolio of mortgage-backed securities. It reported net income of $80.9 billion in 2010. Up 51% from 2009, largely due to returns on its much larger portfolio of mortgage-backed securities.

Most of the net income was distributed to the US Treasury. The graph depicting this distribution can be found on our website. This income helped mitigate the deficit, and needs to be counted as a counterbalance to the cost of backstopping the GSEs, and has provided much-needed interest rate relief to the American consumer, at a time when credit markets are shunning them. This speaks to the value of the government guarantee of mortgages as we discussed in our prior calls, especially during the earnings call for the first quarter 2010 entitled Its a Wonderful Wrap.

The agency mortgage-backed securities market attracts a large number of many different types of investors, all seeking the same thing, the liquidity of government guaranteed securities, and the opportunity to manage the interest rate risk associated with mortgage-backed securities, not the credit risk. The private label MBS market on the other hand has a different investor base, different liquidity characteristics, and different return dynamics. The differences in these two markets are visible in the economics to the home, American home mortgage borrower, and never in starker terms than we see today.

The concluding point of my discussion today is that we are in the 50th anniversary year of the enactment of the Real Estate Investment Trust law, passed by our Congress and signed by a President frustrated by the lack of public access to real estate investments. To my mind, REITs have achieved the goals of that original legislation. In 1983 the total capitalization of all REITs was about $5 billion. Today there are 19 REITs that have market caps in excess of $5 billion, and all REITs have a combined market capitalization of almost $400 billion. More investors than ever before have accessed the institutional world of real estate investment.

REIT covers the spectrum of real estate investing, everything from apartments to storage facilities, timber, office buildings and student housing, and they invested in all levels of the capital structure from mortgages to preferred to equity. I believe the recent investment activities across the capital stack have helped support the market in a number of asset classes over the past few years especially. Congress today is faced with similar frustrations as the Congress in 1960, but the problem today is very particular and peculiar to our time.

Specifically our policymakers are delivering over the funding challenges facing homeowners and the potential homeowners in the aftermath and collapse of the housing market. As Annaly has demonstrated Congress today has before it the coherent, socially valuable solution that is at once familiar and embraced by the capital mortgage REITs. Sometime in the future when my grandchildren ask what is it that you exactly do, I think I will have a much better answer I did than the last time.

With that said, we will close out the formal comments, and we begin the Q&A. Amy, can you open up the line please?

Certainly. The question-and-answer session will now begin. (Operator Instructions). We will pause momentarily to assemble the roster. Our first question is from Bose George with KBW. Please go ahead.

Good morning Bose.

Good morning. A couple things. First wanted to check on where incremental spreads are for stuff you are putting on now?

Bose, it varies, but obviously the market as it worked its way into the new year has presented us with very attractive returns. If you just look at the market relative to swaps you are still in the 120 to 150-ish range, depending on the tenor of the swap. And if you are just looking at pure spreads to financing, you are still looking at tremendously attractive levels. You just look at three-month LIBOR to the current coupon. You are somewhere in the high 300's to low 400's. It is a very attractive market.

But just using your typical mix with mid to high-200's be kind of reasonable?

You are in there, in that ballpark.

Great. And the second thing I had was a little clarification on the dividend. When you think about the difference between using your basic shares and diluted shares to calculate the dividend, doesn't it make more sense to use the basic since that is what you are paying the dividend out on, so in terms of a number that should track, the dividend should really be EPS based on your basic shares, is that right?

Dividends paid on actual shares, you get that number from the balance sheet, so the basic shares are the weighted average. That is not what the dividend is paid off of.

Once there is sort of the shares normalize it should be closer to that then to the, because the diluted shares will always include the preferred stuff that you are not paying a dividend on, right?

That is correct. You did see that change this quarter. The diluted, there was a bigger difference from the basic, and that is because of the convertible debt.

Right.

And in the prior two quarters because of the swap book you had a net loss, so that does not come into the calculation, but I would focus on the basic number.

Okay. Thanks.

Our next question is from Steve DeLaney with JMP Securities. Please go ahead, sir.

Thank you, good morning, everyone.

Good morning, Steve.

I guess this is for Kathryn for starters. Kathryn, the sequential increase in premium amortization from 3Q to 4Q was an increase of about $50 million, or maybe 33%. We note that there was this temporary spike up in CPR from $20 million to $23 million. But can you offer us any other color or explanation as to why we moved up from like $150 million to $207 million in premium amortization in the fourth quarter?

I can take a shot if you like. The composition of the underlying portfolio is constantly changing, so if you look at the prepayment number it is just one number, but the way that that breaks down with respect to the underlying assets can fluctuate around.

Even though it has a 23% CPR, that doesn't take into account if it is purchased at a premium or a discount at a particular security. It gives you an indication what the weighted average on the portfolio is. You can have a premium security that you bought at par, but that is not reflected in the, a security bought at par or a security purchased at a premium, that is not flowing through to that 23%. Which is a snapshot of the last day of the quarter.

Understand.

Steve, the bottom line is with the back up in interest rates, you should have a somewhat more subdued profile on the refi front.

Steve, that just leads to a point that I think we should be aware of that we spoke about on the third quarter call, which was we noted on that call that when interest rates go up there won't be a bell ringing, and we won't be in a position to take advantage of the swaps market the way that we have been taking advantage of while the rates were declining. For those who don't follow the nuances of the credit markets every day, it is important to notice that during the fourth quarter, the rate on the tenure went up by the highest ratio that I have ever seen it in my career, roughly 35%.

That drop-off clearly has a lag to it to the prepayment curve, so we think fundamentally that you are probably past the spike here in rates, and that people should also be aware that ever since the Jackson Hole speech last August, that in effect the sovereign rates at the long end of the curve have done nothing but go up, despite having the world's largest sovereign wealth fund of our reserve committing to buy hundreds of billions of dollars worth of securities. So we think fundamentally and technically the mortgage market is an extremely good position here.

And it sounds like the fourth quarter was really just an anomaly. We had the big drop in rates late in the third quarter, and I guess mortgages got as low as 4.2, and when the refi index was up in the 4's and 5's there briefly, even though now the outlook for prepays is slower, because mortgages are back to 4.9, you had sort of an anomaly in that speeds for your fourth quarter actually picked up a touch?

Yes, you always have a lag between the event in rates and the experience in the refi.

I think that also touches on an aspect which maybe not everybody is aware of, which is in December, 46% of all of the refinancings that went on in the United States were cash in refinancings. In other words, people had to put more money in order to drop their, to get their loan to value ratios to a point where they could actually take advantage of the lower rates.

Makes you wonder how many people are sitting there with checkbook in hand ready to write that check.

Exactly.

This is helpful. Just one final thing. Kathryn, can you comment, I know Reuters finally came out maybe 45 minutes ago, and put something out about sort of comparative quarter to quarter, and EPS versus Consensus. You guys have been reporting on core going all the way back to like first quarter of 2006, and this quarter you changed. Could you comment on that as to maybe why the change, and what should we expect going forward in terms of GAAP versus core, or how you plan to present your EPS each quarter? Thanks.

Sure. Back in 2006 we made the determination to report core earnings, because we had capital loss carry forwards from securities that we sold in 2005 and in 2006. So the tax GAAP number was very different. As you know during this year and the year 2010, we did use all of the capital loss carry forwards, and we started paying out capital gains as part of our dividends.

Right.

You will see that on your 1099, $0.15 of your dividend was in capital gains. So the core number is not as meaningful as it was for that time period, because now we can pay out those gains, and it is reflected in your dividend. One thing that does skew the GAAP number is the market value swings on your interest rate swaps. Those are really dramatic, and maybe not a true reflection of the operating business. So we do strip those out and provide an EPS number without the affect of interest rate swaps. And that is what you will see going forward.

Okay. So if we just took the old core methodology which was pretty straightforward, even though you are not going to use that, if we took that old core methodology and added back realized gain on sale of MBS, that should give us a pretty good indication of your dividend power, if you will, the combination of those two.

You are assuming no gains during the quarter, That is how you would calculate the number.

And actually we broke out core analyst by analyst, and we outperformed core, based on what we think they were incorporating in their numbers.

Thanks very much.

Thank you, Steve.

Our next question is from Jason Arnold with RBC Capital Markets. Please go ahead, sir.

Good morning everyone. Great commentary as usual, Mike. Just curious if you could offer some more color on the portfolio activity inter quarter. Just looking at the Fannie 5, I thought we might see some flattish marks on the MBS portfolio. I know you own a wide spectrum of bonds, not just Fannie 5s, but the MBS volatility in the quarter probably played a role here, but it would be great to get your take?

Thank you Jason.

Well in the third quarter you had mortgages underperforming. That is the quarter in which we had Treasury rates at some pretty low levels. Mortgages were underperforming at that time. Swaps were doing what they should have been doing which resulted in the book value for the third quarter. Now the book value improvement that you have seen in the fourth quarter, the premium sector of the market obviously had been taking some beating in the third quarter due to the level of rates. That has since improved. And the swap book has performed as it should perform giving us some relief.

I think to put it all into perspective, you have had a fairly dramatic sell-off in the bond market, and are looking at a portfolio of a leveraged mortgage position that actually improved in value, which just gives you an idea of the flexibility and the strength of the portfolio position having gone through such a move. We do continue to pay for these swaps, and we have talked about it, and I don't know if it has really resonated with investors, on why we would carry such a large book, but again it has done what it was meant to do, and has protected shareholder value while still delivering very attractive returns. Now going forward I see the market, I love to see this type of volatility setting in. I think there is going to be a tremendous amount of opportunity not only in the swap book and in the mortgage book going forward, so that we can continue to take advantage of all that the market has to offer for shareholders.

Great, okay, thank you for that. And then I guess one for Mike, and anyone else who would like to chime in. I was just curious about your thoughts of home prices going forward here, and the implications this might have on what the Fed does going forward as well as the long end of the curve? Thanks.

I think you have to take Chairman Bernanke at his word yesterday, despite the enthusiasm some people might paint on the unemployment number that was released this morning. This is a long-term problem in employment and incomes in the United States, and I think that whether you are a government employee, a Federal government employee and just got your salary frozen for the next two years by the President. Or you are a state employee who is under the gun because the pension fund needs to be funded or restructured, and you will see the consequences of that, either in your hours worked, or in your pension check. Across the board we have had stagnant incomes in the United States for a while.

Taxes are definitely, taxes and fees are definitely going to go up on an inflation adjusted basis across the United States. The result is that house prices are going to stay under pressure as a result of that. There is still a huge amount of shadow inventory out there. There was an article out this morning that food stamps actually had their highest participation ever by the population. So that doesn't bode well for the 42% of GDP that is sort of daisy-chained into the housing, construction and formation businesses. So I am extremely cautious about house prices here. I don't think that they can really do anything other than maintain a flat to declining ratio.

Great. Thank you for the color. I appreciate it.

Your next question is from Matt Kelly with Morgan Stanley. Please go ahead.

Thanks, guys. Just wondering, given your thoughts on the forward curve, how we should think about your MBS sales going forward, what sort of opportunities you are seeing in the market now in the first quarter to sell?

We will continue to optimize the portfolio. We are not going to go into details about what we are going to sell and what we are going to buy quarter by quarter, but I will just tell you as we have in the past, we will continue to try and maximize our return potential, and maximize our flexibility in return, as we continue to navigate through the markets. Mortgages are a unique asset in that they present a lot of opportunity to maximize returns.

I mean, if you look at 2007, 2006 as an industry we were generating $3 trillion worth of originations and refinancings during that period, at the boom, at the peak. This year you will see less than $1 trillion done. We think that is going to continue to maintain itself as a very powerful, tactical support for the industry in general, and also for the spreads. So I think that within that you are going to get aberrations, because of either government policy intervention, or interest rate moves that might surprise people with the up and downside, but the spreads and the swaps and the funding are in the best position that they have ever been in. So anything that is additive here, can be additive at very low amounts of leverage, and as we just demonstrated in this quarter, the whole conversation on the third quarter, Matt, with many people was about the effect of the swaps and how come we got hit on books. We just had the largest hit that we ever had to the tenure, and probably the history of the United States, and our book value went up. I didn't see that anywhere in the notes this morning. So from our perspective, the position of the Company is in an extremely powerful position to take advantage of the opportunities that are out there and across the different coupon stacks.

That makes sense. On the swap book then, and just the overall hedging of your book, what sort of duration gap are you looking at here, and what is the right amount of hedging of your repo?

We continually reassess our outlook on the market, and how comfortable we are with our placement on the curve. But generally speaking we hang very short, close to the short end of the curve, anywhere between a half a year to one and a half year-type positions. Again there is nothing hard and fast about it. We continually reassess where we feel comfortable.

Okay, great. Thanks, guys.

Thank you.

(Operator Instructions). Our next question is from Jim Ballan with Lazard Capital Markets, please go ahead.

Thanks a lot. The averaged fixed pay rate on your swap portfolio continues to go down each quarter, and it looks like there is a good amount of room to go there. Can you give us any color on the swap, the rates of the swaps that are going to be rolling off over the next year or two? I mean, can you give us some bit of color on that?

No, not specifics. All I can say is obviously the higher pay rates that were put on a long time ago should be coming due. We continue to roll down into this market, and continue to take advantage of what the market has to offer.

Okay.

Keeping in mind we will not be at zero Fed funds forever.

Right. Okay, well just a little bit more on the decision to step up the pace of asset sales in the quarter. Are you thinking directionally about adjustments in the barbell strategy in terms of, like you said, we are not going to at the zero Fed fund level forever. Are you making adjustments to that strategy in anticipation of an eventual tightening cycle here? Can you give us a little color on that?

We will constantly monitor our outlook on Fed activity, Fed policy, with respect to, because this is really one of the first times where you have them as a large participant in the market, not only setting rates for the market. So we keep all of that in mind as we continue to move the portfolio through time. There is no question that you can sit at zero rates for a very long time. I think we have another large economy out there that has demonstrated that for everybody. You have to strike a balance between expectations and reality, and being able to navigate those two with a large portfolio of mortgage securities.

Like I said, we will continue to be opportunistic with changing our position in the stack, and taking advantage of the volatility in the market. We certainly look forward to continued volatility, and we look forward to the debate about what is the next move for the Fed. All of those things in our minds are tremendous opportunity for shareholders, and as Mike said in his opening remarks, about what we have delivered to shareholders over the years, none of the markets have been similar. They have all been very different, and very different challenges that we face. I think it is a very interesting place to be in the mortgage market. And sitting on the forefront of what ultimately will unfold, and being in a position to take advantage of it.

I would say, Jim, just from the perspective of the way we look at the businesses that there are two ways to take advantage of what is going on in the market from being at this zero-bound interest rate policy, that seems to be the main factor or the main weapon that the Fed is using to regenerate economic activity. The bump up and write-down on amortization for the quarter, as we pointed out earlier in the call, that was $50 million in one quarter that we ate. So I think our share count at 7 million shares and divide it by that. Just assume that at this point as we pointed out on our second quarter's earnings call, effectively we think all of the Stimulus has been removed pretty much from the mortgage market, and you had this last shove through of rates and refinancings in the fourth quarter.

We could be in a protracted period of declining CPRs. The CPRs that went through last year were roughly 27% on average for the year. The highest parts were in the beginning. So those metrics per share can be a very powerful result without having to do anything to the portfolio, other than just let that burn out. So I think a middle-teens return at a lower amount of leverage is a pretty attractive thing. So not only defend book but increase book, when you have got a huge back-off on the rates on top of it. That is certainly not the position that we were in in 1999, when we had a 24% peak to trough move in book. So we are pretty pumped about the environment that we can invest in today. But we have to be circumspect about how we go after it.

Thanks a lot.

Our next question is from Douglas Harter with Credit Suisse. Please go ahead.

Thanks. Mike, I wonder if you can talk about your expectation of GSC reform, and the headlines that we should be seeing in the next couple of weeks?

Thanks, Doug. Well, I appreciate the opportunity to get a little bit to talk about this because I think it is very important. We have been very active obviously on both the legislative and the policy front, as many levels we can be involved in. Educating and explaining to people the balance of why the markets are in need of a government guarantee, and what form we should take. So I will take a little moment here to explain what we think the perspective should be, and then I will explain to you what the summary is of our three-point plan.

First off, as I said in the opening comments, the environment today, if we did not Fannie and Freddy today, congress would be scrambling to create something like Fannie and Freddy, in order to generate economic activity and support for real estate prices and housing. 95% of all of the mortgages that are being originated in the United States right now are government guaranteed in some way, shape, or form. The market has shrunk from about $15 trillion at its peak, to about $11 trillion today. About half of that is government guaranteed. From a policy perspective, we think that they will not be able to get away from the government guarantee, although they might have to modify it. But we think we don't want to throw out the baby with the bath water here. And we want to recognize what was done correctly and not done correctly.

What was done correctly was for the vast amount of its lifespan, Fannie and Freddy and Ginnie Mae have basically set pretty good underwriting standards, except perhaps at the beginning part of this decade when it got dragged into the policy debate of affordable housing, and supporting policy initiatives as opposed to investment or capital initiatives. So when you look at the swath of government policy that over came that, what is the problem with a government guarantee? Well, we can put a government guarantee out there. Obviously the insurance has paid off over time as I demonstrated earlier in our remarks. The Federal Reserve has paid back about $80 billion worth of mortgage payments back into the Treasury, which helps reduce the deficit, which also helps reduce the amount of money that is being taken out of Treasury to support and backstop Fannie and Freddy. We think the government guarantee is important, and frankly as an investor what we hear from people they would rather lend to their neighbors at 6% than to Portugal at 6%. Nothing against Portugal or Ireland.

The second thing is they cannot be subject to two masters. Fannie and Freddy, one of the key elements of their failure in our view was the fact that they were reporting to the government, and it was via Congress, and they were reporting to the capital markets. And the result was that they were given access to portfolio leverage that was totally unsustainable and also a real competitive disadvantage in the market to try to price the premium. So if we estimate those numbers to be at 70 to 1 debt to equity when you take all of the off balance sheet considerations in swaps, et cetera, if they were not allowed to lever at those ratios, we would not even be having this discussion as a nation today.

So we don't think that they are going to allow portfolios to be run by the government any more, unless they are run by the Federal Reserve. The way they are doing it now and adding to the Fed balance sheet which is roughly around $2.5 trillion. And that would be only in urgent and exigent circumstances as it has been over the past couple years. The other things are that they need to provide for and maintain the TBA market, and that seems pretty clear. The TBA market is the forward rate market. It allows Americans to move between states, and also have household formation over a 120-day period.

That is a very important aspect of the way the cycle works for the United States, including schools and neighborhoods, et cetera. It allows people to move between New York and Texas and California and Nevada and Florida, and have the ability to plan, and to rely on what the financing costs are going to be. So that is already margined through clearinghouses here in the Street. It is a well margined business, it will be a profile for what we believe for what goes on in the derivatives markets. Perhaps as they are introduced into clearinghouse form, and margined again and netted out. But if I was a betting man I would bet on three aspects of this policy coming out.

One is, there will be a government guarantee. It might not be called Fannie and Freddy any more, it might be called something else, but there will be one. The second thing is, it that it will not be allowed to portfolio alone. That will be allowed and that will be a private market function, and companies like Annaly and the other people that are in the arena will be the price setters with investors of what that premium is worth. And then the last thing is that the forward market will be protected. If it is not protected that will cause a great deal of outrage at the consumer level, and also hurt the mobility of the US consumer to move between different markets, and I don't think that is something that will go over very well in most of the November elections. So that is where we think it will wind up.

We think that the paper that is coming out is going to kick the problem down the can. It was supposed to be a solution. It is going to wind up being a series of options. We are involved in that discussion along with the industry group. We are one of the leading voices there, and we continue to have very good dialogue with the Senate, the Congress, Legislators, and the regulators on top of it.

Great, thank you.

Thank you, Doug.

Our next question is from Greg Roer with Goldman Sachs Asset Management. Please go ahead.

Yes, hi. Thanks for taking the call. Growth in book value was obviously very impressive. I was just wondering how you reconcile that with the interest rate sensitivity table provided in the 9/30 Q that suggested a 75 basis point increase in rates would result in a 0.84% decline in the portfolio?

The tables provided in the Q and the K, they are based on just parallel market moves, it doesn't take into consideration any changes that are not driven by the mathematical changes in the market value. So it doesn't take into account market perception. Prepayment speeds are is going to happen in the market place. It is basically a snapshot at the last day of the quarter if we have a parallel move on both sides of the balance sheet, what is going to happen, with everything else being stagnant, no time for repositioning, and it is a one-year horizon. Really if you look back through time, it is not going to be a true picture of what is happening in the market, but more an indication of what could happen if all of the fundamentals go in the right direction.

Is there a CPR assumption that goes into that table?

It does, but it is based on an assumption on the last day of the quarter.

And then in terms of the decline in the annualized interest rate spread during the quarter, is that explained by the spike up in CPR?

Primarily, yes.

And so does this interest rate spread at the end of the quarter, which looked like it picked up suggest that things will be improving in first quarter 2011?

Based on market moves thus far, we should be in an improved position. I just caution everybody that these numbers are snapshots at one point in time. The market has improved since then, and continues to look attractive.

And just in terms of looking at core earnings as historically defined by the Company, is the dividend sustainable on a go forward basis based on core earnings, or is it dependent now on on gains from the sales security as well?

Gains have always been a part of our strategy going back from1997 forward. The dividend will reflect the income that the portfolio has generated, whether that comes in the form of spread income or gain.

I would say that if you run a total rain of return on any standard operating measure, on Bloomberg, or any of the other vendors, if you just run a total rate of return from inception on the Company, you will see that we ran a total rate of return around 590% through 12/31. Price appreciation accounted for about 50%, and dividends accounted for about 535% to 540%. The balance of what you are going to get from us will be a total rate of return that will be heavily weighted towards income.

And then one last thing, just curious, you guys obviously are operating at pretty low leverage, just wondering how you thought about leverage, and the possibility of increasing leverage to expand core earnings going forward?

In case anybody missed it, Mike did mention that we have delivered 590% over the years, and we think that is pretty attractive without having to reach for anything more via the leverage. Also you are going into an environment where you potentially have monetary policy changes, whether it comes through the form of the target rate or purchased activity from the Fed. I just think that it is a good idea to continue to operate with maximum flexibility, and you get that in one way through your leverage levels.

Great, thanks. That is very helpful.

Our next question is from Mike Taiano with Sandler O'Neill. Please go ahead.

Hi, thanks for taking the question. Was just curious, I had heard the FHFA was considering changing the way it compensates servicers by perhaps or lowering the minimum servicing fee, and I was just wondering if you think that would have an impact on prepayment speeds at all?

I think everything that is going on at the government level is a tightening of credit, Mike. And I think that ultimately, it has already raised the costs to refinance loans and concentrated the originations into about three or four large originators across the United States. So the price of refinancing a house is definitely a lot higher than it was back during the bubble, and I think all of this is leading to a tightening of credit that will slow the access to credit, whether it is FICO score creep, or if it is changing the underwriting criteria creep, all of this is intended to slow down consumer credits, and the macro picture by which we paint that against is that, as we said in our last call, it depends on which economy you are trying to save should be driving what Fed policy is. If you are trying to save an economy that was being run 70% by consumer access to credit and from a GDP point of view, and that was also 20% of global GDP, then I think that all of this is going to continue to shut down and mute growth going forward.

Okay. And then just a separate question, if you can maybe talk a little about the establishment of Shannon Funding that you announced I guess in November, as sort of what you think the opportunity there is in providing warehouse financing and what do you think maybe your competitive advantages would be there?

Shannon is still in the early, early phases as we announced. We think the opportunities are that there is an under bank sector of originators with smaller capitalization, that are being overlooked by the large banks right now. And obviously as a vertical integration in the business, that is a strategic decision for us to do. It is up and beginning to put in place all of the necessary controls and procedures and methods, to start originating loans this year. So as that develops we will share more information with the market.

Great, thanks.

Our next question is from Daniel Furtado with Jefferies. Please go ahead.

Thanks for the time. Do you expect Shannon, is that going to be primarily a conforming strategy, or will you also have non-agency exposure there, or not exposure, but warehouse funding there?

We are going to start off obviously with the agencies and do it simple. And as credit clear as we can possibly be, but we expect that that will grow over time. And more with the mortgage market. Regardless of what they do with GSA reform, we think that there will be a mortgage market, and we have prepared the business model from every aspect to take advantage of the hub and spoke, to take advantage of whatever emerges out on the other side here.

So theoretically under the right circumstances could that provide raw materials, for lack of a better word, for the Chimera strategy?

I think of it like GM owning the parts manufacturer, yes.

Okay. And then the other question, it is minor, but curious, the increase in goodwill, do you mind talking about that just a little bit?

Sure. We acquired Merganser, and there was an earn-out provision in the Merganser acquisition, and we made a payment in this quarter.

Okay, and finally if you happen to have it, do you know the fair value of the Annaly portfolio as a percent of par was at the end of the year?

Yes, I think it was 103. Let me just get the exact.

Thank you.

Yes, 103.9.

Perfect. Thanks again, take care.

Thank you.

Our next question have from Jasper Birch with Macquarie. Please go ahead.

Hi, guys it is Matt Howlett. Thanks for taking my question. Just getting back to volatility in the agency MBS, has there been any change in haircuts, and do you foresee with the announcement with the GSC or the proposal, any changes here this year in terms of rates?

No, the repo markets are extremely liquid. Cash is very available. I think it is important for everybody on this call to understand that one of the major changes that went in post-Lehman, was a reworking of the plumbing by the Federal Reserve that you saw, in terms of the way that they pay interest on reserves, and the way that they have organized the repurchase market, especially post-Bear Stearns. So we think that that is an extremely valuable asset for the United States relative to the other central governments. Obviously if you look at Euros, there is no central plumbing mechanism, that is similar to what is achieved here by the Federal Reserve. I think that they have done an excellent job under the radar screen here correcting all of that stuff. So I think haircuts are stable.

I think cash is extremely liquid, and the settlement system is working extremely well, and providing very good liquidity across the board. I would say the concerns that we have are more macro in nature, about whether or not the Suez Canal is going to be open on Tuesday for business, or whether or not the Euro is really going to survive as intact as it is today, which could effect market rates, et cetera.

It speaks to caution, but in the mortgage market, I think we are in good shape. And I would point out in terms of vertical integration we spoke a little about it, about Shannon. We also spoke about it in Merganser, in terms of that being a further distribution of the kinds of things that we do from an interest rate management point of view and a money management point of view. I would also point out in our caps, the flexibility that gives us as a wholesale dealer in that financing market that you have asked us about.

Got you. Great, thanks. And Mike just on the Fed and purchases with MBS, they stopped at they are reinvesting proceeds in the Treasuries, what is your take on what they could do this year, do they start up QE3, do they run down MBS? What is your take, and how does Annaly position itself?

We are on record as saying, I think we said it in 2007 or 2008 that we thought that an outcome, the potential outcome here for the Fed balance sheet, if they are still trying to save the economy that existed for 50 years here, the baby boomer access to credit economy that we spoke about and swimming back to the Titanic in the last call, that that sheet, that balance sheet could grow to $4 trillion when everything is said and done, which is at around $2.5 trillion right now.

We think that from a mortgage point of view, and this is something we spoke about last year on the June call, that in effect the legislation, the Federal Reserve, policymakers in general, have thrown $6.5 trillion worth of stimulation at the mortgage market and the housing market, and I think that they have had enough, and they now have to move onto the next problem, which is going to be trying to solve municipal finance issues, and also economic growth across the country as a result of the fall-out in jobs, and the retraining that needs to go on here. So from our perspective, we think that they are done with the mortgage market for now. It is up to private market participants like us to fund it. I think those tools are in place, and I think the advantages are that the markets are already reflecting wider spreads as a result of that.

Great, thanks for the color.

Thank you.

Our next question is from David Miyazaki with Confluence Investment Management. Please go ahead.

Good morning. Mike, you did a great job of walking through the growth of your Company over time, and obviously the management has exercised substantial care and skill in making sure you didn't grow too fast. And just thinking about the recent capital raise that you have had, how different are the challenges and efficiencies that you face now, as you put that capital to work? Are there any limitations of how tactical you can be? On the right side of the balance sheet, how does the capacity look out there, with regard to counterparties for repo financing and then interest rate management?

Well I would say that, the first thing that [Mike Frow] gets beaten up for all of the time is, I did not raise capital when interest rates were falling. In other words, we sat on the sidelines all of the way up until June of last year, before we did significant capital raises in the Annaly structure. We focused instead on where we thought opportunities were in Chimera, and Wellington was very direct about where she thought those values were, and how the markets had repriced it. I think that was an extremely intelligent call by the management team to go after that market, and grow Chimera into the second largest mortgage REIT from a market cap point of view.

Annaly last June after we had seen the affects of all the Stimulus start to erode and evaporate, and be let expire like the tax incentives and also the primary credit deal facilities, and all of the support vehicles that the Fed and the Treasury put together, we felt that it was safe to go back to the market, and do accretive capital raisings. And certainly during the blow-off of the fourth quarter, those of you who have listened to the calls before, know that Wellington was sitting on the sidelines waiting for that to happen, and wanted to have a blow-off in spread and defend book as well.

So from the point of view of capacity, it is a $5.5 trillion market we are at roughly $100 billion worth of assets, and we are still a rounding error in that market. We have taken a number of steps in order to make the Company more flexible and more resilient against the volatility that emerges out of all of the things that are not related to interest rate risk, like counterparty risk, et cetera. If you think of Annaly as a holding company structure, the way I like to think about it is when we are raising capital, we are shooting it down into bar caps, to capitalize at the higher levels so that we can go through the margin system and be an active player, and on the wholesale side of the business and get access to the cash. Everyone needs to understand that the mortgage business in general in the United States is a levered business, and always will be a levered business. There are not enough deposits in the banks globally to cash in the United States mortgage-backed business and the commercial real estate business, and fund it for cash.

So there will be some amount of leverage that is always in the system. And I think that the steps we have taken with the Company in terms of diversifying itself, and putting our taxable REIT subsidiaries in place to do this, clearly replaced a lot of the balance sheet that was destroyed, and I think we have a lot more faith in our ability to navigate some of the messes that are out there that are going forward, than we have ever had in our past. So I think as a credit to the management team, they have done an excellent job in putting all of the methods, procedures, regulatory embracement that has to go on here into the balance sheet, and into all of the structural stuff that goes on here, so it is not two people with a Bloomberg taking shot at rates any more.

And it is a very dynamic business. There is a lot of stuff to do in the mortgage business, and I would say that there are three opportunities that are emerging on the field for everyone that is in this sector. I think we are at the forefront of it. The first thing is that we realized over a year ago that FASB-166 to 167, the consolidation issue for the banks, in terms of securitization was going to drive business into companies like Chimera. So we took the opportunity to build out Chimera and to get balance sheet strength in that company, and also acquire assets that we thought had already fairly priced in a draconian measure of the mortgage market performance.

The second thing is Basel 3. If you look at the ratios that are being touted by the banks and the implementation of Basel 3, which the United States hasn't even fully implemented Basel 2 yet, are you talking about capital ratios that are going to be much more liquid at the banking level, which means that they are going to leave big parts of the market under banked. So therefore we don't think there will be Annaly clones being launched into a zero-interest rate environment by these banks anytime soon. So for people who looked at this as a commodity market where someone can start up tomorrow, you have to go through the credit process of some of these banks to understand that now. And Basel 3 only will reinforce that going forward. If you are a credit officer at a bank, and you are looking at whether or not you are going to a bank at a company that started off at zero interest rates, or somebody who has been through 13 years and provided a return, and navigated and built out the business, that will be two very separate decisions that you have to make.

And the last thing is Dodd-Frank. We talked about it on the last call. Dodd-Frank has generated a great deal of discussion about [vocarization] of the balance sheets. Where the prop desk that we used to compete with at the banks as part of an ongoing business inside, are no longer inside of those banks. So from our perspective Fannie and Freddy were competitors, the banks were competitors, the prop desks were competitors, they don't have access to the credit anymore, and those strategies are now being incorporated into public company structures like ours. So we think we have a real advantage across all of that in the hub and spoke structure that we built out.

Dave, I just want to say we will not raise money if we cannot be additive to the track record that we have delivered to investors over the years.

That would be consistent with what you have done over the timeframe that we have worked with you. We thank you for that pledge going forward, and appreciate the color on the opportunities in front of you, Mike.

Thank you, Dave.

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Farrell for any closing remarks.

I want to thank you all again for taking the time to listen to the Annaly call. It is clear that there are a lot of things that are going to happen over the course of the next quarter, in terms of government policy and direction. We will continue to try to reach out to you through the various methods that we push stuff out of here, whether it is in our commentaries, or on our blog. And if not we will see you at the end of the next quarter. Thank you again, and we will speak with you soon.

Ladies and gentlemen, if you wish to access the replay for this call, you may do so by dialing 877-344-7529 or 412-317-0088, with an ID number of 448105. This concludes our conference for today. Thank you for participating, and have a nice day. All parties may now disconnect.