Annaly Capital Management Inc (NLY) 2011 Q1 法說會逐字稿

Good morning, and welcome to the first 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 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 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 effecting our business, our ability to maintain our process case as a REIT for federal income tax purposes, risks associated with the broker deal business of our subsidiary, risks associated with the investment advisory 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, which 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 conference over to Mr. Michael Farrell, Chairman, Chief Executive Officer, and President. Please proceed, sir.

Thank you, Andrew. Good morning everyone, and welcome to the first quarter 2011 earnings call for Annaly Capital Management. I'm Mike Farrell and with me today are Wellington Denahan, our Vice Chair Person, Chief Investment Officer, and Chief Operating Officer, and Kathryn Fagan, our Chief Financial Officer. As usual, I'd like to start our call off with prepared remarks, which will be available on our website after our call. In addition, we have also prepared a short companion video to my remarks that you can also take access to at our website, www.Annaly.com. Please take a moment to check it out.

Financial future shock. Alvin Toffler captured the zeitgeist of his era with the publication of Future Shock in 1970. He described the psychological state of mind for individuals and, by extension, entire nations, and societies because of what he called the premature arrival of the future and the emerging effects of too much change in too short a period of time. As he said in a later interview, he wasn't predicting future, but arguing that change was going to accelerate and that the seed of change could induce disorientation, which future shock, you stay in one place but your culture changes so rapidly that it has the same disorienting effect as going to another culture.

Although it might not have seemed so at the time, what he was talking about seems so obvious today. By end of 1960s, technology was transforming every corner of American lives. The birth control pill was invented, travel had morphed from trains to jet planes, and space exploration had begun. Nuclear power was coming into wider commercial use. There were extraordinary and unprecedented revolutionary shifts in age demographics, gender politics, and racial equality. Toffler saw all this and directed his commentary towards these huge social and technological changes that were beginning to revamp and reshape the United States.

Simultaneously, his insights into the political governance of this change were very telling. He noted that the politicians seemed totally unaware of what was going on around them and that they were content to continue to fund and manage antiquated systems that were the handiwork of past policies.

Certain changes hadn't even started to happen. By the end of the early 1970s, cable television wasn't even mainstream yet. The Brady Bunch had just given an inkling of the new age nuclear family, and gasoline was still about $0.30 a gallon. As immense as these changes would be, Toffler couldn't even begin to conceive of the new iPad replacing the old iPad in six months, Facebook, the television show Modern Family, or $4 a gallon for gasoline. That is part of our future shock.

This brings us to the financial marks circa 2011 and beyond. Practitioners of the art of finance from the late 20th century and earlier this decade won't recognize it. The word reset has been used to describe the effects of the post-Lehman, post-credit crisis, post-shadow banking economy. It's happening through market forces, risk reassessment, and of course hyper-regulation. It is, I submit, an attempt to return to a simpler, more parochial, less global financial system, albeit with the very latest information technology and financial engineering.

At the same time, the funding of all strategies and systems had led the United States to a crossroads of decision where the immediate needs of the funding of our national debt will crowd out the private sector in a material way. Where does that leave us? I believe we are in another state of future shock, and I want to make two points about it and I will be blunt.

First, the change that's happening in the financial markets is a chaotic mess. I believe that the simultaneous execution of radical monetary policy, fiscal policy, and financial and regulatory reform is introducing rather than reducing systemic risk in the global financial system by ignoring the simplest lesson of the scientific method. Rather than change one variable in a complex system and test the outcome, regulators and policymakers are virtually changing all around them and all at the same time.

QRM, risk retention, the Volcker Rule, Basel III Capital Rules, derivatives clearing, and related margin requirements. GSE reform, FASB 166-167, zero balance Fed Fund for all policies and QE2, deficit financing, structural budgetary imbalances, and the debt limit debate. From where I sit, each and every one of these variables is certainly worthy an examination after the credit crisis. However, there is a lack of understanding of just how interconnected they all are and therefore little visibility to unintended consequences. This is the issue.

Just to give you a real time example, the FDIC decides to change an assessment fee and repo rates go negative. Here's another. Persistent ultra-low interest rates lead to a lowering discount rate for calculating future pension fund obligation, which leads to municipal layoffs. Here's a third. The desired portfolio channel effects of QE2 and the other central bank policies around the world have been achieved, but it throws into question the valuation of virtually every financial and real asset on the planet. Here is one more, we've never had over $2 trillion of excess bank reserves sitting on deposit at the Fed. So no one can really say with any degree of confidence how they know this story will end.

And here's a forward-looking example for you. The combination of a narrow QRM definition with risk retention and the reduction of a removal of the government's role in mortgage finance is intended to protect taxpayers, make safer mortgages, and attract private capital to take more mortgage credit risk. But the taxpayer may be more exposed than ever and private capital is frozen in its tracks.

Capital rules coming down from Basel III, the shrinking of market share, the disintermediated banking system, and the rates markets, assets from financial and residential mortgage credit risk will have a profound effect on the availability of mortgage credit. The level of mortgage rates, the value of our nation's housing stock, our collective household net worth, and our national macroeconomic performance.

Here's another example of future policy cause and effect, likely coming as a secondary wave of tax legislation that will further muddy the waters of home ownership and asset valuations. Rising personal income taxes are coming, including the partial or complete elimination of the home mortgage interest rate deduction.

The connection here is that the recaptured tax revenues from the elimination of the tax break, currently about $120 billion annually, will likely be given back in the reduced property taxes and slower sales tax from lower consumption. There's a graph of this on our website for those of you who want to take a look at it. It's striking how it's changed since 2007.

Here's my second point. Despite the issue I've just raised, this change is occurring, and happening, and future shock is upon us. Deleveraging is occurring, real estate is repricing, Basel III is just over the horizon, and Dodd-Frank is the law of the land. In times of chaos, the evolutionary process of survival of the fittest doesn't work. Those that survive aren't necessarily the biggest or the bravest. In times like this, the survivors are those that are smart, nimble, resourceful, and yes, lucky enough to avoid the pitfalls of uncertainty. Large banks may be restricted in the types of risk that they can take and businesses that they can be in, but as I said in my annual report letter, we are building a Company that we believe is prepared to perform through all of these tumultuous times, through risk reduction and to the preparation of our subsidiaries, FIDAC, Merganser, RCap, and [Soon] Shannon.

To conclude, Alvin Toffler also coined the term information overload. I don't want to be guilty of that so I'll just end here by saying simply that the times of changing chaos are also times of tremendous opportunity and progress. My partners and I will work to make sure that Annaly and its subsidiaries and its affiliates are positioned to take advantage of it, and exploit any outcomes that come out of it.

Thank you, and now we'll open up the call for questions.

(Operator Instructions) The first question comes from Mike Taiano of Sandler O'Neill. Please go ahead.

Hi. Good morning. Mike, maybe you could just help us understand. So given all the comments you made and all the uncertainties that still exist, what is it specifically that when you talk about building your Company to deal with all these potential variables, I mean I guess how do you do that? How do you think about it? Aren't there -- don't you have to ultimately take a risk or make a bet one way or the other how certain of these things are going to play out?

Well, I think that we've been very clear about what we think the outcome eventually will wind up being and we stated that on white papers and on past earnings calls. There will be a mortgage market when everything is said and done and you need to be prepared for every piece and element of it. I think it's nave for anyone in the government to believe, or in the capital markets to believe, for that matter, that there won't be a government based mortgage credit at a refined price or charge for insurance going forward being that the housing market today at even zero interest rates is 95% of originations are going through the government programs.

So as a mortgage investor, you always have to be cautious about the insurance that you buy on those pulls and certainly, if you want to look back over the past ten years especially, there's been a huge failure of the insurance regulation business as it regards mortgage insurance especially. The underwriting is clearly has not led to the outcomes that everyone would have thought of.

So from my perspective, this uncertainty has already been visited into the mortgage market and it's providing a huge amount of opportunity here. And you don't create the kinds of returns that we're creating in this zero interest rate environment without taking some risks already. But in our hub and spoke, which is unique to us, and in our investment style, which is unique to us, I think we're exploiting it, and integrating it, and making it a vertically integrated organization that has eliminated a lot of the risks and the -- mitigated a lot of the uncertainties in the vision of the way that we see the Company being built out.

That's helpful. I guess, just given the Treasury's white paper, your comments about the mortgage interest tax deduction probably going away, mortgage rates probably headed higher at some point, is the bottom line here is that mortgage rates go up, values of the homes go down and at the end of the day, home ownership in the United States has to go down from where it's been?

I think that we operated in the United States with about a 63% home ownership rate for many, many years, most of my career very comfortable. To get to the 70% that occurred in the early part of this decade, look at the price that we're paying to stretch to that. So I think that it's going to overshoot to the downside while clearing prices are allowed to fail and government intervention, in terms of foreclosure rules and the clearing of shadow inventories, and what I think is an assault on incomes across the board, whether it's at the municipal or federal level, or even at the interest rate level take place. All of this is going to mean weak asset prices. The bottom line is the world is still deleveraging. It's going to continue to deleverage in a material way. We've been talking about this in a year and a half from the perspective of has FASB 166 and 167 have played out, which is the integration and consolidation of risk back onto the balance sheets of the banks. B

Basel III calls for higher Tier I capital ratios, which means financial institutions are going to have to keep more skin in the game on their balance sheet from a liquidity point of view, which will mean less lending. The losers in that are the poor credits at the end of the day. If you talk to some of the Swiss banks, they're talking about a middle teen sort of ratio for Tier I capital. If you talk to some of the US banks, they're talking about a high single digit kind of number. In any event, it means less cash available, less leverage in the system and simultaneously you have the Dodd-Frank Bill, or whatever elements of it that will be adopted that are going to change the financial retention rules and the risk taking that goes into consumer activities, which means that there will be fewer consumer access.

So on our last earnings call, I questioned which economy are we trying to save. Are we trying to save the economy that is 70% generated out of consumer consumption GDP or are we going to morph towards a more business-to-business kind of consumption, which I think is what the stock market has been telling you is that that's really where the numbers are. If you want to look at the aberration historically, the last 50 years, the Baby Boomer years have been the aberration, not the 150, or 120 other years that surround it.

That's helpful. And then just the last question on the quarter. I was a little surprised that on the expense side, as a percentage of assets actually kicked up a bit given the strong growth on the asset side. Should we think about expenses, are most of the increases in expenses coming from some of the ancillary businesses that you've been building over the last couple years? Is that the way to think about it?

Yes, I think that we're investing earnings in these other businesses. There's no question about it and I think in this environment, it's hard to argue with the core strategy what Annaly is doing, but you have to plan for the future. And our future is clearly that we're integrating ourselves into what we think is the unique mortgage model of the future.

Okay. Thanks a lot.

The next question comes from Bose George of KBW. Please go ahead.

Hey, good morning. Actually, I had a couple of things. One just on your spreads. They went up pretty nicely in the quarter. I was just curious what incremental spreads were on the capital that you deployed?

Bose, it's round about where you see the quarter coming in. Obviously, spreads change on a daily basis, but I think the quarters speak for itself in the results. We've been communicating to the market that as we start to roll into hopefully what we see is downsizing of nonconventional policy intervention in our markets that we will continue to see an improvement in spread. And I think it's evidenced itself. Obviously, the market moves around on a daily basis. So I think we look at it on a longer-term basis and it is a very fundamentally advantageous market for us in our strategy.

Okay, great. Thanks. Then a couple of little things on your financials. There's the $18.8 million, the trading securities mark. I was just wondering what that represented.

It's a combination of some of the business done in RCap and some settlements of forward purchases.

And the forward purchases are from Annaly or -- ?

I said forward purchases, but it's a forward sale that actually settled during the quarter that was started as a derivative at the end of the year. And those are at the Annaly level.

And the last couple of quarters you've also had about $20 million of corporate debt on the asset side of the balance sheet. I was just curious what that was.

If you look at our filings, you do see a company that rolls up into the financial statements called Charles [Fort]. That does have the ability to buy corporate debt, businesses, and acquisition in that structure.

Okay, great. Thanks a lot.

The next question comes from Steven DeLaney of JMP Securities. Please go ahead.

Thank you. Good morning.

Good morning, Steve.

Mike, when you were talking about expenses we talked a little bit about building the other businesses. One of those is of course RCap and I wondered if you could give us a little update there, and what I'm specifically interested in is if you've got $80 billion of repo out and to what extent has RCap been able to sort of put you, put Annaly directly in contact with cash providers and kind of skirt around the primary dealers?

I wouldn't say that we're skirting around the primary dealers. I think that the -- one of the fundamental changes that has happened in the repo markets, which I think that we've been a leader in thinking about this and also executing it is that post the Lehman crisis, one of the elements that blew up during that period were money market funds. And you recall that there was a large money market fund that actually broke the buck. And if you read any of the books that have been written afterwards, there is speculation there that a lot of the large money market funds actually broke the book but didn't report it during that period because they were given some accounting leniencies.

So from the perspective of reformation, we always think of the repo market as being one of the critical pluming pieces of the way that the markets work and not very well understood by a lot of people and a lot of financial institutions. But if you can step back in time to 2008, one of the critical things that was occurring during that period was that the providers of cash pension funds, money market funds, et cetera, became just as concerned about counterparty risk inside the system whether it was a US bank or a foreign bank, and directly intervened with some of the reforms that needed to take place in there. So now there's been the creation of a very well structured, supervised by the Federal Reserve, large tri-party system operating in the banking system. The haircuts, et cetera, are being monitored daily by the Federal Reserve. There are teams of Federal Serve auditors in all of the large banks that monitor all of the tickets.

This is a sea change kind of reformation that's happened and if you look at the date that we founded RCap, which is 2007, 2008, it took us several months to get all the correct licenses, get the right people in here, to get all the right systems and test all of it out. It speaks to the earlier questions about how long it takes for us to start things. As you're aware, Steve, you've been with us a long time. I can be torturously slow in terms of making sure that everything is vetted out and torture the new people that we hire, and sometimes make them wait for two years before we start to really execute, as we get comfortable with integrating all of the expertise into the system and the controls, the procedures that we want.

And I think that that repo market today is being complimented very nicely through RCap. Backs us into, directly into the repo markets. So we see a lot of change that we have to take advantage of in there and it's given an enormously flexible tool for us in terms of managing the cash flows of the companies, getting best execution, and also being able to do arm's length transactions between Annaly and the other elements of regulatory reform.

I think at the end of 2007 I said, you know what, we have to embrace the fact that we are going to be regulated a higher level. There are costs that are related to that and we better embrace them earlier rather than later, and I think that we've kept our word to that. That's what this hub and spoke has provided.

Well, it sounds like between the Feds' oversight of the market and this expanded tri-party system in RCap that from a funding risk standpoint that you probably sleep better tonight than you did three or four years ago.

Yes, I would also point out in there is that if you look at the compliment that our RCap has been able to add, just look at our underwriting when we do our bought deals. We are recapturing some of those fees back up into the Annaly structure with RCap being named as an underwriter and as a book runner. At one point in January, RCap was the largest, was number four. It was tied for number two in the lead tables.

You got off to a good start on January 2.

Yes, exactly. So I think from our perspective, we think that this is the new way that the world has to work and it's all part of this change and being flexible to manage that change. And I think that's proven to be a very effective weapon in our tool belt.

And just one final thing, Mike. We're hearing -- this ties into the federal deficit questions. I mean, obviously we've got that shadow group of six senators. But I heard something in the past week that Treasury is kicking around an idea -- they've got their own ideas about tax reform and the deficit, and they're kicking around the idea of maybe subjecting REITs to corporate taxation. Curious with your involvement in NAREIT if you're hearing anything about that and would it be logical to assume that if REITs in some way are taxed, our REIT dividends, instead of being ordinary income would become qualified dividends for the 15% rate?

I have not heard any dialogue like that. What I will share with you, and I've heard this through not only my discussions down there with the NAREIT people, but as well as individual discussions with the Senate and Congress, is that my sense is, is that almost everything in the tax code is on the table. There are a lot of things up for discussions and there is a lot of thought being put into what the changes would be in the tax rate if we were to eliminate, for instance, the home interest deduction. And let's say that they could take it down to $800,000 then maybe the tax rate for a high net worth drops to 34%. Think of it like a seesaw or a tinker toy where they're tinkering with it.

But in terms of wholesale changes in the way that that is being handled from REITs, I don't think there's any discussion about that. We have always taken the view here that our primary regulatory is the IRS code and we have run the business that way since the first day. We have monitored the way that we think about that and we've been faithful to the way that REITs have to operate underneath that, which means not acting like a -- as an investment company or high turnover securities, et cetera.

There's all sorts of limits that the REIT rules put on you. But it argues for the long-term formation and ownership of real estate cash flows and that's the opportunity that's being afforded REITs today. I will say that I do think that they don't want to tinker with anything having to do with real estate now because of the sensitive and fragile nature of the other recovery, and that they know that if they take any supportive capital away this is going to happen -- this is going to hurt the voters, the people who vote, the homeowners. So that is one message I've gotten back from whether it's the right or the left that they can agree on in the center is that we don't want to hurt any capability to raise real estate funds right now.

Well, that makes sense. Appreciate the time and comments, Mike.

Thank you, Steve.

(Operator Instructions) The next question comes from Joe Stieven of Stieven Capital. Please go ahead.

Morning, Mike.

Hey, Joe. How are you?

I'm doing great. Mike, I do not have any questions on Annaly because you guys did a great job. I do have a different question. About three months ago, there was an appointed blue-ribbon panel that released their report on the causes of the financial crisis and very interestingly, Freddie and Fannie were not measured, really mentioned in this. Can you give us, because you're maybe one of the most foremost experts in the country on the mortgage business, can you tell us in your opinion what role Freddie and Fannie played in this debacle? Thanks, Mike.

Sure, Joe. I'd like to repeat what I said under testimony in Congress and I think that this has been played out, by the way, in some of the scenarios that people have talked about. And there's actually a very interesting paper out by JPMorgan this week that talks about the role of Fannie and Freddie, which they first dismissed, but now they admit was there. What I've told Congress is that in my opinion the debacle began when Congress allowed Fannie and Freddie's balance sheets to go over $1 trillion each.

Because what that did with their preferred funding costs in terms of being a too big to fail or being an arm of the government, or viewed as an arm of the government, what it did was it forced the private sector into a position where now in order to gain market share back they had to come up with creative products and diluted underwriting standards in order to buy market share. And they were successful in that happening. I think it was a combination of all the policy decisions as well as the financial decisions that were made in the late '90s that led to the debacle in the early part of this decade.

So from my perspective, the solution that we put forward, which we've been very clear about and it's on our website in our whitepaper return, is there will be a government guarantee when everything is said and done during the loop back toward the discussion that we had at the beginning with Mike from Sandler. There will be a government guarantee. We'll probably have higher insurance premiums placed on top of it. It will probably not be a portfolio run at the government level like it was at Fannie and Freddie. If you look at what the Fed has done over the past year and a half, what it's really done is replace the buying power that Fannie and Freddie gave in and that program expired last June.

And finally, what they need to do is protect the forward market, which when I was trading in the late '70s and the early '80s, essentially I could trade two years forward without margin, which gave people the capability to move across the country. And I think what people don't understand is that it's not easy to get mortgage credit if you're moving your family from New York to Texas to take advantage of jobs without the government guarantee forward market. It's just not that simple to do. You can't sell your house in New Jersey and move to Texas as easily if you don't have that forward market. So that needs to be protected. It already is very well margined. It goes through clearinghouses. There's a lot of collateral against it, but we don't want to touch that. So that's our solution. That's where we think this is going to wind up after all the noise and it's our belief that the system will cure itself over time.

Okay. How could this panel not even mention Freddie and Fannie?

It's a political football from my perspective. No one wants to touch the fact that they allowed these things to grow at the rate that they did or that they basically socialized risk by putting diluted underwriting standards into the community reinvestment act and into affordability goals. Fannie and Freddie, I will say this about those companies and this is something that we should all take into heart as Americans, is that there are only two companies in the world that can do what Fannie and Freddie do, and that's them.

If you listen to the President of Ginnie Mae in his testimony, he'll tell you that his big concern is, is that there's a concentration issue in servicing that there aren't enough good services out there and the new rules are basically going to limit that even further. And Fannie and Freddie, for the faults that may have occurred in portfolio management and growth of the market for social risk, at the end of the day they do an exceptional job in terms of monitoring the servicing programs that go on throughout the United States. And I think that that's an investment that's well worth it for us as a nation.

Mike, good quarter and thanks for your comments.

Thank you, Joe.

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

Well, I'd like to thank you all for taking the time to listen to us today. We look forward to seeing you again at the end of the next quarter and I'd like to congratulate the team here for an outstanding job of exploiting what is a terrifically uncertain environment but laden with opportunities and we've been able to take advantage of them because of our flexible structure and our cost centers.

Thank you.

Ladies and gentlemen, if you wish to access the replay for this call you may do so one hour after this call ends by dialing 877-344-7529 or 412-317-0088 with an ID number of 450677. This concludes our conference for today. Thank you for participating and have a nice day. All parties may now disconnect.