Annaly Capital Management Inc (NLY) 2011 Q2 法說會逐字稿

Good morning, and welcome to the second-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 question 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, 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 financings; changes in the market value of our assets; changes in business conditions, and the general economy; changes in governmental regulations affecting our 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 requirements, and competition in the 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 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, Rocco. Good morning, and welcome to Annaly's call for the second quarter of 2011. I am Mike Farrell, and with me today are Wellington Denahan-Norris, our Chief Operating Officer and Chief Investment Officer; Kathryn Fagan, our Chief Financial Officer; and Nick Singh, our General Counsel, and other members of Management. As customary, I will begin the call with some prepared remarks and then we will follow up with a question-and-answer period. The text of my comments can be found on our website, www.Annaly.com, as well as a video companion to today's remarks.

The title of this missive is "The Face That Launched 1000 Ships, Or In This Case, Bankers." The title of this note is taken from the sixteenth century play, Dr. Faustus, by Christopher Marlowe. It is the iconic story about a man who trades his sole in exchange for power and knowledge. Faust uses the phrase when expressing his desire for the most beautiful woman in history, Helen of Troy. Legendary Helen, considered a Greek treasure, was so beautiful that wars were fought over her. Homer's Iliad describes the theft of Helen by the Trojan Prince Paris from the Greek province ruled by her husband Menelaus. Menelaus and the Greeks tried to get her back during the decade long Trojan war, one of the greatest organized seizures in history that finally ended with the infamous ruse of the Trojan horse.

The rest is history. Cassandra warned the Trojans not to keep the gift brought by the Greeks, but she was ignored, and the soldiers hidden in the belly of the giant wooden horse, came out at night, opened up the city gates to let in the soldiers, who ransacked the city and massacred the sleeping population. These stories are rich with metaphorical possibilities as it relates to the present-day situation and sovereign credits. And I am going to use them all today. Let's presume that the treasure of Greece is not Helen, but its national assets, and the Euro is the Trojan horse. The promise of the beauty of cheap money and the consumption benefits that emerge from it drew Greece into a siege that may end with the release of its treasure -- islands, buildings, national companies, its economic way of life.

Or, risk a long costly siege from neighboring nations, creditors, and rating agencies. The Euro took about 10 years to create this position for Greece. The Trojan war took about 10 years. The only question today is, which restructuring will the diplomats and bankers accept? As I write this, economic conditions in Greece are worsening, interest rates are pricing into default, companies are not shipping goods to Greek destinations, hospitals are not receiving supplies from big pharma, and the requisite strikes are occurring as the bill for the last 10 years of cheap money is now being delivered. Marlowe's play suggests a different metaphor.

The Euro represents temptation and Dr. Faustus is Europe. So obsessed with pursuit of knowledge and the power it brings that he calls on Mephistopheles to give him the power to rule, to heal others through science, and to resurrect Helen in return for the acceptance of internal damnation. The more he bargains, the deeper in debt he gets; his desires become so intertwined that he loses the ability to negotiate his grand Faustian bargain, and he loses his soul. Faust is still obsessed with the power of the Euro and the relative benefit that it's given its export markets, and it's desperately trying to hold together the Euro's own by throwing more and more debt at the problem.

All politicians eventually learn that their people become tired of the monetary and human cost of the bargain, and they will lose their souls and their offices, either to revolt physically or in the voting booth. Just ask the people of Iceland. For over 2000 years, most people believe that the city of Troy was a figment of Homer's imagination, and that the story of the Trojan War and Helen were legends linked to Greek mythology. It turns out that the legend may be rooted more in history. One of the first books I ever read was in archaeology and the discovery of Troy in 1871 by Germany amateur archaeologist named Heinrich Schliemann. His identification of the city's walls, consistent with Homer's descriptions in the poem, convinced the world that the Iliad might be more than an epic novel. It might actually be a historical document.

The city was buried below 7 other cities that were built over it after the destruction in Helen's time. Over time, urns and other artifacts describing Helen and Paris have emerged. It seems hardly a coincidence to me that on June 29 -- the date that the Greek Parliament voted on the austerity measures -- a lightning bolt, probably thrown in frustration by Zeus, nearly hit the Parthenon. There's a picture of the lightning bolt posted on our website and in the written version of my remarks. If you do it a clockwise turn and look at it from a Y access point of view, it looks a lot like the graph of the Greek yield curve, which is also on our website. In all seriousness, the point of all this history teaches us much, and we are prone to repeat it. The price of mortgaging the future is incredibly transparent in the relatively small economies of Greece, Portugal, Ireland, Italy, and Spain. It is a Faustian promise of an easy life, sprinkled liberally with the open-ended debt restructuring. It is much more opaque in the more complex economies of France, Germany, the UK, and here in the US. Nevertheless, it is still present and creeping towards judgment day.

To stay with my metaphors, we have dragged into the front gates of capitalism a Trojan horse of amend, extend, and pretend, quantitative easing, and fiscal austerity promises that cannot be kept. Inside, it is the main weapons of capitalism, capitulation, creative destruction, and the repricing of risk, and they are just waiting for their moment to be released. Today's metaphorical Trojans will be twice as surprised by the wreckage of their sovereignty. America is hardly immune, as our sovereign credit moves into unknown territory. As we have discussed on prior communications and earnings calls, the mortgage market has been Cassandra, the correction of spreads on asset opportunities has been predicting this outcome in downgrades since 2008. The evidence of this is offered in the accompanying chart, also found on our website, that demonstrates the performance of the agency current coupon mortgages versus the Canadian covered-bond market credit.

The market has already adjusted the American mortgage market to wider spreads allowing us, through NLY, to capture lucrative opportunities against funding rates. Like Cassandra of legend, will the mortgage market suffer the frustration of having her prophecy ignored? I don't think so. I think the world is finally figuring out that Cassandra has been correct, and that the mortgage market has already adjusted to the new realities facing America. Informed investors recognize that they should invest in markets that have already corrected and adjusted to the new fundamentals. In closing, I think that the mortgage market is more like Heinrich Schliemann, who dug down through 7 layers of history, and proved that myth can indeed turn out to be fact. With that said, we open up the call for questions.

The question and answer session will begin at this time. (Operator Instructions) Our first question comes from a Mike Taiano of Sandler O'Niell.

Hello. Good morning. Thanks for taking my question. I guess the first question, obviously, repo is on a lot of people's minds last week or so. Just curious, given the environment that we are in, seems like the repo market and the short-term market in general are destined to continuously run into these short-term glitches. And, just from your standpoint, just curious, other than obviously keeping leverage relatively low and investing in a high-quality liquid asset class, is there anything else that you could do to protect against the short-term volatility such as back bank lines, back up credit facilities, anything of that nature? Or would that be too high cost at this point?

It is not about the cost. The issue is, Mike, that none of those facilities saved anyone in 2008. Those systems were not reliable. The commercial paper market has not recovered. None of those back up lines are worth the credit of a sovereign credit bank or its surrogate that is not performing. Liquidity is the best option for everyone. It would have been the best option in 2008 and it certainly was for Annaly and the other people who navigated through this.

So, you can rely on us to continue to operate the Company in the same conservative manner that we've operated for the past two, three years. Because the market has recognized already the mortgage spreads are wider, it's allowing us to generate the highest amounts of income that we've ever generated on the most shares outstanding, using the least amount of leverage that we have ever used. So, we will continue to be opportunistic in that way.

Okay. Just a second question, if I can. It seems like the macro economy seems to be a little bit like deja vu all over again, going back to last summer on the sovereign issue that you kind of talked about in your comments. I think you made the comment last summer about, you thought the government was going to pull back instead of trying to bail out the housing market, and just curious how the situation now compared to where we were last summer in your view? Is it better, worse, the same?

Well, as regards to the housing market, I think we've been pretty consistent with our message to markets that, we felt that house prices were going to continue be under pressure. There certainly are enough of media reports now going through about houses being bulldozed by banks who own them, because they would rather foreclose them, knock them down rather than maintain the properties. We think there is a shadow inventory of housing out there.

The government, in my mind, in June of 2010, as it allowed the tax credits to expire, and the Federal Reserve finished its purchase program as well as extending its unusual credit facility, that PDCF, et cetera, the TALF. I think at that point they were looking forward to the sovereign issues that were going to exist in the market going forward. That said, the repo markets are extremely liquid. They have been extremely reliable.

The Federal Reserve is extremely well-prepared compared to where it was in 2007 because of the education that they went through over the past four or five years. We feel that they are supervising this in an extremely delicate and diligent way. And that they understand that the repo markets are the canary in the coal mine in terms of liquidity as well as the health of the banking system globally. I don't see any issues that would emerge that would be different than anything that happened in 2008. I think that, because of all of the things that the Fed has put in place and learned, especially on the supervisory side, that they are well ahead of the curve in terms of protecting the repo market.

Thanks. I appreciate the comments.

Sure.

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

Hello. Good morning. Just to follow-up on Mike's question. If there is a downgrade of sovereign debt by the SMP, do you think that will have any impact on the agency market or on repo?

Thank you for that opportunity, Bose. I am very well prepared for the question. We've done a complete study going back into 2008. One of the things that people should be aware of on this call, is that the definition of a government security starting with that of a broker/dealer rule, 15C31 under the SEC is stated pretty much along these lines. In case of a security issued or guarantee as a principal or interest by the United States or any agency thereof, the applicable percentage of the market value of the net, or long or short position in each of the categories, specified below, and then they are broken out by percentages, and also by maturity dates.

The bottom line is, that there is no link in any of the broker dealer documents, the banking documents, the money market funds, or any of the investment adventures that cover agency investments across the board with the exception of perhaps of some corporate funds that rely on either S&P, Moody's, or Fitch, or any outside credit rating agency. It refers to sovereign credit. Therefore anyone who has concerned about selling off of assets under forced liquidation because of a downgrade, is making the severe misjudgment in my view. The second thing is, is that, in the event of a default or if there really was a default by the government, mortgages have been excluded since 2008 as pass though securities, and in fact they were verified by the Housing Reform Act, HERA, 2008 as by being outside, and we hold a private claim under the Constitution on those cash flows.

So, under the extreme circumstances of the default by the United States government, the agencies securities, because they are off balance sheet and that $5 trillion market is secured by loans and borrowing activities underneath the Fannie and Freddie umbrella, and Ginnie Mae umbrella. Those asset cash flows are actually outside of any default that would happen to the general obligation debt of the agencies and/or the Treasury market. I think that there is a great deal of hysteria and misinformation about that, and in fact, we are prepared to talk about it at length if you want to go any deeper than that, but that's the highlight of that conversation.

Mortgages could actually be the beneficiary of a slight quality, if you will. They are the premier asset-backed security.

Okay. Great. Makes sense. Thanks. And then just one question on the portfolio. Your prepayments were down very sharply this quarter. Just curious where the number was in July and where you see that the back half of the year?

We continue to see prepayments moderating. Housing is a big factor there. House price, depreciation, or stabilization, and you have had a significant number of borrowers, actually, refinance and bring money to the table. They're putting themselves in a better equity position, but nonetheless, I don't think rates are going to be the big driver that they were in the past, because of where house price appreciation is.

Our next question comes from Jason Weaver of Sterne Agee. Please go ahead.

Hello, good morning. Thanks for taking my question. First and more broadly, Mike, I know you touched on this in your release, but it seems that the implications of both the current legislation as well as some of the numbers coming out, point to an even longer period of low short rates and prepayments going forward. I guess my question is, is there an inflection point in there, where you start to become concerned about downside risks rising from involuntary prepays as a result of last year's buyout?

I think the opposite is occurring. If you look at the credits stack, there was a headline out yesterday that, in the first half of the year from Freddie Mac, that 77% of all people who re-financed their mortgages actually put more money down into their mortgage in order to by the lower rate. So, our view of the agency credit stack is actually that the credit, the underlying credit, is actually getting more powerful. And, more clean than it's ever been as people are doing what we consider rational activities. They are pre-paying their ARMs and they are moving into long dated financing that is available from the government, extremely low generational rates. So, the credit stack, underneath, and the underwriting LCDs, are in probably the best shape of my career as a result of this.

This isn't the first time. We brought this up -- actually if I could just be a little redundant them on the fourth quarter's call, about, we have noticed that in December, we noticed it again in the first quarter, and certainly the first half's information would lead us to believe that the credit stack is going to protect great deal of what's left out the mortgage market from prepaying involuntarily, unless you're talking about 25% unemployment, et cetera

So, it is going to fish along the bottom here, we think. Obviously, people aren't building new homes in any great details. The banks are still under the cloud of foreclosure. House price appreciation will not lead, probably, the market forward in terms of credit access of or ability for people to move easily between different states, et cetera But, I feel pretty comfortable that, a great deal of the damage by poor qualified buyers is behind us.

Okay. Thank you. Just a little bit more specific. I know you don't explicitly disclose your hedge book composition, but can you give us any insight on the portfolios growth in the duration that includes the impact of swaps?

My hedge fund?

No --

The hedge book.

No, again, we constantly adjust it based on our outlook in the market. We continue to be a conservative player in the space. We are not going to give specifics about where we see value, but we will always -- I think our macro view is that we are going to be in this environment for some time. Nonetheless, we still take precautionary measures by having a large swapped out portion of the portfolio, and maintaining the duration of the portfolio in line with it where it has been in the past. And again, running leverage at very historically low levels, and maintaining liquidity via the assets that we invest in.

All of these things combine to make the portfolio and the Company as flexible as possible to deal with things that we have been mentioning quite right regularly on our call about the volatility that we expect in the markets. As the markets transition from the easy money to potentially other challenges that it needs to face going forward, the Company, I think, is very well-positioned to deal with a lot of those variables.

Okay. Thank you very much.

Our next question comes from Douglas Harter of Credit Suisse. Please go ahead.

Thanks. I was wondering if you talk little bit about the benefits you're seeing from being able to source your own repo from your broker dealer subsidiary?

Sure, I will give you an overview. Obviously, as we grow the Company, just to update everybody on a quick timeline review. Back in 2007, as we start to become concerned about what we thought was going to be balance sheet impairment in the banking system, we have agreed our own balance sheet inside of Annaly and founded RCap, our broker dealer subsidiary, to act as a complement to our lending activities with other banks, and broker dealers around the world.

The result is that we capitalize the broker, to prepare it to access the repo markets where balance sheet is impaired, or to be flexible around the markets when people are closing down quarter end et cetera, and they need the window-dressing on their balance sheets. We have tremendous amount of flexibility at the wholesale level inside of Annaly to take advantage of those dislocations in the market or those opportunities to move collateral around into the markets.

Secondarily, RCap clearly has been giving us, not only on the repurchase side, some strength away from and creation of balance sheets so we can become more independent from a lending point of view and a borrowing point of view. But we've also used it in the equity markets. If you have noticed, as we raise capital, RCap has been an underwriter and in some cases have been the lead underwriter in the lead tables. For a Company its size to have the position is very enviable, but it also helps reduce our cost of capital we are raising secondary markets, and it's adding to our bottom line and our efficiency rates, in terms of deployment of capital across the entire Annaly family.

So, RCap today, is well capitalized, it has been quoted by one of the clearing banks as being one of the largest and fastest broker dealer in the system in terms of capitalization. Every time we raise money, we consider adding more capital into that so we can add more repo capacity into it if we need to. And, it is just another very powerful weapon in our belt in terms of taxable subsidiaries. It gives us a view on the markets, but also gives us efficiency and scale. Currently, it is greater than $15 billion, to $20 billion worth of repo through there, and it's all margins through the FICC and the clearing corporations were fully incorporated into that clearing system, supervisory system and its managed by a great group of people here on the repo side.

Thank you. Is there any way to quantify any benefit you get by doing it direct?

Certainly we do get some better flexibility on haircuts, relative to the market. We have more control over that. In terms of rate structure, it is an arm's length transaction as a taxable subsidiary. Annaly has to pay RCap for access exactly on market, along with other transactions that happen in the market. So we have to satisfy all the regulatory ARMS length transactions that go on there. And, in fact, if you ever come up to visit our space, you'll see that RCap is located in an entirely separate area away from the advisory and public company activities on the floor. It's separated church and state, just the way the regulations are calling for.

Great. Thanks, Mike.

Thank you, Doug.

Our next question comes from Mike Widner, of Stifel Nicolaus. Please go ahead.

Good morning guys, and congratulations on another solid quarter.

Thank you, Mike.

I'm going to follow up on couple of other questions. On the repo pricing, specifically, people pulling Bloomberg tickers and whatnot, just kind of getting commentary. We heard chatter that repo had blown out to 50 basis points. That order as of Monday morning and sort of by midday we sort of coming in, closer to 30 basis points. So, just wondering if you can comment a little bit on what kind of hiccups we might have seen and where we stand today and again, where you think we might be heading, on that pricing front as all that nonsense about debt rolls through.

Yes. I mean, first of all, there's a direct correlation between repo expenses and asset yields. And the markets understand that. The thing that we find amusing about the chatter that has been spiced around on the repo market in the past week or so, is that all of that is based off of overnight money and no one was chattering when the overnight money would actually negative in the first quarter when we could basically do the repo book below 10 basis points. Nobody was calling us up and asking where we are boosting earnings at that point.

We've taken a long-term view as expressed in our activities and you can see where that view is expressed on our repo based on maturity. We relied less on overnight money. We have made some very strong decisions over time, that were sometimes costly from an economics point of view, but important for us to build a long-term reputation in the swaps market and the borrowing market, for longer date of maturities. Our liability desk has done an excellent job of taking advantage of that over time, and I don't think that these overnight aberrations of 15 to 20 basis points, are really going to impact us, particularly in the sector. I realize that others may operate on a very short duration overnight basis, and I'm sure that these variations might effect them, but out see them closing major hiccups in the system.

As a repo player, and anybody who hasn't been doing it are long period of time should understand that there is always -- everybody will always be opportunistic when they can. We should all keep in mind that a couple of basis points here and there is really nothing, and is almost comical to speak in terms of a blowout in the repo market with a couple of basis points either side. We were at a historic event with the country potentially defaulting and the repo markets, I think, otherwise that's the most smoothly operating and most fluid and as Mike mentioned earlier, the canary in the coal mine. And we treat them with a tremendous amount of respect and discipline.

The Company has been communicating for some time now, about the potential volatility in the markets, and why liquidity is important during these transitional times in, not only the country, but the global macro economic backdrop. So, repo is always something that moves around, I don't think it is anything new. Haircuts, potentially, always move around. I don't think that should be surprising to anyone. And if it is, they probably shouldn't be in the market.

Thank you for that perspective and the color. Just another follow-up on a topic. I recognize that you don't like to disclose a whole lot about the specific composition of your hedging and sort of how you look at that. Let me ask you philosophically, and comparing where you have been and where you are today. A couple of years back, there was obviously much broader availability is long-term repo, 120 days plus, but also that 365 plus. That more or less vanished, it sort of came back a little bit, but as we understand it, the little bit of a pricing premium there.

So, as you think about overall hedging of the liabilities, or hedging of your funding costs, can you maybe comment a little bit about the relative level of notional swaps, and the duration of notional swaps and the interplay of that, with the availability of long term repo? In general, for a long time, you add up all the numbers somewhat in the vicinity of 50% of funding was hedged. It looks like you are a tad shy of that at the moment, but again, it's kind of in the ballpark. So, any comments sort of relative mixed shift duration changes or anything along those lines?

No. I mean, we continue to look at -- we cannot ignore the global macro backdrop. As much as we would like to and say, we probably didn't need to be doing any hedging whatsoever, and we would have been well served to have the longest duration portfolio, had no hedges on, for the last couple of years. What we will always do is a constant assessment of the marketplace, the rate structures, and how the cost of hedging stacks up relative to your economic outlook and what it could cost you to be wrong in that. So, the team here will be constantly navigating the various markets, whether it's how house price depreciation is going to impact long term duration of the assets, versus global economic forces that may set the United States on a track that looks very similar to Japan.

These things all come into play when we are constructing the portfolio. So, there's not any one thing that will overly outweigh another, but we will --. I think the Company has shown through its track record, that it has done a pretty good job of not getting everything exactly right but being able to have the flexibility and the portfolio and the balance sheet to be able to navigate the changes in the landscape that we have to face every single day. So, with respect to how we have the portfolio set up, again, I think it's a fairly conservative position that we maintain and have always maintained that, you see reflected in the numbers.

Oh, great. Thanks. Just one quick final one, and if I might, obviously you have done a great job with RCap, expanding that into all the requisite businesses there. Arguably, the next step there for you, would be getting to be a primary dealer. I was just wondering, how many months away that potential change is?

We're not going to comment on that. Thank you.

Thank you.

Our next question comes from Steven Laws of Deutsche Bank. Please go ahead.

Hello. Good morning. Nice quarter.

Thank you, Steve. Good morning.

Most of my larger picture questions have been hit on, but, maybe could you comment about really what you have done since the July, I think it was fifteenth secondary offering, think it's the fifteenth, the mid-July raising about $2.4 billion? How you are viewing leverage, investment opportunities, over the last couple of weeks versus potentially what you think might be coming in the next few weeks. And maybe how you have used the capital from that deal and where leverage and investment spreads are today.

We continue to be opportunistic, and we conveyed to investors that participated in that transaction that we felt it was prudent to continue with a very conservative leverage level, which is exactly what we are doing, and has served us well. Not only during this period, but during a lot of the other volatility of the market. And we will continue to be opportunistic. I think the market is dealing with a lot of transition. It has to face-- and a lot of challenges, not only from domestic forces, but global forces. So, we are lucky enough to be dealing in the largest liquid asset class, and as we mentioned earlier, it is an asset backed security. So, default is not as meaningful as being with waiting for your bills to mature.

I think the broader issue that we were able to deliver to the market with that offering, which, I think really validated the vision that we've been able to communicate since January about what is happening, in all of the mortgage sectors, residential and commercial as well. That we are sitting in the middle of the largest privatization opportunity in the history of the financial markets. And that there is no appetite to own portfolios of anything at the government level as they struggle with the budget deficit, and the issues that are going to be around, retrenching the economy around that budget deficit over the next 10 years.

In the meantime, this asset class, is the premier asset-backed security. Up until Thursday of last week it was outperforming everything in the markets including the sovereign credit treasuries. Until things started to fall apart at the Senate level and the Congress level about the discussion on the deal. And then treasuries took off and mortgages just couldn't keep up with them. But, this asset class is worthy of capital allocation.

The spreads that we are enjoying in here reflect the fact that the mortgage market, as I said in my opening comments, realized in 2008, that a downgrade was coming and that the spread had to be wider. It downgraded the entire mortgage stack across every aspect of it. Essentially, in some of the non-agency spaces, we were making assumptions on asset acquisitions that every mortgage in the United States was going to go bad at some point during 2008. So, I think that the reality is those wider spreads are providing us with the unique opportunity in the 14 year history of the firm, to capture some very valuable cash creation relative to any other market and any other asset class that's out there.

Great. I appreciate the comments and it's always nice to see you beating the numbers on a wider spread as opposed to higher leverage. So thank you.

Thank you Steve.

Our next question comes from Jim Ballan of Lazard Capital Markets. Please go ahead.

Great. Thanks a lot. I wanted to ask about -- there's about $1 billion increase in the accumulated OCI in the quarter. Maybe you could talk a little bit about the factors that caused the increase. And also, given that was what contributed to the decline in leverage, what the implications of that kind of increase in OCI, what the impact of your target leverage going forward.

No, that is a snapshot valuation of the assets of quarter end. You can have periods where mortgages are outperforming swaps and vice versa. Again, we will always take a broader view of our leverage position, keeping in mind that your assets do move around and move leverage up or down either way. So, you know, we tend to not overlook, but not put too much into small movements either way when we are making our broader outlook on where we want to carry the leverage of the Company. We also always stress the portfolio in a number of ways and how it will impact that leverage number outside of just taking a quick snapshot of the Company's assets.

All right. Got it. Just one other very good thing. It looks like there's about a 27 million share -- increase in the share count between mid-May and the end of June. What was the source of those incremental shares?

We have a direct purchase program. We actually sell shares into that program in the quarter.

Got it. Perfect. Thanks a lot.

Our next question, and pardon the pronunciation, comes from Joel Houck of Wells Fargo. Please go ahead.

Thanks and good morning. Wondering if you could provide a little more color on -- the weighted average yield on assets is up 25 basis points in the quarter. Obviously, I don't think you -- the big capital raise was after the quarter. So maybe talk about what drove that significant increase in the quarter?

Again, repayments will impact it. Dollar prices. In my mind it's not -- these are all snapshots. I think longer term, if you just look longer term at our markets, you're going to be in a position, I think anybody participating in these markets will be in a position where you have very attractive spreads relative to certainly where Annaly started, relative to the recent past. I think this is the backdrop that we are faced with in all financials due to the fact that economic activity is where it is, and uncertainty is where does. So, I think you're going to see attractive spreads for quite some time.

Okay. I guess and an unrelated question. When you look at what happened in the past couple of weeks and the face of potential defaults which looks like it's passing, but certainly the downgrade threat is still out there, yet you see in this massive rally in treasuries which we'd argue would be more in Japan type of situation as opposed to Greece or Europe. How do you think about the business if we are in that scenario, which perhaps would imply even lower rates flattening in the curve in the long end. How do you think about that both with respect to investing and hedging?

Well, the mortgages will always stay wide on a flattening of the curve, whether it's a bear market, sell off, or rally. It doesn't matter. Mortgages, that you are seeing here, the uncertainty of the prepayment option is allowing for greatest rate opportunities and lower amounts of leverage. I tried to nail home, in the opening comments, is that, the dirty little secret of the capital markets for the past 3 years, is that the downgrade has been predicted by the agencies, by the mortgage market. So, from the perspective of the way that these cash flows have been thought up, they are outside of the government. Any downgrade is not going to force any selling of any treasuries. And certainly in Japan, after they were downgraded, their sovereign credit yields fell to all-time lows because, what it does, it just widens out spreads on a deflationary basis for other borrowers in the market.

So, $5 trillion market is a lot of activity in there. At $100 billion, plus worth assets, we are still around inside of that market, and we are going to continue to be opportunistic going forward, to take advantage of what we think are dislocations either through, the great amount of flexibility we built into the operating structure in terms of it, and not only leverage, but operations in RCap, et cetera. Or build out our money market business and our money management business [through Merganser and Fridek], continue to grow those companies.

Great. Thank you.

Our next question comes from Daniel Furtado, of Jefferies. Please go ahead.

Thanks for taking my question. The question is actually on Shannon Funding, and trying to get update there in terms of what you're seeing on volumes and how that is -- how that segment, how the integration is coming along, the growth of that business.

Yes. Is going to be consistent with the other things that we brought on board over time. Is going to take a while for that to grow to some scale. We are very careful about how we integrate businesses in here. We take our time and make sure that all the licenses are correct and all of the incentives and characteristics and underwriting standards for warehouse lending are where we want them to be. I feel very good about that business.

I think if the mortgage market gets more clarity in terms of where the government is going to be and its spot in it, as well as where the banking segment is going to be, We are going to continue to see growth in there. We are closing loans through that. They are not material. In terms of the operations or the expenses of the Company, we think that is going to be a valuable outlet for us to feed into all of these companies going forward.

Thanks, Michael. And, then, where, after the loans close, what do they typically go from there?

We've just gone through the first closing, but they have to be priced out at market. So, they might go into the secondary market or they might go up into one of our subsidiaries.

Okay. Understood. Thank you.

Our next question comes from Ken Bruce of Bank of America Merrill Lynch. Please go ahead.

Thanks. Good morning, Mike.

Good morning Ken, how are you?

I'm good. Thank you. I want to first congratulate you on showing that a large, wholesale funded company can operate quite nimbly through periods of market disruption, again, so congratulations on that.

Thank you. I want to make a point that these guys are awesome that work here.

Well, you seem to have a sixth sense. So continue to use it where appropriate. On the -- I guess my question does relate to size. How much counter-party risk with any one bank are you willing to take? Do you think that the repo market is a deep enough for you to get diversification across counter parties and how do you think about, what the growth profile of the company needs to look like for needs to expand outside of the traditional repo?

Well, I think that, we typically have concentration issues that we review on our credit committee. And we do regular reviews of all the banks and all the people whom we do business with. By being a participant in FICC, we obviously get some mitigation of that because it is dispersed through the clearing corporation and margining facilities that are there. My quick answer to that would be that there have been more people joining the ranks of potential lenders into the repo markets over the past year and there have been people withdrawing. So, we would have been very careful.

There have been a number of definite opportunities work with new entities that are global entities that are coming into the market and looking for new outlets of investments, short-term investments. So, as the emerging markets create some of these new powerful banks, some of those guys are entering and other guys are either stagnant or clearing out. But we feel that the Fed has a pretty good handle on the repo markets in general. One of the things that probably everybody should be aware of that post the 2008 blowup in Bear Stearns, that there are actually supervisory teams inside of every one of the primary dealers from the Federal Reserve, who help mitigate some of the risk that was graded for Lehman and Bear Stearns activities during that blow up. For instance, [leap] repo 105, et cetera.

I think that capital supervision has led to a great deal of confidence in that market. As a result, they've also done a tremendous amount of work in the tri-party arrangements. You know the primary dealers, operations committees. I have worked very closely with clearing banks, especially JPMorgan and Chase, to put in tighter safeguards for the way the cash flow works, and the daylight exposure. I am very comfortable in that market that it is being well supervised, and is being well monitored by the Federal Reserve, and what I've learned early in my life is don't fight the Fed, especially in the credit markets. The equity markets might disappear with you from some time to time, but the credit it certainly respect the Fed here. And the Fed has been respecting the credit markets and listening to participants both on the buy and sell side.

So, we are not at any point where we don't feel like the balance sheets are the borrowers around us, and we certainly need you to understand I think, that we are replacing multi-trillion dollar companies' balance sheets that have existed in these markets for well over 30 years. We will never to be the size of scale of Fannie Mae and Freddie Mac, but their each independent balance sheet was over $1 trillion each. All of the prophets that were out in the route and Wall Street are no longer doing this activity. George Soros has retired from this lending market.

So, the competition for those balance sheets and those assets is not at the same level that it has been for the balance of my career. So, I really feel, as I said on the first quarter's earnings call, that this is like a rebirth of the mortgage market and the credit market. This is a huge opportunity, having seen what went wrong, to take that which is right and make it work better.

Great. Thank you for that comment, and if I could stick with the credit markets. I would be very interested in your comments on the recent change in tune from S&P and how the rating agencies are reacting at the moment. How you see that percolating into the broader Annaly businesses.

I think is basically open out opportunity, because we've been able to express on some of the earlier calls, if you look at all the regulation going through -- FAS D, 166, 167, which has morphed to a new rule, the basil tree restrictions that are being put onto your one capital, which is raising your percentages, therefore shrinking the lending pie. All of these activities, Dodd, Frank et cetera, are doing nothing more than opening up opportunities for comedies like REITs to be the long-term capital raising and initiatives inside the real estate markets on the commercial side as well as on the residential side. And, we are in discussion daily with people both on the residential and commercial side about how we can play a role as a partner. Certainly in the Barkley's transaction that took place in Crexus, we saw that. We saw it in Chimera over the past year and a half.

All of those opportunities are wide open for us now, and we've been able to prove that structure. The buyback structure is an extremely powerful beneficiary of all the restructuring that is going on the markets as a result of S&P and Moody's playing games with the rating agencies as well as in the CMBS structure as they did with last week. Real institutional investors never relied on the rating agencies to validate -- or mortgage insurers to validate that credit. We did our own work, we checked our own cash flows, and we put our own capital at risk. That's what the capital markets are supposed to do, and that's what we're doing.

Great. Thank you, and good to hear from you as always.

Thank you, Ken. Good hear from you.

Our next question comes from Steve Delaney of JMP Securities. Please go ahead.

Thanks. Good morning everyone. Congrats on an excellent quarter.

Thank you, Steve.

Wellington, you and Mike had a conversation earlier about your hedge position, your swap book, specifically. You know, how well hedged you are, then the press release that you're swaps were 39% or something of MBS. I was just wondering, I don't necessarily know that reflects your true hedge position. I wondered if you would comment on how you view the use of interest-only securities as part of an overall hedging strategy. I guess specifically under that, there's a new line item on the P&L about IO's, and I wanted to confirm that was simply of fair value mark on some of the IO positions. Also, the use of IO possibly, part of the reason why your average purchase price in the quarter actually fell from over the little $103 to $102.6. Sorry for the long-winded question, but I wanted to ask a philosophical question about IO and then those couple specifics.

IOs have been a part of our hedging strategy for sometime now. On a weighted average dollar basis, we will always percent things on a market value. So, a notional representation of the IO position will not drag down, make our dollar price look a lot lower than it actually is. There is always a lot of portfolio re-balancing going on where we take advantage of market forces, and we may have changed things around a bit to lower the dollar price over the overall asset. But, IOs--.

So, that really ended the phenomenon in the second quarter. I should really look as maybe more of a shift to lower coupons in the mix, rather than really any impact from the --.

Our weighted average coupon did not change dramatically. And again, our weighted average dollar price has been around $102 handle for sometime now. Not sure where you are focusing on a big price drop?

I'll have to go back and check my $103 from last quarter. I may have a bad number, Wellington.

I think you are just looking at one of the tables in the 10-Q, that give you amortized cost to principal amount.

Right.

That might be where you were getting the number.

It was.

No. IO's have been part of our hedging strategy for some time. I won't go into detail of why we choose certain things over others. But again, it's not a new addition to the portfolio. Now, the breakout on the financial statements is, and I will let Kathryn go into detail there, the presentation is a little different.

So any IO that was purchased in the second quarter and going forward, the fair value election was made. The market value change will run through the income statement. Economically, this is no different than what we've done in the past. But you will see that market value run through the income statement.

So we should make an adjustment or get back to core from GAAP?

That is correct. In all of our numbers, that's what we are reflecting. So you will see that disclosure.

Okay. Thanks very much for that color. That was helpful.

Thanks, Steve.

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

Okay. Well, thank you all for joining us today. Certainly, looking forward to hearing what the senate has to say in a couple of hours. But, I want to take a moment to reflect that the power inside of the mortgage market has been a predictor over the past couple of years. These wider spreads certainly have provided a generous opportunity for shareholders and investors in the sector. We think that is going to continue for sometime to come. Our outlook remains unchanged from where we were probably at the end of 2008. Where we think that the Fed is going to continue to be accommodative and is going to fight this recession as hard as they can, with the monetary influence.

So, the result is, the mortgage market is extremely valuable component of these assets and liabilities that are run by the Federal Reserve to the balance sheet every day, and we continue to look forward to providing you with many years of color and earnings regarding the performance of that market going forward. I'll take a second to congratulate the management team for providing the kinds of returns that we are in this environment, especially with all the certainties that have existed over the last few years. I think they've done a terrific job here, and I congratulation them. With that said, we look forward to speaking to you in the fall, for our third quarter remarks.

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 10002635. This concludes our conference for today. Thank you for participating, and have a nice day. All parties may now disconnect.